With 2008’s mortgage meltdown, the failures of Bear-Stearns, Lehman Brothers, AIG, Fannie Mae
and Freddie Mac, and the massive federal bail-outs that followed, the media was quick to argue that “capitalism had
failed.” Joining in that parade were many Democrats, eager to garner additional support for their anti-capitalist Presidential
candidate, Barack Obama. But their argument is invalid. What we have witnessed is not a failure of capitalism, but a failure
of government. Critics of capitalism use comparisons of the current economic crisis to the Great Depression of the 1930s to
bolster their argument. But there, again, they are incorrect. The Great Depression was also a failure of government, not capitalism.
The economy was booming in the 1920s – the “Roaring Twenties.” One of Herbert Hoover’s
Presidential campaign slogans was, “A chicken in every pot and a car in every garage.” Money was being made in
the stock market, hand over fist, and it seemed logical that to make everyone rich all that had to be done was to make it
easier for more people to get into the stock market. The solution? Buy stock “on margin,” which simply meant buying
stock for pennies on the dollar. Typically the up-front requirement was only 10 per cent, so that a person could give a broker
$10 and purchase $100 worth of stock.
Of course, the buyer eventually had to come up with the remaining $90, but that wasn’t difficult
– all he had to do was wait until the stock value went up, sell enough shares to pay the broker the $90 he was owed,
and sit back and watch the remaining shares go up in value. As long as the stock market kept going up, you’d keep making
money.
The problem was that stock prices were going up not because the underlying values of the companies
they represented were going up, but because of speculation. (Price-earnings ratios were seriously inflated, as they were during
the “tech bubble” of the 1990s.) Buyers simply assumed stock values would keep going up, so they kept buying.
They bought anything, often without looking into the soundness of the company they were buying. Money was flying around so
freely that unwise (and many incredibly stupid) investments were becoming common. As an example, railroads were constructed
between towns that didn’t really need a connecting railroad – but people bought stock in those railroads anyway.
(There were a lot of “bridges to nowhere” being sold.) It seemed that everyone had a “hot tip” on
a new stock, yet few probably knew what they were buying, let alone doing.
Eventually things startled to unravel. The stock market finally started reflecting the real value
of those speculative stocks, and their prices fell dramatically. When that happened, the brokers started making “margin
calls,” that is, they called their investors who paid $10 for $100 worth of stock and said, “Remember that $100
of ABC Railroad stock you bought last month? Well, it’s now worth only $5 – and you still owe me $90.” The
more people sold off their stocks to pay their brokers, the lower the stock prices went. The last people to act were in the
worst position, holding worthless stocks but still owing their brokers.
The trend downward started in early September of 1929. The wealthiest investors tried to buy up stocks
to keep prices from falling, but it was too little and too late. The worst decline in stock prices came on “Black Friday,”
October 29, 1929, which signaled the start of the Great Depression. Investors lost millions, brokerage firms went out of business,
banks were depleted of assets and failed, and not a small number of investors leaped to their deaths from Wall Street windows.
At that point, the federal government should have done almost nothing. Yes, investors lost money
– but they were the ones who had made the poor investments in the first place. People who owned stock in sound companies
eventually saw their stocks regain their value. Yes, there would have been a difficult recession, but it wouldn’t have
been a depression. What made it worse? The single most aggravating factor was probably the passage of the Smoot-Hawley tariff
bill, which placed extraordinarily high tariffs on foreign goods. The law was intended to protect American businesses from
global competition. Its result was, of course, immediate retaliation by other nations – which passed their own high
tariffs on imported American goods, causing firms in the United States to go out of business.
Had the free market been allowed to work, America
would have suffered a tough but possibly brief recession – and certainly not a 10 year depression! By imposing high
import tariffs, the federal government caused the recession to develop into a full depression. Reciprocal actions by other
nations then extended the depression to Europe, where economic miseries helped propel Adolph
Hitler to power.
