Compensation regulation obscures role of housing policy in recent economic collapse

Allan Meltzer [Professor of Political Economy, Carnegie Mellon University]: "Congress and the administration typically try to find scapegoats to satisfy the public that they are dong something about failed policies. In the 1980s, the alleged culprits were venal operators of a few savings and loans. This time it is the greedy bankers. I agree that the incentives in most bank compensation arrangements should be changed. But to think that compensation arrangements were a major reason for the the financial and housing crisis is wrong and misleading. Other banks had similar compensation practices, but all banks did not take excessive risks. JP Morgan Chase is an example, and here in Pittsburgh we have PNC Bank, now the fifth or sixth largest. It did not accept excessive risk and borrowed from the TARP to reduce the cost of buying another failing bank.

As many have pointed out, compensation should be aligned with long term risk. That would increase the incentive for more prudent behavior by many. Bankers and traders should do more and better due diligence instead of taking the ratings given by the rating agencies. That would lower risk by making the trader bear the cost. In too many cases, they faced a choice of taking on risk to boost the firm's short-term profits or losing their jobs. That's a poor incentive system.

The major faults with concentration on compensation is that it panders to public belief that something important is being done. The larger problem is that the ruckus about compensation obscures the more serious problem - housing policy. Before the crisis many critics warned that the government's housing policy would bring a disaster. My AEI colleague Peter Wallison, a former Treasury General Counsel, warned about Fannie Mae and Freddie Mac countless times. Bill Poole, former President of the St. Louis Federal Reserve Bank wrote and spoke about the problem with housing policy. Alan Greenspan testified about the problem. And there were other warnings. The House Financial Service Committee would not act. Congressman Barney Frank, now the committee's chair, dismissed the warnings and continued the misguided policies.

Housing policy encouraged buyers to purchase with no down payment and no credit record. For many buyers, the mortgages required payment of interest only. This was supposed to encourage home ownership by the disadvantaged. With no down payment and interest only loans, it is hard to claim that the buyers owned anything. For many it was simply cheaper than paying rent and gave the hope of a capital gain when the property sold. A badly mistaken policy should end. Fannie Mae and Freddie Mac are interest subsidy programs. They should be closed, and the subsidies should be on the budget. That is the honest way and the proper procedure for subsidies in a democracy.

Large banks were "too big to fail." Many took risks believing that they made the profits and the public took the losses. That policy, in place for 30 or more years, should end. If a bank is too big to fail, it is too big. Should the government limit the size? Yes, it should let the bank choose its size but require that the bank's capital has to increase more than in proportion to the increase in its assets. That way, the bank protects the public and, no less important, the banker has to wonder every day about the risks on his or her balance sheet. That is where concern should concentrate. Incentives work far better than regulation."

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