Deregulation and the Financial Crisis

It would be nice to write off the current crisis on Wall Street and global financial markets as something that only matters to the investor class.

Unfortunately, the effects are already being felt in lower-income communities around the United States. Worst-case scenarios for what spins out from the US mortgage meltdown are truly frightening — a severe world recession is a distinct possibility.

Whether such worst-case scenarios can be averted, or softened — and preventing the recurrence of similar crises in the future — depends on abandoning the laissez-faire financial regulatory regime entrenched over the last decade.

The current crisis is the predictable (and predicted) result of a massive US housing bubble, which itself can be traced in part to global economic imbalances that could have been prevented.

At least five distinct regulatory failures led to the current crisis.

Regulatory Failure Number One: Failure to Manage the US Trade Deficit
The housing bubble (as well as the surge in leveraged buyouts of publicly traded companies (“private equity”)) was fueled by cheap credit– low interest rates. One reason for the cheap credit was an influx of capital into the United States from China. China’s capital surplus was the mirror image of the US trade deficit — US corporations were sending lots of dollars to China in exchange for the cheap stuff sold to US consumers.

Regulatory Failure Number Two: Failure to Intervene to Pop the Housing Bubble
Along with an influx of capital, Federal Reserve policy kept interest rates very low. There were good reasons for the Fed Policy, but that did not mean the Fed was helpless to prevent the housing bubble. As economists Dean Baker and Mark Weisbrot of the Center for Economic and Policy Research insisted at the time, Federal Reserve Chair Alan Greenspan simply by identifying the bubble — and adjusting public perception of the future of the housing market — could have prevented or at least contained the bubble. He declined, and even denied the existence of a bubble.

Regulatory Failure Number Three: Financial Deregulation and Unchecked Financial “Innovation”
A key reason that mortgages were made available so widely and with such little review of recipients’ qualifications was a shift in which institutions hold the mortgages. Traditionally, banks made mortgages and held them. In the new era, banks and non-bank mortgage lenders made loans, but then sold the loans to others. Investment banks packaged lots of mortgage loans into “Collateralized Debt Obligations” (CDOs) and then sold them on Wall Street, with a promise of a steady stream of revenue from interest payments. These operations were pretty much unregulated. Despite the supposed sophistication of the investors involved, no one took account of how shoddy the loans were or — more fundamentally — the certainty that huge numbers would go bad if and when the housing bubble popped.

Regulatory Failure Number Four: Private Regulatory Failure
It was the job of ratings agencies (like Standard and Poor’s, and Moody’s) to assess the CDOs and give investors guidance on how risky they were. They failed totally, likely in part because they wanted to maintain good relations with the investment banks issuing the CDOs.

Regulatory Failure Number Five: No Controls Over Predatory Lenders
The toxic stew of financial deregulation and the housing bubble created the circumstances in which aggressive lenders were nearly certain to abuse vulnerable borrowers. The terms of your loan don’t matter, they effectively purred to borrowers, so long as the value of your house is going up. Lenders duped borrowers into conditions they could not possibly satisfy, making the current rash of foreclosures on subprime loans inevitable. Effective regulation of lending practices could have prevented the abusive loans, but none was to be found.

Unfortunately, the consequences of the mortgage meltdown go far beyond the foreclosure epidemic, as horrible a toll as that is taking. The entanglement of the financial sector with mortgage instruments, and the ripple effects of the housing bubble, has made lenders uncertain of who even among large corporations and financial institutions is credit worthy. The resulting credit crunch endangers the functioning of the global economy. Financial markets are guessing wildly about the prospects of banks, insurers and other financial corporations, and the plunging value of stocks poses immediate dangers to the real global economy.

Less acute, but probably more profoundly, the popping of the housing bubble is driving down home prices. US consumer demand over the last five years has been driven by consumers borrowing against the increased value of their homes; with housing values falling, that process is working in reverse. The depressed housing market is also ravaging the construction sector, a nontrivial portion of the US economy. A serious recession looms as a real possibility.

Mitigating these harms and preventing the worst now depends on active and interventionist government — a government stimulus plan, and aggressive efforts to force lenders to adjust mortgage terms and let people stay in their homes. Preventing financial panics of the kind now underway require new standards of transparency and regulation for high finance. The coming days and months will tell whether any lessons have been learned.

Robert Weissman is editor of the Washington, D.C.-based Multinational Monitor, and director of Essential Action. Copyright © 2007 Robert Weissman Read other articles by Robert, or visit Robert's website.

6 comments on this article so far ...

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  1. Irving said on February 1st, 2008 at 12:45pm #

    I totally agree. Home prices rose far above their true values, as mortgage money was given out in huge amounts to people who did not have the ability to repay. Middlemen were making huge commissions based on the number of transactions, so the game was to qualify as many borrowers as possible. The whole thing was just a smokey illusion, so now we are all left to deal with the reality of what is left after the smoke clears.

  2. SCH said on February 1st, 2008 at 3:40pm #

    I don’t see the homebuilding industry as a victim at all. They got right in on predatory lending and even fraud, by opening in-house lenders. Beazer is being investigated, HUD has already fined KB and other builders millions, and many more are doing it that are not being investigated or fined. Fines don’t even work; builders treat them as a cost of doing business.

    Sometimes the greedy, the stupid, and the law breakers, must be allowed to pay the price for what they did wrong, whether they are home buyers who ignored common sense, flippers who put on blinders when they thought they saw money, or anyone in the industry who has NEVER had any good excuse for what they did. The industry insiders created the bubble and drove up housing to the point where no one could legitimately afford a house, then pushed “The Dream of Homeownership” as if you were defective if you didn’t buy into it.

