October 16, 2021

Who will cast the first stone?

Who got us into this painful economic crisis? Polls show that most Americans blame the Republicans more than the Democrats, and the evidence supports this view. But are the Democrats so innocent that they may fairly cast the proverbial first stone?

The answer is “no,” and a close look at the origins of the crisis shows why. Let’s begin with the Clinton administration’s failure to regulate the markets for fancy financial derivatives.

The markets for derivatives – so called because they derive their value from something else, such as bonds, currency rates or stock market indexes – grew rapidly throughout the 1990s. In 1998, the head of the Commodities Futures Trading Commission was Brooksley Born, a Clinton appointee. She believed the new derivatives markets put the economy at risk: the markets were not transparent and traders did not have to put up collateral for settling deals gone bad. She wisely tried to begin a formal study of these markets, to examine whether new safeguards or regulations were needed.

An impressive combination of Democrats and Republicans opposed Born’s effort. Initial opposition came from Robert Rubin, Clinton’s Treasury Secretary and Arthur Levitt, Clinton’s Chairman of the Securities and Exchange Commission. When these people and others failed to stop Born, the Republican-controlled Congress, following the lead of Republican Sens. Richard Lugar and Phil Gramm, passed a law prohibiting the CFTC from examining the derivatives markets.

Over the next few years, housing prices rose and the derivatives markets grew rapidly. New derivatives called mortgage-backed securities – complex financial instruments based on the value of a bundle of mortgages – helped fuel the booming housing market.

In 2006, home values started to slump, leading to rising defaults on mortgage loans. This in turn drove down the market value of mortgage-backed securities of all types. In the following months, major financial institutions had to write down billions of dollars in the values of mortgage-backed securities. A routine slump in the housing market was turning into a full-blown economic crisis.

If Democrats and Republicans had supported Born’s 1998 initiative, we probably would not have avoided this economic crisis completely, but it’s likely that at the least we would have learned some valuable lessons a lot earlier.

Next, let’s examine Democrats’ and Republicans’ roles in a disastrous 2004 ruling by the Securities and Exchange Commission. For years, the SEC had regulated the amount of debt that the brokerage units of investment banks could take on. The biggest banks -Lehman Bros., Bear Stearns, Goldman Sachs and others – opposed this restriction: They wanted to borrow more so they could buy more earning assets. They vigorously lobbied the SEC for more permissive regulations and in April 2004 the SEC complied, voting unanimously for the desired changes.

After the SEC adopted the new regulations, the five big banks directly affected moved quickly. Bear Stearns increased its assets so rapidly that it soon had $33 of assets for every dollar of its capital. Because the banks’ new assets were, in large part, the very mortgage-backed securities that rapidly lost value after 2006, they soon were in serious trouble.

You know the rest of the story. Last March, Bear Stearns, on the verge of collapse, was taken over by JPMorgan Chase; later, Lehman Bros. declared bankruptcy. By late September none of the five big investment banks had survived in its previous form. Christopher Cox, the Bush-appointed SEC chairman, admitted that the new regulations had failed and abruptly suspended them.

Republicans on the commission and in Congress provided the intellectual rationale and the political firepower behind the 2004 rule modifications, but the two Democrats on the commission joined the three Republicans in voting for the changes. And, it seems, no prominent Democrat publicly opposed the changes. Clearly, both Democrats and Republicans were responsible for the 2004 bank deregulation.

These regulatory failures teach us some valuable lessons. First, the derivatives markets should be reformed; for starters, traders should have to put up collateral to settle bad deals. Second, banks should be required to hold substantial reserves to back up their holdings of derivatives.

And third, if you see a self-righteous Democrat about to cast that first stone, take a good look at his nose – it might be as long as Pinocchio’s.

Edwin Dean, an economist and seasonal resident of Vinalhaven, writes monthly about economic issues.

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