Choosing Our Economic Future Wisely
This article is about the underreported, systematic errors committed by the federal government of the United States that are at the heart of the global financial crisis. It challenges the storyline being offered by those who believe in the beneficence and wisdom of government relative to individual liberty and free markets.
What is at stake is the interpretation or narrative with regard to who was responsible for the global financial crisis, and what institutional arrangements failed. Those at the highest levels of the political and intellectual classes are doing all they can to shape this narrative because they know that the resulting “accepted wisdom” will inform our common sense and operate in the background as we respond to this challenge and challenges in the future. This new orthodoxy of who or what caused the crisis has the potential to radically increase the power of those who believe in expanding the role of government in ruling the day-to-day lives of the American people relative to those who believe in limiting government while expanding individual liberty and free markets.
As a consequence, in choosing which narrative to believe with regard to the origins of this crisis, you and I are in many respects choosing the shape of our future. Make no mistake, the dominant narrative that comes out of this financial crisis will have a direct impact on our liberty, our prosperity, and the kind of society we become.
During the presidential campaign, you probably heard John McCain blame the crisis on “greed and corruption on Wall Street.”
Barack Obama went even further, saying that the crisis shows that the philosophy of free markets and lax regulations is fundamentally flawed.
Or as liberal columnist Thomas Frank asked, “Why did government stand back and permit all the misconduct that generated all this bad debt? What particular ideas led us to believe that our government should just keep its hands off and let markets run their course?”
There is plenty of blame to go around – from Wall Street to Main Street. And, Congressional hearings will assure that we all learn about the errors and poor judgments on Wall Street and to a lesser extent, about the poor decisions made by many who took out loans that they had little chance of repaying.
But, what those hearings are unlikely to explore is the fundamental role played by the federal government itself in creating the financial crisis that is impacting all of our lives.
And yet, failing to take fully into account government’s role constitutes a clear and present danger to our future.
I use the word “danger” because the interpretation of these seismic events will influence the electorate and policymakers for years to come. If we ignore the central role of government in creating this crisis, and place blame solely on private markets and free people, then we are likely to end up with a more intrusive government, less freedom, a lot less prosperity, and future crises caused by government that will be blamed on the private sector.
On the other hand, if we acknowledge the contribution that well-intentioned, but unsound policies had in creating this crisis, then we will have an opportunity to achieve a better balance between the role of government and the private sector. The benefit would be more liberty to live our lives the way we choose, more opportunity to achieve success and to take care of our families, a greater level of prosperity from which we can take care of those in need, and a reduced risk of future financial crises.
Free markets did not bring the world’s financial system to the edge of collapse. Rather, the epicenter of the crisis was a massive dose of state capitalism. By state capitalism, I mean that the state, in this case the federal government, used its vast powers to intervene in, and distort capital markets in a manner that led directly to the creation of trillions of dollars in bad loans. Moreover, in the pursuit of a social policy to increase affordable housing and home ownership, the federal government engaged in policies that disrupted the financial market’s ability to be self-regulating; that is to attenuate if not avoid the crisis we are in.
In particular, the federal Government through Fannie Mae and Freddie Mac directed $5.2 trillion (that is trillion with a "t") of capital to increase the supply of mortgages. In addition, it passed a law that required banks to make billions of dollars in loans to individuals who were unlikely to pay off the loans, in the end with 0% down.
In 1998, Fannie Mae announced it would purchase mortgages with only 3% down. And, in 2001, it offered a program that required no down payment at all. Between 2001 and 2004, subprime mortgages grew from $160 billion to $540 billion. And between 2005 and 2007, Fannie Mae’s acquisition of mortgages with less than 10% down almost tripled. These loans are now known as “subprime” and “alt A” loans. At the time they were made, Fannie Mae and Freddie Mac encouraged their issuance by lowering their standards and buying them up from the now vilified mortgage brokers, S&Ls, banks and Wall Street investment banks.
This activity was not due to a lack of regulation or oversight. Both companies are under the direct supervision of a federal regulator and Congress. At the time these loans were being purchased by these two Government Sponsored Enterprises (GSEs), their actions were defended by many in Congress as a successful government initiative. Below is a link to a u-tube video that provides clips from a 2004 Congressional hearing in response to a report by Fannie and Freddie’s regulator that identified specific irregularities, and which warned of trouble to come. In one priceless clip, Congresswoman Maxine Waters approvingly noted that Fannie had made it possible for individuals to purchase homes with 0% down. Efforts by the Bush administration to reform these two institutions and restrain their growth were thwarted by a coalition led by Democrats and joined by more than a few Republicans. Sadly, if action had been taken then, there is a high probability that the current crisis would have been avoided completely, or would be far less in magnitude.
Yes, mortgage brokers and banks encouraged reckless borrowing. I bet that we will learn of some fraudulent behavior among some of the more aggressive mortgage brokers. And, I state emphatically that I neither condone nor excuse their behavior in any way. Nor, do I excuse the lack of responsibility exhibited by many who, with a little honest reflection, could have known that they would be unable to meet the financial obligation of paying the mortgage that they were using to buy a house that they could not afford.
