Financial reform is another front in the United States Government’s (USG) war against the forces of deflation and economic contraction. While there is frequently political motivation behind their actions, pragmatically there is a need to address the conditions to better the welfare of the constituencies.
The March and April 2009 issues of The Sentinel Economic and Financial Newsletter explored the efficacy of government actions and doubted the expected outcomes. In fact, government actions intended to benefit their constituencies often has the reverse effect. The April issue revealed a NY Times article from 1999 detailing how a relaxation of mortgage standards, encouraged by the Clinton administration, fostered the expansion of loans to sub-prime borrowers. While the encouragement was paved with good intentions, the downstream effects of the decision were devastating. The ensuing sub-prime mortgage expansion was a catalyst for derivative creation and other speculative excesses.
In 1999, the USG provided combustible material to the current economic fires by the repeal of something known as the Glass-Steagall Act (also known as the Banking act of 1933).
Congress passed the Glass-Steagall Act at the final stock market bottom of 1932. We reference the stock market bottom since government frequently acts after an event occurs. The Act materialized to fight the economic crisis of that day. Specifically, the Act expanded the abilities of the Federal Reserve and permitted paper currency to be part of the Fed’s war chest. (The inaugural issue of The Sentinel explores the effects of paper currency in detail). Secondly, the Act separated the functions of banking (investment and commercial). The reasoning behind the second portion of the Act was to allow banks to either lend (commercial) or be involved with stocks/bonds etc. (investment) but not both.
The mixing of commercial and investment banking created risk for depositors. Since commercial banks focus on risk limitation, they may not operate in that fashion if they can also play in the more speculative securities business.
In the 1980s, the banking industry lobbied for the repeal of this act citing various competitive and deregulation reasons. In 1999, President Clinton signed into law a repeal of the act formerly separating investment and commercial banking. Congress discarded what seemed prudent for 67 years. After the Act’s repeal, sub-prime loans increased from 5% of all loans to 30%.
Now we have yet another call to action. Congress, with White House support, is embarking on yet another wave of financial reform. Barney Frank recently suggested the FHA take a softer approach towards lenders. Despite government being complicit in encouraging lower credit standards which ultimately fueled the housing bubble, Mr. Frank wants more. He feels it a government obligation to lend even more at a time when the FHA is struggling with its reserves from loan losses.
We should all be concerned when politicians unfamiliar with the telephone book-sized legislation they will no doubt approve act as if they understand banking and credit risk. If Mr. Frank is any example, this will simply be another case of throwing a flammable liquid on the fire.
Jim publishes The Sentinel Economic and Financial Newsletter.