The Great Recession Blame Game
Banks took the heat, but it was Washington that propped up subprime debt and then stymied recovery.
By Phil Gramm and Michael Solon
WSJ, April 15, 2016 6:09 p.m. ET
When the subprime crisis broke in the 2008 presidential election
year, there was little chance for a serious discussion of its root
causes. Candidate
Barack Obama weaponized the crisis by blaming greedy bankers, unleashed when
financial regulations were “simply dismantled.” He would
go on to blame them for taking “huge, reckless risks in pursuit of quick profits and massive bonuses.”
That
mistaken diagnosis was the justification for the Dodd-Frank Act and the
stifling regulations that shackled the financial system, stunted the
recovery and diminished the American dream.
In fact, when the
crisis struck, banks were better capitalized and less leveraged than
they had been in the previous 30 years. The FDIC’s
reported capital-to-asset
ratio for insured commercial banks in 2007 was 10.2%—76% higher than it
was in 1978. Federal Reserve data on all insured financial institutions
show the capital-to-asset ratio was 10.3% in 2007, almost double its
1984 level, and the biggest banks doubled their capitalization ratios.
On Sept. 30, 2008, the month Lehman failed, the FDIC
found that
98% of all FDIC institutions with 99% of all bank assets were “well
capitalized,” and only 43 smaller institutions were undercapitalized.
In
addition, U.S. banks were by far the best-capitalized banks in the
world. While the collapse of 31 million subprime mortgages fractured
financial capital, the banking system in the 30 years before 2007 would
have fared even worse under such massive stress.
Virtually all
of the undercapitalization, overleveraging and “reckless risks” flowed
from government policies and institutions. Federal regulators followed
international banking standards that treated most
subprime-mortgage-backed securities as low-risk, with lower capital
requirements that gave banks the incentive to hold them. Government
quotas forced Fannie Mae and Freddie Mac to hold ever larger volumes of
subprime mortgages, and politicians rolled the dice by letting them
operate with a leverage ratio of 75 to one—compared with Lehman’s
leverage ratio of 29 to one.
Regulators also eroded the safety
of the financial system by pressuring banks to make subprime loans in
order to increase homeownership. After eight years of vilification and
government extortion of bank assets, often for carrying out government
mandates, it is increasingly clear that banks were more scapegoats than
villains in the subprime crisis.
Similarly, the charge that banks
had been deregulated before the crisis is a myth. From 1980 to 2007
four major banking laws—the Competitive Equality Banking Act (1987), the
Financial Institutions, Reform, Recovery and Enforcement Act (1989),
the Federal Deposit Insurance Corporation Improvement Act (1991), and
Sarbanes-Oxley (2002)—undeniably increased bank regulations and
reporting requirements. The charge that financial regulation had been
dismantled rests almost solely on the disputed effects of the 1999
Gramm-Leach-Bliley Act (GLBA).
Prior to GLBA, the decades-old
Glass-Steagall Act prohibited deposit-taking, commercial banks from
engaging in securities trading. GLBA, which was signed into law by
President Bill Clinton, allowed highly regulated financial-services
holding companies to compete in banking, insurance and the securities
business. But each activity was still required to operate separately and
remained subject to the regulations and capital requirements that
existed before GLBA. A bank operating within a holding company was still
subject to Glass-Steagall (which was not repealed by GLBA)—but
Glass-Steagall never banned banks from holding mortgages or
mortgage-backed securities in the first place.
GLBA loosened
federal regulations only in the narrow sense that it promoted more
competition across financial services and lowered prices. When he signed
the law, President Clinton
said that
“removal of barriers to competition will enhance the stability of our
financial system, diversify their product offerings and thus their
sources of revenue.” The financial crisis proved his point. Financial
institutions that had used GLBA provisions to diversify fared better
than those that didn’t.
Mr. Clinton has always insisted that
“there is not a single solitary example that [GLBA] had anything to do
with the financial crisis,” a conclusion that has never been refuted.
When asked by the
New York Times in 2012, Sen.
Elizabeth Warren
agreed that the financial crisis would not have been avoided had GLBA
never been adopted. And President Obama effectively exonerated GLBA from
any culpability in the financial crisis when, with massive majorities
in both Houses of Congress, he chose not to repeal GLBA. In fact,
Dodd-Frank expanded GLBA by using its holding-company structure to
impose new regulations on systemically important financial institutions.
Another myth of the financial crisis is that the bailout was
required because some banks were too big to fail. Had the government’s
massive injection of capital—the Troubled Asset Relief Program, or
TARP—been only about bailing out too-big-to-fail financial institutions,
at most a dozen institutions might have received aid. Instead, 954
financial institutions received assistance, with more than half the
money going to small banks.
Many of the largest banks did not
want or need aid—and Lehman’s collapse was not a case of a
too-big-to-fail institution spreading the crisis. The entire financial
sector was already poisoned by the same subprime assets that felled
Lehman. The subprime bailout occurred because the U.S. financial sector
was, and always should be, too important to be allowed to fail.
Consider
that, according to the Congressional Budget Office, bailing out the
depositors of insolvent S&Ls in the 1980s on net cost taxpayers $258
billion in real 2009 dollars. By contrast, of the $245 billion
disbursed by TARP to banks, 67% was repaid within 14 months, 81% within
two years and the final totals show that taxpayers earned $24 billion on
the banking component of TARP. The rapid and complete payback of TARP
funds by banks strongly suggests that the financial crisis was more a
liquidity crisis than a solvency crisis.
What turned the subprime
crisis and ensuing recession into the “Great Recession” was not a
failure of policies that addressed the financial crisis. Instead, it was
the failure of subsequent economic policies that impeded the recovery.
The
subprime crisis was largely the product of government policy to promote
housing ownership and regulators who chose to promote that social
policy over their traditional mission of guaranteeing safety and
soundness. But blaming the financial crisis on reckless bankers and
deregulation made it possible for the Obama administration to seize
effective control of the financial system and put government bureaucrats
in the corporate boardrooms of many of the most significant U.S. banks
and insurance companies.
Suffocating under Dodd-Frank’s
“enhanced supervision,” banks now focus on passing stress tests, writing
living wills, parking capital at the Federal Reserve, and knowing their
regulators better than they know their customers. But their ability to
help the U.S. economy turn dreams into businesses and jobs has suffered.
In postwar America, it took on average just 2 1/4 years to
regain in each succeeding recovery all of the real per capita income
that had been lost in the previous recession. At the current rate of the
Obama recovery, it will take six more years, 14 years in all, for the
average American just to earn back what he lost in the last recession.
Mr. Obama’s policies in banking, health care, power generation, the
Internet and so much else have Europeanized America and American
exceptionalism has waned—sadly proving that collectivism does not work
any better in America than it has ever worked anywhere else.
Mr.
Gramm, a former chairman of the Senate Banking Committee, is a visiting
scholar at the American Enterprise Institute. Mr. Solon is a partner of
US Policy Metrics.