42 Days to Election Day--Finally, my analysis of the financial "crisis"

Well here we are at the end of September facing a proposed $700 Billion nationalization of the financial sector of our economy and likely with a gaggle of potential companies, industries, and individuals lining up with their hands out for the next big government giveaway...

How did we get here?

This is not an easy question...there are many policies, programs, and institutions with all sorts of culpability in this mess. One thing I can say, however, with certainty--THIS WAS NOT A FAILURE OF THE FREE MARKET!!! My friend, DJ McGuire, the free market was never tried! His post is worth reading (including several other of his posts related to this mess).

I believe the root of this problem goes back several decades, but can be diluted to a short phrase...AFFORDABLE HOUSING and Fannie Mae and Freddie Mac are the culprits along with several policies affecting their operations over the last 40 years. As Kevin Hasset posted on Bloomberg.com on 9/22, "Take away Fannie and Freddie, or regulate them more wisely, and it's hard to imagine how these highly liquid markets would ever have emerged. This whole mess would never have happened."

So, what are the policies which made Fannie and Freddie the liabilities they would become?

1. The creation of Fannie
   As part of FDR's New Deal, Fannie was created as a government agency in 1938 to provide liquidity to the mortgage market. As my friend, DJ McGuire, said in a well-researched post, Fannie was "set up to provide loans to banks that they themselves could loan out to homeowners. Since these were government loans created from a policy deliberately designed to make homes 'affordable,' the banks treated it like the free money it really was, and loaned it out like they were supposed to do. Thus did the government begin artificially inflating property demand."


2. The quasi-privatization of Fannie and the creation of Freddie
   In 1968, to remove the activity of Fannie Mae from the annual balance sheet of the federal budget, the Johnson Administration converted into a private corporation. To provide competition in the secondary mortgage market, and to end Fannie Mae's monopoly, Freddie Mac was created by the Democratic Congress as a private corporation in the Emergency Home Finance Act of 1970 created. The goal was to create a secondary market for conventional mortgages, as indicated in the Fannie Mae charter.
   Again, from DJ's post, "So now, there were two companies, both ostensibly private but with obvious government favors, government ties, and the implied government backing that came with them..." (emphasis added). It was this implied government backing that propped these entities up, with investors knowing that the government would never let them fail!


3. The Community Reinvestment Act
   The Community Reinvestment Act (CRA) was passed during the Carter Administration. It was passed in order to make sure that each banking institution was meeting the "credit needs of its entire community." It sounds harmless enough, but it was used to force lenders to begin to extend credit to less-than-creditworthy people in the name of "fairness" and "diversity."
   According to a commentary by Yaron Brook in Forbes, "The CRA forces banks to make loans in poor communities, loans that banks may otherwise reject as financially unsound. 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?"


4. The Community Reinvestment Act Revised and Extended
   In 1995, the Clinton Administration further liberalized the CRA and the Reno Justice Department warned lenders against "redlining" and stated that the Adminstration would take strong action against any suspected instances of the practice. Again, seems harmless enough--even noble--but it was used to force more sub-prime mortgages onto the books. These revisions with an effective starting date of January 31, 1995, were credited with substantially increasing the number and aggregate amount of loans to small businesses and to low- and moderate-income borrowers for home loans (sub-prime). These changes were very controversial.
   According to Yaron Brook's article, "In a free market, lending large amounts of money to low-income, low-credit borrowers with no down payment would quickly prove disastrous. But the Federal Reserve Board's inflationary policy of artificially low interest rates made investing in subprime loans extraordinarily profitable. Subprime borrowers who would normally not be able to pay off their expensive houses could do so, thanks to payments that plummeted along with Fed rates. And the inflationary housing boom meant homeowners rarely defaulted; so long as housing prices went up, even the worst-credit borrowers could always sell or refinance." (emphasis added)
   
5. Sarbanes-Oxley (SOX)
   In an overreaction to a number of major corporate and accounting scandals from 2000 to 2002, President George W. Bush signed SOX into law, on July 30, 2002, stating it included "the most far-reaching reforms of American business practices since the time of Franklin D. Roosevelt." Indeed--complete with the unintended consequences of these types of market-interfering legislation.
   SOX has crippled entrepreneurial start ups, driven public companies private, driven smart business people off public boards, and driven offerings from New York to London. Congressman and presidential candidate Ron Paul has been a vocal critic of SOX, specifically Section 404, citing, among other things, that "Financial analysts have identified Section 404 as the major reason why American corporations are hoarding cash instead of investing it in new ventures."(emphasis added).
   Taking such a large amount of capital out of the market has added to this current "crisis".


