The stock market is in greater turmoil this week than it’s been since the “Great Depression.” (Ok, I said the words, even though I know they are scary). Lots of people ask why. Lots of people say it started with real estate. Not so, I think.
First, why were the 1930s called the Great Depression? To distinguish them from the other depressions! Yes, there had been one about 1908. And there had been several in the 19th Century. The regulatory agencies created in the 1930s and the powers granted to the Federal Reserve were supposed to stave off further depressions.
Then along came the 1980s. Yep, over 20 years ago. “Deregulate!” was the cry of the day. “Too much government!” The result: “irrational exuberance,” in the words of Greenspan. First, a mini-stock market tumble in the late 1990s, then a real estate bubble, now this. I’m grateful that there is still enough regulation that the SEC could send its troops into Lehman’s offices Friday night to prevent the funds from the solvent brokerage side of the business from being transferred to the irrationally exuberant, bankrupt side – saving the investors who had put their IRAs and 401(k)s in Lehman’s hands. Of course, the stock in those funds may not be worth much for the next few years, but at least it’s there.
So, last night I got a series of cartoons from one of my friends purporting to explain the mess we are in. One of the selections from the series is displayed here. The problem with the series is that it started with a local loan officer explaining about “liar loans” and buying homes without down payments. That is NOT where it started. It started in the offices of Wall Street where investment bankers and their lawyers cooked up the idea of “securitizing mortgages.” Not a bad idea at first. Investment banks would buy groups of mortgages and make more money available for additional mortgages to expand housing availability. The problem is that they got greedy and there was no government regulation to keep that greed in check. Wall Street ran out of good loans to make, so to keep the investment fees rolling, they created loan “programs” that would allow people who weren’t really ready to be homeowners to get home loans. And since no one in the securities regulation business (i.e. the federal government) was looking over their shoulders and blowing the whistle, they pushed these programs on the local bankers and brokers (who, of course, eagerly, in most cases pushed them to potential homeowners). This summer, it all began to collapse.
In response, the Treasury got Congress to pass the Housing and Economic Recovery Act at the end of July. There were a lot of tidbits for the small guys, and President Bush threatened to veto it, but ultimately, he signed the bill into law. The big piece of the Act, which Treasury had insisted it would not really need, was authority to nationalize Fannie Mae and Freddie Mac. A month later, it happened. The Treasury has replaced the management of both companies and will presumably oversee their operation. The only interpretation of this desparate decision by an "anti-government" administration is that the mortgage market and the institutions to make it operate are broken. But there are other broken pieces also, and they broke for the same reasons -- lack of proper government regulation.
Fannie Mae and Freddie Mac were created as “quasi-government” institutions to help the housing market. They were to guarantee mortgages (provided those mortgages met certain standards), and were able to fund these guarantees by issuing their own debt, which was in turn kinda-maybe-backed by the government. In principle, these companies were supposed to use the government guarantee to reduce the mortgage cost to the homeowners, but some at the Federal Reserve and others have argued for quite a while that this hardly occurred. Instead, Fannie and Freddie used the funding advantage to rack up huge profits and squeeze the true private sector out of the “conforming” mortgage market. There were no small companies to compete and drive out the crazy, worthless loans. And no government regulators around to say these loans made no sense. The result is government deregulation and government subsidies run-amok. (The links in this paragraph were grabbed from the NY Times column -- I don't do that research myself!)
As the Freakonomics guys said in their guest NY Times blog this morning:
“Fannie and Freddie were weakly supervised and strayed from the core mission. They began using their subsidized financing to buy mortgage-backed securities which were backed by pools of mortgages that did not meet their usual standards. Over the last year, it became clear that their thin capital was not enough to cover the losses on these subprime mortgages. The massive amount of diffusely held debt would have caused collapses everywhere if it was defaulted upon; so the Treasury announced that it would explicitly guarantee the debt.
"But once the debt was guaranteed to be secure (and the government would wipe out shareholders if it carried through with the guarantee), no self-interested investor was willing to supply more equity to help buffer the losses. Hence, the Treasury ended up taking them over.”
So, that’s the story of the housing contribution to where we are – it was just a middle-man for the transfer of a crisis that started in Washington and Wall Street back in the 1980s. To prevent the problems in the future, what change do we need? Who can lead us to rational regulation? That’s up to the voters in November. | 
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