Excerpts from an Autopsy of The American Financial Meltdown

(Credit: Wikimedia Commons)

(Credit: Wikimedia Commons)

The recent report from the U.S. House Committee on Oversight and Government Reform entitled “The Role of Government Affordable Housing Policy in Creating the Global Financial Crisis of 2008” contains information extremely important in understand the nature and cause of last year’s financial meltdown that began in the housing and lending market.

Still, sitting down to read a 26-page government report can be daunting for some, so I will provide some pertinent excerpts from the report which provides a good overview of what caused this massive financial implosion that is still hammering the American economy.

You will be amazed that this kind of corruption and incompetence was ever allowed to take root in a free nation with a constitution which places limits on government.  You will be stunned that the “mainstream” media ever managed to pass off the financial implosion as the result of “lack of regulation of the free market.”

-Fannie and Freddie were charged by Congress with keeping the secondary mortgage market liquid and increasing the availability of affordable housing. They enjoyed a $2.25 billion line of credit from the U.S. Treasury. Because of this mission and their special connection to the Federal government, the market viewed them as extensions of the U.S. government and therefore “too big to fail.” No other private companies could borrow money at such an affordable rate.

-Another advantage Fannie and Freddie enjoyed was that Congress, by statute, allowed them to operate with much lower capital requirements than their private sector competitors. Federally-regulated banks are required to hold 4 percent capital against their mortgages. By federal law, however, Fannie Mae and Freddie Mac were only required to hold 2.5 percent capital against their on-balance sheet mortgages, and only 0.45 percent against mortgages they guaranteed.

-In other words, the federal government encouraged regulated banks to purchase GSE preferred stock by allowing them to hold 80 percent less capital against it compared to similar assets, providing a major subsidy to their purchase of what amounted to cheap borrowing by Fannie and Freddie.

Fannie Mae and Freddie Mac were also exempt from key regulatory and market oversight.

-unlike any other publicly traded corporation, Fannie Mae and Freddie Mac also answered in a very direct way to the federal government and elected officials in a manner reminiscent of the “crony capitalism” of countries such as Russia or China, which preserve a large state-owned enterprise sector.

-A deeply flawed 1992 study published by the Federal Reserve Bank of Boston, purporting that minorities faced discrimination in mortgage lending, was particularly influential at the time. This study has since been shown to have been based on inaccurate data, including loans which were supposedly made to borrowers with a negative net worth. When researchers ran the models again after correcting the flawed data, the discrimination that had been the study’s central finding disappeared. Yet the damage had been done and Congress seized on the study as part of a major legislative reorganization of the GSEs’ function.

The GSEs also allowed politicians to claim credit for earmark-like affordable housing initiatives in their districts without having to appropriate the money in Congress. In 1994, Johnson opened Fannie Mae’s first “partnership office” in a congressional district. These partnership offices “issued thousands of press releases” featuring Members of Congress assisting Fannie Mae with affordable housing initiatives. They also had a reputation for hiring relatives of Members of Congress as employees. This political strategy won Fannie and Freddie allies on Capitol Hill who would prove invaluable in fending off calls to rein in their risky borrowing and lending practices.

one paper coauthored by now-Director of the Office of Management and Budget Peter Orszag, concluded that the chance was minimal that the GSEs were not holding sufficient capital to cover their losses in the event of a severe economic shock. The authors suggested that “the risk to the government from a potential default on GSE debt is effectively zero,” and that “the expected cost to the government of providing an explicit government guarantee on $1 trillion in GSE debt is just $2 million.”15 As of May 14, 2009, the taxpayers had already been exposed to $700 billion of GSE bailouts, including $59.8 billion of capital injections by the U.S. Treasury, $73 billion of GSE debt purchases by the Federal Reserve, and $567.3 billion of direct purchases of GSE mortgage-backed securities by both the Fed and Treasury.

When combined with the endorsement of “flexible and innovative” mortgage underwriting, this change in the CRA represented a troubling move away from prudent and sustainable mortgage lending towards government endorsement of lower quality lending to those of modest means.

A Freddie Mac spokeswoman later acknowledged that the Clinton HUD’s decision on subprime loans “forced us to go into that market to serve the targeted populations that HUD wanted us to serve.” Clinton’s HUD Assistant Secretary William C. Apgar, Jr. has since called the decision a “mistake,” while his former advisor Allen Fishbein called the loans that the GSEs started buying to meet their affordable housing goals “contrary to good lending practices,” and examples of “dangerous lending.” President Clinton himself acknowledged his role in efforts to loosen mortgage lending standards when he admitted that “there was possible danger in his administration’s policy of pressuring Fannie Mae…to lower its credit standards for lower- and middle-income families seeking homes.” These accumulated government affordable housing policies, including the Clinton Strategy, trapped millions of Americans in mortgages they could not afford.

Borrowers – regardless of income level – took advantage of the erosion of underwriting standards that started with government affordable housing policy. As one study observed,“[o]ver the past decade, most, if not all, the products offered to subprime borrowers have also been offered to prime borrowers.” For example, Alt-A and adjustable-rate mortgages became incredibly popular with borrowers – who were generally not low-income – engaging in housing speculation. As home prices continued their dizzying rise, many people decided to cash in by buying a house with an adjustablerate mortgage featuring a low introductory teaser rate set to increase after a few years. These borrowers, confident in the oft-cited assertion that U.S. home values had never before fallen in the aggregate, planned to sell or refinance their investment before the mortgage rate adjusted upward, pocketing the difference between the initial purchase price and the subsequent appreciation in value. However, buyers failed to grasp the effect of a government policy that had quietly eroded the prudential limits on mortgage leverage, creating a dangerous speculative bubble.

