Today, an audience of 600 business and civic leaders attended the 30th annual Economic Outlook Conference at Century II, produced by the Center for Economic Development and Business Research (CEDBR) at Wichita State University.
The featured speaker was John A. Allison, chairman and former CEO of BB&T Corporation, the nation’s 10th largest financial-holding company. Its headquarters are in Winston-Salem, North Carolina.
The primary cause of the recent financial crisis is our federal government’s policies and actions, Allison said.
It’s not the fault of free markets, as some allege, because we don’t have a free market economy. We have a mixed economy, with some industries such as financial services being highly regulated by government.
What was the cause of the real estate bubble? We built too many houses, many of larger size than we should have built, and we built them in the wrong places, he said.
How did we make such a mistake? Allison said there are four causes or actors that contributed to the problem: the Federal Reserve Bank, the Federal Deposit Insurance Corporation (FDIC), housing policy as implemented by Freddie Mac and Fannie Mae, and the Securities and Exchange Commission (SEC).
The action of these agencies turned a natural correction into a panic. Also, the policies government has taken since then may help us in the short term, but will almost certainly hurt us in the long run.
The Federal Reserve’s errors include creating inducements to take risk based on false signals. The inverted yield curve that Fed Chairman Ben Bernanke created induced banks to take on more risk than they had been assuming. Also, “The huge level of federal debt we have today would not be practical if the government did not own the monetary system.”
The Fed has sophisticated financial models to help it manage the economy, but these can’t integrate the economic activity of billions of humans. Illustrating this, Allison mentioned Frederich Hayek’s “fatal conceit,” where smart people believe they can do the impossible.
The FDIC contributed to the problem by allowing start-up banks to offer high interest rates to depositors. With FDIC insurance, depositors don’t have any incentive to investigate the soundness of the banks in which they place their deposits. This has led to a lack of market discipline.
Government housing policy has been a long-term problem. Spurred by the theory that home ownership for everyone is a good thing, in 1999, the Clinton administration announced that it would be the goal of Freddie Mac and Fannie Mae to have at least half their loans in so-called “affordable housing,” now called sub-prime mortgages.
At the time, economists, including liberal economists, warned that this is risky, and that this course could take them down, and the U.S. economy with it within ten years. Nine years later it happened, Allison said, and the government was forced to bail out these two agencies.
Politics played a role in this. Allison said he served on financial services roundtable committee for nine years. This committee warned Congress numerous times that it was certain that Freddie Mac and Fannie Mae would go broke. But Congress wouldn’t listen. Part of the reason was the political contributions to both Democrats (that party’s single largest contributor) and Republicans made by these two agencies.
Fair value accounting regulations, particularly mark-to-market, led to inaccurate valuation of some assets when markets are thin (not many buyers). When banks were forced to mark down the values of assets more than what economic reality indicated, the loss of capital was multiplied, because banks are leveraged. This lead to larger losses in lending capacity that what was necessary.
Banks with cash might be willing to assume the economic risk of purchasing some of these assets, but they couldn’t assume the accounting risk of future losses. This is an example of the distortions produced by our government-created accounting system, regulated by the SEC. Large and even small businesses don’t use this accounting system for their own management, because it’s not a good measure of value.
The actions of Freddie Mac and Fannie Mae also led to the end of the “originate and hold” model for home mortgages, where banks and thrifts would make home loans, and then hold those loans as part of their portfolio of assets. Private institutions simply could not compete with these government-backed institutions.
This led to the “broker model” or “originate and sell,” which had a terrible incentive. If you simply originate loans but don’t hold them and its risk, your incentive is to originate as many loans as possible, without regard to the riskiness of the loan.
Summarizing the first part of Allison’s lecture: It is government policy that is largely responsible for the crisis. Free markets are commonly being blamed for the crisis, but this assessment is false. Our economy, as Allison has shown, is far removed from free and unregulated. Government intervenes everywhere.
Allison presented a great deal of information in his talk, including some steps we should take to get out of this crisis and to prevent another. I’ll report on this soon.