But, the culpability of those in the private sector should not be used to cover-up or excuse the irresponsible behavior of the federal government. The self-regulatory check normally provided by markets on activities that are likely to loose money -- lenders backing away -- was over-whelmed by first the perception, now validated, that Fannie Mae and Freddie Mac debt was backed by the full faith and credit of the Federal government, and second, by the use of this guarantee to borrow trillions of dollars at rates only slightly above that paid by the U. S. Treasury itself to fund purchases of trillions of dollars of mortgages that they kept on their balance sheets. When you have a willing buyer backed by the federal government with unlimited access to credit markets and a trillion dollar budget, markets should not be blamed for responding by providing that buyer, effectively a government agency, with what it was seeking.
For example, Countrywide Bank, now criticized as one of the perpetrators of the financial crisis, in 2000 was lauded by the Fannie Mae Foundation for its leadership in providing flexible lending standards. The report stated: “Countrywide tends to follow the most flexible underwriting criteria permitted under GSE and FHA guidelines…When necessary – in cases where applicants have no established credit history, for example – Countrywide uses nontraditional credit, a practice now accepted by the GSEs.” (emphasis added).
The easy credit terms also fueled a rise in residential home prices that took on a life of its own. Rising prices caused more buyers to jump in with risky mortgages that stretched their finances so as not to be left behind, further boosting prices. The easy terms also attracted speculators who, without the need to put significant amounts of money down, purchased houses and condos, sometimes renovating them, all with the goal of selling them at a profit in a year or less.
Once the party got going, the investment banks on Wall Street piled in and created new ways to splice, dice and otherwise package these mortgage-backed securities. They created different “tranches”, some that the received the highest (least risky) AAA rating, and other tranches that were more speculative and offered the prospects of higher returns. Fannie Mae and Freddie Mac did not originate these securities. But they effectively made their creation possible by being the biggest buyers of the AAA tranches of pools of subprime mortgages in the 2005-2007 period. Bankers all over the world followed, buying these securities under the illusion that they were as good as the “investment grade” label that they had been given by rating agencies (designated by the federal government), and, in any event, could be sold easily in what then were very liquid markets.
In 2006, U.S. housing prices stopped going up, and defaults started heading higher. In the end, junk is junk. When the cash flow is not forthcoming, it matters little how good your intentions were, or how socially desirable the goal. The loans go bad. And, in this case, banks all over the world go bankrupt, and the world’s credit markets freeze up.
Fortunes have been lost. Thousands of homes are in foreclosure. All of the major independent investment banks on Wall Street have either gone bankrupt (Lehman Brothers), become part of a large bank holding company (Bear Stearns, Merrill Lynch and Wachovia) or – in the case of Goldman Sachs and Morgan Stanley, put themselves under the regulatory authority of the Federal Reserve by becoming bank holding companies themselves.
The point that is easy to lose in the midst of all of this drama and 24-hour news cycles is that the force behind all of this stupidity and bad judgment, the force behind the so-called market failure, was the federal government’s demand that lenders ease their lending standards.
Moreover, by standing ready to buy the AAA tranches of the subprime mortgage pools created by Wall Street investment banks, they made possible the creation and marketing of these securities to financial institutions around the world. Once again, the center of the global financial crisis can be found in the state capitalism pursued by the federal government through its GSEs, Fannie Mae and Freddie Mac.
Greed and Corruption? Here are just a just a few items that are not likely to be discussed at congressional hearings, or on the 6 p.m. news.
Let’s start with the irresponsible behavior on the part of the politicians who encouraged and cheered what they now criticize as predatory lending. Rather than accept at least some of the responsibility for the crisis, they shamelessly shift the blame to “free” markets that had been, in fact, doing their bidding.
• Corruption? Both Freddie and Fannie were found to have committed accounting fraud, making their profits higher, and their CEO bonuses richer.
• Executive compensation: Fannie’s CEO, Franklin Raines, made $90 million between 1998 and 2004.
• Buying influence: Fannie and Freddie were two of the biggest campaign contributors to congressmen and senators. According to the American Enterprise Institute study, “The Last Trillion Dollar Commitment: The Destruction of Fannie Mae and Freddie Mac,” between the “2000 and 2008 election cycles, the GSEs and their employees contributed more than $14.6 million to the campaign funds of dozens of Senators and Representatives, most of them on committees that were important to preserving the GSEs’ privileges.” The study goes on to point out that Fannie Mae in particular enhanced its power by setting up “partnership offices” in the districts and states of important lawmakers, often hiring relatives of those lawmakers to staff the local offices. It doesn’t stop there. In the ten years ending 2008, Fannie Mae spent $79.5 million, and Freddie Mac spent $94.9 million lobbying Congress, often hiring lobbyists that their opponents might otherwise have employed. Countrywide Credit also made available special arrangements for influential members of Congress and their staffs, including Connecticut Senator Chris Dodd, now Chairman of the Senate Committee on Banking, Housing and Urban Affairs and a perennial advocate for both Fannie Mae and Freddie Mac.
