Roots of Financial Crisis

The other day a talk radio host state that the economic crisis was solely the blame of the Democrats and Fannie Mae/Freddie Mac. I will wade into the matter by noting the argument starts blaming Clinton for changing the lending rules to make it possible for more loans to be made to low income families and in marginal communities. The argument continues that Fannie and Freddie “forced” the banks to make hundreds of thousands of bad loans to these people who in the past they banks would have disqualified. The implication is that the banks were “forced” to make these loans and these loans going unpaid are at the heart of the financial crisis.

No bank was forced or required to make loans they it did not want to make. The changes allowed banks to modify their policy. Thousands of banks and credit unions, primarily small local or regional banks, never made these loans. They felt uncomfortable about increasing their risk. Many other banks made the loans sparingly and thoughtfully as a way to help more people to become homeowners. Coupled with subprime loans a large number of regional and national banks strongly promoted the loans. The choice was the banks’. Some did not take the risk whereas others recklessly issued as many loans as possible.

Second, Fannie and Freddie are purchasers of the loans from the banks. They did not make the loans. Banks issued loans that Fannie and Freddie would purchase from the banks via prescribed terms. It was the banks who skewed the process when they did not verify the income information was correct (or in some cases noted to the borrower that the bank was trusting the income was correct…thereby hinting they were not verifying the information on the forms). The banks pushed on a good number of marginal loans to Fannie and Freddie for which the bank had not done due diligence.

Third, the bulk of “troubled” loans are loans that the banks were making before the changes and had more to do with the banks decisions the subprime loans that the changes signed into law by Clinton.

Fourth, the argument should not be accepted a face value. It is clearly an oversimplification and put forward by political operatives with a political agenda of seeing their party as noble and the other as ignoble. What is not articulated in the argument against Clinton is that it was a Republican Congress that promoted, pushed through the changes, and prevailed upon Clinton to sign them into law.

Fifth, we should keep a balanced view by remembering that there are multiple causes that flowed together. Fannie and Freddie are factors, but there are many more significant causes than Fannie and Freddie changing their policies and purchasing a large number of subprime loans. Amongst those factors are:
- The defining of swaps as being investment vehicles rather than defining them as insurance vehicles (swaps regardless of the title they were given were insurance vehicles). The change was pushed through a Republican Congress so as to avoid the higher cash reserve requirements required to back-up insurance vehicles. The prime advocates, including the authors of the bill allowing the change, were Republicans. Various Democrats too supported the change.
- Subprime loans. These loans eliminated the requirement to have a down-payment to secure a mortgage. Subprime loans were based upon the assumption that prices of homes would keep going up.
- The false assumption that housing prices will keep increasingly and the real estate/mortgage industry encouraging potential home buyers do buy now/upgrade now or they will not be able to afford to buy it later.
- Eliminating various regulations that allowed banks to merge and to have investment arms that in some cases engaged in questionable investment practices.
- The rosy view by the Fed Chair and Congressional leadership of financial executives. They held that they executives would never do anything to put their firms at risk. Yah, right.
- Overheated housing market driving prices increasingly higher. Demand being higher than supply of modest priced homes pushed prices higher.