In the recent financial crisis, most of us have some vague idea that a lot of bad mortgage debt got packaged together, disguised, sold, and bought using more debt.  Wall Street played a lot of games with this bad mortgage debt packaging that most of us will never understand.  Government regulation and a new bureaucracy aim mostly to end these games. Wouldn’t it be better and easier to end most of the bad mortgage debt instead?

Progressives stress that the predatory lending practices of mortgage companies allowed them to sell mortgages to people who could not afford to maintain them.  Before the home owner had time to default, the mortgage was already sold off by the lender and disguised in a bundle advertised as containing only good mortgages.

Conservatives point out that government policies implemented through the Community Reinvestment Act, and Fannie Mae and Freddie Mac, which were intended to expand home ownership among minority groups and the poor, were the drivers that established lowered lending standards and created all of those bad mortgages.

It does not matter which of these narratives is more true.  The sensible public response should be not to create a vast new regulatory bureaucracy, but instead to simply raise lending standards and thus discourage the creation of more bad mortgages.

For whatever reason, in the 1990s credit standards for mortgages began to slip.  Today the government should insist that these same standards be tightened up.  No one with less than very good credit should be allowed to buy real estate, since taxpayers ultimately share in the underwriting through Fannie Mae, Freddie Mac, the FDIC and the implicit doctrine of “too big too fail.”

No buyer should be able to walk painlessly away from a mortgage.  Five, ten or even twenty percent down should be required in some cases.  Shockingly, highly intelligent  public-policy makers have learned nothing with regard to down-payment requirements since the housing collapse.   Congressman Barney Frank, Chair of the House Financial Services Committee, has led efforts for the approval of FHA loans of up to $700,000 with almost no money down (See “Rolling the Dice with Barney Frank”).  Is this not a sort of ongoing public-policy madness, or is there something us dummies are missing?

Common sense says that we should eliminate or make it more difficult to obtain more exotic loans.  Perhaps higher income and longer job stability should be required to obtain an Adjustable Rate Mortgage.  And as for so-called ”No Doc Loans,” mortgages that require almost no documentation at all, these seem designed for criminals engaged in disguising the sources of their wealth.

Republicans are correct to challenge the usefulness of Freddie Mac and Fannie Mae, government mortgage agencies that by their nature privatize profit and socialize risk.  Not only did they encourage loose lending standards, but they are so far the biggest sink holes for taxpayer bailout money.  All of the private “too big too fail” banks have paid back their debts, but not so Fannie and Freddie, which remain unreformed in the Democrats’ bill.  Instead, their debt ceilings were raised, giving them more of our money to lose.

“Too big to fail” is not going away.   Breaking up the banks is not the answer.  Having many medium-sized financial institutions going belly-up is not better than a fewer large ones kicking the bucket.  In that case we would have “too medium to fail.”  The language in our legislation can swear up and down many times that we are going to let big institutions fail “next time.”  Promise.  But the odds are that the next President who finds him or herself staring into the abyss of a huge financial crisis will act just like George W. “Deer in the Headlights” Bush did, and start cutting big checks to bail out private industry.  The important thing is not to reduce bigness, but to reduce the risk of failure.

The biggest obstacle to the kind of simple and sensible finance reform that even us dummies can understand is politics.   Renters want to buy homes today, not tomorrow.   Home buyers want bigger and more expensive homes, not larger down-payments.  Voters with bad credit want their elected leaders to cut them a break.  The banking and housing industries want customers and profits.  Tightening up on lending standards will make all of these groups unhappy, which makes politicians unhappy.  But sometimes unhappy politicians are a good thing, and sometimes dummies are not so dumb after all.

The White House and Democratic leadership went ballistic.  They said that McConnell arrived at his conclusion after meetings with Wall Street executives and pollster Frank Luntz.  In the words of President Obama, “Lo and behold, when he [McConnell] returned to Washington, the Senate Republican Leader came out against the common-sense reforms we’ve proposed.”  Obama  continued,  “In doing so, he made the cynical and deceptive assertion that reform would somehow enable future bailouts — when he knows that it would do just the opposite.”  The President essentially called McConnell a liar.

It’s true that McConnell had just met with the Wall Street Executives.   Luntz had also apparently suggested that attacking the prospect of future bailouts would win points with voters.  Here perhaps was a way to kill finance reform and make the Democrats look bad.  It is also true that during the recent campaign cycle Mitch McConnell raised $1,147,924 from the Securities and Investment industry.  Certainly this man cannot be trusted with finance reform.

