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SMITH/BERLAU: Dealing with the threat of global recession

By Fred L. Smith Jr. and John Berlau | Sunday, November 9, 2008

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At the global economic summit to be held at the White House later this month - likely the last significant meeting of foreign leaders in which the Bush administration will participate - the U.S. should seek a goal that has so far eluded all self-anointed saviors of the financial markets. That "something" would be a good dose of humility.

As the meltdown has unfolded, the private "masters of the universe" on Wall Street have been supplanted by the political "masters of the universe" in Washington and European capitals. That transition followed the rude awakenings of "smartest guys" in business that their financial engineering had many flaws.

But now, the new bureaucratic "gods of finance" are assumed to have this infallible ability to pick winners and losers through their awarding of bailout money. Yet ironically, in many instances, the same "masters" from Wall Street are the ones running the bailouts in Washington. Treasury Secretary Henry M. Paulson Jr., a former chief executive officer at Goldman Sachs, has hired former Goldman employees to decide how to dole out the $700 billion.

But the bailouts and partial nationalizations are still premised on what Friedrich A. Hayek, Nobel laureate in economics, called the "fatal conceit." Once again, it is assumed that government bureaucrats can plan the direction of the economy better than millions of consumers and investors can. Bailout proponents also rest on a misread of recent history in viewing the current mess as the result of "unfettered" markets. In truth, numerous government interventions from housing subsidies to directed lending have been big factors in this crisis.

Government-sponsored enterprises Fannie Mae and Freddie Mac were able to purchase trillions of dollars of mortgages at low cost due to their implicit (and now explicit) backing by the government. By the end of 2007, according to the New York Times, Fannie and Freddie had guaranteed or invested in $717 billion of subprime loans, and they bought many more that were just slightly above the subprime category. Their tremendous market power allowed Fannie and Freddie to buy many lower-quality mortgages that likely would not have been issued by lenders in the absence of such guarantees.

The Community Reinvestment Act, enacted in 1977 and expanded in the mid- '90s, mandated that banks issue a certain number of loans to the local communities they serve, including lower-income borrowers. To meet these goals or quotas, banks were encouraged to lower lending standards.

In the early '90s, the Federal Reserve Bank of Boston wrote a manual for mortgage lenders stating that "discrimination may be observed when a lender's underwriting policies contain arbitrary or outdated criteria that effectively disqualify many urban or lower-income minority applicants." As Stan Liebowitz, a professor of economics at the University of Texas at Dallas Business School, noted recently in the New York Post, "some of these 'outdated' criteria included the size of the mortgage payment relative to income, credit history, savings history and income verification." In other words, the Boston Fed and other agencies were discouraging the very criteria that would have protected lower-income families from overextending their indebtedness and could have prevented the subprime meltdown.

Private credit-rating agencies clearly dropped the ball in rubber-stamping these mortgage-backed securities as "AAA." The deeper problem is, though, that the ratings of Standard & Poor's and Moody's are enshrined in government regulations dictating the capital requirements of banks, broker-dealers and pension funds. These institutions frequently can only buy securities of a certain rating to comply with capital rules. And until very recently, the Securities and Exchange Commission had only designated S&P and Moody's as "nationally recognized statistical rating organizations," giving them essentially a government-protected duopoly

Despite the existence of foolish lending practices and perverse policy incentive, by itself the sheer number of mortgage delinquencies and foreclosures doesn't justify a crisis of this magnitude. In the Mortgage Bankers Association's latest National Delinquency Survey, the mortgage delinquency rate is just 6.4 percent - historically high, but not anywhere close to the mortgage default rate of more than 40 percent in the depths of the Great Depression.

Among the crucial factors that helped make this crisis a global financial "contagion" were new accounting rules going into effect in the U.S. and Europe just as foreclosures were spiking and real estate was losing value. So-called mark-to-market accounting forces financial institutions to take losses in their regulatory capital - which determines how much they can lend - if another bank sells similar loans at a fire-sale price, even if the loans at the bank in question are still performing and are being held to maturity.

And now the bailouts are having their own perverse effects by giving what is seen as a government seal of approval to banks that receive the money and a black mark to those that don't. The new fear is that depositors may make a rush to safety and pull out of banks not receiving the bailout dough.

So the best concrete achievement coming out of this meeting would be for governments to agree to a timetable to end the bailouts and denationalize their banks.

• Fred L. Smith Jr. is president of the Competitive Enterprise Institute in Washington, D.C. John Berlau is director of CEI's Center for Entrepreneurship.