John Allison

“While the regulators had a legitimate concern, the manner in which they chose to handle WaMu was even more destructive. They decided to take the extra losses created by covering the uninsured depositors from WaMu’s bondholders. The bondholders had expected significant losses on their bonds, but the losses were more than they had expected because the FDIC had taken part of the money that should have been available to pay bondholders and given it to uninsured depositors. This was in complete contradiction to past practice. The bondholders suddenly realized that there is no rule of law when government regulators are involved. In other words, the regulators can make up the law as they go along because of the extreme flexibility of the regulatory structure.”

“The decision to treat WaMu bondholders this way closed the capital markets for banks. BB&T had issued bonds a few weeks before the WaMu decision. It was a choppy market, but we had been able to raise capital funding. However, after the WaMu debtholders were crushed, the capital markets closed for all banks. I believe this was an even more significant event than Lehman Brothers’ failure. I think one of the main reasons that Bernanke and Paulson were so panicky when they went to Congress for $700 billion for the Troubled Asset Relief Program (TARP)—the so-called bank bailout—was that they realized that they had closed the capital markets for banks.”

“Unquestionably, the handling of WaMu forced the failure of Wachovia. Wachovia had been struggling, but its fate had not been completely determined. However, once the bond market saw how WaMu’s creditors had been treated, the market closed for Wachovia. Wachovia did not have a run by individual depositors, but rather a run in the capital markets. Wachovia probably would have ultimately failed, but not necessarily. By the way, Wachovia did fail. Even though it was sold to Wells Fargo (with the shareholders getting a small amount) and the FDIC did not suffer a loss, its sale was mandated by the FDIC and the Fed. If the government forces the sale of a company, that company has failed (fairly or not).”

Excerpt From: John A. Allison. “The Financial Crisis and the Free Market Cure:  Why Pure Capitalism is the World Economy’s Only Hope.” McGraw-Hill, 2013. iBooks.

This material may be protected by copyright.

Check out this book on the iBookstore: https://itunes.apple.com/us/book/financial-crisis-free-market/id553202865?mt=11

The default belief  of our economic history of the last 100 years has been an acceptance of the dynamic growth of capitalism punctuated by excesses of market greed that have to be corrected by the singular wisdom of government regulation. On closer examination many of those moments of market greed and excess look more like incompetent government meddling caused the problem.

During the Depression of 1929 nearly 10,000 banks collapsed in the United States during that historic bank run. Yet during that same period the number of bank failures in Canada was zero.  Was Canada spared the depression that engulfed the United States? No, but Canada was spared a regulation that prevented banks from crossing state lines. Bending to pressure to protect local banks from encountering big business center banks, they got relief and protection from the Federal government in the restriction of interstate competition.  But that also severely limited their flexibility in dealing with a crisis, a limit that did not exist in Canada where risks were spread over larger areas and underutilized assets could be easily relocated.

Yet to respond to the bank failures that the government largely caused they created the FDIC (Federal Deposit Insurance Corporation).  FDR opposed the FDIC because he saw it would create a sanction for reckless behavior and penalize prudently run banks.  FDR capitulated in a compromise and the FDIC began by insuring deposits for $2500 in 1934. It was raised to $5,000 in 1935, $10,000 in 1950 (Truman), $15,000 in 1966 (Johnson), $20,000 in 1968 (LBJ again), $40,000 in 1974 (Nixon), and then $100,000 under Jimmy Carter in 1980.  Bush raised it to $250,000 before he left office, but it is due to revert back to $100,000 in 2013.

Ten years after Carter raised the limit we experienced the Savings and Loans meltdown, caused by the excessive risk taking in that industry. The government again intervened and created the Resolution Trust Corporation (RTC) to dispose of failed thrift institutions taken over by regulators after January 1, 1989 in an orderly manner. The FDIC created the moral hazard FDR feared. It privatized the profits and socialized the risks.

