Finally, the True Story of the Financial Crisis Breaks Through

Since the financial crisis in 2008, the American people have heard—through the media and from the government—only one narrative about the causes of the crisis. In that narrative, the villain was the private sector, usually identified as Wall Street. Blaming Wall Street is an American  tradition, so there is nothing unusual in that, but in this case it resulted in a new law—the Dodd-Frank Act—that is gradually strangling the economic recovery in its crib.

It had seemed for a while as though the real story would never get out. In reality, the financial crisis was caused by government housing policy, which—beginning in the Clinton administration and continuing through Bush—sought to increase home ownership by requiring Fannie Mae and Freddie Mac and other government agencies (and banks covered by the Community Reinvestment Act) to make mortgage credit available to borrowers who were at or below the median income in the places where they lived.

It is possible, of course, to find prime borrowers who are below the median income where they live, but by 2000 half of all loans Fannie and Freddie bought were required to be made to borrowers at or below the median income; after that, the the requirements got even stiffer.  To find these loans, Fannie and Freddie had to reduce their underwriting standards.  As a result, before the financial crisis in 2008, about half of all mortgages in the United States—27 million loans—were subprime or otherwise of low quality because of low or no down payments or other deficiencies.  Over 19 million of these loans were held or guaranteed by Fannie and Freddie, other government agencies, or banks under the CRA—not by Wall Street. When the great housing bubble deflated in 2007, these loans began to default in unprecedented numbers, driving down house prices and weakening financial institutions in the US and around the world that held them as investments. That’s what caused the financial crisis.

Now it appears that this accurate narrative about the financial crisis will finally get a full hearing in the U.S. Michele Bachman has apparently been doing a good deal of research on this topic, and as recorded in an article by Bob Tyrrell yesterday in the New York Sun, she has correctly identified where the responsibility for the financial crisis actually lies: “The Liberals have, like a vast shoal of squid, spread an inky cloud over the financial meltdown,” Tyrrell writes,  “Mrs. Bachmann dispels the darkness regarding its origins. Says she, ‘There were a lot of bad actors involved, but it started with the Community Reinvestment Act under Jimmy Carter and then the enhanced amendments that Bill Clinton made to force, in effect, banks to make loans to people who lacked creditworthiness. If you want to come down to a bottom line of “How did we get in this mess?” I think it was a reduction in standards.’ Whereupon she goes on to say, ‘Being of the Financial Services Committee, I can assure you, all roads lead to Freddie and Fannie, the mortgage lenders…’”

As a presidential candidate, Michele Bachman will have a big megaphone, and on this issue she will be saying things that many Americans have never heard.

  1. Kenneth

    Your narrative is accurate as far as it goes.  But it doesn’t cover the role of derivatives, especially credit-default swaps – which allowed financial institutions to pile enormous leverage on top of those teetering mortgages.

    Nor does it cover the role of “mark-to-market” regulations. Mortgages were bundled into collateralized debt obligations (CDO’s).  When mortgage holders began defaulting in large numbers, it was impossible to determine an accurate market price for any particular CDO, because no one could predict which loans would go bad.  Under those circumstances, no one wanted to buy CDO’s.  When no one wants to buy something, the price goes to zero.  Under SEC rules, banks were required to mark these assets down to zero; absurd, but logical.

    I was in the mortgage business up until 2005.  I remember brokers describing CDO’s as something like a layer cake, that could be sliced up into varying layers of risk.  I said at the time that if these puppies go bad, what you’ll have won’t be a layer cake, it will be a raisin pudding  – with toxic raisins.  Which is exactly what happened.

  2. Diane Ellis
    C

    Peter,

    Early this year, Nicole Gelinas of the Manhattan Institute joined us to talk a little bit about the financial crisis for a week.  Her position was that Fannie and Freddie were certainly a problem, but not the problem.  Citing the Financial Crisis Commission Report (to which you yourself contributed, if I’m not mistaken), she went on to list a few actors in the crisis that she considered more responsible.  These included:

    • a derivatives market that allowed financial-market participants to incur hundreds of billions of dollars in potential liabilities with no cash cushion for potential losses;

    • synthetic securities that magnified the results of any one investment, including a mortgage-related-investment, going wrong, thus amplifying bubble mania and bust panic;
    • a “repo” securities market that invites “runs” on the global financial system and attendant bailouts;
    • dependence on ratings agencies’ determinations of risk that encourages everyone to make the same mistake all at once;

    I suppose it’s a chicken or the egg problem.  In your opinion, did these problems stem from the existence of Fannie and Freddie, or were Fannie and Freddie simply a product of these problematic conditions?

  3. River

    Exactly right. It’s the concept of ‘social justice’ combined with economic illiteracy that is so toxic. These ‘progressives’  believed that providing more money for housing without allowing for an increase in supply would make houses more affordable. All they did was drive up prices and create a massive bubble.

