And the Walls Came Tumbling Down: Deregulation & the Current Financial Crisis

I. Introduction

While intellectuals, economists, bankers, and pundits try to explain the ins and outs of the economic downturn we are currently facing, many on "main street" are asking "what happened to make my 401k retirement savings account diminish so much in value since I looked at it in August?" The fact is that many hard working individuals have no idea what happened to cause the global economic downturn we are currently facing, and the explanations being put forth by most media outlets simply do not make sense to many people.

In trying to understand the situation, there are without question many factors that played a role. Trying to identify one overwhelming factor would be futile, however, this article will look specifically at the role deregulation played in the financial crisis.

II. Deregulation

Deregulation has received a lot of the blame for the current crisis. [1] Deregulation can be defined loosely as the removal of regulatory barriers to permit free markets to perform their functions. The deregulation movement that we currently have in the United States began in the late 1970s under the Jimmy Carter administration. [2] With the notion that less government intervention allowed the market to do what it was supposed to and foster more growth, deregulation spread from the Airline Deregulation Act of 1978 to telecommunications, and later banking and financial markets. [3] Many now say the consequence of allowing the financial markets to go unregulated was the impetus for the current financial crisis. [4]

III. The Deregulation of Savings and Loans

The last major deregulation related crisis in the United States stemmed from the savings and loans collapse that started in 1966. [5] In the 1960s, there was a lot of volatility in interest rates. [6] Back then, depositors with funds in savings and loans institutions at the time would withdraw their cash whenever interest rates went up, in order to maximize their returns by putting the cash in higher interest investment vehicles. [7] Because interest rate ceilings prevented savings and loan organizations from increasing their interest rates, and other regulations limited their business prospects to granting home mortgages and accepting deposits, the savings and loans industry could not compete with other financial services institutions. [8] In 1979, Paul Volcker, the then Federal Reserve Board chairman, decided to restrict money supply which in turn caused interest rates to increase significantly, resulting in losses of approximately $9 billion for the savings and loans industry in 1981 and 1982. [9]

Subsequently, congress enacted legislation to prevent shutting down the savings and loan industry, including the Depository Institutions Deregulation and Monetary Control Act (DIDMCA), [10] and the Economic Tax Recovery Act of 1981 (ETRA). [11] Under DIDMCA, substantial regulatory requirements for savings and loans organizations were eliminated. The statute made savings and loans similar to any other depository institution, allowing them to make real estate loans without regard to location, and invest directly in corporations. [12] The ETRA further gave substantial incentives to individual taxpayers for real estate investment, permitting individuals to seek loans from whatever institution would be willing to make the loans. For instance, Section 123 of ETRA increased the one time exclusion for an individual who had attained the age of 55 from $100,000 to $125,000. [13] Considering the situation that the savings and loan industry was in, it made sense that they would lend to anyone that came into their doors to stop the bleeding. The Garn-St Germain Depository Act of 1982 was the final step in the deregulation of savings and loan organizations. [14] The act essentially completed the process of deregulating the savings and loan industry by allowing such institutions to invest in commercial, corporate, business or agricultural loans and loans secured by personal property and non-residential real estate. [15]

Even with all the deregulation, the savings and loan industry still was unable to compete. This failure to compete resulted in aggressive lending and riskier investments, all of which led to mounting losses in the industry. From 1982 through 1989 when regulation was once again infused into the savings and loan industry by a government bailout, many savings and loan organizations had gone under, and many more were unprofitable. [16] Estimates of the cost of the savings and loans crisis vary from expert to expert. However, according to the Federal Deposit Insurance Corporation, the cost to taxpayers was $124 billion, with another $29 billion borne by the thrift industry. [17]

