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Blaming Deregulation
by Daniel Ruwe | November 21, 2008 at 7:52 AM
Crossposted at Right Minds
Does anyone know precisely what caused the economic crisis? That question can’t be answered, at least right now—the matter is far too complex and multifaceted for anyone to fully understand its causes. The sheer number of players involved (banks, mortgage lenders, Fannie and Freddie, and Congress, just to name a few) and the inherent difficulties of economics make comprehending all the causes and reasons for the worldwide credit crunch immensely difficult for even for experts, and virtually impossible for laypeople.
Unless you happen to be a liberal. Then, all the reasons for the crisis can be summed up in one word—deregulation. If a liberal wants to expand on the root causes of the recession, he might mention George Bush, or maybe Wall Street greed. On the Left, there is no doubt that it was laissez-faire economics and deregulation that brought down Wall Street. Barack Obama said that the recession was a “final verdict” on the policies of the Bush Administration.
Deregulation (or perhaps more accurately, poor regulation) undoubtedly played a part in Wall Street’s collapse. But to saddle deregulation with all the blame in to grossly oversimplify the reasons for the current economic situation.
In reality, government is as much responsible as big business for the mess we’re in. At the root of the problem are former mortgage giants Fannie Mae and Freddie Mac—and both were originally created by the federal government. Eventually, both became hybrid corporations—owned by both private individuals and the federal government. So the federal government had a great deal of control over Fannie and Freddie.
Congressmen like homeowners—homeowners tend to be content, and contented voters mean reelection. Fannie and Freddie were in the business of buying mortgages, which meant that the number of mortgages sold was closely connected to the number they would buy. So Congress pressured Fannie and Freddie to accept risky subprime mortgages, thus allowing more Americans to realize the American Dream of owning a house. And Fannie and Freddie did as Congress wanted—both unveiled programs to ensure that low-income buyers could get mortgages, and spent billions on risky subprime mortgages.
Fannie and Freddie both bought and sold mortgages. They didn’t actually sell mortgages to future homeowners, but rather bought them from mortgage lenders. They then kept some, and sold the rest to third-party investors. Fannie and Freddie were seen as safe, reliable investments.
So on one end, Fannie and Freddie determined (in large part) the habits of mortgage companies (and so the housing market), on the other, they sold billions of dollars worth of mortgages, including many to banks and large corporations. Given their size and reach, these institutions were cornerstones of our economy.
Congress thought so too—when billions in subprime loans started worrying banks and other financial institutions, Congress stepped in to help—by pressuring Fannie Mae to buy tens of billions worth of bad debts. That kind of risk (and given the subprime market, this was a disastrous investment) is a horrible way to run a company, and contributed to Fannie Mae’s collapse. But it was a result of government intervention, not regulation run amuck.
But deregulation was to blame for the fact that no one saw the collapse coming, right? Not so much. Early in 2008, Henry Paulson noticed Fannie’s and Freddie’s instability, so he sent Robert K. Steel to deal with the problem. Steel failed miserably—he was unable to get either company to raise any meaningful amount of money to cover bad loans. Had the federal government (or the leadership of Fannie Mae or Freddie Mac, for that matter) done something then, perhaps much of the resulting crisis might have been forestalled.
Finally, in July, Paulson asked Congress for authority to take over Fannie and Freddie should the situation require it. He thought the prospect of a takeover alone should stabilize the situation—he compared the takeover authority to a bazooka—“ff you’ve got a bazooka and people know you’ve got it, you may not have to take it out”—but the idea of a takeover did nothing to stabilize the situation.
After Fannie’s and Freddie’s stock became worthless, banks realized that any mortgages they had bought to shore up their portfolios were now virtually worthless. Fannie Mae’s and Freddie Mac’s collapse sent ripples throughout the economy.
Would better regulation have, possibly, prevented the economic meltdown? Maybe.
But had the federal government not mishandled Fannie and Freddie so terribly, perhaps the economy could have avoided recession, or at least the horribly lengthy and expensive sort we’re in. (Either way, a lot of blame still attaches itself to the Bush Administration—it both pushed deregulation and pressured Fannie and Freddie to accept risky mortgages). Deregulation was certainly not solely, and probably not even primarily, responsible for the economy’s failure.
