Are you a Democrat or a Republican? Do you support government regulation or are you a free market person? Does de-regulation promote the free market system or does de-regulation result in the need for government intervention? Do you care? I do, and whether you are a Democrat or Republican, you are currently a statistic of de-regulation. Want to know why?
A little history throws a spotlight on this issue. Remember Ronald Reagan? He was, and is remembered as, a great President. His theory of “trickle down” economics has been a Republican economic foundation. Did you know that his de-regulation/free market approach significantly contributed to, if not single-handedly caused, the Great Real Estate Crash of the late 1980’s and early 1990’s? That can’t be true, can it? Not Reaganomics! Well, it is true.
In 1982, President Reagan (whom I voted for and still consider a great President) signed into law the Garn/St.Germain Act, the effect of which was to de-regulate the Savings and Loan (S&L) industry. Since inception, S&L’s were sleepy institutions that took deposits and made home loans, restricted to such activity by federal regulations. As a result of President’s Carter regime, when the Prime rate hit 20%, S&L’s were about to go under because S&L’s had long term assets (30 year home loans) at low interest rates (5%) against short term borrowings (from the Fed) at high interest rates (10% or more). You don’t need a PHD in economics to determine that negative arbitrage over a period of time presents a disaster waiting to happen. Thinking he was doing the S&L’s and the economy a big favor, President Reagan de-regulated S&L’s so they could compete with banks in commercial lending (apartments, office building, retail and industrial loans). At the same time, the Regan administration “encouraged” the Federal regulators of S&L’s (the Federal Home Loan Bank Board, or FHLB) to “ease” the accounting standards for S&L’s so they could make more loans against their capital (leverage up). President’s Reagan’s premise was simple enough: increased financial strength of S&L’s would lead to more home lending, which, in turn, would ignite the sluggish economy (and igniting sluggish economies is what any President and political party wants to do because good economies lead to re-election). And compete and leverage up the S&L’s did. A few really smart entrepreneurs realized the gold mine S&L’s presented with de-regulation and lax accounting standards. So, those really bright men raised some equity from other really bright men and bought the sleepy old S&L’s and turned them into highly aggressive, risk taking commercial real estate investment firms. Gone were 30 year fixed rate home loans and in were high interest rate commercial real estate loans at 110% of Made As Instructed (MAI)appraisals (many, many lawsuits ensued against appraisers for issuing appraisals prepared as instructed by S&L lenders…some of those suits are referred to as the Lake Ray Hubbard suits).
So, what was the result? True market values and real rents came no where close to the “appraised” value and proforma rents used to justify the higher loan amounts. That market reality had been avoided because, prior to 1986, real estate investors could receive 4 to 1 tax write offs on real investments (put up $1 and get $4 in tax write offs). The 1986 Tax Code eliminated multiple write offs, with the ensuing result that investors were no longer able to justify paying more than true market value to buy commercial real estate properties.
And then what happened? Market reality set in. Real rents could not satisfy bloated debt service and loans went into default. Then, the Feds once again tightened the accounting standards they had loosened. The result: the assets (loans) on the books of the S&L’s were determined to be far less in value than the loan amounts. Borrowers, through FHLB directives, were then requested to put up additional collateral to shore up the “bad” loans the FHLB had encouraged the S&L’s to make. Because of the 1986 Tax Code, real estate investment equity had dried up virtually overnight and the borrowers could not put up the required cash collateral. The Feds intervened in the form of the Federal Asset Disposition Agency (FADA), seized control of the S&L’s, indicted scores of S&L executives for essentially bad lending practices (which, ironically, the Feds had encouraged them to engage in), sold off S&L assets at pennies on the dollars and crippled the real estate industry. A total disaster.
Sound familiar? This is exactly where we are again, but, this time, the villain isn’t S&L’s. This time the villain is commercial banks masquerading as investment bankers. How did that happen? Politics as usual.
In 1933, following the Great Depression and runs on banks (both foreign withdrawals of gold-backed currency and domestic withdrawals caused by fear that the US would go off the gold standard), the Glass-Steagall Act was passed and signed into law by FDR to restrict banks from engaging in Wall Street investment banking activities. Why? To return banks to the lending business, and prohibit banks from engaging in the business of investment speculation. Prior to the Act, you could not distinguish bankers and brokers (sound familiar?). It was a good plan and it worked well for decades. Even China adopted the economic policy of separating banks and speculative investment. But, along came de-regulation in an effort to promote the free enterprise system and ignite Wall Street, which, in turn, would ignite the sluggish economy still not fully recovered from the S&L debacle.
Lead by a free market/de-regulation proponent, Phil Gramm, Congress passed on November 12, 19999 and Bill Clinton signed into law the Gramm-Leach-Biley Act, which repealed the Glass-Steagall Act and, once again, allowed banks to engage in investment speculation. The Gramm-Leach Act allowed commercial banks to underwrite and trade in mortgage backed securities and collateralized debt obligations and even allowed the creation of structured investment vehicles (SIV’s) to buy these new securities. And just like in the 1980″s, the Clinton administration and then the Bush administration, encouraged Fannie Mae and Freddie Mac (the nation’s largest home lenders) to “ease” their underwriting restrictions so more people could qualify for home loans. And ease their restrictions they did, and the sub-prime home loan was invented. Some really bright banking people realized a fortune could be made if these new sub-prime loans were packaged and sold as securities to unsuspecting folks all over the globe. Fortunately, Congress had made that possible by once again allowing commercial bankers to masquerade as investment brokers. Wall Street loved the new “securities” and they sold like hot cakes on a cold morning. The result: the economy was ignited and every mom and pop became a Wall Street stock picker, with stocks replacing cash as the favorite retirement vehicle; other banks all over the world and even towns and pension funds bought in; and AIG, the largest insurer in the world, insured everyone that these new “securities” were good investments, adding fuel to the fire. The world economy was on fire.
And then what happened? Well, those sub-prime borrowers were not able to pay the debt service on their home loans, loans sub-prime borrowers couldn’t possibly have obtained prior to the “easing” of underwriting standards and loans sub-prime borrowers couldn’t possibly afford once they had the loans. The result: the bubble burst, and our economy is once again crippled. It’s worse this time because the world economy has been crippled.
Did anyone intend these consequences? Of course not. Our politicians intended to ignite a sluggish economy. But our politicians never seem to learn from history. Greed is a powerful force and left unregulated will prevail over good intentions every time. I believe in the free market system, but not one left to unbridled greed. We have the Ten Commandments to structure our social behavior. We need laws to restrain greed.
Even as the Obama administration is attempting in good conscience to cure the economy with unimaginable large amounts of bailout money, the restraints against greed are missing. Maybe the use of our taxpayer money by bailout recipients for bonuses to those who dug the hole we are in, investments in foreign banks, lavish parties and corporate jets will, once and for all, teach our politicians that greed must be restrained. Well, probably not once and for all but, hopefully, for at least a couple of decades.
Thanks for listening. I hope your 401(k) fared better than most.