Legends of the Fall

(Guest Post by Matthew Ladner)

If I live to be 120 years old, I won’t live to see a statement so brazenly and knowingly mistaken as the one uttered by Congressman Barney Frank (D-MA) regarding the current financial crisis: “The private sector got us into this mess. The government has to get us out of it.”

 

Say the statement out loud. Swish the sour taste in your mouth. This statement is the precise opposite of the truth. As chairman of the House Financial Services committee, Frank knows better.

 

It was in fact the public sector that got us into the subprime mess: specifically, government sponsored entities Fannie Mae and Freddie Mac. These “Government Sponsored Entities” engaged in social engineering in the housing market by buying up reckless mortgages. Perversely, lenders now had no incentive to consider the credit worthiness of borrowers, as they could quickly off-load even absurd mortgages to the GSE’s.

 

On September 30th, 1999 the New York Times reported on Congressional efforts to expand subprime lending. “Fannie Mae, the nation’s biggest underwriter of home mortgages, has been under increasing pressure from the Clinton administration to expand mortgage loans among low and moderate income people and felt pressure from stock holders to maintain phenomenal growth in profits,” the Times reported.

 

“Fannie Mae has expanded home ownership for millions of families in the 1990s by reducing down payment requirements,” Franklin Raines, former Clinton administration official and Fannie Mae chairman told the Times. “Yet there remain too many borrowers whose credit is just a notch below what our underwriting has required who have been relegated to paying significantly higher mortgage rates in the so-called subprime market.”

 

Raines made this statement as a justification for Fannie Mae easing the credit requirements on loans purchased from lenders. In other words, Fannie blew even harder into the housing bubble. “By expanding the types of loans it will buy, Fannie Mae is hoping to spur banks to make more loans to people with less-than stellar credit ratings,” the New York Times reported.

 

See video on unsuccessful efforts to rein in Freddie and Fannie from 2004-2005 here:

 

 

Sadly in all of this, the housing market social engineers were unable to suspend the law of unintended consequences. Bartenders became would be real estate moguls, and the lenders played along collecting fees secure in the knowledge that when it all went south, they wouldn’t be left holding the bag. Speculative bubbles thrive on someone making a quick buck, drawing others into trying to do the same. Freddie and Fannie fueled the bonfire of stupidity.

 

The ultimate blame lies not with the lenders, but rather with those who created the perverse incentives.

 

Sadly, similar economic myths have been promoted in the past, and still afflict us to this day. As a university student, I was fed the story of how the Great Depression proved the ultimate failure of free-markets, and how the administration of Franklin Roosevelt heroically saved the nation from crisis.

 

This version of history is also very much at odds with the truth. Research by Milton Friedman and others has firmly established that the Stock Market Crash of 1929 played only a limited role in creating and sustaining the Great Depression. Rather, a series of policy errors by Congress, the Hoover Administration (creating a global trade war), the Federal Reserve (tightening monetary policy during a contraction) and the Roosevelt Administration (too many errors to list) created a prolonged downturn.

 

The United States had suffered plenty of stock market crashes, and economic downturns. What stands out about the Great Depression is not that it happened, but rather that it lasted so long due to a series of tragic missteps.

 

This too provides a lesson for today: the main thing we should fear are not bank failures or stock market declines, but rather the rushed and foolish actions of politicians. The only thing we have to fear is not fear itself, but rather fear and reckless government mistakes.

 

Congressman Frank, who defended Freddie and Fannie from attempt to rein them in after scandals emerged, was even so brazen as to dismissively put this crisis “back to Ronald Reagan, when at his inauguration he said, ‘Government is not the answer to our problems; government is the problem.’”

 

Sorry Congressman: Reagan got it exactly right and you have it precisely wrong.

20 Responses to Legends of the Fall

  1. Jack Archer says:

    The phrase (next-to-last paragraph) is “reined them in,” not “reigned them in.” I don’t know why this mistake is made so frequently, and by people who should know better.

  2. matthewladner says:

    Slow down coach: I only recently switched from “rained them in.”

    Just kidding- good catch.

  3. Greg Forster says:

    Welcome to the new All Bailout All the Time edition of Jay P. Greene’s Blog! But it’s not that much of a stretch from our usual topics to this one – education policy and financial markets are two of the few places where people have difficulty seeing how bad public policy creates perverse incentives – a point they grasp with ease in most other policy areas.

