September 25, 2008, Matthew Cochrane, The Economic Crisis Made Simple
I have never been, nor do I expect to ever be, confused with an economist or financial guru. However, I am a firm believer in capitalism and have always strongly held to a few guiding economic principles. With the financial markets in shambles and the government proposing a massive ($700 billion!!!) bailout I figured I would attempt a quick explanation of what’s going on and what should be done to fix the problem.
First, how did this all happen? It started with the housing bubble and worsened as more and more bad home loans were given out. But it’s important to understand that the crisis does not have to do with the housing industry, but the financing industry. Let’s start from the beginning. From 2000 to 2006 the gigantic global pool of money being invested doubled, from $35 trillion to $70 trillion. This was due to a wide variety of reasons, but mostly because traditionally poor countries (think China, India and Brazil) all of a sudden emerged as industrial powerhouses. As these countries became flush with cash, the financial powers that be in these countries began to look for ways to invest their new found wealth. They searched the globe for worthy investments and though some of this newly created wealth was invested in diverse ways, most of the money ended up being invested in one market and one market alone – the U.S. housing industry.
Wall Street, in all their wisdom, began to produce bonds of bundled mortgages that global investors could invest in. These were deemed great assets because they produced a steady stream of mortgage payments. It quickly became a common practice to bundle up a group of these mortgages and sell them as these bonds to foreign investors. The problem was there was just too much money looking for good investments. Since U.S. mortgages were in such high demand restrictions on obtaining a mortgage were relaxed – first gradually, then rapidly. Karen and I experienced this firsthand when we first went house hunting a few years ago. The loan we were approved for was far too high and there would have been no way we could have covered the payments. Eventually it got so bad that the lenders didn’t even require proof of income for those seeking loans; they would merely accept the word of those seeking loans about trivial matters like income and job status.
Naturally, this resulted in a lot of bad loans being handed out to undeserving recipients. If you care to listen, this
NPR story is excellent and does a better job of explaining this mess from start to finish than any other news piece I’ve seen or read.
I’ll allow banking experts Douglas W. Diamond and Anil Kashyap explain what happened next and how Fannie Mae and Freddie Mac were involved. In the
New York Times, they write:
This episode started when the Treasury nationalized Fannie Mae and Freddie Mac on September 8. Their combined assets are over $5 trillion. These firms help guarantee most of the mortgages in the United States. The Treasury only got authority from Congress to take this action in July, and in seeking the authority had insisted that no intervention would be needed.
The Treasury has replaced the management of both companies and will presumably oversee their operation. This decision marked an acknowledgment by the government that the mortgage market and the institutions to make it operate in the U.S. are broken.
They continue:
The Fannie and Freddie situation was a result of their unique roles in the economy. They had been set up to support the housing market. They helped guarantee mortgages (provided they met certain standards), and were able to fund these guarantees by issuing their own debt, which was in turn tacitly backed by the government. The government guarantees allowed Fannie and Freddie to take on far more debt than a normal company. In principle, they were also supposed to use the government guarantee to reduce the mortgage cost to the homeowners, but the Fed and others have argued that this hardly occurred. Instead, they appear to have used the funding advantage to rack up huge profits and squeeze the private sector out of the “conforming” mortgage market. Regardless, many firms and foreign governments considered the debt of Fannie and Freddie as a substitute for U.S. Treasury securities and snapped it up eagerly.
Fannie and Freddie were weakly supervised and strayed from the core mission. They began using their subsidized financing to buy mortgage-backed securities which were backed by pools of mortgages that did not meet their usual standards. Over the last year, it became clear that their thin capital was not enough to cover the losses on these subprime mortgages. The massive amount of diffusely held debt would have caused collapses everywhere if it was defaulted upon; so the Treasury announced that it would explicitly guarantee the debt.
But once the debt was guaranteed to be secure (and the government would wipe out shareholders if it carried through with the guarantee), no self-interested investor was willing to supply more equity to help buffer the losses. Hence, the Treasury ended up taking them over.
So the Federal government bailed out Freddie Mac and Fannie Mae using money they didn’t have. And now the U.S government wants to bail out other financial businesses whose downfall affect the stability of the economy – with money they don’t have. Whatever happened to free markets and capitalism? Texas congressman
Ron Paul understands the crisis and the road to a solution:
I am afraid that policymakers today have not learned the lesson that prices must adjust to economic reality. The bailout of Fannie and Freddie, the purchase of AIG, and the latest multi-hundred billion dollar Treasury scheme all have one thing in common: They seek to prevent the liquidation of bad debt and worthless assets at market prices, and instead try to prop up those markets and keep those assets trading at prices far in excess of what any buyer would be willing to pay.
Additionally, the government's actions encourage moral hazard of the worst sort. Now that the precedent has been set, the likelihood of financial institutions to engage in riskier investment schemes is increased, because they now know that an investment position so overextended as to threaten the stability of the financial system will result in a government bailout and purchase of worthless, illiquid assets.
Using trillions of dollars of taxpayer money to purchase illusory short-term security, the government is actually ensuring even greater instability in the financial system in the long term.
The solution to the problem is to end government meddling in the market. Government intervention leads to distortions in the market, and government reacts to each distortion by enacting new laws and regulations, which create their own distortions, and so on ad infinitum.
It is time this process is put to an end. But the government cannot just sit back idly and let the bust occur. It must actively roll back stifling laws and regulations that allowed the boom to form in the first place.
The government must divorce itself of the albatross of Fannie and Freddie, balance and drastically decrease the size of the federal budget, and reduce onerous regulations on banks and credit unions that lead to structural rigidity in the financial sector.