IV. The Deregulation of Banks and Financial Institutions

Fast forward two decades to 1999, when president Clinton signed another act of deregulation, the Gramm-Leach-Bliley Act of 1999 (GLBA). [18] The GLBA repealed the parts of the Glass-Steagall Act of 1933, passed during the Great Depression era, that prevented investment banks from offering commercial banking and insurance services. [19] With limited regulation, banks and other lending institutions began to offer high risk mortgage-backed securities. Mortgage-backed securities are "debt obligations that represent claims to the cash flows from pools of mortgage loans, most commonly on residential property."[20] Individual mortgage loans are purchased from banks and other loan originators and bundled into pools by mostly private entities. [21] These entities then issue securities that represent the principal and interest payments on the home mortgages, and sell them to investors. [22] The principal and monthly payments from the home owners are paid to the financial institution that created the mortgage-backed security, and the thousands of investors that buy the securities are paid from the mortgage receipts.

In highly simplified terms, a large portion of current mortgage crisis can be traced to these mortgage-backed securities. With home prices rising over the last several years, banks were making high risk, unsecured loans to individuals who simply could not afford to pay them back. With the advent of adjustable rate mortgages and sub-prime loans, individuals with a less than stellar credit history were allowed to purchase homes that were far beyond their economic reach. An adjustable rate mortgage is a loan whose rates will change. [23] Lenders give a prospective buyer an introductory rate that is fixed for a period of time, ranging from six months to five years. After the fixed period, the interest rate will change, sometimes significantly, and many homeowners are then unable to handle the revised payments. Similarly, a sub-prime loan is one offered above prime rates. [24] Homeowners that cannot qualify for prime rate loans, typically borrowers with low credit scores, or ones with a limited credit history, were the targets for sub-prime loans. [25] Over the last several years, mortgage-backed securities were increasingly made up of mostly these high risk sub-prime and adjustable rate mortgages. [26] Because these mortgage-backed securities are essentially spreading the risk of a default over thousands of investors, such that one default would have little impact on the security, they were considered a minimal risk, high reward investment, and increasingly purchased and sold all over the world.

Further, banks and other financial institutions were willing to make these loans because of the substantial increases in home prices over the last decade. The prevailing logic was that if a few homeowners were unable to pay the loans when the adjustable rate mortgages reset to a higher rate, or subprime lenders simply could not afford the homes anymore, then the homes would have appreciated in value sufficiently enough that the mortgagor could foreclose on the home with the expectation of being able to sell the property at an increased price. However, when home prices began to fall and the Federal Reserve Board began to raise interest rates in 2006, the once vaulted mortgage-backed securities fell into disfavor with investors. When interest rates are low and housing prices are rising, mortgage-backed securities are generally a safe investment. [27] However, when the opposite happens, financial institutions receive less money to honor the products' obligations with a fixed return product such as a morgage-backed security. [28] Further, when financial institutions have heavily leveraged to purchase these mortgage-backed securities, they feel the pinch from both ends. [29] They are unable to make payments on the loans taken to purchase the securities, and they are required to pay the purchasors of said securities based on the terms of purchase.

V. The Consequences

The general consequences of deregulation of banks and the financial services industry, and specifically of failed mortgage-backed securities are far reaching. The federal government has had to nationalize financial giants Fannie Mae and Freddie Mac, which owned a combined $5.4 trillion in mortgage-backed securities. [30] In addition, the Emergency Economic Stabilization Act of 2008, better known as the $700 billion bailout bill, will more than likely exceed the $1 trillion dollar mark when the economic clean-up is all is said and done. [31]

VI. Conclusion

While deregulation is surely not the cause of the financial crisis the country is currently facing, it would be irrational to say that it did not play a part. However, one cannot discount the fact that if consumers did not bite of more than they could chew by borrowing money for homes they absolutely knew they could not afford, and financial executives did not create designer products that they had to knew would someday go up in smoke, we would not have to look to other causes to validate the mess we are currently in.