    Our own govt was complicit in all this. If the govt or law enforcement would’ve called it “mortgage fraud” and acted on it years ago when consumers were complaining, this could’ve been averted. But instead, it was not considered “fraud” or acted upon, until banks and investors got burned. Now it’s simply too late to undo the damage and all the stupid bailout plans in the world won’t do anything to help those who are deserving of any help.

    All of us will now pay for the greed and foolishness of everyone from uneducated consumers on up to the industries who chose to put personal get rich quick schemes ahead of long term economic sense.

    Investors should’ve done AT LEAST the amount of “homework” any home buyer is expected to do: get on Google and see what’s going on with that builder, lender or whatever, BEFORE signing on the dotted line. Had they done this, they’d have seen consumers were already complaining loudly about builders, etc, committing predatory lending, shoddy construction, breach of warranty, etc. They easily could’ve seen these loans were garbage. What NUT would invest in THAT???

    Why are consumers held to a higher standard than “professionals,” of ability to do research before buying, and of financial knowledge? Why aren’t the “professionals,” who all should’ve known better, not being held ACCOUNTABLE for their knowing acts? Industry people are NOT victims…they’re perps!

  3. History Repeats said on February 1st, 2008 at 7:39pm #

    Was this really a regulatory failure, or was it a brilliant success for predatory capitalists such as Bush and the Wall Street bankers? The result of the entire housing bubble was to make the US economy appear strong during Bush’s pwesidency, following the dot-com burst. This was a larger replay of the first President Bush’s Savings and Loan Crisis of the late 1980’s and early 1990’s, during which criminal sibling Neil Bush helped bilk taxpayers out of $1.6 billion alone. To write this off as a mere regulatory failure is to deny that hundreds of Wall Street’s white collar criminals have bilked taxpayers of billions of dollars by design, and are laughing all the way to the bank at the gullibility of the working class in letting the same crime repeat on a bigger scale.

    Rather than taxpayers bailing out criminal bankers through a “government stimulus plan,” it is time to seize the assets of the criminal bankers who profited from this fraud, such as the CEOs of Morgan Stanley, Citigroup, Moody’s, Goldman-Sachs, Standard and Poor, and even Greenspan himself, and put these funds towards making the mortgage industry solvent again.

  4. John Wilkinson said on February 2nd, 2008 at 1:51pm #

    Not only seize the assets, but HANG the bastards. From the TALLEST tree, for all to see. And put THEIR families into penury, never to be allowed to OWN anything EVER, because their debt to society and decency will NEVER be repaid no matter what. I know, they “aren’t responsible”. Really, that wasn’t a motivation to comit these crimes, no matter what the consequences to these criminals personally, so they can provide for theirs forever? Are the millions of children who go hungry to bed, and more millions to come, are THEY responsible?

  5. Mulga Mumblebrain said on February 2nd, 2008 at 5:14pm #

    Although I have some sympathy with History Repeats thesis, that this was simply a gigantic scam all along, carefully crafted by the parasite class to further entrench their dominance, I think it may have run beyond their control. ‘Events, dear boy, events’ may have turned out differently from their calculations. Perhaps they really did imagine that by now Iraq and Iran would have been conquered and their hydro-carbon resources flowing at $20 a barrel. Thank God for the Iraqi resistance, unless it is itself part of a deeper, even more mephitic, plan. I am merely an amateur eschatologist, which along with scatology I find quite useful in studying the lunatics of the ‘Clash of Civilisations’ mob,but believe the danger that elements of the neo-con, Judeofascist ascendancy are actively seeking a generalised war throught Eurasia is not beyond the realms of loony speculation. Whether out of religious fanaticism or neo-Imperialist ambition, or elements of both, there are aspects of recent US policy that defy ordinary, human, logic.
    Whatever the truth, I reject Mr Weissman’s search for solutions to this crisis. You see, I believe our one slim chance of survival can only come from a complete collapse of capitalism, and its cancerous doctrine of endless growth. Solving these current crises, inherent as they are in the very nature of capitalist parasitism and the psychopathology of unlimited avarice so essential in the capitalist mentality, merely ensures a deadlier, final, reckoning, with Nature, one that cannot be averted no matter how many millions are spent on Denialist propaganda. Mr Weissman would be better served, in my opinion, working on plans for negative growth, income redistribution, renewable energy, local organic food production, and radical population decline, but certainly not through the Malthusian methods are leaders are so plainly preparing to inflict on the poor world.

  6. joe said on September 18th, 2008 at 12:58am #

    1) after the major market crash this week, it is obvious to me the author was correct in his assessment. well done. some of us would have agreed at the time it was published, but now, none can deny it.
    2) to the comment regarding the Bush regime being at fault: it was the democrats and Clinton, who are principally responsible for this predicament. Deregulation of the mortgage industry, allowance of fraudulent investment practices (passed off as innovative investment products), the China trade bill, NAFTA, etc. all predate the Bush regime. My point is that there is little difference between the so called democratic party and the so called republican party, and while bush has been a catastrophic failure, neither party has our (the common man’s) interests at heart. We would all benefit from the realization that we do not benefit from this two party system of greedy capitalists and self-righteous capitalists, and that the criticism of one party over the other obfuscates the fact that we have no meaningful choice or power as voters in this country, and that our real enemies are greed, unbridled capitalism, incorrect pricing of limited natural resources, lack of education and awareness of these facts, lack of free time (indentured servitude to the greedy ruling class) to consider these facts or self educate, and a general breakdown of a culture that could collectively conceive of a way out of this situation.