A $500 Billion Correction

By Steven Pearlstein
Wednesday, December 19, 2007

Any doubts about the breadth and depth of the global credit crisis should have been dispelled by yesterday's move by the European Central Bank to pump $500 billion in freshly printed euros into the banking system.

That's not a misprint. That's half a trillion dollars. Until now, it's been big news when the a central bank let loose with a $20 billion injection. In this case, it's not only $500 billion, but $500 billion lent against almost any collateral, including a handwritten IOU from Uncle Ludwig in Dusseldorf.

The problem is that banks everywhere are suddenly short of cash. The traditional year-end demands of customers is part of it. But it's also that the banks with extra cash are reluctant to lend to the others because they're unsure of the borrowers' financial conditions. The banks also anticipate they will have to take more write-offs and reserves for bad loans when they close their books on the year.

The result is that there's less money available for loans to businesses and consumers. So in an effort to forestall an economy-wide credit crunch, central banks are offering what amounts to unlimited funds at an interest rate of 4.25 percent, hoping banks will lend it out at 7.25 percent or more. So far, the results have been positive, but less than expected given the huge sums involved.

Meanwhile, back at the Fed, the board of governors yesterday proposed rules to prevent the kind of loosey-goosey mortgage lending that helped get us into this trouble in the first place. At the Fed, they think of this initiative as a timely response to an unanticipated breakdown of market discipline. In the newspaper business, we'd call it a correction.

In truth, the breakdown in subprime lending standards was foreseen by housing advocates and even some top government officials as far back as 2004, but their warnings were not heeded. So it may be useful to recall the reasons given by the Fed and other regulators for rejecting the same rules that they now consider necessary.

Back in 2004, the first line of defense against new regulation was to argue that consumers and markets could be protected through voluntary industry self-regulation. In fact, that was tried in the case of predatory lending. But without any willing enforcer or timely enforcement mechanism, even well-meaning companies got sucked into the race to the bottom, degrading lending standards to maintain market share or meet Wall Street expectations.

Lesson 1 from the subprime fiasco: Industry self-regulation almost never works.

The second line of defense is to argue that in a competitive market, disclosure and transparency are the keys. But anyone who has gone through a house closing and signed "disclosure" documents knows that this process is inevitably hijacked by lawyers who are more interested in protecting clients from lawsuits than protecting consumers.

Lesson 2: Disclosure alone won't deter bad behavior.

Another common defense against regulation is that, if you properly align incentives, markets can discipline themselves. By this logic, rating agencies could be relied on to make sure that lending standards were maintained for loans that were securitized, while banks could be relied on to police independent brokers because of the small loss they would suffer if a loan went bad. And of course there were the lawyers, accountants and bankers with reputations to maintain. This was all great in theory. But in real life, it turned out the vigilance of these gatekeepers was easily subverted by fees which, however exorbitant, were a pittance compared with the potential profits to be made from hoodwinking homeowners and investors.

Lesson 3: Market discipline can be easily corrupted.

One of the most common arguments against financial regulation is that most of the parties involved are knowledgeable, sophisticated players who can look out for themselves. In the real world, however, the people who run German savings, Florida savings banks and some of the world's largest mutual funds did not understand the risks behind the complex, asset-backed securities they were buying. Even Robert Rubin, the former head of Goldman Sachs, former Treasury secretary and current vice chairman of Citigroup, recently admitted that he had no idea what a "liquidity put" was until they started blowing up on Citi's balance sheet.

Lesson 4: Even sophisticated buyers and sellers cannot always protect themselves, let alone the safety and soundness of the financial system.

Opponents of regulation are right about one thing: In the long run, markets correct for their own excesses. But it is also true that the people who get hurt during that corrective process -- or are forced to live with economic uncertainty while it is going on -- are not necessarily the people who caused the problem.

Deregulation zealots and free-market purists may not value things like fairness or stability, but the rest of us do. That's why people are willing to accept a measure of lost innovation and lost output that inevitably results from economic regulation. And it is why people are willing to have their governments pump half a trillion dollars into the private banking system to avoid a financial meltdown.

One hopes the Fed recalls those lessons the next time it is tempted to worship before the altar of financial deregulation.

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