Instead, we can more surely rely on the President’s “common-sense reforms”  to defend taxpayers against Wall Street greed, yes?  But wait.  According to the non-partisan Center for Responsive Politics, five of candidate Obama’s top donors came from the financial sector, including his number-one contributor, people and PACs associated with Goldman Sachs, who donated a whopping $994,795 to his Presidential campaign.  In addition, Citigroup gave Obama $701,290; J.P.Morgan, $695,132; UBS, $543,219; and Morgan Stanley, $514,881.  All of these firms were “too big to fail” and most were eventually given taxpayer cash.  But not so Lehman Brothers, which was allowed to fail.  Funny, but Lehman Brothers is not on Obama’s campaign donors list.

It’s also true that the revolving door between the White House and Goldman Sachs swings open and shut so much that it threatens – like our democracy – to become unhinged (See here).

Investment bankers can be fairly accused of many failings, but stupidity is not one of them.  They reasonably expect a return on every investment they make, including those investments in politicians.

There must be some place a taxpayer can turn for some clean finance industry regulation written by a disinterested lawmaker.  Perhaps that self-taught master of the finance industry, progressive hero and Chairman of the House Financial Services Committee, Barney Frank?  Nope.  Barney Frank, during his current two-year election cycle, has collected $111,400 from the finance industry.  He also deposited another $151,249 from the insurance industry, though this would never affect his judgment regarding bailout-related legislation for insurance companies like  taxpayer-fed insurance giant AIG, would it?

Democrat Chris Dodd, who oversees banking legislation in the Senate and is the author of current  financial reform legislation, is under a cloud for a sweetheart deal he personally got from Countrywide Mortgage.  Dodd, who won’t be seeking reelection, is also widely blamed for a loophole in bailout legislation that allowed AIG executives to give themselves juicy bonuses after collecting bailout money.   Dodd, by the way, raised $1,286,598 for his campaign war chest from the financial industry he oversees.

Ah well.  Maybe the Republicans are actually better and will take over after the fall elections.  Not so fast.  Dodd’s Republican replacement would be Richard Shelby, who collected $537,888 from financial interests.  Sure, it’s not half the sum scooped up by Dodd, but Shelby is from Alabama, with much cheaper media markets than Dodd’s Connecticut; Shelby doesn’t need so much cash to insure his own reelection.

All of this begs the question:  Is this any way to run a democracy?

Otherwise phrased:  Is institutionalized bribery any way to make public policy?

Why do the American people stand for such legal corruption?  Part of the answer is partisanship.  Politicians, and their aiders and abettors in the media, constantly stoke partisan passions and thereby distract ordinary people of various political stripes from the common interests they share against entrenched privilege and power.  Just at the moment when a citizen might start to get concerned about a legislative system based on institutionalized bribery, an angry partisan voice points a finger at the other side, and we all descend into raging and rabid recriminations.  We become dizzy and light-headed with partisan fervor and forget the good democratic common ground on which we all should be standing.

No one who takes a single dime from the banking industry should be permitted to vote on – let alone write -  legislation that purports to regulate that same industry.  Yet this is how legislation in America is made.  Shame on us for what we have allowed our political system to become.  It is high time to  consider the great divide, not the one that splits left and right, but the chasm between insiders and outsiders, the one that separates ordinary citizens from those who claim to represent them, but routinely act otherwise.

Americans should take a good and sustained look at Europe next month.  Germany has  key district elections on May 9, and Greece has $11.4 billion in eurobonds maturing on May 18.  We can learn a lot about politics , economics, and their intersection by studying these two events and then asking ourselves some hard questions.   Europe’s situation could well be ours, just a few months or years down the road.

THE ECONOMICS
Greece’s government has been spending above its means and being disingenuous about the scale of its deficit and debts.  Government debt was 115% of GDP last year, and is expected to total 123% at the end of this year.  A year ago, officials said the country’s 2009 deficit would be 3.7% of GDP.  In October, the figure was raised to 12.5%; now it’s considered to have been at least 12.7%.  Not just corruption and graft but poor bookkeeping practices account for this outrageous discrepancy.

