Sep 6th 2007 From The Economist print edition
Illustration by David SimondsWHERE there is crisis, there is opportunity. That is something politicians surveying the wreckage of the subprime-mortgage crash know only too well. With America's Congress now back from its summer break, Democrats are scrambling to do something, anything, about the mess.
Ideas are already piling up on the doormat like so many bailiff's letters: a rescue fund for borrowers, fines for unscrupulous lenders, federal regulation for state-supervised mortgage brokers and greater liability for buyers of mortgage-backed bonds. Wary of being outflanked, George Bush may extend mortgage insurance for some cash-strapped borrowers. Hearings starting this week are likely to lead to reams of further suggestions (see article). Some will be helpful, but most will probably do more harm than good.
Nobody doubts things are bad out there. More than 2m homeowners face higher interest charges thanks to resets on adjustable-rate mortgages. Perhaps a quarter of them could lose their homes. Mortgage delinquencies have shaken global credit markets because yield-hungry investors piled into illiquid paper backed by risky loans. Banks far and wide are showing enduring signs of distress (see article).
So it is easy to see why the call for more regulation is tempting. But it is also easy to descend into caricature, portraying borrowers as victims of villainous banks, brokers, rating agencies and hedge funds. By one estimate, half of all subprime borrowers lied about their income. Many chose to ignore the risk that house prices might fall. Heaping all the blame on Wall Street and its clients ignores the role of broader forces. Ultra-low interest rates and Asia's savings glut provided much of the liquidity that inflated the bubble.
Of course, nobody could suppose that today's regulation is fine just as it is. The failures in mortgages and the credit markets have revealed flaws. But two thoughts should stay the hands of over-eager reformers. Across the markets, self-correction is under way. Shares of the most egregious mortgage lenders have plunged and dozens have gone bust. Loan-underwriting standards are tighter. The riskiest subprime securities have almost no takers. These spasms are how the market cleans up its mistakes and learns not to repeat them. That sounds cold-hearted, but pain is a necessary part of this correction.
When politicians seek to deaden that pain and supplant those lessons with hasty fixes of their own, they almost always blunder. Look at the Sarbanes-Oxley act, pushed through Congress in the turbulent aftermath of Enron's collapse. Although it was not all bad, the law placed a straitjacket on companies and their auditors which was so tight that it has since had to be loosened. And consider the proposal today, backed by Senator Charles Schumer, that a “suitability” standard be applied when a subprime loan is made. This may cut the risk of default, but it would also make it difficult for anyone with a blemish on his record to get a mortgage. Surely the legislators do not mean to heap still more pain on to the poor?
Slowly does it Rather than rushing into a bail-out of housing, politicians should give the financial authorities time to lean on the market. The government has a lousy record of doling out money in crises (think of the mess it has made in New Orleans). State-led rescues are fraught with moral hazard: what investor wouldn't take on that “liar loan”, knowing that the taxpayer is ready to jump in and help when it all goes wrong? Money should go first, and perhaps only, to those who can show they were defrauded or deceived. Encouragingly, American banking regulators this week issued guidance that should coax lenders to restructure bad debts, in part by offering to take a sympathetic view of the accounting hits that follow. Time, too, is the essential ingredient in reforming the capital markets, especially the conduct of the rating agencies, the whipping boys of the crisis right now (see article).
Above all, if legislators want to avoid unintended consequences, they should prefer information to regulation. Brokers who are getting three times the normal commission rate for selling an exotic subprime product should have to disclose that. They should also be made to spell out the terms of interest-rate resets more clearly to borrowers. And other financial markets might be less prone to catching mortgage flu if the off-balance-sheet “conduits” that buy wads of asset-backed securities had to reveal more about their exposures.
Politicians say they want to help. What the financial system needs just now is the rarest of political virtues: self-restraint.