(1 vote)
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Comments
er, no
Fannie and Freddie are not the reason behind this mess.
Really?
Not at all? I think anyone would have to admit that Fannie and Freddie are least partially responsible for this mess.
they didn't create subprime mortgages
and as kos is fond of saying, they were moving out of that market well before the whole castle of cards came down.
The trickery and blatant lying involved in subprime mortgage lending has a lot to blame. Yes, some people knew better. Anyone making over $50k a year should go live in their car for six months, before we do anything about helping them. Fair's fair, and I have no patience for stupidity.
However, there were a lot of householders tricked or unfairly given disadvantageous terms when they qualified for better ones.
Also, the main problem was that there was free money floating around. THAT CAUSED THE HOUSING BUBBLE.
The blame rests squarely on Greenspan, who was pro-deregulation and "pro-free money to any business for any reason"
yeah...
Well, if kos says it, it's pretty much taken for granted on this blog. And I think that the fact that Congress asked Fannie and Freddie to buy billions in subprime loans might weaken your "moving out of the market" idea just a tad. And how do householders get "tricked"? I mean, isn't the free market supposed to prevent that kind of thing? I mean, maybe you're not a big fan of free markets, but wouldn't it be kinda hard to "trick" people to tune of tens of billions of dollars? And it's not like there weren't plenty of people offering mortgages--if one is tricking you, just go somewhere else. And given that much of the problem lies in the fact that many people were given too generous terms, I'm not sure that disadvantagous terms are really the problem here.
"too generous terms" is a fancy way for saying that
they took all the safeties out of the system. Then gave people ruinous rates -- and it's those, just as much as Bush's Ownership society that I object to.
Free money gotta go somewhere folks.
How do homeowners get tricked? By telling them that all they qualify for is ruinous rates, even while giving other people with the same credit ratings better rates. 50% of lenders in Massachussetts discriminated against black lenders. Let that sink in, chum. I've worked sales -- I know what it's like when you're trying to find anyone to take the terms that you get paid more for. You find the ignorant, the elderly, the uninformed, and you fleece them for all they're worth.
It's a bad business model, but if you give the lenders incentives like that, that's what they do to keep a roof over their head.
Wait till the alt-As go up in flames, and then where will your fanny mae fallacy be?
Mortgage pig is underwater!
http://www.topix.com/us/2008/10/nearly-1-in-6-homeowners-is-underwater
It's just common sense to walk away from stupid loans that even if you repay in full, you will still be in debt for.
Problem is loan originators are paid on commission...
... and do not end up with any liability after they sell the loan to the secondary market. The brokers also got better comission percentages on the subprime loans because somehow those loans were being packaged into MBS's with higher margins.
Therefore the perverse incentives were to originate as many (subprime) loans as possible and ignore lending standards as long as there was someone in the secondary market (Countrywide, Fannie, etc.) willing to buy them.
Once the mortgages were sold and resold, packaged, sliced, and sold as derivatives, the shaky underwriting was quickly forgotten, and Moody's & S&P had them highly overrated.
I am a strong believer in free markets, and oppose burdensome regulations. However, a proper role of government is to protect private property by maintaining orderly markets and preventing/punishing fraud. For instance, if someone has a rigged scale, it is the role of government to inspect, respond to complaints, and fine or imprison as appropriate.
In the case of mortgages, I don't see any easy way to make brokers liable for future performance of the mortgages, so I think the best thing to do is for government to insist on minimum standards for a mortgage loan.
Of course this is exactly the opposite of what Democrats have been pushing for for 20 years.
banks used to be liable for any loan
that they would sign on. they didn't sell to other people.
we could go back to that system, if gov't intervention bothers you.
Gov't should also intervene in markets for national security purposes. I don't care if I have to pay more, if it's for national security.
partially
can mean 1% or it can mean 99%. So yes, given that latitude almost anyone would agree that Fannie and Freddie are 'partially' responsible.
