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150 | Regulation of Business and the Flight from Accountability termination, the SEC prepared a supplemental evaluation with negative material justifying the termination—a step unheard of at the SEC,39 and an echo of the shoddy treatment received by the nine fired United States Attorneys. Antiregulatory Bias and the Subprime Collapse The administration’s antiregulatory bias was most clearly manifest in its too-little , too-late response to the subprime mortgage crisis. The subprime crisis was a classic instance of market failure, which cried out for timely, effective regulation . A market failure involves a breakdown in the enlightened self-interest that makes markets both profitable for participants and beneficial for the public. Although markets generally perform better than wholly state-owned economies , in certain situations markets fail to properly align private and public interests. In such situations, government must step in to fill the gap. The Bush administration had abundant evidence that a market failure of gigantic proportions was developing in the area of subprime loans. Nevertheless, the administration failed to take remedial action until the problem spiraled out of control. A central aspect of the subprime debacle was the erosion of the relationship over time between lender and borrower. When lenders and borrowers develop a relationship, the lender has an incentive to ensure that the borrower is a good credit risk. The lender values the borrower’s goodwill and repeat business more than making an extra buck in the short term. Moreover , the lender will usually try to reach an accommodation with a distressed borrower who has encountered tough times.40 The practices that led to the subprime crisis destroyed this relationship, creating a gap between the public interest and the incentive structure for loan originators. Loan originators are not the old-fashioned savings and loan associations depicted in movies like Frank Capra’s It’s a Wonderful Life. Instead of holding onto loans and building relationships, loan originators got paid up front through fees. They then sold the loans to entities that securitized the loans for sale to investors.41 Loan originators had every incentive to charge higher fees to borrowers, even if those borrowers would be better off with a loan that cost less up front. In fact, a significant percentage of borrowers with more expensive subprime mortgages were eligible for less expensive fixed-rate loans.42 Unscrupulous lenders often targeted the vulnerable, signing them up for loans at higher interest rates over the life of the loan, with a low “teaser rate” that reeled in unsophisticated borrowers.43 When the rate charged to customers “ballooned” from the teaser rate to a market rate, customers started defaulting on payments.44 Regulation of Business and the Flight from Accountability | 151 The SEC also contributed to the subprime mortgage meltdown. In April 2004, the SEC voted to respond to appeals from the biggest investment banks, including Lehman Brothers and Goldman Sachs, that the SEC reduce the amounts of cash the banks needed to keep on hand to guard against the effects of losses in securities trading. The big investment banks complained bitterly that they would lose market power because of unduly harsh Washington regulation.45 At least one commissioner asked questions—Harvey Goldschmid, a professor at Columbia, commented that “if anything goes wrong, it’s going to be an awful mess.”46 Goldschmid went along, however, convinced that the big banks would never do anything so risky that it would put their continued existence in doubt. The SEC approved the measure, which freed up billions of dollars that the banks then used to borrow even more money for investments in mortgage -backed securities. The SEC might have helped to head off the subprime crisis by monitoring the big investment banks, who had all agreed to voluntary self-regulation in exchange for the lowered reserve requirements. Unfortunately, the selfregulation plan went nowhere. It was a low priority for the incoming SEC chair, Christopher Cox, who had arrived at the agency after a career as a corporate securities lawyer and an anti-regulation member of Congress from California. For a year and a half, starting at March 2007, as the subprime crisis accelerated, the self-regulation division lacked a director.47 The Commission ignored warning signs about the riskiness of the subprime investments and the increased use of borrowing among these elite firms.48 For example, the Commission staff knew that Bear Stearns, a major investment house, had too many mortgage securities in its portfolio and had borrowed too much to...

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