Anatomy of a Breakdown

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

It was not an absence of federal intervention that produced the GreatFinancial Panic of 2008. Contrary to the assertions of those clamoringfor new regulations (see "Is Deregulation to Blame?," page 36), theliquidity shortage and credit freeze that triggered Washington'sbiggest intrusion into the economy since Richard Nixon's wage and pricecontrols were caused by bad government policy and worse crisismanagement.

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

In 2008 the Bush administration took a series of frantic stepsto stop the bleeding. It backed a hostile takeover of the investmentbank Bear Stearns. It took over home lending behemoths Fannie Mae andFreddie 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 Fannieand Freddie's debts. It made hundreds of billions of dollars availableto banks through the Fed's "discount window," its mechanism to makeshort-term loans to certain institutions, put up $85 billion to takeover the insurance giant AIG, and offered another $250 billion toindividual banks to rebuild their balance sheets.

In Octoberthe administration convinced Congress to authorize the TreasuryDepartment to spend upward of $700 billion buying up toxicmortgage-backed securities, most of which contain sizeable numbers ofsubprime mortgages. Each step not only failed to calm the market butseemed to increase the sense of impending doom (also fanned bysky-is-falling pronouncements from President Bush on down). After amonth of U.S. government action, the mortgage crisis had grown into aglobal financial panic, the repercussions of which we'll be living withfor decades.

The Roots of the Crisis

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

Manyconservative commentators have blamed the housing mess on the 1977Community Reinvestment Act (CRA), which essentially required banks toincrease lending in low-income areas. While the CRA was a bad law, itsrole in recent events has been overblown. After all, it was on thebooks for decades before the bubble began. The law's worst legacy isthe permanent network of "affordable housing" advocates that sprang upafter it passed. These groups, which were intended to facilitatelending in poor areas, continually called for increased activity bybanks and additional government support for affordable housinginitiatives. The CRA also helped create a climate in which lending tolow-income households was a key metric and condition regulators used inapproving bank mergers.

Other, more recent developments playeda bigger role in the financial crisis. In 1993 the Federal Reserve Bankof Boston published "Closing the Gap: A Guide to Equal OpportunityLending." The report recommended a series of measures to better servelow-income and minority households. Most of the recommendations wereroutine and mundane: better staff training, improved outreach andcommunication, and the like. But the report also urged banks to loosentheir income thresholds for receiving a mortgage. In the years afterthe report was published, activists and officials—especially in theDepartment of Housing and Urban Development, under both Bill Clintonand George W. Bush—used its findings to pressure banks to increasetheir lending to low-income households. By the turn of the century,other changes in federal policy made those demands more achievable.

Youcan't lend money if you don't have it. And beginning in 2001, theFederal Reserve made sure lots of people had it. In January 2001, whenPresident Bush took office, the federal funds rate, the key benchmarkfor all interest rates in this country, was 6.5 percent. Then, inresponse to the meltdown in the technology sector, the Fed begancutting the rate. By August 2001, it was at 3.75 percent. And after theterrorist attacks of September 11, the Fed opened the spigot. By thesummer of 2002, the federal funds rate was 1 percent.

Thecentral bank's efforts went so far that, at one point in 2003, we hadinterest 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. Undertraditional models, they were very safe and, because of Fed policy,even the most conservative fund could earn better returns than theycould on Treasury notes.

Investment houses would bundleindividual mortgages from several banks together into bond-likeproducts that they would sell to individual investors. Mortgageshistorically have been seen as among the safest investments, and theera of rising house values transformed "safe" into "guaranteed returns."

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

The additional capital to underwrite mortgages was a goodthing—up to a point. Homeownership expanded throughout most of Bush'spresidency. During the last few decades, the American homeownershiprate has been around 60 percent of adult households. At the height ofthe bubble, it reached almost 70 percent. It is clear now that manypeople who got mortgages at the high-water mark should not have. ButWall Street needed to feed the stream of mortgage-backed securities.

Fannie and Freddie

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

Thechief mission of Fannie Mae and Freddie Mac was to buy up mortgagesissued by banks, freeing up bank money for additional mortgages. Fannieand Freddie would package these mortgages into mortgage-backedsecurities and sell those on the secondary mortgage market, providingcash to continue the cycle. Even when selling these securities, theyoften retained the full risk for any default, pocketing a portion ofthe interest payments in return.

Fannie and Freddie would alsokeep a portion of these mortgages in their own investment portfolios,providing a constant influx of interest payments. Starting in the1990s, they increasingly created and traded in complex derivatives,financial instruments designed to insulate them, through hedging, frommortgage loan defaults and interest rate increases. From the mid-'90sthrough the early 2000s, Fannie Mae and Freddie Mac were the darlingsof Wall Street, with steady earnings growth and solid credit ratings.Fannie's share priced peaked in 2001 almost 400 percent above its 1995level; Freddie peaked in 2004, almost 500 percent higher than in 1995.This growth would not last.

