The Financial Crisis of 2008

A roadmap to calamity.

On October 3, 2008, a solemn-looking President Bush signed legislation committing the federal government to an estimated $700 billion to $800 billion of Wall Street. That was supposed to calm the stock market, but so far it has not. And so, in the waning days of a presidential political campaign, Americans are nervously contemplating numerous questions. How did we get to this point? Who is most to blame? What are the underlying lessons? Reader’s Digest Washington bureau chief Carl M. Cannon spoke to several financial experts to address these and other questions that have arisen.

Q: What caused this mess, exactly?
A:  The intricacies of the mortgage market are quite complex, but before we tackle them let’s start with this: During the last two decades, housing prices in the United States increased dramatically nearly everywhere, most particularly in the states along the two coasts. Banks packaged and resold huge portfolios of mortgage loans based on those inflated prices, and when the housing bubble burst, so did the most highly leveraged financial institutions.

Q: But why did housing prices crater in the first place?
A: The short answer is that home prices had become artificially high, eventually losing touch with market-based realities. One of those ignored realities was construction costs—the actual outlays in material and labor that it takes to build a home—while another was wages. In other words, the sales price on homes in many places bore no logical relation to what it cost to build a house, while salaries earned by prospective homebuyers simply did not keep up with the hyper inflation in the home market. In the end, as the nation overbuilt, the supply of houses outstripped the demand. This was a precarious situation, with inevitable results.

Q: Did the government play a role?
A: Oh boy, did it ever. Where do you want to start?

Q: Can we start at the beginning?
A: Government’s original sin, if you want to call it that, might have been the passage of what is now every homeowner’s favorite tax break—the income tax deduction for interest on mortgage loans. After a lengthy legal challenge culminating in a constitutional amendment, Congress enacted the income tax in 1913—with the caveat that all interest payments over $3,000 a year were deductible. This certainly wasn’t done to spur homeownership (and credit cards did not exist); it was envisioned as a way to keep normal business expenses from being taxed. Most American homes had no mortgages on them at that time, and only a fraction of those would have been greater than $3,000 anyway. A good primer on this law is here.

In any event, the main effect the mortgage deduction has had in recent years is to prop up housing prices artificially, and to offer incentives for builders to build luxury second homes—and for wealthy people to buy them. A long and interesting look at the impact of the deduction (and the doomed effort to repeal it) is here.

Q: Was this an example of the “law of unintended consequences” at work?
A: You ain’t heard nothin’ yet. In 1938, as the nation endured its fifth year of the Great Depression, Congress and Franklin Roosevelt’s administration created the Federal National Mortgage Association to help ameliorate the collapse of the nation’s housing market. Fannie Mae, as it came to be called, was a government institution, which used government money to buy up mortgages from local banks. Think Jimmy Stewart’s Bailey Building and Loan Association from the movie “It’s a Wonderful Life.” Fannie Mae could pool mortgages from these small town institutions, freeing them up to make more loans. Presto! The secondary mortgage market was created. The system worked reasonably well for awhile. But in the years 1968-1970, Congress and the Johnson administration, coping with budget deficits brought on by the cost of the Vietnam War, privatized Fannie Mae and chartered a competitor, the Federal Home Mortgage Corporation. It wasn’t immediately apparent, but these two companies were troubling hybrids: They were universally perceived to be government-backed, but they were largely free of government control and oversight. And, oh yes, they were tax exempt. They had this innocent-sounding acronym, GSE, which stood for “government sponsored enterprises,” but their role in the economy would prove anything but harmless.

Q: What did the GSEs do wrong?
A: Eventually, just about everything. Due to their origins, the culture of each organization was to be responsive to political pressure. Moreover, they were often headed by political hangers-on, not actual financiers—although they certainly proved adept at enriching themselves personally, even while running their institutions into conservatorship, with the U.S. taxpayers being the fall-guy.

Q: What were the first signs of trouble?
A: The problems were gradual in the making. Let’s go back for a minute to 1977 when  Congress passed, and Jimmy Carter signed, a measure called the Community Reinvestment Act.

This law forced the nation’s banks to make loans to poor and minority neighborhoods, on penalty of being denied the ability to merge, expand, or open new branches. Understandably, the banking industry fought this provision, as did Fannie Mae and Freddie Mac. But when Fannie and Freddie lost that fight and the law took effect, Fannie and Freddie decided to profit from it by buying up billions upon billions of dollars of securitized packages of CRA loans (from companies such as the now-defunct Bear Stearns.) In 1999, Congress, at President Clinton’s request, beefed up the enforcement of the CRA, and applied it to Fannie Mae and Freddie Mac as well.

