Economic Mess: How did it happen?
Were we all lulled to sleep? Believing the good times could/would never end? That every year would somehow magically be better than the last? That any financial risk, regardless of how outrageous, would be rewarded with greater wealth? That we were somehow entitled to ‘more’ forever? This is America after all, right?
Over that last month reality has set in. It was preceded by evidence of the housing market in crisis. After years of robust home sales, low cost mortgages, expansion of home ownership the house of cards started to fall. Foreclosures spiked. Homebuilders scrambled with growing inventories and evaporating financing. Value of existing homes actually depreciated – unheard of in anybody’s lifetime. Mortgage companies vanished. Underwriting giants were suddenly on life support or worse. Fannie and Freddie needed rescued by the government. Quasi-government backed ‘creative’ mortgage securities suddenly had no market, and financial behemoths holding them crumbled.
As the great American Bear rolled over, much of the world’s economy was crushed.
Washington weighed in with a $700 billion rescue package. Treasury Secretary Henry Paulson called it “distasteful capital” but something that had to be done. The federal government (that means us) now owns the largest mortgage underwriters, one of the world’s largest insurance companies, and is in process of taking stock positions in the nation’s largest banks.
Our political leaders have explained that this is a one time, financial industry only effort to save the economy from collapse. Such unprecedented efforts would, they pledge, never be done or needed again.
Regardless, the whimpering moans of the auto and airline industries are growing louder and one has to wonder if Washington with precedence now firmly established could possibly restrain themselves from throwing a lifeline to other “too big to fail” industries?
In all of the scrambling, posturing, and finger pointing of recent weeks much has been said about what must be done. Quite obviously Washington is scrambling with uncertainty about what to do. The old cliché about “throwing something up against the wall and hoping it sticks” was perhaps never more true. One congressman offered me the most honest assessment I’ve heard, when he said, “No one has the answers.”
Regardless, Washington was compelled to “do something.” But, what remains is diagnosing the patient and determining what caused the sickness in the first place. With much said about everything else, precious little has been said about how we got here. Following is my attempt to offer my perspective from a life spent in business, including as a community banker, and also as a member of Congress. There is no pretense that the issues addressed herein are a comprehensive analysis, but it is a summary of major misguided public policy and leadership failings that straw-by-straw finally broke the back of even the powerful American economic camel.
Cheap money and a weak dollar: Face it, we all enjoyed and took advantage of the low interest rates and cheap money policy of the Greenspan era at the Federal Reserve. It made borrowing decisions easy, debt readily available, and ownership more accessible to more people.
Throughout the period, Capitol Hill was doing like some Americans, spending more than they took in and accumulating more debt, and hoping that the good times would never end. Except government owns printing presses and churned out ever more money. The result was an increase in the supply of dollars beyond the growth in the gross productivity of the economy contributing to a weakened US dollar. Some saw that as a good thing for trade. Others recognized a weak dollar as just that – weakness.
Few, including myself I must admit, were critical of the Fed’s policy. And, in and of itself, the effects would likely have been minimal to the system. But, when combined with bad public policy as will be discussed below, tragic consequences were bound to happen.
The Community Reinvestment Act: Following the Great Society era of the 1960’s, when Lyndon Johnson and Congress passed a plethora of legislation aimed at ending all vestiges of discrimination in America, came the Community Reinvestment Act. Aimed at addressing the deterioration and blight of many American cities, and stoked by a host of activist organizations, Congress adopted policies that outlawed so-called ‘redlining’ of credit.
Access to loans for small business, consumer credit, and especially home mortgages should be equally accessible regardless of where a borrower lived, or their race, gender, or marital status. Access to credit, whether the borrower was credit worthy or not, it was argued would solve poverty, crime, and a host of other social problems. Who could argue with that noble objective? So, Congress passed and Jimmy Carter signed the Community Reinvestment Act in 1977 (CRA).
The CRA’s objectives were further supported by other legislation such as the Equal Credit Opportunity Act, the Home Mortgage Disclosure Act, and the Fair Housing Act. Enforcement was in the hands of the bank regulators including the OCC, FDIC, and Federal Reserve, but unlike bank safety and soundness exams which are private information, the results of CRA exams by law were open public information. Activist organizations such as the recently made famous ACORN pawed all over CRA exams to further their own agendas and affect financial policies.
The Clinton Administration utilized the CRA to further its own social agenda and placate the leftist base of the Democrat Party. Banks and other financial institutions were now compelled by law to make loans they otherwise would have denied. Non-income qualifying mortgages, zero or very low interest adjustable rate mortgages (ARMs), and the Home Equity Line of Credit (HELOC) industry exploded in reaction to mandated government policy enforced by law on the lending industry.
Just like every other business, bankers understand that “you might not be able to make the rules, but you better learn to live by them.” And, they did. From Main Street to Wall
Street new products got created to comply with Washington’s mandates. More people got cheap credit and became buyers than ever before in history, and politicians celebrated the results of their perceived brilliance.
Not completely fooled, banks that originated much of this debt didn’t want to hold it. Their upbringing as managers of risk hadn’t completely evaporated. So, a ‘market’ was created for this new debt passing it off to the investment markets. Words like derivatives, collateralized debt obligations, and credit default swaps entered investor vernacular, though few could even explain how these instruments worked.
In theory, little was thought to be more stable than residential real estate value or more reliable than monthly mortgage payments. Occasionally a loan fails, but the underlying ‘value’ is protected by the value of the property. Further, when huge volumes of individual mortgages are packaged together and ‘securitized’ even if a few loans default, the risk is minimized. Or, so at least was the theory.
