Was It Wall Street or the Government?

A recent Securities Exchange Commission (SEC) investigation into Fannie Mae and Freddie Mac, the two government sponsored enterprises (GSEs) that were integral to the housing boom and bust, now formally argues that these two organizations committed massive fraud, which underrepresented their exposure to subprime mortgages and contributed to the economic meltdown.

The Wall Street Journal expounds how this investigation blows holes in the argument, often proffered by anti-capitalist Democrats, that Wall Street is solely to blame:

Democrats have spent years arguing that private lenders created the housing boom and bust, and that Fannie Mae and Freddie Mac merely came along for the ride. This was always a politically convenient fiction, and now thanks to the unlikely source of the Securities and Exchange Commission we have a trail of evidence showing how the failed mortgage giants turbocharged the crisis. 

That's the story revealed Friday by the SEC's civil lawsuits against six former Fannie and Freddie executives, including a pair of CEOs. The SEC says the companies defrauded investors because they "knew and approved of misleading statements" about Fan and Fred's exposure to subprime loans, and it chronicles their push to expand the business.

And while the GSEs were somewhat independent from the legislature and the bureaucracy, the paper trail seems to go further back. At least some of the incentive for the alleged fraud was directly caused by government's social policy of getting every American his or her own house - regardless of the ability to afford it.

The Beltway story of the crisis claims that Congress's affordable housing mandates had nothing to do with it. But the SEC's lawsuit shows that Fannie degraded its underwriting standards to increase its market share in subprime loans. According to the SEC suit, for instance, in 2006 Fannie Mae adjusted its widely used automated underwriting system, "Desktop Underwriter." Fannie did so as part of its "Say Yes" strategy to "provide more 'approve' messages . . . for larger volumes of loans with lower FICO [credit] scores and higher LTVs [loan-to-value] than previously permitted."

Unfortunately, this is what happens when the government meddles in private-markets for social engineering purposes - prices (and risk) get mispriced, bubbles are grown, and then busts bring the economy down. And while this does not fully absolve Wall Street (fraud did occur and non-criminal stupid decisions were made) or the consumer (the role that greedy homeowners played in buying too much house or refinancing to buy flat-screen TVs and BMWs is unfortunately overlooked), it does shed light on the harm government can do. Sometimes trying to help people ends up with a worse outcome than doing nothing, especially if all potential consequences are not considered from the outset.

Fed Up!

The economic meltdown was caused by the underestimation and mispricing of risk. The small town broker,  the average family, and the Wall Street banker were all responsible for taking on too much risk. The government has correctly diagnosed the ailment – in part. While the Fed and Treasury both point to the excessive risk taking, they only seem to place the blame on Wall Street.

As The Financial Times reports, the Federal Reserve has unveiled new rules aimed at limiting and controlling executive pay at all institutions under its purview. This follows sharp controls from the Treasury for executive pay at institutions who still have bailout money.

The Fed defends the proposed rules by claiming they will reduce the excessive risk taking that caused the meltdown. Chairman Ben Bernanke, stated that “…compensation plans that encourage, even inadvertently, excessive risk-taking can pose a threat to safety and soundness.” The argument implies that economic downturn was the direct result of risk taking that was driven by high-pay packages for greedy executives.

This perspective is downright foolish. It is unquestionable that mismanagement and so-called ‘fat cat’ bankers played a role in causing the economic mess. However, they are no more culpable than ‘covetous’ housewives who took out a home-equity loan to buy the flat-screen TV or new Mercedes or the ‘greedy’ loan originator who turned a blind eye to the proper documentation in order to make a quick sale. The fact of the matter is all of America is to blame. Most Americans – individuals and companies – did not make smart investment decision.

The Fed’s new pay policy is simply an attempt to make it appear like the government is doing something productive. In reality, it is simply to appease voters who, egged-on by the finger-pointing Obama, are looking for a scapegoat. It is politically and logistically easier to go after a few, big-target banks, than a million or so credit card owners.

Unfortunately government meddling in executive pay will not make things better. It is the wrong medicine for the correct diagnosis. Such a narrow shot at poor risk-management completely misses the fundamental problem. It obscures the fact that the underlying issues are not and will not be addressed. Even more concerning is the fact that it nestles the government far too deep into the private sector.

Not only will the plan fail to address systemic problems, but it will most likely fail to solve the problem at companies. In fact, it is more likely to exacerbate problems. CBS News reports, that talent is already being driven from top firms. Furthermore, individual executives will find ways around the system. They will find alternative ways of compensation or establish unconventional institutions that do not fall under the purview of the Fed. This will move the main banking industry out of the regulatory eye of Bernanke. At the end of the day the risk will still be incorrectly accounted for and nothing will have changed.

Bernanke is correct that excessive risk is to blame. But let’s step back and stop pointing fingers. Smarter policy that is not punitive and spiteful needs to be designed. Flashy regulations that scapegoat a few individuals while absolving the rest of America from responsibility are counterproductive and will only lead to the next bubble and burst. This is particularly true if our government is simultaneously diminishing risk by bailing-out companies. Any market distortions will misprice risk – why doesn’t the Fed understand this?

What Are They Thinking?!! – Socializing and Destroying Our Economy

On Friday, the House voted to give the government sweeping control over pay in the private sector. This plan continues the radical-leftist Congress’s assault on free enterprise and the capitalist system. Essentially the bill, H.R. 3269, prevents large companies from rewarding their employees in ways that may cause excessive risk taking. What excessive risks are is undefined.

