Government Failure

To hear the media pundits and presidential candidates tell it, you’d think Adam Smith has been president for the last eight years and, with a Congress full of free-market advocates, had enacted an agenda of full-blown laissez-faire.

Had that been the case, we would not be in the mess we are in economically. Alas, it has not been the case.

Politicians have an obvious interest in portraying the financial meltdown as the result of a government hands-off policy. They can’t very well advocate government controls if government controls are responsible for the debacle we’re now living through. The pundits just don’t understand economics.

But believe it or not, the problems in the financial and housing industries are not a market failure. They are a government failure.

The U.S. government has heavily regulated the financial sector since the 1930s. Yes, some regulations have been tweaked over the years. In 1999 — under Bill Clinton — the New Deal’s Glass-Steagall Act, which had separated investment and commercial banking, was repealed. But it is important to realize that these regulatory changes were in response to specific problems caused the regulations themselves. Separating commercial and investment banking was an arbitrary and artificial decision by government officials, and this action prevented banks from having the flexibility to better serve their customers in a competitive global economy. They were not part of any laissez-faire program, unless President Clinton was really a secret free-market advocate.

There was no general deregulation. Why do the pundits think differently? Because they are blinded by words. The Bush administration and Republicans talk about the costs of business regulation. But that is not the same as repealing regulations. As economist Tyler Cowen writes in the New York Times, there has been “continuing heavy regulation, with a growing loss of accountability and effectiveness.... When it comes to financial regulation, for example, until the crisis of the last few months, the administration did little to alter a regulatory structure that was built over many decades. Banks continue to be governed by a hodgepodge of rules and agencies including the Office of the Comptroller of the Currency, the international Basel accords on capital standards, state authorities, the Federal Reserve and the Federal Deposit Insurance Corporation. Publicly traded banks, like other corporations, are subject to the Sarbanes-Oxley Act.”

Moreover, as Cowen points out, it has been long-standing government policy to make it easier for non-creditworthy people to get mortgages: “legislation that has been on the books for years — like the Home Mortgage Disclosure Act and the Community Reinvestment Act — helped to encourage the proliferation of high-risk mortgage loans.” In fact, banks could be penalized for appearing to avoid lending money to people with poor prospects for repayment. The passionate advocates of this social-welfare policy now call such bank conduct “predatory lending.”

Even if the Bush administration had ended all oversight of the banking industry, the government would still not be off the hook for the current difficulties. That is because for many years it has intervened in the mortgage and financial markets not by regulating in the traditional sense, but rather by implicitly promising to protect lending and underwriting institutions from their own folly. Most egregious of all has been the understanding that Fannie Mae and Freddie Mac — two government-sponsored enterprises — would not be permitted to go bankrupt. These organizations, both created and subsidized by government, gave us the subprime mess by buying mortgages from banks, bundling them into securities, and then selling the securities to investors — with an explicit guarantee that the income would keep flowing even if the homeowners stopped paying their mortgages. That system nearly assured that banks would lend promiscuously. What did they have to lose? Ultimately, the taxpayers would bail them out.

Make no mistake: the government, not the free market, created this fiasco. The solution, therefore, is not more government, but the end of all regulations and business privileges.

Here is Richmans response to the market impact:

The biggest culprit, I think, is the implicit guarantee the government has always issued to Fannie Mae and Freddie Mac,” Richman said. “Something like 80% of the mortgages these days are held or backed by Fannie Mae or Freddie Mac,” he said, and “they get special treatment from the government like no other lender gets.”

These factors, particularly the government guarantee, have brought about our current financial crisis, said Richman.

Fannie Mae and Freddie Mac have been able to buy bundles of home mortgages, or mortgage-backed securities, in massive quantities without real-world considerations of financial risk, because they could count on the federal government to bail them out if things went south.

“We don’t call them ‘Government Sponsored Enterprises’ for nothing,” Richman said.

