Neil Barofsky was until yesterday the special inspector general for TARP, President Bush and Treasury Secretary Paulson's $700 billion Troubled Asset Relief Program. Barofsky's comments about the overall efficacy of the bank rescue program before the House Oversight and Government Reform subcommittee were less than a ringing endorsement.
"TARP's most significant legacy may be the exacerbation of the problems posed by 'too big to fail,' particularly given the manner in which Treasury executed the bailout, largely sparing executives, shareholder, creditors and counterparties, reinforcing that not only would the government bail out the largest institutions, but would do so in a manner that would do little harm to the responsible stakeholders," Mr. Barofsky said.
Treasury's acting assistant secretary for financial stability, Timothy Massad, saw it differently.
"TARP was necessary to respond to the worst financial crisis we faced in decades," he said in his remarks. "Its most significant legacy is that it, combined with a variety of other government actions, helped save our economy from a catastrophic collapse and may have helped prevent a second Great Depression."
TARP was signed into law on October 3rd, 2008 after a calamitous month for financial institutions. In the preceding 30 days, the federal government had taken over Fannie Mae and Freddie Mac (Government Sponsored Entities/public companies), which between them owned or guaranteed $5 trillion worth of mortgages; allowed legendary investment bank, Lehman Brothers, to fail; bailed out AIG, the world's largest insurer, and counter-party on the short end of tens-of-billions of dollars worth of credit default swaps; engineered the sale of Merrill Lynch to Bank of America; engineered the takeover of Wachovia Bank by Wells Fargo; seized Washington Mutual, which was then sold to J.P. Morgan; guaranteed the $3.5 trillion of savings in the nation's money-market funds; converted investment banks Goldman Sachs and Morgan Stanley into bank holding companies; and more.
Secretary Paulson, Federal Reserve Board Chairman Ben Bernanke and President of the NY Federal Reserve Bank Tim Geithner conceived of the fund as way of getting ahead of the crisis instead of scrambling to keep up with it. The idea was to convince credit markets, which had frozen with fear, that the federal government would spend whatever it took ($700 billion) to protect creditors and financial companies. In selling the program to Congress, Secretary Paulson said that he needed the money to buy toxic assets from banks. Upon approval, he immediately changed direction and (forcibly) purchased bank shares in order to infuse financial institutions with capital. TARP money was used shortly thereafter to bail out automobile manufacturers General Motors and Chrysler. When all was said and done, the program likely cost taxpayers less than $19 billion.
Noman revisits this painful history merely to comment upon what he thinks the program's true legacy was: the election of Barack Obama and overwhelming Democratic majorities in both houses of Congress. It's historical significance was mostly political, and ironically worked wholly in the favor of the Democratic party, which had provoked the sub-prime crisis by insisting for decades that banks lower their lending standards. When Hank Paulson told the American people in late September 2008 that unless Congress appropriated close to a trillion dollars along with nearly unlimited authority to do whatever he wanted with it, the world's financial system would collapse, he sealed the nation's fate. The result has been a $1 trillion dollar slush fund for transfer payments to Democratic constituencies and blue states; ObamaCare; Dodd-Frank; an end to the institution of marriage as we've known it throughout human history; Cap-and-Trade via stealth regulation; a massive increase in estate tax rates; the erosion, if not demise, of American influence in world affairs; and more. Should liberals ever construct a pantheon in America for useful idiots who paved the way for government hegemony over the American spirit, the statues of Hank Paulson et al. should enjoy pride of place.
In her introduction, Gelinas compares the market failures of 2008 with those of the 1930's. Back then, Washington and the public understood that the calamity was "not a sudden outbreak of greed and immorality, but the systemic failure of financial capitalism to regulate itself." Finance, she believes, threatens the free market itself if left completely unrestrained. Prior to the Great Depression, financial firms lent freely to investors for the purpose of speculating in securities, thereby allowing short-term gyrations to distort the long term business of borrowing and lending. "Infusing credit creation with excessive speculation...made the entire economy vulnerable to a financial crisis." Since bankers had used the public's savings to engage in financial experimentation, they lost the trust of depositors, whose abandonment of neighborhood banks disintegrated the infrastructure of money and credit.
FDR and his policy wonks set about to protect financiers from themselves, and to protect the economy by "building the consistent rules that free financial markets need to function effectively and support a free economy." Among them were (1) mechanisms for bad banks to fail in an orderly fashion without imperiling the rest of the economy; (2) the Federal Deposit Insurance Corp (FDIC) to insure the public's deposits; (3) the separation of commercial from investment banking, which afforded deposit-taking banks some insulation from the gyrations of economic cycles; and (4) "clear, consistent limits on risk-taking in the securities business," such as limiting the percentage of a securities purchase that could be made on credit, and imposing an obligation to disclose information fully and fairly. "Taken together, these regulatory reforms enabled the financial and business worlds to continue to innovate and take risks..."
