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.

The Melt-Down, My Thoughts

In the USA the Republicans blame the Obama and the Democrats for the global financial crisis. McCain charges that Fannie Mae and Freddie Mac made risky loans “with the encouragement of Obama and his cronies…in Washington.” McCain and Palin point to Obama and the Democrats not supporting the Senator’s Chuck Hagel’s (R) effort to in 2005 to pass legislation regulate to a greater level in Fannie Mae and Freddie Mac. This is the same legislation that McCain claims he helped author. McCain did not author the bill, he signed on as co-sponsor nine months after it was voted on by the Committee and shortly before it died when Senate Majority Leader Bill Frist (R) refused to bring it out of committee to the Senate for a vote. Though he signed on to the bill, he did not actively work for it to be brought to the Senate or to lobby his peers to vote for it.

Republicans, McCain and Palin included, claim that both these institutions were dominated by Democrats. Their Boards of management being dominated by Democrats is true. What Republicans fail to note is that since 2004 Freddie Mac’s political arm was headed by Republicans who hired a Republican lobbying firm for $2 million to target a short list of seventeen Republican Senators to persuade them not to support Hagel’s bill. McCain’s campaign manager, Rick Davis and his lobbying firm, received $2 million from Freddie and Fannie to help lobby Republicans and kill various regulatory efforts.

It should also be noted that since 2004 all Freddie Mac’s political contributions have been given to Republican candidates, including a small sum of $2,800 to McCain. Hence, for political purposes McCain and the Republicans obfuscate the picture.

The Democrats are not much better. They quickly point to Republican efforts to deregulate the banking and insurance industry as the cause. Republicans pushed for increased deregulation, McCain included. They point to Republican Senator Phil Gramm who retired in 2003 who as a banking lobbyist legislation that withdrew several oversight provisions and blurred the distinctions between insurance and banking institutions. Gramm, also McCain’s financial advisor, persuaded his former peers to support the deregulation.

Democrats also rightly note Senator Dodd leading an effort to keep derivatives/swaps/hedges from coming under regulatory oversight. What Democrats are not noting is that President Clinton supported several of the bills that helped deregulate the financial industry.

There is blame to be shared by all. No single legislative action created this mess. Those claiming otherwise are putting forth self-serving and disingenuous effort at oversimplification. Such oversimplification is an act to wash away the guilt that rests in their hands.

When former Federal Reserve Chairman Alan Greenspan testified on October 23 before Congress he admitted that he was shocked by the credit market meltdown. When Fed, Capitol Hill and other officials provided warnings, Greenspan dismissed their concerns as being unfounded. Part of the problem is that he did not question his economic modeling or pay attention to signals that showed that there were some flaws in his model that needed adjusting.

Greenspan dismissed efforts to regulate mortgage backed derivatives/swaps that were founded upon the assumption that property values would continually increase at a steady rate of 5 to 15% per year. Questions raised by some, including Obama, about what would happen if there was a wide spread decline in housing values was not worth consideration. The shine has clearly come off of the Oracle of Wall Street and history will have just as many harsh words for him as complementary ones.

Greenspan’s and the Republican efforts to deregulate the finance industry was both correct yet deeply flawed. It was correct that a host of regulations put in place since the 1929 crash were out of date. They needed to be rewritten, not tossed aside wholesale. The deregulation effort was based upon two flawed assumptions, that when the wealthy become wealthier the rest of the population will benefit, and that the financial institutions will look after their best interest without government involvement.

History is replete with examples of the wealthy becoming wealthier on the backs of the poor who they keep repressed. No industry has adequately regulated itself unless there is a real threat of government stepping in to do so, and even then it will do only the minimum needed to keep governmental involvement at bay. Greenspan and the Republicans overlooked a critical factor, that humanity is self-centered. When we have unchecked capitalism abuse trickles down, not wealth. When safeguards are removed questionable and fraudulent products will be sold by golden tongued people to those who they can beguile. Republican fiscal philosophy of deregulation has been found wanting.

Banks themselves must shoulder a significant part of the blame. Fannie Mae and Freddie Mac were not the main issuers of poor banking loans. These institutions were the purchasers of loans banks had already made. With regulations lifts Fannie and Freddie required less documentation on loans and were allowed to assume subprime loans (interest only loans). Banks issued loans that in the past if they had to hold onto the loans would not have issued.

With increased availability of mortgage money a housing boom caused home priced to climb rapidly. It was not uncommon to have a house go on the market in Northern Virginia and in other hot markets at the beginning of the week and by the end of the week have two or three people trying to out-bid each other. Rapidly increasing home prices, and the building of a greater number of “luxury homes” increasingly pushed people into buying homes they could not afford.

Home buyers too must shoulder some of the blame. Though real estate and bank officials were able to show buyers how they could afford homes they really could not, it is the home buyer who signed on the line. When a deal seems to be too good to be true, it normally is. When we forget the phrase “buyer beware” we are headed for trouble. I know of individuals who did not buy because they questioned the assumptions upon which the subprime loans were based. Unfortunately, there were too many who did not question those assumptions and have found the road is paved with worthless dross, not gold.

No single group, individual or legislation is to be faulted for the failure. The confluence of greed, deregulation and blind faith that has created the financial meltdown. Hopefully we will have new leaders who will have the wisdom to rebuild a balanced financial industry that has appropriate regulatory oversight that will protect the industry from its own bent toward greed, as well as protecting the general public and the nation in the process.