To most people, financial markets are as obscure and as hard to comprehend as one’s dating options. Because people have more important things in life to think about (family, education, work, relationships, secret love affairs, etc.), they have to work with whatever knowledge they have to understand this financial crisis. Most people believe the symptoms, diagnosis and medication of the financial crisis to be something like this:
In 1980, Ronald Reagan became president and started two decades of deregulating financial markets and lowering taxes. Banks took advantage and pushed this legislation for their own use, gambling with a ton of our money in housing with complex securities, and, as a result, are now obscenely rich while there are people starving here. What needs to happen is that the government has to regulate them, because the free market was a myth to get the rich richer and the poor poorer.
How do you, a college student, make sense of this explanation? This narrative is appealing and simple, and it gives a clear, faceless enemy out in the distance to curse at. But is it true? To figure this out, you would probably have to abandon all your dreams, friends and dub-step parties. So you probably realize that you have better things to do in college and leave the story as is.
Let us talk like college students, then. Wall Street went drunk, I agree. There was some deregulation, I agree. But this story ignores other government actions that drastically increased the likelihood of irresponsible investing. After reading these five government interventions, you’ll understand why Wall Street got EMSed and exactly who brought the keg.
Foolish credit rating agencies: To start, we need to understand the role of credit rating agencies in this crisis. In 1975, the Securities and Exchange Commission established Nationally Recognized Statistical Rating Organizations. This body made Standard & Poor’s, Moody’s and a few smaller credit rating agencies the required auditing agencies for financial institutions. If you were a bank, you had to pay these agencies to get your loans or company approved for the government capital requirements. “Why is this troubling?” the college student may ask. Imagine being told by the government that you, yes you, are now exclusively able to measure and certify how incredible someone is at sex. Under this law, your standard would be the only real globally-accepted standard of sex-measuring —causing every other single human to base their “strategies” on your ratings. For your assessment services, you may charge and make money. No conflict of interest, right? The conflicts of interest were so severe that the ratings agencies believed Enron was perfect up until it failed and that AAA subprime mortgages (actually incredibly risky investments) were perfectly safe investments for pension funds, investors and newborn puppies.
Fed permits CDS as a substitute to capital: In 1996, the Federal Reserve agreed that banks could use insurance funds to replace their required disaster fund of actual money. Hmm … college student, this is oddly familiar to zombie movies. Allow me to explain. Imagine that, since the beginning of time, all the parents in the world forced their children to have an emergency fund in case a zombie apocalypse arrives. It cannot be touched, ever, because it is a safeguard against this risk. Well, these kids, being smart and knowing that is never going to happen, asked their mutual friend the American International Group (he is weird, but everyone trusts him) to front the money should the apocalypse happen. Everyone pays him a premium for him being there when the shit hits the fan. The children then tell this plan to their parents (the Fed), and they concede to their clever kids. The parents then announce that it is perfectly okay for any kid to use this Credit Default Swap (or zombie apocalypse insurance) as a substitute for the emergency disaster fund. Well, now that the children have the rest of the emergency funds insured, they can go have fun with the extra cash. Because of this new law, kids are all continuously incentivized to give AIG a lot of money. Since AIG has so much money, people feel safe that the money will be there when he needs to produce it. But what happens if AIG goes broke?
Fed lowered long-term interest rates in 2001 for too long: The Fed has the power to print money and, with that money, buy government bonds (and recently all kinds of assets) to change interest rates. After the dot-com crisis in 2001, Alan Greenspan, the supposed champion of free markets, artificially lowered interest rates to historic levels. The argument is that by lowering interest rates, investing becomes a better option than saving,and that would restart the economy with real consequences. Seems like a good idea, but it is not. Imagine everyone writes, contributes to and reads the six-month party horoscope, and because they believe it is a good indicator of the future party landscape, everyone truly acts on what it says. The consensus is that six months from now, the prediction for the general party population is “you will not remember but be remembered at this party.” Everyone is going to do everything to prepare for that epic night — saving alcohol, studying ahead of time and not eating too much the night of. What Greenspan did was to rewrite this horoscope after the biggest party fail in 2001. With people totally hungover, drowned in unfinished work, and without much time, Greenspan chose to rewrite this horoscope and yell, “Every day we be shufflin‘!” instead of letting people recover from binge drinking DotcomICE. By changing this horoscope (called the interest rate), people perceived that further partying must be a good idea because this horoscope is naturally supposed to tell the true opinions of other partygoers. As a result, they went overboard in alcohol and indebted themselves to incredibly unreasonable amounts, for they thought that is what everyone else wanted (not actually needed). People who were choosing to save for better parties lost incredibly. When they actually had a good reason to party, everyone else had been destroyed. With this 2001 interest rate manipulation, Greenspan disincentivized saving and promoted an unnecessary boom of unsustainable loans.
Freddie Mac and Fannie Mae: To most people, these institutions sound like some decrepit pets that should have died in the ‘90s with Boyz II Men. These government sponsored enterprises were meant to help make housing more affordable by buying so many mortgages that it would become incredibly inexpensive to buy a new house. GSEs and the Community Reinvestment Act were part of a larger, bipartisan effort to reduce discrimination and predatory lending. Like fruitcake, this sounds like a great idea, but after you try it, you will learn two words very well: never again. Seven trillion dollars’ worth of mortgages were bought and are right now under Congress’ protection. Now if you imagine the three previous metaphors and then combine those processes with almost four times California’s annual gross state product invested in homeownership, how is it not possible that the current housing bust was the direct result of a housing boom perpetuated by these policies? How is it possible that the government did not have a major role in exacerbating this crisis?
On top of this, we have the Federal Deposit Insurance Corporation, which guarantees huge amounts of commercial deposits by the federal government — causing people to not monitor their bank’s portfolio and therefore increase banking systemic risk. We place incredibly high legal requirements under the Sarbanes-Oxley Act of 2002, encouraging the creation of huge firms. To amplify this further, we bailed out in the past (Mexican peso crisis, Long-Term Capital Management, savings and loans crisis) and bail out in the present (too long to list) companies that have absolutely insolvent business models. By changing people’s expectations of the quality of investments (through mandating credit rating agencies), by permitting insurances to substitute capital requirements, by lowering interest rates beyond what the market anticipated and by pushing $7 trillion dollars of debt into this crisis, government policy provided the alcohol to drive the banks into the most epic housing bubble of all time.
All my time here at Brown I hear the words “market failure.” My friend, there’s also government failure.