Tuesday, September 30, 2008

Let He Who Is Without Sin . . .

Many today, including Senator Obama, reflexively opine that Republican "shredding" of regulations enabled the unsupervised greed that caused the current financial crisis. Perhaps the opposite is true--namely, that the political objectives of Democratic leaders incentivized lenders to make loans that they otherwise would not have made as rational profit maximizers. For years, influential Democrats, including and especially Christopher Dodd (D-CT), Chairman of the Senate Banking, Housing, and Urban Affairs Committee, encouraged sub-prime lending to promote the social and political goal of broadening access to affordable housing, and, in particular, encouraged Freddie and Fannie to incentivize private lenders to make loans that they would never have made but for artificial protections (i.e., insurance) against undue financial risk. Thomas Sowell explains:

Among the Congressional "leaders" invited to the White House to devise a bailout "solution" are the very people who have for years created the risks that have now come home to roost.

Five years ago, Barney Frank vouched for the "soundness" of Fannie Mae and Freddie Mac, and said "I do not see" any "possibility of serious financial losses to the treasury."

[No "possibility?"  He was surely being hyperbolic.  Ed.]

Moreover, he said that the federal government has "probably done too little rather than too much to push them to meet the goals of affordable housing."

Earlier this year, Senator Christopher Dodd praised Fannie Mae and Freddie Mac for "riding to the rescue" when other financial institutions were cutting back on mortgage loans. He too said that they "need to do more" to help subprime borrowers get better loans.

In other words, Congressman Frank and Senator Dodd wanted the government to push financial institutions to lend to people they would not lend to otherwise, because of the risk of default.

*   *   *

[T]he magic words "affordable housing" and the ugly word "redlining" led to politicians directing where loans and investments should go, with such things as the Community Reinvestment Act and various other coercions and threats.

The roots of this problem go back many years, but since the crisis to which all this led happened on George W. Bush's watch, that is enough for those who think in terms of talking points, without wanting to be confused by the facts.

In reality, President Bush tried unsuccessfully, years ago, to get Congress to create some regulatory agency to oversee Fannie Mae and Freddie Mac.

N. Gregory Mankiw, his Chairman of the Council of Economic Advisers, warned in February 2004 that expecting a government bailout if things go wrong "creates an incentive for a company to take on risk and enjoy the associated increase in return."

Since risky investments usually pay more than safer investments, the incentive is for a government-supported enterprise to take bigger risks, since they get more profit if the risks pay off and the taxpayers get stuck with the losses if not.

The government does not guarantee Fannie Mae or Freddie Mac, but the widespread assumption has been that the government would step in with a bailout to prevent chaos in financial markets.

Alan Greenspan, then head of the Federal Reserve System, made the same point in testifying before Congress in February 2004. He said: "The Federal Reserve is concerned" that Fannie Mae and Freddie Mac were using this implicit reliance on a government bailout in a crisis to take more risks, in order to "multiply the profitability of subsidized debt."

Chairman Greenspan added his voice to those urging Congress to create a "regulator with authority on a par with that of banking regulators" to reduce the riskiness of Fannie Mae and Freddie Mac, a riskiness ultimately borne by the taxpayers.

Fannie Mae and Freddie Mac do not deserve to be bailed out, but neither do workers, families and businesses deserve to be put through the economic wringer by a collapse of credit markets, such as occurred during the Great Depression of the 1930s.

Neither do the voters deserve to be deceived on the eve of an election by the notion that this is a failure of free markets that should be replaced by political micro-managing.

If Fannie Mae and Freddie Mac were free market institutions they could not have gotten away with their risky financial practices because no one would have bought their securities without the implicit assumption that the politicians would bail them out.


  1. Didn't you want the blog to become less partisan? I have been taking the time to squelch my instincts and put together more careful pieces. In part, to entice you back. I listened to what you were saying, and I thought a more even handed environment may lead to a better blog. And then you come back with this broadside? Com'mon Pericles, let's make an effort here to put out the best blog possible. The most thoughtful, careful, and insightful ideas we can muster.

  2. This is not partisan, much less imprecise. It is a fact that seems too often ignored, an thus needs to be considered. There is a dogma that deregulation was the sole cause. It is important to note that other pressures were brought to bear, and that many people of disparate interests are to blame.

  3. I have to vote with Pericles on this one, although I don't agree with his (implicit)conclusion that, if only the free market had been left alone (and no GSEs allowed to grow up and get big) things would have been okay. And I seem to recall that for the first six years of the current Administration, exemplars of fiscal probity other than Dodd and Franks were chairmen of these committees. So a little more acknowledgement that, say, Phil Gramm is also not without some responsibility here might have been in order, Peri.

    The truth is, ideology, and political opportunism, on both sides, have gotten in the way of sound management.

    As for Bush trying to do something: he didn't try very hard, did he? Unfortunately, financial markets and the problems they pose are just too elusive for the mind of the average voter (or newscaster), so these matters, which should indeed be left in the hands of experts (as long as we have a vise loosely gripping their testicles at all times), devolve to the whims of congresspersons, who often owe their positions to their looks or their bravado (not to mention their $5,000 suits).

  4. This, too, makes sense to me.



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