Unlimited Credit at the Crossroads

The problem with debt is that you are expected to repay it eventually. When you accumulate a lot of debt, the burden of repayment is heavy. Americans--including consumers, home buyers, investors, speculators, and banks--have accumulated a shipload of debt. The ongoing deleveraging of America is the natural result. Refi isn't a legal right. It's just more hair of the dog that bit you.

The Federal Reserve has recently nationalized a major investment bank, Bear Stearns. That's not the precise legal form of the transaction. But that's largely the effect of the deal. The government bears a lot of the risk of loss (on some $30 billion worth of potentially toxic assets). And the government gets a large voice in the management of Bear Stearns' activities. JP Morgan Chase gets the upside if Bear Stearns' shareholders approve the deal. But Bear Stearns' shareholders reportedly can reject the deal and get 12 months to shop the firm for a better deal. In the meantime, presumably the government will run things there. Bear Stearns: now a subsidiary of the Federal Reserve?

It's odd, to say the least, that the full faith and credit of the United States has been pretty much placed behind an investment bank that performed badly. The ones that performed better don't (as yet) have this government guaranty. But let's not be cynical, shrug, and say, "that's life in the rabbit hole." Let's consider whether federal regulators could do better in the future so that we don't have to nationalize more investment banks behaving badly. What could be done?

The problem is that banks can pretty much create unlimited amounts of debt unless someone restrains them. Lack of restraint--by the banks and their regulators--is what got us into this mess. The Federal Reserve and other federal regulators can prevent this from happening again. The Fed has several tools: reserve requirements, monetary policy and regulation of bank accounting rules.

The reserve requirements compel banks to place a certain percentage of their deposits in non-interest bearing accounts at the Federal Reserve Banks. The reserve requirements can encourage lending (if they are low) or discourage lending (if they are high). High reserve requirements reduce the amount of money banks can lend and force them to choose their loan customers with greater care (which means ascertaining whether or not they in fact can repay the loans). Not much attention is paid today to reserve requirements, but they could be dusted off.

Monetary policy, which consists of regulating interest rates and the size of the money supply, is the most prominent way by which the Fed controls lending. There is little evidence of restraint in current monetary policy. Perhaps the Fed is right in combating the recession that it doesn't predict, but it certainly is running the risk of inflating prices, as well as new asset bubbles.

Accounting rules dictate what assets must be on a bank's balance sheet and what assets can be swept under the rug into SIVs and conduits. The size and asset-mix of the bank's reported balance sheet determines its capital requirements. Lack of capital is a severe problem at the major banks today, in substantial part because they in actuality had to bear the risk of loss from assets that weren't on their balance sheets--and which accordingly weren't buffered by increased capital. Accounting must bear a fairly close relationship to reality, or it fails to serve its intended purpose. The federal banking authorities can impose accounting requirements to eliminate this hide-and-seek game with SIVs and conduits, and they can deploy phalanxes of examiners to make sure the banks are complying with the rules.

The administration has announced a flurry of actions designed to clean up the mortgage lending process. That's all well and good. Irresponsible, fraudulent and downright outrageous things have happened to mortgage borrowers. But today's problems extend well beyond the mortgage markets, and into the regulation of financial institutions. Government regulation is a central part of the financial markets, and vigorous, effective regulation is essential to maintaining public confidence. That's the lesson of the Panic of 1907, and it's the lesson that has had to be relearned a century later.