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WASHINGTON, D.C.: Since its earliest days, the United States has
suffered periodic financial crises. The first dates to 1792. In the
19th century, bank panics occurred regularly. Then, of course, came
the great stock market crash of 1929 and the failure of two-fifths
of the nation’s banks in the Great Depression. Now we’re in the
midst of another crisis. It would be reassuring to think that the
Obama administration’s financial “reforms”—or, indeed, any
conceivable alternative—would prevent these collapses for all
time. Dream on.
Every financial crisis originates in a failure
of imagination. It’s not that, before the crisis, no one foresees
problems, “excesses” and losses. There are usually warnings. But
what’s routinely overlooked are the fatal interconnections that
transform problems into panic. People panic because the future goes
dark. They don’t know what to expect, and so they expect the
worst. Markets cascade uncontrollably downward.
The present crisis did not occur merely because
“subprime” mortgages experienced unexpectedly large losses or
even because many of these loans were “securitized” in complex
bonds, argues Yale economist Gary Gorton. The crux of the matter, he
says, was the failure of the “repo” market. The term comes from
“repurchase agreements”— short-term loans (usually overnight)
that require the borrower to pledge collateral (usually bonds) in
return for cash; the collateral is then “repurchased” by
repayment of the loan.
No one knows the size of the repo market;
Gorton thinks perhaps $10 trillion at any moment. Banks relied
heavily on repo loans, which were routinely renewed. But when doubts
arose about banks’ subprime securities, the repo market panicked.
Loans vanished or became costlier. Deprived of credit, Bear Stearns
and Lehman Brothers failed; other institutions were vulnerable.
Hardly anyone expected the panic; once it happened, large—but
bearable—losses became a crisis.
In a crisis, government is the last bulwark
against a complete financial collapse. That’s the main
justification for regulation. Just because all crises can’t be
prevented doesn’t mean that some can’t. Though complex, the
Obama plan would essentially broaden regulation in three ways.
First, it would empower the Federal Reserve to
designate some financial institutions (presumably, the likes of
Citigroup and Goldman Sachs) as so important that their failure
would “pose a threat to financial stability.” These institutions
would face stiffer capital requirements —capital being mainly
shareholders’ investment. More capital would provide a larger
buffer against losses and a crisis.
Second, it would create a Consumer Financial
Protection Agency to police unethical lending practices and to
ensure that loan documents for mortgages, auto loans and other types
of consumer credit are understandable. (The Securities and Exchange
Commission would retain power over stock markets.)
Third, it would change some rules of financial
markets. For example, financial firms issuing securitized
bonds—bundles of mortgages, auto loans and other credits—would
be required to hold 5 percent of the bonds themselves. By keeping
some bonds, it’s argued, sellers would scrutinize the underlying
loans more carefully.
Though these proposals sound sensible, they have
potential drawbacks. Writing in The Wall Street Journal, Peter
Wallison of the American Enterprise Institute argued that the very
largest financial institutions would become the protected and
pampered wards of the state. “Larger firms will squeeze out
smaller ones,” he said. Consumer regulation sounds great. But if
the protections are cumbersome and expensive, consumer credit will,
paradoxically, become costlier. Lenders will compensate by raising
interest rates or lending only to the safest borrowers.
Up to a point, some retrenchment of the
financial sector is healthy. It absorbed too much of America’s
talent while pursuing strategies that, with hindsight, misallocated
the nation’s investment capital. But there are perils to
overregulation. It could dampen the normal risk-taking required for
solid economic expansion.
However, the debate concludes, regulation
isn’t a panacea against future crises. The idea of “enlightened
regulators” who are vastly more perceptive than the bankers,
traders and money managers they regulate is a fiction. Even in early
2007, when the problems of subprime mortgages had emerged, few
regulators or economists anticipated a wider financial meltdown.
They didn’t see the impending chain reaction. The problem wasn’t
a lack of regulation; it was a lack of imagination.
So the next crisis could come from
anywhere—perhaps the follies of government, not finance. Between
now and 2019, the US federal debt could rise $11 trillion, projects
the Congressional Budget Office. American Treasury bonds are the
bedrock of the global financial system; they’re considered safe
and reliable. What if a glut of bonds causes investors to lose
faith? What are the implications? Good questions. The seeds of the
next crisis almost certainly won’t be found in the debris of the
last.—The Washington Post Writers Group / (c) 2009, The Washington
Post Writers Group
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