Monday, November 3, 2008

Origins of the current crisis (3)

This crisis has been tragic, but it will be even worse if we don't learn the proper lessons from it. The housing and subprime mortgage meltdown was most definitely not caused by capitalism, unregulated free markets and executive greed. It was the result of too much government meddling in otherwise free markets, bad regulations, a failure of those with regulatory authority to act, and of course, politicians taking charge of things that are best left to those with a profit motive.

There is an excellent summary of the mortgage crisis that I highly recommend here. The list of guilty parties includes some Republicans but mostly Democrats. The history is long and replete with warnings that went unheeded. These are the highlights as I see it:
1933-38: President Franklin D. Roosevelt initiated a series of "New Deal" reform programs designed to affect the mortgage market and homeownership. Fannie Mae was established to facilitate liquidity among lending institutions.

1968: As part of President Johnson's Great Society reform plan, much of Fannie Mae became a privately owned yet government-chartered company, a government-sponsored enterprise (GSE) providing authority to issue mortgage-backed securities. Though private, it remained backed by the federal government.

1970: President Nixon chartered Freddie Mac, the Federal Home Loan Mortgage Corporation, as a GSE to compete with Fannie Mae.

1977: Sen. William Proxmire, D-Wis., introduced a community reinvestment Senate bill. Opponents argued the bill would allocate credit without regard for merits of loan applications, thereby threatening depository institutions. The bill's sponsor stressed it would neither force high-risk lending nor substitute the views of regulators for those of banks. President Carter signed into law the Community Reinvestment Act.

October 1992: Congress, enacting the Federal Housing Enterprises Financial Safety and Soundness Act of 1992, which created the Office of Federal Housing Enterprise Oversight (OFHEO) within HUD to "ensure that Fannie Mae and Freddie Mac are adequately capitalized and operating safely." Rep. Jim Leach, R-Iowa, warned about the impending danger non-regulated GSEs posed. He was concerned that OFHEO was a "weak regulator." Leach worried that Fannie Mae and Freddie Mac were changing "from being agencies of the public at large to money machines for the stockholding few."

June 1995: The Clinton administration, allied with Rep. Frank, Sen. Ted Kennedy, D-Mass., and Rep. Maxine Waters, D-Calif., directed HUD Secretary Andrew Cuomo to inject GSEs into the subprime mortgage market.

Fall 1999: Treasury Secretary Lawrence Summers issued a warning: "Debates about systemic risk should also now include government-sponsored enterprises, which are large and growing rapidly."

September 1999: With pressure from the Clinton administration, Fannie Mae eased credit requirements on loans it would purchase from lenders, making it easier for banks to lend to borrowers unqualified for conventional loans.

March 2000: Rep. Richard Baker, R-La., proposed a bill to reform Fannie and Freddie's oversight in a House subcommittee on capital markets. Rep. Frank dismissed the idea, saying concerns about the two were "overblown" and there was "no federal liability there whatsoever."

June 2000: Competitive Enterprise Institute President Fred L. Smith Jr. recalls testifying before the House Financial Services Committee that GSE "special privileges create a serious hazard to the market, to taxpayers (and) to the economy." Rep. Paul Kanjorski, D-Pa., responded: "Mr. Smith, that is almost a fallacious argument," adding that rapid growth of GSE debt holdings was nothing to worry about.

April 2001: The fiscal year 2002 budget declares that the size of Fannie Mae and Freddie Mac is "a potential problem," a White House release said, because "financial trouble of a large GSE could cause strong repercussions in financial markets, affecting federally insured entities and economic activity."

September 2004: OFHEO reported that Fannie Mae and CEO Raines had manipulated the agency's accounting to overstate its profits. Congress and the Bush administration sought strong new regulation and authority to put the GSEs under conservatorship if necessary.

May 2006: After years of Democrats blocking legislation, Sens. Hagel, Sununu, Dole and McCain write a letter to Majority Leader Bill Frist demanding that GSE regulatory reform be "enacted this year" to avoid "the enormous risk that Fannie Mae and Freddie Mac pose to the housing market, the overall financial system, and the economy as a whole."

