I have read a lot about the financial collapse and the issue seems to devolve into 2 main narratives that I can perceive
I find both of these narratives flawed. As I see it, the government clearly promoted conditions where evil and misdeeds could much more easily happen (i.e. pushed a social agenda of housing for all). This was coupled to a sense that "markets will take care of themselves". While I am a great believer in free markets, I certainly don't believe that governments can conveniently meddle in them (the social agenda I mentioned above).
The question I have is: what is the moral culpability of Wall Street in the financial collapse? I get that that the government unbolted the doors and left treasure in open sight but I don't hear much about the clear evils of Wall Street here. After all the financial crisis would never have happened without the active connivance and participation of major Wall Street institutions. Were Mortgage bankers proper in their behavior by happily pushing loans to people they knew could never pay them (just to make a buck on the origination fees and the sale of the loan to bond packagers)? Were the bond packagers right in assembling mountains of toxic assets they conveniently labeled AAA?
I totally get that government started the cycle but it seems to me that folks of the Objectivist leanings never seem to rail about how Wall Street gladly jumped into the game and gleefully made immoral billions by beggaring and financially imperiling people they loaned money to. Were they not complicit in the disaster? Is it proper for a financial institution to gleefully prey upon people whom they know are vulnerable to making dumb decisions?
asked Sep 18 '13 at 09:38
There is something to your point, and yes there is some moral culpability on Wall Street. But not as much as you might think.
The gov't obviously introduced moral hazard into the market transactions with their carrot of reduced vetting and greater numbers of loans with their originations fees. But the bulk of the toxic loan packaging was made possible by Fannie and Freddie - ostensibly private organizations that were at least QUANGOs (QUasi-Autonomous Non-Governmental Organizations) - but more accurately operated as government sponsored entities with special privileges and immunities. They were the ones that took the marginal and bad loans off of the books of the mortgage lenders. This expanded the reach of the moral hazard into systemic financial system risk and it also expanded its potential scope.
Left to themselves, banks and mortgage lenders would have hit a hard upper limit in regard to how much of their asset base they would have been willing to place so at risk. Fannie and Freddie obviated this limit. But there was another "negative" incentive; the Community Reinvestment Act.
The Community Reinvestment Act was passed during the Carter Administration (and given more regulatory teeth during the Clinton Administration) ostensibly to combat the racially-discriminatory practice of "red-lining," a policy where a bank would supposedly draw a red-line on the map within which they would not lend.
This policy was supposedly a relic of the "Jim Crow" era and its northern equivalents and while there were racially motivated actions of this nature,1 the vast majority of these redlined areas were created by government actions - specifically, the practice of eminent domain against property holders in the inner cities for the purpose of Urban Renewal. Banks with collateral in such areas could not expect to see their collateral value returned to them; people in those areas who owned their property outright seldom got market value for the takings involved. Thus, the fiduciary responsibility of the bank officers would preclude them from making loans in those areas.
The CRA ignored the historical and fiduciary roots of the practice and essentially opened up the banks to regulatory action and lawsuit; giving any person who thought they had been "red-lined" standing to initiate legal and regulatory action against a bank who refused to loan to them. The bank was then in the position of having to prove their innocence in the charges made. Read the CRA disclosure of your local bank the next time you go there - they are required by law to post the law where their customers can see it - and you will see how sweeping the legal standing can become.
Then, in the 1990's, the Clinton Administration gave more teeth to the law. Previously, banks were open to legal and regulatory action originating in customer complaint;2 under the Clintons, the DOJ could target banks who did not meet certain CRA quotas with fines and "further regulatory actions" including denial of permission to open new branches. I was told by a VP of a national bank that they were specifically told that the ability to open new branches was contingent upon meeting CRA quotas as overseen by the DOJ.
So, in addition to the carrot of moral hazard that you pointed out in your question, there was also the stick of regulatory action - the gun to the head, as it were. The banks could extend dubious loans that were fiduciarily irresponsible but which risk was overtaken by moral hazard, or they could stand on principled ground, do the fiduciarily responsible thing, and be punished for it.
Now one could argue that a sufficiently bright and principled person could navigate these shoals without compromising their principles and they would be right. One such person was John Allison of BB&T.3 But generally speaking, faced with the regulatory club of punishment on the one hand and being able to shuck the questionable fiduciary actions into a moral hazard scenario on the other, most bankers chose the moral hazard route.
Of course, when the housing bubble burst - itself a creation of the government policy with the FED promoting easy money, Freddie and Fannie packaging the dubious loans thus providing the moral hazard, and the CRA acting as a great big hammer to drive it all home - the questionable loans became obvious for what they were. They were bad loans and no amount of derivative4 creation could change the fundamental nature of the investment. This re-packaging of the loans as derivative securities provided an entre of the pathology into the financial system and in addition to the negative effects of as yet unpackaged loans had on banks asset balance sheets was added the systemic effects of massive and fraudulent securities.
