The bubble also requires lax lending standards. Why did lenders make crazy loans? Would you loan money to someone with no income and no job (the “ninja” loan), or make a loan where the loan amount exceeded the value of the collateral (the negative equity loan), or make a secondary loan to someone so they could pay the principle and interest on their first mortgage? No, you would not; or, at least I hope you would not. Still, thousands of professional lenders did just that! Why?
Well, that was the question Alan Greenspan (the former Fed Chairman) asked himself when he testified before Congress; then, he concluded he “overestimated the lender’s ability to protect their interest.”
Three things induced lenders to take what appear to be insane lending risks: financial “innovations in risk management,” a government policy that encouraged lenders to make subprime loans, and an implicit government guarantee of risky mortgage loans.
The infamous credit default swap is a financial innovation that was supposed to allow lenders to hedge the risks they take with subprime loans. Financial innovations have a common history: They work well in the beginning, people become euphoric about how much money they are making, and then the real limitation associated with innovation asserts itself, and a crash follows.
Politicians cannot resist the temptation to use regulations for social engineering. The Community Reinvestment Act was designed to promote home ownership among low income families, particularly minorities; a noble goal. Subprime lending was pushed by both the Clinton administration and the George W. Bush administration. In the early part of the last decade, Congress forced Fannie Mae and Freddie Mac into the subprime lending business. Without this action, the volume of subprime loans would have been severely restricted.
Fannie and Freddie buy mortgage loans, package them and sell the package as mortgage-backed securities. They also hold mortgage loans they finance by selling bonds. Fannie and Freddie played an important role in providing what used to be local mortgage markets with access to national and international capital. This significantly lowered the cost of mortgage borrowing, which expanded home ownership.
Since Fannie and Freddie are quasi-government enterprises, passing these mortgages through Fannie and Freddie stamps them with an implicit federal guarantee. Lenders expect the federal government will bail them out. Since many of Fannie and Freddie’s creditors are labor union pension funds, I suspect they are right. So, there is at least one more bailout to come.
The Obama administration’s financial reform act addresses some of the real issues; specifically, the regulation of derivatives (financial innovations), clarifying some regulatory responsibilities, and making it clear that regulators are supposed to discourage bubbles.
On the other hand, the financial reform act is first and foremost a political document whose purpose is to place the blame on the previous administration and the private sector. That is why Fannie Mae and Freddie Mac were ignored. If they were part of the discussion, all of the forgoing would be brought to light, and it would not be possible to claim our present difficulties are due to greedy capitalists and their running dog Republicans. Government would have to take its share of the blame. Notice, I am not saying the private sector and the Republicans share none of the blame. I am just saying let’s have all the facts on the table.
When the president says the reform act eliminates “too big to fail” and ends the bailouts, he is wrong on both counts. Furthermore, he is setting the next financial crisis in place through extensive government subsidies for “alternative energy.” Governments cannot pick technology winners.
Subsidies create vested interests that demand more subsidies. Just ask Spain, whose wind-powered generating industry is on the verge of bankruptcy because the government can no longer provide the subsidies. If you want to invest in alternative energy, invest in companies not subsidized by the government.
Bob Martin is emeritus Boles Professor of economics at Centre College.