Sources

[1]See e.g. James Ridgeway, Its the Deregulation Stupid, Mother Jones, Mar. 28, 2008, available at http://www.motherjones.com/commentary/columns/2008/03/deregulation-economic-crisis.html; Michael Mandel, 30-Year Deregulation Era Dies a Sudden Death, BusinessWeek, Sept. 18, 2008, available at http://www.msnbc.msn.com/id/26774653/.

[2] Mandel, supra note 1.

[3] Id.

[4] See e.g. Ridgeway, supra note 1; Mandel, supra note 1. See also Robert Kuttner, Seven Deadly Sins of Deregulation… and Three Necessary Reforms, The Am. Prospect, Sept. 17, 2008, available at http://www.prospect.org/cs/articles?article=seven_deadly_sins_of_deregulation_and_three_necessary_reforms.

[5] Federal Deposit Insurance Corporation, The S&L Crisis: A Chrono_Bibliography, http://www.fdic.gov/bank/historical/s&l/ (last visited Nov. 7, 2008) [hereinafter FDIC].

[6] Id.

[7] Id.

[8] Id.

[9] Bert Ely, Savings and Loan Crisis, Libr. of Econ. and Liberty, http://www.econlib.org/library/Enc/SavingsandLoanCrisis.html (last visited, Nov. 9, 2008).

[10] Depository Institutions Deregulation and Monetary Control Act of 1980, Pub.L. No. 96-221, 94 Stat. 132 (1980).

[11] Economic Tax Recovery Act of 1981, Pub.L. No. 97-34, 95 Stat. 132 (1981).

[12] FDIC, supra note 6; Ely, supra note 10.

[13] 95 Stat. 132.

[14] Garn-St. Germain Depository Act of 1982, Pub.L. No. 97-320, 96 Stat. 1469 (1982).

[15] Ahmad W. Salam, Congress, Regulators, RAP, and the Savings and Loan Debacle, C.P.A. J., Jan. 1994, available at http://www.nysscpa.org/cpajournal/old/14979917.htm.

[16] Timothy Curry & Lynn Shibut, The Cost of the Savings and Loans Crisis: Truth and Consequences, FDIC Banking Review, www.fdic.gov/bank/analytical/banking/2000dec/brv13n2_2.pdf.

[17] Id.

[18] Gramm-Leach-Bliley Act of 1999, Pub.L. No. 106-102, 113 Stat. 1338 (1999).

[19] David Leonhardt, Washington's Invisible Hand, N.Y. Times, Sept. 26, 2008, available at http://www.nytimes.com/2008/09/28/magazine/28wwln-reconsider.html?ref=business.

[20] U.S. Securities and Exchange Commission, Mortgage Backed Securities, http://www.sec.gov/answers/mortgagesecurities.htm (last visited Nov. 9, 2008).

[21] Id.

[22] Id.

[23] The Federal Reserve Board, Adjustable Rate Mortgages, http://www.federalreserve.gov/pubs/arms/arms_english.htm (last visited Nov. 9, 2008).

[24] Investopedia, Subprime Loan, http://www.investopedia.com/terms/s/subprimeloan.asp (last visited, Nov. 9, 2008).

[25] Id.

[26] Renae Merle, Resets Peaking on Subprime Loans: Jumping Payments Raise Foreclosure Projections, Wash. Post, July 1, 2008, available at http://www.washingtonpost.com/wp-dyn/content/article/2008/06/30/AR2008063001848.html.

[27] Chris Wilson, What is a Mortgage-Backed Security? The Financial Instrument That Destroyed Bear Sterns, Slate, Mar. 17, 2008. http://www.slate.com/id/2186801/.

[28] Id.

[29] Id.

[30] Liz Peek, Financial Crisis Winners and Losers, N.Y. Sun, Sept. 23, 2008, available at http://www.nysun.com/business/financial-crisis-winners-and-losers/86401/.

[31] Emergency Economic Stabilization Act of 2008, Pub.L. No. 110-343,122 Stat. 3765 (2008).

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