Consequences of Deregulation

Edward J. Dodson

[Comments to Paul Solman of PBS News Hour; 2 August 2012]

Your interview today of Neil Barofsky confirms that not even the most sincere analysts seem to grasp the fact that a long period of deregulation of the financial services sector channeled huge resources into the hands of a criminal element always present but never quite potent enough to bring down the economy. Criminals are but one form of rent-seekers (i.e., individuals who engage in activities that yield high financial rewards without providing real services or goods to others). At least some economists have come to understand that fraud and theft are far easier to orchestrate with financial as opposed to real assets.

For most of the history of banking, the banking profit model was relatively straightforward: price for risk based on statistically reliable performance indicators, then provide credit to whose who meet creditworthiness criteria -- so long as the gross yield covers cost of funds, operating costs and profit targets. This began to change for many banks, but particularly for savings banks and savings and loan association with the creation of the first money market funds in the 1970s. With billions of dollars in deposits being siphoned away to the MMFs, the "thrifts" quickly faced insolvency. Some escaped by moving into higher risk business lending (looking to be profitable until either scandals broke or defaults escalated with the early Reagan recession). Others sold off their FRM portfolios to Fannie Mae or Freddie Mac at a deep discount, but were allowed to amortize the losses over the remaining life of the loans.

Reagan-Bush tax cuts on high marginal incomes and on so-called "capital gains" (note, that rare is the physical capital good sell for greater than its cost; this only occurs with financial instruments) placed hundreds of billions of dollars of added disposable income into the hands of already wealthy individuals, or placed the funds into the hands of their investment managers, who moved heavily into bank and other financial stocks. Deregulation then allows the large banks to begin to acquire other banks in order to achieve risk diversification -- geographically and across business lines. In one of the great ironies of this period, deregulation allowed bank executives to ignore their basic education and gamble newly-acquired financial assets on high-risk, high-reward activities. They acquired finance companies and second mortgage companies, each of which was plagued by predatory lending practices and outright fraud.

Fannie Mae (where I worked as a market analyst and business manager for 20 years) and Freddie Mac grew enormously after the S&L crisis of 1989-1993. The two GSEs allowed banks to turn mortgage portfolios into liquid MBS assets (and, hence, hold lower reserves for credit losses). What neither GSE understood and what no one in the regulatory environment grasped, what that the huge increase in credit provided to residential homebuyers was driving up the demand side of the equation AND allowing landowners to take huge unearned gains, as developers tripped over one another to gain control over developable land. As land prices increased each year, the GSEs were forced to increase their maximum loan limits to accommodate the market. Yet, rising property prices were not matched by increases in household incomes. A smaller and smaller portion of homebuyers (and almost no first-time homebuyers) were able to meet a required 20 percent downpayment. Those who could not were required to purchase mortgage insurance. By the early 2000s, property prices had risen to such a level in the New York, MSA, for example, that any household with an income up to 175% of area median was eligible for the GSEs low-to-moderate income programs. Property appraisals were routinely revealing land-to-total-value ratios above 50% and often as high as 70-75%.

When the GSEs balked at securitizing the type of subprime mortgages being created by firms such as Countrywide, they simply moved the business directly to the banks and to Wall Street. Those of us watching all of this unravel knew a crisis was on the horizon. What brought down Fannie and Freddie was not the subprime mortgage business in which they engaged. Those numbers were a small portion of the total book of business. The crash of the subprime lenders and Wall Street brought on a massive movement of investors out of the MBS business. The recession and long-term unemployment then kicked in to create a level of delinquencies on "conventional" mortgage loans that could only be remediated by job-creation. Instead, TARP and the Congress bailed out bank shareholders and bank executives with almost no corresponding commitment to banking reregulation.

The number one bank reform needed: prohibit any financial institution that accepts government insured deposits from providing credit for the purchase of land or acceptance of land as collateral. What this would do is to remove a good deal of the credit-fueled speculation in the property markets. On the residential side, this would, with some luck, return us to that period of relative stability when the common land-to-total value ratio of a property sale was around 20% (i.e., when buyers essentially paid cash for the land parcel and borrowed to purchase a home).