But the available evidence is that the real number is much closer to 1%. What the exact number is no one knows. But we do know that subprime means "loans Fannie or Freddie won't guarantee". They did, towards the end, buy subprime debt but that was after the crisis was well under way.
It wasn't deregulation
Barack Obama can blame deregulation and dump it on President Bush for as long as he wishes. He need not look any further than his own adviser and dispatched foreign ambassador of his transition team in former Republican Congressman Jim Leach. The Financial Services Act of 1999 is also known as Gramm-Leach-Bliley. Leach was the champion of the bill in the House.
This law is still up for debate as to whether it was good or bad, but I think it's become pretty clear that the financial services industry thought the bill to be "necessary". When banks are in trouble they merge and buy each other up. That's how they insure their industry. They've done this for hundreds of years. Without GLB1999 they would have been unable to merge and restructure the impending financial storm.
Our problems today date back 70 years. The fundamental problem is still "How do you extend credit to person(s) and organization(s) that have neither the credibility, nor the collateral to borrow money?" Government and Industry have held hands together to try to figure this out for last 4 centuries.
free loan societies, Brennan
those are a great choice for people who don't have collateral.
Yes, we do know that some of the whole shebang (and you're missing other pieces that Clinton passed) should fall squarely on the Democrats' shoulders.
But the failure to enforce regulations (of, basically, anything. mines to whales to enron) was a philosophical principle of the Bush Administration.
Clinton had good regulators, who kept a good watch on wall street. Yes, he started the party, but nobody got wasted while he was running a tight ship. Clinton was one of the ablest administrators that we've had as President.
I look forward to these arguments
from the hill that the Bush Administration didn't enforce regulations. We have had a Congress controlled by the Democratic party for the last two years. Was this insufficient time to lay these arguments on the table?
Instead we see blame on "deregulation" which is not the same thing as failure to uphold regulations. Deregulation is rolling back regulation through changes in the law.
the utter demise of the regulatory instruments
that were created after the great depression means absolutely nothing to you, huh?
Yeah, the Gramm bill was bad, so was the bill Clinton failed to veto when he got into office, which relaxed a lot of the regulations on banks.
But even worse is that the last time everythign was on the rocks, we all said "we're never going to let anything get that big again"
But really, without improper money supply regulation, most of this wouldn't have happened in the first place.
Tulips! Anyone want to buy $1000 tulip bulbs!
you act like this is the first time we've seen a disasteriously bad housing crash. Try Japan -- it took them ten years to climb out of the mess.
You're just inventing points you can rebut
I haven't made any of the claims you are attributing to me. You're just inflating your own little bubble.
snort. sorry, this liberal was rebutting your point that
all we want to blame is deregulation.
I'd rather just go shoot Greenspan and his 1% interest rate. I can toss you any number of more educated blogs that would say the same thing (and add in deregulation, that Greenspan also favored, but not as the main culprit)
Blaming government
Simply on its merits as an argument this is not a persuasive post. Here's your sequence:
1. No one knows what caused the credit crisis.
2. Except for the easy answers of liberals.
3. Actually, I know the real cause of the crisis.
That was bad enough. But the substance of your argument is simply irrelevant. It is one thing to argue that deregulation is not solely to blame for the credit crisis. It is quite another to argue that it is all government's fault. I think the case against government is much weaker than the case that lack of regulation played a very significant role in precipitating the crisis.
Let me exerpt a few essential questions from Barry Ritholtz a highly respected market commentator as well as an in-the-trenches financial and investment professional.
The following questions come from a post entitled Misunderstanding Credit and Housing Crises: Blaming the CRA, GSEs. GSEs, of course, refer to Government Sponsored Entities and in this case that's Frannie and Freddie. Though you failed to include the Community Reinvestment Act of 1977 in your argument, I'll leave Ritholtz references to same as these are often companion arguments for how government caused the crisis.
Anyone who truly wants to understand what happened could do much worse than start by reading Ritholtz's post in its entirety.