That is how all the money was raised by the Government Sponsored Enterprises (GSEs) like Fannie and Freddie. Under leadership by people like Franklin Raines and James Johnson, now Obama advisors, these agencies put the CRA on steroids. Loans and loan products previously unheard of were suddenly available and the agencies would buy them all with a market perceived assumption of a government guarantee.
Everyone in the chain also profited from the government imposed scheme. The list that collected a check from every transaction, every refinance, and every deal was enormous. From realtors, to appraisers, to mortgage originators, brokers, underwriters, securities dealers, and investment advisers - the number feeding at the trough built by Washington was large and had a voracious appetite. The really big bucks were made by those in control of rolling all those individual loans together in securities to be churned globally by the markets.
Some blame clearly falls at the feet of lenders who represented, sold, packaged, and profited from loans that should never have been made. However it was government policy, perhaps with the most noble of intentions, that created the demand and the market most certainly responded – particularly when forced to do so by federal regulators. Now, the politicians and bureaucrats are conveniently washing their hands of any complicity in the price we will all have to pay.
Mark-to-Market: Misrepresentation of fair market value of publicly traded companies naturally creates enormous anxiety among shareholders, investors, and policy makers. The sudden collapse of supposedly substantial, strong companies like Enron and WorldCom exposed the accounting illusions that led to a whole series of regulatory reforms including the onerous Sarbanes-Oxley legislation.
The Financial Accounting Standards Board (FASB) also implemented what came to be known as mark-to-market regulations. Companies, including banks and other financial institutions, were required to value marketable securities at current fair market prices clearly in an effort to provide a much more accurate assessment of corporate financial health. In a reasonably stable, normal economic environment periodic variations in the value of securities are not that significant. Typical securities held in the investment portfolio including mortgage backed securities issued by GSEs like Fannie and Freddie were thought to be among the most stable and readily marketable.
However, in recent weeks the real worth of those ‘creative’ securities which evolved to peddle the loans generated from mandated policy like the CRA rapidly became impossible to accurately assess and not only declined in value, but became totally illiquid. Nobody was buying because nobody knew where the bottom was. Obviously the real estate that secured the mortgages still had value and the overwhelming majority of people were still making their mortgage payment. But, as the economy violently spiraled downhill, that value was in question along with the unknown of how many loans would default. If nobody is interested in buying, then the value is zero – at least at that moment. FASB rules required immediate write down of massive investment portfolios of the major institutions in America resulting in paper – not realized – losses of billions literally overnight. Nothing had really changed so suddenly in the long term value of the underlying assets of the overwhelming number of the securities, nor the viability of the vast majority of home mortgages. But, the temporary inability to accurately value and market them created an accounting catastrophe.
The effect of FASB mark-to-market regulation in this whole crisis cannot be underestimated.
Gramm-Leach-Bliley: Throughout the last two decades of the 20th century, the giants of the financial industry had been lobbying Congress to ‘modernize’ regulation that controlled how they did business. Since the Great Depression, the 1933 Glass-Steagall Act imposed barriers between financial sectors such as traditional banking, investments, mortgages, and insurance.
Consumers no longer distinguish between financial services, so went the argument, and they should be able to get all their needs met under one roof in modern day America.
Opponents, including the vast majority of the community bankers, argued that breaking down financial barriers would lead to gigantic institutions that would control such large share of the total market with extensive interdependent relationships to other institutions, industries, and even governments that the possibility of their failure would be unthinkable. Thus was born the concept of ‘too big to fail.’
In the end Congress consented overwhelmingly to dissolve the system that had helped establish the greatest economic power in the history of the world. With Republicans in control of Capitol Hill and largely supporting Gramm-Leach-Bliley, named for the sponsors, President Clinton signed the legislation into law in 1999.
For whatever gains in convenience or efficiency there may have been, Americans are now going to get to pay the bill. To prevent gigantic bank and other financial institutions from collapsing into insolvency and to try to keep credit flowing, the federal government is taking large equity positions in previously private companies (otherwise known as ‘nationalizing’). That is the end result of allowing any company or GSE to become too big to stand the inherent risk in a free-market economy of possible failure – something unthinkable until now. It is also the result of social engineering being imposed by law on a capitalistic economy with no regard for the eventual financial consequences.
The Washington politicians had hoped that their intervention would stabilize the financial markets and restore public faith in the system. Thus far, it’s hard to find evidence of much increased confidence.
Now what: Circumstances being what they are, Washington had little choice but to act. Many have already opined on the worthiness or lack thereof of the $700 billion fix that is now being implemented. Rich Sokol, contributing editor for A Line of Sight, provides his in depth perspective in this issue.
Democrat leaders are even talking about hundreds of billions more ‘stimulus’ in post-election legislation. History will be the ultimate judge of Washington’s wisdom or lack thereof, but the taxpayer will get to pick up the tab for past policy failures as well as future fixes.
Politicians are looking for everyone to blame for the crisis except themselves. Corporate executives have been flogged in front of congressional committees and more will doubtlessly follow. Prosecutions and convictions for fraud, negligence or whatever else can be mustered up will likely result, too.
What will not happen on Capitol Hill is an admission that policies they put in place in the recent past had a huge hand in spreading the trail of bread crumbs that the private sector followed leading straight to the mess in which we now find ourselves.
Whatever was left of free market capitalism in America suffered a serious blow with the unprecedented intervention by our government during the last month. It may have been necessary, but it could have been prevented by avoiding public policy mistakes. A free market can only function if it is truly free, and we long ago allowed other agendas to usurp that freedom.