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Loan Regulation Probably Wouldn't Have Prevented This Crisis

By Jack Guttentag
Saturday, October 18, 2008

With a presidential campaign in the middle of a financial crisis, it is not surprising that we are besieged with misinformation. Much of it is finger-pointing about responsibility for the absence of effective regulation that would have prevented or moderated the crisis.

Who has political responsibility for inadequate regulation? There are two financial sectors where more extensive regulation might have made a difference. These are the investment banks and the government-sponsored enterprises Fannie Mae and Freddie Mac. Both sectors were major players in the events leading up to the crisis.

In 2004, the Securities and Exchange Commission adopted a rule that pretty much allowed investment banks to regulate themselves. While a number of other factors were involved in this decision, the commission's belief was that self-regulation would be more effective than SEC regulation. This was consistent with the free-market ideology of the Republican administration.

In 2003, Congress defeated efforts to bring Fannie Mae and Freddie Mac under tighter regulatory control. This was primarily the work of Democrats, who feared that tighter regulation would crimp the ability of the mortgage-market companies to meet affordable-housing goals.

I call it a tie between the two parties. I hasten to add that had both financial sectors been subject to regulation, an only slightly less severe crisis would have occurred, for reasons explained below.

Deregulation, meaning the scrapping of existing regulations, was not a factor in the crisis. The only significant financial deregulation in the past three decades applied to commercial banks. Restrictions on where they could have branches and on their involvement in investment banking were both removed. Most economists, including me, believe that these actions made the banks stronger than they would have been otherwise.

Regulation in itself is a weak defense against financial crises. One major reason is that it tends to look backward, similar to generals fighting the last war. The savings-and-loan industry was subject to extensive regulation in the 1970s, but that did not prevent the subsequent crisis. The problem was that the wrong things were regulated.

The regulatory system was geared to preventing S&Ls from taking on too much default risk because, historically, that had been the major problem. The exposure of S&Ls to interest rate risk was not controlled. The S&Ls were allowed, even encouraged, to make long-term, fixed-rate mortgages financed with short-term deposits. When market interest rates exploded in the early 1980s, the cost of deposits jumped, income from mortgages barely changed and the industry began to bleed red ink.

The policy changes that were introduced after the S&L crisis were largely designed to prevent another crisis of that type. Among other things, associations were authorized (and encouraged) to write adjustable-rate mortgages. This would make S&Ls, as well as banks, less vulnerable to swings in market rates.

However, ARMs carry more default risk than fixed-rate mortgages, and as the years passed, interest-only and payment-option ARMs evolved that carried substantially more default risk. As the system became increasingly secure against an interest rate shock, it became increasingly vulnerable to a default shock.

Preventing a default shock through existing regulatory tools would be difficult. The core tool is capital requirements: The amount of capital including reserves that firms are required to have to cover the risk of losses from future defaults. The problem is that nobody knows how large any future default shocks will be.

Regulators have no better foresight than do the firms they regulate. Both use statistical models based on experience. A change in the underlying structure of the economy can make such history irrelevant, which is exactly what has happened. Nobody anticipated the severity of the current crisis because, relative to the past, it is off the chart.

But doesn't that mean that regulators, who are not motivated by profit, should err on the side of caution? To a degree, yes. If that were not the case, regulation would be pointless. But capital requirements that are higher than needed to meet potential shocks not only reduce profits but also impose social costs, to which regulators are sensitive. Larger capital requirements reduce loan volume and raise interest rates, a fact well understood by the congressmen who resisted tightening regulatory controls on Fannie Mae and Freddie Mac.

Better regulatory tools are needed. We should take a hard look at applying the system used to regulate mortgage insurance companies to mortgage lenders. Under this system, lenders would be required to allocate a portion of every dollar they receive in interest above some base rate to a reserve account that would not be touchable for 10 years except in an emergency. The higher the interest rate, the larger the payment to the reserve account.

Can we prevent this sort of problem from happening again? Yes, but the next crisis will almost certainly be different.

Jack Guttentag is professor of finance emeritus at the Wharton School of the University of Pennsylvania. He can be contacted through his Web site,http://www.mtgprofessor.com.

Copyright 2008 Jack Guttentag

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