Monday, 29 September 2008

Sub-prime, securitisation and how government caused the financial crisis

The bogeymen-of-the-moment are clearly bankers. Photographs of bankers with their heads – or boxes of their possessions – in their hands are commonplace. The sympathy for the former Lehmans employee does not appear to match that felt for the unemployed docker or miner. Schadenfreude is de rigueur at the moment. And if the banker is the bogeyman, the free markets is the wicked system that is now being exposed for what it is (if only!).

But are our current problems really the fault of capitalists and bankers? There is an altogether different narrative that points the finger in an entirely different direction: the sub-prime and securitisation crises were created by government.

The sub-prime problem begins with the US government's 1977 Community Reinvestment Act (CRA), which allowed the Federal Reserve and other US financial regulators to pressure banks into making loans to less-than-creditworthy borrowers. Far from greed driving bankers to offer 100% loans to unreliable borrowers, this position was forced upon them by government.

Thomas DiLorenzo explains the problem:

When the CRA was created during the Carter administration, the administration also funded with tax dollars numerous ‘community groups’ that have helped the Fed, the Comptroller of the Currency, and other federal regulatory agencies to enforce the act. Under the CRA, if a bank wants to make virtually any change in its business operations — merging, opening up a new branch, getting into a new line of business — it must first prove to regulators that it has made "enough" loans to the government's preferred borrowers. The (partially) tax-funded ‘community groups’ like ACORN (Association of Community Organizations for Reform Now) can file petitions with regulators that stop the bank's activities in their tracks, perhaps defeating them altogether. The banks routinely buy off ACORN and other ‘community groups’ by giving them millions of dollars as well as promising to make even more dubious loans.

Not only is the sub-prime market the result of Federal legislation that forced banks to lend to un-creditworthy borrowers, but the practice of dicing up debts and selling them on in chunks that mixed prime with sub-prime loans was also the creation of a Government body.

In order to try to diversify the risk of these loans, the Federal Home Loan Mortgage Company (‘Freddie Mac’) pioneered the ‘securitization’ of bundles of these high-risk loans so that they could be sold on secondary markets. Such ‘securitization’ exploded during the 1990s as a result of government regulation. As Fed Chairman Ben Bernanke himself stated in a March 30, 2007 speech entitled The Community Reinvestment Act: Its Evolution and New Challenges,

Securitization of affordable housing loans expanded, as did the secondary market for these loans, in part reflecting a 1992 law that required the government-sponsored enterprises, Fannie Mae and Freddie Mac, to devote a large percentage of their activities to meeting affordable housing goals.”

The deregulation of banking in 1994 led to banks to elevate their CRA activities so as to avoid objections by these ‘community groups’ to their business activities. Meanwhile, in 1995 the US Treasury Department created the multibillion-dollar Community Development Financial Institutions to pour taxpayers’ dollars into subsidising sub-prime loans.

Indeed, from 1995 banks were pressurised to make loans “without the benefit of many traditional credit-worthiness criteria, such as the size of the mortgage payment relative to income, savings history, and even income verification! Instead, the Fed told banks that participation in a credit-counseling (sic.) program, many of which are federally funded, could be used as ‘proof’ of a low-income applicant's ability to make his mortgage payments. In other words, federal bank regulators required banks to make bad loans based on nonexistent credit standards.” One cannot help but think that participation in a credit counselling programme suggests that the borrower has had credit trouble in the past and may not be an ideal customer.

Though largely a US based problem analysis has three significant messages for our current situation.

Firstly, the eagerness with which journalists and politicians have blamed bankers is misguided. While there is no doubt that bankers can be and have been greedy, the sub-prime mortgage problem was forced on banks by the US government, while habit of ‘securitising’ debt began with a US government housing agency. This is a problem created by government, not greed.

Secondly, for the above reason, the eagerness with which we look to government to solve the problem is equally misguided. Our faith in more regulation to resolve the current mess is misplaced. To my knowledge HM Government did not force bankers to lend to less reliable borrowers, but the excess of credit in the marketplace as a result of Government’s toleration of inflation in the pursuit of low interest rates meant that banks had to look further down the pecking-order of borrowers to find people to whom to lend. Had money been tighter, there would have been a duel break on the problem as borrowers were more cautious due to facing higher repayments and banks were less eager to accept any borrower due to credit being limited. There might have been fewer 100% mortgages to those with poor credit histories or people who were “self-certificating” (a practice known colloquially as the “Liar’s mortgage”).

Finally, the troubles resulting form the US government’s intervention in housing markets and the deliberate policy of encouraging those on low incomes with poor credit histories to borrow against property casts a cold light upon the Labour government’s proposals to give first time buyers cheap loans, ease the payment of mortgage interest using income support and allow council’s to offer cheap mortgages. This last is particularly pernicious as it opens up the possibility that, in the future, councils will be in the invidious position of having to foreclose on defaulters and repossess their houses (which the defaulter would probably then stay in, now as a tenant of the council!).

Much of the current economic mess has been caused by governments, with the US government to blame for the specific trigger and our own to blame for the underlying mess. Our headlong rush to solve this government-made problem with more regulation risks turning a brief if sharp recession into a long depression. But right now we seem stuck with the mindset that “Something must be done”.


Kit said...

Odd we are not hearing this in the British media. ;)
I have had a dozen left-wing friends phone me up today because they do not understand what is going on. Their confusion is down to terrible reporting by the British press plus they are naturally clueless as most had jumped on the Buy-to-Let bandwagon even when I had told them not too.
(Econtalk has a good podcast on the subject today.)

Jock Coats said...

Plus the *fact* revealed by Eddie George that the BofE deliberately held interests rates in order to fuel a property price boom in order that we may have more borrowed credit in order that we might spend the country's way out of falling prey to catching the last US recessionary period in the early naughties. He was quite explicit "we knew we were storing up problems for the future but that was for our successors to sort out". Well, now we're here. The successors are trying, but nobody is having a go at the people whose policy the property bubble actually was. The "age of irresponsibility" was clearly on Gordon Brown's watch.

ninaKay said...
This comment has been removed by the author.
Anonymous said...

The way Labour manipulates the media in these ways is incredible. Certainly proof - in my mind - that Mandelson and Campbell are well and truly back and on form.