Wall Street Was Not Where The Economic Meltdown Began

Republican complicity in the meltdown started with the 1990s legislation that allowed repackaging of high-risk mortgages as marketable securities. It went on to the legislation that permitted creation of the credit default swap. Both of these pieces of legislation passed in GOP Congresses under Clinton.

But the reason the finance companies and lenders wanted to open trafficking in mortgages up this way was that doing so enabled them to spread the risk of high-risk mortgages. Democrats will pretend that the forcible loosening of lending practices — forced by federal law and robust intimidation of lenders by the Clinton administration — was not a pervasive factor in creating a financial house of cards. It was, however. It was the original problem — the seed effectively planted with the CRA in 1977 — and the one everything else was done to compensate for.

What would have happened if GOP Congresses had not allowed the packaging of mortgages in market debt securities, and the creation of CDSs? The bill would have come due earlier and in a different way. The lenders targeted by the federal government would have had to charge their low-risk customers substantially higher interest rates, regardless of where the Fed had the prime rate, to cover the losses on high-risk loans imposed on them by the federal government.

That would have put those lenders at a disadvantage, compared to lenders that had not been targeted by ACORN, grievance lawyers, and the Justice Department. The targeted lenders would have demanded some form of relief, or legislation that leveled the playing field with artificial restraints so that the more-solvent lenders couldn’t lure all the lower-risk borrowers away from them.

If Fannie and Freddie had not had their reserve requirements loosened, by both Democrat and GOP-led Congresses, that would also have sent the bill for the bad practices earlier. A tougher cut-off on F&F’s backing of high-risk loans would have shifted the cost of those loans from the taxpayer to the private low-risk borrower (the one who’s going to pay his loan off). But of course, the bottom line is that that is mostly the same actual human beings and businesses.

One way or another, the average taxpayer and mortgage/consumer borrower — the same person — was always going to have to pay the freight for mandated lending to bad-risk borrowers. The Dems and Pubs just spent a period of about 15 years trying to forestall that inevitable outcome with “ingenious” ways to burden the future (F&F, Dems) and spread the risk (reselling mortgages, CDSs, Pubs).

All that’s being attacked today is the methods of spreading the risk of unsound lending throughout the private sector. But as long as the federal government reserves the right to force lenders to make high-risk loans, and use F&F to back them, the problem will not be fixed.

J.E. Dyer on April 22, 2010 at 1:44 PM

The question is why by 2008 – not 1998, not 1988, not 1978 – they were implicated in a global financial/credit crisis.

That question is easily answered: federal policy forcing lenders to make unsound loans as a price of doing business was not implemented before 1977, or enforced robustly before 1994. The risk conformity requirements for F&F were not loosened until the same period. It was also not until mortgages could be packaged into marketable debt instruments that Fannie and Freddie had the opportunity to trade in such securities themselves, and list them as assets to bolster their reserve picture.

I have never said Fannie and Freddie by themselves are a source of financial evil. But loosening their reserve requirements and using them as a giant bad-debt sump has turned them into one. Without their existence it would also have been much harder for the federal government to create the conditions for the financial meltdown. F&F badly need reform, and they aren’t even on the table in the current financial reform proposal being pushed by the Democrats.

J.E. Dyer on April 22, 2010 at 2:52 PM

Sorry so long getting back, CKM. Of course Wall Street was also at fault; the best way to tell that is to observe that some players stayed away from the whole risky-debt morass (did not get overleveraged in risky debt or CDSs), and they have come through this unscathed.

But that fact changes the point. It was the decisions of individuals in some companies in the financial sector that drove their companies under — not a practice that everyone on Wall Street was either colluding on, participating in, or was somehow fated to join in. This wasn’t a systemic failure of “capitalism” or “private enterprise,” it was bad judgment on the part of individuals. There were plenty of other individuals who exhibited superb judgment throughout this period, and their companies therefore were not involved in the meltdown.

Again, however, government in an “enabling” role was indispensable to the private companies even going down the path some of them chose.

It is fundamentally unsound to make loans to the unqualified and high-risk borrower on the same terms as the qualified, low-risk borrower. No lender chooses to do that voluntarily.

Government targeting individual companies and forcing them to do so is at the root of this whole problem. Everything else sprang from that dysfunctional mandate. The practice of packaging mortgage debt for resale on the securities market; the development of credit default swaps, which are a form of reinsurance; the frenzy for unconventional mortgage lending in the decade 1998-2008 — all of these were a procedural response to the mounting total of bad debt mandated by federal policy. What each measure represents is an attempt to bolster assets — performing and marketable debt and debt-related instruments (CDSs) — artificially against the climbing liabilities figure — non-performing, dud debt.

Journalists, think tanks, and members of Congress were getting alarmed about this trend as far back as 1999. What it boiled down to was part of the finance industry creating as much new debt as possible, regardless of how it was likely to perform, in order to use it as an asset to lend against. It was obvious that this was a bad idea, and Republicans in Congress got religion on the matter between 1995 and 2003. But the clips are all over the web of Chris Dodd and Barney Frank railing against GOP proposals to rein this unsound practice in by tightening risk conformity requirements for Fannie and Frddie.

The overwhelming majority of the problem was, in fact, facilitated by F&F. They did two things that were fatal: they continued to back high-risk, non-conforming loans (most of the insane ARMs taken out in the period 2002 to 2007), and they traded in packaged-mortgage securities and listed them as assets to lend against.

Wall Street didn’t have to base its calculations on what F&F did — as evidenced by the fact that many companies did not. But if F&F hadn’t been functioning as they did in the first place, Wall Street would have had nothing to respond to. I don’t elect Wall Street and pay it to supervise F&F; I do elect Congress for that purpose. Congress is grossly to blame here.

What Republicans should have done differently goes back to when they took over Congress in 1995. They should have done whatever it took to shut down the Clinton push to target lenders for intimidation and shakedown. (This was done by invoking the CRA.) Citi is one of the ones that got hit the hardest, and was first in line for the bailout money precisely because it was one of ACORN’s longest-running targets.

But the damage, of course, didn’t stop with the individual companies targeted — as witness AIG, which was overleveraged in the collapsing debt instruments. And Republicans have a good 50% of the responsibility for that.

We’d be in a different bad situation today if they hadn’t opened the door to mortgage-packaging and resale, and CDSs. The situation would still be a bad one; we probably, for example, would have still not recovered from the tech bust recession in Clinton’s last years in office. The reason is that ACORN’s targeted lenders would have already gone under, and credit would have been a lot more expensive over the last decade — artificially so, made so by the government’s policy that bad debt must be generated.

But the Pubs in Congress did do what they did, so instead, we got the artificial credit bubble rather than an economy artificially burdened in another way by bad debt and the consequent expensive credit.

Left to their own devices, lenders would simply have continued to vette borrowers with the care they exercised in the 1980s and before, and tried to minimize bad debt absolutely, rather than hedging it about with new trade-able instruments. And high-risk borrowers would have done what we all used to do before the 1990s: taken out small loans at sub-prime rates in their 20s, paid them diligently, and established a good credit history. Then they could have moved on to the bigger stuff.

J.E. Dyer on April 23, 2010 at 2:07 PM