Barack Obama wants to tell a tale about turbulence in the financial markets, and like any good melodrama this story needs a villain. Sen. Obama believes he has found his mustache-twirling Snidely Whiplash in the person of Phil Gramm, the candid-to-a-fault former senator from Texas who presided over a major reform of American banking laws a decade ago. Obama here displays a signal failure to understand the convulsions in the markets. And he also fails to identify the guilty parties — which is odd, since some of them used to sign his paycheck back in his community-organizing days and others are among his most important political donors.
The Gramm-Leach-Bliley Act of 1999 passed the Senate with 90 votes (8 against, 1 absence: John McCain, who supported the legislation) and was signed into law by Bill Clinton. It had little to do with the issues at play in the current crisis: lending standards and the amount of debt banks can take on relative to their equity. The upshot of the Gramm legislation is that it allows financial services companies to diversify their lines of business: Commercial banks can engage in investment banking, banks can offer brokerage services, and you can have an IRA at the same place you have your checking account.
What we have here is a case of what economist Paul H. Rubin calls “folk economics” — value-laden myths that do not reflect financial realities.
It is not at all clear what, if anything, Gramm’s legislation has to do with the current difficulties in the market, other than the fact that Democrats instinctively recoil when they hear the word “deregulation.”
Gramm-Leach-Bliley did not create securitization and collateralized debt obligations. It did not change the rules for banks’ leverage ratios. If anything, Gramm-Leach-Bliley mitigated some risks by allowing financial companies to diversify their businesses, and it is the most diversified firms that are best weathering the storm. Which makes sense: An investment portfolio is more stable the more diversified it is. The firms that have spectacularly imploded have mostly been non-diversified commercial banks, like Countrywide, or pure investment banks, like Lehman Brothers. But the broadly diversified megabanks are enduring — taking a hit from housing, sure, but they have other lines of business to sustain them. And we should not forget: Without the Gramm-Leach-Bliley reforms, Bank of America would have been legally forbidden to take over Merrill Lynch — very possibly leaving taxpayers on the hook for that one, too. Morgan would not have been able to buy Bear Stearns without Gramm’s reforms.
Much more problematic than Gramm-Leach-Bliley is the Community Reinvestment Act, a bit of legislative arm-twisting much beloved by Sen. Obama and his fellow Democrats. One of the reasons so many bad mortgage loans were made in the first place is that Barack Obama’s celebrated community organizers make their careers out of forcing banks to do so. ACORN, for which Obama worked, is one of many left-wing organizations that spent decades pressuring banks and bank regulators to do more to make mortgages available to people without much in the way of income, assets, or credit. These campaigns often were couched in racially inflammatory terms. The result was the Community Reinvestment Act. The CRA empowers the FDIC and other banking regulators to punish those banks which do not lend to the poor and minorities at the level that Obama’s fellow community organizers would like. Among other things, mergers and acquisitions can be blocked if CRA inquisitors are not satisfied that their demands — which are political demands — have been met. There is a name for loans made to people who do not have the credit, assets, income, or down payment to qualify for a normal mortgage: subprime.
The bankers cannot blame CRA entirely; they made a lot of bad bets on rising home prices. But CRA did influence lending standards across the banking industry, even in those institutions that are not strictly liable to its jurisdiction. The subprime debacle is in no trivial part the result of lending decisions in which political extortion trumped businesses’ normal bottom-line concerns.
Along with these bad loans, the underlying problem is that there was a bubble in the price of housing — a bubble caused in no small part by politics, in the form of an easy-money/easy-credit policy from the Fed.
It was politics, too, that created Fannie Mae and Freddie Mac, enabled them to dominate the mortgage market, and implicitly took upon American taxpayers the risks of those business while the rewards were enjoyed, to the tune of hundreds of millions of dollars, by largely Democratic political opportunists, who then gave generously to Democrats, the top recipients of their largesse being: Chris Dodd, Hillary Rodham Clinton, John Kerry, and Barack Obama. And it was politics that unwisely nationalized Fannie and Freddie without resolving the underlying moral hazard — private profit, public risk — that makes those institutions problematic. From this Senator Obama takes away the lesson that there has been a failure of the market, and that what is needed is more politics. In this analysis Obama is as wrong as it is possible to be.
The only reason there are returns on investments is that there is risk involved. Obama talks as though the government can create new regulations that will remove risk from the markets. It cannot. Investors sometimes make bad decisions. Businesses sometimes borrow too much money. “Some of these investment banks look like hedge funds, they’re so leveraged,” says one longtime Wall Street hand. But the markets are addressing that problem, too, in their own brutally Darwinian way: That’s why Bank of America is acquiring Merrill Lynch on the cheap.
Phil Gramm is a fine foil for Obama: a conservative Texan with a furry accent and an unsympathetic demeanor. He’s the perfect symbol — and Obama’s campaign is rooted in nothing but symbolism. The reality is the thousands of dollars in donations from Fannie Mae executives sitting in Obama’s campaign coffers. If Obama wants a villain, he doesn’t have far to look.
Editor’s note: This editorial has been amended since posting.