The Perils of Regulation - 2

Government forces bad business practices and ruins the economy.

The first article in this series outlined the opportunities for corruption which are created when the government tries to forbid profit-making or popular activities.  Builders bribe zoning boards, drug dealers pay off cops, businesses bribe senators and representatives in return for earmarks, and others bribe lawmakers to give them favorable treatment when writing tax law.

Banks are so important to society that they're heavily regulated everywhere.  So many banks failed during the Roosevelt Depression that business seized up - nobody could sell anything because they weren't sure they'd be paid.  In response, the government created the Federal Deposit Insurance Corporation (FDIC) which guaranteed that savers would get their money back if a bank went bust.

That immediately created what's called a "moral hazard" - bankers could make incredibly risky deals with depositors' money.  If the deal worked, they'd make large profits and bonuses.  If the deal went bust, the losses would be carried by the taxpayers.

This risk was so obvious that regulations were passed to limit the types of risks banks could take.  After he'd taken on too much risk, Charles Keating paid 5 senators $1.5 million to stop an investigation of his bank.  If his risks had paid off, he'd be a hero with a big bonus.  If he'd been forced to unwind his risks at that time, however, his bank would be in serious trouble.

The investigation was blocked by the senators he'd bribed, his bank failed, taxpayers paid hundreds of millions to his depositors, 2 of the 5 senators were reprimanded, and Keating went to jail.  The senators kept the money, of course.  There was no reason to return the bribe - they'd kept their end of the deal by spiking the investigation.

The previous article showed the risk of corruption when businesses are forbidden to engage in profitable activities - Keating wanted to win a fortune by betting other people's money which was subsidized by the government.

This article discusses the opposite risk imposed by regulations which require businesses to do things they'd rather not do.  Depending on the money involved, positive regulations generate just as many opportunities for bribery as negative regulations.  In special circumstances, however, positive regulations can also present significant risks to the economy.

The Way Mortgages Were

Bankers say, "Any fool can lend money, the trick is getting it back."  Over the centuries, bankers evolved reliable formulas to set loan limits to make sure they'll get paid.

Years ago, bankers limited home loans to between 2 to 5 times the husband’s salary.  If that plus the down payment wasn’t enough, the seller dropped the price or waited for another buyer with more money.

From a banker’s point of view, any money the wife earned could be used to pay the loan back faster, which reduced risk.  The banker might be persuaded to offer a lower interest rate.  However, since women weren't generally expected to be primary breadwinners nor to work their entire lives as men did, no banker would consider a wife's income when calculating the maximum amount of the loan.

Under feminist pressure, however, banking regulations were changed so that a wife’s income had to be included with the husband’s salary when figuring out the maximum mortgage.

This allowed two-income couples to pay higher prices for houses.  Sellers inflated the “housing bubble” by increasing prices as soon as the government made more mortgage money available, just as colleges increased tuition when student loan programs made more tuition money available.

It wasn’t long before a single income couldn’t afford much house at all.  This forced more and more women to go to work whether they wanted to or not.

Women going to work nearly doubled the supply of labor, so the price of labor fell.  The more the price of labor fell, the harder it was for fathers to provide by themselves; more pressure built for wives to work.  This dropped wages even more.

Basing mortgages on two incomes increased the risk of default.  A non-working wife could take a job to help out if her husband lost his job, but with a mortgage depending on two incomes, the mortgage was at risk if either husband or wife became unemployed or fell ill.

Then the government decided that evil racist bankers weren’t lending enough money to minority borrowers.  On top of requiring banks to include a wife’s income when granting mortgages, they started fining banks for “redlining,” that is, refusing mortgages in areas where minorities were concentrated.  When that didn’t result in enough minority homeowners, bank examiners evaluated loan portfolios to make sure banks had written enough mortgages to minorities regardless of the underlying fundamentals.

The Housing Bubble Grows

This wasn’t too bad when banks had to keep mortgages instead of selling them because losses came out of the bank’s profits.  This forced bankers to be careful.  Then, on Sept. 30, 1999, the New York Times wrote:

In a move that could help increase home ownership rates among minorities and low-income consumers, the Fannie Mae Corporation is easing the credit requirements on loans that it will purchase from banks and other lenders.

The action, which will begin as ar pilot program involving 24 banks in 15 markets -- including the New York metropolitan region -- will encourage those banks to extend home mortgages to individuals whose credit is generally not good enough to qualify for conventional loans. Fannie Mae officials say they hope to make it a nationwide program by next spring.  [emphasis added]

Lending money to borrowers with bad credit increased the risk of mortgages going bad, of course.  The Times foretold the coming crisis:

In moving, even tentatively, into this new area of lending, Fannie Mae is taking on significantly more risk, which may not pose any difficulties during flush economic times. But the government-subsidized corporation may run into trouble in an economic downturn, prompting a government rescue similar to that of the savings and loan industry in the 1980's.  [emphasis added]

They also prophetically explained why the government’s obsession for more minority homeowners could bring down the entire banking system:

Fannie Mae, the nation's biggest underwriter of home mortgages, does not lend money directly to consumers. Instead, it purchases loans that banks make on what is called the secondary market. By expanding the type of loans that it will buy, Fannie Mae is hoping to spur banks to make more loans to people with less-than-stellar credit ratings.  [emphasis added]

The government didn’t write mortgages; it bought mortgages from banks that originated them.  The government was saying that they’d buy riskier loans than they’d bought before.

