The Financial Crisis I. The Cause

 

Only by understanding the factors that led to and amplified the crisis can we hope to guard against a repetition.                                                                                                         Ben Bernanke, September 2, 2010

An outstanding new book by Peter Wallison, ”Hidden in Plain Sight: What Really Caused the World’s Worst Financial Crisis and Why It Could Happen Again” gives a voluminous and highly compelling explanation of the main cause of the financial crisis of 2008.  Mr. Wallison worked at the Treasury Department in the 1980s, was a member of the Financial Crisis Inquiry Commission (2009 – 2011) and is currently a scholar at the American Enterprise Institute.
CaptureHere is the outline of Mr. Wallison’s story:

  • The Department of Housing and Urban Development gradually increased the requirement that loans acquired by Fannie Mae and Freddie Mac be made to low- and moderate-income borrowers from 30% in 1992 to 56% in 2008.
  • As a result of these policies, by the middle of 2008 there were 31 million Nontraditional (low down payment and/or poor credit) Mortgages (NTMs) in the U.S. Financial system, more than half of all mortgages outstanding, with an aggregate value of more than $5 trillion. At least 76% of these were on the books of government agencies such as Fannie, Freddie and the FHA or banks and S&L institutions, holding loans which they were required to make by the Community Reinvestment Act.
  • The 24 million NTMs acquired or guaranteed by government agencies were major contributors to the growth of the housing bubble and its lengthy extension in time.
  • The growth of the bubble suppressed the losses that would ordinarily have brought NTM type Private Mortgage-Backed Securities (PMBS) to a halt but rather made these instruments look like good investments.
  • When the bubble finally burst, the unprecedented number of delinquencies and defaults among NTMs drove down housing prices.
  • Falling home prices produced losses on mortgages, whether they were government backed or PMBS.
  • Losses on mortgages caused investors to flee the PMBS market, reducing the liquidity of the financial institutions that held the PMBS.
  • Once the housing bubble burst, four major errors were made by our top government financial officials: The first and major error was the rescue of Bear Stearns. The moral hazard created by this action reduced the incentive for other firms to restore their capital positions. Once Bear had been rescued it was essential to rescue Lehman Brothers. Treasury Secretary Paulson and Fed Chairman Bernanke’s arguing that they did not have legal authority to rescue Lehman provided an excuse for Congress to pass the destructive Dodd-Frank Act. Finally, TARP accomplished little but caused much popular resentment against the banks which supposedly got bailed out.

Conclusion: as long as the American people don’t understand that government housing policies were the main cause of the financial crisis, we are likely to repeat the same mistakes over again.

Inequality III: Is the Game Rigged?

 

The economist Joseph Stiglitz has an Op Ed column in today’s New York Times, “In No One We Trust”, blaming the financial crisis on the banking industry.  “In the years leading up to the crisis our traditional bankers changed drastically, aggressively branching out into other activities, including those historically associated with investment banking.  Trust went out the window. … When 1 percent of the population takes home more than 22 percent of the country’s income – and 95 percent of the increase in income in the post-crisis recovery – some pretty basic things are at stake. … Reasonable people can look at this absurd distribution and be pretty certain that the game is rigged. … I suspect that there is only one way to really get trust back.  We need to pass strong regulations, embodying norms of good behavior, and appoint bold regulators to enforce them.”  
CaptureMr. Stiglitz is partially correct.  Although the housing bubble, caused by poor government policy – loose money, subprime mortgages, and lax regulation – was the primary cause of the financial crisis, nevertheless, poorly regulated banking practices made the crisis much worse.  But this is all being fixed with Dodd-Frank, a just recently implemented Volker Rule, and a soon coming wind-down of Fannie Mae and Freddie Mac. 
Mr. Stiglitz concludes, “Without trust, there can be no harmony, nor can there be a strong economy.  Inequality is degrading our trust.  For our own sake, and for the sake of future generations, it is time to start rebuilding it. 
But how do we reduce the inequality in order to restore the trust which is necessary for a strong economy?  Mr. Stiglitz doesn’t say!
What we need is faster economic growth in order to create more new jobs.  The last four years have demonstrated that the Federal Reserve can’t accomplish this with quantitative easing.  It needs to be done by private business and entrepreneurship.  Tax reform and the easing of regulations on new businesses is what we need.  It’s too bad that ideological blinders prevent so many people from understanding this basic truth!