  4. Polytope says:

    Sorry folks, institutions such as Fannie and Freddie certainly were complicit in creating the problem but their role was nothing but supporting. This mortgage credit cycle is similar to those of past ‘bubbles” with the addition of a new financial alchemy. The collateralized debt obligations (CDOs) that infected so many institutions are not primarily a GSE phenomenon. The credit default swaps that will be tomorrows cases at business schools and which will result in new chapters in finance textbooks similarly were not the direct result of Fannie and Freddie. I am no fan of the GSEs but there is much more blame to placed than that which rests on their shoulders.

  5. Matthewladner says:

    They seem very, very, very complicit to me:

    http://www.realclearpolitics.com/articles/2008/09/bailout_politics.html

  6. Greg Forster says:

    There’s blame enough to go around – it would be quicker to list the people who weren’t complicit.

  7. Matt,

    Attempting to link this entire mess to simply FNM/FRE is incredibly myopic, and it is indicative of the kind of thinking that led to this mess. Certainly, they played a role by not keeping enough capital on hand, but the sub-prime mess is not their game. FNM/FRE were prohibited by law from extending sub-prime. More than 60% of the bad mortgages in the country were extended by virtually unregulated independent brokers. Investment banks then, on their own capitalistic free will, invested in securities about which they had no real information or understanding.

    The problems at Bear Stearns, Leyman Bros,, Merrill Lynch, Countrywide, IndyBank, etc. had nothing to do with FNM/FRE. Additionally, the meltdown at AIG is even further from a government caused problem. This credit crunch is a result of an infinite number of bad decisions from bankers, brokers, and investors. None of them were forced into these decisions by government policy, nor inhibited by such. From the people who carry too much on their mastercard and an unmanageable ARM to people who don’t understand derivatives investing them caused this mess.

    However, both Bush presidents were correct in their assertions about Reagan. It was “voodoo economics” as history has shown. Secondly, W. pointed out that “only the government can solve this problem.”

    It’s not about size or reach of government, Matt. It’s about efficiency and effectiveness. Government – when not run by people who hate it (an oxymoron if ever) – can be both.

  8. matthewladner says:

    I couldn’t disagree with you more.

    It seems pretty apparent to me that by creating GSEs to buy up mortage backed securities that others wouldn’t buy was a major contributor to the housing bubble. Increase the number of buyers, drive up prices. Prices go up, onto the tulip phenomenon. There were other factors to be sure- including too loose of a monetary policy. Loose monetary policy was ultimately an enabling condition- there were going to be bubbles. The Freddies contributed greatly to the froth going into housing.

    The Freddies are a social experiment gone awry. The question isn’t whether there were contributing factors- there certainly were. When Barney Frank claims that “the free market got us into this mess and the government is going to have to fix it” he is asserting an entirely false history of how we got into this mess.

  9. Patrick says:

    Mike, you can’t make government efficient or very effective. Government tries to be efficient and effective my imitating market forces.

    The market does it best, why mess with anything less.

    This “crisis” is largely the fault of government. The only thing market blamers can point to is one deregulation bill in 2000 and “greed”…as if working for the government absolves people of all their greedy desires.

  10. Patrick says:

    Love the title too Matt…but that is a movie I can stomach only once.

  11. matthewladner says:

    From the 1999 NYT article:

    “From the perspective of many people, including me, this is another thrift industry growing up around us,” said Peter Wallison, a resident fellow at the American Enterprise Institute. “If they fail, the government will have to step up and bail them out the way it stepped up and bailed out the thrift industry.”

    From the video:

    “I think that the responsibility the Democrats have may rest more in resisting any efforts by Republicans in the Congress and me while I was President to put in some standards to tighten up on Freddie Mae and Fannie Mac”

    -Bill Clinton

    If anyone can square these two statements with Frank’s “the private sector got us into this mess” stance, take your best shot. I’m not claiming that GSEs are solely responsible, but Frank is effectively claiming that they are not AT ALL responsible.

  12. Patrick,

    The “government can’t work” mantra is nothing but a logical fallacy. The United States government can and has worked quite well for more than two hundred years. The extent of powers they have can be debated, but government can and will be here.

    As I noted, it certainly won’t be efficient and effective when those in charge don’t believe it can. Yet, by and large it works quite well. Thus, someone who doesn’t think government can work most definitely shouldn’t be a part of it.

