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Avoiding Market Meltdowns

by Robert Brent Toplin on Aug 18, 2007 

Robert Brent Toplin

After Wall Street went into a tailspin because of problems with sub-prime mortgages, Democratic presidential candidates demanded stronger standards for the mortgage industry. Hillary Clinton, Barack Obama and Christopher Dodd asked Congress to exercise more control over the risky lending practices that have harmed homebuyers and frightened investors.

We've heard such sage advice before. But in the past, no one heeded it. Now it's time for leaders in Washington to stop the abuses.

The Democratic candidates' call for tougher regulation looks a lot like the campaigns of reformers in earlier periods of American history. When hazardous practices created troubles in the past, leaders in Washington established new rules for the conduct of business. Free market fundamentalists often denounced these regulatory efforts as meddling by bureaucrats in Washington, but twentieth century history suggests that effective regulation can help both business and the public.

The first significant market crisis of the century occurred in 1907 when some speculative schemes by powerful bankers began to fail. Investors reacted by pulling their money from banks and trust companies. The stock market lost nearly half its value.

J.P. Morgan, Wall Street's most influential figure, helped to end the crisis by encouraging financiers to pump money into banking institutions. But since Congressmen didn't want to rely on tycoons like Morgan in future emergencies, they created the Federal Reserve System in 1913. Congress established a central banking authority that promoted stability in the financial sector and discouraged panics.

The importance of the Federal Reserve System is in evidence today. Since the mortgage crisis threatens to spread trouble throughout the economy, Americans are looking to the Fed to help restore confidence.

Unfortunately, leaders at the Federal Reserve could not avert the big shakeup of the 1920s. In that period some bankers speculated recklessly in the stock market and promoted risky loans. Their practices contributed to the Wall Street crash of 1929 and the Great Depression of the 1930s. Investigations conducted by Congress revealed that banks and brokerage firms had operated with few rules (somewhat in the manner of mortgage brokers in recent years). Reform was necessary.

President Franklin D. Roosevelt demanded protection for depositors and investors. His New Deal organized the Securities and Exchange Commission to monitor the stock market. New legislation required the separation of banks and brokerage businesses, insured bank deposits, and created standards aimed at making business practices more transparent, including the sale of stocks.

The lessons of the thirties appeared to be lost during the 1980s, when President Reagan's administration championed "deregulation," an initiative that contributed to the Savings and Loan crisis. In the early Reagan years important rules for the operation of S & Ls disappeared. Some S & L executives then provided questionable loans and rushed into highly speculative investments. When their institutions got into trouble in 1985, the executives tried to conceal embarrassing information from the public. Eventually, many S & Ls went under.

As had been the case many times earlier, leaders in Congress had to step in to clean up the mess. Their efforts cost the federal government (and American taxpayers) $125 billion. Funding the rescue sharply increased the U.S. budget deficit. A painful recession followed in the early nineties. Americans paid dearly for the experiment in radical deregulation.

The current problems that have triggered fears about sub-prime mortgages can be traced, as well, to a loose, generally unregulated business environment. During the house-buying frenzy of recent years, unscrupulous brokers handed out low interest mortgages to applicants who were not well qualified to take on large debt.

Lenders failed to document applicants' claims of income and they promoted adjustable rate mortgages because those instruments promised greater profits than fixed-rate loans. Now many poorly informed homebuyers are defaulting on those mortgages.

Almost everybody is threatened in some way by the risky practices. An estimated 1.7 million Americans are likely to lose their homes to foreclosure this year and next. Many more Americans (as well as investors around the world) are vulnerable because they hold securities in corporations that had a large stake in the sub-prime lending business. Market analysts fear that the mortgage crisis will create a credit squeeze, undermine business and reduce employment.

Clinton, Obama and Dodd want to establish firm rules for mortgage lending that screen out unscrupulous brokers, establish licensing standards, and give borrowers clearer information about mortgage obligations. Obviously, these senators are proposing remedies to win support for their presidential campaigns. They are on the right track, nevertheless.

Mortgage brokers took dangerous gambles and violated the public's trust recently, much as the promoters of wildcat commercial activities did before 1907, 1929, and 1985. Stronger requirements are sorely needed — rules that promote fair and responsible lending practices. Such regulation would serve not only the citizens on Main Street but also the investors on Wall Street.

Robert Brent Toplin, professor of history at the University of North Carolina, Wilmington, has published books on popular culture and politics, and is a writer for the History News Service.