March 4, 2009 — The current economic crisis is not without precedent, but the notion that deregulation was the sole cause doesn't bear up under close scrutiny, a panel of University of Virginia experts said at the Law School last week.
Law dean Paul Mahoney, Darden School of Business dean Robert Bruner and law professor George Geis analyzed the factors that led to the crisis, the current state of affairs and the government's response going forward. The event was sponsored by the Student Legal Forum.
Bruner, the author of "The Panic of 1907: Lessons Learned from the Market's Perfect Storm," said that economic crises are a normal result of financial markets, and that there have been between 12 and 15 of them over the past century, depending on the definition of "crisis."
"Crises are a regular feature of financial markets, indeed all markets," he said. "We should manage ourselves – our companies and households – in ways to anticipate the regular appearance of these events."
Historical analysis shows that buoyant economic growth typically precedes a crisis, he said, pointing to the dramatic reduction of interest rates during the early part of the decade.
"Interest rates were so low that in real terms, they were negative," Bruner said. "The federal reserve was basically paying people to borrow."
As a result, borrowing in the United States increased dramatically, setting the stage for both the housing bubble and large increases in corporate indebtedness, he said. Investors and speculators grew optimistic, and failed to anticipate a return to normalcy both in the housing market and elsewhere, he said. This optimism led to a reduction in the typical cash "safety buffers" that households and businesses usually hold in reserve.
"Safety buffers are interesting in the study of crises, because they make it possible for trouble to travel," he said. When one person runs out of cash, they turn to another to borrow, and so on. "When banks begin to get into trouble, they cease lending to each other and liquidity seizes up," Bruner said.
But a buoyant period of growth alone doesn't indicate a coming crisis; several factors must be present and there must be some sort of a spark to set it off. In 1907, the spark was an earthquake, Bruner said.
"In this case, I would argue that it was the sudden realization that sub-prime loans were and are much riskier than people had assumed them to be," he said. "It wasn't very long before the spark turned into fire and institutions began to thrash and flounder and some failed."
Geis assessed the most recent conditions and analyzed some of the government's response so far.
"We'll start with the current situation. It's pretty easy to summarize: it's bad," he said.
Geis said there are at least three thorny problems the country is trying to deal with simultaneously. One is a collapse of paper wealth, which can be seen both in the stock market and the housing market.
"The overall monthly sales volume of homes was down the lowest it's been in 12 years," he said. "The prices of the homes were down 15 percent on a year-over-year basis. ... About half of all the sales were distressed sales."
The second problem is that there is a breakdown in our financial markets.
"Financial stocks, I don't need to tell you, are wobbling," Geis said.
The third problem is a slowdown in the production and consumption of goods and services. "This is a global catastrophe, not a domestic one," he said.
Though the United States stands to see its gross domestic product, or GDP, decrease by about 3.8 percent this year if the fourth quarter of 2008 was a good indicator, that number is much higher in other developed countries, he said.
Using that math, Japan would lose 13 percent of its GDP, the United Kingdom 6 percent, and South Korea 21 percent.
Unemployment is also an issue. Though it has spiked to around 7.5 percent, the country is still faring far better than the 27 percent unemployment rate of the Great Depression, Geis said.
Right now, the government is divulging plans to save failing banks by subjecting them to a "stress test" to see if they need an infusion of public dollars, he said, though questions remain about the test's efficacy.
Efforts to unfreeze the credit markets, corral toxic assets and provide foreclosure relief are also underway, he said.
Mahoney addressed the regulatory aspects of the problem, and analyzed what the country is likely to see going forward.
The idea that the current crisis was brought on by deregulation is bandied about a lot in the media and was part of the past presidential campaign season, but details about exactly how that worked are often vague, Mahoney said.
One common scapegoat is the 1999 repeal of the Glass-Steagall Act, a Depression-era piece of legislation designed to reform banks. However, close scrutiny shows that stand-alone investment banks, which were essentially created by the act, were the first to go under during the crisis, Mahoney said.
"For what it's worth, I think that the demise of Glass-Steagall had virtually nothing to do with the current crisis," he said.
One factor that may have had an impact, however, was the Community Reinvestment Act, which legislators in the 1990s used to put pressure on Freddie Mac and Fannie Mae to make loans to low-income borrowers in low-income neighborhoods, he said.
"It turns out that Congress set targets that were sufficiently high that the only way to meet them was for Freddie Mac and Fanny Mae to say to banks: 'Look, we really don't much care what the loan-value ratio is, we pretty much don't care what the person's income is or what their credit score is, you've got to bring us enough loans that we can meet these congressional targets.'"
This had a huge impact on the rise of sub-prime mortgages and their subsequent collapse, Mahoney said.
"So what do we do and how do we fix this?" he said. "Certainly one very simple point that I hope regulators have learned is that any set of policies or regulations that actively encourages banks not to apply sound underwriting standards when making loans is a bad policy, and ought to be rethought."
Mahoney also said the government should revisit regulations that govern how much money a bank or holding company has to have on hand in proportion to its debt.
Though some have blamed a loosening of these regulations in 2004 for the current economic woes, Mahoney said that measure was actually the first aimed to impose capital ratio regulations on the holding companies that owned investment banks.
Mahoney also said government should tighten the regulatory cracks between entities such as the Securities and Exchange Commission, the Commodities Futures Trading Commission, and other state and federal regulatory agencies.
A clever lawyer, he said, might be able to exploit the gaps between the agencies.
"One would like to think that there will be some effort devoted to make sure those cracks are tightened up."