  13. matthewladner says:

    Michael-

    Bill Clinton, Congressional Republicans, the Bush Administration and Alan Greenspan all tried to do something about the Freddies. Plenty of different perspectives on the proper role of government there, but they were all resisted by Barney Frank and company.

    Can it really be the case that Freddie and Fannie have nothing to do with the current crisis, and that it is really something that occured due to Republican hostility to big government?

  14. Matthew,

    Clearly, FNM/FRE played a role. However, countless other credit issues and the frightening world of financial derivatives investing is much more significant.

    Thus, the “government-is-the-problem” and “government-can’t-work” mantra is the ideology I oppose. Blaming government for problems in our collective checkbook doesn’t solve the problem. The “government” has a hugely significant role to play in a democratic-republic; thus, arguing that “government is the problem” is counterproductive.

  15. matthewladner says:

    Michael-

    Barney Frank argued that Reagan’s attitude caused our current crisis, and further that that “the private sector got us into this mess, government is going to have to fix it.”
    These positions simply cannot be squared with the facts.

    Here’s a parsimonious theory:

    “Loose monetary policy, combined with the Community Reinvestment Act and the Freddies, fuelled a gigantic bubble in housing.”

    Please explain the theory for Ronald Reagan’s skepticism of government causing the current crisis.

  16. Matt,

    Clearly, loose monetary policy is accurate – though you must consider the history of Reagan tax cuts which put a great deal of money in the hands of wealthy investors who were perpetually seeking places for that cash – that was key in every bubble developing and bursting. After the bursting of the tech bubble, that money went looking for a place, and housing and financial derivatives were only so happy to oblige – to ultimate detriment of the rest of the economy.

    The only statements that don’t square with the facts are attempting to blame the mess on FNM/FRE, the CRA, and “the government.” This is clearly a problem of the credit habits of ALL Americans and the free market financial industry.

    First let’s consider the words of the President of the San Francisco Federal Reserve Bank:

    “Before I turn to potential interventions, I want to make one final point. There has been a tendency to conflate the current problems in the subprime market with CRA-motivated lending, or with lending to low-income families in general. I believe it is very important to make a distinction between the two. Most of the loans made by depository institutions examined under the CRA have not been higher-priced loans,16 and studies have shown that the CRA has increased the volume of responsible lending to low- and moderate-income households.17 We should not view the current foreclosure trends as justification to abandon the goal of expanding access to credit among low-income households, since access to credit, and the subsequent ability to buy a home, remains one of the most important mechanisms we have to help low-income families build wealth over the long term.”

    This crisis had nothing to do with the Community Reinvestment Act. Few of the loans in the subprime market were covered by the CRA, and most of those are not in trouble.

    Secondly, we should probably acknowledge the links pointed out by Ed Gramlich, a Fed official, who was criticizing sub-prime lending and trying to get Greenspan to increase oversight by 2004. This, of course, he related to the repeal of Glass-Stagall. That deregulation of banking contributed to the problem far more than Fannie Mae’s lending.

    Keep in mind that up to Gramlich’s warnings in 2004, sub-prime was only 8.5 percent of mortgages in the US. However, by three years later, it surpassed twenty percent. At this time, Fannie/Freddie had nothing to do with the sub-prime, and were becoming insignificant in the mortgage game precisely because they can’t do any subprime lending. They are restricted by law from sub-prime lending. Additionally, regulators by 2003 put new restrictions on them as a result of growing financial scandals.

    There was a great deal of predatory lending by independent brokers who lent to those who couldn’t afford the deal, and then packaged and sold off the securities to foolish speculative investors who had no clue what they were buying. Where’s the government’s fault in that? Only maybe in deregulating and breaking down the walls between banks and investment houses. Though, I concur that Glass-Stegal was also helpful in facilitating the buyouts that have protected many assets.

    Granted, FNM/FRE’s problems came not in lending but in not maintaining enough capital to back any downturn in the market. Thus, we have the issue of finance and regulation. NOW, I’m not arguing that deregulation is the sole culprit or that excessive regulation is the answer. But I certainly can’t endorse oversimplying the issue into the standard “government is the problem” mantra.

    Again, this implosion occurred during the past eight years when, in the words of Gramlich “the subprime market was the Wild West. Over half the mortgage loans were made by independent lenders without any federal supervision.” What he didn’t mention was that this was the way the laissez-faire ideologues ruling Washington — a group that very much included Mr. Greenspan — wanted it. They were and are men who believe that government is always the problem, never the solution, that regulation is always a bad thing.”

