Three Questions about Financial Reform
Who are the Evil Bankers?
Make the banks pay! Regulate the banks! Don’t let the banks mess up again! Common sentiments miss a critical question: which banks are you talking about? Consider the large Wall Street institutions, including the current Goldman Sachs and the late Lehman Brothers, as well as the former Bear Stearns, Merrill Lynch and JPMorgan. These firms are very different from your local community bank with one office, or even 100 offices. Their business model was different, their regulations were different, their regulators were different. Any discussion of “banking” should clarify whether we’re talking about investment banking or commercial banking.
Which banks should pay? There’s a desire to punish the miscreants, which seems reasonable. But the worst of the commercial banks have already gone under—further punishment is impossible. So if more punishment is to be meted out, it will go to those institutions that did not make such egregious mistakes, but which had to compete with banks making big mistakes. Some of these survivors were making mistakes on a small scale, but others were trying to avoid the mistakes while still competing with companies lifted up by the housing mania. Penalizing them would, in many cases, amount to punishing the innocent for the crimes of the guilty.
How Will Innovation Proceed?
The 30-year fixed rate mortgage, which we think of as plain vanilla, was wildly innovative back in the 1930s. Before that time, home-buyers typically paid 50 percent down on a house and got a five-year interest-only loan. They refinanced their mortgage at the end of the five-year term, if they could. In the Great Depression, banks needed liquidity and refused to roll over the mortgages into new loans, but the borrowers had trouble finding other loans, so the borrowers defaulted. Bank failures resulted.
When thinking about regulating residential mortgages, we should ask how innovation can occur. Are we locking ourselves into 20 percent down payment, 30-year fixed rate loans? Is 20 percent always the threshold between prudent and imprudent? Should the threshold be lower in a stable real estate market, but higher in a booming market? Or perhaps the other way around? The market system answers these questions through experimentation by profit-seeking lenders. It may appear that the experiment created some pretty bad monsters, but one has to be quite the pessimist to assume that there would be little value to innovation in the future.
Will the Government Continue to Promote Risky Schemes?
It seems that the private financial services sector needs regulation, but think about the major thrust of financial regulation before the crisis: making mortgages more available to people with poor credit. Fannie Mae and Freddie Mac were both established to increase mortgage lending, but proved to be hugely risky. Their liabilities are about $5 trillion. (I’ve seen a $6 trillion figure, but what’s a trillion dollars among friends?)
Look forward a few years and ask what policy would help get a Congressman re-elected: acting to promote financial safety, or acting to make mortgages available to more people? Quis custodiet ipsos custodes?