This regulatory structure, Gelinas believes, started to decay in the 1980's. First, the government bailed out Continental Illinois, a large commercial bank, in 1984. It was deemed "too big to fail." Consequently, all of its lenders, and big depositors--whose deposits far exceeded the FDIC's insurance limit--were made whole. The consequence was that "uninsured lenders to big banks no longer worried that they would lose their investment... As a result, financial innovations proceeded without the natural checks and balances of market forces." Banks, which had purposely been insulated from disorderly failure, were now inadvertently insulated from market discipline as well.
Secondly, the line drawn in the 1930's between the banking and securities industries was blurred by financial innovation, especially in the world of credit. Long term debt, such as the home mortgage, was converted into tradable securities (securitization), once again exposing the vital business of credit creation "to short-term gyrations between optimism and pessimism." Early warning signals regarding the conversion of long-term debt into tradable securities--such as the collapse of Drexel Burnham Lambert (junk bonds) and Askin Capital Management (mortgage backed secirities)--were dismissed as aberrations and addressed with one-off, extraordinary solutions.
Thirdly, derivatives were created to circumvent borrowing limits and disclosure requirements. The combination of "unbridled derivatives creation and speculation on long-term credit" nearly enabled Long Term Capital Management to take down the financial system in 1998, and resulted in Enron's demise in 2001.
For 25 years, "the financial world operated increasingly freely under a long-running illusion that elegant modern theories and technologies made the creation of nearly all manner of credit...perfectly safe." Suffering under this delusion, financiers created mountains of debt, and persuaded ordinary Americans to depend more on borrowing. This merely made them more vulnerable to a contraction in credit markets. Bankers thus created danger out of safety (rather than vice-versa), turning even people's homes into risky bets. Unsustainable price inflation came along with easy credit to buy homes. The illusion created conditions for a collapse.
Gelinas believes that because financial markets became too free, they destroyed themselves and damaged the economy. The government was obliged by the specter of cascading failures among financial firms, and the economic damage they would cause, to force taxpayers to effectively assume all of the risk in the financial system. The financial crisis was "the natural result of two and a half decades of decisions and non-decisions that made the financial regulatory system irrelevant." She believes that the same regulatory philosophy that saved us from the Great Depression will save us from the Great Recession. She counsels (1) that a suitable mechanism imposing losses on bondholders (lenders) as well as on stockholders be developed to permit financial firms to go out of business in an orderly fashion; (2) insulating "long-term borrowing and lending" from short-term excesses (presumably by reestablishing some separation between commercial and investment banking); (3) well-defined limits to borrowing for speculative purposes; and (4) extending the reach of disclosure requirements, to prevent financial markets from becoming too opaque.
Gelinas writes that "consistent, predictable regulation of financial firms and markets is prerequisite for a free-market economy, not a barrier to it." She believes that the government's new power over financial markets and credit extension--claimed by virtue of its extraordinary interventions during the crisis--poses a threat to the market economy. Financiers cannot correctly judge the risks and rewards of extending credit if they implicitly understand that the government will save them from their poor decisions. The distortion of market incentives, caused by a belief that the government will once again save the industry in the next crisis, harms "the private sector's free assumption of financial and economic risk." Moreover, "the global perception that investors in America can expect fair treatment according to a predictable and consistent rule of law" has been damaged. Arbitrary interventions such as those at General Motors and Chrysler, "upsetting precedents for treating creditors to bankrupt firms that date back centuries," fuel a perception that "personal contacts and political power matter more than laws and rules."
Ordinary citizens have consistently defended free enterprise and opposed bailouts. "Americans enjoy seeing success rewarded with great wealth--as long as they aren't forced to subsidize failure." What they want is for the financial system to manage the process of credit allocation, and for the government to rationally regulate financial markets. Unregulated financial capitalism caused the crisis, which could have been prevented.
Nicole Gelinas, a senior fellow at the Manhattan Institute and a contributing editor to City Journal, wrote "After the Fall" in 2009, which Noman proposes to review over the coming weeks. Though the Obama Administration hustled through financial reform (Dodd-Frank, 2010) while the citizenry was still panicked and pliable--indeed, before the release of its own Financial Crisis Inquiry Commission's findings (January, 2011)--Gelinas's prescriptions for reasonable regulation according to well-tested principles should provide a useful scale with which to measure Congress's actions.
