How Our Government Created the Subprime Mess and Led Us to the Brink of Financial Disaster
Boom and Bust
A research paper written in March by Carmen Reinhart and Kenneth Rogoff, This Time is Different: A Panoramic View of Eight Centuries of Financial Crises, reveals that credit and business cycles have several things in common, mainly the debasement of money, which, in our current case, is inflation, otherwise known in its initial stages as “easy money.”1The point of the article is that, this time is not different from other cycles.
During these cycles, easy money is pumped into the system, distorting financial decisions, encouraging the malinvestment of capital, and causing prices to rise. Prices rise faster than their productively useful value. Eventually money is deflated, and prices go back to a price-value equilibrium.
Credit cycles in modern times are created by the central bank: the Fed. These cycles tend to behave the same way, but the asset class differs from cycle to cycle. In 2001, it was dot com tech stocks; in 1990, it was the S&L bust affecting investment real estate; in 1981, it was Fed tight monetary policy trying to kill stagflation.
In the subprime crisis too much money chased residential properties in excess of their useful value in the economy, and now housing prices are seeking the proper market ratio of price to value.
Just look at the Case-Shiller Residential Housing Index:2
You don’t have to be an economist to figure this one out. Some call it the biggest bubble in our history. From January 2001 to June 2004 the federal funds rate went from 6% to 1%. Home ownership grew from an average of about 60% of families to almost 70% at the height of the boom. It has been estimated that up to 24% of all residences were bought by speculators (those who didn’t live in the homes they bought).
From June 2004 to September 2007 the federal funds rate went from 1% to 5.25%. Money got tighter, and then . . . BUST!
How did we get here?
If I hear one more time that this fiasco was caused by the lack of regulation, I’ll throw up, so to speak. This was caused by regulation and your government. Who’s saying this: Barney Frank, Chris Dodd, and Chuck Schumer. I’ll get back to them, but first look at the facts.
1. The Fed created the credit cycle. Easy money flooded the system. This starts the boom part of the boom-bust cycle.
2. Easy money set the stage for the financial community to do what they always do best: make money.
3. Their investment focus during this cycle settled on mortgage debt, and specifically, subprime debt.
4. They focused on subprime debt because that’s where the fees were. Investment bankers, commercial bankers, mortgage lenders and brokers made fortunes originating and selling this stuff.
5. They did so because they could. Now, why would anyone lend to someone who couldn’t afford to buy or finance the purchase of a house? No one in their right mind. Unless . . .
6. Enter Fannie Mae and Freddie Mac: they subsidized the risk of those loans by guaranteeing them.
7. Why would Fannie and Freddie guarantee bad loans? Political pressure. Starting in 1992 the Clinton Administration, using their powers over banks and housing through the Community Reinvestment Act (Carter,1977), instructed lenders, and Fannie and Freddie to make more loans to those who couldn’t afford them. They loosened lending standards to allow it.3. Then Wall Street figured away to bring tons of money into that system: mortgage-backed subprime securities. These were sold throughout the world as safe financial instruments. After all, Freddie and Fannie would guarantee these loans.4
9. So, banks and mortgage lenders geared up to feed the frenzy. They generated billions of dollars of subprime loans, most guaranteed by Fannie and Freddie, and underwritten according to Fannie-Freddie requirements, and sold them to investors. They got their fees and everyone got fat.5
10. It worked until the merry-go-round stopped and homes stopped appreciating. Then the cleverly named “subprime” mortgages became the “junk” mortgages that they always were, and their bonds, junk bonds.
I don’t think I need to explain specifically how the market collapsed, that’s been the topic of the news for the last year. I’ve discussed it a lot in the blog.
So what went wrong?
