You can go bleary eyed reading and watching all the finger pointing going on as to who is to blame for the current credit crisis.  The fact that we are in the final lap of a presidential race means that political pundits are trying to spin the culprit to their advantage.  Why do we care about finding the cause and assigning blame?  Besides, the good feelings of pointing fingers, the main purpose is to try and change things so that it can’t happen again.  If we correctly dianose the cause we have a higher chance of succeeding.

One of the meme’s currently circulating is that the fault lies at the feet of the Community Reinvestment Act (CRA).  This is simply political spin.  While the CRA certainly helped Fannie and Freddie join the party, it was not the creator or leader.  Today’s Wall Street Journal had the following quote.

“they weren’t the leaders in lowering credit standards,” said Andrew Davidson, a mortgage industry consultant in New York who has done work for Fannie and Freddie and also criticized them for taking excessive risks. He noted that the worst-performing mortgages are those that were originated by subprime lenders and packaged into securities sold by Wall Street, rather than by Fannie and Freddie. And while loans for low-income people — programs championed by Democrats as well as many Republicans — have contributed to Fannie and Freddie’s losses, they aren’t the biggest part of the problem.”

The number of actors who have contributed to the problem are too many to count.  There is plenty of blame to go around.  But one aspect clearly rises above the rest for me.  Capitalism is the best game we have found for efficiently allocating resources.  But like all games there need to be referees and rule making bodies that keep the game from devolving into chaos.  New technologies always threaten to undermine sports, but through dilligent rule making and enforcement, the sport can adjust and move on with minimal distruption.

The same is true in financial markets.  People will always be introducing be new financial products.  And to encourage innovation, the weight of regulation should be light at this stage.  Once a products gains traction in the marketplace however, regulators must step in to ensure the proper safeguards and transparency is enforced to prevent systematic risk to the system.  This is done by pushing the new product into a centralized exchange where everyone can see trading and pricing information and by enforcing capital requirements which effectively limit the amount of leverage that can be used.

If all the financial products that came into vogue, such as credit default swaps and collaterlized debt obligations were on central exchanges, we would still of had huge loses as housing prices came down, but the breakdown of trust and the underpinnings of the credit system would have remained stable.  Too much regulation can also stifle creativity in the marketplace, but the unthinking march to greater and greater levels of deregulation simply went too far, forgetting there was a reason regulations came into existance in the first place. 

History has also shown us that lobbying efforts are powerful enough to make our politicians on boths sides of the aisle forget the public trust they hold, allowing systematic risk to build to dangerous levels.  Unfortunately, I don’t have any ideas on how to fix this political problem.

Ideas anyone?