Only a Roosevelt-Scale Counterrevolution Can Prevent Great Depression
II

By Robert Kuttner, The American Prospect. Posted September 18, 2008.

Free-market extremists brought us this needless economic collapse.
Here's a rundown of the mistakes we've made and the reforms we need
now.

The current carnage on Wall Street, with dire spillover effects on
Main Street, is the result of a failed ideology -- the idea that
financial markets could regulate themselves. Serial deregulation fed
on itself. Deliberate repeal of regulations became entangled with
failure to carry out laws still on the books. Corruption mingled with
simple incompetence. And though the ideology was largely Republican,
it was abetted by Wall Street Democrats.

Why regulate?

As we have seen ever since the sub-prime market blew up in the summer
of 2007, government cannot stand by when a financial crash threatens
to turn into a general depression -- even a government like the Bush
administration that fervently believes in free markets. But if
government must act to contain wider damage when large banks fail,
then it is obliged to act to prevent damage from occurring in the
first place. Otherwise, the result is what economists term "moral
hazard"-- an invitation to take excessive risks.

Government, under Franklin Roosevelt, got serious about regulating
financial markets after the first cycle of financial bubble and
economic ruin in the 1920s. Then, as now, the abuses were complex in
their detail but very simple in their essence. They included the sale
of complex securities packaged in deceptive and misleading ways; far
too much borrowing to finance speculative investments; and gross
conflicts of interest on the part of insiders who stood to profit from
flim-flams. When the speculative bubble burst in 1929, sellers
overwhelmed buyers, many investors were wiped out, and the system of
credit contracted, choking the rest of the economy.

In the 1930s, the Roosevelt administration acted to prevent a
repetition of the ruinous 1920s. Commercial banks were separated from
investment banks, so that bankers could not prosper by underwriting
bogus securities and foisting them on retail customers. Leverage was
limited in order to rein in speculation with borrowed money.
Investment banks, stock exchanges, and companies that publicly traded
stocks were required to disclose more information to investors.
Pyramid schemes and conflicts of interest were limited. The system
worked very nicely until the 1970s -- when financial innovators
devised end-runs around the regulated system, and regulators stopped
keeping up with them.

Seven Deadly Sins

Sin One: Allowing Mortgage Lending to Become a Casino. Until 1969,
Fannie Mae was part of the government. Mortgage lenders were tightly
regulated. Homeownership rates soared throughout the postwar era, from
about 44 percent on the eve of World War II to 64 percent by the
mid-1960s. Nobody in the mortgage business got filthy rich, and hardly
anyone lost money. Fannie's job was to buy mortgages from banks and
thrift institutions, to replenish their money to make mortgages, and
along the way to set standards. Fannie financed its operations by
selling bonds. In the late 1970s, private Wall Street firms started
emulating Fannie. They packaged mortgages, and converted them into
bonds. Over time, their standards deteriorated, because they could
make more money creating riskier products. In order to avoid losing
market share, Fannie emulated some of the same abuses. Government did
not step in to regulate the affair -- which was a time bomb waiting
for the creation of the sub-prime mortgage business.

Sin Two: Allowing Unregulated Bond Rating Agencies to Decide What was
Safe. Sub-prime is only the best known of a widespread fad known as
"securitization." The idea is to turn loans into bonds. Bonds are
given ratings by private companies that have official government
recognition, such as Moody's and Standard and Poors, but no government
regulation. These rating agencies have become thoroughly corrupted by
conflicts of interest. If you want to package and sell bonds backed by
risky loans, you go to a bond-rating agency and pay it a hefty fee. In
return, the agency helps you manipulate the bond so that it qualifies
for a triple-A rating, even if the underlying loans include many that
are high-risk. Without the collusion of the bond-rating agencies,
sub-prime lending never would have gotten off the ground, because it
would not have found a mass market. Had regulators looked inside this
black box, they would have shut it down. They might have needed new
legislation, but they never asked for it. And public-minded regulators
might have done a lot under existing law, since banks (which are
regulated) were heavily implicated in the financing of sub-prime.

Sin Three: Failing to Police Sub-prime. The core idea of bank
regulation is that government inspectors periodically examine the