This is not to argue that a totally free market does not often have ups and downs, peaks and valleys,
winners and losers. But the downs and the valleys tend to be short-lived, and the losers tend to deserve their losses. No
one in 1929 forced anyone else to buy stock in a railroad whose existence could not be justified by market conditions in the
first place.
Government, by trying to insulate American businesses from foreign competition, made the situation
infinitely worse and caused misery for millions who did not deserve it – Americans who had not been caught up in the
market, who had not bought stock in foolish businesses, and who had not risked their meager savings in an effort to “get
rich quick.”
Franklin D. Roosevelt easily won the Presidency in November of 1932, promising to balance the federal
budget and cut taxes. He immediately broke his promises, raising taxes and engaging in deficit spending that left a national
debt that is still unpaid. Further, FDR continued some of the faulty practices engaged in by Herbert Hoover, including industry
bailouts, price controls, wage controls, government programs, trade restrictions, and strict regulations on the capital markets.
FDR started program after program in an effort to “make work” for unemployed Americans,
but each program was paid for by raising taxes, essentially causing unemployment somewhere else. Roosevelt’s
primary “brilliance” was funding projects that required inordinate amounts of manpower. If he could find a way
to hire 50 people to do the work of five, that was sufficient reason to embark on the project – even though it cost
the taxpayers 10 times more than it was worth. When the Supreme Court found some of FDR’s ludicrous schemes unconstitutional,
he tried to resolve that by “packing” the Court with more liberal members. (Even his fellow Democrats wouldn’t
let him do that.)
FDR continually tinkered with programs and taxes, leaving everyone in wonderment as to what he would
do next. As a result, businesses were reluctant to do anything risky. That stifled business growth at a time when it was most
needed. FDR pretty much did everything wrong, and unemployment at the end of 1941 wasn’t much better than it was when
he took office. It was not Roosevelt, but the start of World War II and the end of high tariffs in order to enable Europe to arm itself against Hitler, which ended the Depression.
Flash forward to the current mortgage meltdown and the federal government’s intervention in
the market to rescue failed banks and investment firms. What caused the crisis, capitalism or government?
The Community Reinvestment Act was passed in 1977 and signed into law by Jimmy Carter. The purpose
of the law was to encourage Fannie Mae and Freddie Mac to lend in minority communities, and prohibit “redlining”
- a practice where banks ignored high-risk neighborhoods and refused to provide home loans for their residents. (“How
dare you refuse to give mortgages to poor people simply because they can’t afford to pay you back!”) In 1995 and
1999, Bill Clinton toughened the regulations to force more loans to low and moderate-income businesses and homebuyers. The
Clinton rule changes made it more difficult for lenders to
get a satisfactory CRA rating. Banks were given quota targets and their loan portfolios were reviewed for “diversity.”
The result was loans being made solely on the basis of race, to keep the federal reviewers satisfied. The revisions to the
regulations also made it easier to make subprime loans, partly by the expansion of the secondary mortgage market (where mortgages
are bundled and sold off to investors other than the banks that originated the loans).
During the 1990s, regulations and legislation kept getting churned out of Washington for the sole purpose of increasing home ownership among the poor – regardless
of their ability to pay back a mortgage. “Affordable housing” was the goal, even if no one could really afford
it. Lenders who opposed were labeled “racists” who were “encouraging discrimination,” and were told
to use “flexible underwriting standards.” The Federal Reserve’s lending guidelines included the statement,
"Policies regarding applicants with no credit history or problem credit history should be reviewed" and even urged lenders
to include as income "welfare payments and unemployment benefits" when considering loan approvals. Changes to the laws in
1995 led to an astounding 80 per cent increase in bank loans to low and moderate-income families. In 1996, the Clinton Administration
ordered Fannie Mae and Freddie Mac to assist home purchases by low-income earners by buying subprime mortgages, requiring that 12
percent of Fannie's and Freddie's mortgages assist low-income home purchasers in higher-income neighborhoods. In 2000, Clinton increased that to 20 percent. In 1997, Andrew Cuomo, Clinton’s Secretary of Housing and Urban Development, proposed
that a full 50 per cent of Fannie Mae’s and Freddie Mac’s portfolio be made up of sub-prime loans to low and moderate-income
borrowers. Cuomo stated, "GSE presence in the subprime market could be of significant benefit to
lower-income families, minorities, and families living in underserved areas..."
