What Caused The Financial Crisis & Housing Bubble? NOT The Myth About Fannie Mae & Freddie Mac

What did cause the Crash? Many factors: failed government and financial market policy, failed federal and corporate governance, failed ethics and oversight, failed human integrity, greed, and ideology.

First, let’s just look at a chart documenting that the Housing Bubble — and, thence, the Financial Crash — was NOT caused by a government policy encouraging “sub-prime’ mortgages by HUD through Fannie Mae & Freddie Mac.

Then, we will look at the myth that free-marketeer conservatives and the Republican Party espouse… followed by the “doesn’t-matter-what-is-your-ideology” logical reasons for the collapse of housing and financial markets.

Proof That Fannie And Freddie Policies Didn’t Cause The Housing Bubble

The role of government agencies in causing the housing bubble continues to be debated ad nauseam: “It’s all about the ‘sub-prime’ loans forced onto the market.”

Perhaps this chart of various housing bubbles around the world will shed some light.

If one truly thinks the “Crash” was all Fannie and Freddie’s fault, then one must explain how nearly every other industrialized nation at the same time experienced the same basic arc of a housing boom and bust… when the other nations did not have Fannie or Freddie with which to contend?

Take note of the exceptions: Germany never followed US fiscal or monetary (that’s EU/ECB territory) or deregulatory policies. Independent Switzerland never follows anyone’s policies and is not part of the EU/ECB. And, Japan had already experienced it’s housing bubble a decade earlier. Other than that, the balance did not have US policies supposedly encouraging sub-prime lending through Fannie or Freddie, but they did have other policies and actions in common with the U.S, and we will explore those toward the end.

The Myth Espoused By Conservatives And The Republican Party

One group has stood out and apart reshaping the narrative about the housing bubble, financial market collapse, and economic crisis… those whose bad judgment and failed ideology facilitated the crisis: the Ayn Rand-loving, free-marketeer, deregulators.

The game is afoot, and it’s an active campaign to rewrite history. Until the truth is set free from this history re-writing effort, the process of repairing what was broken is greatly hindered. It prevents us from holding guilty parties responsible (and foments the passion of the “Occupy” movement). The charade prevents implementation of measures to prevent another crisis.

Unfortunately, the storytellers shout louder than truth tellers.

Wall Street and its acolytes have their revised tale: “They are mere victims, as the entire boom and bust was caused by dictatorial government policies shoving sub-prime mortgages down their throats by HUD through Fannie Mae and Freddie Mac… Couldn’t possibly be irresponsible lending… not derivatives… not extreme leverage… not excessive compensation packages… Nope, it is, rather, long-standing housing policies of Clinton and Democrats at fault.”

This “blame Fannie & Freddie” story has been articulated by commenters to past articles on Faustian urGe. It is offered in numerous editorials and commentaries over the last couple years in the Wall Street Journal. Rush Limbaugh propagates the myth in speeches and on his radio program. It has been a story delivered in Congressional testimony and by congress members, themselves.

Even just a couple weeks ago, New York Mayor Michael Bloomberg encouraged the distortion field to move the “eye of blame” off his compatriots in the industry where he became wealthy when he stated the mistruth to the “Occupy Wall Street” protestors,

“It was not the banks that created the mortgage crisis. It was, plain and simple, Congress who forced everybody to go and give mortgages to people who were on the cusp.”

This line of argument simply does not hold up… Um, policies designed to facilitate home ownership of “some” lower-income folk just below the normal means of attaining prime mortgages was not mandated upon ANY mortgage originator, nor their derivative-selling brethren. Nope.

Such a line of reasoning does, however, serve the interest of partisan interest groups who advocated for financial market deregulation and serve the interests of those politicians best positioned if deregulation does not receive any blame for the crisis. But, this does not change the truth even a little.

