2008-10-10 / Columnists

The Rockaway Irregular

An Ancient Chinese Curse: 'May You Live in Interesting Times'
Commentary by Stuart W. Mirsky

The current financial crisis is so massive and complex that it offers little opportunity for the kinds of easy explanations a column like this is meant for. Nevertheless, I'm going to give it a try.

Our natural tendency is to look for quick and easy answers to our troubles and, of course, someone to blame. All those "greedy" Wall Streeters who did so well for so long at our expense and, of course, the president. Well, some of us gave George Bush credit for the good years during most of his administration so it's only fitting we blame him now for the current downturn, right? If you listened to his critics (Democrats and most of the media) things have been terrible all along anyway so this is only more of the same. But if so, why do things look worse now?

The roots of this crisis lie deep in our institutions and history. During the latter years of the Great Depression, Democratic president Franklin Roosevelt created a government entity to provide an aftermarket for mortgages. In the old days, when a bank wrote a mortgage it was on the hook for it. If the borrower didn't pay, the bank lost its money. But housing had frozen up in the 1930's and the government wanted mortgage liquidity so banks would start lending again. Though it took World War II to actually pull us out of the Depression, the new agency, Fannie Mae, added liquidity as advertised.

By 1968, another Democratic president, Lyndon Johnson, decided to privatize Fannie Mae to get it off the government's books to reduce visible national debt. Sold to private investors, Fannie retained implicit (but not legislative) government backing, helping LBJ ramp up spending on his Great Society programs. Under Democratic president Jimmy Carter in the '70s, Congress passed, and Carter signed, the Community Reinvestment Act (CRA) mandating local lenders to up the percentage of loans made to economically disadvantaged areas to increase home ownership in poorer neighborhoods. Using the banking system for social policy, banks were told by Congress to lend to the less creditworthy. Congress even created another agency, Freddie Mac, to add still more liquidity to the mortgage market and provide competition for Fannie. By the nineties, these two companies were jointly buying up individual mortgages generated by local and regional banks and packaging them for resale to investors who, because of the implicit government backing, were prepared to pay up for them.

Yet Fannie and Freddie were soon cited for "cooking their books" to make their returns look better, goose their stock prices and justify big salaries and bonuses to executives. Congress chastised their top executives, some of whom stepped down under fire (albeit with huge severance packages) and life went on as their stocks continued to soar and investors flocked to these companies for their near mythic ability to mint money by buying, packaging and reselling mortgages.

Some in Congress did call for Fannie and Freddie to be reined in though, including current Republican presidential candidate John McCain, but few were listening as the companies' executives pumped out campaign contributions. Even McCain took a small part of that though nowhere near the amounts that reportedly went to major Democratic players like Connecticut Senator Chris Dodd (current chair of the Senate Banking Committee) or Massachusetts Congressman Barney Frank (current Chair of the House Financial Services Committee).

In 1995, former Democratic president Bill Clinton signed new legislation allowing securitization of Community Reinvestment Act loans to include so-called sub-prime mortgages (made to less creditworthy borrowers) and, in 1998, Clinton signed further legislation imposing still more aggressive mandates on the nation's banks to lend to those on lower economic rungs.

Enter the computer age. As markets steamed ahead, sophisticated quants dreamed up new ways to generate high yields from the mortgage aftermarket. They learned how to take the packaged and re-packaged Fannie and Freddie securities and slice them up in "tranches," capturing the different creditworthiness levels of the underlying borrowers. Major institutions loved these for their yields and believed the carefully calibrated risk arbitrage built into these packages made them safe. Because so many loans were bundled together, a few defaults could hardly be expected to adversely impact overall value and with the U.S. government implicitly backstopping even the least creditworthy loans in the Fannie and Freddie securities, few institutions wanted to be left behind. Large, experienced companies loaded up on the finely sliced securities, buying and reselling them at a mark-up, or holding them for their own accounts. Before long, they were everywhere in the system.

But some folks were starting to worry. In September 2003 the New York Times reported that "The Bush administration . . . recommended the most significant regulatory overhaul in the housing financial industry since the savings and loan crisis a decade ago" to rein in Freddie and Fannie excesses. Congress refused to go along. Massachusetts Congressman Barney Frank is on record complaining that "the more pressure . . . on these companies, the less we will see in terms of affordable housing." In 2005 the Bush administration followed up by again sending then Treasury Secretary John Snow to Capitol Hill to argue for regulation and a group of Republican Senators, including Arizona's John McCain, Nebraska's Chuck Hagel, North Carolina's Elizabeth Dole, and New Hampshire's John Sununu co-sponsored the Housing Enterprise Regulatory Act of 2005 to regulate Fannie and Freddie. Again nothing happened.

The fraudulent accounting practices of these two companies had been uncovered in the nineties while the increased risk of the sub-prime loans they were frantically pouring into the system was no secret. But the financial industry thought it was protected by the magic of computers and diversification. They were mistaken.

So now we have credit markets seizing up, as major institutions go out of business or get taken over at huge costs to American taxpayers, while others at every level of the economy are afraid to lend to anyone because the prospective collateral might be stinko and the economy is teetering into recession because the business activity is grinding to a halt and we're all mad at somebody and pretty much everyone's blaming George Bush. What else is new?

Our detractors abroad have been crowing over our imminent demise and calling for a diminution of America's role in a future international economy while on the left we hear the same old tune. The Wall Street Journal reports Socialist Workers Party candidate for Congress Seth Dellinger thinks this has all come about because capitalists, finding it harder to make a buck in recent years "turned to gambling on Wall Street." He forgets that Wall Street, like life itself, has always been about gambling and tells the Journal the solution lies in imposing a Cuban-style government in the U.S.

Times like these are made for the angry, and many Americans have been whipped up into a near frenzy over these past eight partisan years. When times were good we were told how bad they were and now that they're bad we're told it's the end of history as we knew it.

The conservative inclination for deregulation is blamed by angry populists without any recollection of who actually put the kibosh on regulating the two agencies at the core of this meltdown. As I write this it's Monday morning and American markets are plunging again after the Asian and European markets collapsed overnight. I see only bleeding on my computer screen - lots of red everywhere. But I can't help remembering that too often forgotten dictum of French financier Baron de Rothschild who famously advised that the time to buy was when blood was in the streets. The last time I saw this much blood it was 1987 and the Dow was dropping like a stone. rockirreg@aol.com

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