Gelinas prefaces her book with a 1993 quote from Wendy Gramm, former Commodity Futures Trading Commission (CFTC) chairwoman: "The only reasons...why firms might underinvest to control risk are due to failures in government: Firms may believe that government will not let them fail under a Too Big to Fail Policy...or that the bankruptcy code may not impose sufficient penalties for failing." Gelinas believes that government worked to create the financial crisis of '08 and the resulting recession by granting "freedom from the fear of failure" to financial firms over a 25-year period, beginning with President Ronald Reagan. Because government adopted the view that some financial firms were "too big to fail," lenders to those firms no longer feared losing their investment. Consequently, their actions--i.e., the amounts they were willing to lend, and at what rate--ceased to transmit "vital signals about the prospects for success or failure."
Firms and bankers enjoying implicit government subsidization became reckless in their measurement of risk-taking, and in the creation of novel instruments that circumvented regulatory limits on borrowing and exposure, and sidestepped disclosure requirements. It was one thing to let finance evolve while saying that markets could regulate themselves better than government could. It was another to allow that same evolution to occur while short circuiting the ability of markets to perform their regulative function. Washington's too-big-to-fail policy prevented the market from reigning in speculative and evolutionary excesses.
Financial firms liberated from market discipline lent profligately to consumers, and lavishly rewarded executives and high performers, thereby draining talent from other industries. By 2007, the market had had enough, and in 2008 Washington was compelled to replace private risk takers in the economy with government capital in order to avert a depression precipitated by the freezing of money and credit markets.
It is the function of the financial system to determine which people and businesses should have access to capital, and on what terms. When lenders make mistakes by extending credit to failed institutions, they must take their losses. That is the market discipline that regulates financial activity, and sends clear signals.
Sowell’s book is a depressing reminder that secular, or religious crusades for social justice are a poor substitute for the Catholic notion of common good, which includes material goods along with those of a social, cultural and spiritual nature. His work highlights a paradox: that the market is ultimately a surer safeguard of the common good than government action predicated on the basis of a presumed solidarity with the oppressed, which pays no heed to proper limits. In Catholic Social Doctrine, the government's exercise of power to regulate and direct economic activity towards the common good must be tempered by the principle of subsidiarity, which requires that a body of higher order (e.g., Congress, HUD, Fannie Mae, The Department of Justice) must not arrogate to itself the function of a body of a lesser order (e.g., lenders, credit officers). Human initiative, ingenuity and creativity are thereby safeguarded by the limiting principle. They are perverted without it. In the run up to the financial crisis, the state mistook its principal role of governing economic and business arrangements to accord with the dictates of distributive justice by badly overstepping its bounds. Politicians and their appointees have no special expertise with respect to lending, or determining its appropriate criteria and conditions; they grossly overstepped their bounds by micromanaging and coercing lending decisions. The consequences were near financial ruin, and a radical adjustment in the relationship between government and business, even further away from the limiting dictates of subsidiarity.
Distributive justice is not served by crude government policies awarding benefits to one class of people at the expense of others merely by virtue of their not having the wherewithal to purchase a home on their own. While housing is a dire need that often is not endowed with purchasing power, and while efforts to help people find housing may be due simply by reason of human dignity, enabling people in need to purchase homes they cannot afford, and do not have the habits to take care of, does not help them make a contribution to the common good. All were disserved when they abandoned their homes in difficult circumstances, leaving others (e.g., taxpayers, lenders, investors) to bear the burden of government’s social experiment. No economic system, or society can work that way, as it will cease to produce the resources at the margin that politicians are so eager to redistribute according to their ideological lights.
Centesimus Annus, section 48 is an important text for consideration of these themes.
The State has the further right to intervene when particular monopolies create delays or obstacles to development. In addition to the tasks of harmonizing and guiding development, in exceptional circumstances the State can also exercise a substitute function, when social sectors or business systems are too weak or are just getting under way, and are not equal to the task at hand. Such supplementary interventions, which are justified by urgent reasons touching the common good, must be as brief as possible, so as to avoid removing permanently from society and business systems the functions which are properly theirs, and so as to avoid enlarging excessively the sphere of state intervention to the detriment of both economic and civil freedom.
FDR’s Fannie Mae is the first “supplementary intervention” that comes to Noman's mind. Created in the 1930s, it is still pursuing its “affordable housing” mission with noxious consequences. In the 1990s, the Clinton Administration seized upon contentious studies that supported what it already believed: that lending decisions were made on the basis of racism, not sound business reasons. It did not want to consider the possibility that, all things considered, Asian borrowers were simply better lending risks than white borrowers, who in turn were better risks than black and Hispanic borrowers. Nor did it care that vast majorities of all borrowers, across race, received loans. It acted in a heavy- handed and relatively permanent manner to appropriate functions that properly belonged to business. It enlarged the “sphere of state intervention to the detriment of both economic and civil freedom.” The results were the Great Recession, and the financial crisis.
