EIN Roundtable Seminar

Pragmatic Answers to the Financial Crisis

Monday 8 December 2008, European Parliament, Brussels

Henri Lepage
"FINANCIAL CRISIS:
THE OTHER VISION"

Disclaimer
The European Ideas Network is a forum for debate, created by the EPP-ED Group in the
European Parliament, to analyse the economic, political and social challenges facing Europe and
to develop practical policy options to meet them.
This paper, like all publications of the European Ideas Network, does not represent the
collective views of the EIN or of the EPP-ED Group but only the view of its author.
Copyright of this publication is held by the author. You may not copy, reproduce, republish or
circulate in any way the content from this publication except for your own personal and noncommercial use. Any other use requires the prior written permission of the author.

FINANCIAL CRISIS: THE OTHER VISION

There is no lack of analyses explaining how the financial crisis started and then how it spread to
the point where the gravest of concerns were raised about the future of the global economy. But,
apart from the odd exception, they all have something in common: although they describe
perfectly the chain of events triggered by the implosion of the US housing bubble and the
subprime crisis, they fail to mention the part played by the adverse effects of regulatory ideology.
Yet in this case it is fundamental to understand what is happening and to be able to draw
conclusions for action.
The usual argument, repeated more or less systematically, presents the financial crisis as the
inevitable product of liberalisation, globalisation and financial innovation which raised too much
steam through neo-liberal dogmatism. The common view is that when the capitalist market
economy is left to its own devices and is not sufficiently controlled then, far from regulating
itself, it invariably leads to excesses, abuses and financial irregularities which via complex
mechanisms inevitably lead eventually to a crash and economic crisis. Current events are just
another illustration of this instability property-based and lethal of the capitalist economy, the
impacts of which can be limited only by public intervention.
But there is another way of looking at the facts and the chain of events, a vision which suggests
that the epicentre of the financial cataclysm lies not so much in the liberalist and capitalist
direction of our economy, but in the unintended consequences of political regulation and the
regulatory environment.
There is no question of denying the existence of market failures, nor the abuses which set off
harmful processes. The capitalists, bankers and managers are no saints. But they alone are not
the cause. In reality, the events which we are experiencing are not so much the result of a
massive failure of the market economy but the manifestation of a crisis in regulatory ideology
and contemporary forms of a mixed economy, shown up in the particular context of a market
(the housing market) that has been corrupted by unreasonable policy objectives and practices.
Let us take the fall of the two mortgage institutions, Fannie Mae and Freddie Mac. They have
been portrayed in the press as collateral victims of the spread of a financial sickness which

swallowed them up as it had swallowed others a few weeks or months before. Nobody has
commented that these companies, private in principle, but benefiting from a semi-public status,
were, if not at the origin, then at least at the very heart of processes which gave rise to the
subprime bubble and the rotten chain of events it triggered.
It all began with a federal directive of the 1970s, the RCA (Reinvestment Community Act),
which aimed at encouraging US banks and financial institutions to develop their activities in
underprivileged areas in the name of tackling social and economic inequalities. This new law
meant that banks in particular had to provide a whole series of statistics (on ethnicity, level of
education, socio-economic background, etc.) in order to better understand the social profile of
their clients and how it was changing.
At the end of the 1980s these statistics were used by universities to establish that the distribution
of housing mortgages was not fair in social terms and that banks were using discriminatory
practices to the detriment of the socially disadvantaged.
At the start of the 1990s the US Government (under Bill Clinton) launched a national home
ownership strategy under the slogan that every American should have the opportunity to own
their own home. This was when the US Department of Housing (HUD) decided that the only
loans that could now benefit from its guarantee would be loans from institutions or money
lenders who agreed to make their selection criteria less stringent (e.g. by attaching less
importance to income and credit rating criteria). At the same time, the RCA was amended to
incorporate provisions that gave associations the legal capacity to inform local authorities about
banks who were not making sufficient efforts to bring themselves in line with the new loan
criteria. Then in 1995 the State revised the status of Fannie Mae and Freddie Mac. In return for
them making an active commitment to contributing to the success of the new housing policy,
they were granted new competitive privileges resulting in considerable financial advantages (such
as an implicit guarantee from the Treasury and exemption from the general rules for calculating
prudential ratios).
Gradually the new RCA became a powerful blackmail weapon used against banks by an army of
citizens' movements linked to the Democrats in the name of tackling discrimination. These
movements made use of federal law to threaten to denounce institutions that were not
responding fast enough to their demands or doing enough to relax their case evaluation criteria

