Bureaucracies Throughout Congressional Hearings Various

Bureaucracies

Throughout Congressional Hearings various speakers (the Secretary of the Treasury, the Chairman of the Federal Reserve, and the Chairperson of the Federal Deposit Insurance Commission) all testified that our banks and financial system have been living in an outdated bureaucratic system that was far behind the times and couldn't meet the demands of a "new age" economy.

Based upon what you know about bureaucracies, what were they saying? More importantly, what were they indicating must be done immediately to stabilize our financial systems in the United States?

I have been going for 40 years or more with very considerable evidence that it was working exceptionally well," said Alan Greenspan to Representative Henry a. Waxman, the California Democrat chairing the House Committee on Oversight and Government Reform. Alan Greenspan, the chairman of the Federal Reserve for 18 years, came before Congress and did what politicians and economists seldom do: he admitted he had made a mistake. Not simply one mistake, but a profound ideological and policy blunder of such a scope that he admitted it frightened him. Although "a fervent proponent of deregulation" while "at the Fed's helm" Mr. Greenspan admitted that he had not foreseen the inability of the market to regulate the use of credit default swaps and the greed of banks in making unwise loans (Grynbaum 2008).

In short, Greenspan conceded that the economic creativity and rapacity of Wall Street had exceeded his and other economist's wildest expectations. The federal bureaucratic system put into place after the debacle of the Great Depression may have addressed the concerns raised by that particular financial catastrophe, but today's economy is a far different world. Perhaps one small but telling example of how little the federal regulatory system of banking had changed since the New Deal was that the government only recently and temporarily raised the amount of money it would ensure for individuals from $100,000 to $250,000 ("U.S. FDIC says higher insurance limits helpful," Reuters, 2008). The wariness about interfering with the banking system was so extreme; it took the threat of another crisis and the failure of such stalwart banks as Washington Mutual to move the Fed's hand to raise the amount, which had existed at $100,000 for decades, despite inflation.

Before Congress, Greenspan was apologetic and blunt: "I made a mistake in presuming that the self-interests of organizations, specifically banks and others, were such as that they were best capable of protecting their own shareholders and their equity in the firms...I have found a flaw. I don't know how significant or permanent it is. But I have been very distressed by that fact" (Grynbaum 2008). Greenspan's words imply that according to classical economic thinking, it makes no sense for a bank to lend money to someone unlikely to pay back a loan like a mortgage. It is not in the bank's self-interest to do so, because even if it forecloses on the home, it makes less money from the foreclosure than it would lending to someone who would pay on time. Conventional wisdom would suggest that it is difficult for people to get loans, not easy, because of the risk involved in lending money and it would be better for the bank to give a lower-interest mortgage to a customer who is a good risk and will pay the bank pack than to extend a high interest rate to someone who is likely to default and not to pay back the loan.

However, during the real estate boom at the beginning of the 21st century, banks lent money to people later called 'NINJAs' (No income, no job, no assets) Some of these people were seduced into buying homes they could ill-afford by predatory lenders extending adjustable rate mortgages with low interest rates for a short period of time that quickly became prohibitively high. They ignored their own self-interest in not buying more homes they could afford out of ignorance, and the bank did nothing to deter them because the bank was cushioned from risk in the world of credit default swaps.

Credit default swaps transfer the risk of lending money to other economic entities. Credit default swaps are the main reason for the failure of the insurance behemoth AIG that was otherwise financially sound, except for its purchase of the risks of too many bad 'NINJA' loans. In these swaps, "the insurer (which could be a bank, an investment bank or a hedge fund) is required to post collateral to support its payment obligation, but in the insane credit environment that preceded the credit crisis, this collateral deposit was generally too small," giving banks an incentive to extend bad loans and then sell the risk ("Credit default swaps," Times Topics, 2008). Then, when the "mortgage-backed securities that many swaps were supporting began to lose value in 2007, investors began to fear that the swaps, originally meant as a hedge against risk, could suddenly become huge liabilities" and tried to sell them on the open market, which of course no for-profit organization wanted ("Credit default swaps," Times Topics, 2008). Buying up bad loans, which may or may not be repaid at some point, was one of the cornerstones of the proposed economic bailout -- only the federal government will buy up the loans which are worth, most economists believe, next to nothing given the likelihood they cannot be repaid.