In other words, the government was telling banks, Fannie Mae, and Freddie Mac to loan money to people
in order for them to buy houses they couldn’t afford, even though common-sense business practices told them not to.
Home ownership was paramount; get everyone into a house and everyone can be wealthy. At the same time, of course, the government
expected the same loosening of standards for the non-poor, in the interests of fairness and equality.
During the 1990s, groups like ACORN intimidated banks into approving “Ninja” loans (“no
income, no job, no assets”) when the applicants clearly were unqualified to get a mortgage. ACORN would stage demonstrations
and sit-ins at banks, protest in bank lobbies, and even picket the homes of bank executives to garner public support and sympathy
for poor people, in order to shame the banks into making risky loans. Barack Obama, it should be noted, was hired by ACORN
to train community organizers in such tactics; that was one of his jobs as a “community
organizer.” (For more information, check the history of ACORN’s involvement with Chicago’s Bell Federal
Savings and Avondale Federal Savings.) ACORN tactics included a 1991 two-day “sit-in” at the House Banking Committee
room.
Where banks had followed strict lending guidelines concerning the percentage of income that a buyer
should apply to mortgage payments, the government said they should lower those standards because “many lower-income
households are accustomed to allocating a large percentage of their income toward rent." Smaller down payments and closing
costs should be considered because saving for them is “…often a significant barrier to homeownership by lower-income
applicants." (To the government, the fact that someone has no money to buy a house shouldn’t be held against him when
selling him one.)
The lenders saw the lunacy in these practices, but they “no longer held the paper” of
the mortgages. As soon as the mortgage was granted, the loans were bundled and sold off to other investors – like Fannie
Mae, Freddie Mac, Lehman Brothers, and AIG. The banks essentially said, “If they’re willing to accept the risk,
let them.”
The banks also had little choice. If they
were tough on lending requirements, the accusations of discrimination came down on them and they were threatened with exorbitant
fines and penalties. Under the Equal Credit Opportunity Act, or “Regulation B” of federal lending guidelines,
lending discrimination can result in punitive damages as high as $10,000 in individual actions and the lesser of $500,000
or one percent of the creditor’s net worth in class actions. Lenders, therefore, had the choice of being prudent and
paying heavy fines for “discriminating against poor people,” or making high-risk loans they immediately sold in
order to avoid the financial exposure. Guess which path they followed.
Fannie Mae and Freddie Mac, being “government
sponsored entities,” were susceptible to the pressures of Congressmen and their congressional committees that kept encouraging
them to keep buying sub-prime mortgages to increase home ownership among the poor. (A high-ranking Democrat even telephoned
Fannie Mae executives and demanded that they purchase more loans from low-income borrowers.) With an “implied guarantee”
of the federal government behind Fannie and Freddie, no one seemed to care about the consequences of risky behavior. Add to
the mix a fair amount of Enron-like “creative accounting” at both enterprises, and all the ingredients for a disaster
are present.
Rules changes made during the Clinton Administration also allowed Fannie Mae and Freddie Mac to hold a
mere 2.5 per cent of capital to back their assets, rather than the 10 per cent required of banks. Fannie and Freddie could
thus have $100 billion in outstanding loans with just $2.5 billion in reserves.
