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The Antecedents to 2008

During the past 200 years, there have been 16 credit crises in the United States, all marked by speculative excesses in the years immediately preceding. Following the 1907 and early 1930s crises, the Congress undertook substantial reform of the financial services industry. Again it is time for substantial regulatory/supervisory change. Recall that beginning in the late 1970s, there began a period of deregulation of financial services in the United States. Much good came in lowering costs and inconvenience, but it came with greater risk taking and less disciplined behavior. No longer did a lender need to carry a loan on its own books, but could securitize it and capture fat front-end fees and not have to worry if the borrower paid. Self-regulation and market discipline, frequently quixotic, cannot stem the type of systemic risk we have recently experienced.

The Reform Needed

As the ultimate safeguard to stem a financial panic, the government should have in place the apparatus that will allow it to curtail speculative excesses in advance of their triggering a financial panic. “An ounce of prevention is worth a pound of cure,” if you will. A number of things are in order. Regulatory authorities dealing with the financial services industry broadly defined should be consolidated. There are too many of them, often with conflicting objectives, and competition among them—relics of the past. More specifically, I would have the Securities and Exchange Commission responsible only for disclosure of information to investors on new and existing securities, together with oversight of mutual funds. No regulation of investment banks and others, for which it has proven to be inept. The FDIC should continue its present role, as should the Fed under its now expanded mandate.

I would consolidate all other regulatory agencies into a new agency with broad powers to regulate investment banks, insurance companies, mortgage companies, hedge funds, finance companies, thrifts, credit unions, commodity firms, brokerage firms, prime brokers, derivative and futures markets dealers, and banks not regulated by the Fed and FDIC. Any U.S. or foreign financial institution that operates in U.S. financial markets would fall under the agency’s purview. For other than depository institutions, however, I would establish size thresholds for inclusion in regulatory oversight; say, above $10 billion in assets and/or $40 billion in derivative positions (notional amount) for a single institution or collective institutions under interlocking ownership. Supervisory and regulatory oversight would embrace asset quality, leverage, and counterparty risk, as well as overall risk with full power of the agency to curtail overly risky activities. The governing board should be independent and appointed by the Congress and the president for, say, 10-year terms on a staggered basis.

As part of the change, a new department should be established to facilitate workouts for mortgages and other loans. Presently many loans have been securitized with legal impediments to workouts. Efficiently managed workouts benefit both the borrower, in reducing payment outlays, and the lender, in not having to charge off as much of the loan. While many other worthwhile changes are possible, I will mention only three. 1) Restore the uptick rule, where short sales can be consummated only upon a rise in security price. This is a better remedy than periodically freezing short sales. 2) Require loan originators to retain a small portion, say 5 to 7 percent, of loans that are securitized. This creates a discipline that otherwise does not occur. 3) Have credit-rating agencies paid by the government from fees collected by the government from security issuers. This move will result in more objectivity and align the incentives of the rating agencies with investors.

Social Allocation of Capital

Finally, the method by which the capital is socially allocated is a matter of concern. Fannie Mae and Freddie Mac were actively pressured by the Congress and the Department of Housing and Urban Development to promote housing ownership through low/no down payment and deferred interest types of mortgages. Seemingly there is no cost, as long as the government’s implicit guarantee of these agencies does not occur. When it did in 2008, the cost is huge. A more efficient method for socially allocating capital is for the government to pay an interest-rate and/or principal subsidy to the lender or to the borrower for certain types of socially desirable loans. In this manner, the lender receives the market clearing rate of interest while the borrower pays this rate minus the subsidy. The cost of socially allocating capital is recognized up front and the allocation of capital in society is more efficient.

A Closing Thought

While not a complete or comprehensive set of reforms, I believe the proposals outlined above would do much to reduce systemic risk in the financial services industry and save taxpayers much in the process.

James VanHorne, A.P. Giannini Professor of Banking and Finance, Emeritus
Note:
Below are listed the credit crises in the United States during the past 200 years by year in which they (approximately) began and/or peaked.  There is no beginning/peak in the 1930s, as there were several.  During the War of 1812 there was a credit crisis of sorts. However, it was not occasioned by speculative excesses in the years preceding but rather by the British occupying Washington and I have chosen not to include it. The classifications are partially subjective on my part – particularly with respect to the exact year in which a crisis occurred.

The credit crises by year are: 1819; 1837; 1857; 1873; 1893; 1907; 1919; 1930s; 1949; 1958; 1970; 1974; 1981; 1991; 2002; 2008.

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Also on Stanford Knowledgebase:

  1. Q&A: Stanford financial economist Darrell Duffie discusses government takeover of Fannie Mae and Freddie Mac
  2. Achieving Financial Stability
  3. Incentives and the Financial Crisis

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