Washington - No one cog in the federal government's
machine of financial regulation let down the country by failing to prevent the
latest shakeout on Wall Street. The entire system did.
    "They just haven't done a particularly good job,"
said James Barth, a senior finance fellow at the Milken Institute, a nonpartisan
research group based in Los Angeles.
    Kathleen Day, a spokeswoman for the Center for
Responsible Lending, a consumer-oriented research group, explained the
regulatory lapses more starkly: "The job of regulators is that when the party's
in full swing, make sure the partygoers drink responsibly," she said. "Instead,
they let everyone drink as much as they wanted and then handed them the car
keys."
    Analysts and politicians are raising serious
questions about the nation's financial regulatory system, which dates to the New
Deal era.
    On Monday, one Wall Street bank, Lehman Brothers,
filed for bankruptcy protection and another, Merrill Lynch, sought comfort by
selling itself to Bank of America for $50 billion. Earlier this year, the
government helped enable the sale of faltering investment bank Bear Stearns to
J.P. Morgan Chase, and more recently took over mortgage giants Fannie Mae and
Freddie Mac.
    Such troubles were supposed to have been prevented,
or at least mitigated, by regulatory systems that the nation began to put in
place after the banking system collapsed at the start of the Great
Depression.
    Many banks at the time were badly wounded by their
personal and financial ties to securities trading. The 1933 Glass-Steagall Act,
and later the 1956 Bank Holding Company Act, mandated the separation of banks,
insurance companies and securities firms.
    Those and many other federal laws stabilized the
banking and securities markets, but by the 1970s, a stumbling U.S. economy led
to a change in America's political-economic values. Ronald Reagan led a movement
that came to power in 1980 proclaiming faith in free markets and mistrust of
government. That conservative philosophy has dominated America for the past 28
years.
    Even after taxpayers had to rescue deregulated
savings and loans, or S&Ls, with a $200 billion bailout in the late 1980s,
the push to loosen regulation paused only briefly.
    In 1999, President Clinton signed the Financial
Services Modernization Act, which tore down Glass-Steagall's reforms by removing
the walls separating banks, securities firms and insurers.
    Under President Clinton and his successor, the
government became eager to promote home ownership. Interest rates were low, the
market grew for loans to borrowers with weak credit and private-sector mortgage
bonds boomed. About 38 percent of those bonds were backed by subprime loans.
They are at the root of today's financial crisis.
    A generation ago, banks, credit unions and S&Ls
issued home mortgages that they retained on their books as an asset. The lenders
had a stake in receiving full repayment of the loans from creditworthy
borrowers.
    But in recent years, mortgages began to be sold to
firms that cobbled the loans together to create mortgage-backed securities, or
mortgage bonds. Loans to the least creditworthy borrowers carried the highest
risk but gave the highest returns, so banks and other institutional investors
bought loads of them. Except no one was policing the creditworthiness of the
borrowers.
    The process helped more people buy homes, and a
booming mortgage-bond market, led by investment banks, was in full swing by
2005.
    When borrowers who had secured loans with adjustable
interest rates, however, found their rates going up, many were unable to pay.
That meant that holders of bonds backed by these mortgages were stuck with
securities worth much less than their face value - or nothing at all. That
created a solvency crisis for the banks that loaded up on them - and virtually
all of them had.
    Some regulatory agencies issued warnings, but
credit-rating agencies still said that the bonds - and the banks that issued and
bought them - were safe. It turns out, of course, that many were not.
    "There was a view that the secondary market excesses
could be prevented by the broader application of risk-evaluation models by the
investment firms," said Barry Bosworth, senior fellow in economic studies at the
Brookings Institution, a Washington think tank. "In fact, risk evaluation is
more of an art than a science, and the (private-sector) institutions fooled
themselves," said Bosworth, a former adviser to President Jimmy Carter.
    With Congress eager to expand home-ownership,
regulators felt pressure to deal lightly with mortgage loans to low-income
households, and virtually no one proposed national regulation of non-bank
lenders or mortgage brokers.
    Had regulators questioned sub-prime lending, they
would have been harshly criticized, said Edward Kane, a professor of finance at
Boston College.
    "Imagine what congressional committees would have
said," Kane said. "They would have asked about affordable housing. It was a
no-win situation for regulators,"
    Warning signs began to appear. At least nine federal
agencies oversee some part of the mortgage market, and from 2004 to 2007, at
least three had issued warnings about risky loans.
    Still, none was willing to end the financial
revelry.
    "It was another example of an asset bubble that
appears periodically. An economy will disregard risk, and when people see
another investor making money by investing in an asset, others will throw
caution to the wind," explained Nicolas Bollen, professor in finance at
Vanderbilt University's Owen Graduate School of Management in Nashville,
Tenn.
    In such an environment, said Day, of the Center for
Responsible Lending: "No one wanted to kill the goose that laid the golden
egg."