Moreover, the financial incentives offered by the government for “some” mortgage originators to offer these products to “some” home buyers NEVER negated the financial due diligence of originators, lenders, packagers, cds funds… everyone in the financial industry. The fault lay clearly at the feet of the financial titans who lost sight of their fiduciary obligation to their shareholders and oversight bodies. In a word, GREED of the marketplace encouraged by lax deregulatory and monetary policy caused the crashes.

It should be noted, banks and other financial institution’s actions are — and always will be — a risk to the entire economy (that’s why we had and need to reinstate the “Glass-Steagall Act”); thus, reducing this risk by increasing capital reserve requirements and reducing extreme leveraging is required, even while this also reduces profitability. Oh well, the trade off is having a secure and predictable market in which to make profits.

Still, fear of increased regulations and constrained financial market profits due to the public and congress acknowledging the industry’s failures make for profound motivation to distort the reality field.

But, the biggest reason for the continued distortions is likely much more human… “cognitive dissonance” — the state of having inconsistent thoughts, beliefs, or attitudes, esp. as relating to behavioral decisions and attitude change, such as happens when a belief system or ideology fails profoundly.

“Doesn’t-Matter-What-Is-Your-Ideology” Explanation For Housing & Financial Market Collapse

So what are the facts; what is the reality field? The US economy is quite complex and intricate, so certainly, no single problem or matter was the cause. But, to be sure, there is a cause.

Check it out:

● Former Federal Reserve Chair Alan Greenspan reduced rates to 1 percent — lowest in 50 years — and kept them there for a uniquely long time…

● Low rates led to lower general yields on municipal bonds or Treasurys. Fund managers then turned to high-yield mortgage-backed securities — failing to do adequate due diligence before buying them.

● Fund managers made this error and relied on credit ratings agencies to do their work — Moody’s, S&P and Fitch. But, the ratings agencies had placed AAA ratings on junk securities, claiming they were as safe as U.S. Treasurys.

● Derivatives became an unregulated financial instrument hiding the truth of real risk. Exempt from proper oversight, insurance supervision, and reserve requirements, derivatives permitted AIG to write $3 trillion in instruments while reserving absolutely nothing against future claims.

● The Securities and Exchange Commission changed the leverage rules for the exclusive pleasure of five Wall Street banks in 2004. The “Bear Stearns exemption” replaced the previous capitalization rule  leverage limit and permitted unlimited leverage for Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers and Bear Stearns.

● Wall Street’s compensation system encouraged a short-term performance perspective, and offered traders great upside with none of the downside, leading to excessive risk-taking.

● The demand for higher-yields led Wall Street to begin bundling mortgages, with the highest yields coming from subprime mortgages cleverly buried in piles with prime mortgages. This deceptive market for packaging mortgage-backed instruments was exempt from most regulations. The Federal Reserve could and should have provided oversight, but Greenspan chose not to… ever the Ayn Rand free marketeer.

● The mortgage originators’ unregulated scheme saw them holding mortgages for a very short period, thus allowing them to be creative/unscrupulous with underwriting standards, ignoring all traditional lending metrics such as income, credit rating, debt-service history and loan-to-value.

● New mortgage products came on the market to attract more subprime borrowers to create higher yielding packaged instruments — adjustable-rate mortgages, interest-only, piggy-back mortgages (concurrent mortgage and home-equity line) and negative amortization loans (borrower’s indebtedness goes up each month). These “innovative” private-sector mortgages — not those encouraged by HUD policies — defaulted in hugely disproportionate frequency compared to traditional 30-year fixed mortgages.

● To remain competitive and satisfy demanding boards and shareholders, traditional banks developed computerized underwriting systems for mortgages and relied on software programs instead of thoughtful managers. Employees were paid on loan volume, not quality.

● The Glass-Steagall Act — previously the fire wall separating Wall Street investment banks and Main Street commercial banks — was repealed in 1999 during our deregulatory zeal, thus allowing FDIC-insured banks (deposits guaranteed by the government) to enter into excessively risky business arrangements. The law’s repeal also permitted industry consolidation to the extreme.