This behavior was repeated, but on steroids, with the implicit assumption of risk by Fannie Mae and Freddie Mac. Housing was deemed a federal priority, and helping the poorer people get into housing has been a priority since Fannie Mae was created again by FDR in 1938.  But housing prices were highest and least affordable in select areas where local ordinances had restricted supply and raised prices far more than in areas were market forces prevailed. Tax policies such as mortgage interest deductions and preferred capital gains treatment increased the demand for housing.

The Community Reinvestment Act, passed under Carter but exploited under Clinton and Bush, pressured banks to make mortgage loans to less and less qualified buyers. Fannie Mae guaranteed loans, clearing the ratings agencies which had a government protected franchise; to give higher ratings than these mortgage backed securities could have conceivably obtained on the merits of their assets. This widened the market for these securities and caused even more money to be driven into the housing market from all over the world creating the bubble that had to burst.

Compounding the damage, the government required a mark to market rule for valuing these mortgage loans at the worst possible time; when no market existed.  The market to market rule causes valuations to go to extremes, high and low.  This caused capital to dry up and regulations required banks to rebuild capital reserves instead of making loans. Then at a time when information was critical to valuing these securities, the government suspended short selling, a critical source of such information.

During the recent financial disaster, Canada did not exhibit near the real estate collapse we did in the United States.  In Canada they had far less exposure to sub prime loans, large down payments were still required while we all but eliminated down payments for the poorest home buyers in the name of ‘compassionate conservatism’, and mortgage borrowers in Canada were still held personally liable for their loans. Canada had tougher and more prudent lending standards, but they avoided the fiasco foisted on us by well intentioned but misguided moral supremacists on the government payroll.

The government in the U.S. inflated this bubble as eagerly as any on Wall Street, but our government “had a much bigger pump”. Seventy five years ago we could have looked to our northern neighbor and learned better behavior instead of demonizing capitalism. Today we can learn the same lesson, but again we seek to demonize the private sector for conditions created by incompetent government regulation. Wall Street clearly has its demons to account for, but its greed was enabled and often encouraged by incompetent regulations and policy that has a long history. As we crave more government oversight we should ask who will oversee the government that has demonstrated such spectacular failure.

The president seeks a fairer distribution of wealth; he claims not to admonish prosperity, but seeks to be sure it is shared.  There is a proven method to this noble objective and it lies under his nose. Instead of promoting it he is effectively destroying it.

In The Wall Street Journal, 1/26/12 Henry Nau writes Lessons from the Great Expansion.  (p A15 in the print version, the link may require a paid subscription, which I encourage.)

Excerpts:

Yes, “the middle class has shrunk,” as Mr. Obama said while campaigning last month. But not because it’s getting poorer, rather because it’s getting richer.

According to Stephen Rose of the Georgetown University Center on Education and the Workforce, fewer people live today in middle-class households with incomes between $35,000 and $105,000, while the percentage of households making less than $35,000 has remained the same. Where did the missing households go? They became richer. In the past three decades, the percentage of households making more than $105,000 in inflation-adjusted dollars doubled to 24% from 11%.

Even more importantly, the global surge in growth spread wealth from the rich to the poor countries, creating greater equality in global markets than ever before. Throughout this period, developing countries grew two and even three times faster than developed countries. As a result, the share of world GDP held by emerging markets increased to 22% from 13%, while the U.S. share remained steady at approximately 26%. The “Great Expansion” created a global middle class of some 600 million-800 million people in China, India, Brazil and other developing countries.

What were the policy trends that produced this Great Expansion? Precisely the free-market policies of deregulation and lower marginal income-tax rates that Mr. Obama decries.

HKO Comments:

Capitalism replaced the feudal societies where capital was allocated based on rank and privilege with an allocation based on merit, innovation, and often, luck.  We may decry the impact of luck, but it is more fair than rank, privilege,  or social class. The re-emergence of a more state controlled economy is in a very real sense a return to allocating capital based on privilege and power as opposed to individual merit and freedom. By overreacting to a short period of correction and adjustment this administration risks damaging the very best system for achieving the objectives he claims to value so highly.

