Congress Should Ask Treasury: Can the US Self-Regulate?
As Congress debates bills to let government buy $700 billion of distressed mortgage assets, it may want to ask if the US can still self-regulate or needs advice from outside experts. With little fanfare or media coverage, the Treasury Department recently signaled willingness to invite representatives of the International Monetary Fund to conduct an examination of the US economy, financial infrastructure, regulatory apparatus and other systemic elements.
This IMF examination, commonly performed for emerging economies, could identify causes of the current crisis and offer reforms less subject to domestic political pressures. It may be premature for the current bill to address causes or prescribe cures with specificity. But Members and Senators could ask both Treasury and the IMF about whether anything should be in the asset purchase legislation to enable or require Treasury to undertake such an examination.
The IMF is imperfect, of course, having occasionally failed to forestall looming financial crises or offered policies that worsened a brewing crisis. But it has plenty of experience with these problems. An example, with parallels to the current crisis, and indeed a contributing cause of it, is 1997’s Asian financial crisis.
That crisis arose because borrowing in the region’s countries, including Indonesia, Korea and Thailand, increased heavily, financial risk was measured poorly, and a speculative asset bubble formed. When the bubble burst and prices collapsed, defaults on debt spiked. The IMF intervened with a series of policy prescriptions, including directives to allow certain financial institutions to fail, support to rescue others, and stringent conditions on those economies, including limitations on debt.
One result of IMF’s stringency was a massive increase in personal savings rates in the affected economies. This, in turn, produced cash that would find its way into the US mortgage finance system, which was already expanding. Expansion in the US mortgage market arose in part from low interest rates maintained to combat a recession threatened by the collapse of the US tech bubble in 2000 and terrorist attacks of late 2001. Existing institutions, including Fannie Mae and Freddie Mac, supported this expansion by continuing to buy or guarantee mortgage loans. Expansion was propelled by growing use of mortgage-backed securities, pools of mortgages that pay interest and principal to investors.
These forces led lenders to offer attractive deals to large numbers of borrowers lacking traditional indicia of creditworthiness. Trillions of dollars worth of loans were made on easy terms, including loans not requiring a down payment and low or no interest payments for extended initial periods, subject to reset at higher rates later. Reinforcing this expansion in weak credit were novel financial insurance products, called credit default swaps. These promised investors in mortgage backed securities, and other debt, repayment by an insurer if their own debtor defaulted.
The result was an increase in housing prices that assumed dimensions of a speculative bubble. The bubble began to deflate in 2004. Interest rates rose, sales slowed, lenders tightened standards and rating agencies identified greater risk in financial instruments supporting the expansion. Large numbers of people defaulted on mortgage loans when their outstanding balances exceeded a home’s market value.
In outline, if not details, these forces parallel those leading to the 1997 Asian financial crisis. Clean-up efforts now fall not to the IMF, but to the Fed and Treasury. They have struggled but failed to stabilize the situation. This is so despite supporting the takeover of mortgage-backed securities player Bear Stearns by JP Morgan Chase in March; taking control of mortgage-finance lubricators Fannie Mae and Freddie Mac in early September; extending credit to credit default swap insurer American International General two weeks ago; and expanding credit to other financial institutions, including investment banks.
Now, the Fed and Treasury ask Congress for authority to buy up all the bad assets. Treasury Secretary Hank Paulson and Fed Chair Ben Bernanke will testify today about why they want a “clean” bill, simply granting the authority. Lawmakers, apparently not ready to consider such causes as those I’ve suggested or reforms they may indicate, talk of adding provisions to protect homeowners (limiting foreclosure rights or loosening bankruptcy laws) and taxpayers (giving them warrants to buy the assets) or address collateral matters like capping executive compensation for recipient firms and prohibiting recipients from managing the governmental program. On the campaign trail, neither Senator Obama nor Senator McCain offers specific diagnosis or reform, other than loose of talk of deregulation as a cause and re-regulation as a cure.
Even if it is too soon to be sure what caused the crisis and what, if anything, to change to prevent recurrence, and even if some of the additions that some lawmakers want in the bill are reasonable, it may not be premature for Congress to consider whether someone other than officials within Treasury, the Fed or Congress should have an independent look. Few candidates appear qualified for such a task. The IMF, imperfect though it is, may offer requisite expertise and independence to contribute useful insight.