2008's Regulatory 'Solutions' May Author the Next Crisis

Hester Peirce at Real Clear Markets.

At this time five years ago, our financial markets were confronting the failures or near-failures of financial companies with household names and global reach. Part of the legacy of the events of September 2008 may end up being more bad regulatory policy.

September 7, 2008: Fannie Mae and Freddie Mac-the government-sponsored enterprises that had become the basis of our corrupted mortgage finance system-were put into conservatorship by the federal government. Taxpayer money was poured into the gaping holes left by their deep entanglement with subprime mortgages. Five years later, the government remains the conservator of Fannie and Freddie. Congress is finally getting around to crafting housing finance reforms, but many voices are calling for nothing more than a repackaging of the housing GSEs. Instead of keeping taxpayers on the hook for mortgages, we ought to be engaging in a nuts-and bolts consideration of how we can back the government out of housing finance. As Edward Glaeser wrote in his introduction to the Mercatus Center's compilation of ideas for reforming housing finance, "we need to move intelligently away from the mistakes of the past and toward a safer system that does less to distort housing markets and more to protect taxpayers."

September 15, 2008: Lehman Brothers filed for bankruptcy, a momentous event both because of the record-breaking size of the bankruptcy and the breathtaking realization that the government bailouts were not inevitable. A lot has been made of the bankruptcy and its destabilizing effects, but experts such as David Skeel have argued, "Whatever problems arose when Lehman filed for bankruptcy were not caused by the bankruptcy laws. They were caused instead by the government's bait and switch." The government's treatment of Bear Stearns created an expectation that it would not sit back and allow Lehman to file for bankruptcy. Dodd-Frank's creation of a regulator-driven alternative to bankruptcy that might be used to resolve certain financial companies merely adds to the uncertainty about what, if anything, the government will do if another large financial company runs into trouble.

September 16, 2008: The government rescued American International Group, a massive insurance company that also dabbled in a number of other businesses. The government's initial $85 billion loan more than doubled as the depth of the company's troubles became more evident. Now, five years later, AIG has been designated as a systemically important financial institution and is being regulated by the Federal Reserve. Other insurance companies are likely to follow. Designating large insurance companies like AIG for regulation by the Fed only subjects them to a regulatory scheme that is not suited for insurers, thus increasing the likelihood of regulation-related failure. Further, the Dodd-Frank systemically important designation fertilizes expectations of future bailouts and decreases private monitoring.

September 16, 2008. The Reserve Primary Fund, a money market mutual fund, "broke the buck." In other words, its shareholders would not receive one dollar for every dollar they put into the fund. This was only the second time a fund had broken the buck, so it shocked the financial system, particularly because other money market funds that appeared to have troubled portfolios also experienced high levels of redemption. The government, worried that money market funds would stop financing big banks, responded with a temporary insurance program that effectively guaranteed the value of all investments in money market funds as of the inception of the program. Money market fund reforms have been proposed by the Securities and Exchange Commission, and the Financial Stability Oversight Council-under the strong sway of bank regulators-threatens to move forward with its own proposal if the SEC does not make dramatic enough changes. Although there is a good case to be made for sensible reforms, the reform discussion seems to be driven more by a concern for the financial institutions that rely on money market funds for short-term funding rather than a concern for investors.

September 2008 was a momentous month and included many events in addition to those mentioned above, such as the conception of the Troubled Asset Relief Program and the conversion of Goldman Sachs and Morgan Stanley to the bank holding company structure, which made it easier for those firms to borrow from the Fed. Five years later, we can see the imprint of all of these events on current policy debates. We ought to be forewarned, as Arnold Kling explained in his "History of the Policies that Produced the Financial Crisis," "the seeds for much of the [2007-2009] crisis were sown in the policy ‘solutions' to previous financial and economic crises." The events of five years ago must not become the basis for policies that create a financial crisis five years from now.