In 2002 many people were saying that a train wreck was heading for us and it was called Federal National Mortgage Association (Fannie Mae) and Federal Home Loan Mortgage Association (Freddie Mac). Fannie and Freddie are among the largest financial companies in the world. They control one-half of the mortgages and related securities in America: about $5 trillion worth. The Wall Street Journal ran a series of articles and opinions about the oncoming disaster as early as 2002.6
Who listened? Thanks to some generous lobbying funds spread around Congress by Fannie and Freddie, apparently no one in Congress. In fact the politicians who regulated them went out of their way to encourage more loose lending standards.
Here are a series of hearing transcripts reported in the Wall Street Journal.7 Some of these can be seen on You Tube. Barney Frank is now Chairman of the House committee and Chris Dodd is now Chairman of the Senate committee, that regulate Fannie and Freddie. These aren’t taken out of context; these hearings were about the oncoming train wreck.8
House Financial Services Committee hearing, Sept. 10, 2003:
Rep. Barney Frank (D., Mass.): I worry, frankly, that there’s a tension here. The more people, in my judgment, exaggerate a threat of safety and soundness, the more people conjure up the possibility of serious financial losses to the Treasury, which I do not see. I think we see entities that are fundamentally sound financially and withstand some of the disaster scenarios. .
House Financial Services Committee hearing, Sept. 25, 2003:
Rep. Frank: I do think I do not want the same kind of focus on safety and soundness that we have in OCC [Office of the Comptroller of the Currency] and OTS [Office of Thrift Supervision]. I want to roll the dice a little bit more in this situation towards subsidized housing. . . .
* * *
Rep. Frank: Let me ask [George] Gould [President of Freddie] and [Franklin] Raines [President of Fannie]: on behalf of Freddie Mac and Fannie Mae, do you feel that over the past years you have been substantially under-regulated?
Mr. Raines: No, sir.
Mr. Frank: Mr. Gould?
Mr. Gould: No, sir. . . .
Mr. Frank: OK. Then I am not entirely sure why we are here. . . . I believe there has been more alarm raised about potential unsafety and unsoundness than, in fact, exists.
Senate Banking Committee, Oct. 16, 2003:
Sen. Charles Schumer (D., N.Y.): And my worry is that we’re using the recent safety and soundness concerns, particularly with Freddie, and with a poor regulator, as a straw man to curtail Fannie and Freddie’s mission. And I don’t think there is any doubt that there are some in the administration who don’t believe in Fannie and Freddie altogether, say let the private sector do it. That would be sort of an ideological position.
Mr. Raines [President of Fannie]: But more importantly, banks are in a far more risky business than we are.
Senate Banking Committee, Feb. 24-25, 2004:
After Fed Chairman Alan Greenspan informed the Committee of the oncoming train wreck:
Sen. Christopher Dodd (D., Conn.): I, just briefly will say, Mr. Chairman, obviously, like most of us here, this [Fannie and Freddie] is one of the great success stories of all time. And we don’t want to lose sight of that and [what] has been pointed out by all of our witnesses here, obviously, the 70% of Americans who own their own homes today, in no small measure, due because of the work that’s been done here. And that shouldn’t be lost in this debate and discussion. . . .
Senate Banking Committee, April 6, 2005:
Sen. Schumer: I’ll lay my marker down right now, Mr. Chairman. I think Fannie and Freddie need some changes, but I don’t think they need dramatic restructuring in terms of their mission, in terms of their role in the secondary mortgage market, et cetera. Change some of the accounting and regulatory issues, yes, but don’t undo Fannie and Freddie.
Senate Banking Committee, June 15, 2006:
Sen. Chuck Hagel (R., Neb.): Mr. Chairman, what we’re dealing with is an astounding failure of management and [the Fannie] board [of directors] responsibility, driven clearly by self interest and greed. And when we reference this issue in the context of — the best we can say is, “It’s no Enron.” Now, that’s a hell of a high standard.
Now we have to hear Barney Frank and his friends say, quite loudly, that this crisis has been caused by the Bush Administration’s failed deregulation and free market policies. Nothing could be farther from the truth.
