The Reckoning

SEC Puts Small Downpayment on Justice

Hardly worth the fanfare the SEC gave it Friday - taken in context, this remains enormously underwhelming - but the charges against six pre-cataclysm Fannie Mae and Freddie Mac executives could be the beginning of a new attitude I referenced in this post.

Sadly, the Obama administration’s usual tin-ear for the vitals of a political debate is fully deployed here. While most economists long ago settled on private sector investment bank recklessness - and the opaque nature of the derivatives market in a globalized world - as the main cause for the 2008 disaster, a vocal minority on the right clings to the usual “government is the problem” script. No doubt, some will soon be citing the SEC’s decision to make Fannie and Freddie leaders the target of the first serious attempt to prosecute major figures as proof that the banks aren’t to blame.

Purveyors of this line of nonsense have been busy preparing the ground.

Peter J. Wallison, for instance, a senior fellow at the American Enterprise Institute, recently published an op-ed in USA Today pointing his finger at Freddie and Fannie as the sole culprits. Wallison, a member of the federal commission who investigated the crisis and a dissenter from the report (which blamed unregulated banking practices), claims that “[e]fforts to blame the banks for the financial crisis are failing because they are not supported by data.”

He then cites, selectively, data about the extent of Fannie and Freddie’s involvement in the subprime market, along with the fact that government policy beginning in 1992 required Fannie and Freddie to skew their lending to meet “affordable housing” standards that, inevitably, included more and more loans to borrowers who were questionable risks. All this is true.

What the short op-ed (and this line of argument generally) leaves out completely is that subprime lending was not the cause of the crisis. Subprime mortgages, in and of themselves, may well have been bad bets. There is no way to know how many of them would have wound up in default ultimately had reckless practices on Wall Street not converted bad lending practices into a super virus invisibly sunk into every organ of the national and global economy.

How did that happen? Securitization is the answer. By bundling thousands of subprime and prime mortgages into reeking tubes of financial sausage, then bundling them again and, with the help of ratings agencies, selling them to investors as AAA securities, the virus quickly seeped into virtually every market in the world. Because such derivatives were (and remain!) virtually unregulated, no government agency had any clue how much these SIVs (structured investment vehicles) had added to bank leverage ratios.

The final non-Fannie/Freddie nail in the coffin came courtesy of the 1997 repeal of the Glass-Steagal Act - that wise FDR reaction to the Great Depression that prohibited commercial banks and corporations from acting like an investment banks. Those constraints (or inefficiencies, as the critics would have it) gone, firms of all kinds leveraged their risks up to nose-bleed levels.

The result: when the sausage pyramid came tumbling down after Lehman Bros. bankruptcy in 2008, the government only learned that same weekend that every virtually major bank in the world had insured all this reckless “creativity” through one firm: Ameican International Group – AIG. One hundred and eighty-two billion dollars of taxpayer money went to bailing AIG out - most of it handed over immediately to investment banks the world over to cover the reckless bets they had made with SIVs which ultimately shattered the post-Cold War global financial system, not to mention the reputation of the United States for financial leadership (a neat coda to the destruction of our geopolitical mojo in Iraq).

So, is this all the fault of congressional action mandating Fannie and Freddie to lend to lower income families? Hardly. Fannie and Freddie were reckless, too, and Congress showed its usual lack of economic savvy when pushing legislation. But at least Fannie and Freddie never kidded anyone about who would be on the hook if they failed.

What’s more, Wallison and others making the “Fannie and Freddie are Satan” argument deftly leave out the fact that those lowered lending standards were supported by congressional majorities of both parties - on the left, with the usual eye toward contituency pleasing income redistribution, on the right, as a paean to the populist notion that homeownership is a prerequisite (presumably like being white or Christian) to being a “real American.”

Put in simpler terms, think of it this way: You win the lottery, get roaring drunk to celebrate, then drive a car that you built yourself - a car that didn’t need breaks, because of your theory that gravity no longer applied to brilliant people like yourself – off a cliff. You’re now close to dead and facing all sorts of restrictions on your actions int eh future. You’ll probably never be quite the same, which frankly is not the worse outcome. However, you’ve decided to sue the traffic engineer who set the speed limit, the company that designed the guard rails you blew through and the city government that agreed, after considerable lobbying by you, not to waste taxpayer funds to put lights along that roadway.

Alan Dershowitz has a word for that.