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Q: This sounds like it’s a Democratic Party scandal—is that true?
A: Not solely. Republicans were hired during this time at Fannie Mae, too, including a former aide to Newt Gingrich, and Fannie spent some $170 million lobbying Congress—dispensing this largesse to Republican and Democratic fixers, and contributing to members of both parties. Here’s a quick primer on the bipartisan nature of the roster at Fannie Mae.
Q: Still, despite the obvious evidence of greed, these people couldn’t have known what they were setting in motion—could they?
A: At Freddie Mac, at least, top executive Richard F. Syron was warned explicitly by his institution’s top risk officer in mid-2004 that the subprime loans it was gobbling up “would likely pose an enormous financial and reputational risk to the company and the country.” Truer words were never spoken by a banker, whose name was David A. Andrukonis—but they were ignored. Meanwhile, Syron has collected some $38 million in compensation in the last five years. (The New York Times broke this story.)
Q: Are we putting too much of the onus on poor people who were given mortgages they couldn’t handle. Isn’t that a copout?
A: Yes, let’s be fair. For starters, another factor was the huge number—nobody really knows how many—of real estate speculators who devoured the cheap money available after 9/11 to buy properties and flip them for quick profits. This worked, for awhile.
Q: Why was there so much money available for this kind of thing?
A: Two reasons: Remember the mortgage deduction we mentioned? The government will subsidize you (through the tax code) to speculate in real estate, but not to build a factory. It’s a peculiar system, and hardly in anyone’s interest save those in the construction sector, but you can understand why people utilize it. The second reason is that after 9/11 Fed chairman Alan Greenspan lowered interest rates as a way of keeping the economy from stagnating.
It seemed a good idea at the time.
Q: Still, I’ve heard people say that minorities and the poor are being unfairly scapegoated, and that the real problem was allowing mortgage banks to essentially operate without regulation and for Wall Street to use a series of accounting shenanigans to hide what was happening. Is this true?
A: In politics, particularly in an election year, you will see partisan finger-pointing—and we’re seeing it now. Conservatives are blaming the Democrats for their decades of pressure on commercial banks to be agents of social engineering, while liberals are saying that an aversion to regulation that reached critical mass during a Republican administration is to blame, and that the regulators essentially went AWOL during the Bush administration. Michael S. Barr, a professor at the University of Michigan Law School, told Congress that most of the subprime loans were made by independent mortgage companies not subject to the Community Reinvestment Act goals, let alone federal supervision. “The worst and most widespread abuses occurred in the institutions with the least federal oversight,” Barr testified recently. Here’s a link to a thoughtful column on this side of the issue.
And here’s another, on the opposite side of the question.
Q: Okay, that’s both sides of the argument. Which is right?
A: They are not mutually exclusive. It’s certainly true that millions of Americans were lent money they couldn’t repay—even though they promised to do so. Not great behavior, no. And hardly laudable of their allies in Congress to keep up the pressure on the banks without bothering to check and see how well it was working, and what modifications should have been made. But those unfortunate homeowners (or former homeowners) didn’t cause the real estate bubble. Nor are they responsible for creating an intrinsically irrational mortgage banking system: It’s initial transaction—the lending of money by a mortgage broker to a prospective home buyer—contains a built-in conflict-of-interest. In business what’s missing is called “agency,” and it leads to accountability. In the mortgage business, there isn’t any. Here’s what I mean: A loan officer makes you a loan. He or she gets a commission. That loan is then packaged and bundled and sold to Lord-knows-what-commercial bank. It doesn’t matter to the loan officer at all if you repay the loan.
And finally, poor people had nothing to do with the nefarious Wall Street schemes that took root all around the world, epitomized by “credit default swaps.”
Q: I’ve heard that phrase. What in the world are they?
A: Credit default swaps are insurance contracts purchased by investors to protect them against losses to banks and bondholders when corporations cannot pay their debts. They are the financial instrument that did in American International Group, the nation’s largest insurer, because it had accumulated some $118 billion in mortgage-backed securities.
Warren Buffett once called them “financial weapons of mass destruction.” He was right.
Q: Should the government have stopped them? Could it have?
A: At one time it could, but on a bipartisan basis in the last decade, Congress and the oversight agencies of the federal government systemically dismantled the mechanisms that gave government leverage over Wall Street and the nation’s investment banks. In 1999, President Clinton signed the Gramm-Leach-Bliley Act, a deregulating measure that essentially repealed a Depression-era law known as Glass-Steagall. That law required investment banks and commercial banks to remain separate. But in the 1990s, Congress’ hand was forced by the $70 billion merger of Citicorp and Travelers Insurance. Clinton’s Justice Department waived any anti-trust considerations; Greenspan’s Fed gave it a green light as well. Gramm-Leach-Bliley essentially made legal what was already happening, and so the Senate passed the bill 90-8, and Clinton signed it on November 12, 1999. It was, the president said, “a major achievement that will benefit American consumers, communities, and businesses of all sizes.” One of the eight Senators in opposition, North Dakota Democrat Byron Dorgan, had a different notion: “I think we will look back in 10 years’ time and say we should not have done this,” he said. “But we did because we forgot the lessons of the past.”
Q: It didn’t take ten years for him to be proven right, did it?
A: No, but it took another decision, an unheralded rule change by the Securities and Exchange Commission to complete the deregulation process. A thorough New York Times account is here.
The long and short of it is that on April 28, 2004, all five members of the Securities and Exchange Commission convened in a hearing room to listen to a plea from the nation’s largest investment banks: In the absence of Glass-Steagall, investment banking authority had devolved to the S.E.C. On this day, the investment houses asked the S.E.C. to vacate the regulations requiring them to keep billions of dollars in reserve against potential losses. They wanted to use that capital to gobble up these new credit derivatives and packaged mortgage securities that were paying such high rates of return. Only one witness objected. His name was Leonard D. Bole, an Indiana-based financial software consultant. “With the stroke of a pen, capital requirements are removed!” he wrote in a letter to the S.E.C. on January 22, 2004. “Has the trading environment changed sufficiently since 1997, when the current requirements were enacted, that the commission is confident (they) can be discarded?” Bole never heard a word back, but the answer turned out to be that the trading environment had changed all right—for the worse. Soon, Bear Stearns would be leveraged to the tune of $33 in debt for every dollar in reserve. The nation’s entire investment banking system was on the brink.
Q: Penultimate question: Is this an American-caused problem? And what are the lessons from around the world?A: That’s not easy to say. Ireland has experienced a devastating collapse in housing prices—and it doesn’t have Fannie Mae or Freddie Mac. Iceland’s banks are on the brink, and they don’t have any minorities to speak of, let alone a Community Reinvestment Act to contend with. On the other hand, Canada is looking like it might weather this thing just fine, thank you, and all it has are strict and staid old banking regulations—like the United States once had—and no income tax deduction for home mortgages.
Q: So what’s the moral of the story?
A: Every U.S. president since Jimmy Carter has supported the goal of increased home ownership. It’s a noble goal. But the lesson here just may be that government is more effective preventing bad behavior than it is fostering good behavior. There are limits, it seems, to what government can accomplish and they flow directly from the limitations of human nature itself.
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