Catastrophe is a precondition to financial reform: Part 2, Postwar
[Continued from yesterday’s Part 1.]
Yesterday, in search of the answer to whether the sweeping reforms proposed by Treasury Secretary Paulson might be enacted any time soon, I posed the question: is the current catastrophe big enough?
Paste one on the nearest financial crisis
We saw how Shay’s Rebellion led to the Constitution, the Panic of 1907 to the Federal Reserve, and the 1929 stock market crash to the SEC and even to the FHA, which with its country cousin FmHA was our sole Federal housing finance or subsidy entity until the next catastrophe:
The 1965-68 urban riots and HUD’s housing programs. After the 1965 riots, President Johnson concatenated a variety of agencies into a newly formed cabinet branch, the Department of Housing and Urban Development. As I posted some time ago:
In the mid-Sixties, when I was a stripling of twelve and thirteen, television brought into our homes something we thought inconceivable in America: urban riots, in our core cities, like Watts (Los Angeles) in 1965, Detroit in 1967, and Chicago, Washington and many other places in 1968 (after the hammer blows of the assassinations of Martin Luther King and Robert F. Kennedy).
Pointing from the motel balcony to the spot from which assassin James Earl Ray fired
Suddenly it became frighteningly, immediately clear to Americans in their living rooms that something had gone violently and inconceivably wrong in our cities.
Out of those riots, in other words, was born HUD, which Johnson elevated to a Cabinet-level branch by cobbling together the Depression-era government bank the Federal Housing Administration, the Office of Economic Opportunity (OEO), and a couple of minor agencies.
HUD’s first secretary, Robert C. Weaver (after whom the HUD building is now named)
The 1986 savings and loan bailout and FIRREA. The late-1980’s S&L bailout had far-reaching consequences, starting with the insolvency and eventual demise of FSLIC. As perpetual banking gadfly Bert Ely has put it, acerbically if accurately:
An incomplete and bungled deregulation of S&Ls in 1980 and 1982 lifted restrictions on the kinds of investments that S&Ls could make. In 1980 and again in 1982, Congress and the regulators granted S&Ls the power to invest directly in service corporations, permitted them to make real estate loans without regard to the geographical location of the loan, and permitted them to lend up to 40 percent of their assets in commercial real estate loans. Congress and the Reagan administration naïvely hoped that if S&Ls made higher-yielding, but riskier, investments, they would make more money to offset the long-term damage caused by fixed-rate mortgages. However, the 1980 and 1982 legislation did not change how premiums were set for federal deposit insurance. Riskier S&Ls still were not charged higher rates for deposit insurance than their prudent siblings. As a result deregulation encouraged increased risk taking by S&Ls.
Because S&Ls’ deposits were federally insured, savers thought their money safe, and accepted low rates, which the banks could use to lend long at higher rates – yet another variant of balance sheet turbocharging.
Small but he packs a rhetorical punch
Ely then reels off quite a list of causes:
Capital standards were debased in the early eighties in an extremely unwise attempt to hide the economic insolvency of many S&Ls.
Inept supervision and the permissive attitude of the FHLBB during the eighties allowed badly managed and insolvent S&Ls to continue operating.
Delayed closure of insolvent S&Ls greatly compounded FSLIC’s losses by postponing the burial of already dead S&Ls. Chart 1 shows how losses in insolvent S&Ls grew during the eighties as the closure of insolvent S&Ls was delayed.
A lack of truthfulness in quantifying FSLIC’s problems hid from the general public the size of the FSLIC’s losses. Neither the FHLBB nor the General Accounting Office (GAO) provided realistic cost estimates of the problem as it was growing. On May 19, 1988, for example, Frederick Wolf of the GAO testified that the FSLIC bailout would cost $30 billion to $35 billion. Over the next eight months, the GAO increased its estimate by $46 billion.
Ely’s chart. His point? That costs were recognized years after they should have been
Congressional and administration delay and inaction, due to an unwillingness to confront the true size of the S&L mess and anger politically influential S&Ls.
