Ideas for Financial Regulatory Reform

I received an email from Vasos Panagiotopoulos recommending an article by Edward M. Gramlich, “Booms and Busts: The Case of Subprime Mortgages,” Economic Review, Federal Reserve Bank of Kansas City, Fourth Quarter 2007, 105-113 [official Summary here]. Vasos provided a brief summary that I have with his permission amplified as follows: "The Monetary Control Act of 1980 ended usury limits for risky mortgages. The subprime industry since 1993 created 12 million new homeowners, raising the total by five percent [106]. It is important to appreciate that the boom and bust has left, besides investor losses, about 88 percent of the homes still solvent [107]. Borrowers had difficulty comprehending the implications of teaser adjustable mortgage rates and their often-onerous prepayment penalties [107]. Moreover, because the debt was immediately securitized, risk was transferred to buyers of collateralized securities. Independent brokers, unlike banks in the traditional mortgage relationship, had nothing to lose when borrowers defaulted. A “giant hole” in financial supervision has existed, exactly where supervision was needed the most. The weaknesses seem concentrated among on state-chartered lenders but joint Fed/Office of Thrift Supervision action, with the support of state banking supervisors, has already started to bring these under supervision without new legislation [109]. The Fed has a predatory lending statute it can use to intervene in some cases [111]. Strenuous efforts be made to prevent foreclosures [112], in part by buying up properties in default for rentals. Above all, weaknesses in supervision must be corrected soon."

Time for Reform of Financial Regulation

After the meltdown of the savings and loan industry in the 1980s, the Federal Home Loan Bank Board was ended and the Office of Thrift Supervision was put in its place in 1989 to end mortgage chicanery once and for all. With Meltdown II originating in the subprime loan business, it is clear that the 1989 reform was inadequate. Risks were mispriced, mortgage lenders were out of control and the effects are being felt with foreclosures and financial losses in every community in America.
A December 27 Wall Street Journal article, Wall Street Wizardry, showed how subprime mortgage loans were repackaged and resold at prices that did not reflect their risk, using the example of Norma to show a "hairball of risk".
It's no surprise that Wall Street was able to engage in such practices because the financial regulatory system is a hairball of its own. The Comptroller of the Currency, Federal Reserve, the Federal Deposit Insurance Corporation and 50 state bank regulators share with the Office of Thrift Supervision and the SEC the responsibility for overseeing financial institutions and their innovations. Bankers prefer multiple regulators because they can then shop among them for the one they like best. The idea of a super-regulator "sends chills down the spine" of bankers, says a 2003 memo prepared for the FDIC, which observes that calls for consolidation of bank regulation are "nothing new" and argues for competition among regulators.
However, the outcome of the existing system has been the subprime meltdown, which has also sent chills down the spine of bankers, with more chills and spines to come.
One problem is that bank supervision is not a priority for the top management of the Federal Reserve System, which clusters around the FOMC and the federal funds rate like moths around a flame. An article by Gretchen Morgenson of the NY Times describes Fed Chairman Alan Greenspan's meeting with two representatives of the 15-year-old Greenlining Institute, who expressed concern about the lack of oversight over subprime mortgage lending practices. Greenspan is reported as not being interested because he did not wish to interfere with financial innovation.
To be fair to Mr. Greenspan, he and his colleagues have had other things to worry about besides bank supervision. The Fed was originally created in 1913 to maintain orderly financial markets and maintain the value of the dollar. In 1946 it was given the additional task of ensuring full employment. These multiple tasks conflict. How does one tackle a threatened debt-induced recession in 2008 when oil hits $100 a barrel and commodity prices generally are rising along with global growth? If orderly markets require continued infusion of liquidity, how does one battle inflation? What is the long-run impact on the Fed's ability to control inflation of perennial budget deficits?
The problem with the lack of oversight over the Wall Street wizards is that when their innovations blow up, the taxpayer histroically picks up the pieces, and the breakdown in financial markets poses problems for monetary policy.
When President Bush addressed the hairball of multiple agencies involved in homeland security, he consolidated the agencies under one leadership. We have a problem now with financial security. The subprime crisis is worse than the savings and loan mess. As subprime losses are revealed in other countries, it can't be good for the future of Wall Street as a global competitor.
The agency best equipped to assess and charge for financial risk is the FDIC. Washington legislators should hold hearings about possibilities for consolidating financial regulatory functions under the FDIC, which can price risk and assess insured institutions a deposit insurance premium based on this risk. This would encourage market-based incentives to disclose and control risks.