Monday, December 22, 2008

Continuation of Prior Post from Last Night: 2004 SEC Rule Change

Continuing my discussion from last night, Accurate Information is Not a Side to an Issue/ W & the Housing Crisis/Lying Works In Politics, the Democrats had the power to stop changes in the existing laws for the past two years. They did not have the power to enact their own economic policies or alter the course of the policies enacted during the first six years of Bush's Presidency.

Thus, the Democrats could effectively block any new effective regulations for the GSEs (Fannie and Freddie) which they did do, but could not materially change the tax code, for example, in a manner disfavored by W and the Senate Republicans.

Moreover, many of the changes advocated by the Republican party had some Democratic support, with the most damaging to the world economies being the reversal of financial regulations that had been based on prudence and a realistic assessment of human frailties, many arising from the lessons learned during the Great Depression. 

I discussed earlier what I call the seminal event in the current credit meltdown, which I identified as the SEC rule change that removed the limitations on the amount of leverage investment banks could add to their balance sheets. While Chris Cox deserves a lot of blame for what has happened over the past 3 years. THIS IS A CRASH, he was not even at the SEC when this rule change was made, although some place him there at the time.  No, the Chairman of the SEC in 2004 was Donaldson, a Clinton Democrat, and the Clinton Democrats still had 3 SEC Commissioners who could have block the rule change if all had voted no. The vote however was 5 to 0 to revoke the rule limiting leverage to 12 to 1 against equity US SEC Clears New Net-Capital Rules For Brokerages - 04/28/2004

I discussed this rule change in this post: Marsha Blackburn and the Bailout  (also, while at Goldman, Paulson lobbied for this rule change: GOLDMAN SACH'S FORECAST/ALEX THE PARROT ). 

One SEC commissioner who voted for the rule change made the following observation: 
"If anything goes wrong, it's going to be an awfully big mess." US SEC Clears New Net-Capital Rules For Brokerages - 04/28/2004

Yes, it would be an awfully big mess.

Subsequently, it took the investment banks, loading up on leverage sometimes exceeding 40 to 1 debt to equity, a mere three years to blow themselves up, with a great deal of the leverage used to fund the expansion of the subprime and Alt-A mortgage mess. (think of it this way, if you borrow 40 dollars for each dollar of equity, a 3% wipe out in the investments bought with the excess leverage would destroy the firm's equity)

The Clinton Democrats had bought into the Reagan philosophy, that any regulation of human behavior was bad and actually interfered with economic growth. Sure, a rule like no more than 12 to 1 leverage would limit growth fueled by excessive leverage, but it was a prudent rule designed to prevent the greedy from endangering the entire economic system in pursuit of their narrow self interest. A great deal of the growth in the U.S. economy during the first two years of Bush's second term had nothing to do with his tax policies, but the use and abuse of easy credit and excessive leverage to fund growth.

In summary, the Reagan philosophy of little or no regulations is a prescription for economic disaster and fails to take into account the basic personality traits of human beings-the undesirable ones.  

One basic rule is that greed will always trump common sense. Another rule is that the big financial institutions are incapable of policing themselves. Yet another rule is that easy credit and excessive leverage will distort price.

The lack of appropriate credit standards and regulations fueled increases in housing prices far beyond what would have occurred without easy credit. Thus, prices did not reflect economic reality and the abnormal prices were often being paid by those who could not afford to service the debt. Particularly in the last two years of the easy credit fueled housing bubble, home prices rose way above what people could afford to pay based on their incomes, and those unrealistic increases in price were fueled by easy credit. The housing crisis would not have occurred without the existence of the easy credit fuel.