In the elaborate roll-out of its proposed overhaul of financial regulations, the one thing that President Obama, Timothy Geithner, and their economic advisers have not done is explain how their recommendations--if they had been in place four or five year ago--would have prevented the present financial and economic crisis. There are skeptics. Gary Gorton, a professor of finance at the Yale School of Management, is one. "Only if you were in the market trading [suprime mortgage securities] did you see it coming," says Gorton of the period before August 2007, when the crisis surfaced. "I don't think you can legislate foresight."
The history of the crisis suggests some skepticism. By early 2007, delinquencies and defaults on subprime mortgages--which had been well below the radar level of most government officials and economists--were beginning to attract attention, as was the deepening slump in housing construction and the incipient decline of home prices. Still, Federal Reserve chairman Ben Bernanke testified before Congress that housing's problems seem to be contained and probably wouldn't lead to recession--never mind the worst financial crisis since the Great Depression. Most economists agreed. With a few exceptions, economists, regulators and bankers expressed little alarm or apprehension about an impending financial collapse.
On paper, it's possible to argue that the Obama proposals might have prevented the crisis. One propsoal is that issuers of "securitized" bonds--consisting of underlying loans for home and autos, for example--would have to hold a percentage of the bonds in their own portfolios (the amount is unspecified but is thought to be about 5 percent). If that rule had existed, underwriters might have rejected some "subprime" mortgages as too risky. Had the proposed Consumer Finance Protection Agency been in existence, it might have issued mortgage rules and disclosures that also would have prevented some of the riskiest loans. Finally, the Obama proposals include authority for the government to lend to financial institutions whose failure might disrupt the entire system; if that had existed last Sept., the government might have rescued Lehman Brothers, whose failure sent shock waves through the global financial system.
Against that stylized story lies what actually happened in the 2003 to 2006 period. Interest rates were low; so were delinquencies on most mortgages; the home-ownership rate was edging up. Bankers, borrowers and politicians were all pleased--the housing boom was a bright spot in the economy. Is it likely that regulators would have curbed the boom?
But just because the proposals might not have prevented the crisis, that's not an ironclad argument against them. In general, the proposals would give both the Federal Reserve and the Securities and Exchange Commission more power to ask for more information from financial institutions, including hedge funds. Capital requirements for banks and some other financial institutions would be increased. Trading in many derivatives (such as Credit Default Swaps) would be directed onto exchanges and clearing houses, where financial responsibility is more dispersed and more information is available. Risk can't be purged from the system, says one Administration official. "You've got to make the system a little safer for ignorance and failure," he says, "because we're going to have ignorance and failure."
Uncommon Knowledge
Newsweek is committed to challenging conventional wisdom and finding connections in the search for common ground.
Newsweek is committed to challenging conventional wisdom and finding connections in the search for common ground.
