High Finance Laid Low

By Robert Samuelson

WASHINGTON -- Except for oil executives, no group of business leaders is now more resented than the titans of finance -- bankers, traders, hedge fund managers. They are blamed for causing the housing crisis, global financial turmoil and a possible recession. But this sweeping indictment, though true, is only half the story. The job of modern finance is to allocate Americans' nearly $2 trillion in annual savings to its most productive uses; the paradox of finance is that its virtues and vices come tightly packaged together.

What we call "financial services" -- insurance and real estate, as well as banking and securities trading -- has been a growth sector. In 1976, it was 15 percent of gross domestic product; now it's 21 percent. The expansion has produced many benefits: more credit for families and businesses; more investment choices for people saving for retirement and anything else; more investment capital for start-ups and smaller firms. Unfortunately, financial advances have also created periodic episodes of massive waste that threaten to destabilize the entire economy.

The subprime-mortgage debacle is not a rare exception. Before that, there was the tech bubble of the late 1990s when stock valuations floated into La-La Land and anyone with a business plan ending with .com could get money from venture capitalists. Earlier, the junk-bond mania of the late 1980s ended badly. According to finance professor Josh Lerner of the Harvard Business School, there seems to be a regular cycle of financial innovation (good), imitation (good up to a point, because it provides competition) and finally suicidal excess. Herd psychology reigns.

The idea that enlightened government regulation can outlaw this cycle is at best an optimistic exaggeration. Some of Treasury Secretary Henry Paulson's new proposals for regulation are worth adopting: merging the Securities and Exchange Commission and the Commodity Futures Trading Commission; expanding the Federal Reserve's powers. But the basic problem is that as long as people are benefiting from innovation and investors are making money, it's hard to impose restraints on the excesses. Only a crackup brings clarity.

In 2005, foreclosures on subprime mortgages totaled a modest 3.4 percent. Warnings about abusive and reckless lending practices went unheeded, as overpaid Wall Street investment bankers stuffed the mortgages into ever more complicated securities. In the disastrous aftermath -- the foreclosure rate is now nearly 9 percent and rising -- it's easy to forget the brighter side of financial innovation.

Consider mortgages. In 1980, they came in one flavor: 30-year fixed-rate loans. Because fees and closing costs were so high, it was hard to refinance into a cheaper loan even if interest rates fell. The rule of thumb was that rates had to drop 2 percentage points before refinancing made sense. Now homeowners can choose from many mortgages with different maturities, as well as fixed and floating rates. Lower fees and transaction costs (from automated underwriting, among other things) make refinancing attractive if interest rates drop a half a point or even less.

The story is similar for other innovations. Personal investment choices have mushroomed. In 1980, households had half their financial assets in bank deposits and savings accounts; only 34 percent were in stocks and a meager 2 percent in mutual funds. Since then, Americans have diversified: In 2006, 25 percent of household assets were in mutual funds, 28 percent in stocks and 28 percent in bank deposits and savings accounts.

Or take a more sophisticated innovation: the rise in the 1980s of "leveraged buyouts" (LBOs), now known as "private equity." On balance, the threat or reality of a takeover has improved corporate performance, says finance professor Steven Kaplan of the University of Chicago. But there's also a dark side, he says. In the speculative climaxes, the LBOs' bet is that companies can simply be bought with cheap money and later sold profitably in a rising stock market. If the bet fails, defaults will ensue.

It is often wrongly said that the present problems originated in the mindless financial deregulation begun in the 1980s, as if everything would be fine if the old financial system remained. Actually, the old system -- dominated by banks and savings and loans -- collapsed. Many S&Ls failed when high inflation raised interest rates on their short-term deposits above the levels on their long-term mortgages. Banks suffered huge losses on energy, commercial real estate and developing-country loans. Securitization and other new forms of financing filled the void left by weak banks and S&Ls.

So modern finance has a split personality. Greed, shortsightedness and herd behavior compromise its usefulness. But regulation cannot cure this dilemma, because regulators can't anticipate all the problems and hazards either. The best protection against human fallibility is to insist that major financial institutions have ample capital to absorb unexpected losses. Paulson's recommended reforms barely dwelled on that; Congress should.