James Pethokoukis

Politics and policy from inside Washington

4 ways Congress caused the financial crisis

May 5, 2010 15:08 UTC

That bankers disdain their new Washington overlords is no surprise. To many of them, Congress is plagued by “unnerving ignorance” and a refusal to admit its own role in the financial crisis. At least that is how a controversial JPMorgan report puts it. Impolitic perhaps, but not inaccurate.

It’s one thing to discuss such grumbles in the executive suite. It’s another to explicitly lay them out in a widely disseminated research report, accompanied by data and a full-color chart for emphasis — in the midst of the delicate financial reform debate in the U.S. Senate, to boot. But that’s what JPMorgan’s James Glassman did in a May 3 economic note.

In last week’s Senate committee interrogation of Goldman Sachs executives, senators displayed “confusion about our market economy,” according to Glassman, along with plenty of unearned self-righteousness. He snarkily noted that the economic implosion of rust-belt Michigan, home of Carl Levin, the committee chairman, had nothing to do with esoteric derivatives.

It’s not news that many senators appear to have only a tenuous grasp of the financial industry. But Glassman’s larger point is more relevant. It’s not just that Congress doesn’t understand what Goldman, as a market-maker, does — it’s also that elected officials may not recognize that the financial crisis was rooted in Washington as well as Wall Street.

A similar point is made in new study by Ross Levine of Brown University, “An Autopsy of the U.S. Financial System.” Bankers may have rushed to create fancy new securities, but it was legislators who enabled risky behavior by housing giants Fannie Mae and Freddie Mac — and failed to instill watchdogs like the Federal Reserve and the Securities and Exchange Commission with the backbone needed to rein in risky activities. In detail, Levine makes these points that illustrate the role of Congress:

1) Credit Ratings Agencies. While the crisis does not have a single cause, the behavior of the credit rating agencies is a defining characteristic. It is impossible to imagine the current crisis without the activities of the NRSROs. And, it is difficult to imagine the behavior of the NRSROs without the regulations that permitted, protected, and encouraged their activities. … Rather the evidence is most consistent with the view that regulatory policies and Congressional laws protected and encouraged the behavior of NRSROs.

2) Credit Default Swaps. I am suggesting that the evolution of the CDS market, the fragility of the banks, and the Fed’s capital rules illustrate a key feature of the financial crisis that is frequently ignored. The problems with CDSs and bank capital were not a surprise in 2008; there was ample warning that things were going awry. Senior government policymakers created policies that encouraged excessive risk taking by bankers and adhered to those policies over many years even as they learned about the ramifications of their policies.

3) The SEC and Investment Banks. Consider three interrelated SEC decisions regarding the regulation of investment banks. First, the SEC in 2004 exempted the five largest investment banks from the net capital rule, which was a 1975 rule for computing minimum capital standards at broker- dealers. Second, in a related, coordinated 2004 policy change, the SEC enacted a rule that induced the five investment banks to become “consolidated supervised entities” (CSEs): The SEC would oversee the entire financial firm. Specifically, the SEC now had responsibility for supervising the holding company, broker-dealer affiliates, and all other affiliates on a consolidated basis. Third, the SEC neutered its ability to conduct consolidated supervision of major investment banks. … The combination of these three policies contributed to the onset, magnitude, and breadth of the financial crisis. The SEC’s decisions created enormous latitude and incentives for investment banks to increase risk, and they did.

4) Fannie and Freddie. Deterioration in the financial condition of the GSEs was not a surprise. … But, Congress did not respond and allowed increasingly fragile GSEs to endanger the entire financial system. It is difficult to discern why. Some did not want to jeopardize the increased provision of affordable housing. Many received generous financial support from the GSEs in return for their protection. For the purposes of this paper, the critical issue is that policymakers did not respond as the GSEs became systemically fragile. Again, I am not arguing that the timing, extent, and full nature of the housing bubble were perfectly known. I am arguing that policymakers created incentives for massive risk-taking by the GSEs and then did not respond to information that this risk-taking threatened the financial system.

