Capital Markets

Anatomy of a Breakdown

Concerted government policy helped trigger the financial meltdown-and will almost certainly extend it.

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It was not an absence of federal intervention that produced the Great Financial Panic of 2008. Contrary to the assertions of those clamoring for new regulations (see "Is Deregulation to Blame?," page 36), the liquidity shortage and credit freeze that triggered Washington's biggest intrusion into the economy since Richard Nixon's wage and price controls were caused by bad government policy and worse crisis management.

As the housing bubble inflated from 1997 to 2006, banks, fueled by the Federal Reserve, prodded by activists, and egged on by Wall Street, created ever more exotic mortgage loans that pushed up housing prices and extended mortgage debt to families vulnerable to economic downturns. Several layers of financial products were tied to these mortgages. As some of the derivative instruments and underlying mortgages collapsed, collateral damage raced through the entire system.

In 2008 the Bush administration took a series of frantic steps to stop the bleeding. It backed a hostile takeover of the investment bank Bear Stearns. It took over home lending behemoths Fannie Mae and Freddie Mac, an act that put $5 trillion worth of mortgages—more than $1 trillion of which are subprime—on the federal government's books, not to mention the $200 billion it had to commit to guarantee Fannie and Freddie's debts. It made hundreds of billions of dollars available to banks through the Fed's "discount window," its mechanism to make short-term loans to certain institutions, put up $85 billion to take over the insurance giant AIG, and offered another $250 billion to individual banks to rebuild their balance sheets.

In October the administration convinced Congress to authorize the Treasury Department to spend upward of $700 billion buying up toxic mortgage-backed securities, most of which contain sizeable numbers of subprime mortgages. Each step not only failed to calm the market but seemed to increase the sense of impending doom (also fanned by sky-is-falling pronouncements from President Bush on down). After a month of U.S. government action, the mortgage crisis had grown into a global financial panic, the repercussions of which we'll be living with for decades.

The Roots of the Crisis

Throughout the 1990s and the early years of this century, both major political parties became intoxicated with the idea of promoting "affordable" housing. By the time the crisis blew up, Congress was mandating that roughly 50 percent of the mortgages issued by Fannie and Freddie go to households making below their area's median income.

Many conservative commentators have blamed the housing mess on the 1977 Community Reinvestment Act (CRA), which essentially required banks to increase lending in low-income areas. While the CRA was a bad law, its role in recent events has been overblown. After all, it was on the books for decades before the bubble began. The law's worst legacy is the permanent network of "affordable housing" advocates that sprang up after it passed. These groups, which were intended to facilitate lending in poor areas, continually called for increased activity by banks and additional government support for affordable housing initiatives. The CRA also helped create a climate in which lending to low-income households was a key metric and condition regulators used in approving bank mergers.

Other, more recent developments played a bigger role in the financial crisis. In 1993 the Federal Reserve Bank of Boston published "Closing the Gap: A Guide to Equal Opportunity Lending." The report recommended a series of measures to better serve low-income and minority households. Most of the recommendations were routine and mundane: better staff training, improved outreach and communication, and the like. But the report also urged banks to loosen their income thresholds for receiving a mortgage. In the years after the report was published, activists and officials—especially in the Department of Housing and Urban Development, under both Bill Clinton and George W. Bush—used its findings to pressure banks to increase their lending to low-income households. By the turn of the century, other changes in federal policy made those demands more achievable.

You can't lend money if you don't have it. And beginning in 2001, the Federal Reserve made sure lots of people had it. In January 2001, when President Bush took office, the federal funds rate, the key benchmark for all interest rates in this country, was 6.5 percent. Then, in response to the meltdown in the technology sector, the Fed began cutting the rate. By August 2001, it was at 3.75 percent. And after the terrorist attacks of September 11, the Fed opened the spigot. By the summer of 2002, the federal funds rate was 1 percent.

The central bank's efforts went so far that, at one point in 2003, we had interest rates below the rate of inflation, or effectively negative. Institutional investors, looking at low yields on Treasury securities, needed a place to park money and earn some kind of return. Mortgage-backed securities became a favorite investment vehicle. Under traditional models, they were very safe and, because of Fed policy, even the most conservative fund could earn better returns than they could on Treasury notes.

Investment houses would bundle individual mortgages from several banks together into bond-like products that they would sell to individual investors. Mortgages historically have been seen as among the safest investments, and the era of rising house values transformed "safe" into "guaranteed returns."

For the first half of this decade, trading in mortgage-backed securities exploded. Their growth provided unprecedented levels of capital in the mortgage market. At the same time, investment houses were looking to replace the healthy fees earned during the dot-com bubble. Mortgage-backed securities had fat margins, so everyone jumped into the game.