Pope John Paul II continues:
However, excesses and abuses, especially in recent years, have provoked very harsh criticisms of the Welfare State, dubbed the "Social Assistance State." Malfunctions and defects in the Social Assistance State are the result of an inadequate understanding of the tasks proper to the State. Here again the principle of subsidiarity must be respected: a community of a higher order should not interfere in the internal life of a community of a lower order, depriving the latter of its functions, but rather should support it in case of need and help to coordinate its activity with the activities of the rest of society, always with a view to the common good.
The US government, especially when under the sway of the Democratic Party, manifests a similarly “inadequate understanding of the tasks proper to the State.” The principle of subsidiarity safeguards the existence of intermediate associations—societies intermediate to the individual and the state (e.g., corporations, banks)—permitting them to fulfill their mission and enjoy their proper sphere of autonomy. Unless the freedom of these intermediate associations is respected, the common good cannot be administered properly. Closer to home, the Obama Administration’s corporatist management of vast sectors of the American economy would seem to fail the test.
In section 13 of Centesimus Annus, John Paul II discusses intermediate associations, along with the human nature that gives them life and meaning:
[T]he social nature of man is not completely fulfilled in the State, but is realized in various intermediary groups, beginning with the family and including economic, social, political and cultural groups which stem from human nature itself and have their own autonomy, always with a view to the common good. This is what I have called the "subjectivity" of society, which, together with the subjectivity of the individual, was canceled out by "Real Socialism.”
Avoiding comparisons between contemporary American politics and “Real Socialism,” the point stands that government encroachments on the autonomy of economic, social and cultural groups (always with a view to the common good) disserves the person. Sowell’s analysis indicates that mistakes of a monumental nature were made, and continue to be made, and provides reasons for Catholics to do something about it. This gives a new twist to a venerable term: Catholic action.
Sowell returns to the imperfections of government in the final chapter, reminding us that while perfect regulation might have prevented the crisis, no such thing exists anymore than do perfect markets, perfect people or perfect decision-making. The problems that nearly torpedoed the global economy were caused in the first instance by borrowers mass failure to make mortgage payments, a failure made possible by GSE quotas for the purchase and promulgation of shaky loans, as well as more direct political pressure on lending institutions to make them. In short, the boom and bust were caused by governments' carrots and sticks. Government is not the public interest personified. Rather it is the political actions of elected officials, to whom Adam Smith referred as "that insidious and crafty animal, vulgarly called a statesman or politician, whose councils are directed by the momentary fluctuations of public affairs." Today's problems are the consequences of yesterday's quick-fix solutions to "perceived" problems. As stated previously, "[f]acts have no such coercive power in politics as they have in markets... [The ultimate reality for elected officials] is what most voters believe, or can be induced to believe." Where market survival often requires acknowledging mistakes and changing course, political survival too often requires "denying mistakes, continuing the current policies and blaming the bad consequences on others."
No policy goal is categorically good, including homeownership. In the real world, costs and risks always have to be considered before making such an assessment. "These costs and risks were ignored, downplayed or dismissed by politicians and social crusaders during the housing crusades that led to the boom and bust." Politicians created a problem that didn't exist--unaffordable housing--outside of a few areas where people had to pay half their income to buy a modest home, and resort to exotic mortgages in order to do so. In the 1990s, when the political crusade took off, Americans on average were spending just 17% of their incomes on housing. The number was 30% in the early 1980s, and still only 22% in 2005. Yet, "[f]ew things blind human beings to the actual consequences of what they are doing like a heady feeling of self-reighteousness during a crusade to smite the wicked and rescue the downtrodden." The presumed boogie man here was racial discrimination in lending--as if to say that "greedy bankers" were somehow not willing to make a profit off minority borrowers without government suasion. When the floodgates to reform are opened, however, it's no longer possible to control where the water will flow. In this case, the unintended consequence was a housing market collapse. And while the creative financing and lax lending standards that fueled the crusade have stopped, "even the ensuing national crisis did nothing to end the political attractiveness of the goal of making housing affordable by government fiat, rather than by individuals buying or renting housing that was within their own income range."