Q: What happened next?
A: In 1991, James A. Johnson, a top aide to former Vice President Walter Mondale, left Lehman Brothers (now also defunct) to run Fannie Mae. He promptly announced a policy called “Opening Doors” in which Fannie would purchase $10 billion worth of mortgages for low and moderate income Americans. Three years later, under overt pressure from Congress and the Clinton administration, Fannie Mae announced it was increasing this figure to $1 trillion in targeted housing finance to minorities and the poor. The seeds of the “subprime mortgage” crisis had been planted. “Fannie Mae was buying up not just the mortgages of responsible working folks, but also those of a lot of deadbeats and house-flippers out to make an easy profit,” says economist Arthur Brooks, president of the American Enterprise Institute. “Bad business practices were not just allowed, they were demanded by the government.”

Q: Did anyone see this coming?
A: Some did.

• More  than three years ago, The Economist, a prestigious British-based magazine wrote that the world was in the biggest real estate bubble in history. “Never before have real house prices risen so fast, for so long, in so many countries. Rising property prices helped to prop up the world economy after the stock market bubble burst in 2000. What if the housing boom now turns to bust?” 
  
• Five years ago, in 2003, former Goldman Sachs vice president John R. Talbott wrote a book called, The Coming Crash in the Housing Market. Talbott began writing that book after a friend who was a San Diego schoolteacher making $45,000 a year refinanced his condo by taking out a $255,000 mortgage. A salary that small doesn’t justify a mortgage that large, and Talbott realized that the nation’s mortgage lending system was operating on the same logic as a Ponzi scheme—and had all the makings of a classic bubble.
  
• One of the earliest alarms was sounded by A.E.I. scholar Peter J. Wallison, who served as general counsel at the U.S. Treasury Department during the Reagan administration. In the years 2000-2004 he warned in a series of books, articles, and public lectures that Freddie Mac and Fannie Mae had come to dominate the residential mortgage market. Wallison warned that by 2003 they would be responsible for half the residential mortgage risk in the United States and that, because of their unique charters, it was really the American taxpayers who were holding the bag to a portfolio—held by just two companies—of some six trillion dollars. “The level of risk was just insane,” Arthur Brooks told Reader’s Digest. Congress simply wouldn’t listen to any of Wallison’s warnings, however. It’s too bad. If they had, this entire financial crisis might have been avoided.

Q: So why weren’t these voices heeded?
A: Psychologists call it “denial,” and it’s a powerful phenomenon. The American public, members of Congress, government regulators, and even most of those in the housing and banking industries simply couldn’t bring themselves to believe that a housing bust was coming. Home prices had always gone up and up and up, and after awhile, it became embedded in people’s minds that they could only go in one direction. No one in authority seems to have been immune from the group-think. Alan Greenspan, a smart man and the longtime chairman of America’s central bank, the Federal Reserve Board (known as the Fed), said in May 2005 that although he’d noticed “a lot of local bubbles” in the nation’s housing sector, he didn’t perceive a national problem on the horizon. This proved to be wishful thinking.

Q: What about greed; you’re not discounting that as a factor, are you?
A: No. It’s clear that many of those profiteering from the bubble simply didn’t want to get off the gravy train—even after it became clear something had gone terribly wrong.

Q: Can you name names?
A: Sadly, any number of names can be rattled off, beginning with James Johnson, who earned $6 million to $7 million per year as the head of Fannie Mae, along with a going- away present of $21 million when he left in 1998. Even as Fannie Mae’s exposure grew, the habit of executives paying themselves enormous salaries continued unabated. Johnson was replaced by former Clinton White House official Franklin D. Raines, whose total compensation in 2002 alone was $17.7 million. That year, 19 other top Fannie Mae executives were paid more than $1 million, a dozen more made better than $2 million and nine made more than $3 million. Here’s a 2004 news account raising questions about the propriety of those salaries for a government-backed entity.

Q: Maybe it’s gross, but is there anything fraudulent about it?
A: Quite possibly. In 2006, an oversight investigation of Fannie Mae’s conduct from 1998 to 2004 revealed that the reason Fannie Mae engaged in “extensive financial fraud” by doctoring its earnings was so that its executives could reap hundreds of millions in bonuses. According to the report by the Securities and Exchange Commission and the Office of Federal Housing Oversight, Fannie Mae was able to report “extremely smooth profit growth and hit announced targets” only because it was using “inappropriate accounting” methods designed to overstate earnings so top executives could make their bonuses. And make them they did: While Fannie Mae was over-reporting its earnings and capital by some $10.6 billion, Raines was paying himself $90 million during a six-year span—some $52 million because of the improper bookkeeping. Jamie S. Gorelick, another former Clinton administration hand hired at Fannie Mae despite having no background in finance, was paid $26.4 million during that period. Here’s the complete report, but a warning—it’s a very large pdf file:

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.