When Less is More

In the wake of the collapse of Lehman Brothers and Merrill Lynch, both presidential candidates are calling for tighter regulation of the U.S. financial markets. That might make for good soundbites, but it’s more important to look back at the root cause of today’s troubles.

Under Presidents Bill Clinton and George W. Bush, the government heavily promoted home ownership to all citizens, even those with lower incomes and weak credit. Fannie Mae and Freddie Mac bought these loans from the primary lenders (banks) because they offered the highest rate of return, and coincidentally, the most risk. Fannie and Freddie casually assumed those risks, because the two companies were effectively guaranteed by the federal government, i.e., the taxpayer.

Whose idea was it to create Fannie Mae? It was part of Franklin Roosevelt’s New Deal administration. Who’s idea was it to make Fannie Mae a private corporation with implicit government backing? It was Lyndon Johnson’s (Freddie Mac was created in 1970 during Richard Nixon’s administration to provide some competition to Fannie Mae). Whose jobs were to make sure that Fannie and Freddie were able to handle these high-risk mortgages? The regulators. Why didn’t the regulators do their jobs? It might be that the incentive for someone to do his/her job as a regulator is much less than the incentive for someone else to try to make millions of dollars. The end result is that the seeds sown by the government years ago probably set the stage for the takedown of two huge financial companies, and possibly more to come.

I think what we can learn from all this is that when the government intervenes in the free market, any short-term benefit will likely be counteracted by an unforeseen catastrophe in the long-term. What’s happening now is probably a much needed correction in the financial markets that will be necessary for long-term economic health. Hopefully, the government doesn’t throw too many wrenches in the works during the meantime.