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Guest Post: Tracing the Roots of the Current Financial Mess

September 23rd, 2008 by Halli

By Richard Larsen

Last month Bear Stearns collapsed. This last week the 170 year-old Lehman Brothers did, while Bank of America saved Merrill Lynch from a similar fate. Morgan Stanley and Wachovia are in talks to prevent collapse of their firms. Washington Mutual has been brought to the precipice of illiquidity. AIG (American International Group) has been essentially bought by all of us, and Fannie Mae and Freddie Mac, the largest underwriters of mortgages in the country were similarly saved by the Feds (us). In short, the entire financial landscape is in the process of being restructured.

It’s important to know the origins of the current mortgage market meltdown and the role the Federal Government has had in this collapse. Let’s look at the root causes from a historical perspective.

Tracing the roots of the current milieu we must go back to the Community Reinvestment Act of 1977 (CRA). This Federal law intimidated lenders into offering credit throughout their entire market and discouraged them from restricting their credit services to low-risk markets, a practice sometimes called redlining. Banks were thereafter required to submit regular reports proving that they were not avoiding home lending in impoverished regions. This started the process that has peaked over the past few years of lending with little proof of ability to pay. Lenders were willing to make creative interest-only loans, high-risk “no doc” and “liar loans,” in order to allow people to buy more housing than they could afford. We have come to know these loans as “sub-prime,” or loans issued with much higher recognition of risk. Some economists point to the CRA as a contributing factor to the savings and loan meltdown of the 1980s as they experienced the interest rate squeeze of paying higher and higher interest rates on deposits in order to have the assets to write illiquid long-term mortgages.

In 1992, Boston’s Federal Reserve funded a study that resulted in increased pressure on banks to fund mortgages that, on paper, should not have been funded. It increased the regulation of the mortgage market to the point where four government agencies were monitoring banking activities relative to CRA demands. A ranking system was put into place where financial institutions were rated based on CRA lending, and the penalties could be stiff against banks whose CRA rating declined. The data and analysis of that research was later discredited.

In 1994 then Attorney General Janet Reno declared they were going to aggressively pursue lending institutions not in full compliance with the CRA.

At Fannie Mae and Freddie Mac, the two government-sponsored mortgage giants, the temptation to augment earnings reports through expanding sub-prime lending was just too great. Company leaders bragged in internal memos about their expansion into the sub-prime business, essentially erasing the lines of demarcation with “conforming” loans, those which ostensibly fall within what had been the higher lending standards of the two GSEs (government sponsored enterprises).

Jim Johnson, CEO of Fannie Mae, resigned in 1999 under a cloud of suspicion over accounting irregularities. Franklin Raines replaced him and proceeded to “cook the books” even more. Through questionable accounting and questionable funding of sub-prime loans the company’s stock climbed, netting him a cool $100 million payout by the time he left in 2005 under an ethical cloud. Meanwhile, his company was levied a $400 million fine by the SEC for their fraudulent bookkeeping and risk management. There is a political component to this part of the historical timeline, as Franklin Raines and Jim Johnson are now economic advisors for the Obama campaign.

Also in 1999, Congress repealed the law that established a line between commercial and investment banks. This meant bad investments by banks could jeopardize depositors

In 2003 the present administration attempted a reform of government involvement in the mortgage industry. That attempt failed. An attempt was made again in 2005 with John McCain partnering with three other senators to do the same thing. That attempt failed in part because of massive contributions from Fannie Mae to senators’ reelection campaigns. The top recipients of those funds were Chris Dodd and Barack Obama.

What we see now in financial markets, is the market working properly. It is taking out the excesses built into the mortgage market and the investment banks and other financial entities that leveraged heavily into those markets. The casualties have been significant, and there may be more to follow. The most disturbing part of all this is how the Federal Reserve has stepped in along with the Treasury Department, to bail out most of these institutions at the tax-payers expense. Some of the guarantees by the Feds may be repaid, like the $85 billion bridge-loan established for AIG, with an 11.5% interest rate on the loan (that is if they can survive), but the establishment of a Resolution Trust Corporation type buyout of illiquid mortgage securities by the Feds at $.70 on the dollar will likely not be.

If we can look at the lighter side of this mess, the assets now owned by the Feds should probably be named “Securitized Housing Investment Trust.” It would make for a perfect acronym.

In short, the government created the problem by socially engineering the lending process and pushed lenders too far to make mortgages to too many and for too much. The foolhardy governmental mortgage lending policies have brought our financial industry’s “chickens home to roost.” As the Investor’s Business Daily observes, the law of unintended consequences of government policy is now fully manifest. And now the clarion calls for increased regulation are reaching a crescendo among all the political players.
What we need is more accountability of government, not more regulation of the markets who are already over-regulated and are doing precisely what the government has been telling them to do for thirty years. After all, it’s Congress that wrote the banking rules creating this mess.

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