Back to the future: Regulatory reform guided by morality

Contrary to a view popularized during the 2008 presidential election season, the current economic crisis led by a declining real estate market was not the result of deregulation under the Bush Administration. Not only was there no major deregulation passed during the last eight years, but the Bush administration approved the most sweeping financial market regulation in decades in the passage of the Sarbanes-Oxley Act. Originally enacted in 2002 to prevent corporate fraud and restore investor confidence after the collapse of Enron and WorldCom, Sarbanes-Oxley failed to prevent the accounting fraud and influence peddling scandals at Fannie Mae and Freddie Mac, the failures of which have been far more damaging to the U.S. economy.

Overall, the Bush administration supported new regulations that added more than 7,000 pages to the Federal Register, nearly a record for any president. We are in this mess largely because critical thought and moral judgment have been subordinated to the politicization of our economy, resulting in both regulatory gaps and excessive controls of the wrong kind. Government regulations should be limited to those that increase and protect transparency and competition, protect both public and private property, promote individual and counter-party responsibility and enforce equal opportunity under the law. But even if the right laws and regulations could be found, they would prove insufficient to protect freedom and prosperity.

It turns out that going back to the wisdom expressed by George Washington in his Farewell Address in which he said that religion and morality are essential to sustain democracy in America is also just as indispensable to its economy. When the captains of banking and finance and their Congressional overseers fail in moral judgment the results are disastrous for everyone. And as we are now witnessing in the real estate and stock market dislocations, once trust is lost, financial and credit markets freeze and long-standing relationships break down resulting in illiquidity, irrational pricing and severe losses.

Today's problems have their roots in programs and financial instruments that shifted the locus of moral responsibility away from individuals and private sector institutions to wider circles that ultimately ended with a government backstop. Heads of all the top banks and financial institutions could and did knowingly approve substandard home mortgage underwriting prone to increased default because those loans could securitized by Wall Street and sold off to investors or to Government Sponsored Enterprises GSEs, for short with no likely recourse to the financial institution of origin.

Our present crisis began in the 1970s during the Carter Administration with passage of the Community Reinvestment Act to stem bank redlining and liberalize lending in order to extend home ownership in lower income communities. Nearly 20 years later during the Clinton Administration, under pressure from Rep.

Barney Frank and Senator Ted Kennedy, HUD took a fateful step in getting the GSEs to accept subprime mortgages. With Fannie and Freddie easing credit requirements on loans it would purchase from lenders, the skids were greased for banks to greatly increase lending to borrowers unqualified for conventional loans. In the name of extending affordable housing, this broadening of the acceptability of risky loans throughout the financial system was a slippery slope leading to affirmative action-like quotas for GSEs to accept up to $1 trillion in subprime mortgage paper.

The systemic risk growing in the multi-trillion dollar GSE portfolios was acknowledged in the Bush Administration's first fiscal year budget released in April 2001. It stated that Fannie and Freddie were "a potential problem" because "financial trouble of a large GSE could cause strong repercussions in the financial markets, affecting federally insured entities and economic activity." In the ensuing years reform efforts by Republicans were effectively blocked by Democrats, until billion dollar accounting scandals rocked Fannie and Freddie. With the help of Fed Chairman Greenspan's repeated warnings that the GSEs "placed the total financial system of the future at substantial risk," reform finally got back on the legislative agenda in 2005. But voting continued to get stalled in large part by congressmen who received large campaign contributions from the GSEs. By the time a bill passed, reform was watered down and too little and too late.

The collapse and government seizure of Fannie and Freddie in September 2008 was essentially another failed socialist experiment. Concentration of power and political corruption at the federal government level abrogated moral judgment on every level:

the poor were encouraged to live beyond their means; speculators were lured into excessive risk-taking; banks were rewarded to lower their loan standards; and Wall Street was applauded for securitizing and reselling those bad loans in bulk. And not to be left behind by the gravy train, Moody's and S & P provided cover for the whole charade by extracting excessive fees for bogus bond ratings based more on politicized groupthink than serious credit analysis.

Rewarding the party more complicit in the worst financial crisis since the Great Depression may not make rational sense. And while a self-absorbed electorate may be confused about how we got here or prefer to live in denial, the new administration and congress cannot fool their way out of the current economic predicament. The present course of socializing failure is not a long-term solution. The regulatory reform needed now must be guided by a morality that fosters responsible behavior and financial accountability on every level a sweeping task for which the new president's oratory skills are particularly well-suited.

Scott S. Powell is a senior vice president at ELP Capital in Reno and is a visiting fellow at Stanford's Hoover Institution.