Regulation Chatter

17 09 2008

In a post entitled, “Obama’s Faulty Logic” Sebastian Mallaby at the WaPo’s blog Post-Partisan apparently has grown tired of the regulation versus deregulation soundbites on the campaign trail have devolved into an “appealingly simple” rhetorical trope. The UK economist takes issue with how the Obama campaign tried to draw “link between the Wall Street blow-ups and a lack of regulation,” and suggesting that the conventional wisdom regarding deregulation was somehow unique to Bush, McCain and his advisers.

Malaby tells us that:

Embarrassingly for Obama, the principal piece of financial deregulation over the past decade was the reform of Glass-Steagall, the law that separated investment banks from deposit-taking ones. This reform was sponsored by McCain’s friend, former Republican Senator Phil Gramm, but ending the division between the two types of bank was a policy that the Clinton team also supported, which does not fit the Obama narrative.

Mallaby fails to point out, however, that even after the push for deregulation of financial markets and other areas of our economy including telecom and elsewhere was not only met with deep skepticism within the Democratic party, but was widely considered an long term strategy for generating economic growth.  Yes, the Washington consensus of the Clinton years erred on the side of deregulation as a means of harnessing the power of the market, but few thought the federal government should permanently abdicate its role as a regulator or overseer of the market.

To the contrary, one of the great lessons of the late 90s, particularly after the financial contagion crisis, is that that government does have a role to play in world where capital – and the shocks associated with it – moves at the speed of a few clicks on a mouse.

But the Bush administration was wedded to the notion that the market will solve its own problems even if industries experience such dramatic change that they necessarily merit regulation and oversight. Consider mortgage lending. Mortgage lending has changed dramatically during the last several years. According to the Pew Center on the States, “10,000 lending institutions were in business 20 years ago; today, just a few dozen lenders dominate.” But once the source of capital went for home loans went from mainly small lenders to primarily bonds underwritten by the financial markets, the evaluation of the loans themselves changed. Put simply, they were less likely to be valued on the basis of their performance than they were on their size and terms.

This evolution of the lending market also coincided with another change. By incorporating the use of data metrics, such as credit scoring and consumer data, credit became much more accessible. As a result, the subprime lending sector expanded as the creditor market overall began to grow.

In order to keep up with the proliferation of loans in a market with increasingly lax lending standards many resorted to a less rigorous computerized underwriting. This imprecise method of rating the creditworthiness of borrowers often led to many people being offered subprime loans despite qualifying for more conventional loans.

Subprime loans are high cost loan products often, but not always, sold to borrowers are low-income or have a modest savings, or with less than pristine credit. By contrast, prime loans are sold at market rate to people with solid credit scores at competitive low interest rates. To hedge against the lending to borrowers with “higher credit risks,” subprime borrowers are charged higher rates. According to the Center for Responsible Lending, more than 80 percent of those loans came with adjustable interest rates as opposed to a 30 or 40 year fix rate mortgage loan.

To be sure, when done responsibly subprime lending can lead to opportunities for many people who might otherwise never own a home or obtain credit civil rights advocates have an interest in preserving the subprime market. But during the past few years, we have witnessed an explosion in risky mortgage products and a rapid decline in the use of sensible lending practices.

Congress should have stepped up their efforts in calling hearings to shine a light on the most egregious violators of fair housing laws and place pressure on federal agencies to go after these so-called independent brookers who are exploiting borrowers and find out why there was such an incentive from wall street investors to get as many loans on the books as possible.

A little oversight would have revealed the inefficiencies withing the market and the looming burst of the bubble was near.

As Obama rightly noted in his speech at Cooper Union in New York earlier this year:

Under Republican and Democratic administrations, we’ve failed to guard against practices that all too often rewarded financial manipulation instead of productivity and sound business practice. We let the special interests put their thumbs on the economic scales. The result has been a distorted market that creates bubbles instead of steady, sustainable growth; a market that favors Wall Street over Main Street, but ends up hurting both.

Nor is this trend new. The concentrations of economic power and the failures of our political system to protect the American economy and American consumers from its worst excesses have been a staple of our past: most famously in the 1920s, when such excesses ultimately plunged the country into the Great Depression. That is when government stepped in to create a series of regulatory structures, from FDIC to the Glass-Steagall Act, to serve as a corrective, to protect the American people and American business.

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