IBD Has No Clue about the Origins of the Financial Crisis
November 14, 2008
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I originally posted this as a comment to Turtleread's recent blog post on the Obama Recession/Depression.
Alwaysgolong tried to pin the blame for the current crisis and referenced this IBD editorial. IBD basically follows the Republican logic that the current crisis is the fault of Fannie/Freddie and poor people. It tries to pin the blame on Carter and Clinton due to the Community Reinvestment Act, which required lending institutions to loan money to low-income families to buy houses.
It's a nice story from the Republicans, but it doesn't hold any water.
First, it says that Bush and McCain separately tried to regulate Fannie and Freddie in 2003 and 2005, but were blocked by Congress, especially the Democrats. Ummm, hello IBD, but Congress was controlled by the Republicans in 2003 and 2005 so the Republicans could have passed any reform they wanted. (I'm not saying that the reforms were not proposed, but that you cannot blame blockage on Democrats who were in the minority.)
Second, in 2003 and as late as 2005, the majority of subprime mortgage backed securities were being purchased by Wall Street investment banks. Fannie and Freddie accounted for less than half the market.
Third, the IBD implies that the growth in the sub-prime category was a smooth ride from 1994 to 2008. Not so, check out this graph from that leftist rag the Wall Street Journal. Sub-prime lending exploded off the charts in 2003.
Perhaps most importantly, the financial crisis is not the result of sub-prime lending. It is a result of the bundling of mortgage backed securities (MBS) and credit default swaps (CDS). A credit default swap is an insurance policy against default on the MBS.
Banks all over the world are regulated to have a limit on the amount of leverage they can have on their balance sheets. So, if a bank has $1 million in deposits, they can buy say $10 million in MBS. Now, with a CDS, the MBS is "insured" and is no longer represented as leverage, so the banks went out and bought $30 million or $40 million or $50 million of MBS for every $1 million in deposits. Way, way beyond normal leverage limits.
The problem occurred because the default rates on the loans were far greater than the insurance companies (AIG) had factored into the price of the CDS. They modeled the CDS prices on typical insurance like auto or fire policies. The difference is that with auto insurance, if I crash, it doesn't make it more likely for my neighbors to crash. Or, if my house burns down, it is not more likely for everyone else's house to burn down. With mortgages, if prices go down, it is more likely that everyone defaults.
Second, default rates have been higher than normal across the spectrum of loan categories, not just subprime. Subprime just means that the person has a bad credit score. Stupid lending, however, was not limited to subprime. Lendors totally dropped their standards in the past 8 years, stopped verifying income, stopped requiring down payments, offered interest-only loans, ARMS, option ARMS, and all kinds of other garbage to anyone with a pulse.
What made all this possible? I'll tell you right now, it had nothing to do with the Community Redevopment Act and very little to do with Fannie and Freddie.
In 1998, the Gramm Leach Bliley Act was passed, allowing the merger of investment banking, commercial banking, and insurance companies. This set the stage for overleveraging as the new entities did not have to follow the same banking regulations as your old-fashioned credit unions.
Second, there was clearly a change in lending standards around 2003 which allowed the explosion in subprime lending and other insane lending practices in all credit categories noted above. TV ads for immediate loan approval with no income verification and such... This was not just for sub-prime; this was Main Street.
Which leads us to Bush and the Republicans, "fundamentally deregulators" like John McCain. Banks were taking huge risks, lending was completely out of control, and housing price appreciation was clearly unsustainable, yet they did nothing to address the issue.
I'll be fair, I'm not sure a Democratic administration would have stopped the toga party either. However, they were in the minority until January 2007, by then, the party was ending, the punch bowl was nearly empty, prices were falling, and the defaults were starting to roll in.
Yet, here we are, the economy is being dragged down because banks have balance sheets loaded with bad debt, the CDS they thought would cover defaults is unable to cover the current default rate. Meanwhile, consumers also fed on the orgy of easy credit, leveraged themselves to the hilt, borrowed against their homes, saved nothing, and ran up credit card debt.
The only way out is for everyone to get their finances back in order so that when people start buying again, they are doing it with real money. It's going to be a while, folks.
Welcome to the American Lost Decade.
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