In reaction to these figures, the yield of a Greek ten-year bond rose to 8.92%.  Germany can borrow for 5.85%  less.  The interest rates Greece must now pay to refinance or increase its debt significantly exceed any sustainable growth rate for the country, which lacks a strong manufacturing base and relies on tourism, agriculture and government for most of its jobs.

Working for the government is particularly attractive in Greece.  State unions have some of the most generous benefits in all of Europe.  In addition to high wages relative to the private sector, many members can retire with full pension benefits even before they reach the age of 50.

On December 9,  Greek Prime Minister Papandreau said publicly that he will restore his country’s credibility.  Five days later, he outlined some of the means to this end.  He pledged to cut deficits, in part with 10% reductions in social security payments.  He plans to abolish bonuses at state banks and tax bonuses at private banks at 90%.  He’s also going to raise other taxes on the rich.  Standard & Poor’s wasn’t impressed.  On December 16 it downgraded Greece’s bond ratings from A- to BBB+, and bond yields increased three days later.

On March 5, Papandreau said he’s going to increase Greece’s Value-Added Tax (VAT) 2%, to a new level of 21%, and impose extra taxes on fuel, tobacco and alcohol.  Does it surprise anyone that 1/4 of the Greek economy operates “under the table” with cash that’s hard to track and tax?

On March 9, Papandreau visited D.C., returning home encouraged by Obama’s support for Athens’ efforts to curb speculators, whom both blame for worsening the debt crisis.  Two days later, workers in both the public and the private sector went on strike to protest how the new frugality would affect their wallets.

Greece lacks the funds to redeem that $11.4 billion in bonds due next month.  It also lacks the credibility to sell new debt instruments at reasonably high prices and their inverse, reasonably low interest rates.  Indeed, the country’s bond prices fell so sharply last Thursday that traders must be predicting default.

As a member of the  European Union (EU), Greece abandoned its drachma for the euro.  In so doing, the country also gave up its control over monetary policy.  It can neither lower interest rates nor print its way out of its problems; such powers have been yielded to the European Central Bank. Foreign exchange adjustments involve the whole EU and its trade with the rest of the world.  The exchange rate dipped last week to below $1.33, but this doesn’t help Greece with its neighbors. It does help the whole region with exports to the rest of the world, while it makes imports more expensive. Further, the EU fears “crisis contagion”.  Portugal, Spain and Italy are already in poor fiscal health.

Last Friday, Greece asked all its fellow euro-zone members for bailout funds. The EU is now in a rush to comply, trying to build consensus to loan Greece Euro30 billion at 5%.  Greece also requested help from the International Monetary Fund (IMF, and really more like a ”bank” than the World Bank), even though 52% of the Greeks polled say the IMF  has more hurt than helped other distressed countries and 51% say the IMF will likewise injure their own country.    The IMF may loan the remaining Euro15 billion at an even lower rate than the EU.  Given the risk as assessed by markets, both loans would be subsidies.  Some 80% of  Greece’s $300 billion debt is owned by foreigners, mostly pension funds and banks in Germany, Great Britain and France.  The levels of redistribution are many.  They may extend to bailouts of other EU members — most notably, Portugal, but also Spain and Italy.  The EU worries about “crisis contagion”, but it should also worry about “moral hazard”.  Precedent can be dangerous.  If the bailouts go through, expect Portugal to approach the trough soon unless the strings attached are as onerous as once feared.

The timing of these releases may not be intentional, but it’s nonetheless significant. The breaking news of SEC’s civil suit against Goldman Sachs boosted considerably Senate Democrats’ rushed efforts to pass legislation to regulate the financial sector.  The charges are that Goldman sold trusting customers “collateralized debt obligations” (“CGOs”) composed of bonds backed by particularly risky mortgages they’d let special client John Paulson (no relation to the former CEO with the same last name) select so that he could reduce his own risk when he used a fund to bet against the CGOs..

If true, this behavior is decidedly unsavory, even if it doesn’t break any laws.  No politician wants to look like a Big Bank supporter at this point.  All forty-one Republican Senators vowed to vote against the finance bill as it existed last week, thereby exposing its passage process to filibuster. But are all forty-one still willing to hold tight in opposition to legislation that purports to prevent nasty bank behaviors that favor the big guys over the average Joe’s?  Do they dare risk being branded “friends” of a Wall Street that Main Street is even more predisposed to love hating?  The weekend certainly didn’t cool the rage. Monday headlines screamed about “shockwaves” as the SEC started investigating other “soured” deals on Wall Street.  Politicians eager to punish the banks with regulation smell blood and press eagerly forward with “reform”.

