Consider this fact. Any child under the age of 18 is prohibited from gambling in a casino in most states. Yet, that same sub-18 teenager can legally engage in trading derivative securities. What is the difference between casino gambling and derivative training? Well, for one, gambling risks are more readily calculable. Secondly, gambling is regulated by individual states while derivative trading is exclusively controlled by federal regulators. And those same regulators have very little interest doing their job.   This disturbing fact leads an important lesson about the economic catastrophe that is bruising just about every American budget.

That lesson can be summed up in one word: oversight. The main definitions of oversight make the point. The first means a complete missing or overlooking of important details. The second means watchful and responsible care. To truly understand what caused our current credit cataclysm, consider that we had a lot of the first definition and not enough of the second.

In the last few months we’ve witnessed the graphic carnage caused by government regulators’ “overlooking” important details. America’s credit markets have collapsed as a result of fractured and incompetent regulatory oversight of banks and (soon) credit card companies.  Bernard Madoff made off with as much as $50 billion while the Securities Exchange Commission looks askance for the better part of a decade.   A majority of our six major domestic airlines are effectively bankrupt and their service quality has dropped faster than a stricken airliner because of regulatory disregard.

Similarly, America’s three biggest auto-makers now teeter on the brink of bankruptcy because of a dysfunctional credit market and government indulgence of fuel-guzzling cars. Government’s myopic oversight in energy markets brought us $4.60 a gallon gas and $5 a gallon diesel and jet fuel. These critical regulatory “oversights” have harmed you and your families in ways that you can’t even imagine….yet.

Americans need to know what really caused the financial cataclysm. Decisions will be made in 2009 based on what policy makers decide are the root causes of the financial crises that plague our economy. Knowing the causes is critical to determining the correct fixes. As will be explained below, the credit markets’ unfettered efforts to keep Americans spending will likely prove to be the primary culprit behind the current credit collapse. And the credit markets’ dysfunction can be attributed to what I refer to as “duh”-regulation.

The Causes of the Crisis

Apologists will point the finger of blame at consumers. Greedy consumers, they’ll say, are the cause of the failure of the mortgage markets. There’s a grain of truth in this theoretical silo. True, we did experience an evolution of a lifestyle based upon consumption and reliance upon debt funded by housing and the stock market. But in actuality, the seeds of our current crisis started in 1972 when wages flattened (a fully employed male earns $800 a year less than in 1971) and other necessary costs rose. Health care, housing, fuel, food, education all rose faster than the rate of inflation since 1971. Wages haven’t followed suit. The American family compensated using two strategies: (1) double (or triple) income households and (2) debt. Families leveraged their increasing real estate values to get the loans necessary to keep up with the rate of inflated necessary goods and services. During this period, real income increased at 2.9% but consumption increased by 3.5%. So, yes, there’s a grain of truth, but just a grain.

So do we blame these families for just trying to keep up? Before you reach a premature conclusion, consider another important cause of our current tough times: the failure of regulation. As more facts come to the surface, the public will learn that our financial regulators looked away as financial predators siphoned money out of consumers’ bank accounts under the guise of allowing families to keep up with their dwindling spending power. Initially, they did it by expanding the role of the credit card and issuing irresponsible mortgages. But the hole began to be dug in earnest with the introduction of securitization.

Securitization is a very powerful force. It is the pooling of non-traded assets for the purpose of issuing standardized securities backed by those assets, which can then be traded like any other security. It can be used for good. It can be used for evil. It was up to our federal regulators to ensure that this new tool would be used for good. They didn’t.

Part of this is due to an oversight by Congress that effectively deregulated credit default swaps in late 2000. The Commodity Futures Modernization Act of 2000 (H.R. 5660 and companion bill S.3283 ) was introduced in Congress during the last days of the Clinton administration. Neither bill was debated in the House or Senate. They bypassed the substantive policy committees in both the House and the Senate so that there would be no hearings or opportunities for recorded committee votes. The leadership of the Republican-controlled Senate and House inserted the Act into an omnibus budget bill during the waning day of Bill Clinton’s lame duck administration, which was in no position to veto anything. It gained some notoriety afterward for containing the infamous “Enron Loophole.” It was drafted by lobbyists for Enron working with former Senator Phil Gramm to exempt most over-the-counter energy trades and trading on electronic energy commodity markets. However, it will gain a full chapter of infamy for its deregulation of all trades that allowed for asset securitization, as it placed almost all regulatory oversight into the pass-dropping hands of the Federal Reserve.

