Where the meltdown began

From the WSJ on Saturday:

'Perhaps the largest regulatory failure of all time." That's how J.P. Morgan Chase CEO Jamie Dimon describes the "inadequate regulation of Fannie Mae and Freddie Mac" in his annual shareholder letter, released this week.

Mr. Dimon devotes nearly a quarter of the 28-page letter to analyzing what caused the panic of 2008, and he hands out plenty of blame all around. But he calls it "amazing" that Fannie and Freddie were allowed to grow "larger than the Federal Reserve" thanks to Uncle Sam's implicit guarantee of their obligations.

Quoting from the letter:

Perhaps the largest regulatory failure of all time was the inadequate regulation of Fannie Mae and Freddie Mac
The extraordinary growth and high leverage of Fannie Mae and Freddie Mac were well-known. Many talked about these issues, including their use of derivatives. Surprisingly, they had their own regulator, which clearly was not up to the task. These government-sponsored entities had grown to become larger than the Federal Reserve. Both had dramatically increased their leverage over the last 20 years. And, amazingly, a situation was allowed to exist where the very fundamental premise of their credit was implicit, not explicit. This should never happen again. Their collapse caused damage to the mortgage markets and the financial system.

Dimon also makes some very interesting points about the prevalence of positive-feedback (he calls “pro-cyclical”) loops in the system: when things got bad, these policies made things worse. An example would be stringent mark-to-market rules (despite their other advantages) that encourage liquidation of assets at firesale prices — thus depressing the value of similar assets across the industry.

I certainly can’t agree with everything Dimon says. He seems quite enamored with more regulation to prevent failure rather than designing markets to be more self-governing and thus more resilient to the inevitable failure. But then as the CEO of one of America’s largest banks, he has a huge stake in preserving the current industry positions rather than seeking what’s best for the American economy as a whole.

Interestingly, Dimon is running at full tilt away from Federal money for Chase and thus Federal micromanagement, in hopes of gaining market share on its two main rivals, the TARP-enabled, bureaucratically hobbled Citibank and BofA. I suppose this is a form of market incentive — if these two banks will perform worse with government shareholders, they have a strong incentive to pay back what they owe and soon rejoin the ranks of (somewhat) free market companies.