    The realtors and mortgage lenders were happy to oblige, knowing they would get a hefty cut from every transaction – until the crash came. They knew exactly what they were doing.

    Things were so bad in southern California that the per-square-foot price of an entry level condo was the same as the finest houses in excellent neighborhoods.

  4. BThompson

    I agree with Kenneth and Diane. Conservatives shouldn’t be too anxious to lay this all at the feet of CRA and try to play simplistic blame games to score political points. CRA and federal banking institutions certainly helped create and inflate the subprime market. But lots of banks and institutions happily, urgently jumped into that market with both feet without any arm twisting whatsoever. CDOs and CDSs let them develop a false sense of security about the danger of those loans and the credit rating agencies were totally negligent in their assessment of thoses CDOs and CDSs. Also the SECs desire to get its regulatory hooks into investment banks led to the SEC to make a deal regarding Basel II accounting standards which let financial institutions raise their liability to capital ratios to foolish and irresponsible levels. This is a complicated mess and saying that it was all the fault of CRA is not accurate IMO.

  5. SteveS

    I don’t profess any working knowledge in the areas you are discussing as maybe is true of most Americans but regardless of bad regulations and the like how can financial people make such disastrous decisions. Is it just plan greed, ignorance or arrogance knowing that they, even though they may initially lose money, at least on paper I suspect are never truly on the hook as say a true business would be when they make bad decisions. .

    Can you please help me understand and not get sidetracked by all of the false rhetoric we have hearing for the last four years.

  6. LowcountryJoe

    I think this is a part of what happened.  The larger part of this was the expectations of everyday people and the political machinery’s will to keep people content by meeting those expectations — keeping those expectations met even though it wasn’t healthy for the economy longer-term.

    1. Stock market loses a lot a of value in ’98-’00 => lower the Fed Fund rate, making it easier for businesses to borrow and ultimately prop up equity-securities prices.

    2. Terrorist attacks cause market to take a hit just when it’s beginning to recover => lower rates to near zero so stock owners can rest easier.
    3. Unsustainable mortgage rates become the norm because of these low rates => 
      • re-financing to suck out equity and spend, spend, spend becomes all the rage

      • ARMs rate allow people to get teased into buying because the payment looks sweet
      • this new demand causes prices to rise…fast.  This causes even more re-fi and home building.
      • people get used to all this new spending and adjust their habits (and employment) on, what they believe is, the ‘new normal’.
  7. Todd
    Kenneth: It doesn’t cover the role of derivatives, especially credit-default swaps – which allowed financial institutions to pile enormous leverage on top of those teetering mortgages.

    I don’t think there is anything inherently wrong with  CDS or derivatives. The group most well suited to regulate the leverage of financial institutions are the lenders.  

    If I am a lender to a financial institution, and I see that they are engaging in riskier and riskier activities, and that they are getting more and more levered, I am going to start demanding a much higher rate of return or stop lending all together. After all, I don’t participate in the upside of these risky bets.

    But for some reason, we didn’t see that happen.  It didn’t happen with Fannie and Freddie because lenders were counting on the implicit govt guarantee.  And we also didn’t see it with Wall Street firms and other financial institutions.  Lehman was able to get debt financing almost up until the very end. 

    Why?  Maybe because over the last 30 years, creditors to large financial institutions have almost always been made completely whole.  

  8. Kenneth

    Peter is correct with regard to the root cause, which was the Community Reinvestment Act.  The instruments through which government believed it possible to extend home ownership to lower-income borrowers were Fannie Mae and Freddie Mac.  Once those institutions stepped in to buy all of the higher-risk loans, the party heated up very nicely. 

  9. BThompson

    Great points, Joe. I think the point about Fed policy needs reemphasis. Money was too cheap for too long under Greenspan following the dotcom bubble. That fed a lot of the fever. The bubble became much larger than it otherwise would have, the over-leveraging was made much worse, and irresponsible spending habits were enabled largely by bad monetary policy.

  10. LowcountryJoe

    Of course we know what ended up happening.  The Fed thought that it could finally do the responsible thing and begin raising the Fed Funds rate.  The problem resulted in an unwinding of all those expectations that their easy-money policy helped to create.  The resulting cascade of effects from raising the rate caused people to lose a lot of their equity, lose their jobs that only existed because of the unsustainable economic activity, and make new preparations based on the new reality.

    But of course the political machinery cannot and will not allow people to feel economic pain for very long without making new promises and trying new things.  So, here we are.  A nation of child-like and spoiled people that feel entitled to standards of living that could not be sustained, long-term, based on how these standard were being derived.  And a small collection of elected representatives who, acting like parents to their children, will try not disappoint by attempting to postpone adulthood.