Such a power grab greatly hampers the abilities of companies to structure their businesses according to what works best. While companies certainly have, and will continue, to make mistakes, there is no reason to assume that the government can make better decisions. In fact, there is much reason to believe that government interest does not coincide with what is best for a company. Governments have a whole host of groups that they must pander to; including, constituents, lobbyists, party members, and others.

Government meddling in corporate business strategy can only lead to bad situations where politics trump good business sense, sapping initiative and dampening the industrious and innovative American spirit. In such instances, the government role is inefficient, impractical, and downright foolish. It brings politics into a realm where they don’t belong. The very motivation for greater government involvement is completely imbued with political motivations. Such bills are precisely motivated by the populist rage that the Congressional Democrats are nurturing and harnessing, rather than any objective logic. Destroying the fictitious ‘fat-cat Wall Street’ apparently wins votes, even if it hurts the very Americans who cry for blood.

The damage that this bill could cause is foreshadowed by the government’s meddling in the relationship between Citigroup and one of its prime breadwinners, Andrew Hall. Hall, who runs a division of Citigroup called Phibro, which often earns a large chunk of revenue for the company, is admittedly a well compensated man (he owns a castle). He is now demanding a contractually committed bonus of $100 million. Citigroup, which received a lot of taxpayer cash through the bailout, is under immense pressure to renege.

The tensions in this are obvious. However, whether he is right or wrong, Hall, and his massive amounts of revenue, will leave Citigroup if his contract is not upheld. Citigroup is naturally in a tough position– stuck between the same populist anger that is pressuring the government and a large capital outlay that may reap future rewards. This tough decision is only complicated by the presence of government decision makers who, motivated by reasons not necessarily in line with Citigroup’s financial success, can severely influence what happens.

Proponents argue that government intervention is necessary to mitigate excessive risk taking on Wall Street. However, the excessive risk taking that this bill attempts to eradicate, is the very same excessive risk taking that Congress has helped build into the system. The financial bailout and other such programs encourage risky behavior. After all, if one knows one will not have to suffer the consequences, one will be more likely to take risks. When the suffered consequences do not match the risk level it encourages individuals to have a surplus of hazard. The bailout encourages just that.

Congress is in the process of establishing such a backwards system. If a system cushions the consequences of missteps, it simultaneously encourages missteps to be taken. Ultimately, people and institutions need to be able to feel the pinch in order to learn to avoid behavior in the future. The only alternative to eradicate risk is to have one party dictate every action– compensation, production, consumption. This is a failed political system often called communism.

Welfare Moms and Bailout Banks

Unfortunately, it has become far too acceptable, in modern American society, to expect government handouts. Through a long history of increased government assistance and programs, society has developed an inflated notion of entitlement. This problem is clearly seen in two nearly dichotomous phenomena in the news today- Nadya Suleman (the invitro-welfare mother of 14) and the economic bailout. In both instances, we see the excess of government “entitlements” run rampant.

The key parallel is that in both instances the government is serving as an enabler of poor behavior. By serving as an overinflated safety net, the government is encouraging future individuals or groups to behave in a similar fashion. Clearly, Suleman has seen no incentive to stop having children despite her past (and current) status of being on welfare (which she ironically denies is welfare). Likewise, what incentives will future investment bankers have to avoid taking on too much risk (or more properly, mispricing risk)? The government’s actions today essentially limit the downside risk an individual or group can face. This risk assessment is naturally a huge factor when an individual or group is making a decision. If they foresee less risk, because they know the government will bail them out, they will be more willing to make risky, poor decisions. This in turn spirals downward, increasing the role of the government and negating the individual’s personal responsibility.

Do not make the conclusion that I am calling for a complete end to social welfare or that I believe the government should completely be laissez-faire in dealing with the economic crisis. I don’t believe either. What I do believe is that government policies should be more principle-based (rather than rules-based). This is particularly true in the case of welfare. Abuse of the system should be punished harshly; thereby, precluding people from taking advantage. Welfare should only be available to those who absolutely need it AND who are taking steps not to need it any more. Abusers such as Suleman should not only be precluded from collecting any form of government aid but should be punished for their abuse. It would be worthwhile to consider charging her with child abuse (in regards to her current children and for purposefully and irresponsibly bringing 8 new children into the world when she does not have the means to support them). [The doctor who performed the procedure should at a minimum have a moral, if not a legal responsibility, not to perform elective procedures that will become a burden on the state- but this is a separate discussion]. Government resources should be used for the truly needy, in a more discretionary fashion that allows greater scrutiny in distinguishing between abusers and the truly disadvantaged.

Likewise, the economic bailout needs to be focused in more general fashions. I do believe that the government has a role to play in righting the economy. But, it does not mean just throwing away money to failing industries. The auto industry is a prime example. Giving a largely unrepentant, inflexible, and poorly structured industry a vast some of money only incentivizes it to continue its broken ways. What reason would GM have to make radical new changes if it gets money when it messes up? Furthermore, by supporting the old dinosaurs we squash the new upstart innovators that may have better and more efficient products and methodologies (and those we don’t squash will just set up shop in other countries). There will certainly be costs if the auto industry fails- but a few short term costs are much better if they enable a long term fix. We suffer more harm by building on a broken foundation rather than just tearing down the building and starting anew. (This is partially our own fault by having policies which encourage anticompetitive industries that are too heavily reliant on two or three companies).

The bottom line is that the government has to step back- let people and corporate entities fully assess the risk of a situation without the promise of bailout from Uncle Sam. If each actor knows they might have to fend for themselves, they’ll take the appropriate responsibility to make sure they are heading down the right path. Maybe it is simply tough love- after all, we would all ridicule a parent for doing their child’s homework because the child struggles. Sometimes failure is necessary to ensure that individuals learn the correct way to act, and thereby prevent future failure.