In 1999, the Los Angeles Times praised
the Democrats and the Clinton Administration for their efforts in expanding lending to the poor: “It’s one of
the hidden success stories of the Clinton era” and “…Congress
mandated that Fannie and Freddie increase their purchases of mortgages for low-income and medium-income borrowers. Operating
under that requirement, Fannie Mae, in particular, has been aggressive and creative in stimulating minority gains. It has
aimed extensive advertising campaigns at minorities that explain how to buy a home and opened three dozen local offices to
encourage lenders to serve these markets.” The Times continued, “Most importantly, Fannie Mae has agreed to buy
more loans with very low down payments – or with mortgage payments that represent an unusually high percentage of a
buyer’s income. That’s made banks willing to lend to lower-income families they once might have rejected.”
Apparently the Los Angeles Times didn’t stop to
wonder why banks thought it was prudent to reject those loans.
Reckless lending and accounting practices
by Fannie Mae and Freddie Mac ultimately lead to their demise and to economic problems for the entire nation. Former Fannie
Mae CEOs James Johnson and Franklin Raines were major proponents of relaxing lending standards. (Both have worked as advisors
for the Obama campaign, and despite having been in the Senate only a few years, Obama is behind only Christopher Dodd in the
amount of lifetime campaign contributions received by Fannie Mae executives. According to OpenSecrets.org, first-term Senator
Obama has collected almost $300,000 per year from Goldman Sachs, Lehman Brothers, Bear Stearns, Fannie Mae, Freddie Mac, AIG,
Countrywide Financial, and Washington Mutual. In less than four years in the Senate Obama has received a total of $1,093,329.00
from those eight companies and their employees.)
In April of 2001, barely three months after George W. Bush had been sworn in, his administration’s
Fiscal year 2002 budget warned that the growing size of Fannie Mae and Freddie Mac was “a potential problem” and
any problems with them would “…cause strong repercussions in the financial markets, affecting Federally insured
entities and economic activity.” In May of 2002 the President produced a 19-point plan for corporate responsibility
to apply to Fannie Mae and Freddie Mac. Gregory Mankiw, chairman of the Council of Economic Advisors, warned that the “implicit
subsidy” of Fannie and Freddie was risky and could cause problems throughout the entire financial system. Congressman
Barney Frank (D-MA), who had no “concern about housing,” condemned Mankiw. The New York Times, no friend of the
Bush Administration, complained that the GSEs were “under heavy assault by the Republicans,” but those Democrat
allies of the GSEs could withstand those attacks.
In January of 2003, Freddie Mac had to restate its financial results for the prior three years;
problems were already seeing the light of day. The Bush Administration sensed some of the dangers inherent in the sub-prime structure and, in 2003, recommended a significant
overhaul of housing industry regulations, including closer supervision of Fannie Mae and Freddie Mac. His suggestions were
fiercely opposed, generally along party lines, and they failed to be passed into law. As an example of the criticism, Congressman
Barney Frank (D-MA) said, “Fannie Mae and Freddie Mac… are not facing any kind of financial crisis, the more people exaggerate
these problems, the more pressure there is on these companies, the less we will see in terms of affordable housing." Congressman
Mel Watt (D-NC) complained the changes would only lead to a “…weakening (of) the bargaining power of poorer families
and their ability to get affordable housing.” Frank also criticized the chairman of the President Bush’s Council of Economic Advisers, Greg Mankiw, because
he was “…worried about the tiny little matter of safety and soundness rather than ‘concern about housing.’”
The National Association of Home Builders and many Congressional Democrats were opposed to Bush’s 2003 recommendations,
which would have been the most significant regulatory overhaul in the housing finance industry in 10 years. Democrats expressed
the fear that the tighter regulations would “…sharply reduce their commitment to financing low-income and affordable
housing."
In September of 2003, Treasury Secretary John Snow recommended to the House Financial Services Committee that it enact
“legislation to create a new federal agency to regulate and supervise the financial activities of (the) housing-related
government sponsored enterprises” (GSEs, meaning Fannie Mae and Freddie Mac) and set prudent minimal capital requirements.