  11. Kenneth

    Keeping it simple, the crash was occasioned by a deliberate lowering of lending standards, shifting of risk from private lenders to government agencies and the invention of gimmick loans that provided an illusion of affordability. 

    No down payment?  Don’t have enough income to qualify?  No problem.  You could get a loan for 105% of value, with zero down and closing costs rolled into the mortgage.  Payment still too high?  Here’s a tasty ARM – by the time your payment adjusts upwards, the home will be worth much more, so you can re-finance.  

    Why would we offer you such a deal?  Are we crazy?  No, we’re gonna sell your loan to Fannie Mae next Friday morning. 

  12. Todd
    BThompson: I agree with Kenneth and Diane. Conservatives shouldn’t be too anxious to lay this all at the feet of CRA and try to play simplistic blame games to score political points.

    CRA is important because it, along with the affordable housing goals imposed on Fannie and Freddie,  caused an industry wide reduction in lending standards. Fannie and Freddie could get away with it because the risk they were taking on had essentially been nationalized.  The bond market fully believed that Fannie and Freddie lenders would be bailed out. And the market was right.

    The only missing piece to that story is why did private Wall Street firms go along with it if it was such a bad idea. There are probably lots of reasons, but I think one reason is that creditors to Wall Street firms also may have been banking on a bailout. After all, they had been bailed out time and time again (LTCM, the Mexican peso crisis, etc,) and as a result, they were allowed the firms to get more and more levered and engage in riskier and riskier activities.

  13. BThompson
    Kenneth: Keeping it simple, the crash was occasioned by a deliberate lowering of lending standards, shifting of risk from private lenders to government agencies and the invention of gimmick loans that provided an illusion of affordability. 

    I just don’t think there is a way to keep it simple. Overleveraged firms and easy money that fueled a bubble in home prices were very important factors as well. If not for financial institutions being so exposed and if not for such a big drop in the price of houses which had been inflated by loose monetary policy, the crisis would not have been so severe, or not been really a crisis at all.

  14. TeeJaw
    Blaming derivatives or credit default swaps or mortgage backed securities or any other market innovation is a false promise.  Like most human folly, it’s the humans, their qualities and what they do, not the tools they use. Stephen S., you might like to take a look at this new book:   Reckless Endangerment: How Outsized Ambition, Greed, and Corruption Led to Economic Armageddon.
  15. Mel Foil

    The profits were private and the risk was public. What did people expect? Moderation? The complete failure to account for human nature seems to implicate Democrats in Congress. That’s their fingerprint. They designed a rudderless airplane, and were shocked when it fell out of the sky.

  16. SteveS

    Thank you Ducatista for the book recommendation and to everyone else’s contribution to the discussion. 

    Hats off to Ricochet for the forum.

  17. Diego Sun Devil

    Don’t forget to include the ratings agencies in this whole mess.  They continued to rate these investments as AAA even though they clearly weren’t.  There were regulations and agencies in place to stop this, but they didn’t do their job.  In some ways, I equate it to the Bernie Madoff situation.  People tried to raise the red flags earlier on, but they were ignored.  He could have and should have been caught much sooner.

    The answer – more regulations (Dodd/Frank), which will just allow for more agencies to not do their job the next time.  There will never be a perfect system, and the more largess we create, the more the little man is hurt.  How about simply enforcing the laws we have?  This goes for the illegal immigration problem as well.  I know it’s a novel concept, but I think we should give it a try.

  18. Duane Oyen

    This is nowhere as simple as is suggested.  I encourage all of you to get the Fannie-Freddie story from Gretchen Morgenstern- that will reinforce Bachmann’s claims and really expose scummy Jim Johnson.  But there is also a lot more to the story, which is analyzed by many people in detail at Russ Roberts’ EconTalk, especially Roberts himself and his interview with Gary Stern on “too big to fail.”

  19. Louie Mungaray (Squishy Blue RINO)
    Stephen S.: I don’t profess any working knowledge in the areas you are discussing as maybe is true of most Americans but regardless of bad regulations and the like how can financial people make such disastrous decisions. Is it just plan greed, ignorance or arrogance knowing that they, even though they may initially lose money, at least on paper I suspect are never truly on the hook as say a true business would be when they make bad decisions. .

    Can you please help me understand and not get sidetracked by all of the false rhetoric we have hearing for the last four years. · Jun 16 at 9:35am

    Stephen,

    As a complete neophyte on this subject I found Michael Lewis’ book The Big Short a good jumping off point.

    The Giant Pool of Money episode of This American Life is basic and informative, perfect for a beginner like me.

    Despite being on NPR, Planet Money is very informative without being partisan.

    Nicole Gelinas’ book After The Fall requires careful reading, but you will come away confident you understand this subject reasonably well. You can see her lecture on the book free online. Video here, Longer version here.

  20. BThompson

    It’s already up there Big K, take a look.