In June 2003, Freddie Macsurprised Washington and Wall Street with a management shakeup. The topexecutives were sent packing, and a new auditor,PricewaterhouseCoopers, identified several accounting irregularities onthe company's books, especially related to its portfolio ofderivatives. The company would have to restate earnings for theprevious several years.

Just days before, the agencyresponsible for regulating Freddie, the Office of Federal HousingEnterprise Oversight, had reported to Congress that the company'smanagement "effectively conveys an appropriate message of integrity andethical values." Just how wrong this assessment was would soon becomeabundantly clear.

As the extent of the accountingirregularities emerged, federal regulators descended on the company andquickly determined that the accounting troubles extended to Fannie Maeas well. With concerns about the companies growing, the Bushadministration unveiled proposals to rein them in. Then-TreasurySecretary John Snow proposed putting Fannie and Freddie under hisdepartment's oversight and subjecting them to the kind of controls overrisk and capital reserves that apply to commercial banks. (Fannie'sdebt-to-capital ratio was 30 to 1, whereas conventional banks havedebt-to-capital ratios of around 11 to 1.)

But Fannie andFreddie by this point were political powerhouses. When the accountingscandal first emerged, Fannie's chairman was Franklin Raines, formerdirector of the Office of Management and Budget under President BillClinton. Its vice chairman was Jamie Gorelick, a former JusticeDepartment official who had served on the 9/11 commission. The twocompanies provided tens of millions of dollars in annual campaigncontributions and spent more than $10 million a year combined onoutside lobbyists.

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

In 2006 the Office of Federal HousingEnterprise Oversight issued the blistering results of itsinvestigation. 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 increasingreturns and maximize executive bonuses. Raines, for example, earnedmore than $50 million in bonuses tied to earnings growth during hissix-year tenure.

Interestingly, the report noted twoquestionable transactions Fannie conducted with the investment bankGoldman Sachs in 2001 and 2002 that pushed more than $100 million ofexisting profits into the future, creating a kind of cushion for futureearnings. The chairman of Goldman Sachs when the dodgy transactionstook place was the man behind the 2008 bailout: Treasury SecretaryHenry Paulson.

In the end, Fannie and Freddie had to restatemore than $15 billion in earnings. The Office of Federal HousingEnterprise Oversight and the Securities and Exchange Commission finedFannie $400 million and Freddie $125 million. There was a new push fortighter oversight on the Hill, but this too withered as Fannie andFreddie rallied support through increased lending to low-incomeborrowers.

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

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

Banksrealized they could make ever more exotic loan products (such asinterest-only loans), get the affordable housing activists off theirbacks, and immediately diffuse their risks by folding the mortgagesinto mortgage-backed securities. After all, Fannie and Freddie wouldbuy anything.

The Crash

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

Theoverall foreclosure numbers were small; someone simply looking athousing statistics could be forgiven for wondering what all the fusswas about. Nationally, throughout 2007 and 2008, the number ofmortgages moving into foreclosure was only about 1 percent to 2percent, suggesting that 98 percent to 99 percent of mortgages aresound. But the foreclosed mortgages punched way above their weightclass; they were laced throughout the mortgage-backed securities ownedby most financial institutions.

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

Noone fully understood how exposed the mortgage-backed securities were tothe rising foreclosures. Because of this uncertainty, it was hard toplace 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.

Thisthrew off banks' capital-to-loan ratios. The law requires banks to holdassets equal to a certain percentage of the loans they give out. Lotsof financial institutions had mortgage-backed securities on theirbooks. With the value of these securities moving to zero (at least inaccounting terms), banks didn't have enough capital on hand for theloans that were outstanding. So banks rushed to raise money, whichraised self-fulfilling fears about their solvency.

Two simpleregulatory tweaks could have prevented much of the carnage. Suspendingmark-to-market accounting rules (using a five-year rolling averagevaluation instead, for example) would have helped shore up the balancesheets of some banks. And a temporary easing of capital requirementswould have given banks the breathing room to sort out themortgage-backed security mess. Although it is hard to fix an exactprice for these securities in this market, given that 98 percent ofunderlying mortgages are sound, they clearly aren't worth zero. (Formore proposed solutions, see "Better Than a Bailout," page 30.)