“Despite the limited authority of any specific regulators,” the economists said, “more should have been done to prevent the crisis.”

But lack of oversight is hardly the problem, Richman said, because “the financial industry is regulated all over the place.” In Richman’s analysis, it is precisely the government guarantee of Fannie and Freddie that is “short-circuiting” the market.”

That guarantee “removes market discipline,” emboldens banks to make bad loans, and encourages Fannie and Freddie to back them. This, Richman asserted, is a “moral hazard.”

“It’s like if I invite you to Vegas and say the winnings are all yours and I’ll cover your losses,” Richman said. “You’re going to have a great old time. On the other [hand], if you go by yourself and you know you’ve got to cover your losses, you’re going to behave differently, and that’s been the problem.”

Providing context, Richman said government policy laid the foundation of this crisis more than 30 years ago when Congress passed the Community Reinvestment Act of 1977. This law forced banks to loan money to low-income borrowers as a way to ensure that financial institutions would “meet the credit needs of the local community.”

Under the Clinton administration, federal regulators began using the act to combat “red-lining,” a practice by which banks loaned money to some communities but not to others, based on economic status. “No loan is exempt, no bank is immune,” warned then-Attorney General Janet Reno. “For those who thumb their nose at us, I promise vigorous enforcement.”

The Clinton-Reno threat of “vigorous enforcement” pushed banks to make the now infamous loans that many blame for the current meltdown, Richman said. “Banks, in order to not get in trouble with the regulators, had to make loans to people who shouldn’t have been getting mortgage loans.”

This threat combined with the government backing of Fannie and Freddie set the stage for the current uncertainty, because the “banks could just sell the loans off to Fannie or Freddie,” who could buy them with little regard for negative financial outcomes, Richman said.

However, the most harmful federal policy may not have been backing Fannie and Freddie per se, but bailing them out.

“When the government basically expropriates stockholders, that makes other stockholders nervous and therefore drives down other stocks that are similar,” said Cato Institute economist Alan Reynolds. “Most obviously, Morgan Stanley [going] down after Lehman goes down.”

That nervousness can help drive poor economic policy decision-making. AIG, Reynolds explained, “has just got fabulous assets. It’s a trillion dollar company. It’s just short of cash.” The federal government bailout of AIG has been “draconian.”

Moreover, Reynolds said, the bailouts have forced these companies into a kind of “quasi-bankruptcy” when no one knew in fact whether the firms were or were not solvent.

Reynolds called the government’s intervention “capricious” and “whimsical” and said it appears to have “no rules.” No wonder, he said, investors have been scared away from infusing financial institutions with the capital they need to maintain solvency and stave off bankruptcy.

Economist Robert E. Litan challenged a negative view of government intervention. In bailing out Bear Stearns, Fannie, Freddie, and AIG, he said, “federal policymakers appropriately used their authority to stabilize the markets and protect the American economy from systemic risk and collapse.”

“We have learned from the past,” he said. “While Depression-era policy makers watched idly while events spiraled out of control, today’s policy-makers have recognized the need for swift action to contain the damage.”

What this financial crisis really shows, Richman said, is that politicians “don’t know what they’re doing. They don’t understand economics. They think there are no laws of economics, that they can decree whatever they want and that there won’t be consequences.”

(Taken from a circulating e-mail) From a 1999 article by Steven A. Holmes

Fannie Mae, the nation’s biggest underwriter of home mortgages, has been under increasing pressure from the Clinton Administration to expand mortgage loans among low and moderate income people and felt pressure from stock holders to maintain its phenomenal growth in profits.

In addition, banks, thrift institutions and mortgage companies have been pressing Fannie Mae to help them make more loans to so-called subprime borrowers. These borrowers whose incomes, credit ratings and savings are not good enough to qualify for conventional loans, can only
get loans from finance companies that charge much higher interest rates -anywhere from three to four percentage points higher than conventional loans.