September 2008. Rep. Arthur Davis, D-Ala., admits Democrats were in error: "Like a lot of my Democratic colleagues, I was too slow to appreciate the recklessness of Fannie and Freddie. I defended their efforts to encourage affordable homeownership when in retrospect I should have heeded the concerns raised by their regulator in 2004. Frankly, I wish my Democratic colleagues would admit when it comes to Fannie and Freddie: We were wrong."


Mark Gerber said...

Thanks for another great blog entry. No doubt, Fannie and Freddie have been a disaster waiting to happen, and the Democrats contributed the most to this disaster. Had Fannie and Freddie risk been properly constrained, as John McCain warned in his letter years ago, we would not have had such a large housing bubble. If it were up to me, I would have shut down the GSEs a long time ago.

At the same time, however, this IBD summary makes no mention of the asset back securities (eg. CDOs, shadow banking SIVs) that funded much (if not most) of the subprime bubble. It does not mention the fact that in 2004 Bush's SEC raised the limit on investment bank leverage from 20:1 to 40:1, which allowed them to make huge profits securitizing mortgages while taking excessive risk. Without Fannie and Freddie, I suspect this high risk subrime securitization would have been contained in the subprime lending arena, but the combination proved to be a potent source of excess leverage and systemic risk.

chaim said...

The painful irony is that the very Party that predominantly caused and perpetuated this horrible crisis has succeeded in deflecting the blame on the other Party and thereby will probably win a mind-blowing victory in 2 of the three branches of government,... and, in the next 4-8 years, unchecked by the right, will get to select 4-6 radical left of center activist individuals for the third branch, creating a supermajority in the judiciary, thereby further perverting legal interpretation for decades to come.

It appears that a large portion of our economic freedom and personal liberties will have been check-mated.

Just a short time ago this was unimaginable.

Scott Grannis said...

Mark: it's hard to dispute your point, but I don't think that derivative securities or leverage were the protagonists in this drama. Leverage per se is not necessarily a bad thing. If housing prices had not collapsed, nothing would have happened. Subprime mortgage derivatives blew up, to be sure, but only because home prices collapsed to an extent no one envisioned. The role of F&F was also key, since F&F bought $1 trillion of AAA subprime stuff, leaving Wall Street to package and sell the rest (a fraction of what F&F bought). Without F&F, there would have been far less subprime stuff to go belly up.

Scott Grannis said...

Chaim: we can only hope that President O will use his great intelligence and avoid doing that which the market is terrified of.

Mark Gerber said...

Thanks for your reply Scott. I agree that neither derivatives nor leverage were the protaganists in this drama. That key role does indeed go to Fannie and Freddie and all the politicans that enabled F&F, which were by and large Democrats.

You make an excellent point that was not clear in my comment above: Without F&F, far fewer subprime mortgages would have been funded. Thanks for making that important fact so clear.

chaim said...

Possible Hope or Grasping at Straws?:

Just ran accross this on

It's a computer-and-media story, but the possible parallels to this year's election struck me as interesting.


"....Pre-election polls had predicted anything from a Democratic landslide to a tight race with the Demo candidate, Illinois Gov. Adlai Stevenson, slightly ahead of the Republican, five-star Gen. Dwight D. Eisenhower, Supreme Commander of Allied Forces in Europe in World War II.

So it was a surprise at 8:30 p.m. Eastern time when Univac predicted Eisenhower would pile up 438 electoral votes to Stevenson's 93. The odds of Eisenhower garnering at least 266 electoral votes — the minimum needed to win — were 100-1.

In New York, news boss Mickelson scoffed at putting the improbable prediction on air. In Philadelphia, Woodbury added new data to the mix. At 9 p.m. correspondent Charles Collingwood announced to the audience that Univac was predicting 8-7 odds for an Eisenhower win.

But wait! Back in Philly, Woodbury discovered that he'd mistakenly added a zero to Stevenson's totals from New York state. When he entered the correct data and ran it through Univac, he got the same prediction as before: Ike 438, Adlai 93, again with 100-1 chances of an Eisenhower victory.

As the evening wore on, an Eisenhower landslide gathered momentum. The final vote was 442 to 89. Univac was less than 1 percent off.

Late at night, Collingwood made an embarrassing confession to millions of viewers: Univac had made an accurate prediction hours before, but CBS hadn't aired it...."


Is there a parallel to 2008? Democrat from Illinois with polling suggesting a blow-out to close race running against a war hero....

Who knows?