What We Can Do To Prevent Self-Inflicted Bubbles

The Lesson of the Housing Bubble

Government should not overtly interfere in or manipulate private enterprise to achieve social agendas. Every time government attempts social engineering through market manipulation distortions are created, unintended behavior is encouraged and economic damage results. Such manipulation is particularly dangerous when it directly influences asset prices.

Government should restrict its influence on private enterprise to minimal regulation that is designed to prevent unacceptable abuses or restrain behavior that the free market can not regulate itself.

Greenspan’s Fatal Flaw

Greenspan believed that the Federal Reserve could reduce the economic pain and damage of the business cycle’s downside. He concluded that such manipulation was a good idea and, if successful, would produce positive results. The Greenspan Put was best illustrated by his response to the Internet Bubble.

The downside of the credit bubble is a vitally important component to capitalism. It is comparable to the risk of bankruptcy confronted by private companies and the risk of capital losses facing individual investors.

When markets steadily rise, positive returns are consistent or volatility is reduced for an extended period of time, the perception of the risk is discounted by investors, companies and governmental policy makers. When people convince themselves that investments are less risky or that the chance of capital loss is small, behavior becomes distorted.

The Internet Bubble and Housing Bubble from 1996 through 2001 was an example of such a distortion. Following the Internet collapse it is possible that a recession would have occurred, the credit expansion would have mitigated and house price appreciation would have normalized. In fact, immediately following September 11th house prices stopped appreciating. But the dramatic cut in interest rates implemented by the Federal Reserve distorted capital flows and the behavior of potential buyers and investors.

Government should take special care when manipulating business cycles. The impact of such intervention may cause more damage than benefit. Furthermore, capitalism requires the profit incentive associated with investment as well as the risk premium and potential for capital losses to ensure that investments are allocated efficiently. Influencing perceptions of these characteristics creates harmful distortions as assuredly as overt interference in private enterprise.

Regulating Leverage Ratios

A responsibility of government should be to regulate leverage ratios employed by financial institutions and utilized in asset purchases. This observation has been vetted by history, represents common sense and is necessary to avoid the catastrophic abuses of excessive leverage that are inevitable in a financial system defined by free markets and unfettered competition.

To the extent leverage is made available to individuals, companies, investment funds and governments it will inevitably be utilized to excess. Regulators should determine leverage ratios that are suitable and consistent with a vibrant, flexible and growing economy. These ratios should not be excessive or promote dangerous and unreasonably speculative behavior. The government has recognized the necessity of such restrictions on stock purchases as well as on banking and insurance companies. Despite these well founded lessons, government has recently promoted the use of destructive debt in housing through tax incentives, Government Sponsored Entities, legislative distortions and overt cheerleading efforts.

In this capacity our government has failed miserably. In no respect did excesses of capitalism cause our current predicament. There were inexcusable abuses which steadily intensified during the mania. But capitalism does not dependably restrain the use of debt and leverage to buy assets, capitalize certain companies and finance speculative investments. The allure of leveraged returns is too attractive, especially while markets are stable and rising. Even rational or conservative individuals and companies come under pressure as their competitors access excessive leverage. Most individuals could not afford to buy a house in 2005 with a 20% down payment because prices had risen to insane levels driven by people using infinite leverage. Companies see competitors growing faster, capturing superior equity returns and extending better terms to customers through the magic of excessive leverage. Rational individuals and companies have the option of sitting the mania out, which may not be possible in the case of a company, or to rely on prevailing leverage ratios to compete.

If excessive leverage is made available to individuals, companies, investment funds and governments, those entities will inevitably make use of it irrespective of the potential for and inevitability of catastrophic damage.

Examples

We learned the lesson of allowing individuals to access dangerous leverage to buy stocks in the 1920s. As a result, margin requirements have been at the 50% level for decades. Since this regulatory requirement was introduced we have not had a leverage induced stock market bubble. The stock market bubbles we have experienced have been less broad and damaging than if extreme leverage had been available.

We learned that commercial banks and insurance companies required regulatory limits on their leverage ratios to prevent insolvency. Excess leverage in these industries is a recipe for eventual trouble as business cycles inevitably occur.

The loose credit standards of recent years were a failure of regulation similar to the 1920s. Individuals should not be able to buy stocks by borrowing 90% of the value of the asset purchase. In the same way, individuals should not be allowed to borrow 100% or more of the value of a home. This equates to an infinite leverage ratio as no money down is required. The availability of such leverage will inevitably be accessed and abused.

Investment banks should never have had access to leverage ratios that were demonstrated by Lehman Brothers and Bear Stearns. Hedge funds should not have access to extreme leverage. Many of the hedge funds that have failed or will fail have leverage ratios of more than 10 to 1. Given the volatility of the asset classes in which many invest or the inevitability of business cycle volatility, such leverage is insane and ensures that large numbers of these funds will fail.

The credit default swap industry is at the center of current economic volatility and will have a material impact on the global economic system as companies continue to fail. This industry has largely been unregulated to date. I am sympathetic to those who argued for it to be left alone from government interference. The one area where government should have injected itself is in regulating leverage ratios and minimum capital requirements. The credit default swap industry effectively provides insurance for bonds. Government recognizes that insurance companies should maintain minimum levels of capital relative to policy liabilities, but we ignored the same sensible requirements for credit default swaps.

In what was one of the most disturbing activities of the Housing Bubble, Congress overtly marketed Fannie and Freddie as private companies, yet allowed GSEs to leverage themselves to a degree unheard of by private financial institutions. Congress, addicted to the market access and low interest rates enjoyed by the GSEs, used these institutions to create and perpetuate the Housing Bubble. Their unconscionable actions during March of 2008 approach the threshold of criminality. These companies with dramatically deteriorating fundamentals and leveraged to a degree which ensured failure should have been doing everything in their power to survive. Rationality required eliminating dividends, dramatically reducing operations and tightening credit standards. Instead Congress compelled these institutions to increase activities, raised the cap on mortgage purchases, reduced capital requirements and directed them to buy mortgages in areas where prices were collapsing. Congress used these pseudo private GSEs in a desperate attempt to prop up falling real estate prices.

Congress’ attempt to double down on Fannie and Freddie’s activities were inexcusable. Fannie and Freddie were already likely to fail given their government mandate to buy low credit quality mortgages attached to overvalued houses and their extraordinary leverage. Congress’ panicked directives accelerated the collapse which occurred mere months after this latest government intervention.

Regulate Maximum Leverage Ratios

Regulators should establish minimal capital requirements and maximum leverage ratios with regards to the use of debt. The stock market bubbles of the 1920s and the Housing Bubble would not have occurred without abusive leverage. Investment banks and hedge funds would not be destabilizing the global market had they not had access to extreme leverage.

I am not advocating specific regulatory requirements. I think the 50% margin requirement to buy stock has worked well, but I can’t say whether we would be better off if that requirement was set at 40% or 60%. What I do know is that congress should have no direct ability to set or manipulate these ratios. Regulators should be insulated from such intervention. The Housing Bubble has clearly demonstrated the damage caused when government has the ability to manipulate market forces to achieve social agendas.

Irrespective of what minimum down payment requirement for home purchases is adopted, some economically deficient politician with an agenda will attempt to manipulate that rate lower to realize a social goal or purchase reelection. Relevant regulations must be adopted with the long term, sustainable health of the economy in mind, not the short-term, expedient goals of politicians.