Regulatory Reform Shouldn't Rely on the Fed

I am still shaking my head in amazement at Alan Greenspan’s editorial in last Wednesday’s Wall Street Journal titled The Fed Didn’t Cause the Housing Bubble. In the article Greenspan explained why the housing bubble wasn’t the Fed’s fault (and since he was Chairman of the Fed, by implication it wasn’t his fault either).

While Greenspan said monetary policy didn’t cause the current economic crisis, he conveniently ignored the Fed’s regulatory authority and whether or not better enforcement could have stopped the mortgage liquidity bubble before it inflated. The primary regulator of the banking system is the Fed which also has responsibility to maintain financial stability. Even if Greenspan is correct that it wasn’t monetary policy which caused the current crisis, he is still partially to blame because of the Fed’s regulatory complacency.

It is disappointing that Greenspan doesn’t accept personal responsibility for failing to ensure the safety and soundness of the banking system and doesn’t understand the connection between unsound banking practices and the housing bubble. As the Obama Administration works on regulatory reform, they should consider lowering regulatory reliance on the Fed; it is too much to ask one agency to be both the central banker and the primary regulator of the financial system. Unfortunately, I suspect that Obama and Geithner will go the other way and will concentrate more responsibility and authority in the Fed.

Even before regulatory reform, the Federal Reserve is the central regulatory player in the U.S. banking system. The Fed’s web site lists four primary duties for the Fed. The first of the Fed’s primary duties is to set monetary policy. However, two of the other three primary duties relate to its regulatory mission and controlling systemic risk. The below bullet points are from the Fed’s web site describing its two regulatory duties:

-Supervising and regulating banking institutions to ensure the safety and soundness of the nation’s banking and financial system and to protect the credit rights of consumers

-Maintaining the stability of the financial system and containing systemic risk that may arise in financial markets

Nowhere in Greenspan’s WSJ article does he discuss whether or not the Fed did its job of supervising and regulating banking institutions and their real estate lending activities. Conveniently, Greenspan never mentions whether the Fed considered inflated housing prices as a systemic menace. Of course, events of the last 24 months suggest that the Fed should have taken its regulatory responsibilities more seriously and that we are all paying the price for this failure.

The Fed could have changed history without modifying monetary policy if it chose to use its regulatory powers to ensure the safety and soundness of bank holding companies and their subsidiaries. The Fed could have also used its powers to restrict liquidity in CDO and other mortgage derivative instruments that fueled the housing bubble. Instead of standing by while bank holding company subsidiaries created and financed unsafe and unsound CDOs, the Fed could have set capital adequacy standards that would have required equity, and not debt, to pay for CDO and other mortgage derivative investments. And, the Fed could have told bank holding companies that they couldn’t do indirectly that which they couldn’t do directly; in other words no loans from bank holding companies or their subsidiaries to investors that wanted to buy mortgage derivatives at stupidly high leverage levels.

Greenspan had other authority to prick the sub-prime mortgage bubble as it inflated. The Fed could have enforced anti-fraud rules for mortgage brokers, mortgage bankers, banks and thrifts so that fraudulent sub-prime mortgage loans weren’t originated (or if they were originated, there was jail time involved for individuals that broke the rules). I am still shocked at the Fed’s July 2008 modification of mortgage rules that, among other things, made it a crime to originate “high rate” mortgage loans without regard to the borrower’s ability to pay and outlawed coercion of appraisers. Apparently, when Greenspan was Chairman of the Fed it was OK to coerce appraisers and to originate loans without any regard to the ability of the borrower to pay.

It is unbelievable that the Bernanke Fed still allows mortgage originators to coerce appraisers, just so long as the related loan isn’t a “high priced” mortgage loan. I am personally thrilled to know that since the mortgage on my house isn’t a “high priced” mortgage loan my lender can “pyramid” late fees and not apply payments I make on my mortgage on the date received without concern of violating Fed rules.

The Obama Administration is working on regulatory reform of the banking system and is leaning towards giving the Fed more regulatory responsibility. Unfortunately, that doesn’t seem like a good idea. While I think that the Fed fundamentally does a great job with monetary policy, I don’t think that the Fed has been effective in its regulatory role. It may just be too much to ask one agency to execute multiple missions that are often contradictory and require different skill sets.

As for Alan Greenspan, Winston Churchill summed it up the best when he said “The price of greatness is responsibility” and Greenspan sure doesn’t seem to be accepting responsibility for what took place during the last few years of his term.

Comments

[dcb:]

If you start to assume the Feds actions are intended to help out industry and the expense of the tax payer, then all the feds actions become easily understood. If you don't believe me, try it yourself. I used to try and figure these types of things out assuming the first basic assumption was true. If you assume it is false it's really very easy. Please feel free to ask any question, cause I'll have a very plausible answer that makes all the pieces fit together.

Mar 19 05:24 PM