Phil Gramm Strikes Back!

GLB repealed part of the Great Depression era Glass-Steagall Act, and allowed banks, securities companies and insurance companies to affiliate under a Financial Services Holding Company. It seems clear that if GLB was the problem, the crisis would have been expected to have originated in Europe where they never had Glass-Steagall requirements to begin with. Also, the financial firms that failed in this crisis, like Lehman, were the least diversified and the ones that survived, like J.P. Morgan, were the most diversified.

Gramm has some valid points in the above, and in general. Why didn't Europe originate the crisis? And indeed, the major difference seems to be the semi-official "right to homeownership" policy that has prevailed in the US since the Great Depression. No such presumed right exists in Europe. France recently even rejected a mortgage interest deduction, rightfully calling it biased against renters. On housing, we've out-socialisted France!

However, Gramm conveniently ignores the fact that banks are perhaps even more leveraged in Europe (and the UK) than the US, and they are still reckoning with the horrible results of that. One would think he would bring this obvious point up as a key contributor to the mess.

Of course, Glass-Steagall didn't say anything about leverage, so it is invisible to Gramm! This brings us back to our argument we've been pushing as long as this web site has existed: the biggest problem was the gradual erosion of reserve requirements in the banking system, allowing more and more gross leverage, and hence systemic risk.

Who regulates these capital requirements? That would be the Fed. Indeed, Gramm comes back to the Fed in his next paragraph:

Moreover, GLB didn't deregulate anything. It established the Federal Reserve as a superregulator, overseeing all Financial Services Holding Companies. All activities of financial institutions continued to be regulated on a functional basis by the regulators that had regulated those activities prior to GLB.

But Gramm doesn't finish connecting the dots -- one of the key fouls of the Greenspan Fed was vocally advocating ARMs in 2004, at the (then) historical interest rate low. Greenspan all but jeered at holders of traditional 30-year-fixed mortgages. At the same time, Fannie and Freddie were (rightfully) being restricted due to their accounting scandals. Combine the two factors, and it is easy to see why the private sector took off with all maner of unsound "affordability loans" -- subprime and otherwise.

Note also that Gramm does not mention that the CRA arguments don't apply to "rich people" unsound loans, like Pay Option ARMs. Together all the unsound affordability loans added up to almost 50% of lending at the end of 2006 -- much more than subprime's 20%. Neither does he explain how if the CRA per se was such a huge cause of the bubble, when it didn't really take off until 2004.

Again, Gramm fails to finish the thought regarding the Fed: if GLB gave the Fed more regulatory authority, and it was even in the Fed's authority to regulate subprime (as Barney Frank has harped on), then doesn't the Fed deserve more blame in this debacle? Don't they deserve more blame for apparently setting off the free-for-all of leveraged housing loans in 2004? And if so, why are we turning to this failed financial politburo to fix the system now?

Gramm also valiantly takes on the Commodity Futures Modernization Act, which closed the door to the CFTC regulating credit default swaps (CDS). He rightly points out that it doesn't make sense to have the CFTC regulate CDS. But the answer to that isn't to have no one regulate them (not even self-regulation by the industry!) Derivatives are insurance, and must be handled accordingly -- or at least be traded on a properly-capitalized and margined exchange. The CFMA was a great non sequitur as far as derivatives go. It was clear the approach of Gramm and his buddies was to cut off all possibility of regulating derivatives -- not to substitute a bad idea for that regulation with something else.

Gramm's final argument on this topic -- that the derivatives market has "performed well so far" -- is one of the most ludicrous, delusional and self-apologetic arguments I've ever seen come from a politician. The impact on the market has been a disaster (catastrophic deleveraging and stock market crash, much?) Further, to the extent things are still holding together at all, there seems to be an unprecedented reliance on public authorities to provide the scotch tape and bailing wire of cash injections and loan guarantees to make it happen. This is hardly a "success" for the market or its prior regulatory regime.

Gramm then worries about "politization" of banking. Well, there sure hasn't seemed to be much risk of that so far, with no real restrictions put on the companies receiving tens or hundreds of billions in bailouts, no supervision or even transparency of the lending and guarantees, and generous deals for the banks on equity stakes with no taxpayer control. The concern for insolvent institutions is misplaced, except that we should not be intervening by unduly extending their existence and making it harder for sound institutions to compete.

Gramm does a fine job of illustrating that he personally was not the culprit of the current mess (as has become popular left-wing mythology), but his attitude regarding regulation and moral hazard was obviously negligent. His incoherent excusing of the Fed from culpability, even while admitting he helped concentrate more regulatory power with them, is at best disingenuous.

Nice try, Phil. But a gaggle of poor people agitating for houses didn't collapse the financial system -- leverage did. And it was well within the power of the Fed and other financial regulators the whole time to keep that variable under control.

-apk