The True Causes of the 2008 Financial Crisis

Scapegoating Fannie and Freddie - the New Republican Orthodoxy
Submitted by Michael Collins on Thu, 12/16/2010 - 21:42

By Numerian, posted by Michael Collins

Yesterday the four Republican members of the 10-member Financial Crisis Inquiry Commission issued their own report on what caused the credit crisis of 2008-2009. They did this because they wanted to put down a “marker” on what they think happened to the markets and the economy, before the whole commission releases its official report next month. Many observers say this unusual move will damage the credibility of the official report, and reflects yet again the bitter partisan struggle that is taking place in Washington between Republicans and Democrats.

This is not a partisan political struggle going on here, at least not for the most part. Enough Democrats on the Commission have spoken up that we see what is really happening. The Democrats who run the Commission are using fact-based arguments and reality-based research to determine what happened during the financial crisis. The Republican minority members are all theologians using a faith-based approach that says government is evil and fundamentally at fault here, the market is all-pure and all-wise, and the “financial industry” is certainly not to blame.

As reported by one of the Democratic Commission members, Brooksley Born, the Republicans demanded but failed to get the Commission to remove all references in the final report to “Wall Street” and “shadow banking”. Sure enough, you will not find these phrases in the Republican 13-page document issued yesterday, which is a fantasy statement that complies with Republican theology on the markets, but conforms very little to a realistic view of what happened during the credit crisis. We should definitely pay attention to the Republican statement, not for what it says about the financial crisis, but for what it says about the state of the Republican Party.

It All Began With Bill Clinton

Under the heading How did the U.S. government contribute to declining lending standards?, the Republican members of the Commission finger their culprit for the financial crisis – Fannie Mae and Freddie Mac. The Republicans argue that these two Government Sponsored Enterprises, through their practice of buying and insuring trillions of dollars of mortgages and mortgaged-backed securities, created the housing bubble. They then made things much worse, ensuring that a financial crisis would ensue, by lowering their credit standards to include sub-prime mortgages for financially weak borrowers in their portfolios. All of this was done because the government, starting with Bill Clinton but including George W. Bush, wanted to increase home ownership among poor people, and anytime government interferes with the economy or the markets in a big way, bad things happen. Anyone who knows anything about Fannie Mae and Freddie Mac knows that they were favorite creatures of Democratic politicians, and by highlighting them as the principal cause of the financial crisis, the Republicans are clearly laying blame on Bill Clinton and the Democrats.

We don’t know what the final Commission report will say, but Fannie Mae and Freddie Mac certainly deserve criticism for jump-starting the housing bubble. In the early 1990s, the two GSEs began to expand their balance sheets significantly, ultimately buying or guaranteeing over $6 trillion in retail mortgages. They became quasi-central banks in the process, since every mortgage they bought or guaranteed involved the creation of credit. The Federal Reserve sat back quietly, refusing to stop these rivals from inflating a housing bubble (the Fed could have crimped the whole campaign if it clamped down on bank lending), but every so often the Fed reminded Congress that this could end very badly.

What the Republicans decline to acknowledge is that the GSEs had grave difficulty hedging their mortgage portfolios, and eventually their regulator was forced to shut them down in 2004 for several years until they got their accounting records in order. This was a crucial moment in the housing bubble. Without the GSEs buying and guaranteeing mortgages, the whole market would have slowed down considerably and the housing bubble, once it began to collapse, would have been much less damaging. Instead, “the market” took a different turn, by turning to investors around the world to buy mortgages, thus replacing the GSEs.

And just who was this “market” that supplanted Fannie Mae and Freddie Mac? You can count the actors pretty much on two hands: Goldman Sachs, Merrill Lynch, Morgan Stanley, Lehman Brothers, and Bear Stearns, all of which were investment banks, and JP Morgan Chase, Bank of America, Citigroup, and Wells Fargo, which were commercial banks. The first group was not regulated by the Fed, while the commercial banks were. Collectively they were known as “Wall Street”, because the business of Wall Street has always been bringing securities to market.

These were the players, plus a few banks from overseas, that bought up mortgages in a feeding frenzy, and they did so with no credit standards whatsoever. Whereas Fannie Mae and Freddie Mac had minimum deposit requirements and homeowner credit checks necessary to buy or guarantee a mortgage, Wall Street had nothing and didn’t care about it – the paper was sold instantly to guileless investors anxious for a little bit better yield than they were getting on government securities. This was the era of NINJA loans – no income, no job, and no assets required - or as industry observers said at the time, anyone who could breathe into a mirror qualified for a mortgage.

If you do a quick check of the mortgages which have caused by far the greatest losses in the financial crisis, it is the 2004 – 2007 vintage of NINJA loans. The Fannie Mae and Freddie Mac loans have held up much better, though the losses on these mortgages have still been significant. Note too that when Fannie and Freddie got back into the mortgage business in 2007, they felt they had to catch up to the market and they began buying securities with NINJA loans. These securities caused enormous losses for the GSEs and helped push them into receivership and the hands of the government to be rescued, but this was the tail end of the housing bubble. At the height of the bubble, it was Wall Street which destroyed what was left of credit standards in the housing market.

What About the Shadow Banking System?

You have to be blind, dumb, or maliciously misleading to miss the contribution of Wall Street to the housing bubble and the financial crisis. The Republicans compound their damage by denying that something called the shadow banking system even existed.

It was the shadow banking system which collapsed in the financial crisis, and the whole bank rescue program by the Federal Reserve, which we now know involved at least $3 trillion of loans to the remaining financial institutions, was necessary because the Fed had to replace the shadow banking system in order for the economy to survive the shock of its demise.

