Who's Really to Blame for the Financial Crisis?
The conventional wisdom today lays the blame for today's financial crisis on the free market. The mortgage market collapse is thought to be due to unscrupulous lenders who relaxed lending standards and then sold risky mortgages to unsuspecting investors. Both Presidents Bush and Obama used this narrative in justifying their policy actions. Closer examination reveals that government interference played a much more fundamental role. Specifically, the ballooning of the secondary mortgage market by government sponsored entities, followed by the "cheap money" policy of the FED created the basic structural distortions which would ultimately lead to the financial crisis.
Government sponsored entities [GSE] such as Freddie Mac and Fannie Mae are key players in home mortgage markets. They were created by and have a specific mandate from congress to help assure "affordable" housing. Although these entities operate as "private corporations" today, they receive favorable treatment by the government and their boards and hence their operating policies are primarily government controlled.
The secondary mortgage market was created primarily by these GSE's. Up through the 1990's, most mortgages were held by private corporations in what is known as the "originate to hold" model. However, GSE's increased the flow of capital into the mortgage market through what is known as the "originate to distribute" model. Through this model loans are bought, packaged into securities, and sold to investors on the secondary market. GSE's either perform this activity directly or they insure the securities created by private firms. Practices like these effectively mask risk from investors and give mortgage originators no reason to closely examine the quality of the loans they issue. GSE's fueled the mortgage practices that today are blamed on the free market.
GSE involvement had been relatively small up until the 1990's. The most striking growth in the secondary mortgage market occurred in the 1990's, before the housing boom, with that market reaching a size of $3.3 trillion by 2001. Eighty five percent of that market was based upon securities issued or insured by the GSE's. This growth was fueled by specific changes to GSE policy to stimulate home ownership. Structurally, the stage had been set for a large housing boom, and all that was needed was a precipitating condition.
That condition came in the form of the monetary policy of the Federal Reserve during 2001-2004. During that time the FED lowered and held interest rates at near record lows. Chairman Alan Greenspan noted that he was attempting to stimulate the economy, and specifically home ownership. He states in his autobiography, "I was aware that the loosening of mortgage credit terms for subprime borrowers increased financial risk, and that subsidised home ownership initiatives distort market outcomes. But I believed then, as now, that the benefits of broadened home ownership are worth the risk."
The FED is a government entity and itself acknowledges the role of low interest rates in fueling housing boom cycles. From a 2005 study on housing booms and monetary policy, FED analysts indicate that "house price booms are typically preceded by a period of easing monetary policy, but then diminishing slack and rising inflation lead monetary authorities to begin tightening policy."
Demand for housing, previously steady at 3% annual growth, ballooned to 9% as a result of FED policy. Construction boomed, home prices escalated significantly, and debt levels rose on this rising tide of newfound "home equity." The well-established secondary mortgage market served as a ready catalyst to funnel capital into the market to meet this ballooning demand, magnifying the size of the boom.
During an artificial boom, risk levels are masked. Because house prices are escalating dramatically, borrowers feel that they can take on more debt. Because foreclosure rates actually go down, lenders begin to feel that they can lend to borrowers who before might have been perceived as risky. And because mortgage securities continue to pay out well, investors continue to demand them. Some even begin to think that this boom will be sustained and increase their risk levels beyond what would normally have been considered prudent. These effects are not a result of an unexplained aberration in the free market. Rather they result from the fundamental distortions that created the boom in the first place.
The FED's fiscal tightening in 2005-6 precipitated the crash. Because of the extended boom however, a significant amount of capital had been placed into poor investments, and the magnitude of the crash had already been determined, left only to play itself out.
While the conventional wisdom may blame markets for the financial crisis, government interference in the mortgage market for the expressed purpose of stimulating home ownership was at the heart of the collapse.
[Editor’s Note: this article was written for a writing class I’m taking, as an example of an op-ed article.]
Could you explain more about how this works? I often hear the charge that Freddie and Fannie are private entities, then hear this same response, but then hear little about exactly what that means? How are their operating policies effected by Government favouritism?
I know it might sound like a rather simple-minded question, but I really don't know.
The first aspect is their charter. With the typical private company, private people form the company by agreement. Fannie was formed via government charter. I'm no lawyer, but I'd guess the government thus retains the legal power to shut it down by revoking its charter, or (more likely) to modify its charter by law.
Apart from possible control, the charter does not set these companies up as solely profit-making enterprises. Instead, they have public-policy goals as well: e.g. increasing home ownership and making home-ownership more affordable.
In addition to the charter, the president directly appointed about a third of the company's directors. The CEO was also appointed by the president. This last is probably not how it is done "on paper", but that is how it has been in practice. When Johnson moved FNM from government-owned to being a "government-sponsored" enterprise(GSE), the existing CEO remained in place. The next administration (Nixon) wanted to fire him (he was Dem, they were GOP). The CEO claimed this was outside the powers of the President and he went to court, but his challenge failed. [Supposedly, the Housing Act of 1968 allows this, according to the courts].
Finally, the government set up a special regulator solely to regulate the two GSE's (Fannie, and Freddie which was created to replace a monopoly with a duopoly). So, the government had pretty direct control over FNM via the regulator.
In English, the Federal government was saying: FNM debt is not our debt, but we will ensure that it is just as safe.
This implicit guarantee was the cornerstone of GSE business. This guarantee meant that they could borrow at rates that were lower than those at which a truly private corporation could borrow. In turn, this meant that private competitors were at a disadvantage. No wonder there were few such competitors within the area that FNM focused [homes within a certain price-range].
Via law, the government could remove that so called "implicit guarantee", and undermine FNM's uniqueness. This is a good concrete example of monopoly power -- quite similar to that enjoyed by various other government-charter companies of the past. FNM was our East India Company :)
He reckons the USA is Germany II
http://www.freelists.org/archive/harbor
It will leave you thinking about everything!
: 8/22/09 1:53 PM C.W. krazyeconomy.blogspot.com
: 12/14/09 1:30 PM Links to this post:
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