The root of the problem

In all this panic about the markets and Wall Street there has been a lot of glib and partisan finger-pointing about whose’ fault it was that we got into this situation. A little quiet reflection, and some research, leads me to conclude that at root, the fundamental errors that probably got us into this situation include (not necessarily in priority order):

1. Failure by the SEC to enforce existing regulations. No doubt some will argue for a slew of new and more restrictive market regulations in the wake of this debacle, but it’s not clear to me that we need more regulations – just effective enforcement of the existing regulations. A reasonable summary of the SEC’s regulatory failures can be found at http://seekingalpha.com/article/96487-5-failures-of-sec-chairman-cox. To be fair to SEC Chairman Cox, Congress has kept the SEC’s funding almost flat throughout the recent years of Wall Street growth, and they are badly understaffed. And administrations from President Reagan through to the current administration, including President Clinton’s administration, have given clear instruction to regulatory agencies throughout the government (including the SEC) to interfere less, not more, with private markets.

2. Failure of the bond rating agencies such as Standard & Poors and Moody’s to do their jobs. Many of the debt instruments which are now almost worthless were rated AA or even AAA by these agencies. Some previous employees of these agencies are now admitting that in recent years they were ordered to simply accept the rating suggested by the investment banks that issued the bonds, rather than independently verifying the creditworthiness. No doubt the fact that the rating agencies depend on fees from the very investment banks they are assessing influences this behavior.

3. Failure of shareholders to demand better information and more accountability from the management of firms they invest in. Obscene executive pay is probably not a root cause of this mess, even though it has powerful political implications. But it probably is a symptom of the failure of shareholders to demand more of management. Some will argue that shareholders have little power to make such demands, but that is false. Investors have all the power – they can simply refuse to buy shares in a company whose management doesn’t act responsibly. Shareholders who don’t perform “due diligence” before buying shares in a company deserve whatever befalls them. I would bet that few individual investors even bother to read the prospectus of a company before buying shares, let alone demand management accountability.

4. Congressional pressure on Fanny Mae and Freddie Mac to increase financing of “affordable housing”. Part of the recent history of that effort is documented at http://online.wsj.com/article/SB122212948811465427.html. Briefly, Congress pressured these agencies to accept more sub-prime loans, and since Freddie Mac and Fannie May would buy them (as Congress ordered), that created a good market for them and encouraged banks to make more of them. Actually, subprime mortgages originated back in 1977 in the Carter Administration with the Community Reinvestment Act (CRA), an effort to help more people own their own homes. Yet another example of “good intentions” leading to bad policy.

Those partisans who are hell-bent on blaming the whole mess on the current administration ought to know that Republicans tried to get legislation enacted in 2003 to regulate Fannie Mae and Freddie Mac, but were fiercely opposed by Democrats who claimed we were “not facing any kind of financial crisis” (Rep. Barney Frank, D-MA, current Chairman of the House Financial Services Committee.).

5. The abysmal level of American public education. Behind the bad mortgages now choking the system are a slew of gullible American home buyers who, for one reason or another, took out a loan they were not in a position to pay back. Some fell for balloon mortgages or adjustable-rate mortgages without understanding the (rather simple) math behind them, or the (rather obvious) risks they entailed. Some “flipped” houses, trying to make a profit on a housing market they thought could never go down. Some were simply conned by their real estate agents and banks into buying a bigger house than they could afford. One wonders if this could have happened if American schools taught children even the most basic facts about real life or how to handle money.

6. The short-term focus of American society. Asian societies think in terms of decades, generations, even centuries. America thinks in terms of months, quarters, and occasionally a year or two. We suffer from national ADD (Attention Deficit Disorder). Far too often management, shareholders, and government leaders alike think short-term, with little or no attention to possible long-term consequences.

These are all fundamental structural problems with our government, our financial system and our society, and they are not going to be solved quickly or easily. Indeed, with our present government system, it’s hard to see how they will even be addressed, but address them we must if we are not to have a repeat of this sort of crisis, or indeed a total economic disaster.