The national retrogression to a "New Deal ideal," and the resuscitation of Keynesian nostrums are hardly harbingers of recovery and progress. "This is equivalent to what FDR had to do...to save capitalism from its own excesses," crowed Barney Frank, a key architect of the ruin. Sowell reminds us that unemployment exceded 20% for the first 21 months of Roosevelt's administration, and it never fell below double digits for his first seven years. The government created vast numbers of new jobs, but at the expense of taking money from the private sector and creating less demand and less employment there. The market had been trusted to end prior recessions and depressions, none of which proved to be as persistent, deep and long-lived as FDR's great depression. The New Deal did "create a large class of people beholden to government," however, and the political--as opposed to economic--success of the New Deal is indisputable.
Two months after the October 1929 crash--the event regarded as the depression's catalyst--unemployment peaked at 9%, but subsided over the ensuing months to 6.3% by June 1930. In June of that year (under President Hoover), Congress passed protectionist legislation in order to foment employment, the Smoot-Hawley tarrifs. By November of that year, one year after the crash, unemployment reached double digits for the first time at 11.6%, and didn't see single digits for the remainder of the decade. Smoot-Hawley was followed by FDR's legislative onslaught: The National Industrial Recovery Act of 1933 (wage and price controls); The Agricultural Adjustment Act of 1933 (price and output controls); The National Labor Relations Act of 1935 (union enshrinement). The point of the exercise was to create enduring institutions that would transcend current economic conditions to fundamentally transform the way the American economy operated. "Thus we are, in the twenty-first century, paying agricultural subsidies to millionaires and billionaires because of a program created during the Great Depression to help small farmer who were having a hard time. Again, once you have opened the floodgates you cannot tell the water where to go." Uncertainty regarding the actions of government deterred business investment, and wound up prolonging the depression by several years. It didn't end until "Dr. New Deal" was replaced by "Dr. Win-the -War" (in Roosevelt's own words), twelve million men were taken out of the work force to serve in the military, and cost-plus government contracts guaranteeing a profit were given to producers of war materials. It was not ended by deficit spending in 1940 as many claim. Unemployment at the time was 14.6%. But, the deficit was higher in 1936, as was unemployment with the rate at 17%. Were deficit spending the key to recovery, the economy would have recovered in 1936, not 1940.
Several lessons can be learned from that epoch. The first is that "massive and unpredictable government interventions in the economy create uncertainties... [In such environments] people tend to hold on to their money. The velocity of circulation of money slowed down during the Great Depression, just as it has today." It is instructive that President Ronald Reagan did not intervene in 1987 when the stock market crashed in spectacular fashion similar to the way it did in 1929. His inaction proved to be the wiser course, and ironically accorded with a reference of Karl Marx's to "crackbrained meddling by the authorities" that can "aggravate an existing crisis." But, success is ultimately measured by purpose. According to journalist Walter Lippmann's contemporaneous accounts, the New Dealers would "rather not have recovery if the revival of private initiative means a resumption of private control in the management of corporate business... [T]he essence of the New Deal is the reduction of private corporate control by collective bargaining and labor legislation, on the one side, and by restrictive, competitive and deterrent government action on the other side." Measured by its true purpose, rather than by economic recovery, the New Deal was a rousing success. Many of the New Dealers advocated the same policies long before the Great Depression, which proved to be a convenient excuse for enacting their program rather than a cause of doing so. "The New Deal succeeded in using a transient crisis to create enduring institutions, including among others the Federal National Mortgage Association or 'Fannie Mae,' which FDR created in 1938, and which has been at the heart of the housing boom and bust that led to today's financial crises."
Sowell sees the same dynamic at work in the Obama Administration, which within a month of taking office passed a thousand-page spending bill involving hundreds of billions of dollars in just two days, even though the bulk of the money wouldn't be released until just before the 2010 elections. "If the purpose was to get the current economic crisis behind us, then the slow-moving policies passed in haste make no sense. But if the purpose is to use the current crisis to create enduring changes in the institutions of the American economy and society, then the haste makes perfect sense... what matters is how fast the law gets passed, while the public is panicked, and before any opposition can get organized." He cites then chief-of-staff, Rahm Emanuel, who said that "you never want a serious crisis to go to waste... it's an opportunity to do things you could not do before." Americans may as well wake up to the fact that the crisis caused by big-government politicians was used by the same big-government politicians to fundamentally and enduringly change the institutions of American society. "To those who are eager for an expansion of government, the market has always failed." Yet, the notion that politicians will consider a crisis to have gone to waste unless used successfully for partisan purposes, while the people are too panicked to resist, should give them pause, if not raise red flags for them.
