Lost in all the discussion of toxic assets, bank insolvencies, and CEO golden parachutes is the real reason we’re in a financial crisis: there were no limits on how much investment banks could borrow against the assets they held. This led some of the high-fliers to leverage, or borrow, up to 30 to 60 times as much capital as they had, and use it to invest in financial derivatives based largely on mortgage values; when home prices went into free fall, this led to such huge losses that the banks went belly-up (or will, once their remaining assets are properly valued).
Traditional banks can at most borrow (or lend out) approximately 10 times the reserves they hold. This ensures that they will always have enough capital on hand to meet withdrawal requests (except during financial panics). The derivatives market at its peak was estimated to be “worth” about $60 trillion; to put that number in perspective, it’s more than the entire global economy and should have been a red flag to anyone paying attention. If investment houses, like banks, had been required to hold the same percentage of reserves, the market would have been significantly smaller and the damage from its collapse more manageable and containable.
We no doubt would still have experienced major losses in the financial sector, large overall stock declines, and large decreases in home values, but nothing approaching what we are now facing. It also needs to be said that the sharp decline in home prices is really a blessing; it’s always good when bubbles burst, the sooner the better. What’s happening now isn’t a crisis, it’s prices beginning to return to their long term trends. The real crisis was the ridiculous rise in home prices in the first place, and the numerous government policies that helped make it happen (e.g., those lax reserve requirements for investment banks).
But home ownership is sacrosanct in America, and it’s politically incorrect to question the (usually regressive) tax subsidies that help make it attractive: deductions for mortgage interest and property taxes, and a capital gains deduction of at least $250,000 on a home sale (which means there’s no capital gains tax at all on most sales). The elimination of preferential tax breaks for home ownership would be a step towards greater fairness, and it would remove one of the drivers of any future real estate bubbles.
The real culprits in our financial crisis, however, are the Democratic and Republican lawmakers who passed the legislation exempting non-traditional banks from traditional capital requirements. This includes many in the Clinton team, some of whom are now in Obama’s Administration. Former Senator Phil Gramm (R-TX), a top economic advisor to John McCain, is probably the most culpable on the GOP side.
These men were blinded by ideology into believing that the market for fancy financial products would regulate itself, and that the benefits these instruments would provide was so great that no rules should get in their way. Fortunately, Obama has made it clear that anything that operates like a bank must be treated like one, and he will not tolerate an unregulated, rogue financial sector.
In the meantime we need to clean up the mess that has laid to waste almost the entire U.S. banking system. This will cost a lot of money; but if the Obama Administration can get over its aversion to nationalization, and structure the plan in the interests of the American taxpayer, the government may be able to recoup much of its investment in the medium term.
Jason Scorse