Snow was warning Congress that Fannie and Freddie didn’t have enough capital for all the high-risk loans they had been
making. One month later, Fannie Mae admits a $1.2 billion accounting error.
In November of 2003, Council of the Economic Advisors Chairman Greg Mankiw discusses the need for additional regulation
and powers to reduce “systemic risk” in the GSEs, including authority to set minimum capital standards.
In 2004, the President’s FY 2005 budget again brings up the risks of low levels of capital in the GSE and suggests
additional regulation. In February, Mankiw warns Congress not to take the strength of the financial markets for granted. In
June of 2004, Deputy Secretary of the Treasury Samuel Bodman highlights GSE risks and calls for more regulation and oversight
and funding minimums. Congress does nothing in response to the warnings of the Bush Administration.
Exacerbating the problem was the Federal Reserve Board, which was doing its best to keep interest rates low to stimulate
the economy. While this made sense immediately following the terrorist attacks of September 11, 2001, in order to prevent
the United States from falling into a severe recession or even a depression, the practice went on far too long. Higher interest
rates would have put a powerful damper on the rampant lending to unqualified buyers.
Because banks were making loans to people who couldn’t afford
houses in the first place, more home buyers entered the housing market. That artificially raised the prices of homes, as more
buyers bid for the limited number of houses available. The inflated prices encouraged otherwise reasonable people to take
chances they would not ordinarily take. “I know that house isn’t really worth $350,000, but if we need to we can
always sell it next year for $400,000 to someone else and pocket $50,000 in profit.”
Blowing further air into the balloon to help lead to its eventual bursting
was the widespread practice of using home equity loans to pay off credit cards or to finance car purchases. Americans had
been over-relying on credit cards for a long time. In the past, interest on credit cards had an allowable income tax deduction.
That tax deduction was eventually phased out, making the cost of credit card interest intolerable for many - yet not so intolerable
that they would cut up their credit cards and throw them away. When the chance came to pay off that high-interest debt with
lower-interest home equity loans, people took advantage of the opportunity. But borrowing against a home’s equity assumes
it will retain that equity, and most borrowers neglected to consider that home prices aren’t always guaranteed to rise.
Federal Reserve Board Chairman Alan Greenspan told Congress in 2005
it needed to act. He warned that “If Fannie and Freddie ``continue to grow, continue to have the low capital that they
have, continue to engage in the dynamic hedging of their portfolios, which they need to do for interest rate risk aversion,
they potentially create ever-growing potential systemic risk down the road… We are placing the total financial system
of the future at a substantial risk.''
Some in Washington listened to Greenspan. To his
credit, John McCain co-sponsored and argued on behalf of the “Federal Housing Enterprise Regulatory Reform Act of 2005,”
and warned against disastrous consequences if it was not passed. In defense of his bill, McCain said, “…this week Fannie Mae's regulator reported that the company's quarterly reports of profit growth over
the past few years were "illusions deliberately and systematically created" by the company's senior management, which resulted
in a $10.6 billion accounting scandal.
The Office of Federal Housing Enterprise
Oversight's report goes on to say that Fannie Mae employees deliberately and intentionally manipulated financial reports to
hit earnings targets in order to trigger bonuses for senior executives. In the case of Franklin Raines, Fannie Mae's former
chief executive officer, OFHEO's report shows that over half of Mr. Raines' compensation for the 6 years through 2003 was
directly tied to meeting earnings targets. The report of financial misconduct at Fannie Mae echoes the deeply troubling $5
billion profit restatement at Freddie Mac.
The OFHEO report also states that Fannie Mae used its political power to lobby Congress in an effort to
interfere with the regulator's examination of the company's accounting problems. This report comes some weeks after Freddie
Mac paid a record $3.8 million fine in a settlement with the Federal Election Commission and restated lobbying disclosure
reports from 2004 to 2005. These are entities that have demonstrated over and over again that they are deeply in need of reform.