What was the shadow banking system? It was, once again, Wall Street, this time usurping the role of the commercial banks in the economy, while at the same time avoiding any of the regulatory oversight or capital charges that commercial banks had to suffer. As early as the 1980s, the large Wall Street investment banks branched out of their safe world of bond and equity underwriting, for the lucrative world of trading, collecting deposits in money market accounts, running mutual funds, investing in corporations through their own hedge funds, lending billions of dollars to corporations and financial firms with short tem securities like repos, auctioning off municipal bonds, and joining in the explosive growth of the derivatives market. Most of this business involved lending money, which put the Wall Street investment banks directly in the credit business of banking, for amounts that grew to trillions of dollars of loans.

The commercial banks, seeing their franchise invaded by the investment banks, stepped up by invading the bond and equity business of the investment banks. By 1999, the barriers which separated the two industries under the Glass-Steagall Depression-era legislation, had largely disappeared, and the act was repealed by Congress. The way was open for full-scale integration of commercial banking with investment banking, except one side of the equation – the investment banks – had no credit culture or experience managing loans, and they were not heavily regulated in this area. They thought they got rid of this problem by securitizing and selling these loans to investors as quickly as possible. The commercial banks had a related problem: they didn’t have enough capital to support all the lending the brave new post-1999 world allowed. They thought they got around this problem by selling off these loans into loosely-connected subsidiaries they called Special Investment Vehicles.

Both were wrong. The financial crisis of 2008 – 2009 was as much about the collapse of the money market industry, the commercial paper market, the municipal auction market, the mortgage securitization market, the asset-backed securities market, and the bank Special Investment Vehicles, as it was about the fall in housing values. To deny this – not even to mention the existence of a shadow banking system – is to practice deceit on a grand scale, and to ignore all the evidence in front of everyone’s eyes from the behavior of the Federal Reserve once the crisis hit. The entirety of the Fed rescue program has been to replace or prop up the shadow banking system; you can look at the Fed balance sheet under its two Quantitative Easing programs to see over $2 trillion in loans taken on as a consequence.

This is just part of the deceit perpetrated by the Republican Commission members. There is no mention of Alan Greenspan and the Fed’s dangerous policy of ultra-low interest rates in 2001-2002, of the Fed’s refusal to clamp down on NINJA loans being booked or bought by commercial banks, of why and how the rating agencies badly misread the risk in mortgage-backed and other securities, of the role of derivatives (other than a passing reference to CDOs) and the failure of Wall Street to develop a robust pricing model for these instruments, of the mounting evidence of outright and prevalent fraud in the solicitation, booking, documentation, and securitization processes for mortgages, of the continuing use of fraud by banks in foreclosing on homes, of the egregious conflicts of interest Wall Street had when it shorted the very securities it was selling to its customers, of the fines Goldman Sachs has had to pay as a result of such behavior, of the existence of housing bubbles all around the world, or of the global systemic risk that tied large banks together, making them Too Big To Fail.

What motivates Republicans to act in this way?

The Theology of Market Perfection

The Republicans who sit on the Commission are men like Bill Thomas, a former Republican Congressman, and Douglas Holtz-Eakin, head of the Congressional Budget Office under George W. Bush. Their familiarity with the financial industry comes from meeting with bank executives or industry lobbyists, not from meeting with community activists. They are acutely aware of the financial support the party receives from the financial industry. They have spent their entire careers steeped in the Republican worship of the financial markets, which according to conservative orthodoxy are the only fair arbiters of society’s wealth. Government, on the other hand, is the problem, not the solution, as the revered Ronald Reagan said.

The narrative that the GSEs are the source of all the financial problems began with Republican intellectuals like Rush Limbaugh and Sean Hannity, but it dovetails nicely with economic orthodoxy. People like Thomas, Holtz-Eakin, or the other Republican Commissioners have no problem espousing this dogma and applying it to the problem of assigning blame for the financial crisis. Whether they believe in the Republican orthodoxy or not, they cannot in their professional lives abandon it. To do so would be like a Creationist accepting the fact that the earth is about 4.5 billion years old.

The “market”, therefore, cannot be blamed for this crisis because it has no imperfections to speak of. Neither do the practitioners of the financial arts, such as the investment and large commercial banks, who are assigned no blame whatsoever in the Republican report (other than to say they like everyone else believed housing prices would never decline). There is no talk in their report about price imperfections or price manipulation, because again, such things cannot exist. Read your Ayn Rand to be assured on this point. And speaking of Ayn Rand, it was her acolyte Alan Greenspan who refused to allow the Fed to stamp out NINJA loans and other dangerous bank practices. While he has since expressed disappointment in learning that bank self-interest could cause such damage to the economy, he has not abandoned the movement theology at all.

Democrats on the panel apparently spent most of the summer negotiating with the Republicans over conclusions and wording in the final report, only to realize that no agreement was possible. They did not comprehend they weren’t dealing with men who valued rationality or consistency, or who respected the evidence in front of their eyes. The Republican Commissioners are theologians in the tradition of the new Republican Party, and they are every bit as rigid and dogmatic in their thinking as the evangelical Christian Republicans who equate abortion with murder.

When Fed Chairman Ben Bernanke came before the Commission in a closed session, he highlighted one of the biggest questions that the Commission would have to address. Subprime mortgages constitute a small asset class in comparison to the vast size of the global financial markets. And yet, these mortgages were the trigger for the collapse of some of the most important financial firms in the world, a financial panic, and ultimately severe economic losses. How did it happen?

The answer: leverage and maturity mismatch. Because of the perceived safety of highly rated MBS and CDOs, firms held minuscule capital against the probability of loss. We have already discussed how leverage on mortgage assets permeated the regulatory apparatus. The danger was not in the size of the market; the danger was that no one expected the market to turn down, and mortgage investments were thus leveraged to the hilt.