to the authorities in each State who were responsible for renewing annual banking licences. This
was how it became common practice in the United States to give mortgages to households where
the repayment guarantees were more and more uncertain: subprimes were born.
The banking profession was more than happy to lets its arm be twisted because the institutional
and monetary environment lent itself to the situation. There did not seem to be any cause for
concern in the context of plenty of liquidity being generated by the international monetary and
financial system since the appearance on the global scene of new emerging powers, low interest
rates that had become structural, the continued rise in property prices, an asymmetric monetary
policy (cf. Greenspan) and property speculation that was accentuated by tougher policies on land
and development regulation in a number of major US towns and cities.
Initially Fannie Mae and Freddie Mac werent very involved in subprimes. Their competitive
advantage compared to other mortgage firms because of specific accounting characteristics
linked to their status did not really encourage them to take risks. However, this approach did not
take into account the HUD and the power of the ideology which drove its directors. Increasingly
they required the institutions to go further in relaxing their criteria. Disappointed by the slow
growth in property rates among poorer households, they imposed ever higher subprime loan
quotas on Fannie Mae and Freddie Mac. The 2Fs went about their task with enthusiasm, all the
more so because the privileged status generated considerable personal financial benefits and
because their directors, not wanting to lose these advantages, practised a very active lobbying
policy in political circles so that affordable housing became a key electoral argument.
They showed even greater enthusiasm from 2004 onwards following a series of accusations of
fraud and accounting irregularities going back several years and involving several successive
directors (with links to the Democrats) which drew the attention of Congress to the way in
which the two companies were managed. Some economists were concerned about the drift in
their activities as far back as the start of this decade. It was already clear that in terms of risks
their commitments had become totally unreasonable and that the two companies risked finding
themselves in deep trouble very quickly should there be a downturn in the market. But there was
little concern about this because of the implicit guarantee given to them by the US Government.
The dotcom bubble masked the gradual development of a housing bubble, particularly because
the HUD did not hesitate to authorise the heads of Fannie Mae and Freddie Mac (who were

themselves financially involved in the whole affair) to cover up the real figures in order to
protect its policy objectives.
The politico-financial scandal could have broken in 2004 and had it done so what happened
afterwards would probably have been very different. But Fannie Mae and Freddie Mac mobilised
every last one of their political contacts, all those who in some way or another had benefited
from their generous lobbying policy (such as Barack Obama). Democrat representatives were
there in force and blocked the setting up of a Senate investigating committee.
It wasnt long before the favour was returned. To show their gratitude, the heads of the 2Fs were
more enthusiastic than ever to serve the political ideology of housing for everyone supported by
the democrats and their allies at the head of the HUD administration (by this time Bush was
already President). This was when all the dams burst. 2004 was when the 2Fs started to finance
the production of subprimes in increasingly industrial quantities and when the bubble really
began to expand disproportionately (see figures). This was also when these toxic products
(considered secure at the time because of the guarantee from the US Treasury) began to flow
through all channels of the US financial system and contaminated the whole international
financial system.
The day the bubble burst was inevitably the day when US property prices did an about-turn.
What happened next is common knowledge. What is not so well known, however, is the way in
which the institutional and regulatory environment gradually set up after the Reagan-Thatcher
era to respond to the major economic and financial shocks of the previous fifteen years, such as
the 1987 crash, the case of the LTCM hedge fund, the crisis in Asia in 1997, the Enron collapse,
the internet/telecoms bubble and the 2001 stock exchange crisis, exacerbated these events and
transformed a crisis that was purely American in origin into a global disaster.
Much is known today about the leveraging, deleveraging and even debt deflation mechanisms
which rule financial cycles and the transition from boom to crisis. But there is still a lack of
knowledge concerning the essential part that the regulatory environment plays in amplifying
cyclical processes and intensifying boom and bust phases.
Capitalism isnt perfect. Booms and crises are part of its natural metabolism and are the ransom
of the dynamic of creative destruction which means that we have never found anything better