For years I have been concerned about the regulatory structure that governs Fannie Mae and Freddie Mac--known
as Government-sponsored entities or GSEs--and the sheer magnitude of these companies and the role they play in the housing
market. OFHEO's report this week does nothing to ease these concerns. In fact, the report does quite the contrary. OFHEO's
report solidifies my view that the GSEs need to be reformed without delay.
I join as a cosponsor of the Federal Housing Enterprise
Regulatory Reform Act of 2005, S. 190, to underscore my support for quick passage of GSE regulatory reform legislation. If
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.
I urge my colleagues to support swift action on this GSE reform legislation.”
That bill, which could have prevented the current economic crisis, did not pass. The bill, prevented by a Democrat
party-line vote, did not even make it out of the Senate Banking Committee (chaired by Christopher Dodd). As a result, Fannie
and Freddie continued to accept risky loans in 2006, 2007, and 2008, with each one increasing the likelihood of a financial
collapse.
According to a Harvard study, from 1999 to 2005 an astounding 49 per cent of 12.5 million new homeowners were members
of minorities. Clearly, the Clinton Administration’s rule changes to encourage, if not force, lending to minorities
“worked.” But those rule changes never addressed the ability of the new homeowners to pay back their loans, which
were often granted with recklessly loose documentation and income requirements.
In July of 2007 two Bear Stearns hedge funds collapse; they were heavily
invested in mortgage securities. In August, President Bush again calls on Congress to pass a Fannie Mae/Freddie Mac reform
bill. “Congress needs to get them reformed, get them streamlined, get them focused.”
The handwriting was on the wall, but no action is taken by Congress. In fact,
it makes things worse. Representative Maxine Waters (D-CA) introduced HR 1852, the “Expanding American Homeownership Act,” which
expanded mortgage insurance programs under the National Housing Act, enabled the Federal Housing Administration
to “use risk-based pricing to more effectively reach underserved borrowers,” raised the maximum amount that may
be approved for multi-family mortgage insurance by the FHA to 170 percent in normal cost areas and 215 percent in high cost
areas, and established a pilot program to allow mortgagors with insufficient credit histories to obtain an alternative credit
rating based on rent, utilities, and insurance payment histories. In other words, the bill made it even easier for people
who couldn’t afford to buy a house to buy a house.
In December of 2007 the president again warns Congress. "These institutions
provide liquidity in the mortgage market that benefits millions of homeowners, and it is vital they operate safely and operate
soundly. So I've called on Congress to pass legislation that strengthens independent regulation of the GSEs – and ensures
they focus on their important housing mission. The GSE reform bill passed by the House earlier this year is a good start.
But the Senate has not acted. And the United States Senate needs to pass this legislation soon." The Senate did
not act.
Throughout the first six months of 2008 the Administration warns Congress
several times about the risks inherent in the GSEs and requests action. The warnings are not heeded. Between 2001 and 2008,
the Bush Administration had tried 18 times to place controls on Fannie Mae and Freddie Mac.
Eventually the bubble had to burst, as the stock market crashed in
1929. Just as it was foolish in 1929 for someone to spend money he didn’t have on stocks that were grossly overpriced,
it was foolish in 2007 to pay $350,000 for a house that was worth only $250,000 on the assumption that someone even more foolish
would pay $400,000 for it in 2008.
A majority of Americans would probably say that those who made the
poor decisions should suffer. If someone loses a house that he shouldn’t have bought in the first place, too bad –
dust yourself off and consider it a learning experience. The problem is that a horrendously large number of those loans were
made, and many Americans had unknowingly invested in them through their mutual fund purchases, 401(k) accounts, and retirement
plans. (Americans mistakenly assumed that their brokers and the people on Wall Street knew what they were doing.)
If the situation had been recognized earlier, several banks and investment
firms could have been allowed to fail, and Fannie Mae and Freddie Mac would have been made to tighten up their standards.
But the situation was not recognized in time, and to