Sanity Injection

Injecting a dose of sanity into your day’s news and current events.

First crack at the big bailout

Posted by sanityinjection on September 25, 2008

Canadian David Warren points out that those who are blaming capitalism and free markets run amok for the financial crisis couldn’t be more wrong:

In fact, one of the major factors that led to the creation of the dubious subprime loans was *anti-capitalist* pressure, from governments, non-profits, and discrimination lawyers, on financial institutions to ignore credit math and create programs to help poor people with bad credit buy homes. We were told that home ownership was a basic human right – but that means that the financially irresponsible have that right, too. Not that this excuses deceptive, fraudulent, and manipulative practices by the firms in question and their CEOs. But it does suggest that maybe regulation of the industry by people with agendas other than the smooth sailing of the economy isn’t the best solution.


6 Responses to “First crack at the big bailout”

  1. tubby said

    I’ve also done some thinking about this mess, about who’s to blame, and share some of your views, However, I’d argue the government-regulated framework you and this author rail against was exacerbated by the addition of overly-aggressive financial instruments to the mix.

    #1 problem: Government-sponsorted enterprises (GSEs) – Fannie Mae and Freddit Mac
    In an effort to make mortgages affordable for everyday Americans, Fannie and Freddie became based on risky investment vehicles that dangerously implied a hidden (nonexistent), government-funded guarantee on returns. As this excerpt in Wikipedia explains, the GSEs are not subject to the same regulations on FDIC-insured banks, which are subject to a minimum capital to asset ratio.

    Fannie Mae and Freddie Mac [are] allowed to sell mortgage-backed securities with only half as much capital backing them up as would be required of other financial institutions. Specifically, regulations exist through the FDIC Bank Holding Company Act that govern the solvency of financial institutions. The regulations require normal financial institutions to maintain a capital/asset ratio greater than or equal to 3%.[17] The GSEs, Fannie Mae and Freddie Mac, are exempt from this capital/asset ratio requirement and can, and often do, maintain a capital/asset ratio less than 3%*. The additional leverage allows for greater returns in good times, but put the companies at greater risk in bad times, such as during the current subprime mortgage crisis.
    * Source:

    On July 11, when the government announced that it would dissolve Fannie and Freddie should financial conditions worsen, investors sold off their stock like crazy, now aware of their actual unsustainably low capital/asset ratio. What could Paulson do at this point, but speak to the nation about the financial soundness of the GSEs? Not only were these companies publicly-traded with investors to please, but the government had a stake in saving them. (The double-edged sword of any public company: While profit and SEC oversight are sought, these rewards come with the vagaries of investor confidence, which ultimately determine the company’s solvency.)

    #2 problem: The repeal of the Glass-Steagall Act
    In 1999, a veto-proof bill led by Senator Phil Gramm (R) passed, overturning the original Glass-Steagall Act, which had been drawn up to set boundaries between FDIC-backed banks and investment banks. Lobbyists for the FDIC-backed banking industry, led by Citigroup, had been seeking the repeal of Glass-Steagall since the 1980s. When Clinton signed it into law, lenders such as Citigroup were given free reign to establish completely new financial instruments – which they called structured investment vehicles (SIVs). These instruments underwrote the mortgage-backed securities and collateralized debt obligations that set the stage for our current subprime meltdown.

    Over time, the GSEs began playing fast and loose with debt, but couldn’t the Treasury Department have changed this at any time? (In fact, Greenspan himself was quoted as telling a Congressional panel that the confidence in artificial government guarantee behind the GSEs made them financially week instruments.) Then, in 1999, the rest of the banking industry was granted access to follow Fannie and Freddie’s bad example. The reckless atmosphere on Wall St. mounted until in 2002, the Sarbanes-Oxley Act was passed to curb the egregious corporate accounting infractions perpetrated simply to make shareholders happy. So, I agree that anti-capitalist pressure from Congress in the 80’s created this “Uncle Sam wants you to buy a house” sentiment characterized by the artificial propping up of Fannie and Freddie. But, I’d argue that it was the Republican-backed capitalist philosophy of letting free-market (eventually reckless) financial vehicles run their course which actually allowed the destruction to occur.

  2. sanityinjection said

    Tubby, your points are valid. Certainly there is plenty of blame to go around. I would point out though, that if Fannie and Freddie had been wholly private institutions, they would never have been allowed by Federal regulators to operate as you describe. It was precisely the fact that these were *government-sponsored* institutions that enabled them to escape the proper oversight. The Democrats who usually like to jump on financial institutions for the smallest thing felt no such desire to pay close attention to what Fannie and Freddie were doing, because they were “helping disadvantaged families”. It comes back to the same old leftist philosophy: Our side doesn’t have to play by rules because our cause is just.

    I think you’re probably on point with the repeal of Glass-Steagall, but I think Sarbanes-Oxley has provisions that have been harmful as well as some that have been helpful. But I think the larger point that supports your argument is this: The free-market philosophy is founded on certain basic assumptions about economic decision making. One of those assumptions is that decisions are being made based on accurate information – probably more true now than ever before. The other is that decisions are being made based on an accurate assessment of underlying economic factors. Financial speculation torpedos this assumption because it moves huge sums of money based on “sniffing the wind” rather than on real economic data. This is the underlying philosophical justification for regulation of complex financial instruments. When the instrument that is changing hands between buyer and seller becomes so convoluted and removed from any real-world monetary value, that is when some oversight is necessary – not in order to counteract free market principles, but to preserve them.

  3. tubby said

    I thought about that. I suppose even a private (not publicly traded) Fannie and Freddie could have arranged private investment in their mortgage securities, if that’s what you mean. I think this setup would have required a much more skilled and economically experienced management team, and one who had a vested interest in seeing the companies succeed. But since it was the government who set them up to begin with, the government alone had this vested interest in making them work. In addition, I would guess they were made public in order to gain enough initial capital to fund the initial large mortgage pool. But this whole concept of them being independently-operated institutions, incidentally “sponsored” by the government, is dangerously vague and misleading labeling (since the government wasn’t really guaranteeing anything about them). I’m sure Congressional Democrats were guilty of perpetuating this image when they conceived them – but Republican Treasury departments are just as guilty of doing everything they could to keep them in their current state.

    Economic decision making based on accurate information? Pipe dreams! 🙂 You say Sarbanes-Oxley had its disadvantages. Maybe so, but I can’t imagine where we would be without it (how powerless the SEC would be against those greedy CFOs exploiting accounting loopholes).

  4. sanityinjection said

    From today’s Pittsburgh Tribune-Review Editorial:

    “Repeal Sarbanes-Oxley. The regulations designed to combat fraud only encumbered many thin-margin smaller businesses with millions in compliance costs, damaging job creation where it can be most prolific.”

  5. Tubby said

    Great point / counterpoint article on today explaining why it’s impossible to place the blame in one place:

    I have to eat my words a bit on my second point about the Glass-Steagall repeal. Even Clinton agrees that this law has softened the severity of the problem. I’m also starting to get more and more annoyed by Barney Frank’s tone (not to mention Pelosi’s). Sure, you are angry with the Bush Administration about separate issues, but why let that turn you into a serially partisan bickerer. We have a common problem to solve people!

  6. sanityinjection said

    Another great column on the causes of the financial crisis from Alvaro Vargas Llosa at The New Republic. Vargas Llosa thoroughly debunks the notion that deregulation is to blame and that more regulation is the answer, and points instead to government intereference in undermining loan underwriting standards to benefit the disadvantaged, which ultimately fueled irresponsible speculation:

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