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Relax, and Do Nothing

By John Tamny

Calvin Coolidge once said, "If you see 10 troubles coming down the road, you can be sure that nine will run into the ditch before they reach you." The 30th president's words are particularly prescient in light of hand-wringing by our political class over subprime mortgages, our "problem" du jour.

Sen. Charles Schumer, New York Democrat has said, "There's going to be a significant role for Congress" in working out the alleged subprime mess, while Sen. Christopher Dodd, Connecticut Democrat, has suggested that Congress should curb what he deems predatory lending. Mr. Dodd has also spoken of finding ways to help "millions of families" facing foreclosure, which, when translated, means Congress will seek to fleece millions of U.S. taxpayers to bail out those who sought financing in the subprime market. Given Congress' track record in dealing with past problems in the banking sector, investors and taxpayers should hope any legislation is stalled in committee. Indeed, the S&L debacle of the late 1980s should make even those in Congress wary of wading into more banking legislation.

Nearly 30 years ago, the savings and loan (S&L) industry was on life support. Amidst skyrocketing interest rates between 1979 and 1982, S&Ls lost $4.6 billion in 1980, and $4.1 billion in 1981. By 1982, S&Ls had a negative net worth of $100 billion. Rather than allow the industry to die a slow death, Congress stepped in to save the day.

The slow death of the S&Ls began in the 1970s when interested rates skyrocketed in response to the weak dollar. In previous decades, the S&L sector was a prosaic one where its assets were long-term mortgages paying higher rates, while its liabilities consisted of short-term, lower-rate deposits. This worked well until short-term rates rose sharply. Unable due to regulations to pay depositors more than 5-1/2 percent, S&Ls gradually lost deposits to money-market funds paying well in excess of 51/2 percent, while the falling dollar eroded the value of their fixed-rate mortgages.

Regulations and poor Fed policy surely hindered the S&L industry, still the explosion of the mortgage-backed securities market and worldwide banking competition rendered S&Ls obsolete.

But like most long-established industries in the U.S., the S&Ls had powerful political benefactors interested in keeping them alive. Congress passed the Depository Institutions Deregulation and Monetary Control Act of 1980, and the Garn-St. Germain Depository Institutions Act of 1982 to keep them afloat. Both acts served to privatize any deregulation successes, while socializing the inevitable failures.

Whereas S&Ls were previously limited in terms of the interest rates they could offer depositors, the aforementioned legislation removed all caps on rates they could post to attract deposits. Capital requirements were reduced from 5 percent to 3 percent, plus S&L loans were no longer limited to home mortgages. To pay the high rates offered on deposits, S&Ls had the incentive to make higher-risk loans and equity investments in areas beyond traditional home mortgages, including commercial and construction loans. If the S&Ls had been left to fend for themselves in this newly deregulated world, the new legislation would have been fine.

The problem, as previously mentioned, was that Congress also chose to socialize any failures. The Garn-St. Germain bill raised the level of federal deposit insurance from $40,000 to $100,000. This created enormous moral hazard in that depositors could place their funds at high rates of interest with the S&Ls worry-free. And just the same, S&L executives could be lax in their lending and investment standards with full knowledge that U.S. taxpayers were on the hook if their investments soured.

Importantly, the weakest S&Ls had the greatest incentive to swing for the fences in making loans, and this made it even more difficult for the healthy S&Ls to compete. The rest, as they say, is history. More than 1,000 S&Ls failed in the 1980s. The bloodbath continued into the 1990s; much of it on the dime of U.S. taxpayers.

Returning to the existing subprime situation, according to a recent report from Morgan Stanley, there are slightly more than $600 billion of subprime mortgages outstanding. If there were defaults on half that (thought by many to be the worst-case scenario), it would work out to 2 percent of the $15.7 trillion U.S. bond market. Considering how active foreign investors are in U.S. debt, this number shrinks to 1 percent of the $33 trillion global market. Further, $300 billion is only 1.3 percent of the U.S. housing market, and constitutes only 0.5 percent of the $55.6 trillion net worth of U.S. households. In short, $300 billion is pretty tiny in the big picture, and something the markets can easily handle. And as this is public information, stocks have already priced any presumed fallout.

Not yet priced is the governmental response to something it should best stay out of. The Bush administration has joined the echo chamber in saying it will vigorously prosecute any cases of predatory lending -- meaning future homebuyers on the riskier end of the lending curve will find it tougher to get financing in the future.

If the heads of failed subprime firms face prosecution, there will be an even greater incentive for successful firms in the subprime space to exit the industry. To the extent either lenders or borrowers are bailed out, U.S. taxpayers will eventually have to pay for the inevitable carelessness that government guarantees engender.

Still, as evidenced by the numbers involved, this is a very small problem. To avoid making it a bigger one, Congress should let the subprime scare slide into the ditch.

John Tamny is an editor at RealClearMarkets. He can be reached at

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