Wednesday, January 6, 2010

Thought of the Day

January 6, 2009

An old English proverb states: “The devil finds mischief for idle hands.” Now I realize there are many, including members of that august body, who will claim that Congress has no idle time (and they will cite this year’s Christmas Eve vote), but there are few occupations in which employees’ crowd microphones like moths to a light and who jostle one another for multiple photo-ops like those on the Hill in Washington. Should those in the private sector spend as much time courting the press, as does this un-photogenic group, profits would sink and tax revenues – the life blood of government – would disappear.

Now that government has invested in banks, insurance companies, the auto industry, finance companies, attempted to control the energy industry with cap-and-trade and now that plans to reorganize healthcare under a federal umbrella seems all but done, they are planning to do their magic in repairing the financial regulatory system.

With Wall Street in the corner wearing a dunce cap, populist politics have become all the rage. Bankers have been vilified, consumers, with unemployment at thirty-year highs and personal bankruptcies at record levels, are chastened, but politicians remain unrepentant.

While there are many reasons as to why the financial system came close to collapse, the root of the problem was the government’s decision to increase home ownership to those who could ill-afford the obligation – so that more people could realize the “American dream”, a dream that became a nightmare. Fannie Mae and Freddie Mac, permitted by the Clinton administration to leverage 40:1, became the uncritical buyers and guarantors of high risk mortgages that government required banks to issue. George Melloan writes in The Great Money Binge: “In short, the Clinton administration drafted the mortgage finance industry into the service of social policy.”

Mortgage backed securities were developed so that mortgages could be bundled and sold to institutional investors. The system worked well as long as the quality of mortgages remained high. The effect was to widen ownership and provide issuers the capital to make more loans, thereby keeping rates lower than they would otherwise be. However, HUD, in the late 1990s, set explicit quotas for Fannie Mae and Freddie Mac – it required that no less than 50% of the mortgages they purchased be for low and moderate income families. That led to the creation of Alt-A loans, commonly known as “liar loans.” AIG, and others, insured the loans, so that rating agencies treated the bundled loans the same as before, despite the obvious deterioration in quality. Buyers, made comfortable by the insurance they had purchased, were guilty of not asking the questions they should have, as the government’s policy was well known.

When the Bush administration – also supporters of the concept of a home in every portfolio – attempted to reform the two GSEs, they were shot down by their two principal supporters (and financial beneficiaries) – Senator Chris Dodd and Representative Barney Frank.

Mr. Melloan quotes Representative Frank, regarding Freddie Mac and Fannie Mae, at the time of the 2007 hearings about President Bush’s reform proposal: “I think it serves us badly to raise safety and soundness as kind of a general shibboleth when it does not seem to be an issue.” A year and a half later, following the collapse of the two entities, George Melloan quotes Dodd: “Where was the administration over the last eight years?” and then answers, “It had been hammering on Chris Dodd to stop blocking Fannie and Freddie reform.” (Senator Dodd’s decision yesterday to not run for re-election, in my opinion, is a cause for celebration!)

It is my sense that there is need for reform, but as important there should be enforcement of existing rules. Realistic leverage ratios should be imposed on banks and other financial corporations, and should be enforced. However, any reduction in leverage ratios should be imposed gradually, for reduced credit availability lowers economic growth. Derivatives, especially credit default swaps, should be exchange traded with improved transparencies.

But government needs to consider the financial impacts of imposing social changes they choose to implement. Consequences, intended or otherwise, will result. Requiring insurance companies, for example, to ignore prior health conditions require changes in actuarial tables – an increase in rates will follow. By permitting young, healthy people to opt out of insurance plans by paying a fine will also cause rates to go up. Allowing people without insurance to buy coverage only when they need it will cause rates to go up. If Congress forbids insurance companies from raising rates, then our taxes will rise; for no matter what they tell you in Washington, nothing in life is free.

“First do no harm” are words attributed to the Hippocratic Oath; it is an oath that should be sworn to by all by members of Congress.

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