Flip-flops on real estate taxation first stimulated an overbuilding of commercial real estate in the early eighties and then accentuated the real estate bust when depreciation and “passive loss” rules were tightened in 1986. The flip-flop had a double-whammy effect: the 1981 tax law caused too much real estate to be built and the 1986 act then hurt the value of much of what had been built.
[I wrote about this when it happened, in an article for Real Estate Review. Small consolation.]
The first serious attempt at cleaning up the FSLIC mess did not come until Congress enacted the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA). Even FIRREA, however, did not provide sufficient funds to completely clean up the S&L mess.
FIRREA, the Financial Institutions Reform Recovery and Enforcement Act, among other things regulates real estate appraisers.
You got a license to estimate that value?
Enron (2001) and Sarbanes-Oxley (2002). Although it’s hard for some of us to realize that Enron was seven years ago, no one can dispute the accuracy of President Bush’s signing statement that Sarbox (or Sox) constituted “the most far-reaching reforms of American business practices since the time of Franklin D. Roosevelt.”[1] Here’s Wikipedia’s summary:
The Sarbanes-Oxley Act of 2002, also known as the Public Company Accounting Reform and Investor Protection Act of 2002 and commonly called SOx or Sarbox; is a United States federal law enacted on July 30, 2002 in response to a number of major corporate and accounting scandals including those affecting Enron, Tyco International, Adelphia, Peregrine Systems and WorldCom.
Got a problem with brand value here …
Would you trust a man with that facial hair?
The legislation establishes new or enhanced standards for all
Because Sarbox makes the inner workings of public companies more transparent, and requires them to report more frequently, it creates information asymmetry which private companies used to their spectacular advantage, as I reported in Press De-REIT and Barbarians at the REIT.
The Act contains 11 titles, or sections, ranging from additional Corporate Board responsibilities to criminal penalties, and requires the Securities and Exchange Commission (SEC) to implement rulings on requirements to comply with the new law.
Sarbanes-Oxley ratcheted up the stakes for directors and officers, most especially the Chief Financial Officer:
The Act establishes a new quasi-public agency, the Public Company Accounting Oversight Board, or PCAOB, which is charged with overseeing, regulating, inspecting, and disciplining accounting firms in their roles as auditors of public companies. The Act also covers issues such as auditor independence, corporate governance, internal control assessment, and enhanced financial disclosure.
Debate rages regarding Sarbox’s aggregate value, but there’s little doubt that improved corporate governance transparency is a good thing, and that said transparency is here to stay.
The 2005 Fannie Mae accounting scandals and … what? Three years ago, when the Fannie Mae accounting scandals broke, I wrote:
Fannie Mae’s accounting scandals will beget properly regulating GSEs, although roughly two years after the fact.
Unfortunately, this prediction proved wrong, as I acknowledged in my AHI-as-guru report card:
At the beginning of 2007, I predicted that:
Congress will enact GSE regulatory reform. Although the lame duck never quite flew, the realpolitik practiced by the Administration and Mr.
No. Didn’t happen. GSE regulatory has all but died, a casualty of the subprime fallout and the pressure on credit. The GSE’s have done a marvelous job of suggesting wistfully that they would have been of immense help, if only Congress had let them off the bench into the game.
We could have provided liquidity if they’d let us play
I doubt anything will happen on GSE reform in 2008 either.
In writing this post, I’ve noticed that for fundamental reform to follow a catastrophe, it has to follow soon after. Sarbox took less than a year after Enron. For those who wanted tighter GSE reform, the time to strike was quickly (and even as I suggested in the 2006 lame duck session). The longer you wait, the more the crisis recedes in the memory, fading into a roseate glow of aw-it-wasn’t-so-bad-was-it? That’s what happened here, as the even bigger political imperative (the subprime mess) put paid to GSE reform.
We interrupt this GSE regulation to bring you a new crisis
Will the credit gridlock lead to fundamental reform? To be sure, it should – but will it?
Don’t worry, be happy!
That depends on whether the great big fed bet, banking on value, wins or loses.
Do you feel lucky, Hank?
Well – do ya?
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