Politicians are really good at finding scapegoats to cover for their policy failures. For the 2008 financial collapse, the sacrificial lambs are bankers. The cover story is that they are all poor managers, driven by greed to sell shady mortgages, which were then fraudulently packaged into complex financial instruments, and then sold without proper disclosure to innocent investors.
With the “crimes” come the penalties. In 2010, the Securities and Exchange Commission compelled Goldman Sachs to pay a $550 million fine. Just recently, it extracted $296.9 million from JP Morgan and $120 million from Credit Suisse. Countless more federal, state, and private claims are pending. “These actions demonstrate,” said the SEC’s Kenneth Lench, “that we intend to hold accountable those who misled investors through poor disclosures in the sale of R.M.B.S. (residential mortgage-backed securities) and other financial products . . .” The suits and penalties are just, claimed New York attorney general Eric T. Schneiderman (who is co-chair of a committee created by President Obama) because they “hold financial institutions accountable for the misconduct that led to the worst financial crisis in nearly a century.”
The truth, however, is more complicated. Some banks did jump the rails by selling toxic assets to other investors, which inevitably exacerbate the problem. But the banks weren’t the only perpetrators. But in reality it was the government’s monetary policies and redistribution schemes set the precedents that poisoned the financial markets.
One such policy is the Community Reinvestment Act (CRA), passed in 1977, which compels banks to eliminate “redlining” within a community. The only problem is that banks draw a redline to distinguish between low-risk and high-risk borrowers. As John Allison (former Chairman and CEO of BB&T) notes in his new book The Financial Crisis and the Free Market Cure, “It was explicitly clear that under the act, banks had a legal duty to make high-risk home loans to low-income borrowers.”
And it was made explicitly clear by community activists and bureaucrats using the coercive powers inherent in regulatory permits. State banking departments and the Federal Reserve can prohibit a bank from opening new branches and completing a merger or acquisition unless it has a sufficiently high CRA rating – i.e., unless the bank has, in the eyes of housing do-gooders, enough subprime loans in its portfolio. The CRA, though, caused merely a trickle of the ensuing flood of toxic debt. The dynamiting of the dam began in the early 2000’s with two government policies.
First, the Federal Reserve kept interest rates artificially low, which swamped the economy with fiat money. Then in 2006, sensing that Greenspan had triggered inflation, it caused whiplash in the banking industry by dramatically (and without prior warning) raising interest rates. That caused an inverted yield curve. With short-term rates higher than long-term ones, writes Allison, “banks started incurring significant losses in their bond portfolios.” This, in turn, made it more difficult for banks to weather the impending 2008 storm.
Starting in early 2000, the Fed’s flood of cash was funneled into the housing market by the government’s “affordable housing” policies. Under the altruistic guise of helping the downtrodden, Fannie Mae and Freddie Mac were put on steroids by President Clinton and, among others, Congressman Barney Frank. Fannie and Freddie – government sponsored enterprises that socialize risk by guaranteeing bailouts – were pressured to have more than half of their loan portfolios in “affordable housing,” i.e., in subprime loans.
Over time, this caused Fannie and Freddie to have leverage ratios of about 1,000 to 1 (versus private banks with a traditional ratio of 10 to 1), which included some $2 trillion in subprime debt. A 1999 article in The New York Times warned that “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 . . .”
This warning is spot on, if understated. Fannie and Freddie did not run into trouble. They were a major cause of the financial collapse. Armed with their new mandate to create homeownership ex nihilo, and awash in Fed dollars, they flooded the financial markets with toxic debt. The only crime committed by financial institutions downstream—e.g., Goldman Sachs, Lehman Brothers, JP Morgan, Bear Stearns – was to divert the murky flood into a complex network of tributaries (e.g., CDS’s and CDO’s). The government has also charged – and the banks have, in some cases, admitted – that they misled investors, or failed to fully disclose information about those complex products.
Those scapegoating these companies are attempting to cover their own complicity. Some, such as Barney Frank during a 2004 congressional hearing, assured the markets that “I don’t see anything in this [Office of Federal Housing Enterprise Oversight] report that raises safety and soundness problems” about Fannie and Freddie.
Worse, the scapegoaters are evading the real lessons to be learned from the 2008 financial debacle. The real cause of an economy’s systemic collapse is government interference in free-market capitalism. Our politicians have clearly not learned this lesson. Just watch what happens when Obamacare really kicks in.
Gary Hull is the director of the Program on Values and Ethics in the Marketplace at Duke University