than capitalism and the free market as factors of growth and increasing global wealth. But only
external factors such as the outbreak of a war, a return to protectionist policies, massive errors in
monetary regulation, or even overzealous regulatory otherworldliness, can explain why some of
these cycles suddenly become the kind of global tsunamis that only happen once or twice a
century as stated by Franois Fillon.
The governments of major democracies seem more or less to have learnt the lessons from the
previous catastrophe in 1929, as the decisions of the last few weeks have apparently shown.
Their leaders who have some sense of responsibility admit today that a return to protectionism
would be the economic equivalent of a capital offence. In theory, we should not see the large
central banks commit the same monetary errors which precipitated the world into the depression
of the 1930s. But regulatory activism, even when it is driven by the best of intentions and seems
an appropriate response, can entail consequences of a similar magnitude if we are not on our
guard.
It is only by considering the regulatory context and the conditions for State intervention that we
can explain the exceptional nature, both in size and scale, of the impact of the US property
bubble.
There are many complex, often closely intertwined, elements that have to be taken into account.
Here are a few to which particular attention should be paid:
1. Smart growth policies. This is an urban planning policy which has expanded very rapidly
in the USA over the past ten years (e.g. in California). I have mentioned above the link
that exists between the tightening of constraints and the US property bubble. Empirical
studies make it very clear that property prices are highest and have undergone the
greatest rise in areas where land regulations have been tightened up the most. Similarly,
there is a strong correlation between the degree of land regulation and the geographical
distribution of areas with the highest subprime rate, and where as a result the downturn
of the property cycle has produced the highest number of victims (i.e. bankruptcies,
people ruined and evictions). Tightening up land regulation, combined with the
peculiarities of the US mortgage regime which allows negotiation of additional loans as
and when the market value of the asset goes up, is without doubt a key element in

explaining the exceptional size of the bubble which formed from 2004 onwards, and also
why the economic bubble, fuelled by plenty of global liquidity, was based on property.
2. The prudential ratios of the BIS (Bank for International Settlements). It all began in fact
with the Basle agreements dating back to July 1988. By setting a maximum prudential
ratio of 8% of equity, they forced the major international banks to reduce their loans
(and therefore their profits) or to increase their own capital (and thus dilute their
shareholding). It was in order to escape this dilemma that the banks launched heart and
soul into producing securitised products. Simply put, they changed jobs. Rather than
giving out loans on which they were repaid by charging interest, they moved towards
giving out loans which they then used as raw material for the resale of increasingly
complex financial products, intended to divide up the risks and produce generous
commissions. It was in these circumstances that structured products came into
existence, the CDSs (Credit Default Swaps), CDOs (Collateralised Debt Obligations),
MBS (Mortgage-Backed Securities) and other SIVs (Special Investment Vehicles), this
whole pyramid of instruments and practices today accused of being primarily responsible
for the financial pyramid. Paradoxically, while new international regulation aimed at
stabilising the financial activity of the major international banks, its effect was on the
contrary to drive their directors towards a management of capital that was ever more
aggressive and unbridled; particularly because they were in direct competition with other
investment and placement bodies such as hedge funds which did not have to meet the
same obligations. Without the Basle ratios (coupled with the diabolical Marked to
market rule) the financial bubble would probably not have been on the same scale. The
Basle agreements were revised in 2004 and replaced by a new, much more complex
regulation, Basle II. This only entered into force in November 2007 for the United States
and September 2008 for the European Union. Pure coincidence? There are legitimate
grounds for asking whether this played a role in triggering recent events.
3. New accounting standards and Marked to market. Strictly speaking, this is not a
regulatory standard imposed by the legislature, as the obligation for investors to carry out
a continuous evaluation and re-evaluation of the assets in their balances at their market
value is the result of a decision taken by the FASB (Financial Accounting Standards
Board) which was then taken up in Europe. But it was a decision largely taken in
response to demands made and pressure applied by the Stock Exchange Commission,
which today monitors its application. The specialists agree in recognising the essential
role that the Marked to market rule has played (and continues to play) in amplifying

deleveraging processes and thereby accentuating the dramatic character of events on