Given that the government was willing to buy risky loans, is it any wonder that banks sold mortgages to people with No Income, No Jobs or Assets, the famous NINJA loans?  Given that they could be fined for not lending to minorities, is it any wonder that so many minority homeowners were unable to pay their mortgages?  The banks didn't care about the long-term stability of the loan; the borrower simply had to make the first handful of mortgage payments, just long enough to sell the loan off to Fannie or Freddie, get their money back to loan again, and make it the taxpayers' problem.

Instead of crowing about the accuracy of their 1999 prediction of disaster, the Times left it to the Independent, a British newspaper, to explain what happened:

What is the proximate cause of the collapse of confidence in the world's banks? Millions of improvident loans to American housebuyers. Which organizations were on their own responsible for guaranteeing half of this $12 trillion market? Freddie Mac and Fannie Mae, the so-called Government Sponsored Enterprises which were formally nationalized to prevent their immediate and catastrophic collapse. Now, who do you think were among the leading figures blocking all the earlier attempts by President Bush - and other Republicans - to bring these lending behemoths under greater regulatory control? Step forward, Barney Frank(D) and Chris Dodd(D).

In September 2003 the Bush administration launched a measure to bring Fannie Mae and Freddie Mac under stricter regulatory control, after a report by outside investigators established that they were not adequately hedging against risks and that Fannie Mae in particular had scandalously mis-stated its accounts. … Yet Barney Frank and his chums blocked all Bush's attempts to put a rein on Raines [the director of Fannie Mae].

Regulatory Mishaps

The government’s attempts to manage the mortgage market pumped money into housing.  This made home prices rise further than they would have without government meddling.

The government’s desire to increase the number of minority homeowners relaxed lending standards so that more loans went into default.  Fannie Mae and Freddie Mac, the two government agencies which were responsible for buying so many loans, racked up more than $150 billion in taxpayer losses, with more to come.

The New York Post reports that opinions differ on whether government meddling caused the “housing bubble” and the following economic collapse.  When addressing the 40th-anniversary breakfast of the Association for a Better New York, for example, Mayor Michael Bloomberg said, “It’s not the banks that created the mortgage crisis.  It was, plain and simple, Congress who forced everybody to go and give mortgages to people who were on the cusp …  They were the ones that pushed the banks to loan to everybody, and now we want to go vilify the banks because ... It’s easy to blame them.”

His predecessor, former Mayor Koch, said, “I want to see somebody ... punished criminally.  There’s something wrong with a kid who steals a bike going to jail and someone who steals millions paying a fine.”

Mayor Bloomberg is alluding to the government’s fining bankers who didn’t make enough loans to minorities.  When they ran out of qualified minorities, the banks lent to people who didn’t qualify and sold the riskiest loans.  This led to huge losses.  Mayor Koch, on the other hand, believes that crooked bankers bent the rules to sell bad loans to the government.

Human nature being what it is, both mayors are correct.  Yes, banks made riskier loans than they would have preferred to make because the government forced them to.  Logically enough, the banks eagerly sold those suspect loans to the government because the government was willing to buy them, and precisely because the banks knew these loans were a ticking time bomb.  Wouldn't you sell such loans if you could?

Once again, we see the hazards government created when it requires banks to make loans that didn't make economic sense and when it meddled in the housing market.  If you start a game of hot potato, don't be surprised if you wind up holding it yourself.

Will Offensicht is a staff writer for and an internationally published author by a different name.  Read other articles by Will Offensicht or other articles on Business.
Reader Comments

There is no question in my mind that the government is 100% responsible, the bankers only acted in their own self interests. Having said that there is also the human casualty that congress caused. The construction worker. Take a young man, fresh out of high school 10-15 years ago and an easy job to find was construction with little skills needed on the front end. Many of the guys became skilled in the trade and were making more money than they ever dreamed of but never realized that their job was artificially propped up by the egregious government policies. When the boom came to and end we find ourselves with nearly a generation of construction workers with no other skills and out of work. They could look until they were blue in the face for a job but could not find a comparable job wage-wise. This event has caused many family problems, divorces, bankruptcies, and a cost of unemployment pay that now lasts up to 99 weeks with that being forecast to be lengthened. This problem, like so many that the government causes when it sticks its nose into business and trying to regulate it, has unintended consequences that cause much more harm than even a fortune teller could foresee. I'm sure that they, congress, will pass more laws and regulations to insure that this WILL NEVER HAPPEN AGAIN. What a joke they are and we are to vote them into office.

November 16, 2011 11:54 AM

It has been said that Keating had no choice but to go the bribe route. He was backed into a corner both on the investigation angle and his land deals at the time. I recently read that had the investgations not started at all and the local land issues not been a problem, his $300 million resort think would have worked and S&L would have been a tremendous success. In fact, the land deal did eventually create a big profit for the people it was sold off to after the scandal. Keating's vision was correct. The fact that the bribed Senator had no punishment, and didn't even have to return the money, shows how stacked the cards were.

November 16, 2011 12:54 PM
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