In the previous banking crisis, the Savings and Loan Scandal of the late 1980's a similar thing happened, though it happened through a change in the tax laws governing commercial property. A friend of mine was a commercial realtor during that time period and he explained that the Tax Reform Act of 1986 changed the way that commercial real estate was depreciated. That this change caused the market value of commercial real estate to drop as much as 50 percent. While I can't recall all of the details, the value of commercial real estate was largely predicated on cash flow generated; a change in depreciation and write-off rules meant that taxes took a larger bite out of cash flow generated, thus commercial market value dropped and banks that were carrying the loans on their asset and liability accounts suddenly found that where they were solvent and well-capitalized in 1986, they were suddenly insolvent and under-capitalized after the TRA86 went into effect. The FDIC then took a closer look and rather than blame the regulatory effect for the reduction in asset balances, they took marginal peccadillos and blew them up into public scandal. Thus, the Savings and Loan crisis was born.
I asked my friend, who was a libertarian, why he sold commercial real estate if the actual cash flow without the favorable tax treatment was not sufficient to justify the purchase value. He pointed out that if one is going to do commercial real estate, one cannot dictate the market terms and the government depreciation and write-off rules were part of the market action at that time. In short, unless one is willing to withdraw from the market entirely, one has to deal with the regulatory apparatus as it stands. In fact, to not take these things into account for a client would be a violation of one's fiduciary responsibility.
Subsequent to the housing bubble in 2007, the same song and dance was trotted out by the government. Ignoring the government induced moral hazard put in place for a specific government policy - middle income housing for low income persons - and the regulatory club wielded by the government functionaries - and the complicit action of government sponsored entities in raising the moral hazard roof and broadening its footage - the politicians once again blamed the object of all these coercive acts - the banker and loan originators. FDIC scrutiny which had previously been held in abeyance suddenly became the Right Thing To Do. Sarbanes-Oxley was passed which diverted actual risk management - already compromised by government action - into regulatory risk management; filling out the right forms for the right regulatory outcomes regardless of how that action impacted the real risk in the real world. FDIC became the means of shorting regional banks without political connections into situations where they could be "acquired" by politically connected banks for pennies on the dollar. In short, the confluence of government initiated disasters was used as a pretext for more government action that will assuredly bear fruit, at some future time, with more disaster.
Did the objects of this storm of government coercion have some culpability? Yes. That culpability amounts to NOT standing on moral grounds and telling the regulators to take their threats and shove it. But that level of culpability is miniscule compared to the systemic moral hazard and outright depravity practiced by the holders of the regulatory club and their minions.
1 My Grandfather made his fortune by lending to those that the mainstream bankers thus discriminated against.
2 Imagine what "community organizing" groups like ACORN could do with this regulatory handle in their grasp.
I spoke to a number of CEOs who were found “guilty,” and they all said, “No, we didn’t engage in racial discrimination; however, it was easier just to pay the small fine, change processes, and then put out a press release that we were guilty of discrimination—and that made the politicians/regulators happy.” Well, the regulators came to BB&T and we didn’t operate that way. They came to me and said we were guilty of racial discrimination, and I said, “Well, if that’s so, that’s against our fundamental ethics. Give me the names of the people who are discriminating. I’m going to go fire them now; I’ll do it personally.” They said, “No, nobody discriminated.” “Okay,” I said, “How about a system? Do we have a system or process that caused discrimination?” They said, “No, it just happened (magically?).” So I said, “Okay, let’s see your evidence.” We looked at the evidence and basically found that every loan we made, we should have made, and every loan we turned down, we should have turned down. There was no racial discrimination. Nevertheless, we were still advised to go ahead and admit guilt, because if we admitted it, we would simply pay a small fine and move on. We said, “No,” over principle, and the regulators stopped our mergers and acquisitions for months; we had several in process that never materialized. We were ready to go to court, and then a very interesting thing happened that will tell you a lot about the rule of law. The Republicans got elected to control Congress in a negative response to Clinton’s policies. Guess what the regulators did? The Republicans were elected on Tuesday, and on Thursday the regulators all went home and we never heard from them again. Fair Lending evolved into “forced” lending to low-income minorities. Another big factor, psychologically, was the Community Reinvestment Act (CRA). This law was supposed to eliminate “redlining” and also forced banks to get into the low-income home lending business—a business we were not designed to be in. Additionally, CRA was a moral crusade; bankers were ethically supposed to do low-income lending. Now I know there’s a lot of greed on Wall Street but when you combine “this is the right thing to do” and “you can make a bunch of money doing it,” you create a huge incentive.
4 Some have argued that derivatives should therefore be outlawed, but this is a classic case of inverting cause and effect. The loans were not bad because they were packaged as derivatives, the derivatives were bad because the loans were not performing and that packaging of bad loans as AAA securities could not have happened without active government connivance and policy.