Here is the way Oklahoma Senator Tom Coburn put it: “The root of the problem is political greed in Congress. Members…from both parties wanted short-term political credit for promoting homeownership even though they were putting our entire economy at risk by encouraging people to buy homes they couldn’t afford. Then, instead of conducting thorough oversight and correcting obvious problems with unstable entities like Fannie Mae and Freddie Mac, members of Congress chose to…distract themselves with unprecedented amounts of pork-barrel spending.”
In mid-September, the federal government seized both Fannie Mae and Freddie Mac, adding $5.2 trillion in debt to the government's balance sheet, and assets worth potentially $1 trillion less in value.
Then, realizing that only the government had enough market power to solve a
$5 trillion plus problem that government had created, Democrats and Republicans voted to put up another $700 billion to stabilize the financial sector and end a credit freeze that threatened a cascading collapse of the U.S. economy. European governments have followed in a coordinated effort to prevent the possible collapse of the global economy.
The harm to our economy and way of life will be recorded over the months and years ahead.
• Trust in our financial institutions and in securitized credit markets has been horribly undermined, and it will take time and a lot of money to rebuild. That will slow our credit system’s ability to function, making credit less available to businesses and individuals, and economic growth slower than it otherwise would have been.
• Hundreds of thousands of individuals in the U.S. alone will loose their jobs in part because of the lack of credit from banks whose capital has been impaired. Millions will suffer around the world.
• The government now has a significant investment in the five largest banks in the U.S. Not surprisingly, in exchange, politicians are seeking to exert political influence over the lending practices of those banks.
• Millions of low income and minority individuals have become victims of a false promise fostered by federal agencies, and delivered by banks, S&Ls, mortgage brokers, and other market participants. For them, the dream of home ownership has been dashed, breeding resentment and anger.
• Half of America’s households, which have investments in equity markets, have seen the value of their 401(k)s, IRAs, and taxable holdings fall 25% or more.
• American taxpayers have already been stuck with $54 billion in combined losses reported by Fannie Mae and Freddie Mac in the September quarter alone. The $100 billion pledge by the U.S. Treasury authorized by Congress likely will prove insufficient. As of August 2008, they held or had guaranteed subprime loans with more than $1.011 trillion in unpaid balances.
• Leaders in Congress are considering proposals to effectively do away with 401(k)s owned by individuals, and to replace them with a program that would effectively force individuals to purchase low yielding government bonds through the Social Security Administration.10
This financial crisis is first and foremost a failure of crony capitalism that fed the greed on Wall Street, fueled the housing bubble and the reckless borrowing by well-intentioned individuals and more than a few speculators.
The biggest danger to our long-term economic well-being and liberty is that those responsible for this failure of state capitalism are using this crisis to discredit free markets and free people. Already the understandable anger of the American people is being tapped in support of policies that will take from “the rich” in order to give to everyone else.
While seductive, such policies in the United States and other places in the world have been associated with poor economic performance, above average unemployment, below average equity market returns, and stagnating to falling living standards, especially for the most vulnerable parts of society. The longer run costs of the narrative that the financial crisis was caused by free markets will be less freedom and less prosperity for all, especially those businesses and individuals facing increased competition from the global economy.
I encourage you to watch the attached u-tube video. And, for those of you who want to dig deeper, I have provided links to the two academic type papers cited below, each of which provides extraordinary detail and evidence for much of what I have said above. They are the best two studies I have read in terms of explaining how we came to this point.
If after reading this article, viewing the video on U-tube and reading one or both of the attached studies, you are as concerned as I am about the danger to our prosperity and liberty created by ignoring the Federal government’s role in creating the current financial crisis, please forward this article to at least two individuals who would find it of interest, and ask them to do the same.
Thomas Frank, “It’s Judgment Day for McCain,” The Wall Street Journal, September 24, 2008, p A27.
Stan J. Liebowitz, Anatomy of a Train Wreck, Causes of the Mortgage Meltdown, Independent Policy Report, Oct 3, 2008, pp 7-15.
Peter J. Wallison and Charles W. Calomiris, “The Last Trillion-Dollar Commitment: The Destruction of Fannie Mae and Freddie Mac,” American Enterprise Institute for Public Policy Research, September 2008, p 6.
Liebowitz, p. 10
James Lockhart, “Reforming the Regulation of the Government Sponsored Enterprises” (testimony, Committee on Banking, Housing and Urban Affairs, U.S. Senate, 110th Cong., 2nd sess., February 7, 2008, 6 as cited in Wallison and Calomiris, p 8.
Wallison and Calomiris, p 3.
Wallison and Calomiris, p 3.
As quoted by Peggy Noonan, “Playing Frisbee on a Precipice,” The Wall Street Journal, October 11-12, 2008, p. A13.
Wallison and Calomiris, p 8.
10 See for example Teresa Ghilarducci, “Saving Retirement in the Face of America’s Creditd Crises: Short Term and Long Term Solutions,: (testimony before the Committee on Educations and Labor, October 7, 2008.