Responses on Financial Crisis

I have a couple of responses to the reader's comments posted by Rick in response to Russ's and my posts on the financial crisis.

With respect to her first paragraph, I agree that a feeling of stewardship for depositor's funds no longer provides "much of a psychological check on banks."  Indeed, that's precisely my point.  Over the past decades, as depositor's funds became less of an important source of the money that banks used in lending, I think that sense of stewardship has lessened.   I disagree with the reader's argument that there's no distinction between money given to a bank as a federally-insured deposit, and money give to a bank as an uninsured investment.  My first projects out of law school, working in the banking regulatory group of a D.C. law firm in 1986, involved helping work through the regulatory obstacles to securitizing credit card and car loans.    Banks had been doing this with mortgages for decades, and were now trying to work out how to do it for assets with irregular payments and cash flows.  This was just the beginning of doing really (for lack of a more technical term) "fancy" stuff with derivatives, leading to the kinds of instruments that we're now considering essentially insuring now that they've gone south.  I can't prove or quantify the weakening of the sense of stewardship that I'm suggesting as a result of the switch in funding sources for banks, but I do believe there was a real change in how the banking industry (from lawyers, to bankers, to regulators) seemed to perceive the need for and the purpose of government regulation between 1986 and when I left practice in 1995.  And this makes sense, if the business of banking shifted from sort of a joint project of banks and the government to provide a safe place for people's savings that was federally-subsidized in order to support lending, to a speculative enterprise based on risk and reward.  (I'm obviously over-simplifying here, but I think the general point is valid.)

One of the most shocking illustrations of how dramatically the role of federal deposit insurance has changed, I think, is last week's approval by the Fed, on an emergency basis, of Goldman Sachs and Morgan Stanley to become bank holding companies.  It used to be that an enterprise couldn't qualify for what was considered a "privilege" of owning federally-insured banks unless they could prove financial stability to support those operations.  Last week's approvals were granted to keep these firms from failing.

On the reader's second point, while I agree with much of what she says, I think the market's hunger for speculative instruments (and the profits they were seeming to generate) fueled the push to make unwise loans, rather than the other way around.   I received the following comments from my colleague Elizabeth Brown (currently visiting at Indiana University School of Law -- Bloomington)  on this point:

The CRA has been around for 30 years and applies to banks and thrifts.  Most of the sub-prime mortgages were originated by mortgage brokers who preyed on the unsophisticated and the poor in order to earn higher commissions.  The more loans that they originated, the more commissions that they made.  They were not pressured to make these loans by the CRA.  Mortgage brokers are not subject to the CRA.  For a good article explaining in more detail why the CRA is not responsible for this crisis, see The American Prospect, Did Liberals Cause the Sub-Prime Crisis? at http://www.prospect.org/cs/articles?article=did_liberals_cause_the_subprime_crisis

We are in this crisis because of lax regulations on a range of institutions (credit rating agencies, financial conglomerates, mortgage brokers, Fannie Mae, Freddie Mac, etc.) and new, unregulated hybrid financial products that have existed only for the past decade.  There is no magic bullet that will solve the problems that led to this crisis.  It will require a new regulatory structure to better handle systemic risks and tighter regulations in a number of areas.

Elizabeth has written extensively about the need for more comprehensive regulation of the new finanical conglomerates:  see "E Pluribus Unum -- Out of Many, One:  Why the United States Needs a Single Financial Services Agency" and "A Preliminary Look at Regulatory Structures for Financial Services."