An overlooked element of the financial crisis: To err is human
The 10-year anniversary this week of the failure of Lehman Brothers has prompted an outpouring of articles and op-eds on what went wrong, what might have happened if the Federal Reserve had decided to rescue Lehman, and what has changed in the interim to make the financial system safer.
A vast chasm still exists among the views of what caused the 2008 financial crisis, from a “devastating failure of the free market,” to inadequate regulation of bank and non-bank lenders, to credit-rating agencies that glossed over the risks in collateralized mortgage obligations, to a fundamental “policy problem,” with inappropriate housing subsidies creating incentives for home ownership. An inadequately capitalized banking system converted what would have been an institutional failure into a systemic one, exposing the taxpayer to enormous potential risk.
At the time, regulatory failure seemed to be the predominant view, which led to the enactment of the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act. But what if the failure was human: a failure of regulators, not regulations?
Remember Ninja loans? No income, no job, no assets. And no verification on the part of the lender, which is the only reason many of the subprime loans could have been made.
Mortgage fraud was, and is, a federal crime. If an applicant is found to have knowingly misstated, misrepresented or omitted information about income, assets, debt or the value of real estate on a mortgage application, it is punishable by time in prison, a fine or both.
Mortgage lenders took a lot of heat after the housing bubble burst for preying on innocent victims, pitching adjustable-rate mortgages to unsuspecting or uneducated borrowers. Once the rate adjusted, the loan turned out to be unaffordable. (Maybe it was unaffordable to begin with.)
But borrowers were hardly innocent bystanders. They were eager participants in mortgage lenders’ race to the bottom. Homeownership is a major responsibility, emotionally as well as financially. Lenders might have taken advantage of unknowing borrowers, but the onus was on the borrower to understand what he was signing on to before plunking down a modest down-payment and assuming tens or hundreds of thousands of dollars in debt.
This was party time. And those who should have been actively reining in fraudulent lending chose to look the other way.
The Fraud Enforcement and Recovery Act of 2009 may have enhanced criminal enforcement of federal fraud laws, but it did not create them. They were there if the authorities had chosen to act on them and, in so doing, set an example, demonstrating the potential consequences for lying on a mortgage application — for both borrower and lender alike.
Before the 2008 financial crisis, the Office of the Comptroller of the Currency, the main regulator for nationally chartered banks, had 60 to 70 regulators embedded in each of the big banks at all times. The Federal Reserve, with oversight of state-chartered banks and bank holding companies, had about half that number at the banks it supervised. These regulators were resident supervisors. They went to work at their assigned bank each day and sat at an assigned desk among bankers, traders and salespeople.
What were all those regulators doing while bad debt exploded and credit risk filtered through the entire financial system? Probably joking and swapping stories with the salesman sitting at the next desk selling CDOs, maybe going out for a few beers after work. Our regulator starts to envision himself in the salesman’s seat, doing the salesman’s job, earning the salesman’s paycheck instead of his measly government salary. So he closes his eyes to the hanky-panky that is going on in broad daylight.
There’s a name for what happened. It’s called regulatory capture, and it means just what the name implies. Regulators become sympathetic to those they are supposed to be regulating, losing sight of their actual function.
Granted, some of the financial chicanery was going on in the accounting department, but regulators have access to the information they need to fulfill their supervisory and regulatory responsibilities. All they have to do is ask.
My point is that there were plenty of regulations already in place if regulators had chosen to take advantage of them.
That they didn’t is a failure of human nature, not the regulations themselves. The rush to enact new and more onerous regulations ignores this simple fact. The onus is on the regulator to make sure his charges play by the rules.
Macroprudential regulation, which seeks to limit systemic risk, became the watchword for central bankers and regulators after the 2008 financial crisis. It sounds nice, but you need macroprudential regulators in order to achieve the desired result.
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