Assigning proper blame in the last financial crisis
As the world wrestles with the sovereign debt crisis in Europe and Americawell see if 2012 is any easier than 2011its worth reviewing what caused the last financial meltdown. Of some help is a new book, Reckless EndangermentHow Outsized Ambition, Greed, and Corruption Led to Economic Armageddon.
Gretchen Morgenson is a Pulitzer-prize winning business reporter for the New York Times; Joshua Rosner is now a managing director at a New York-based consulting company. In 2001, Rosner authored a report critical of the already too-easy approach to American mortgage financing. Their collective talents help identify the various mischief-makers in the last financial crisis and why it occurred.
Exhibit A: Just after Lehman Brothers collapsed in 2008 and as U.S. mortgage giants Fannie Mae and Freddie Mac declined into financial quicksand, Massachusetts congressman Barney Frank was omnipresent on the nightly news.
Frank, then chairman of the powerful House Financial Services Committee, knew who to blame for the mess: Wall Street and other politicians.
Quoted in a January 2009 New Yorker profile, Frank said he predicted and might have prevented the U.S. housing crisisif only others had listened: The I told you so here is that homeownership is a nice thing but it is not suitable for everybody, said Frank to the interviewer.
In fact, until the financial crisis, the congressman favoured expanding home ownership beyond reasonable limits, especially to those who under more prudent lending rules, would never have obtained a mortgage.
Also, Frank had long opposed stripping Fannie Mae and Freddie Mac of their sweetheart deals with the U.S. federal government. The two lenders, created in 1938 and 1970 respectively to help raise levels of U.S. home ownership, were technically private for the last four decades. However, and critically, both were granted de facto government guarantees and other favourable treatment that cut their borrowing costs.
For example, capital requirements for Fannie Mae and Freddie Mac were set low, at just 2.5 per cent, compared to a 10 per cent requirement for American banks. Such favours were opposed by the rest of the financial sector and by critics who thought such favouritism risked a future taxpayer bailout.
In Reckless Endangerment, blame for the last American financial crash is properly attributed to both government and the financial sector: Wall Street again became irrationally exuberant (to use a 1990s phrase from Alan Greenspan). But it did so courtesy of government carrots and sticks, i.e., incentives and regulations to lenders that artificially boosted homeownership levels, risk be damned.
Such encouragement of high-risk behaviour included the Carter administrations Community Reinvestment Act, pumped up in the 1990s under Bill Clinton. That Act pushed financial institutions to lend more money to low-income, high-risk borrowers on the theory that racial discrimination (and not lousy credit scores) explained a previous dearth of low-income mortgage-holders.
Some of this ground has been explored in previous books. Whats new in Reckless Endangerment is the examination of the role Fannie Maes 1990s-era chief executive, James A. Johnson, played in creating the U.S. housing bubble: internal high-risk corporate behaviour that massively expanded Fannie Mae and external attacks on any critic that sought to kill Fannie Maes government-granted privileges.
Johnsons command-and-control management of the mortgage finance giant and his hardball tactics to ensure Fannie Maes dominance amid increasing calls for oversight are crucial to understanding the origins of the worst financial debacle since the Great Depression, write the authors.
Johnson and those who followed him at Fannie Mae spent tens of millions of dollars on campaign contributions, grants to potential allies, and on lobbying. For instance, the company strategically supported a wide swath of American politicians, everyone from the Barney Frank on the left to Newt Gingrich on the right. The cash helped thwart any attempt to put the company on a level playing field with other financial institutions.
Johnson moved on from Fannie Mae in 1999, nine years before the financial sector imploded, but the authors assert he was a major reason for the housing boom and subsequent bust. Johnsons tactics were watched closely and subsequently imitated by others in the private sector, write Morgenson and Rosner.
Whether relaxed lending standards, the elimination of due diligence, repackaging junk loans, and, importantly, supporting disastrous political attempts to push for more home ownership even for those who by any sensible measure, could not afford one, Johnson and Fannie Mae were there first as pioneers.
As for the congressman from Massachusetts, when asked in 2005 whether his political opposition to traditional prudence in the financial sector was wise, and whether this might not lead to mass mortgage defaults, he brushed off the question: Said Frank, Well deal with that problem if it happens.
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