The additional capital to underwrite mortgages was a good thing—up to a point. Homeownership expanded throughout most of Bush's presidency. During the last few decades, the American homeownership rate has been around 60 percent of adult households. At the height of the bubble, it reached almost 70 percent. It is clear now that many people who got mortgages at the high-water mark should not have. But Wall Street needed to feed the stream of mortgage-backed securities.

Fannie and Freddie

It's hard to overstate the role Fannie Mae and Freddie Mac played in creating this crisis. Chartered by Congress, Fannie in 1938 and Freddie in 1970, the two government-sponsored enterprises provided much of the liquidity for the nation's housing market. Because investors believed—correctly, it turns out—that Fannie Mae and Freddie Mac were backed by an implicit guarantee from the federal government, the companies were able to raise money more cheaply than their competitors. They were also exempt from federal, state, and local taxes.

The chief mission of Fannie Mae and Freddie Mac was to buy up mortgages issued by banks, freeing up bank money for additional mortgages. Fannie and Freddie would package these mortgages into mortgage-backed securities and sell those on the secondary mortgage market, providing cash to continue the cycle. Even when selling these securities, they often retained the full risk for any default, pocketing a portion of the interest payments in return.

Fannie and Freddie would also keep a portion of these mortgages in their own investment portfolios, providing a constant influx of interest payments. Starting in the 1990s, they increasingly created and traded in complex derivatives, financial instruments designed to insulate them, through hedging, from mortgage loan defaults and interest rate increases. From the mid-'90s through the early 2000s, Fannie Mae and Freddie Mac were the darlings of Wall Street, with steady earnings growth and solid credit ratings. Fannie's share priced peaked in 2001 almost 400 percent above its 1995 level; Freddie peaked in 2004, almost 500 percent higher than in 1995. This growth would not last.

In June 2003, Freddie Mac surprised Washington and Wall Street with a management shakeup. The top executives were sent packing, and a new auditor, PricewaterhouseCoopers, identified several accounting irregularities on the company's books, especially related to its portfolio of derivatives. The company would have to restate earnings for the previous several years.

Just days before, the agency responsible for regulating Freddie, the Office of Federal Housing Enterprise Oversight, had reported to Congress that the company's management "effectively conveys an appropriate message of integrity and ethical values." Just how wrong this assessment was would soon become abundantly clear.

As the extent of the accounting irregularities emerged, federal regulators descended on the company and quickly determined that the accounting troubles extended to Fannie Mae as well. With concerns about the companies growing, the Bush administration unveiled proposals to rein them in. Then-Treasury Secretary John Snow proposed putting Fannie and Freddie under his department's oversight and subjecting them to the kind of controls over risk and capital reserves that apply to commercial banks. (Fannie's debt-to-capital ratio was 30 to 1, whereas conventional banks have debt-to-capital ratios of around 11 to 1.)

But Fannie and Freddie by this point were political powerhouses. When the accounting scandal first emerged, Fannie's chairman was Franklin Raines, former director of the Office of Management and Budget under President Bill Clinton. Its vice chairman was Jamie Gorelick, a former Justice Department official who had served on the 9/11 commission. The two companies provided tens of millions of dollars in annual campaign contributions and spent more than $10 million a year combined on outside lobbyists.

Fannie and Freddie rallied their friends on Capitol Hill, who immediately pushed back against the Bush proposals. Rep. Barney Frank (D-Mass.), the ranking Democrat on the House Financial Services Committee, said, "These two entities-Fannie Mae and Freddie Mac-are not facing any kind of financial crisis. The more people exaggerate these problems, the more pressure there is on these companies, the less we will see in terms of affordable housing." The reform effort fizzled.

In 2006 the Office of Federal Housing Enterprise Oversight issued the blistering results of its investigation. The irregularities, investigators concluded, amounted to "extensive financial fraud." The purpose of the deception was clear: to "smooth" earnings from year to year in order to maintain increasing returns and maximize executive bonuses. Raines, for example, earned more than $50 million in bonuses tied to earnings growth during his six-year tenure.

Interestingly, the report noted two questionable transactions Fannie conducted with the investment bank Goldman Sachs in 2001 and 2002 that pushed more than $100 million of existing profits into the future, creating a kind of cushion for future earnings. The chairman of Goldman Sachs when the dodgy transactions took place was the man behind the 2008 bailout: Treasury Secretary Henry Paulson.

In the end, Fannie and Freddie had to restate more than $15 billion in earnings. The Office of Federal Housing Enterprise Oversight and the Securities and Exchange Commission fined Fannie $400 million and Freddie $125 million. There was a new push for tighter oversight on the Hill, but this too withered as Fannie and Freddie rallied support through increased lending to low-income borrowers.

