Will the Market Adrenaline Last?

Market watchers are wise to worry that today’s rally, prompted by the EU’s trillion dollar bailout for Greece, won’t last.

On October 13, 2008, the Dow had its best day ever following a weekend announcement of massive aid to banks. Then, in the five months following, it plunged 3000 points. The optimism was short lived because investors couldn’t shake the gnawing feeling that disaster had not been averted but merely delayed.

Deep down they know that whether it is a small government or a big bank, bailing it out is like handing drugs to an addict. It is a great short term fix, but in the long run it destroys the natural safeguards against irresponsible behavior paving the way for the next great collapse.

Capitalism’s thirst for profits promotes two bad habits; cheating and excessive risk taking. Regulations are good for preventing the former, but when it comes to curbing risky behavior there is nothing like a devastating loss to kick the habit.

A major factor in the crises was that the complicated structure of the mortgage finance market insulated players from the risks they took.

The mortgage brokers did not scrutinize the borrowers because they knew the loans would be off-loaded to the banks. The banks didn’t pay much attention, they just bundled the loans and passed them to investors. The investors didn’t look too closely because the bundles supposedly diversified the risk and anyway they were insured. The insurers like AIG and Fannie never expected to pay and so when they couldn’t the government did.

If instead the market knew there would be no bailouts, the discipline would reverberate all the way back up the chain. The mortgage brokers would carefully screen the borrowers because, if they didn’t, the banks wouldn’t buy the loans because the investors wouldn’t purchase them because the insurers wouldn’t underwrite them.

True capitalism would have forced the risk takers to eat their losses and that would have been the surest way to prevent another meltdown.

Instead both parties abandoned their creeds.

Congressional Republicans expound at length on the importance of responsibility and the superiority of capitalism, but when their theory mattered most they lost the courage to adhere to it. Very few were actually prepared to make the banks bear the losses associated with their risks. Not the time to worry about moral hazard said the commentators. Wrong. It is exactly the time to worry about it. The way the government behaves now sets the expectations for next time.

The democrats were even worse. They spent six years complaining bitterly that the administration lied, exaggerated and traded on fear to pass its war agenda. They were particularly galled by being forced into a quick vote on the PATRIOT act “drafted in the middle of night”

and took Congress in 2006 promising never again. But then, suddenly, in the waning days of the Bush administration, White House officials were again on the Hill, in the middle of the night, demanding action on a hastily drafted 400 page bill saying if it weren’t passed the sky would fall, and the democratic controlled Congress panicked and rolled over.

Congress might be forgiven for caving under the stress of the moment, were it not for their long history of dereliction leading up to the crises. Congress was explicitly warned three separate times of systemic risk building in the housing market but ignored it because of their politically correct obsession with affordable housing.

In 2003, The New York Times reported that the “the Bush Administration ... recommended the most significant regulatory overhaul in the housing finance industry since the savings and loan crisis a decade ago,” but the proposal was “denounced” by “Congressional Democrats who fear that tighter regulation of the companies could sharply reduce their commitment to financing low-income and affordable housing.”

Again in 2005, the much maligned Alan Greenspan, to his credit, “urged lawmakers … to impose sharp limits" on Fannie Mae and Freddie Mac, because "the enormous portfolios of the companies...posed significant risks to the nation's financial system...." But, the Times report continued, a leading Democratic Senator dismissed the call as “potentially damaging to the housing markets” and “suggested” advocates of tighter regulation were really “pushing a broader agenda” to “eliminate… affordable housing.”

Then, in April 2008, as the crises deepened, the Federal Housing Authority warned of the need to ban “seller financed mortgages” before the skyrocketing default rates drove it to insolvency. The GAO and IRS confirmed the problem. Nevertheless, powerful congressmen ignored the plea countering such loans provide “much-needed assistance to low-income and minority families who would otherwise be unable to buy homes.”

In all cases, rather than confront the evidence and reassess their policy priorities Congress condemned the warnings as veiled discrimination. By June, 2008, even noted liberal economist Paul Krugman had enough, urging Congress to “drop the obsession” with getting everyone into homes.

By bailing out institutions that made bad bets, Congress disabled the system’s best safeguard against excessive risk. Unless Congress addresses the root problem of letting ideology rather than facts drive its analysis, the regulatory framework it substitutes will be inadequate.

Daniel Huff is General Counsel to the Middle East Forum. Prior to that he was counsel to the Senate Judiciary Committee and an associate at McKinsey & Company.