Washington's failure to regulate adequately led to Wall Street crisis

By David Lightman - 09/20/2008

WASHINGTON — No one cog in the federal government's machine of financial regulation let down the country by failing to prevent the latest shakeout on Wall Street. The entire system did.

"They just haven't done a particularly good job," said James Barth, a senior finance fellow at the Milken Institute, a nonpartisan research group based in Los Angeles.

Kathleen Day, a spokeswoman for the Center for Responsible Lending, a consumer-oriented research group, explained the regulatory lapses more starkly: "The job of regulators is that when the party's in full swing, make sure the partygoers drink responsibly," she said. "Instead, they let everyone drink as much as they wanted and then handed them the car keys." Analysts and politicians are raising serious questions about the nation's financial regulatory system, which dates to the New Deal era.

On Monday, one Wall Street bank, Lehman Brothers, filed for bankruptcy protection and another, Merrill Lynch, sought comfort by selling itself to Bank of America for $50 billion. Earlier this year, the government helped enable the sale of faltering investment bank Bear Stearns to J.P. Morgan Chase, and more recently took over mortgage giants Fannie Mae and Freddie Mac.

Such troubles were supposed to have been prevented, or at least mitigated, by regulatory systems that the nation began to put in place after the banking system collapsed at the start of the Great Depression.

Many banks at the time were badly wounded by their personal and financial ties to securities trading. The 1933 Glass-Steagall Act, and later the 1956 Bank Holding Company Act, mandated the separation of banks, insurance companies and securities firms.

Those and many other federal laws stabilized the banking and securities markets, but by the 1970s, a stumbling U.S. economy led to a change in America's political-economic values. Ronald Reagan led a movement that came to power in 1980 proclaiming faith in free markets and mistrust of government. That conservative philosophy has dominated America for the past 28 years.

Even after taxpayers had to rescue deregulated savings and loans, or S&Ls, with a $200 billion bailout in the late 1980s, the push to loosen regulation paused only briefly.

In 1999, President Clinton signed the Financial Services Modernization Act (also known as the Gramm-Leach-Bliley Act), which tore down Glass-Steagall's reforms by removing the walls separating banks, securities firms and insurers.

Under President Clinton and his successor, the government became eager to promote home ownership. Interest rates were low, the market grew for loans to borrowers with weak credit and private-sector mortgage bonds boomed. About 38 percent of those bonds were backed by subprime loans. They are at the root of today's financial crisis.

Some regulatory agencies issued warnings, but credit-rating agencies still said that the bonds — and the banks that issued and bought them — were safe. It turns out, of course, that many were not.

"There was a view that the secondary market excesses could be prevented by the broader application of risk-evaluation models by the investment firms," said Barry Bosworth, senior fellow in economic studies at the Brookings Institution, a Washington think tank. "In fact, risk evaluation is more of an art than a science, and the (private-sector) institutions fooled themselves," said Bosworth, a former adviser to President Jimmy Carter.

Few in Congress were eager to pressure regulators to crack down on Wall Street, and virtually no one proposed national regulation of non-bank lenders or mortgage brokers. Expanding home ownership was a politically popular achievement.

"Imagine what congressional committees would have said. They would have asked about affordable housing. It was a no-win situation for regulators," said Edward Kane, professor in finance at Boston College.

Warning signs began to appear. At least nine federal agencies oversee some part of the mortgage market, and from 2004 to 2007, at least three had issued warnings about risky loans.

"It was another example of an asset bubble that appears periodically. An economy will disregard risk, and when people see another investor making money by investing in an asset, others will throw caution to the wind," said Nicolas Bollen, professor of finance at Vanderbilt University's Owen Graduate School of Management in Nashville, Tenn.

In such an environment, said Day, of the Center for Responsible Lending: "No one wanted to kill the goose that laid the golden egg." ——— (c) 2008, McClatchy-Tribune Information Services.

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