    Now, I’m no economist (though I did stay at a Holiday Inn Express last night – (sic)), but I think Gramlich has the credentials to know what he’s talking about. All these banks made clear free market decisions to lend to people they shouldn’t have, loan more than they had, leverage beyond reason, purchase and re-sell securities for which they had no clear understanding of value, and hope that it all worked out.

    Matt, I am a fiscal conservative who is as likely to vote Libertarian as Democrat or Republican. However, I am not naively blinded by ideology. I am a pragmatic investor and voter, and I know too much about economics to look back at Reaganomics as anything but a contributing factor to the house of cards that is currently shaking.

  17. Matthewladner says:

    Here’s an article from the Independent:

    http://www.independent.co.uk/opinion/commentators/dominic-lawson/dominic-lawson-democrat-fingerprints-are-all-over-the-financial-crisis-949653.html

    There is much to quote from this article, but I’ll limit myself to this:

    “Thus by 1998 you had the Federal Reserve Bank of Boston producing a document entitled “Closing the Gap: a Guide to Equal Opportunities Lending”, which instructed banks that an applicant’s “lack of credit history should not be seen as a negative factor” in obtaining a mortgage. As Stephen Malanga of the Manhattan *Institute notes: “Of course the new federal standards couldn’t just apply to minorities. If they could pay back loans under these terms, then so could the majority of loan applicants. Quickly, these became the new standards in the industry. As the housing market boomed, banks embraced these new standards with a vengeance. Between 2004 and 2007, Fannie Mae and Freddie Mac became the biggest purchasers of subprime mortgages from all kinds of applicants, white and minority, and most of these loans were based on lending standards promoted by the Government.”

    Now again, try to square that with “the free market got us into this mess, and the government is going to have to fix it.”

  18. Matt,

    I am going to go with the economists and Federal Reserve officials, rather than some unsupported op-ed commentary in the Independent – though I do enjoy the Independent. What I’m trying to see is how the comments in the Independent square with all the mistakes made by all the sectors that I mentioned above. Are you just going to ignore all the independent brokers selling unstable securities to non-government institutions? Do you refuse to acknowledge that CRA is responsible for very few sub-prime losses?

    LTCM, the S&L industry, Bear Stearns, Merrill Lynch, Leyman Bros, IndyMac, and AIG are not government institutions, and are significantly free of government regulation and oversight. (That’s not to mention Enron, WorldCom, Tyco, Qwest, etc.) So how did the government get them into the mess they’re in?

    Clearly, all those failures, as well as huge credit problems with average Americans, were the result of the free market. The logical response for someone who reads ALL the data is that the free market is not always rational and efficient, and the government is not always the problem. When the first vote in the House failed, the market plunged nearly 800 points. President Bush, of the Reagan legacy, said in a national speech, “the government is the only one who has the ability to solve this problem.”

    That is how “the free market got us into this mess, and the government is going to have to fix it.”

  19. matthewladner says:

    Elements of the Fed supported these changes, so having a few people in the Fed defend them doesn’t seem the least bit persuasive. The Fed’s overall credibility, after all, has taken a huge hit here.

    As to your question about LTCM et al. let me once again quote from the article “Of course the new federal standards couldn’t just apply to minorities. If they could pay back loans under these terms, then so could the majority of loan applicants. Quickly, these became the new standards in the industry. As the housing market boomed, banks embraced these new standards with a vengeance. Between 2004 and 2007, Fannie Mae and Freddie Mac became the biggest purchasers of subprime mortgages from all kinds of applicants, white and minority, and most of these loans were based on lending standards promoted by the Government.”

    If you an Mr. Frank want to stake out a position that this is ALL the private sector’s fault, and that government had NOTHING to do with it, feel free, It is a laughably extreme position.

  20. Well, Matt,

    I think we’ve pretty much exhausted our positions, with each appearing to the other as if there’s no ability for rational discernment. I guess that’s why we have numerous political parties and various levels of extremity in ideology.

    I’m sure you’ll continue to vote a strict ideologically pure ticket of neo-conservative Republicanism. I’ll continue to be unaffiliated, and stick to a moderate, fiscally conservative, socially conscious platform.

    Let’s hope Congress and voters take the best of both our positions and makes some progress

    Thanks,

    Michael

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