Then Fannie and Freddie went on a subprime bender. The companies made it clear they wanted to buy up all the subprime mortgages—and Alt-A mortgages, whose risk is somewhere between prime and subprime—that they could find. They eventually acquired around $1 trillion of the paper. The market responded. In 2003 less than 8 percent of all mortgages were subprime. By 2006 the number was more than 20 percent. Banks knew they could sell subprime products to Fannie and Freddie. Investments banks realized that if they laced ever-increasing amounts of subprime mortgages into mortgage-backed securities, they could add slightly higher levels of risk and, as a result, boost the returns and earn bigger fees. The ratings agencies, thinking they were simply dealing with traditionally appreciating mortgages, didn't look under the hood.

But after several years of a housing boom, the pool of households that could responsibly use the more exotic financing products had dried up. Essentially, there were no more people who qualified for even a subprime mortgage.

Banks realized they could make ever more exotic loan products (such as interest-only loans), get the affordable housing activists off their backs, and immediately diffuse their risks by folding the mortgages into mortgage-backed securities. After all, Fannie and Freddie would buy anything.

The Crash

Everything worked as long as housing prices continued to rise. Suddenly, though, there weren't enough buyers. (See "Houses of Pain," page 40.) At the same time, the first wave of the more exotic mortgages began to falter. Interest rates on adjustable-rate mortgages moved higher; the Fed was finally constricting the money flow, with the federal funds rate peaking at 5.25 percent in July 2006. Mortgages that were initially interestonly were close to resetting, with monthly payments jumping to include principal. A significant number of these mortgages moved into default and foreclosure, which further dampened housing prices.

The overall foreclosure numbers were small; someone simply looking at housing statistics could be forgiven for wondering what all the fuss was about. Nationally, throughout 2007 and 2008, the number of mortgages moving into foreclosure was only about 1 percent to 2 percent, suggesting that 98 percent to 99 percent of mortgages are sound. But the foreclosed mortgages punched way above their weight class; they were laced throughout the mortgage-backed securities owned by most financial institutions.

The complexity of these financial products cannot be overstated. They usually had two or three "tranches," different baskets of mortgages that paid out in different ways. Worse, as different firms bought and sold them, they were sliced and diced in varying ways. A mortgage-backed security owned by one company could be very different when it was sold to another.

No one fully understood how exposed the mortgage-backed securities were to the rising foreclosures. Because of this uncertainty, it was hard to place a value on them, and the market for the instruments dried up. Accounting regulations required firms to value their assets using the "mark-to-market" rule, i.e., based on the price they could fetch that very day. Because no one was trading mortgage-backed securities anymore, most had to be "marked" at something close to zero.

This threw off banks' capital-to-loan ratios. The law requires banks to hold assets equal to a certain percentage of the loans they give out. Lots of financial institutions had mortgage-backed securities on their books. With the value of these securities moving to zero (at least in accounting terms), banks didn't have enough capital on hand for the loans that were outstanding. So banks rushed to raise money, which raised self-fulfilling fears about their solvency.

Two simple regulatory tweaks could have prevented much of the carnage. Suspending mark-to-market accounting rules (using a five-year rolling average valuation instead, for example) would have helped shore up the balance sheets of some banks. And a temporary easing of capital requirements would have given banks the breathing room to sort out the mortgage-backed security mess. Although it is hard to fix an exact price for these securities in this market, given that 98 percent of underlying mortgages are sound, they clearly aren't worth zero. (For more proposed solutions, see "Better Than a Bailout," page 30.)

Alas, the Fed and the Treasury Department, in full crisis mode, decided to provide their own capital to meet the regulatory requirements. The first misstep, in March, was to force a hostile takeover of Bear Stearns, putting up $30 billion to $40 billion to back J.P. Morgan's purchase of the distressed investment bank. In the long term, it probably would have been better to let Bear Stearns fail and go into bankruptcy. That would have set in motion legal proceedings that would have established a baseline price for mortgage-backed securities. From this established price, banks could have begun to sort out their balance sheets.

Immediately after the collapse of Bear Stearns, rumors circulated on Wall Street of trouble at another investment bank, Lehman Brothers. Lehman went on a P.R. offensive to beat back those rumors. The company was successful in the short term but then did nothing during the next several months to shore up its balance sheet. Its demise in September-the only major bankruptcy allowed during bailout season-was largely self-inflicted.

The collapse of the mortgage-backed security market now started to pollute other financial products. Collateralized debt obligations and credit default swaps are complicated financial products intended to help spread the risk of defaults. An investor holding a bond or mortgage-backed security may purchase one of these products so that, in the event the bond or mortgage-backed security defaults, they would recoup their investment. Bonds rarely default, so collateralized debt obligations and credit default swaps had traditionally been a fairly safe and conservative market.

But like the underlying bonds and mortgage-backed securities, these instruments became more exotic. Companies sold credit default swaps on an individual bond or security to multiple investors. If there was a default, each one of these investors would have to be paid up to the full amount of the bond or security. Imagine if you bought fire insurance on your house and all your neighbors did too. If your house burned, everyone would be compensated for the loss of your house.

