For some, this month’s election answered a lot of questions. But there are still some nagging questions hanging over the financial markets.
There remain three unaddressed problems from the 2007-2009 financial crisis: government mortgage banking, bank rule incentives, and the too-big-to-fail problem. If these three issues are not addressed soon, we are in for another financial market panic.
The financial crisis was precipitated by a run-up in housing prices. Much research since then has shown that the bubble in housing prices was due to the implicit government guarantee given to Fannie Mae and Freddie Mac. The government has now made good on this guarantee and fully backs both firms.
These two corporations buy mortgage loans off the books of local banks. These loans now account for nine of every 10 mortgage loans written in the United States. At the height of the financial crisis, these previously private corporations went bankrupt and were forced into government receivership, where they remain today.
Fannie Mae and Freddie Mac have more than $5 trillion in outstanding debt that is now the responsibility of the federal government. If we add these values to the direct federal debt of $16 trillion, you get $21 trillion, or 133 percent of GDP. As Idaho Sen. Mike Crapo said two years ago, Fannie Mae and Freddie Mac “stand out as the source of the greatest taxpayer losses and a root cause of the financial crisis.”
If we don’t address the root cause, we are bound for another crisis.
The second unanswered question is banking regulation. In 2010, Congress passed and President Obama signed the most extensive bank regulation bill since the Great Depression. The 2,000-plus-page Dodd-Frank bill doesn’t fully specify how bank mortgage loans will be restricted or what amount of capital banks will have to hold in reserve when trading certain types of securities.
The bill left the details for regulators at the Federal Reserve, the U.S. Treasury, and various other agencies. Even two years later, potentially devilish details remain to be worked out.
What didn’t change is the incentive for banks to hold government debt. Under current rules, when a bank takes your deposit and lends it to a business, it must hold a percentage of its own capital against the loan. That is, the bank and its owners must have capital to back up the risk it is taking with the loan.
Not so when lending to the government. If the same bank takes your deposit and invests it in a government bond with a higher (albeit slightly) return, the bank and its owners don’t have to have any capital behind the loan. So bankers have a much bigger incentive to lend to the government, including Fannie Mae and Freddie Mac, than to lend to your business.
Finally, regulatory changes since the financial crisis have done nothing about the too-big-to-fail problem in the financial markets.
The Dodd-Frank bill does require regulators to start identifying financial institutions that are very important to the whole financial system and thereby need government guarantees when markets freeze up. But which banks these will be is still up in the air.
In fact, many non-bank companies are being considered for this guarantee even though they make money in both good and bad financial times. As reported in The New York Times this month, financial contract clearinghouses, such as the Chicago Mercantile Exchange and the Options Clearing Corp., have been designated as “systemically important financial-market utilities.”
Banks lost money during the crisis, but not this group. The CME Group, which owns the Chicago Mercantile Exchange, has averaged more than $1 billion a year in net income over the past five years, including 2007-2009.
So, just as with Fannie Mae and Freddie Mac, the U.S. Treasury is now on record as willing to cover the obligations of these financial clearinghouses. The government guarantees just keep adding up.
Election results notwithstanding, the financial markets still face considerable uncertainty.
Peter Crabb, professor of finance and economics at Northwest Nazarene University in Nampa. email@example.com