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Friday, October 26, 2007

Paul Krugman: A Catastrophe Foretold

The causes and consequences of ineffective regulation of financial markets:

A Catastrophe Foretold, by Paul Krugman, Commentary, NY Times: “Increased subprime lending has been associated with higher levels of delinquency, foreclosure and, in some cases, abusive lending practices.” So declared Edward M. Gramlich, a Federal Reserve official. ...

Mr. Gramlich said those words in May 2004. And it wasn’t his first warning. ... Mr. Gramlich, who recently died of cancer, ... tried to get Alan Greenspan to increase oversight of subprime lending as early as 2000, but got nowhere.

So why was nothing done to avert the subprime fiasco? Before I try to answer..., there are a few things you should know.

First, the situation for both borrowers and investors looks increasingly dire. A new report from Congress ... predicts ... two million foreclosures on subprime mortgages by the end of next year. That’s two million American families facing the humiliation and financial pain of losing their homes.

At the same time, investors who bought assets backed by subprime loans are continuing to suffer severe losses. ...

Second, much if not most of the subprime lending that is now going so catastrophically bad took place after it was clear ... that there was a serious housing bubble, and after people like Mr. Gramlich had issued public warnings... As late as 2003, subprime loans accounted for only 8.5 percent of the value of mortgages issued in this country. In 2005 and 2006, the peak years of the housing bubble, subprime was 20 percent of the total — and the delinquency rates on recent subprime loans are much higher than those on older loans.

So, once again, why was nothing done to head off this disaster? The answer is ideology.

In a paper presented just before his death, Mr. Gramlich wrote that “the subprime market was the Wild West. Over half the mortgage loans were made by independent lenders without any federal supervision.” What he didn’t mention was that this was the way the laissez-faire ideologues ruling Washington — a group that very much included Mr. Greenspan — wanted it. They were and are men who believe that government is always the problem, never the solution, that regulation is always a bad thing.

Unfortunately, assertions that unregulated financial markets would take care of themselves have proved as wrong as claims that deregulation would reduce electricity prices.

As Barney Frank ... put it ... the lessons ... are clear: “To the extent that the system did work, it is because of prudential regulation and oversight. Where it was absent, the result was tragedy.” ...

In his final paper, Mr. Gramlich stressed the extent to which unregulated lending is prone to the “abusive lending practices”... The fact is that many borrowers are ill-equipped to make judgments about “exotic” loans, like subprime loans that offer a low initial “teaser” rate that suddenly jumps after two years, and that include prepayment penalties preventing the borrowers from undoing their mistakes.

Yet such loans were primarily offered to those least able to evaluate them. “Why are the most risky loan products sold to the least sophisticated borrowers?” Mr. Gramlich asked. “The question answers itself — the least sophisticated borrowers are probably duped into taking these products.” And “the predictable result was carnage.”

Mr. Frank is now trying to push through legislation that extends moderate regulation to the subprime market. Despite the scale of the disaster, he’s facing an uphill fight: money still talks in Washington, and the mortgage industry is a huge source of campaign finance. But maybe the subprime catastrophe will be enough to remind us why financial regulation was introduced in the first place.

    Posted by on Friday, October 26, 2007 at 12:42 AM in Economics, Financial System, Market Failure, Regulation | Permalink  TrackBack (0)  Comments (55)

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