Sowell ends by concluding that "Despite differences of personalities and of the times, the underlying vision of the New Deal and that the current administration are fundamentally similar... What the government buys with the enormous sums of money it dispenses is the power to give orders to the recipients that the Constitution never authorized them to give. Politicians are, in effect, buying up our freedom with our own tax money." Noman says that is a powerful money line, and thinks its a pity that it rings so true. Adding insult to injury, the cause of our crisis--big government politicians tinkering with business decisions--successfully posed as its cure; the people and party most responsible for the mess were put in charge of cleaning it up. And, that they have, throwing the baby out with the bathwater.
The assumptions and beliefs, in short the vision, that drives housing policy have weathered the crisis unscathed. One aspect of the prevailing vision is that "unaffordable housing prices are produced by the free market and that making housing affordable requires government intervention." This belief has withstood countless failed experiments with government housing projects, and the like. "Even after many public housing projects had become such social disaster areas that they have been demolished with explosives, what was not demolished were the assumptions that had led to such hugely costly failures in the first place. When that particular way of trying to change people's behavior by moving them into better housing failed, it simply led to other ways of attempting to do the same thing..." Politically, the beauty of a vision is that its power doesn't reside in hard evidence, empirical verification or logical analysis. Neither does it need these things to survive. Rhetoric will suffice.
Current "affordable housing" rhetoric rests on "a widespread belief that lenders' existing standards and practices discriminated against non-white applicants," systemically if not intentionally. A 1991 Federal Reserve System study provided the spark for a nationwide outcry against lending discrimination. What fiery denunciations declined to mention, however, was that the vast majority of applicants of any race were approved. Also omitted in media accounts was that the same data indicated preference to Asian borrowers over whites. There was, however, no corresponding outcry against Asian racism in lending practices. Moreover, the study simply compared income figures with approval rates. It did not consider the myriad other factors upon which loans are granted, e.g., "the proportion of the consumer's income that will need to be dedicated to the repayment of the proposed loan plus other outstanding debts, the level of equity (through the down payment) that the consumer is able and willing to put into the property, the consumer's employment experience and prospects, and the consumer's history of repaying debts." Wealth and net worth are also factors. Thus, the data did not support the conclusions drawn. Consider also that if 98% of one group had their mortgages approved, while another had 99% approved, it would be true that group-one applicants were rejected at twice the rate of group-two applicants. It would also be irrelevant, and deeply misleading to present the data straight up.
The legal case against "lending discrimination" was easy to make--and groups like ACORN lived by making it--because the mere existence of statistical disparities sufficed for plaintiffs to establish their prima facie case, with the burden of proof shifting onto the accused. Defending oneself from such a charge can be very expensive in terms of dollar cost and negative publicity. Moreover, banks are heavily regulated and must get approval from regulatory agencies in order to make business decisions such as merging, acquiring another company, or expanding. Government has many levers over financial institutions, and used them heavily in the 1990s.
The rhetoric of housing always favors proponents of "open space" and "smart growth" laws that promise to "protect the environment" or "preserve farmland." Yet, despite the universal economic problem of allocating scarce resources among alternative uses, the fundamental question of "why the government should intervene to direct those resources to one citizen rather than another" is never asked. Besides driving prices higher, land use restrictions also have the practical affect of keeping neighborhoods segregated by income, and race. "Upscale communities ... that keep moderate-income or low-income people from moving in, by such things as requiring several acres of land per house, would never gain public support by saying that they want to keep out the masses to protect the elite."
Sowell ends the chapter with a contrast between "the market" and "social programs." The term "market" connotes the impression of an impersonal mechanism, but actually denotes "many people competing with one another, and making voluntary transactions with each other, on such terms as are mutually agreeable." It is social programs that eliminate the aspect of voluntariness, and require "following government orders." The virtue of economic decisions is that costs in the real world must always be considered. Not so of political decisions, which often ignore such costs and consequently shift them onto others than those who advocate particular policies. One such cost: "smart growth" policies, which one study indicated added costs of $100,000 per home in 50 metropolitan areas. In a community of only 10,000 families, such policies impose $1 billion worth of extra housing cost.
Despite fierce propaganda to the contrary, including the recently released final report of the Financial Crisis Inquiry Commission (which covers up the role of CRA, government agencies and GSEs in the crisis), government regulation and oversight caused lax lending standards in the financial industry. That was the foundation of the house of cards that collapsed in Septermber 2008. As Sowell puts it, "The spread of financial disaster from local housing markets to national and international financial markets was much like a heavy rainfall in the mountains, filling a thousand little creeks and streams that empty into a big river, ultimately flooding people living far downstream from the source of the water. Perhaps better levees might have saved the people downstream. But that does not change the fact that the flood originated in heavy rainfalls in the mountains. In the case of the housing market collapse, much has been made of the claim that there was inadequate regulatory agency oversight of the financial markets that turned home mortgages into esoteric Wall Street securities which added to the risk. But these securities would have remained secure if people had continued to make their monthly mortgage payments. It was ultimately the skyrocketing rates of mortgage delinquencies and defaults that were like the heavy rain the mountains that caused the flooding downstream... 'From the current handwringing, you'd think that the banks came up with the idea of looser underwriting standards on their own, with regulators just asleep on the job.'"
