We must learn the right lessons from the financial crisis. Given the complicity of many politicians, voters should insist on a 9/11-style, bipartisan commission to investigate and make recommendations for reform.
The financial meltdown is due to a complex combination of failures. The absence of regulation, the presence of regulation, and political interference with regulation all contributed to the problem. Fraud and greed by lenders, borrowers and Wall Street are part of the equation.
The problem started with good intentions: The government wanted to expand home ownership among low-income families. In 1995, the government set quotas and began to penalize lenders who did not make subprime loans. Later, President Bush encouraged more home ownership through the "ownership economy."
Inability to repay loans
Unfortunately, there are sound reasons why lenders did not make home loans to many subprime borrowers; they could not repay the loans. Wishing it was otherwise could not make it so.
The government encouraged Fannie Mae and Freddie Mac to make more money available for subprime loans. Because Fannie and Freddie are government sponsored enterprises, they were exempt from the normal and prudent regulations that are imposed on private financial institutions. In the process, they took enormous highly-leveraged risks. When Fannie and Freddie's problems surfaced, politicians stopped reform efforts.
Real estate speculation grew as borrowers took risky loans on property they could not afford, betting on ever rising prices to bail them out. When prices started to decline, their loans went upside down (they had negative equity) and they could not "flip" the house without coming up with cash to pay off the loan - they would have to pay someone to take the house off their hands. If they do not have the income to pay the mortgage, their only option is to default on the loan. This aggravates the downward spiral in housing prices which makes the problem worse.
The final player in this disaster is the market for credit default swaps. The market for credit default swaps is unregulated. These swaps are in reality insurance products; they are called "swaps" to avoid regulation. Default swaps are supposed to hedge risk. In this case, they hide risk, which prevents an accurate assessment of the financial institution's balance sheet.
Bear-Stearns, Lehman Brothers and AIG Insurance sold billions of dollars of credit default swaps. Regulated insurance products have strict capital reserve requirements that make sure the insurer has adequate capital to back up the insurance. The unregulated sales of credit default swaps were made without adequate capital reserves, and that is what drove these firms into bankruptcy.
The important lessons are that encouraging loans where loans were not made in the past significantly raises default rates, government-sponsored enterprises, like Fannie and Freddie, lead to political tampering, and mixtures of unregulated and regulated financial markets reduce financial transparency. The public's righteous anger over this mess must lead to a careful and complete overhaul of our financial regulatory system.
Bob Martin is emeritus professor of economics at Centre College. Email: bmart@centre.edu.
