Bank Boss Schumer

“Government is not reason. It is not eloquence, it is force. Like fire, it a dangerous servant and fearful master.” –George Washington

The threat to your wealth has been temporarily salvaged by the Fed’s decision last week to cut interest rates to banks and inject lots of new money into the financial system. A stock market crash and credit crunch has been avoided for now.

The summer of 2007 hasn’t been easy. If you are like most conservative investors, you’ve seen your portfolio eroded by 10% or more. If you help high income real estate investment trusts (REITs) or financial stocks, you were hurt even more.

But don’t think for a minute that your wealth is safe from another round of bear markets. Another danger lurks in the halls of Congress. Remember what happened when a rash of corporate and accounting scandals (Enron, Worldcom, and Tyco) hit Wall Street in 2002, following the go-go years of the Nineties Bubble in tech stocks? We got hit with one of the most sweeping regulatory laws in history, “The Public Company Accounting Reform and Investor Protection Act of 2002.” Today the law is known the Sarbanes-Oxley Act, or Sarbox for short, named after its two sponsors, Senator Paul Sarbanes (D–Md.) and Representative Michael G. Oxley (R–Oh.). The Act was approved by the House, 423-3, and in the Senate 99-0.

I suspect a lot of congressmen would like to rescind their votes on Sarbox. It is estimated that compliance cost $6.1 billion for public companies overall. One academic study calculated that Sarbox has resulted in a cumulative loss of $1.4 trillion in shareholder value since going into effect, an average loss of $460 for every person in America.

Already there’s talk in Congress of imposing strict new rules and regulations on banks and mortgage companies. Senator Chuck Schumer (D-N.Y.) has already introduced the first major legislation to deal with “unscrupulous” lending practices, called the Borrowers Protection Act, which would upgrade standards that mortgage brokers must abide by when making new loans to borrowers.

It’s easy to blame the bankers and mortgage lenders for the credit meltdown, but if you examine the real causes further, you discover government mismanagement of the worst sort.

Since the 9/11 terrorist attacks, investors put most of the new money in real estate, and the banks and financial institutions encouraged them with their easy terms. But who encouraged those easy terms? It was none other than Alan Greenspan, and the Fed. Starting in 2002, Greenspan & Co. aggressively expanded the money supply and lowered interest rates far below the normal market. Greenspan himself admitted (wrongly, it turned out) that he feared that the U.S. would go the way of deflationary Japan. His Fed gradually cut rates to 1% by 2003.

Not surprisingly, the new money went into risky mortgages. Where were the banks to put all that low-interest money? The banks and investment companies found it extremely profitable to encourage profligate homebuyers to buy bigger and bigger homes with little down and less financial background checks.

Look at the following chart, courtesy of Jerry Bowyer.


As Greenspan & Co. lowered the Fed Funds Target Rate from 6% to 1%, banks borrowed cheaply from the Fed window, and invested in risky mortgages. The subprime mortgage market took off like a rocket, from 2% to 14% of all mortgages over a five-year period (2000-2005). In 2003, the year of the great money flood, when the Fed cut rates to only 1%, the sub-prime lending went from 4% of total lending to more than 10%. That’s in one year!

But there is no free lunch, as sound economists have warned repeatedly. At some point, the harvest time comes and genuine prosperity must be be separated from the artificial. This is the crisis stage, where the boom turns into the bust. Now it’s harvest time, and we are weeping the effects of the Greenspan era.

The Greenspan Blunder

Last month (August 7), The Wall Street Journal did a major front-page story on "How Credit Got So Easy And Why It’s Tightening." The authors quoted Greenspan saying in 2003/04: "I don’t know what it is, but we’re doing some damage because this is not the way credit markets should operate."

Moreover, at the time, Greenspan brushed off an idea to boost scrutiny of subprime mortgage lenders. A former Fed governor told The Wall Street Journal that he proposed to Greenspan in or around 2000 that the Fed start sending examiners into the offices of consumer-finance lenders that were units of Fed-regulated banks. But the Fed official said, "He [Greenspan] was opposed to it, so I didn’t really pursue it."

The Lesson is clear: There is no market failure here. The collapse in the subprime lending market and the subsequent credit squeeze can be laid at the feet of our Fed officials, primarily Alan Greenspan, the so-called "maestro." And now we are paying the price.

Only the Fed can extricate out of this mess, and not surprisingly, it is working in concert with the other central banks to inject massive liquidity to bail out the banking system. But it hasn’t been enough to forestall a financial crisis. Last Friday, it wisely cut the Discount Rate by half a percentage point, but it will probably need to do more before the credit and stock markets show a solid recovery.

When will we learn? Globalization and supply-side, free-market policies have justified genuine economic growth and higher stock prices over the past two decades. But "easy money" policies have at the same time created an artificial boom and "irrational exuberance" on Main Street and Wall Street.

Congress can only make matters worse by passing a draconian new law going overboard in regulating the credit markets. The markets are already cleaning up their act. Let them do their duty, and the economy will recover on its own.