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Source of the Financial Crisis: Government Interference on Behalf of Community Organizers (Update)

John on September 22, 2008 at 1:13 am

Tonight I watched the 60 Minutes interview with Barack Obama. When asked about the financial crisis, he argued that the core of the problem was deregulation. This argument has political advantages for Obama, since he can tie John McCain to Phil Gramm, architect of deregulation.

The ideological and competitive opponents of Fannie Mae are repudiated on every issue. – Barney Frank, 2004But deregulation isn’t the problem. Just to get us started, Megan McArdle at The Atlantic calls the suggestion “bizarre” and labels those who wield it (like NY Times financial guru Paul Krugman) “moronic.”

Also taking a crack at Krugman, Yaron Brook has this to say in Forbes:

For too long, the refrain has gone, Congress and the administration have been asleep at the wheel when they should have been steering the economy by expanding government control over the housing and financial markets. Economist Paul Krugman slams the administration’s “free-market ideology”; he urges Bush to “reverse course now” and “seek expanded regulation.”

All this overlooks a crucial fact: There has been no free market in housing or finance. Government has long exercised massive control over the housing and financial markets–including its creation of Fannie Mae and Freddie Mac (which have now amassed $5 trillion in liabilities)–leading to many of the problems being blamed on the free market today.

Consider the low lending standards that were a significant component of the mortgage crisis. Lenders made millions of loans to borrowers who, under normal market conditions, weren’t able to pay them off. These decisions have cost lenders, especially leading financial institutions, tens of billions of dollars.

It is popular to take low lending standards as proof that the free market has failed, that the system that is supposed to reward productive behavior and punish unproductive behavior has failed to do so. Yet this claim ignores that for years irrational lending standards have been forced on lenders by the federal Community Reinvestment Act (CRA) and rewarded (at taxpayers’ expense) by multiple government bodies.

At some point it’s better we don’t mess with this than do a bad job. – Paul Kanjorski (D), 2003The CRA was a Carter-era law which resulted from a grassroots campaign by community organizing groups including ACORN. An earlier law (the Fair Housing Act) passed in 1968 had made it a crime to discriminate in lending on the basis of race, religion, etc. The CRA took things a step further, mandating that banks offering loans distribute the money to “under-served” communities. Continuing with the Forbes piece:

Under the CRA, banks must convince a set of bureaucracies that they are not engaging in discrimination, a charge that the act encourages any CRA-recognized community group to bring forward. Otherwise, any merger or expansion the banks attempt will likely be denied. But what counts as discrimination?

According to one enforcement agency, “discrimination exists when a lender’s underwriting policies contain arbitrary or outdated criteria that effectively disqualify many urban or lower-income minority applicants.” Note that these “arbitrary or outdated criteria” include most of the essentials of responsible lending: income level, income verification, credit history and savings history–the very factors lenders are now being criticized for ignoring.

The government has promoted bad loans not just through the stick of the CRA but through the carrot of Fannie Mae and Freddie Mac, which purchase, securitize and guarantee loans made by lenders and whose debt is itself implicitly guaranteed by the federal government. This setup created an easy, artificial profit opportunity for lenders to wrap up bundles of subprime loans and sell them to a government-backed buyer whose primary mandate was to “promote homeownership,” not to apply sound lending standards.

These two entities — Fannie Mae and Freddie Mac — are not facing any kind of financial crisis. – Barney FrankAware that this was not a good situation, President Bush recommended changes in oversight in 2003. The NY Times reported on the proposal, calling it “the most significant regulatory overhaul in the housing finance industry since the savings and loan crisis a decade ago.” The Times’ story also quoted Republican congressman Richard Baker noting that lobbying is part of the problem, “The regulator has not only been outmanned, it has been outlobbied.” The story ends with quotes of opposition:

”These two entities — Fannie Mae and Freddie Mac — are not facing any kind of financial crisis,” said Representative Barney Frank of Massachusetts, the ranking Democrat on the Financial Services Committee. ”The more people exaggerate these problems, the more pressure there is on these companies, the less we will see in terms of affordable housing.”

Representative Melvin L. Watt, Democrat of North Carolina, agreed.

”I don’t see much other than a shell game going on here, moving something from one agency to another and in the process weakening the bargaining power of poorer families and their ability to get affordable housing,” Mr. Watt said.

