Stimulus a Moral Hazard

, Heather Latham, Leave a comment

Still in the shadows of an already-in-progress bailout plan and a yet-to-be-passed stimulus package, Congress seriously considers what to do to protect the fragile economy and help it grow again. In hopes of finding an umbrella under which to wait out the storm, the U.S. Senate Committee on Homeland Security and Governmental Affairs, led by Chairman Joseph Lieberman (I-Conn.), invited three witnesses to a hearing on the financial crisis.

The first witness was Gene Dodaro, the Acting Comptroller General at the U.S. Government Accountability Office (GAO). Dodaro claimed that “the system’s outdated. It’s fragmented, and it’s ill-suited to meet the twenty-first century challenges.” He claims that there are four evidences of this: “First is that regulators have struggled and often failed to address the systemic risk of large, financial conglomerates…. The second major trend is the fact that the financial regulators have had to deal with now some of the problems that are being created by entities that have been less regulated…. The third main trend was the emergence of a wide variety of complex, financial products…. The other conclusion that we come to is there’s no one central entity that’s basically charged with looking at risk across the system.”

To fix the problem, Dodaro lists ten characteristics necessary for comprehensive reform.

• The goals and statutes of the regulatory system need to be clearly stated.
• The reform has to actually be comprehensive and close gaps in the regulatory system.
• There has to be a move to cover the financial products as well as the entities.
• The reform “has to be system-wide.”
• The reform “needs to be flexible and adaptable.”

• “We need to have an efficient system.”
• “There needs to be strong consumer protections.”
• There has to be more effort towards “financial literacy.”
• “We have to make sure that the regulators are independent, resourced properly…and give them necessary authority to move forward.
• “We need to protect the taxpayers.”

The next witness was Howell Jackson, James S. Reid Jr. Professor of Law, Harvard Law School. He names six areas the he believes need the most attention—all deal with more regulations:

• “The absence of a market stability regulator.”

• Congress needs to “create broad jurisdictional mandates” to give the regulators the power they need to do their job.
• The regulatory organizations need to have the appropriate experts to do the job.
• “Vulnerability of specialized regulatory agencies to the problem of regulatory capture.”
• Consumers need financial education to protect themselves from any imprudent business.
• There needs to be something that keeps companies from moving overseas to block regulations.

Jackson also calls for the government to look to other economies as models for the United States and use the financial crisis as a catalyst for change.

The third and final witness was Steven Davidoff, a professor of law at the University of Connecticut School of Law. Davidoff has his own ideas of what caused the financial crisis:

“In summary, historically low interest rates led to excessive borrowing by both individuals and financial institutions. The consequence was the rapid rise of housing prices. These prices were increased by demand from so-called sub-prime borrowers. During the period from 2000 to 2006, the amount of outstanding sub-prime mortgage debt grew an outstanding 801% to 732 billion. These loans were often issued and underwritten under the assumption that housing prices do not fall…it is now all too clear that in many instances, borrowers were placed into loans they cannot now afford. Theoretically, bankers should have been more concerned with whether their loan would be repaid…. Mortgages are now securitized into asset-backed facilities called Collateralized Debt Obligations, or CDOs, and sold into the market…. Many of these lenders, particularly for sub-prime mortgages, were non-bank lenders, subject to differing oversight and regulation than their bank counterparts…. In 2005… the SEC discarded the obligation of underwriters of CDOs to perform due diligence on these CDOs to confirm adequate loan documentation.”

In other words, the agencies were basically in charge of checking on themselves. Left to themselves, they created more and more problems that, in the end, the economy could not handle. Davidoff says, “I do not have time in my testimony to recommend solutions,” but in the conclusion of his written testimony, he provides a few answers.

• Congress needs to make a “flexible regulatory apparatus which can respond to the unknown perils and change of the future.”

• “Regulatory gaps and black holes should no longer grow and thrive.”

• “It is time for the Congress to create comprehensive regulators who can ably assess and economically regulate, if necessary, the entirety of the U.S. financial market.”

• “Financial regulators should be provided the tools to meet, and perhaps prevent, the next crisis.”

In each statement given by the witnesses—and in their responses to questions from the senators, the solution varies only slightly. Each carries a call for more regulations. They all support more involvement by the government in the market.

What they don’t talk about is how well that approach has fared in the past.

Heather Latham is an intern at the American Journalism Center, a training program run by Accuracy in Media and Accuracy in Academia.