Regulators and Government Activism Are Prolonging The Housing Crisis

Banks never seem to learn as they lurch from one lending crisis to the next.

In the early 1970’s the largest banks in the country lent recklessly to Latin American countries under the theory that sovereign nations would not default.  The ensuing Latin American debt crisis  and sovereign defaults shattered that complacent theory and many of the largest banks in the U.S. had to be rescued by the government.

Not even two decades later in the early 1990’s, the U.S. suffered the largest number of banking failures since the 1930’s during the infamous S&L banking crisis.  Banks that had defied common sense by funding long term mortgages with short term deposits suddenly found themselves insolvent as interest rates rose.  Government bailouts of the banking industry were once again required through the Resolution Trust Corporation.

In the early 2000’s banks once again struck gold by operating under the theory that income and credit had little correlation to a borrower’s ability to repay, especially since the banks were offloading most of their loans to government agencies and investors.   During the boom times, the banks made huge profits as they encouraged Americans to engage in the most reckless credit expansion in history.  As the massive credit bubble finally stated to burst in 2007, the financial system came very close to an outright collapse.

Although the roots of each banking crisis developed from the common elements of a classic boom bust credit cycle, the latest banking crisis differs from the previous two in terms of recovery time.  Previous banking and real estate crises were painful but bottomed out relatively fast as insolvent banks were quickly closed.  Distressed bank assets were rapidly liquidated at the highest market bid.  Real estate markets quickly reached a market clearing bottom from which prices recovered.  Rather than attempt to prop up zombie banks and overpriced real estate, a laissez faire attitude by regulators allowed free markets to establish prices.

In the aftermath of the latest banking and housing crisis, the country is still in a mess 5 years later.  Problem banks, many of which will never wind up surviving, currently account for 10% of all FDIC insured banks, property markets are still searching for a bottom, banks are still black boxes that investors can’t trust, the economy is still in the doldrums with almost double digit unemployment, the FDIC Deposit Insurance Fund is essentially depleted and the FDIC is still sitting on almost $22 billion of failed bank assets.  This time is different from past banking crises and not in a positive way.

In a very candid interview with Bloomberg Businessweek, former Fed Chairman Alan Greenspan explains why the government’s current activist policy with problem banks and problem borrowers is prolonging the agony for homeowners, banks and the overall economy.

What do you think of this administration’s policies to address this?
Well, it’s not the present administration, it’s the current view of most policy-oriented economists. And here, regrettably, I am in the minority. The notion that if there is an economic problem, the government is obligated to address it, necessarily creates uncertainty about the future. And there’s hard research that shows such activism is responsible in part for the very heavy discounting of earnings on longer-lived business investments, and by households that had dramatically shifted from owner occupancy to short-lived rentals in the face of the uncertainty of the direction of home prices. We need to replace such activism with a policy that allows the markets to correct their own imbalances. Remember the Resolution Trust Corporation in the early ’90s? I was on the oversight board of the RTC. It got stuck with the job of liquidating more than 700 failed savings and loans. Some of the stuff that the RTC wound up with was perfectly liquid and saleable. But a big chunk was uncompleted eight-hole golf courses, half-built office towers, and vacant malls. Nobody wanted it. We all sat around and said, “This stuff is deteriorating very rapidly, and if we don’t get rid of it, the taxpayers are going to take a huge hit.” I mean, the numbers were very, very large. Somebody suggested, “Let’s package it and sell it.” And we did. Needless to say, the bids were less than 50 percent of the original cost. Congress was outraged. We were giving away taxpayer-owned assets to greedy vulture funds.

They wanted in on that action.
Indeed, that’s what happened. Hitting whatever bids were available in this stagnant market defined the low point on prices. Then something happened.

Real estate prices went up again?
Yes. Investors cleared out our illiquid inventory in a matter of months. The final cost to the taxpayers for the savings and loan crisis amounted to $87 billion, a fraction of the original estimate. Allowing the markets to liquidate worked.

Echoing Greenspan’s comments in the same issue of Bloomberg, Joshua Brown of The Reformed Broker, argues that regulators in Europe are currently making the same mistakes as regulators made at the height of the U.S. financial crisis.

Joshua Brown, blogs as The Reformed Broker, Vice President, Fusion Analytics Investment Partners
I saw your blog piece today. There were two words: “F-‍-‍- Europe.”
Yeah. That should be the cover of your magazine. … Euro Fatigue. Euro fatigue, enough already. If you’re going to implode, just do it, and let’s see what happens on the other side.

Didn’t we say that about Lehman Brothers, too? Just let it implode and see what happens.
Yeah. And you know what? Anyone die?

No one died, but we had a near-death experience.
So what? So what? Let me tell you something. Because counterfactual to the way we handled all this bailout s— is: What if we nationalized all the banks in the middle of ’08 prior to Lehman but after Bear [Stearns]? If we said, “No more Bears. All these banks are now property of the U.S. until such time as we can separate the good from the bad and spin them back out.” We probably would have gone down to Dow 5,000 instead of 6,500, but we would have already been through a lot of this s—. And so instead of doing that, we opted for incrementalism.

So we kind of amortized the pain over the past four years?
Yeah, so if the euro is done, then f—ing let it be done. Let’s see how much damage we can do, and let’s all wake up the next morning and rebuild.

Not a bad idea Mr. Brown – I will take the discipline of the free markets any day over convoluted and incoherent government policies that are prolonging the economic agony for a nation seeking recovery.