stock exchanges. There is no doubt that this Marked to market was the principal
transmission vector of the violent crises in credit and liquidity which beat down again
and again upon the very companies that seemed most solid. It is this provision, which
came into general use in 2004, which explains to a very large extent the exceptional
nature of this hurricane compared to previous crises. Since the end of September, the
SEC and European authorities have decided to relax the application of the Marked to
market rule. Some companies, in certain circumstances, will be authorised to go back to
the Marked to model technique. But the inevitably vague and imprecise nature of this
exception could bring about a totally unintended effect because of the additional
uncertainty that it introduces into accounting decisions.
4. The responsibilities of the SEC (Stock Exchange Commission). Rating agencies have
without doubt played a role in the spiral which led to the formation of the bubble and
the way it then burst. They let their guard down when they awarded the triple A too
freely to a large number of banking subsidiaries specialised in subprime portfolios and
derivatives (simply because, as we have seen, these were assets based on loans that were
in principle guaranteed by the State). It is plausible that this may be explained in many
cases by a conflict of interest. Clearly rating agencies didnt do their job. But whose fault
is that? Is the reason for this the lack of a sufficient regulatory framework for their
activities? Or is it not simply because this is a good example of a profession where there
is basically no longer much competition? Most commentators forget that at the start of
the 1980s the SEC created new regulatory provisions which ended up closing the market
to new firms. Since then, rating is a profession reserved for a small cartel of protected
firms. Moreover, some people are surprised that the leveraging coefficient of major US
investment banks could reach such high thresholds that they could multiply their capital
for placements by thirty (instead of the normal multiplier of around 10). With these
figures, it stands to reason that these institutions would eventually end up encountering
insurmountable obstacles. But who has pointed out that the origin of these leveraging
levels was the decision by the Stock Exchange Commission in 2004 to change the way
prudential ratios were calculated for the five major US investment banks and them alone?
Of the five Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers and
Bear Stearns three have already disappeared or changed hands.
5. The unintended effects of bail-outs. Given the state we were in, huge State
interventions, such as the Paulson Plan, decisions by the European G5, partial

nationalisation of the banks, etc., was almost certainly inevitable. There needed to be
urgent action to thaw the freeze of interbank markets. However, the economic price to
pay for these bail-outs may be very high. The bail-outs of the banks paradoxically put the
brakes on the restructuring process. In these circumstances, as for any industry where
there is overproduction, the way out of the financial crisis is massive restructuring where
the institutions that are ailing most are taken over and restructured by healthier
companies. Yet from the moment the State jumps in as rescuer, it is to be expected that
managers in difficulties prefer to rely more heavily on the providence of their network of
political friendships rather than focusing on looking for unpleasant market solutions.
With this in mind, we have the right to ask whether the events of autumn 2008 were not
the manifestation of some sort of delayed effect of the first decisions taken a year earlier,
when, for example, the US Treasury came to the rescue of Bear Stearns, but at the same
time left Merrill Lynch to its own devices; then again, a few months ago, when the US
Government intervened to nationalise Fannie Mae and Freddie Mac and to save the
insurance company AIG, but abandoned Lehman Brothers to its fate. Far from bringing
peace and stability to the markets, such decisions, which are discriminatory by their very
nature (why rescue one and not the other?), therefore compound uncertainty for the
others. Rescuing the first institutions triggered a spiral which could lead only to the
ultimate decision of semi-nationalising the banks. But now this stage has been reached it
would be a mistake to believe that the story is over. The same calculation will have to be
made outside of finance, in industries that are most threatened by the economic crisis,
e.g. the car industry, the insurance industry, or even SMEs. Why refuse a loan for a few
tens of thousands of euros to a small company when the State has just committed several
hundred billion to save the banks? If the State has intervened to save the banks, why not
other major companies who are too big to fail? We end up with the dominant logic of a
political market where we know in advance what the consequences are in terms of
economic efficiency and growth. The fact that the authorities may not have committed
the same monetary errors as their predecessors in the 30s does not stop the fear that we
have now entered into a chain of negative events similar to that of Roosevelts New
Deal, a period when massive intervention by the State, contrary to what we find in
economic history lessons, in reality delayed the way out of the crisis (until the war) and
did not in fact pull the United States out of the crisis.

The logical conclusion from this is that the solutions to the problems raised by the crisis cannot
be found by calling into question globalisation as a whole or the principle of opening up and
liberalising markets, nor by the State returning massively to regulating economic and financial
activities, but on the contrary by an in-depth critical examination of the pyramid of public
intervention (starting with monetary policy which is primarily responsible for the cyclical return
of boom and bust).
Although contemporary economic (and political) thought is shaped by the idea that there are
market failures and that it is up to the authorities to correct them, the final message is this: it is
time to re-think the way in which the global economic system works, not by relying on the a
priori principle that a free market is necessarily perfect there is no liberal nirvana but by
showing how, in reality, the otherworldly vision of a regulatory authority which would have the
knowledge and means to at least guide and act as a moral compass for the markets, if not act as
a substitute for them, leads in reality to results ( in terms of instability, but also of justice, for
example) which, more often than not, go against the very aims which have justified the powers
conferred upon them. The lesser of two evils is not necessarily the one we expect.
Henri Lepage
henri.lepage@neuf.fr
Tel (mobile): 00 336 1412 7161
3 November 2008