There is a also a very serious problem with your post from a political perspective, Daniel. The credit crisis is going to cause a lot of suffering. The GOP would do much better to simply remain silent on the causes than to try to pass off incorrect information. The price we will pay for failing to address this in a serious and authentic fashion in the context of the genuine economic pain that is under way and, I'm sorry to say, far from over will be very high indeed.We would do much better by working hard to develop a genuine solution than to continue to offer incorrect analyses.
You are correct in one thing; the situation is a complex one. Developing solutions begins with understanding the true nature of the problem. This post unfortunately does not move us in that direction.
Freddie & Fannie Example of Democrat Policy on Housing
johnson springs,
You cite some good points that Ritholtz made which illuminate some of the practices that were going on at lending institutions. Focusing solely on Freddie & Fannie leaves a lot out. Actually, focusing solely on subprime loans leaves out a large group of other risky loans too.
The biggest group of forclosures is not on low-income folks who bought a home to live in -- it is middle-to-upper income people who were speculating in highly overpriced markets. Those were not CRA loans.
And obviously, Greenspan's low interest rates helped feed the housing boom, though I didn't hear many Democrats complaining at the time.
However, the Democrats position in relation to Freddie and Fannie is indicative of their policy toward housing and their push to avoid effective regulation on the housing sector as a whole. Fannie and Freddie, and the expansion of the CRA in the mid 90's, can be pointed to as the root of the erosion of lending standards.
The CRA and Freddie & Fannie obviously did not require poor lending standards, but they are complicit in allowing and encouraging them, by relaxing standards on low income (which the lenders then expanded to all) borrowers and by purchasing the shaky loans. Freddie and Fannie were clear examples to the rest of the lenders that subprime and otherwise shaky loans were ok.
Here's some questions for you:
Republicans obviously did not do enough, but the Democrats were enablers.
Going forward, we have got to add some sensible regulation to tighten up lending standards and require enough transparency that ratings agencies and investors are accurately able to guage risk.
Not Dem vs. Rep issue IMO [update]
You may have misinterpreted my thrust. I don't think the crisis can be understood as a question of whether the GOP or the Dems bear more blame for the housing bubble. There is plenty of blame to go around, first of all. Second of all, your questions which I'll get to in a moment still focus on laying the blame on the GSEs. There is simply no evidence for that. If you disagree please present evidence.
My thrust is this: if we focus on a blame-the-Democrats strategy on this I think we are long-term losers. Americans are looking for actual policy solutions during a dire crisis that is severely impacting their quality of life. If we fail to offer serious, thoughtful solutions conservatives will be shunted aside as irrelevant to any emerging solutions. And we would deserve it in my view. Further, offering up faulty, demonstrably faulty analysis, such as this focus on the GSEs, will only succeed in further discrediting the GOP/conservative brand vis-a-vis solving problems voters care about. That's what's at stake. If you really think the solution is to convince the American people against all odds that the housing crisis and follow on credit crunch are due exclusively to Democratic policy then we should probably discontinue the discussion.
As for your questions:
1. No, though I wish Bush had urged Greenspan to raise rates as the bubble was heating up in early 2005. Other than absurdly low interest rates, there was little the executive could do (SEC maybe, not clear) because most of the real damage was being done in unregulated markets and activities. Wall Street torqued the demand curve, but the supply came for mortgage underwriters operating with no one looking over their shoulders. Hence, I don't see the crisis as failure to enforce existing regulations.
2. No. There were none.
3. GOP has worked harder to rein in the GSEs. But the housing crisis and follow credit crunch do not begin or end with the GSEs. They are a sideshow.
4. Democrats have enabled problems at GSEs obviously. But again, see above. Not relevant.
5. No. But whose fault is it among the political parties is not the issue. The solution provider is going to win this thing.
6. Democrats. But as to relevancy, see above.
7. Democrats. But a word of caution. There was so much money sloshing around and we know as yet so little about it don't be surprized to see lots of dirty hands in the till.
Thanks for your response.
UPDATE: Via Calculated Risk comes a link to a Washington Post piece on banking regulators failing to heed warnings on housing bubble. This to address a couple of the questions above for anyone interested.