Tuesday, September 30, 2008

Obama on Financial Crisis: Wrong Diagnosis, Wrong Remedy

Senator Obama believes that he knows what caused the financial crisis: "The old trickle-down theory has failed us," the Illinois senator said in an ad. "We can't afford four more years like the last eight." He and his allies now claim that the mess that we're in is a repudiation of the free-market ideology favored by Republicans.

He's got it backwards. While people in both parties must share the blame for this crisis, the fundamental problem is not that we had too much faith in market principles. It's that we had too little faith.

Our financial system is tumbling down upon the shaky foundation of loans which would have never been made had market principles been allowed to prevail. A well intentioned effort by Democrats to support affordable housing led to misguided pressure on banks to relax lending standards for mortgages. As a result, thousands of people took out loans that they ultimately were unable to repay. Fannie Mae and Freddie Mac, which began their supercharged growth under the Clinton Administration, encouraged these unsound loans by relaxing the standards for loans that they would purchase.

The role of Fannie and Freddie here was crucial. Their mandate was to make more more funds available for people to buy their own homes. They did this by buying mortgage loans from banks and other lenders, packaging those loans into large pools, and then selling interests in those pools of mortgage loans on Wall Street to investors.

If you were a typical person wanting a mortgage loan, you would go into your local bank and apply for one. Under the old way of doing business, the local bank would only give you a loan if they thought you would be able to pay it back. They would carefully evaluate your ability to repay the loan, because if you didn't, they would be left holding the bag.

Fannie and Freddie helped to make more money available for home loans by buying mortgage loans from local banks. Your local bank, rather than keeping the loan that it made to you on its books, would sell the loan to Fannie or Freddie and get cash up front. In exchange for that cash, Fannie and Freddie, rather than your local bank, would be entitled to the monthly mortgage payments that you would be making over the next several years. (Your mortgage bill would not indicate that Fannie or Freddie had purchased your loan; you would be paying a "servicer", perhaps even the local bank that you got your loan from, and the servicer would then pass your payment on to the appropriate place.) Your local bank would no longer have to worry about whether you would be making your payments on time. That headache was passed on to Fannie or Freddie--or, more accurately, to investors who bought pieces of mortgage pools that were put together by Fannie and Freddie. Your local bank could then take the cash that it had received from Fannie or Freddie to make another mortgage loan, which it would then sell to Fannie or Freddie as the cycle continued.

While that process might sound a little exotic to some, there's nothing inherently wrong with it. Rather than your small local bank having to take the risk of you not repaying your loan, that risk was shared by thousands of investors who were willing to pump money into the system. That money meant that there was more funding available for people who wanted to buy homes.

If market forces had been allowed to work, then the system would have worked fine and helped more families purchase homes that they could afford. If the market had been allowed to work, then Fannie and Freddie would have been very careful about the loans that they purchased. In a properly functioning market, investors would only buy shares in Fannie's or Freddie's mortgage pools if they were satisfied that the riskiness of the mortgages had been properly evaluated and that the return was sufficient to compensate for that risk.

How did the system break down? In a nutshell, well-intentioned affordable housing advocates complained that not enough poor people were getting home loans. Under the Carter Administration, the Community Reinvestment Act pressured banks to make more loans in poor communities. Under the Clinton Administration, Fannie Mae and Freddie Mac relaxed the standards they used to decide which mortgages to buy. The intention was laudable: to help more families buy homes. The result, as we are seeing today, was disastrous: Thousands of those people are now losing homes that they could not afford, and the effect of these bad loans has spread like a deadly epidemic throughout the worldwide financial system.

Your local bank was getting both a carrot and a stick to approve loan applications of people who really couldn't afford loans. The stick was mandates like the Community Reinvestment Act. The carrot was Fannie and Freddie essentially saying: "Go ahead and make that loan. We'll buy it from you, and then you won't have to worry about whether it ever gets paid back." At that point, making the loan becomes a no-brainer for the local bank.

But the system wouldn't work unless Wall Street investors were willing to put their cash into it, buying shares in those mortgage pools that Fannie and Freddie were putting together. Why would they do that without assurances that sound, market-based underwriting standards were being followed? Simple. Since Fannie and Freddie were government-sponsored entities (although they were owned by shareholders, not the government), everyone assumed that the government was guaranteeing Fannie and Freddie's obligations. In other words, investors assumed that if they bought shares in those mortgage pools, and the money they were expecting eventually didn't materialize because people were defaulting on the underlying mortgage loans, Uncle Sam (i.e. you, the taxpayer) would come to the rescue and pay off the investors.