Suddenly, stable firms such as AIG, which aggressively sold credit default swaps, were over-exposed. These developments threw off the accounting in one division of AIG, threatening the rest of the firm. Given a few days, AIG could have sold enough assets to cover the spread, but ironclad accounting regulations precluded this. So the government stepped in.

The Bailout

The one-two punch of Lehman's failure and the government's $85 billion bailout of AIG on September 16 spooked both Wall Street and the White House. With Fannie Mae and Freddie Mac already in government receivership, there were fears that the weakness stemming from mortgage-backed securities would spread through the entire financial system. Money began leaving the markets to seek the security of Treasury bonds.

Then, on September 18, it was reported that the Reserve Primary Fund and the Reserve International Liquidity Fund, two commercial paper money market funds, "broke the buck," meaning they lost money. The commercial paper market is supposed to be boring. Every day, companies around the world borrow hundreds of billions to smooth cash flows; the next day they pay it back, giving the bank that lent the money a very small return. When these money market funds lost money, it was a signal that the commercial paper market was drying up, that banks were hesitant to make even these very safe loans.

That's when the market freaked out. The Dow Jones Industrial Average fell over 600 points on September 19. When the government announced that there would be a rescue plan, the market temporarily rebounded. After some details of the plan emerged over the weekend, the Dow had another selloff. A roller-coaster of selloffs and rallies followed, as the market waited to see what the government would do. Every gyration, up or down, was used as an argument for the bailout. If the market moved lower, it was because Congress hadn't approved the bailout. If it moved higher, it was because the market was convinced the bailout would happen. On October 2, after initially defeating the package, the House of Representatives bowed to pressure and passed it.

The original plan crafted by the Treasury Department would have authorized the government to spend up to $700 billion on mortgage-backed securities and other "toxic" debt, thereby removing them from banks' balance sheets. With the "bad loans" off the books, the banks would become sound. Because it was assumed that the mortgage-backed security market was "illiquid," the government would become the buyer of last resort for these products. There was a certain simple elegance to the plan. To paraphrase H.L. Mencken, the solution was neat, plausible, and wrong.

No market is truly illiquid. Last summer, Merrill Lynch unloaded a bunch of bad debt at 22 cents on the dollar. There are likely plenty of buyers for the banks' toxic debt, just not at the price the banks would prefer. Enter the government, which clearly intended to purchase mortgage-backed securities at some premium above the market price.

We don't know yet what the premium will be nor how it will be determined. Well, in a sense we do. It will mostly be determined by politics, not economics. This is the foundational flaw in the Treasury Department plan.

The department has begun a process to determine the assets it will buy and the manner it will set a price. As with everything in government, these are lobbyable moments, a time when swarms of financial service firms, investor groups, and housing advocates try to game the system for their clients or members. The further away from economics these decisions are made, the more risk there is for taxpayers. The higher the premium over any current market price, the longer the government will have to hold the assets and the more exposure there will be for taxpayers.

The risk here is particularly high given the complicated and opaque nature of the financial instruments involved. Few on Wall Street truly understand these products. The bailout authorizes the Treasury Department to bypass normal contracting rules and hire outside private firms to handle the purchases and manage the toxic assets. The fact that these private firms have ongoing relationships with the banks selling the bad assets creates a serious conflict of interest.

Some commentators have drawn parallels to the savings and loan bailout in the 1980s, when the government established the Resolution Trust Corporation to dispose of the assets of failed thrifts. But the Resolution Trust Corporation took on those assets only as thrifts went bankrupt. Under the new plan, by contrast, federal bureaucrats and their outside contractors decide which assets to buy, including equity stakes in commercial banks that aren't particularly happy about having Uncle Sam as a major shareholder. Bureaucrats will be actively investing taxpayer funds in individual securities and then managing the portfolio until they decide to sell. You don't have to be paranoid to fear the political dynamics that will shape these decisions.

More to Come

We have crossed a financial Rubicon. The bailout is just the beginning of Washington's increased involvement in the economy. The government has now taken partial ownership of the nation's nine largest banks. There is talk of bailouts for other weak industries, including the carmakers and the airlines. There certainly will be a host of new regulations that will likely be with us long after the government has sold off the last of the bad debt. We could be entering an era where the financial services sector evolves into a kind of regulated utility.

Libertarians used to joke that we were on the verge of another rerun of That '70s Show, with a return to old regulations and high taxation. We should be so lucky. The events of the last several months presage a return to the 1930s, with a new surge of direct federal involvement in the economy. If we fail to beat back these new controls, future historians may mark this time as the beginning of a long winter of statism and stagnation.

Mike Flynn is director of government affairs at the Reason Foundation.