The collapse was triggered by Fed Chairman Bernanke's decision to raise rates from 1% in 2004 to 5.25% in 2006. Too many creative mortgages with rate resets, taken out by too many sub-prime borrowers, resulted in too many defaults with resulting harm to financial securities built from the faulty mortgages. The markets hardest hit were those with stringent land use restrictions, where prices had run up the highest, and borrowers stretched the furthest in order to get into homes. Holman Jenkins of the Wall Street Journal drew attention to the fact that much of the subprime crisis originated in particular counties of just four states. CRA mortgages were especially hard hit. For instance, only 7% of Bank of America's loans had been made under Community Reinvestment criteria, while 29% of its mortgage losses came from that group. In sum, as home prices fell, incentives to sub-prime and prime borrowers alike increased to default on mortgages; financial institutions' assets fell correspondingly; securities built on defaulting mortgages plummeted in value; rates of delinquency and default skyrocketed feeding the vicious cycle anew; panic set in.
Ironically, given the blame that the free market took for the debacle, the market was quick to learn from its mistakes, and adjust. Buyers learned to stay within their means; down payments once again rose; the percentage of innovative mortgages taken out plummeted; the use of second mortgages to enter homes dropped significantly. Yet, the political response was to look for scapegoats especially on Wall Street, to hunker down, and to brazen out mistakes without admitting to them. In other words, politicians learned nothing, and they've given us more of the same. Chris Dodd blamed George Bush and Alan Greenspan, and dug in to defend Fannie Mae and Freddie Mac for continuing to flow credit into markets keeping housing "affordable." Sowell observes, "That private financial institutions, which were risking their own money, were reluctant to continue [lending], while government-sponsored enterprises that could pass their risks on to the taxpayers were still going full steam ahead was not ... a reason for congratulating them for getting in deeper... Yet Senator Dodd acted as if those who had issued the warnings he had consistently rejected were now discredited by the continued risky lending of Fannie Mae and Freddie Mac." As late as July of 2008, he protested that Fannie and Freddie were fundamentally strong, and that it was not a good time to panick about their leverage and massive holdings of bankrupt mortgages. Barney Frank blamed "a conservative philosophy that says markets know best," and proclaimed that "the subprime crisis demonstrates the serious negative economic and social consequences that result from too little regulation." Both joined forces to bailout home purchasers and to prevent housing prices from falling, which would have had the effect of making housing affordable, their alleged aim. Neither asked the question of why it was morally superior, or economically more sensible, to spare decision-makers the consequences of their risky or simply poor decisions, and to foist the cost of those decisions onto the backs of others who didn't make the same mistakes.
Sowell puts the trillions of dollars expended in order to bailout and stimulate sectors of the economy in perspective. "A trillion seconds ago, no one on this planet coud read or write. The ancient Chinese dynasties and the Roman Empire had not yet come into being. None of the founders of christianity, Judaism or Islam had yet been born." He is critical of President Obama's stimulus plan which was passed with great urgency in two days, though its release of a funds was not to occur for nearly two years. The government's ad hoc responses to the crisis served merely to create uncertainty, and thereby stunt the economy's natural responses.
One curiosity of the housing boom and bust is the acquiescence of bank and lending regulators to the relaxation of bank lending standards, which led to the fateful explosion in, and of, sub-prime lending. The rather shocking, but not surprising, aspect of this fateful relaxation is that "government officials were in fact the driving force behind the loosening of mortgage loan requirements." In 1999, for instance, Fannie Mae eased the credit requirements on loans it purchased from banks and other lenders. Fannie Mae's business was to (1) borrow money cheaply in the capital markets, (2) use it to purchase mortgages from lending institutions (thereby replenishing those institutions' supply of money to lend), (3) packaging the loans into securities, and (4) selling the securities back to financial institutions and other investors (many abroad) with a quasi-governmental guarantee. Thus, by widening the quality range of mortgages it would buy, Fannie was putting money into the hands of lenders specifically for the purpose of making loans to borrowers of dubious creditworthiness. Fannie and Freddie's activity did not pose a significant financial risk until they started trafficking in low quality loans. By entering that market, it made trillions of dollars available for loans to "underserved" (risky) segments of the population. This was precisely the object of government intervention.