In late 2008, we began to feel the effects of the nasty brew created by the deregulation of securitization combined with artificially low interest rates set by the Federal Reserve and the globalization of the world financial markets. The flood of cheap money unleashed by the Federal Reserve monetary policy was funneled into a financial community that was unable to properly gauge risk – largely due to these unsupervised derivative securities. The securities weren’t adequately asset-backed. And markets behaved as if real estate values would never drop. So when the market began to slow, there was no controlling the chain reaction that hit the risk-shocked credit markets.

Many commentators blame subprime loans. Yes, they were the financial canary in the credit mine explosion; they marked a time when the entire mortgage model changed — lenders were no longer the lender. Distance was created between the lender and the borrower, so assessment of risk got lost. Agents who wrote these risky loans were immune from any risk because they were able to securitize the loans and pass them onto the secondary market with impunity. It became clear to everyone but the federal regulators that loan company compensation structures were askew.

Another particularly bad actor in this Shakespearean-proportioned tragedy was the Office of the Comptroller of the Currency (or OCC). This little known office is charged with ensuring the safety and soundness of the national banking system and promoting competition in the banking sector. This office lost its way. Rather than safely protecting consumers, it obsessed over whether or not the national banks were financially sound. Over the past decade, it made sure that national banks were supremely profitable — but at the cost of protecting the public from these banks’ excesses. And the OCC’s gradual preemption of state regulators has made it harder for states to perform their historical oversight role over banks.

Calculating the Costs

It is too early to know the true cost of the cataclysm with any certainty. Our president-elect says the economy will get worse before it gets better. But it doesn’t take a doctorate in physics or winning the presidency to know that the damage is real and severe. Credit starved companies are declaring bankruptcy, lining up for federal bailouts and laying off workers in the millions. National unemployment is at 6.3% and rising quickly. Increased unemployment will lead to large credit card defaults — the next big shoe to drop in this credit crisis. Over $15 trillion has been lost in the domestic stock market in 2008 and 5% of all home loans are currently delinquent. Next year, estimates suggest that delinquencies will approach 7%. These are sobering numbers considering that historical levels for mortgage delinquencies have hovered at 1%. Reasonable projections say that 5 million families will lose their homes by 2013. Consumer insolvency is skyrocketing; there was a 38% rise in consumer bankruptcy filings in last year. 100,000 families declaring bankruptcy every month.

Moreover, as a result of the easy credit, the US economy has become too dependent upon consumer consumption. Home prices are still too high relative to real income. American workers are producing too few exportable products and are, instead, offering productivity-draining services like health care and luxury services. Until American workers begin to make their consumption more productive, the U.S. will continue to lose its competitive advantage. A sobering result: the U.S. has lost its lead in R&D and education. As of 2007, US college education has dropped below the world’s top 20. Our best and brightest educators have begun to flee to other countries.

Perhaps the most worrisome development in the financial markets is that the large banks have devoured the weak ones, leading to a massive consolidation of the country’s financial service sector. In sum, the remaining banks have become too big to fail and too entrenched to break-up. As a result, they no longer face any real business risk that can’t be solved by a government rescue. In the near term, the only thing standing between oligopolic tyranny and the consumer is federal regulation.

Combatting the Crisis


To end the crisis, regulators at the federal levels and the state level must stop engaging in willful oversight of their oversight responsibilities. Effective oversight involves making sure competitive markets work and consumers have meaningful choices and are not subjected to irresponsible business practices. For the last decade, most of the large companies offering necessary services have acted as predators rather than proprietors. And these abuses won’t stop until regulators are forced to accept responsibility for their malfeasance.