It’s hard not to see the SEC’s double release as deliberate.  It pretty much guaranteed that the second Friday announcement, the one about Stanford and his Ponzi scheme, would be overshadowed by the first and that the Senate would be sufficiently grateful for the political boost that it would overlook rather than punish the SEC for its mistakes.

Stanford didn’t make the front pages of newspapers or the opening minutes of TV and radio news and talk shows. This lesser status is unfortunate. The commission’s failure to stop Stanford in a timely fashion should be an important component of the financial regulatory issues before the Senate. Its lesson is to slow down, cool the emotions, and exercise logical thinking before legislating even more government programs and responsibilities.

It was SEC Inspector-General H. David Kotz who disclosed his commission’s ineptitude in bringing scam artist Sir Allen Stanford to justice.  The Fort Worth branch of the SEC, he said, had conducted examinations of Stanford’s business affairs in 1997, 1998, 2002, and 2004, each time concluding that the “certificates of deposit” (“CDs”) he marketed and sold were fake, more likely to be Ponzi or “similarly fraudulent” schemes than valid vehicles for saving.  Yet, the commission failed to press charges for years.  While the SEC delayed taking action, the number of victims of soared.  Stanford was finally indicted on a case involving at least $7 billion; had the dealing been stopped in 1997, Kotz reported, the losses would have topped out at some $250 million.

This is the same Kotz who announced last year that the SEC had botched five investigations of Bernard Madoff, the king of deception whose Ponzi scheme stole $50 billion from individuals and charities alike. Although in dollar terms it involved a mere 14% or so of Madoff’s theft, in regulatory import the Stanford debacle is even worse.  We’re still talking about billions of dollars, and in this case we’re also talking about ignoring the advice of people who actually worked for the SEC.  In the Madoff case, at least it was an outsider — Harry Markopolos — who could find no one in the commission willing to follow through on his suspicions.

A major part of proposed financial “reform” involves the creation of a “Consumer Financial Protection Agency” dedicated to helping Main Street decipher financial products, and President Obama says he will veto any bill that doesn’t regulate derivatives.  Come on.  The President is calling for transparency so soon after passing the massive healthcare law that even the Congress is still seeking to understand?

As Nobel laureate George Stigler cynically but accurately once observed, we “can’t understand the effects of regulation by reading the statute.”   Why should we believe the government is capable of handling the myriad details of derivatives when the SEC didn’t recognize Madoff’s misdeeds even when evidence of returns too good to be true was brought right to their doorstep? If derivatives are indeed as complicated as Government would like us to believe, won’t we have to recruit regulators from the industry they’re then supposed to rein in?  Goldman Sachs has been called “Government Sachs” because of the crowded revolving door between Goldman and Government employment.  Picking former or future bankers to regulate banks is like putting the fox in charge of the hen house.  Meantime, Christopher Dodd, the Democrat from Connecticut who was recently in considerable trouble as recipient of “sweetheart” mortgage deals from Countrywide Financial Corp.’s “VIP” program,  is now empowered to design bank regulation as Chair of the Senate Committee on Banking, Housing and Urban Affairs.  Dodd’s comrades chose not to press charges, but he has decided not to run for re-election in November.

And what’s this about a new ”Federal Insurance Office” serving as “an informational resource” for Congress and other policy legislators and a new federal “Systemic Risk Regulator”, with expanded powers to avoid future credit meltdowns?  They sound good, but will they actually do good?  At what direct and indirect cost to taxpayers?  Nothing  generates cheaper and better information than individuals following their best interests.  All politics may not be local, but most timely and good information most definitely is.

The SEC already exists to ferret out fraud, and the market actually does a good job in punishing bad deeds once they’re exposed.  For both these reasons, the Goldman news should not affect the Senate finance-reform bill and its passage.  Goldman’s stock dropped 13% on Friday in immediate response to SEC’s announcement about its civil case.  $12 billion in market capitalization was destroyed in just one day.  All those stock options with delayed redemptions in last year’s executive bonuses don’t look so attractive right now.  Don’t you think these executives are going to tighten up their supervision and procedures in response?