“Fannie Mae has expanded home ownership for millions of families in the 1990’s by reducing down payment requirements,” said Franklin D. Raines, Fannie Mae’s chairman and chief executive officer. “Yet there
remain too many borrowers whose credit is just a notch below what our underwriting has required who have been relegated to paying significantly higher mortgage rates in the so-called subprime market.”...

...In moving. even tentatively into this new area of lending, Fannie Mae is taking on significantly more risk, which may not pose any difficulties during flush economic times. But the government subsidized corporation may run into trouble in an economic downturn, prompting a government rescue similar to that of the savings and loan industry in the 1980’s.”...

I received this e-mail. Anyone know if it is true?

Here is a quick look into 3 former Fannie Mae executives who have brought down Wall Street. Franklin Raines was a Chairman and Chief Executive Officer at Fannie Mae. Raines was forced to retire from his position with Fannie Mae when auditing discovered severe irregularities in Fannie Mae’s accounting activities. At the time of his departure The Wall Street Journal noted, ‘ Raines, who long defended the company’s accounting despite mounting evidence that it wasn’t proper, issued a statement late Tuesday conceding that ‘mistakes were made’ and saying he would assume responsibility as he had earlier promised. News reports indicate the company was under growing pressure from regulators to shake up its management in the wake of findings that the company’s books ran afoul of generally accepted accounting principles for four years.’ Fannie Mae had to reduce its surplus by $9 billion. Raines left with a ‘golden parachute valued at $240 Million in benefits. The Government filed suit against Raines when the depth of the accounting scandal became clear.

http://housingdoom.com/2006/12/18/fannie-charges/ . The Government noted, ‘The 101 charges reveal how the individuals improperly manipulated earnings to maximize their bonuses, while knowingly neglecting accounting systems and internal controls, misapplying over twenty accounting principles and misleading the regulator and the public. The Notice explains how they submitted six years of misleading and inaccurate accounting statements and inaccurate capital reports that enabled them to grow Fannie Mae in an unsafe and unsound manner.’ These charges were made in 2006. The Court ordered Raines to return $50 Million Dollars he received in bonuses based on the miss-stated Fannie Mae profits.

Tim Howard - Was the Chief Financial Officer of Fannie Mae. Howard ‘was a strong internal proponent of using accounting strategies that would ensure a ‘stable pattern of earnings’ at Fannie. (In everyday English - it appeared that he was cooking the books.) The Government Investigation determined that, ‘Chief Financial Officer, Tim Howard, failed to provide adequate oversight to key control and reporting functions within Fannie Mae,’ On June 16, 2006, Rep. Richard Baker, R-La., asked the Justice Department to investigate his allegations that two former Fannie Mae executives lied to Congress in October 2004 when they denied manipulating the mortgage-finance giant’s income statement to achieve management pay bonuses. Investigations by federal regulators and the company’s board of directors since concluded that management did manipulate 1998 earnings to trigger bonuses. Raines and Howard resigned under pressure in late 2004. Howard’s Golden Parachute was estimated at $20 Million!

Jim Johnson - A former executive at Lehman Brothers and who was later forced from his position as Fannie Mae CEO. A look at the Office of Federal Housing Enterprise Oversight’s May 2006 report on mismanagement and corruption inside Fannie Mae, and you’ll see some interesting things about Johnson. Investigators found that Fannie Mae had hidden a substantial amount of Johnson’s 1998 compensation from the public, reporting that it was between $6 million and $7 million when it fact it was $21 million.’ Johnson is currently under investigation for taking illegal loans from Countrywide while serving as CEO of Fannie Mae. Johnson’s Golden Parachute was estimated at $28 Million.

WHERE ARE THEY NOW?
FRANKLIN RAINES? Raines works for the Obama Campaign as Chief Economic Advisor
TIM HOWARD? Howard is also a Chief Economic Advisor to Obama
JIM JOHNSON? Johnson hired as a Senior Obama Finance Advisor and was selected to run Obama’s Vice Presidential Search Committee

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