For the 30 years prior to 2000, the ratio of U.S. home prices to income averaged only about 4-to-1 – in other words, the average American lived in a home costing four times his annual income. In just five years, from 2000 to 2005, that ratio doubled to 8-to-1. As a result of homes becoming more expansive and seemingly less affordable, the only way for many Americans to buy a home during the housing bubble was to dramatically increase their leverage. It is not surprising, then, that between 2000 and 2006 mortgage debt in the U.S. increased by 80 percent. According to one early warning in 2006, the odds against such an increase in the price-to-income ratio occurring naturally were greater than 300-to-1.

The nexus of political advocates…came together to create a powerful affordable housing coalition led by Fannie Mae and Freddie Mac and their congressional allies. This group of vested interests used its money, power and influence to protect its political prerogatives and profits, blocking repeated attempts at reform and distorting the relationship between government and business.

Fannie Mae also forced then-Treasury Secretary Larry Summers to “tone down” a report that was originally going to criticize the cozy relationship between the federal government and the GSEs. When Congressman Paul Ryan (R-WI) sought to increase regulation of the GSEs, Fannie Mae sent lobbyists to harass him in his Wisconsin congressional district, going so far as to call his constituents and accuse him of seeking to increase mortgage rates, generating 6,000 angry responses to his office.

When Congressman Christopher Shays (R-CT) introduced legislation to end the GSEs’ unique exemption from SEC registration, he “had lobbyists literally barging into my room,” while Fannie CEO Raines reportedly called the lawmaker to ask, “What the hell have [you] done?” The GSEs retaliated by ending their home-buying forums in Shays’ congressional district in an attempt to hurt him politically.

In 2006, Freddie Mac paid the largest fine in Federal Election Commission history – $3.8 million – for improperly using corporate resources to hold 85 fundraisers for Members of Congress, raising a total of $1.7 million.

Fannie and Freddie also served as a revolving door for powerful former politicians, their aides and even their family members. Jim Johnson managed Walter Mondale’s 1984 presidential campaign, chaired the vice presidential selection committee for presidential candidate John Kerry, and was involved in President Barack Obama’s vice presidential selection process. Franklin Raines had been President Clinton’s Director of the Office of Management and Budget. Former Clinton Deputy Attorney General Jamie Gorelick served as Vice-Chairman of Fannie Mae and earned over $26 million in compensation. Former Fannie Senior Vice President John Buckley had served as a Republican Congressional staffer and senior advisor to the presidential campaigns of Ronald Reagan in 1984 and Bob Dole in 1996. Another former Fannie Senior Vice President, Arne Christenson, had been a senior advisor to Republican House Speaker Newt Gingrich. The son of Republican Senator Bob Bennett worked for Fannie Mae’s Utah regional office, while Democratic Representative Barney Frank’s partner, Herb Moses, worked at Fannie Mae from 1991 to 1998 as Assistant Director for Product Initiatives while Frank sat on the House Banking Committee with responsibility for oversight of the GSEs.

In 2003 and 2004, it became known that GSE executives had manipulated accounting rules to maximize profits and executive compensation, breathing new life into efforts by the Bush Administration and some in Congress to properly regulate them. This in turn forced the GSEs to seek shelter with their congressional benefactors, the advocates of affordable housing policy.

The fact that Freddie’s Board of Directors had been briefed on management’s plan to massage earnings yet did not question it raised serious doubts about the board’s motivations and effectiveness. In its report on the scandal, OFHEO singled out the presidentially-appointed board members such as Rahm Emanuel, who sat on the Board at the time it was apprised of the improper accounting scheme, as an “anachronism” which should be “repealed so shareholders can elect all Directors.” This was a stinging indictment of the crony capitalism that led directly to lax oversight and perverse incentives for the GSEs to behave improperly.

All told, the government experiment in unsustainable affordable mortgage lending based on low down payments and “flexible” credit criteria has sucked the equity out of the U.S. housing market, trapped millions of Americans under crushing debt, and seriously damaged global financial markets. In 2006, the value of U.S. housing was estimated at $22 trillion. By October 31, 2008 this had fallen to $18.5 trillion.

So what is the end result of all this government meddling? It’s outlined in the introduction of the report. This section encapsulates it well:

This intervention began with two government-backed corporations, Fannie Mae and Freddie Mac, which privatized their profits but socialized their risks, creating powerful incentives for them to act recklessly and exposing taxpayers to tremendous losses. Government intervention also created “affordable” but dangerous lending policies which encouraged lower down payments, looser underwriting standards and higher leverage. Finally, government intervention created a nexus of vested interests – politicians, lenders and lobbyists – who profited from the “affordable” housing market and acted to kill reforms.

And there you have it: a quick lesson in how government meddling in the free market distorts the normal checks and balances inherent in the capitalist system and creates a huge mess. This mess threatens the private property and livelihood of millions of Americans, creating an atmosphere of desperation where government considers itself obligated to rush in and…meddle even more in the market.

If these excerpts have whetted your appetite to know more, I encourage you to take the time to read the entire report.   Even someone without a financial background can understand it if you just take the time.  Certainly that time is not too much to ask in the interest of our nation’s freedom and prosperity.

We cannot sustain this kind of havoc to our free market–the market upon which our prosperity and ultimately a great degree of our other freedoms depend. We must roll back this unrestrained expansion of government and once again put the federal government back in the cage of the U.S. Constitution.

That Constitution is what limits government–and government always tends toward power and oppression–and we must renew our obedience and respect for our Constitution if we are to survive as a free people and prosperous nation.

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