Goldman Sachs has also been known as the “Gold Standard” of investment banking.  Its biggest asset is not its big-brained bankers but its reputation – its name. Even if it wins or settles the case, and has broken no laws, Goldman’s reputation is now tarnished.  The firm will lose some of its treasured clientele.  They’re less likely to buy complicated and  opaque products now that their trust has been shaken.  Goldman behaved stupidly, and it’s unlikely to repeat this mistake with or without regulation.

More controversial in the Senate bill than new bureaucracies to protect consumers is a $50 billion fund to help troubled banks “wind down” in the event of another credit crisis. Based on size, some banks would be assessed fees “pre-event” to spare taxpayers the ugly necessity of bailing out banks “too big to fail” but nonetheless in danger of failing. Republicans have criticized this part of the bill as almost guaranteeing future bailouts by protecting Wall Street from some of the costs of bad decision-making.  Timothy Geithner says we don’t need an “ex ante” (Latin for “pre-event”) emergency fund, because we can just set up one “ex post” (more Latin, this time for “after the crisis occurs”).  With this timing, he continues, we’d avoid the “moral hazard” (fancy verbiage for “bad incentives”) of socializing the risk while keeping the rewards private.  Meanwhile, Barney Frank says the funds would not bail out the banks, but instead ease them into bankruptcy in a way that would lessen the impact on our economy and cost the banks, not the taxpayers.  The counter argument is that taxpayers will indeed pay something: higher prices for all their services as the Government raises bank costs of doing business.

All these points are likely to be moot, however. Even though the House passed its financial-reform bill in December with this fund a key element, President Obama is campaigning to eliminate it from the Senate bill.  He’s likely to succeed. The real problem, though, is that moral hazard exists whether or not the fund exists and when it’s created.  The United States panicked and rescued banks when credit froze up, and bankers surely predict that we’ll panic and bail them out again if bank behavior repeats itself.  At least taxpayer money was loaned, not given, to the Big Banks in their Bailout, and we were paid back with interest. Regrettably, taxpayers didn’t get a good return on their “loans”.  Non-banks like General Motors also got bailout funds, and Obama would now like any returned funds to go back out and fund “job creation”.

“Too Big to Fail” is also misleading.  Lehman Brothers, a rival of Goldman, was deemed not to big to fail.  The real problem was that so many banks of all sizes acted like a bunch of lemmings, all jumping off the cliff with near simultaneity.  The whole financial sector seized up.  An advanced economy like ours runs on credit, and we had to keep it flowing.

The banks weren’t the only ones who adopted too sunny a view about prosperity and, in an era of low interest rates, sought to create higher returns through derivatives.  No one was forced to buy these instruments, and those who bought products they didn’t understand were foolish.  The country as a whole forgot that risk is real and that liquidity therefore has value.  Even the Harvard investment-endowment geniuses were bamboozled by their optimism and relentless search for higher returns.

When the House passed its financial-reform bill in December, a jubilant Nancy Pelosis announced, “We are sending a clear message to Wall Street: The party is over!”   But Fannie Mae and Freddie Mac are still partying with drunken abandon, exempt from any new restrictions and instead empowered by higher debt ceilings that guarantee higher losses.  Nearly 90% of the American mortgage market is controlled by government-related agencies.  This means that Government is likely to have originated the risky mortgages that Goldman Sachs picked and pooled for its CGOs.

Because the financial sector is too big to fail and the banks seem infected by the mass contagion of optimism and greed, the Government must reconsider its regulatory discipline.  Reserve requirements should probably be extended from checking and savings accounts to other bank liabilities. We should also think about disbanding Fannie May and Freddie Mac, making no-document loans illegal, and raising down-payment requirements on all home mortgages. None of these regulations will require a large or Goldman-Sachs-trained bureaucracy to understand and implement.  Often the best solutions are the simple and straightforward solutions.

The direction our President and the Democrat Majority in Congress are taking in their pursuit of financial reform is problematic.  In assuming that the best response to derivatives and other sources of consumer fraud or deception is more legislation and more bureaucrats, they disregard lessons from the immediate past and undervalue enforcement issues.

The most recent PEW political poll reveals that 75% of Americans don’t trust our country’s leadership.  Only 22% say that they trust Government “almost always” or at least “most of the time”.  The real consequence of all these new government programs to supervise and discipline the private sector is that the Government is now growing so big that it’s likely to fail, too.