Too much money makes many people stupid. After the prosperity and growth of the 1980’s, Clinton thought that he could expand the prosperity to more people by enacting government programs without consequences.

In the Investor’s Business Daily editorial, Bill Clinton, Home Wrecker, the writers explore the policy that began the housing bubble and collapse.

Rewind to 1994. While everyone was worried about Clinton socializing health care, he was busy socializing mortgages. To boost minority homeownership, Clinton toughened anti-redlining rules and launched a federal assault on mortgage underwriting standards.

He enlisted no fewer than 10 federal regulatory agencies to crack down on prudent lenders. He named his anti-bank SWAT team the Interagency Task Force on Fair Lending.

“I want to target new (housing) markets, underserved populations, tear down the barriers to discrimination wherever they are found,” Clinton said. “We have to do a better job of reaching the underserved; of eradicating discriminatory practices that prevent minorities from finding, financing or buying the home of their choice.

“We can widen the circle of homeownership beyond anything we have ever seen,” he added.

Indeed, Clinton’s policies for the first time threw millions of previously unqualified buyers into the mortgage mix, fueling an unprecedented housing bubble.

Between 1995 and 2005, according to a new book, “The Great American Bank Robbery,” minorities accounted for nearly two-thirds of household growth and contributed a whopping 49% of the 12.5 million rise in homeowners over the decade.

HKO comments:

It is hard to avoid the desire to share the wealth when there is plenty to share, but when this overrides basic prudent lending standards then the prosperity shared is short lived and in this case very destructive.

This does not excuse reckless leverage in the case of the banks, but it does raise the risk of regulators who are pressured politically to become blind to reality.

Too much money often makes for bad decisions in the private sector as well, but it is more likely to cause systemic failure when it precipitated by the volume, power and force of government.

The president’s jobs bill is a non starter, a desperate attempt to do something by doubling down on failed policies.

Point  one- He offers tax breaks to workers by extending the reduction in FICA taxes, and making up the deficit with higher taxes to the general fund.  He promotes  incentives to get employers to hire the chronically unemployed and to raise wages, yet plans to fund this effort by raising taxes on the same employers.

Point two-  While he demagogues about the millionaires and billionaires, the truth is that there is not enough of them to fund his programs and thus he has to define ‘rich’ down to include the small business people which he cherishes in rhetoric but clearly knows nothing about.

Point three- Businesses do not create long term jobs with short term incentives.  After the ‘tax breaks’ wear off, the business is left with the full fare for the new jobs.  Often creating such jobs  requires investment in new equipment and those pieces of machinery still cost after the incentives have expired.

Point four- The bureaucracy required to utilize these tax credits, and the conditions are so onerous that few of the small business will be able to use them.  If you are only able to hire a few workers it just isn’t worthwhile to ramp up and learn how to comply with an incentive that will only last a few years.  Like most other regulations it is an advantage to larger companies with the infrastructure and the mass to justify the expense of compliance.

Point five-  By giving incentives to hire the chronically unemployed we are creating a perverse incentive to penalize the workers who have NOT relied on the largesse of the extended unemployment benefits.  If I have a choice between two workers and one has been unemployed for a month and the other has been unemployed for a year, I will lean more toward the one who has not been out of the work force for so long.  I will question the work ethic of the worker who has managed not to work for a year.  The advantage of the proposed tax break will not offset the natural incentive to hire a worker with a better motivation. This may seem unfair, but  trust me- this is how most small business employers will think.

At a recent business conference owners and employers from several different small businesses told similar tales.  I could sum it up with two observations: Generous unemployment benefits have made it hard to hire low level jobs such as dishwashers and busboys, and the uncertainty of pending regulations and tax increases has stifled business incentives to expand.  For the amateur economists in the room (and there were several professional economists there as well) it seems obvious that if you create incentives such as generous unemployment benefits not to work, and you also create incentives not to hire (Obamacare, Dodd-Frank, NLRB, higher taxes pending) then you should not be surprised if unemployment remains high.