Vermont View: Subprime lending was the match that lit fuse of financial time bomb
Toolbox
By John Fairbanks - Published: November 2, 2008
"A mistake." That is, in a nutshell, how former Federal Reserve Chairman Alan Greenspan recently explained the worst economic crisis since the Great Depression.
In recent weeks, several of the world's largest investment houses and the world's largest insurance company have collapsed. The Dow plummeted and bond markets froze. Americans watched retirement funds and other investments dry up. The panic ran so deep, banks wouldn't even lend to one another. The contagion spread across the globe. Extraordinary steps were taken and extraordinary sums of money were provided by the federal government to stave off what many feared would be an even greater debacle. Today, weeks after the crisis exploded, no one can say for certain what ripple effects could turn into economic tidal waves. No one can predict how long the crisis will last or how deeply it will gouge into our lives.
As "mistakes" go, this one was a doozy.
While Greenspan had plenty of company in his mistake, he has been the most visible and influential preacher of the gospel of so-called "free" markets, decrying government regulation as an obstacle to prosperity. Occasional turmoil in the financial world during his tenure could not shake his belief that bankers and brokers could control themselves better than regulators could. Early warning signs of the current crisis from colleagues were dismissed, and Greenspan treated Members of Congress and Senators who questioned him with avuncular condescension. After all, who would dare challenge the word of the Oracle, the Maestro?
When it all came tumbling down, Greenspan declared he was shocked, shocked, that financial institutions, staffed by some of our country's best and brightest, could fail to police themselves and protect investors and consumers. It seems odd that such a staunch libertarian, whose belief system is anchored in the concept that human beings operate, first and foremost, in their own interests, would be surprised when some of them would not subordinate that interest — read, getting rich — to the interests of a stable financial system or the protection of consumers.
That's why we have regulations in the first place, for the same reason our highways have speed limits, that sports have referees and umpires, and that many of our professions must be licensed. Because, sometimes, people don't behave in a responsible manner.
Greenspan and his allies fought regulation, particularly the proposed regulation of the complex financial instruments called derivatives, which one expert identified as the "centerpiece of the crisis." Derivatives, essentially bets against losses, helped spread risk through the financial system by allowing institutions to take risks they might have otherwise shunned. They also nodded in approval at legislation that broke down the barriers between commercial banks and investment banks that had been erected during the Depression.
To paraphrase conservative writer P.J. O'Rourke, that was like giving beer and car keys to a bunch of 17-year-old boys.
Still, some continue to deny the current mess is the result of the financial cowboys and con artists (who sometimes wear similar clothing). No, they claim, it's the fault of Big Government forcing the Market to provide financing for affordable housing. Critics point to the Community Reinvestment Act of 1977 and the government-sponsored mortgage giants the Federal National Mortgage Association, commonly known as Fannie Mae, and the Federal Home Loan Mortgage Company, or Freddie Mac as the villains.
A recent report from the President's Working Group on Financial Markets tells a different story. It wasn't the regulations that caused this crisis, but fact that they were ignored. The main causes of turmoil in financial markets, according to the group, was a breakdown in underwriting standards, an erosion of market discipline, flaws in credit rating agencies' assessments, weaknesses in risk management and failure of regulatory policies to mitigate those weaknesses.
In a recent interview, former bank examiner Diane Buckshnis, who was part of the team that investigated Charles Keating, architect of the 1980s savings and loan scandal, looked at the current mess and said, "Where were the regulators? Where were the auditors? Huge banks don't just collapse overnight. I would have thought (we) would have learned from the 1980s."
While subprime lending served as the match that lit the fuse, that market wasn't being driven by the requirements of the Community Reinvestment Act nor by Fannie and Freddie. Data from the Federal Reserve indicate that subprime lending was not being done by regulated lenders. In 2006, according to the Fed, more than 84 percent of subprime mortgage loans were made by private financial institutions. Of the 25 largest subprime lenders that year, only one was subject to the Community Reinvestment Act. When subprime lending was booming, Fannie and Freddie's share of subprime loan purchases on the secondary market dropped by half.
We're in the midst of a situation that is generally regarded as the most significant challenge to both our financial and political systems in nearly a century. We're here because too many lenders looking to cash in on the booming housing market made loans they shouldn't have made. Too many complex financial transactions spread the risk and lured banks and insurance companies into shaky markets. While there were plenty of people warning that we were heading for a major crash, the lure of big money to be made overwhelmed all reason.
We're here because too many people didn't want to follow the rules.
As we try to rebuild in the wreckage he helped create, Greenspan, though perhaps dismayed at the possible blight on his reputation, can still retire to his comfortable home in the company of his power-couple wife, NBC reporter Andrea Mitchell, enjoy a good meal, perhaps with a glass of fine wine, and go to sleep secure in the knowledge that he will not suffer materially from his "mistake."
That burden will be picked up by millions of Americans and their families, who face a far less secure future and whose taxes will be likely be diverted from the kind of public policy initiatives that are most needed when times are tough to cover the debts — and pay for the parties and the executive bonuses — of the institutions that profited so mightily by Greenspan's policies.
No one can say for sure how all this will end, although it is also generally agreed there is more pain coming in the form of lost jobs, stagnant markets, and, in all likelihood, a fraying of the economic safety net. Officials have tried a number of different strategies to try to rebuild some stability in the markets, but we are still largely in uncharted territory, and there are no guarantees that we're taking the right measures. However, one thing is clear, we cannot restore stability until we have rules in place to prevent this sort of thing from happening again.
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