A Lesson Unlearned


At several points during his Monday sermon to Wall Street, President Obama referred to the “lessons we’ve learned” from the financial crisis. But to judge from the speech, it’s clear that he failed to learn the most important lesson: Regulations, no matter how well designed, cannot prevent the formation of speculative bubbles — particularly those inflated by government policies.

More often than not, regulations cannot keep pace with financial innovation. Obama argued that credit-default swaps need to be regulated and that banks should have stronger capital requirements. The reality is that banks used credit-default swaps to get around their existing capital requirements. A credit-default swap is like insurance on a debt, and regulators allowed banks with insured debts to operate with less capital. Regulate swaps, raise capital requirements, and watch banks invent another way to evade these regulations. There is too much money at stake.

The only effective check against excessive risk-taking in the market is the prospect of failure and financial loss. The current crisis was fueled in no small part by government policies that insulated key players in the housing market from risk. Fannie Mae and Freddie Mac, which together owned or guaranteed half of the mortgages in the country, operated with the implicit understanding that the government would rescue them if they collapsed. This understanding gave them access to easy credit, which allowed them to grow dangerously overleveraged.

On the lending side, government officials — Republicans and Democrats alike — urged banks to loosen their underwriting standards in the name of expanding home ownership, even to those who weren’t prepared for the responsibility. This race to the bottom of underwriting standards started with Fannie and Freddie but came to include all banks, thanks in part to initiatives such as the Community Reinvestment Act, which gave regulators the power to push banks to increase mortgage lending to low-income borrowers. A loose monetary policy from 2002 to 2005 lured investors looking for a good return into seemingly safe mortgage-backed securities. Investors, banks, and borrowers bet big that home prices would always go up.

Unsurprisingly, this is not the narrative Obama presented in his speech. According to Obama, a big reason for the housing crisis is that “millions of Americans . . . signed contracts they didn’t fully understand, offered by lenders who didn’t always tell the truth.” The centerpiece of Obama’s regulatory overhaul — the creation of a Consumer Financial Protection Agency (CFPA) — would allegedly prevent this kind of mass deception from happening again.

In theory, the CFPA would protect Americans from “contracts designed to be unintelligible, hidden fees . . . and financial penalties.” (Could they begin by reviewing Obama’s health-care plan?) In reality, the agency would have a chilling effect on financial innovation, reducing choice in the name of protecting consumers. Responsible borrowers would see their options curtailed — to what benefit? Does anyone seriously think this would prevent fools from parting with their money?

Fittingly, the real reason left-wing groups like ACORN are pushing for the CFPA goes back to the Community Reinvestment Act, and to the origins of the crisis. The legislation creating the CFPA, drafted by Barney Frank and Chris Dodd, would transfer authority over Community Reinvestment Act enforcement from the FDIC and the Fed to the CFPA. The FDIC and the Fed have proven imperfect regulators, far too vulnerable to political pressure for expanding home ownership — but, unlike the CFPA, each has a mandate to ensure the safety and soundness of the banking system. The new agency would have broad authority to define “unfair” or “abusive” lending practices, and the power to pressure banks to lower their lending standards, but no regulatory mandate to police safety and soundness. That is not a recipe for stability. Thinking of charging low-income borrowers a higher interest rate to offset the higher risk? You can’t — that would be “abusive” — but you may still have to make the loan.

Obama also called for a “resolution authority” for large, non-bank financial firms. We have supported this idea in the past as an alternative to bailouts. The unfortunate fact of the matter is that the bailouts have dulled Wall Street to the prospect of failure and created a level of moral hazard that calls for a strong corrective. Policymakers need a credible alternative to bailouts that requires all stakeholders in a collapsing giant — not just stockholders and taxpayers — to bear losses, and one that results in the orderly dissolution of the firm.

When Obama says we need to put an end to the idea of “too big to fail,” we wholeheartedly agree. But on the matter of resolution authority, his speech was lacking details, and we definitely don’t trust Dr. Obamacare to get the details right. We’ll reserve judgment and keep a close eye on the legislation as it develops. As far as Obama’s overall approach to regulation, our judgment already is in: For all Obama’s talk of lessons, the collapse of the government-engineered housing bubble appears to have taught him nothing.