Because of this "implied guaranty" by the Federal Government and the need to satisfy their shareholders' demands for more and more profits, the management of Fannie and Freddie embarked on a hyper-growth strategy during the Clinton Administration that made CEOs like Franklin Raines and Jim Johnson (both Obama allies) extremely rich. (Both Fannie and Freddie would eventually get into trouble over accounting irregularities, including overstating earnings in a manner that boosted bonuses for top executives like Raines.)

Both Fannie and Freddie were able to borrow at very low rates: since investors assumed that Uncle Sam would ultimately protect them against losses on their Fannie and Freddie investments, investors did not demand the higher returns that they would have demanded on investments that they perceived to be more risky. Fannie and Freddie could thus access funds from investors rather cheaply, and had every incentive to turn these funds into profits by buying up and selling interests in as many mortgages as they could.

This implied guaranty, like the pressure to ignore sound underwriting standards, was a distortion of the free market. Fannie and Freddie had the incentive to take much more risk and grow much faster than they would have had free market principles been allowed to impose discipline on the system. The implied guaranty became a self-fulfilling prophesy: It allowed Fannie and Freddie to grow so large that they became "too big to fail." Thus, even though the Federal Government never promised to bail out Fannie and Freddie, everyone assumed that they would and they were right.

But couldn't anyone see that this whole system was being built on a house of cards, and that the failure to follow free market principles would eventually cause the type of crisis that we now find ourselves in? Yes, some did see it. The Bush Adminstration expressed great concern about this situation. Back in 2003, Bush proposed what even The New York Times called "the most significant regulatory overhaul in the housing finance industry since the savings and loan crisis." The proposal was designed to head off a disaster by reining in the market distortions that were being perpetrated by Fannie and Freddie.

Bush's proposal was ultimately defeated in the face of stiff Democratic opposition. From The New York Times on September 11, 2003:

Among the groups denouncing the proposal today were...Congressional Democrats who fear that tighter regulation of the companies could sharply reduce their commitment to financing low-income and affordable housing. "These two entities — Fannie Mae and Freddie Mac — are not facing any kind of financial crisis," said Representative Barney Frank of Massachusetts, the ranking Democrat on the Financial Services Committee. "The more people exaggerate these problems, the more pressure there is on these companies, the less we will see in terms of affordable housing." Representative Melvin L. Watt, Democrat of North Carolina, agreed. "I don’t see much other than a shell game going on here, moving something from one agency to another and in the process weakening the bargaining power of poorer families and their ability to get affordable housing," Mr. Watt said.

Boy, did Barney Frank get it wrong. John McCain, by the way, got it right. He sponsored legislation to reform Fannie and Freddie in 2005. In 2006, while the bill was still languishing, he warned that "[i]f Congress does not act, American taxpayers will continue to be exposed to the enormous risk that Fannie Mae and Freddie Mac pose to the housing market, the overall financial system, and the economy as a whole." The Democrats ultimately killed the bill in Committee, preventing the Senate from voting on it.

My point here is not to say that it's all the Democrats' fault. I strongly object, however, to Democrats like Obama and Frank now pushing the fiction that this crisis was caused by Republican free market ideology. Not only do I find that objectionable; I find it scary. Because if the public buys this nonsense, they are also likely to buy the nonsensical "solutions" that are likely to follow from it--"solutions" that move us farther from the free market principles that could have averted this disaster. People like Frank, by misplacing the blame for this mess (and in Frank's case, not accepting his significant share of it), would move us closer to a stultifying socialism where the state takes responsibility for people's bad decisions.

We can't have it both ways: We can't have a hybrid system where people are allowed to gamble and keep their winnings but get bailed out if they lose. Under such a system, people will have every incentive to take excessive risk and pass that risk on to all of us. If we're going to socialize losses, as the misguided Barney Franks of the world would have us do, then the only way to protect us from reckless risk-taking is to deny people the freedom to take risks. If we get to that point, then America can no longer be that special place where visionary entrepreneurs are free to take inspired risks that can enrich us all. We will have lost an essential element in what made us the greatest country on Earth.

This time of crisis is a time for us to renew our commitment to the principles that made this country great. I fear that many of the people who are leading the charge to address this crisis don't understand those principles. Barney Frank did not see this crisis coming, does not understand what caused this crisis and hence does not understand how to solve this crisis. I'm sorry to say that the same applies to Barack Obama.

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