Enter an intriguing idea put forward by Harvard Law professor Elizabeth Warren. She has equated financial products as the equivalent of any other product purchased by consumers. (see her article)   Just as the Consumer Products Safety Commission protects against unreasonable risks of injuries associated with consumer products, she has advanced the creation of a Financial Products Safety Commission to protect consumers against unsafe financial service products. Warren persuasively argues that where it is impossible to buy a toaster that has a one-in-five chance of bursting into flames and burning down your house because of product safety protections, it is possible to refinance your home with a mortgage that has the same one-in-five chance of putting your family out on the street. And, adding insult to injury, that dangerous mortgage won’t even carry a disclosure of its danger. Warren claims that financial services aren’t contractual transactions any more than buying an electrical appliance is a contract-based. Mortgages, banking services and investment schemes are financial products and consumers need more than just disclosure to buy them safely.

Warren notes that the business model today for credit cards and mortgages relies upon strategies of tricks and traps to get usury-like profits from lending. Lenders set traps so when consumers stumble they are subject to excessive fees and interest demands that boost the profitability of the lenders. They get away with these tactics because they are subjected to fractured regulation. All of the financial markets are regulated by a complex web of different federal offices. There is neither a big picture nor any unifying principles. Worse yet, the fractured nature of federal regulation encourages regulatory arbitrage. And in the last decade, Bush-appointed regulators have focused more upon protecting the profitability of lenders rather than protecting consumers.

Warren’s modest proposal has gained traction. In 2008, the House passed the Consumer Credit Safety Commission Act but it didn’t succeed in the Senate. Next year, it will be teed up again. This Commission would be charged with ferreting out the fraudulent business practices that brought us to the brink of a credit precipice. It will focus on principle-based regulation rather than just issuing prescriptive rules that could be circumvented by clever credit companies. If the agency identifies a problem, it will ask the industry to come up with a solutio. If it doesn’t come up with an adequate one, the Commission will impose one. Generally though, the Commission will focus more on enforcing principles than issuing lots of rules. Most importantly, it will consolidate regulatory oversight over the financial industry into one single regulatory office. The companies will no longer be able to play the various agencies off one another.

Another intriguing proposition is converting the moribund Small Business Association into a microfinance tool to fill the void created by the credit market meltdown. “Microcredit” and “Microfinance” are often associated with lending to the poor in third-world countries. But increasingly, Western banks are finding that microfinance principles can be adopted to first-world commerce. In light of the turmoil amongst large lenders, the U.S. may need to look to the local banks to get money to small businesses. Those local banks need to play an increasingly important role in breaking the credit freeze and getting money to smaller companies and, perhaps, individuals whose credit-worthiness may have been undermined during the current recession.

The importance of making credit available to small businesses has been long recognized. Congress seized upon this concept to help small businesses during a post-war recession of the early 1950s. In passing the Small Business Act of 1953, Congress created an independent agency charged with the responsibility to ” aid, counsel, assist and protect, insofar as is possible, the interests of small business concerns.”

In 1996 the then newly Republican-controlled House of Representatives tried to eliminate the SBA. The most recent Bush Administration continued the Republican assault on the SBA and in 2004 certain expenditures were frozen. The Obama Administration has an opportunity to revamp and revitalize this important agency and expand its charge to work with local banks to make small and medium-sized loans to those who will be ignored by the risk-averse institutional national banks.

Another important part of the fix involves a revision of the Commodities Future Modernization Act. It must be reformed to allow for the oversight of derivatives. And the federal government must also begin to make credit rating companies more accountable to the public. The SEC needs to be empowered to step up to the plate on the credit rating agencies.

Conclusion


This story is just beginning to write itself. American consumers face a number of very trying years ahead. And economic historians will spend decades trying to sort out the causes of and casualties associated with the first major recession of the 21st century. Yes, there are a number of contributing factors and there’s probably no one singular fix. In the coming years, policy makers will struggle to find and fund more cost-effective education, lower-cost health care and other necessary services. But the promise of all of these important reforms will not be realized if the voracious financial predators are permitted to continue tear away wealth from American families. Until we can get our financial houses in order, just about every other reform will be neutralized. And without a new set of re-energized and accountable regulators, that financial housecleaning will not materialize.