No More Financial Katrinas

Why did the mortgage-lending mess get so out of hand? One explanation, promoted by Treasury Secretary Henry Paulson last week, is that the system for regulating U.S. financial institutions is too antique to work. He seeks reforms, and some of them make sense. But he's also throwing sand in your eyes. The government had plenty of power to stop the frauds and financial pyramid schemes that brought home buyers down. It just didn't use it. You're looking at what amounts to a financial Katrina, brought to you by regulators who didn't do their jobs.

Apologists like to argue that, despite its eventual crash, flaky subprime lending did a lot of good. By 2004, a record 69.2 percent of the population owned their own homes. Now, however, the homeowners are being shoved back out. At the end of 2007, the rate of homeownership dropped by a record amount—to 67.8 percent. That's a level not seen since 2002 and 2001, and will probably sink lower still.

Losing a house is costlier, to your purse and future prospects, than never having owned one at all. By that standard, it's hard to call heedless subprime mortgage credit a social good. Not to mention the daisy chain of financial-instruments loans that almost caused a 1930s-style collapse. How were the regulators complicit? Let me count the ways.

• The Federal Reserve had the authority to force lenders to quit giving mortgages to people who couldn't afford them. Lenders were minting money on fees; they got rid of the loans by selling them to investors who didn't grasp the risks. Consumer organizations shouted about the abuses, but consumers don't have much of a voice in Washington today. "The regulators should have noticed banks were giving money away to poor people," the Nobel economist Joseph Stiglitz says. Maybe they did. They just didn't act. At least not until the subprime structure actually collapsed.
• The Securities and Exchange Commission could have required investment firms to carry more capital against their riskiest loans. This might have calmed the speculation that helped bring down Bear Stearns. The SEC also could have inspected the Street's risk-management systems and leaned on them to improve. Cassandras begged the commission to require disclosure about the weird financial instruments Wall Street has been playing poker with. No deal.
• One of the Enron lessons is that aggressive companies will shift big liabilities off balance sheets, where investors can't find them. New accounting rules were supposed to fix the problem but didn't. Some banks were closer to insolvency than anybody knew.
• When the states tried to move against predatory lending by national banks, they were blocked by the banks' federal regulator, the Office of the Comptroller of the Currency. "That empowered money lenders who were fleecing the people," says an angry Lynn Turner, former chief accountant for the SEC.
• Where was Congress? "It should have hauled the heads of these agencies up on the Hill for grilling," Turner says. But much of Congress is owned (through campaign contributions) by the banks and brokers whose wealth depends on fending off the financial police.
• Even now, the big banks—cheered on the by Treasury Department—are heading into a new, international deregulatory process. It lets them use their own "risk models" to help decide how much safety capital they should hold. But those are the very models that failed spectacularly last year "because they didn't put enough weight on common sense," says economist Jerry Caprio of Williams College. Will the Fed have to bail them out again?

The reforms Paulson offered last week were cheered by the investment community, which tells you something. I'd rather have had them screaming "overkill." There's a bit more oversight of financial firms, a bit more disclosure and much less scrutiny of the stock exchanges. You can't expect a strong hand from guys who don't want to regulate in the first place.

I've been thinking about the phrase "P.C." (politically correct), routinely used to deride the ideas of liberals. Today's P.C. turns the other way—to knee-jerk support of phrases like "free market" and "deregulate." Markets need clarity and regulation to keep from drowning in their own excess. They'll drag us down with them, if the cops give Wall Street a pass again.

Reporter Associate: Temma Ehrenfeld

© 2008