This article on U.S. financial disasters provides a lot of background on the real estate financing boom and bust that I haven’t seen elsewhere.
He ends up blaming the current crisis on greedy capitalists and politicians.
But historically there was also a class, made up mostly of American blacks, for whom home ownership was out of reach. Although simple racial prejudice had long been a factor here, it was, ironically, the New Deal that institutionalized discrimination against blacks seeking mortgages. In 1935 the Federal Housing Administration (FHA), established in 1934 to insure home mortgages, asked the Home Owner’s Loan Corporation””another New Deal agency, this one created to help prevent foreclosures””to draw up maps of residential areas according to the risk of lending in them. Affluent suburbs were outlined in blue, less desirable areas in yellow, and the least desirable in red.
The FHA used the maps to decide whether or not to insure a mortgage, which in turn caused banks to avoid the redlined neighborhoods. These tended to be in the inner city and to comprise largely black populations. As most blacks at this time were unable to buy in white neighborhoods, the effect of redlining was largely to exclude even affluent blacks from the mortgage market.
Even after the end of Jim Crow in the 1960’s, the effect of redlining lingered, perhaps more out of habit than of racial prejudice. In 1977, responding to political pressure to abolish the practice, Congress finally passed the Community Reinvestment Act, requiring banks to offer credit throughout their marketing areas and rating them on their compliance. This effectively outlawed redlining.
Then, in 1995, regulations adopted by the Clinton administration took the Community Reinvestment Act to a new level. Instead of forbidding banks to discriminate against blacks and black neighborhoods, the new regulations positively forced banks to seek out such customers and areas. Without saying so, the revised law established quotas for loans to specific neighborhoods, specific income classes, and specific races. It also encouraged community groups to monitor compliance and allowed them to receive fees for marketing loans to target groups.
Forward again to the Clinton changes in 1995. As part of them, Fannie and Freddie were now permitted to invest up to 40 times their capital in mortgages; banks, by contrast, were limited to only ten times their capital. Put briefly, in order to increase the number of mortgages Fannie and Freddie could underwrite, the federal government allowed them to become grossly undercapitalized””that is, grossly to reduce their one source of insurance against failure. The risk of a mammoth failure was then greatly augmented by the sheer number of mortgages given out in the country.
That was bad enough; then came politics to make it much worse. Fannie and Freddie quickly evolved into two of the largest financial institutions on the planet, with assets and liabilities in the trillions. But unlike other large, profit-seeking financial institutions, they were headquartered in Washington, D.C., and were political to their fingertips. Their management and boards tended to come from the political world, not the business world. And some were corrupt: the management of Fannie Mae manipulated the books in order to trigger executive bonuses worth tens of millions of dollars, and Freddie Mac was found in 2003 to have understated earnings by almost $5 billion.
Both companies, moreover, made generous political contributions, especially to those members of Congress who sat on oversight committees. Their charitable foundations could be counted on to kick in to causes that Congressmen and Senators deemed worthy. Many of the political contributions were illegal: in 2006, Freddie was fined $3.8 million””a record amount””for improper election activity.
By 2007, Fannie and Freddie owned about half of the $12 trillion in outstanding mortgages, an unprecedented concentration of debt””and of risk. Much of the debt was concentrated in the class of sub-prime mortgages that had proliferated after the 1995 regulations. These were mortgages given to people of questionable credit standing, in one of the attempts by the federal government to increase home ownership among the less well-to-do.
Since banks knew they could offload these sub-prime mortgages to Fannie and Freddie, they had no reason to be careful about issuing them. As for the firms that bought the mortgage-based securities issued by Fannie and Freddie, they thought they could rely on the government’s implicit guarantee. AIG, the world’s largest insurance firm, was happy to insure vast quantities of these securities against default; it must have seemed like insuring against the sun rising in the West.
In 2006, after an astonishing and unsustainable climb in home values, the inevitable correction set in. By mid-2007, many sub-prime mortgages were backed by real estate that was now of lesser value than the amount of debt. As the market started to doubt the soundness of these mortgages, their value and even their salability began to deteriorate. So did the securities backed by them. Companies that had heavily invested in sub-prime mortgages saw their stock prices and their net worth erode sharply. This caused other companies to avoid lending them money. Credit markets began to tighten sharply as greed in the marketplace was replaced by fear.
A vicious downward spiral ensued. Bear Stearns, the smallest investment bank on Wall Street, was forced into a merger in March with JPMorgan Chase, with guarantees from the Federal Reserve. Fannie and Freddie were taken over by the government in early September; Merrill Lynch sold itself to Bank of America; AIG had to be bailed out by the government to the tune of $85 billion; Lehman Brothers filed for bankruptcy; Washington Mutual became the biggest bank failure in American history and was taken over by JPMorgan Chase; to avoid failure, Wachovia, the sixth largest bank in the country, was taken over by Wells Fargo. The most creditworthy institutions saw interest rates climb to unprecedented levels””even for overnight loans of bank reserves, which are the foundation of the high-functioning capitalist system of the West. Finally it became clear that only a systemic intervention by the government would stem the growing panic and allow credit markets to begin to function normally again.
Many people, especially liberal politicians, have blamed the disaster on the deregulation of the last 30 years. But they do so in order to avoid the blame’s falling where it should””squarely on their own shoulders. For the same politicians now loudly proclaiming that deregulation caused the problem are the ones who fought tooth and nail to prevent increased regulation of Fannie and Freddie””the source of so much political money, their mother’s milk.
To be sure, there is more than enough blame to go around. Forgetting the lessons of the past, Wall Street acted as though the only direction that markets and prices could move was up. Credit agencies like Moody’s, Standard & Poor’s, and Fitch gave high ratings to securities that, in retrospect, they clearly did not understand. The news media did not even try to investigate the often complex economics behind the housing market.
But remaining at the heart of the financial beast now abroad in the world are Fannie Mae and Freddie Mac and the mortgages they bought and turned into securities. Protected by their political patrons, they were allowed to pile up colossal debt on an inadequate capital base and to escape much of the regulatory oversight and rules to which other financial institutions are subject. Had they been treated as the potential risks to financial stability they were from the beginning, the housing bubble could not have grown so large and the pain that is now accompanying its end would not have hurt so much.
Herbert Hoover famously remarked that ” the trouble with capitalism is capitalists. They’re too greedy.” That is true. But another and equal trouble with capitalism is politicians. Like the rest of us, they are made of all-too-human clay and can be easily blinded to reality by naked self-interest, at a cost we are only now beginning to fathom.