The goal was to increase the supply of "affordable housing,"which in political speak meant to encourage low-income, often minority individuals to choose their housing, and the government would make it possible for them to have it. As stated in a previous post, except in the metropolitan and coastal areas where land use restrictions drove up the cost of real estate, there was no generalized affordable housing problem in the US. (Consider that the median price of a US home is 3.6 times the median income of a US worker. In Great Britain, the number is 5.5 times; in Australia and New Zealand it is 6.3 times.) Yet, the federal government acted over the years to change the process of private mortgage lending, first in 1977 with the Community Reinvestment Act (CRA). The Clinton administration seized the initiative when in the 1990's, studies showed different loan approval rates for blacks and whites (despite the fact that substantial majorities of both groups' applicants were approved by lenders). It pushed for quotas in home lending by having Attorney General Janet Reno threaten legal action on the basis of racial statistics, and by establishing "objective criteria" by which banks would indicate their compliance with CRA. The failure to show a requisite number of loans to low and moderate income (LMI) borrowers would result in banks being prevented from enjoying the benefits of, say, diversification under 1999's Graham-Leach-Bliley Act, which liberalized activity within the financial sector. New regulations in 1995 "required the use of 'innovative or flexible' lending practices to address credit needs of LMI borrowers and neighborhoods."
In 1993, HUD "began bringing legal actions against mortgage bankers that declined a higher percentage of minority applicants than white applicants. It also pressured Fannie Mae and Freddie Mac to increase their purchases of mortgages made to LMI borrowers. By 1996, HUD had set a target of 42% of such mortgages to be purchased by the GSEs. In a different forum, regulators engaged in concerted actions with community activists on the streets such as ACORN, which stepped up pressure on banks to lower lending standards, using the threat of regulatory denials to merger or expansion plans. These, and other tactics engaged in by governmental agencies and politicians had the desired affect of lowering lending standards, relaxing or eliminating down payment requirements, and otherwise debasing bank qualification standards. "Under political pressures, traditional mortgage loans with traditional safeguards began to decline and mortgage loans made under the 'innovative' and 'flexible' standards urged by government increased." The traditional 30-year fixed rate mortgage declined from 57% of all mortgages in 2001 to 33% by the end of 2006. Subprime loans rose from 7% to 19% over the same period of time. Between 2005 and 2007, the GSEs acquired $1 trillion of subprime and other non-traditional mortgages, or 40% of the value of their total purchases. The total of their mortgage guarantees at the time surpassed the GDP all but four nations. And, the increasing riskiness of their assets posed an immediate threat to taxpayers who were oblivious to the danger posed by the "good intentions" of public officials and government agents.
Warnings were sounded from such diverse quarters as The Economist (2003 and 2005), US Treasury Secretary John W. Snow (2003), Fortune magazine (2004), Josh Rosner, an analyst at Medley Global Advisors in New York (2004), Peter J. Wallison, a resident scholar at the American Enterprise Institute (2005), Barron's magazine (2005) and Federal Reserve Governor Alan Greenspan (2005 and 2007). They were met with ferocious opposition by Congressman Barney Frank, who in 2003 said, inter alia, "I want to roll the dice a little bit more in this situation towards subsidized housing." He was seconded by Chairman Christopher Dodd of the Senate Banking Committee, who in 2004 called the GSEs "one of the great success stories of all time." Congresswoman Maxine Waters said in 2003 that "we do not have a crisis at Freddie Mac, and in particular at Fannie Mae, under the outstanding leadership of Mr. Frank Raines" (who later resigned under the weight of an accounting scandal). Congressman Joe Baca cautioned that "a long protracted debate on regulation" might cause "instability of the markets."
In response to President Bush's 2004 expressed concerns with GSE safety, seventy-six Democrats--including Nancy Pelosi, Barney Frank, Maxine Waters and Charles Rangel--in the House of Representatives wrote a letter admonishing the President that "an exclusive focus on safety and soundness is likely to come, in practice, at the expense of affordable housing." The GSEs were able to funnel their windfall profits into campaign contributions sufficient to co-opt politicians on both sides of the isle, the very politicians who were supposed to control them. In the words of Gerald P. O'Driscoll, a scholar in residence at the Cato Institute: "At heart, Fannie and Freddie had become classic examples of 'crony capitalism.' The 'cronies' were businessmen and politicians working together to line each other's pockets while claiming to serve the public good."
The GSEs were taken into government conservatorship in September of 2008. The total cost to taxpayers is expected to reach $400 billion. Noman says that was certainly one expensive dice roll. Personally, he'll never gamble again by voting for a Democrat.
