Photo from: REUTERS/Jim Young
From the WaPo: As Subprime Lending Crisis Unfolded, Watchdog Fed Didn’t Bother Barking
“… Under a policy quietly formalized in 1998, the Fed refused to police lenders’ compliance with federal laws protecting borrowers, despite repeated urging by consumer advocates across the country and even by other government agencies.
The hands-off policy, which the Fed reversed earlier this month, created a double standard. Banks and their subprime affiliates made loans under the same laws, but only the banks faced regular federal scrutiny. Under the policy, the Fed did not even investigate consumer complaints against the affiliates.
“In the prime market, where we need supervision less, we have lots of it. In the subprime market, where we badly need supervision, a majority of loans are made with very little supervision,” former Fed Governor Edward M. Gramlich, a critic of the hands-off policy, wrote in 2007. “It is like a city with a murder law, but no cops on the beat.”
… since its creation, the Fed has held a second job as a banking regulator, one of four federal agencies responsible for keeping banks healthy and protecting their customers. … During the boom, however, the Fed left those powers largely unused. … The Fed’s performance was undercut by … the doubts of senior officials about the value of regulation …”The failure of oversight was a serious and unfortunately common problem during the boom. For more examples see: Inspector General: FDIC saw risks at IndyMac in 2002 and Federal Reserve Oversight and the Failure of Riverside Bank of the Gulf Coast.
How well has the Federal Reserve performed for America? Mainstream pundits, of course, say that Bernanke has saved the world . . . . but they said the same thing about Greenspan. So let’s look at the actual historical record to determine how well the Fed has done.
Initially, Milton Friedman and Ben Bernanke have both said that the Federal Reserve caused (or at least failed to cure) the Great Depression through its poor monetary policy.
Many also blame the Fed for blowing an unsustainable bubble between 2001-2007 through artificially low interest rates. If this sounds too much like an Austrian economics perspective, that may be true. But remember that Hayek won the Nobel prize in 1974 partly for arguing that artificially low interest rates lead to the misallocation of capital and to bubbles, which in turn lead to busts.
Moreover, one of the Fed’s main justification has been that it can provide a “counter-cyclical” balance. In other words, during boom times it can put on the brakes (”take the punch bowl away right as the party gets started”), and during busts it can get things moving again. But as economist Jane D’Arista has shown, the Fed has failed miserably at that task:
“Jane D’Arista, a reform-minded economist and retired professor with a deep conceptual understanding of money and credit [has a] devastating critique of the central bank. The Federal Reserve, she explains, has failed in its most essential function: to serve as the balance wheel that keeps economic cycles from going too far. It is supposed to be a moderating force in American capitalism on the upside and on the downside, the role popularly described as “leaning against the wind.” By applying its leverage on the available supply of credit, the Fed can slow down a boom that is dangerously overwrought or, likewise, stimulate the economy if it is sinking into recession. The Fed’s job, a former chairman once joked, is “to take away the punch bowl just when the party gets going.” Economists know this function as “counter-cyclical policy.”
The Fed not only lost control, D’Arista asserts, but its policy actions have unintentionally become “pro-cyclical”–encouraging financial excesses instead of countering the extremes. “The pattern that has developed over the last two decades,” she wrote in 2008, “suggests that relying on changes in interest rates as the primary tool of monetary policy can set off pro-cyclical foreign capital flows that tend to reverse the intended result of the action taken. As a result, monetary policy can no longer reliably perform its counter-cyclical function–its raison d’être–and its attempts to do so may exacerbate instability.”…”
Mike Konczal (Rortybomb):
Let’s look at the transcript from “Morning Session of Public Hearing on Home Equity Lending, July 27, 2000″, moderated by Glenn Loney, the Deputy Director of the Division of Consumer and Community Affairs, and one of the four signers of the proposal that the Federal Reserve would not regulate non-banks mortgage lenders the same way as they would banks, even if they were held by banks.
I am not a historian or a journalist, but I’ll do my best to see what I can find. This conference is Loney gathering several representatives from subprime banks, community banks, and consumer watchdog groups in North Carolina, along with several Federal Reserve people, including someone whom may be his boss. I love when you do historical research, and someone who is known for other things wanders into the frame. And sure enough, Martin Eakes, 2 years before he founds The Center For Responsible Lending, is there talking. He founds the CRL based in part from how ignored he was by regulators, and this conference gives me a sense of where he’s coming from.
[...]
It’s worth noting once again that community investment groups weren’t looking for subprime to extend credit – the idea that subprime loans, that were modeled on the logic of credit cards with high interest jumps and gotcha penalties, were called out as crap very early like we see above.
I also understand where the community bankers are coming from. Here they are, complaining about the subprime lenders and how the Fed isn’t doing their job. A decade later, now that all the subprime lenders are bankrupt, or were bought by Too Big To Fail institutions that are receiving cash infusions from the government, the idea that they would be pissed about having to fill out new paperwork makes a lot of sense to me, even if it would clear a market space for them.
This is more than just the usual issue of regulatory capture (though it’s that too). The Fed is a bad choice to regulate this stuff because their first priority is always going to be macroeconomic stability. That’s exactly as it should be, but it means that regulating consumer products will simply never be anything more than an afterthought for them.
The same is true for virtually every other existing regulator too: they already have settled missions and settled cultures that value specific tasks. Consumer lending regulation isn’t one of them, so it will never be able to compete effectively for attention. The only place it has a chance of succeeding is at a new agency in which everyone from top to bottom considers it their primary mission in life. That’s what a strong CFPA brings to the table.
Will it eventually be captured by the industry it’s supposed to regulate? Sure. And then we’ll have to try to fix things again. But no solution is eternal, so that’s hardly a good reason not to act. We should set up a CFPA that’s as strong as we can make it; that has its incentives aligned as precisely as we can align them; and that has an institutional base of power that allows it to actually get things done. It won’t be perfect, but it will be a lot better than anything we have now.
UPDATE: Felix Salmon
UPDATE #2: Ezra Klein