● In 2004, the Office of the Comptroller of the Currency preempted state laws regulating mortgage credit and national banks. Thereafter, national lenders sold increasingly risky mortgage products in those states. Then… default and foreclosure rates skyrocketed.

Deregulating the financial sector, jettisoning protections that had succeeded for decades is THE FATAL FLAW.

Congress failed its obligation and permitted Wall Street to self-regulate, and Greenspan through the Fed ignored financial market abuses, falling prey to his own coined phrase of “irrational exuberance.” His exuberance was his belief in the purity of free markets.

The discredited belief that free markets require no adult supervision is the reason for our crisis and why a new false narrative has been created.

So Here’s The Big Truth Bottom Line

1) The Fed kept its policy interest rate, the federal funds rate, below the natural or neutral interest rate for an extended period.

2) Given the excessive monetary easing shown above, the Fed helped create a credit boom that found its way–via financial innovation, lax governance (both private and public), and misaligned incentives–into the housing market.

3) Given the Fed’s monetary worldwide influence, its too-loose, too-long monetary policy was exported across the globe. As a result, the Fed helped create a global liquidity glut that in turn helped fuel a global housing boom.

4) The G7-G20 regularly meet to synchronize their fiscal and monetary policies, which would effect the money supply and interest rates across the economies in the housing chart atop this post. Other than Germany (note its line in the housing chart), most of Europe is right there with the US of A. Though Eurofund/ECB rates were held relatively high due to Germany’s insistence, the ECB rates generally followed the curve of Fed rates while most of Europe followed US-style fiscal policies.

5) Imitation takes hold with the drastic financial market deregulatory path: Europe, after watching the U.S. bubble up since 1980, took a page from our deregulatory manual and started their own financial and economic liberalization, ala Reagan. For example, the same irresponsible and deregulated private-sector behavior as seen in the US can be noted in the UK, “During the period 2001-2007, many lenders began offering loans of increasing multiples of income sometimes to people with poor credit ratings; products that did not require a deposit became more common — 125% mortgage products appeared.” ( Simon Lambert, “This is MONEY,” Daily Mail UK). Deregulated loans became too easy to get in the UK, as in the US., connected with Thatcher’s banking deregulation that happened in the 1980s. Spain, France, Belgium, et al… followed suit.


3 responses to “What Caused The Financial Crisis & Housing Bubble? NOT The Myth About Fannie Mae & Freddie Mac

  • cvgwhitaker

    I am not sure that I am aware of any person who blames the housing collapse on Fannie/Freddie solely. There were multiple causes. Krugman has a way of waving the bloody flag and arguing against straw men. I am afraid that his contributions to economics have faded.
    To a certain extent, the blame game is a waste of time. It will happen again and soon. Regulations will not stop it either.
    You really should spend some time reading the voluminous literature on the issue. Papers published under the watch of the Federal Reserve warned of the coming fiasco as early as 2004.
    Glass-Steagall was basically irrelevant by the time it was dumped, sorry to say.
    .

  • rogueoperator

    The underlying cause of the bubble was central bank driven inflation. That explains both the nationwide and European housing market bubble; while Fannie Mae and Freddie Mac, providing perverse incentives by socializing risk, leading to the MBS’-CDS scheme, accumulated the “cluster of errors” in the mortgage-lending market.

    • Coronare Modestus Faust

      I believe I adequately detailed the process in the article. Moreover, inflation is a broad-based phenomenon in the overall economy, not an industry-specific one. The bubble represented increasing costs that can lead to cost-push inflation in the economy but did not over this time period, and I adequately detailed how Federal Reserve Bank policy led to that cost bubble in the housing industry. To the point, Fannie Mae and Freddie Mac are specifically designed to “socialize risk.” This was the exact purpose of establishing these public-private corporations so as to make home ownership more broadly available. That process went too far, and I adequately explained how this occurred with excessive risk reduction instruments (CDC, et al) due to exotic financial innovations possible without proper regulation and Glass-Steagall. Still, I appreciate the dialog. Thanks for participating.

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