Until the big-government apologists realize the error of their ways, and until vocal free-market advocates act in a manner which buttresses their rhetoric, I am afraid we are headed for a rough ride.
While I do not believe Paul is correct about everything, he gets far more right than he does wrong. This is a basic (and probably oversimplified) primer on the economic crisis facing our nation today. There is plenty of blame to pass around but the lion’s share has to be put squarely on the heads of the three principal parties involved in this mess: President George W. Bush and Democratic Senators Chris Dodd and Barney Frank. Their policies and practices have put the world’s strongest economy at risk; the fact that all this happened under the watch of a Republican president particuarly disgusts me. I hope to post a more insightful and substantial post next week by a friend who is far more knowledgeable than I am on these matters. In the meantime, I hope this helps.
Update: A few more things I would like to add about the CRA (Community Reinvestment Act), a Federal law passed by President Jimmy Carter and Congress in 1977. It basically requires banks to offer credit throughout their communities, including poorer areas. I’ll allow
Constitutional lawyer Mark Levin to continue:
And so the law is enforced by the federal government and in 1995, as a result of interest from Bill Clinton’s Administration - particularly Janet Reno and the Department of Housing and Urban Development, the implementing regulations for the law were strengthened by focusing the financial regulator’s attention on institution’s performance in helping to meet community credit needs.
So they really, really pushed them. They used the FORCE OF LAW to compel these private institutions to make bad loans.
These changes were very controversial.
…The Clinton Administration’s regulatory revisions with an effective starting date of January 31 1995, were credited with substantially increasing the number and aggregate amount of loans to small businesses and to low and moderate income borrowers for home loans. Clinton used to brag about this…
The loans were not capitalized. So you have No Down Payment loans, No Interest loans, Low Interest loans that turn into higher interest loans over time (ARMs), and on and on. They were trying to be creative in what they could do, and they HAD TO BE under the threat of losing business practices and activities as compelled by the Federal Government.
The Federal Government compelled this activity and compelled this behavior.
The first securitization of CRA loans, started in 1997 with Bear Stearns (remember them?)
Now in 2003, The Bush Administration recommended what the New York Slimes (Times) called “The most significant regulatory overhaul in the Housing Financial Industry since the Savings and Loan crisis a decade ago”. This change was to move governmental supervision of two of the primary agents guaranteeing subprime loans; Fannie Mae and Freddie Mac, under a wholly new agency created within the Department of Justice, which would give it more oversight power and more auditing power. It would require these two so-called “companies” to better capitalize their debt.
Even so, what remained was the implied guarantee that the American taxpayer, should anything go wrong, would back-up these loans.
But that legislation to strengthen these programs, to move the oversight to an independent separate agency WAS BLOCKED in 2003 by Congress. And it was blocked by the Democrats, because the Democrats were in bed with ACORN and these other “community activists grassroots groups”, of whom Barrack The Hussein Obama is quite familiar. These are the constituents of the Democrat party - that is these Left wing groups like ACORN.
(Barney) Frank (D-MA) was in bed with them; Chris Dodd (D-CT) was in bed with them; the Clinton Administration was in bed with them; and so they blocked the reforms the Bush Administration proposed in 2003.
Barney Frank said at the time “These two entities Fannie Mae and Freddie Mac, are NOT FACING ANY KIND OF FINANCIAL CRISIS. The more people exaggerate these problems…the more pressure there is on these companies, the less we will see in terms of affordable housing”.
Here’s another account from Bloomberg about the attempted reform of the system by Congress a few years ago:
Some might say the current mess couldn't be foreseen, yet in 2005 Alan Greenspantold Congress how urgent it was for it to act in the clearest possible terms: If Fannie and Freddie ``continue to grow, continue to have the low capital that they have, continue to engage in the dynamic hedging of their portfolios, which they need to do for interest rate risk aversion, they potentially create ever-growing potential systemic risk down the road,' he said. ``We are placing the total financial system of the future at a substantial risk.' What happened next was extraordinary. For the first time in history, a serious Fannie and Freddie reform bill was passed by the Senate Banking Committee. The bill gave a regulator power to crack down, and would have required the companies to eliminate their investments in risky assets.
If that bill had become law, then the world today would be different. In 2005, 2006 and 2007, a blizzard of terrible mortgage paper fluttered out of the Fannie and Freddie clouds, burying many of our oldest and most venerable institutions. Without their checkbooks keeping the market liquid and buying up excess supply, the market would likely have not existed. But the bill didn't become law, for a simple reason: Democrats opposed it on a party-line vote in the committee, signaling that this would be a partisan issue. Republicans, tied in knots by the tight Democratic opposition, couldn't even get the Senate to vote on the matter.
The article continues:
But we now know that many of the senators who protected Fannie and Freddie, including Barack Obama, Hillary Clinton and Christopher Dodd, have received mind-boggling levels of financial support from them over the years. Throughout his political career, Obama has gotten more than $125,000 in campaign contributions from employees and political action committees of Fannie Mae and Freddie Mac, second only to Dodd, the Senate Banking Committee chairman, who received more than $165,000. Clinton, the 12th-ranked recipient of Fannie and Freddie PAC and employee contributions, has received more than $75,000 from the two enterprises and their employees. The private profit found its way back to the senators who killed the fix.
Again, by no mean am I the expert here, but these are the articles and pieces I’ve found most helpful since researching this topic a few days ago. If you have something to add to the discussion, by all means, bring it up. I think that all Americans are now trying to get up to speed on how politicians hijacked the world’s greatest economy.