6. Refusal to heed warning signs
   In a commentary on Bloomberg.com, Kevin Hasset points out when the "turning point" happened in this mess.
   "Back in 2005, Fannie and Freddie were....enmeshed in accounting scandals that led to turnover at the top. At one telling moment in late 2004...the Securities and Exchange Comiission's chief accountant told disgraced Fannie Mae chief Franklin Raines that Fannie's position on the relevant accounting issue was not even 'on the page' of allowable interpretations.
   "Then legislative momentum emerged for an attempt to create a 'world-class regulator' that would oversee the pair more like banks, imposing strict requirements on their ability to take excessive risks. Politicians who previously had associated themselves proudly with the two accounting miscreants were less eager to be associated with them. The time was ripe.
   "The clear gravity of the situation pushed the legislation forward.
   "What happened next was extraordinary. For the first time in history, a serious Fannie and Freddie reform bill was passed by the Senate Banking Committee. The bill gave a regulator power to crack down, and would have required the companies to eliminate their investments in risky assets.
   "But the bill didn't become law, for a simple reason: Democrats opposed it on a party-line vote in the committee, signaling that this would be a partisan issue. Republicans, tied in knots by the tight Democratic opposition, couldn't even get the Senate to vote on the matter."

Now, I realize that the preponderance of this focuses on the Democrats and what they did over the last four decades. However, I also blame the Bush Administration for not taking a much stronger position in this mess much earlier. Bush's SOX policy and the lack of pushing for the 2005 reform of Fannie and Freddy were also inexcusable! As mentioned in a Politico.com article by Jeanne Cummings, "One of the Bush administration’s signature goals has been promoting an 'ownership society.' To achieve that end, the administration promoted a series of programs designed to encourage consumers to buy homes, stocks and other goods that would convert them into free market advocates."

The Bush Administration has also been quick to bail out the actors in this mess...as I have quipped, we are nationalizing faster than Chavez and Venezuela! Unfortunately, we have a lack of true leadership in this country--and what passes for it often is a poorly disguised populism (as we can see from The One and McCain). The Administration should have said in no uncertain terms that Fannie and Freddie are private entities and not secured by the US government. If that meant the two of them had to go bankrupt, so be it and let their investors take the hit! That is what happens in the free market--entities must be free to FAIL!!!

There is a great article that captures much of my sentiment on all of this in the Washington Post, of all places. Here is a short excerpt (emphasis added):

"I've been financially responsible with my own money. Why should I now be responsible for the fact that you were not?" he said.
This may be a Main Street bailout backlash in the making. The details of the financial crisis are still hard for most people to follow -- what with talk of exotic "derivatives" known as "credit-default swaps" and so on -- but the central fact of the matter hasn't been lost on anyone in this Northern Virginia community: The taxpayers are on the hook for the bad judgment of others.
And they say they don't like it. They didn't break it, but now they've bought it. Political leaders and financial titans say the bailout is necessary to save the economy, but on the ground, in such places as Manassas Park, people think that the bailout will reward the wrong people. There's a sense that too many folks bought houses they couldn't really afford, banks urged them on, common sense went on vacation, and now the grown-ups have to clean up the mess.
"If I spent more money than I have, I don't deserve to have somebody bail me out," said John Owens, 45, a developer who lives on Eagle Court, where three houses have gone through foreclosure.
The anti-bailout sentiment appears to cut across class lines. You hear it from one end of Manassas Drive, the main drag through town, to the other -- from the small, Cape Cod-style homes built with G.I. Bill money after World War II to the muscle-bound houses newly risen along the golf course.
"I'm not overextended," Merkle said. "I didn't buy a large home that I can't afford. I'm not behind on any of my payments. I'm not sure I want the government to take my tax dollars and buy someone else's house for them."

Thank you for your patience and your attention...will get back to the election tomorrow!