The government, not underregulated markets, spurred the economic meltdown.

• Author: Hendershott, Patric H.
• Position: The Great Recession

THE CURRENT narrative regarding the 2008 systemic financial system collapse is that numerous seemingly unrelated events occurred in unregulated or underregulated markets, requiring widespread bailouts of actors across the financial spectrum, from mortgage borrowers to investors in money market funds. The Financial Crisis Inquiry Commission, created by Congress to investigate the causes of the crisis, promotes this politically convenient myth, and the 2010 Dodd-Frank Act operationalizes it by completing the progressive extension of Federal protection and regulation of banking and finance that began in the 1930s so that it now covers virtually all financial activities, including hedge funds and proprietary Wading. The Dodd-Frank Act further charges the newly created Financial Stability Oversight Council--made up of politicians, bureaucrats, and university professors--with preventing a subsequent systemic crisis.

Markets can become unbalanced, but they generally correct themselves before crises become systemic. Because of the accumulation of past political reactions to previous crises, this did not occur with the most recent crisis. Public enterprises had crowded out private enterprises, and public protection and the associated prudential regulation had trumped market discipline. Prudential regulation created moral hazard and public protection invited mission regulation, both of which undermined prudential regulation itself. This eventually led to systemic failure. Politicians are responsible for regulatory incompetence and mission-induced laxity.

The 2008 global financial collapse emanated from the U.S. subprime lending bubble. Economists generally resort to mass psychology to explain how the bubble could inflate to such an extent, assuming that borrower and lender behavior was irrational. The Fraud Enforcement and Recovery Act of 2009 created the Financial Crisis Inquiry Commission (FCIC) to investigate why the financial crisis became globally systemic. The FCIC was charged with conducting a comprehensive examination of 22 specific and substantive areas of inquiry relating to various and seemingly unrelated hypotheses advanced primarily by politicians, business executives, and university professors. The final FCIC report (2011) found varying degrees of merit for all of these hypotheses, blaming the financial crisis on a confluence of generally independent events, such as "recklessness of the financial industry and the abject failures of policymakers and regulators" to regulate the essentially deregulated or never regulated parts of the mortgage and deposit markets. This justified the 2,300-page Dodd-Frank Act's regulatory approach.

The basic difference between the U.S. and other market economies since 1975 has been that U.S. mortgage and related markets relied more on federally sponsored and regulated enterprises that were more pervasively--that is not to say appropriately--regulated. The conventional narrative is that the unregulated private-label securitizers (PLS) like Countrywide and Bear Stearns funded the subprime bubble, subsequently dragging down the giant government-created mortgage financers Fannie Mae and Freddie Mac with them. However, all of the markets contributing to the crisis already were subject to regulation in one way or another. The FCIC Report's conclusions succeed in diffusing the political responsibility for making the crisis systemic and hence fail as a guide to avoiding future systemic crises.

The specific regulatory failures necessary for Fannie Mae and Freddie Mac to become so heavily entwined in the subprime bubble were allowing them to bypass the primary mortgage insurers; permitting them extreme leverage; and requiting them to finance at least half of the subprime market.

The specific regulatory failures necessary for the private-label securitizers likewise to become heavily entwined in the subprime bubble were the Securities and Exchange Commission (SEC) designation of approved credit rating agencies without the necessary supervision; the use of the credit rating agency designations in risk-based capital requirements; the failure of bank regulators to prevent the deterioration of underwriting guidelines, regulatory arbitrage, off-balance sheet funding, and the rise of the "shadow banking" market; and woefully inadequate SEC capital regulations for investment banks and accounting rules that allowed the acceleration of income and delayed recognition of expense.

Still, all of these failures should not obscure a more general problem: Federal regulators did not understand and mitigate systemic risk.

Public protection of private enterprises creates a "moral hazard," wherein private enterprises are more willing to take risk when they know that they will be rescued if they get into trouble. As a result, protected enterprises will take excessive risks. Virtually all of the behavior that created the subprime lending debacle can be explained by incentive distortions, mostly moral hazard, and none of this behavior was new or irrational. It was not the lack of regulatory authority, but rather its pervasiveness and widespread failure, that not only allowed, but caused, the subprime lending debacle. Adding to this, purely political mission regulation--specifically, the government-embraced "mission" of expanding homeownership rates regardless of risk--pushed the bubble to systemic proportions.

Politicians are responsible for regulatory oversight, but that oversight failed because of incompetence and incentive conflict. Politicians and their regulators consistently failed to understand how regulation would undermine and replace, rather than complement, market discipline. Market discipline cannot be said to have "failed" during the subprime lending bubble, because it did not exist; market forces had been replaced by regulatory oversight. Only market speculation operated largely outside of this regulatory regime, but politicians and their regulators always have tried to limit and even criminalize the stabilizing activity of speculators "shorting the market."

Pointing the finger

Banking deregulation often has been blamed for causing the financial crisis, but it is unclear why that would be the case. The so-called "Reagan Era" banking deregulation (which actually was signed into law by Pres. Jimmy Carter after being passed by a Democrat-controlled Congress) was the phase-out of deposit interest rate ceilings beginning in 1980, and that had nothing to do with housing finance.

The next piece of banking deregulation was the 1994 elimination of bank branching restrictions, which was passed by a Democrat-controlled Congress and signed into law in 1994 by Democratic president Bill Clinton, and which, again, had nothing to do with housing finance.

The 1999 banking reform, passed by a Republican Congress and signed by Pres. Clinton, eliminated the Glass-Steagall Act's forced separation of investment and deposit banking, but that did not seem to contribute to the financial crisis, as the institutions at the heart of the crisis--Bear Steams, Lehman Brothers, Ameriquest, Countrywide, AIG, and so on--were not "universal" banks (though many of those institutions later were merged into universal banks so as to stabilize them). These reforms all removed political distortions and strengthened the financial system.

The credit allocation goals of mission regulation, in contrast, directly conflicted with prudential regulation. In the case of Fannie Mae and Freddie Mac, political mission regulation and corruption explains most of the regulatory failure. In the case of the banks, mission regulation also likely explains why regulators did not raise the credit standards for their loans or increase capital...