Barney Frank helped kill the reform in question by pushing for a new element to the legislation, giving HUD (Housing and Urban Development) control over Fannie and Freddie’s business practices (no doubt in line with the CRA). This story from October 2003 has an eerie ring in light of current events:

Two key Democrats, Reps. Barney Frank of Massachusetts and Paul E. Kanjorski of Pennsylvania, said they will oppose any attempt to make the regulator less independent from Treasury or to move business oversight out of HUD. Kanjorski said he was surprised by the White House position, given that the bill as it stands has wide bipartisan support on the committee.

“At some point it’s better we don’t mess with this than do a bad job,” Kanjorski said.

Freddie and Fannie also put several million dollars into defeating the new legislation:

During the first half of this year [2003], Fannie spent $3.8 million lobbying Congress, and Freddie spent $5.9 million, according to reports the companies filed with Congress… As a House committee was preparing to draft a bill last month that would change how Fannie and Freddie are regulated, Fannie asked mortgage lenders that do business with it to write to a key member of Congress, and provided “talking points” as guidance.

Rep. Chris Shays (R) was angry about how the reform initiative was handled:

“They have all these advantages, yet they have the chutzpah to dictate what laws they will comply with, and they continue to tell Congress and the White House what type of regulation is acceptable to them,” Rep. Christopher Shays (R-Conn.) said in a recent letter to Oxley.

“They publicly praised the regulatory proposals made this fall by the Administration and the House Financial Services Committee, and then proceeded to kill them behind closed doors,” Shays wrote.

In 2004, the pattern of Republicans offering initiatives aimed at reform but failing to get them passed along largely party line votes continued:

The House rejected an amendment proposed by Representative Ed Royce of California, a Republican, that would have given the regulator authority to pare the companies’ mortgage portfolios in order to curtail “systemic risk to the housing or capital markets or the financial system.”

Barney Frank crowed about it at the time, saying “The ideological and competitive opponents of Fannie Mae are repudiated on every issue.” Predictably, once the Democrats took control of Congress in 2006, all bets were off:

Representative Barney Frank, a Newton Democrat set to become the chairman of the House Financial Services Committee in January, said he will aggressively push legislation to ease current restrictions on the amount of a mortgage that can be held by Fannie Mae and Freddie Mac, two private mortgage companies chartered by the federal government.

Current law sets a limit — currently at $417,000 — on the maximum amount of a housing loan held by Fannie Mae and Freddie Mac. But because home prices in Massachusetts are comparatively high, relatively few buyers can benefit from the programs, housing advocates said.

This is why the Wall Street Journal has taken to referring to the Fannie/Freddie failures as Barney’s Rubble:

For years, Mr. Frank and other friends of Fan and Fred opposed not only bills written to limit the size of their portfolios, but any bill that in their view gave an independent regulator too much discretion to order a reduction. This was true of the reform that his House committee passed last year. Only when the White House caved to Mr. Frank and dropped its earlier insistence that a reform bill rein in the portfolios did Mr. Frank move his bill.

If you go back and read some of the stories from 2003 and 2004 it’s clear that President Bush and Republicans in the house and Senate were cognizant of the danger ahead and trying to do something about it. To blame them now that the crisis is at hand is, as Megan McArdle said, bizarre.

Barack Obama’s claims that deregulation is the source of the problem needs to be viewed as the political CYA maneuver it clearly is. This financial crisis began with well-intentioned community organizers who pushed government backed lenders to make risky loans. All of this was supported by well-intentioned Democrats in Congress (who also happened to receive significant sums from lobbyists wanting them to kill legislation aimed at oversight). None of this absolves the individuals who took loans they couldn’t afford, but it should settle which side of the aisle was pro-reform and which was blocking it.

Finally, it’s worth pointing out that John McCain was one of the Republicans who foresaw the problem and, back in 2006, supported legislation to do something about it before it reached this point.

Update 10AM: I just saw Barack Obama speaking in Green Bay, WI. He said that “they let the market run wild” and went on to add that “we can’t afford eight more years of no oversight.” Both statements are true. What Barack didn’t say is who “they” are. They are Democrats in the White House including Jimmy Carter and Bill Clinton who pushed the CRA as well as their counterparts in Congress like Barney Frank who blocked proposed reforms by President Bush and Congressional Republicans. It’s true we can’t afford eight more years of this, but electing Democrats to police themselves doesn’t strike me as a great solution.

[End Update]

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