Of course, even senators who do understand finance may choose to indulge in ignorant-seeming grandstanding for political and electoral reasons. JPMorgan, in turn, has distanced itself from Glassman’s views, presumably to smooth any ruffled political feathers. Even if the bank’s management secretly agrees with its economist, it’s about as likely to say so as members of Congress are to admit their enormous shortcomings.


The list of causes is incomplete. It really began with Jimmy Carter (naturally, did that idiot do *anything* right) when he pushed through the original Community Development Act to get “help” for people who “can’t qualify for mortgages.” Then Bill Clinton and his willing accomplices in Congress made it MUCH WORSE, by strengthening the act, then he sicced Janet Reno on banks that were abiding by sound banking principles to force them to make loans TO UNQUALIFIED PEOPLE, by threatening them with “redlining” lawsuits. Along comes Gramm, Leach, Briley (removing the Glass Steagall act) and the real sharks of Wall Street (investment banks) were turned loose. The government was pushing this on all fronts, and the investment bankers did what comes naturally, they invented a way to handle all the bad debt without any risk to themselves (CDS.) When the Bush administration began to push to tighten the rules, we got Maxine Waters, Barnie Frank, Chris Dodd and many others of our rather stupid congress critters lining up to defend Freddie Mac and Ginnie Mae by saying really dishonest and stupid things like “they are sound.” I really don’t know why some reporter won’t try to unravel this apparent mystery (it’s really not) and report the real facts, along with the culprits in Congress. It’s disgusting, and typical of what has happened with the advent of career politicians who are much more interested in their own power and position, than actually doing something for the people they are supposed to represent.

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Kudlow and Yardeni on Greece

May 5, 2010 14:52 UTC

Some illumination on Greece. First, The Great One, Larry Kudlow:

Merkel and other European leaders would like the IMF to be the fiscal-discipline policeman for Greece and the rest of southern Europe. But as Nobelist Robert Mundell has argued, while the unified and fixed exchange rate of the euro currency system, along with liberalized trade, has been good for economic growth, things have broken down with the failure of the so-called fiscal-stability pact that was never enforced.

With tens of thousands of Greek government union workers marching in the streets of Athens calling for more general strikes in protest of IMF austerity measures to cut back on bloated pensions, voters in Germany and perhaps other EU countries do not believe the bailout conditionality will ever work. Voters see solvent nations being saddled with more debt that the European Central Bank may well monetize into higher inflation.

Indeed, the debt follies of Europe and the bankruptcy of the European entitlement state should be a lesson for Obama’s Washington, where overspending and borrowing have reached absurdly grand heights. As a share of GDP, U.S. debt is projected to move toward 100 percent in the wake of the new Obamacare entitlements. That’s near the 125 percent debt ratio of Greece.

Now Ed Yardeni:

The risks of a sovereign debt contagion clearly increased over the past 48 hours on mounting evidence that the bailout of Greece has been botched. The response of the EU wasn’t swift enough, and Greek workers are staging strikes protesting austerity measures including a second set of wage cuts for public workers, a three-year freeze on pensions, and a second increase this year in sales taxes and the price of fuel, alcohol, and tobacco. … Governments around the world are rapidly becoming the problem rather than the solution. In addition to all the anxiety about a sovereign debt contagion triggered by the mess in Greece, there is mounting evidence that governments are making it more expensive to do business, especially for oil companies, mining companies, and banks:

(1) BP’s liability for the massive Gulf of Mexico oil spill on April 20 is capped by law at $75mn. But Senator Robert Menendez (D-NJ) is co-sponsoring a measure that would raise the liability limit to $10bn–retroactively, so it can apply to the April 20 spill. The measure reportedly has the Obama administration’s support.

(2) The left-center Australian government on Monday slapped a 40% tax on mining company profits to fund increases in worker wages and pensions during this election year. The new tax would raise about A$12bn (US$11bn) and force the companies to reconsider whether to continue their huge investment programs. Shares of Rio Tinto and BHP Billiton fell sharply on the news.

(3) Treasury Secretary Timothy Geithner told the Senate Finance Committee on Tuesday that financial regulatory legislation should include a tax on large financial firms to help recoup financial crisis bailout funds.