The fact is that the mortgage market and industry is one of the most heavily regulated industries in America. The New Deal regulation, the Treasury, the Fed, and SEC regulate the hell out of banks, mortgage lenders, and the issuers of securities. We’ve all seen the reams of paper we have to sign to get a mortgage. These forms disclose every possible thing that could impact a borrower. Banks can’t sneeze without asking the Fed, or the Treasury, or the FDIC. Fannie’s and Freddie’s operations are heavily regulated by the Office of Federal Housing Enterprise Oversight (OFHEO).
I would like Messrs. Frank, Dodd, and Schumer to tell us where this industry was deregulated and why it caused this crisis.9 If it was so foully deregulated, and since they control the House and Senate committees regulating these issues, why didn’t they stop it? They can’t because it didn’t happen. It’s hypocrisy, political theater, and demagoguery at its worst.
Why the worst? Because when the free market makes mistakes, they pay the price. When the government makes mistakes, we pay the price.
The Law of Unintended Consequences
There’s enough blame to go around, including Wall Street, but, this crisis was and still is being caused by government regulation and laws. This couldn’t have happened without misplaced and misunderstood government action. What these politicians failed to understand is another law: the law of unintended consequences.
Choices have consequences. If you choose the wrong policies and pass bad laws, the laws of economics will eventually catch up with you, as it has with us today. Even assuming these politicians meant well, they had no idea what harm their laws and regulations would cause.10 They didn’t consider these risks. Many economic regulations have unfavorable unanticipated consequences.11
The young Wall Street MBAs who invented these new mortgage-backed securities assumed that housing values would continue to rise, or at least not decline. They failed to properly anticipate risk and suffered the unintended consequences of their actions.12
These politicians and financiers failed to consider that they were creating huge potential risk to the economy. Even when the risks were right in front of them, they ignored them. Perhaps we can be charitable and say they just weren’t aware that their well-meaning actions would cause financial disaster.
That is the danger when politics and politicians intervene in the workings of a free society. These decisions affect very complex markets. In a free market decisions are made by millions of people, which generally work out well when you spread risks over a large group. When politicians make decisions affecting the market, you have substituted the actions of millions for the decisions of a handful. These command economy decisions, when wrong, cause widespread suffering.  While politicians talk about reducing risk in the economy they should look to themselves; most often they create it.13
See also a paper published by the St. Louis Fed, Understanding the Subprime Mortgage Crisis, Demyanyk and Van Hemert, 12/10/2007.
 Chart provided by Frank Shostak, Chief Economist of M. F. Global for an article published by the Mises Institute.
 They lent up to 95% of appraised value, with credit scores just above 500, on the basis of what the borrower said they were making without needing to provide proof of earnings (the so-called “liar loans”).
 For a detailed discussion of these securities, see my article, “Peeling Back the Onion,” below in this blog.
 The original lender now is gone and has no investment tied up in these mortgages because Fannie or Freddie bought them. The original lender could care less what happens next.
 Wall Street Journal, February 20, 2002, “Fannie Mae Enron.”
 Wall Street Journal, October 2, 2008.
 Dodd received $165,000 from Fannie and Freddie, Schumer, $24,000, Frank, $42,000, Obama, $126,000, Hagel, $4,500.
 Even Bill Clinton admits that the repeal of Glass-Steagall in 1999 had nothing to do with today’s crisis.
 Dodd, Schumer, and Frank were trained as lawyers, and didn’t have undergraduate degrees in economics or business, which is typical among lawyers and politicians.
 The Great Depression is a classic example of how our government turned a nasty crash into a decade long depression.
 This is a Black Swan event. See the wonderful book, Black Swan by Nasim Taleb about the evaluation of risk in investing. I’ve criticized Wall Street extensively in this blog.
 “Never again!” statement by Sarah Palin in the Vice Presidential debate, October 2, 2008. She further railed on about greed and Wall Street.