Alas,the Fed and the Treasury Department, in full crisis mode, decided toprovide their own capital to meet the regulatory requirements. Thefirst misstep, in March, was to force a hostile takeover of BearStearns, putting up $30 billion to $40 billion to back J.P. Morgan'spurchase of the distressed investment bank. In the long term, itprobably would have been better to let Bear Stearns fail and go intobankruptcy. That would have set in motion legal proceedings that wouldhave established a baseline price for mortgage-backed securities. Fromthis established price, banks could have begun to sort out theirbalance sheets.

Immediately after the collapse of BearStearns, rumors circulated on Wall Street of trouble at anotherinvestment bank, Lehman Brothers. Lehman went on a P.R. offensive tobeat back those rumors. The company was successful in the short termbut then did nothing during the next several months to shore up itsbalance sheet. Its demise in September-the only major bankruptcyallowed during bailout season-was largely self-inflicted.

Thecollapse of the mortgage-backed security market now started to polluteother financial products. Collateralized debt obligations and creditdefault swaps are complicated financial products intended to helpspread the risk of defaults. An investor holding a bond ormortgage-backed security may purchase one of these products so that, inthe event the bond or mortgage-backed security defaults, they wouldrecoup their investment. Bonds rarely default, so collateralized debtobligations and credit default swaps had traditionally been a fairlysafe and conservative market.

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

Suddenly, stable firmssuch as AIG, which aggressively sold credit default swaps, wereover-exposed. These developments threw off the accounting in onedivision of AIG, threatening the rest of the firm. Given a few days,AIG could have sold enough assets to cover the spread, but ironcladaccounting regulations precluded this. So the government stepped in.

The Bailout

Theone-two punch of Lehman's failure and the government's $85 billionbailout of AIG on September 16 spooked both Wall Street and the WhiteHouse. With Fannie Mae and Freddie Mac already in governmentreceivership, there were fears that the weakness stemming frommortgage-backed securities would spread through the entire financialsystem. Money began leaving the markets to seek the security ofTreasury bonds.

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

That'swhen the market freaked out. The Dow Jones Industrial Average fell over600 points on September 19. When the government announced that therewould be a rescue plan, the market temporarily rebounded. After somedetails of the plan emerged over the weekend, the Dow had anotherselloff. A roller-coaster of selloffs and rallies followed, as themarket waited to see what the government would do. Every gyration, upor down, was used as an argument for the bailout. If the market movedlower, it was because Congress hadn't approved the bailout. If it movedhigher, it was because the market was convinced the bailout wouldhappen. On October 2, after initially defeating the package, the Houseof Representatives bowed to pressure and passed it.

Theoriginal plan crafted by the Treasury Department would have authorizedthe government to spend up to $700 billion on mortgage-backedsecurities and other "toxic" debt, thereby removing them from banks'balance sheets. With the "bad loans" off the books, the banks wouldbecome sound. Because it was assumed that the mortgage-backed securitymarket was "illiquid," the government would become the buyer of lastresort for these products. There was a certain simple elegance to theplan. To paraphrase H.L. Mencken, the solution was neat, plausible, andwrong.

No market is truly illiquid. Last summer, Merrill Lynchunloaded a bunch of bad debt at 22 cents on the dollar. There arelikely plenty of buyers for the banks' toxic debt, just not at theprice the banks would prefer. Enter the government, which clearlyintended to purchase mortgage-backed securities at some premium abovethe market price.

We don't know yet what the premium will benor how it will be determined. Well, in a sense we do. It will mostlybe determined by politics, not economics. This is the foundational flawin the Treasury Department plan.

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

The risk here isparticularly high given the complicated and opaque nature of thefinancial instruments involved. Few on Wall Street truly understandthese products. The bailout authorizes the Treasury Department tobypass normal contracting rules and hire outside private firms tohandle the purchases and manage the toxic assets. The fact that theseprivate firms have ongoing relationships with the banks selling the badassets creates a serious conflict of interest.

Somecommentators have drawn parallels to the savings and loan bailout inthe 1980s, when the government established the Resolution TrustCorporation to dispose of the assets of failed thrifts. But theResolution Trust Corporation took on those assets only as thrifts wentbankrupt. Under the new plan, by contrast, federal bureaucrats andtheir outside contractors decide which assets to buy, including equitystakes in commercial banks that aren't particularly happy about havingUncle Sam as a major shareholder. Bureaucrats will be activelyinvesting taxpayer funds in individual securities and then managing theportfolio until they decide to sell. You don't have to be paranoid tofear the political dynamics that will shape these decisions.

More to Come

Wehave crossed a financial Rubicon. The bailout is just the beginning ofWashington's increased involvement in the economy. The government hasnow taken partial ownership of the nation's nine largest banks. Thereis talk of bailouts for other weak industries, including the carmakersand the airlines. There certainly will be a host of new regulationsthat will likely be with us long after the government has sold off thelast of the bad debt. We could be entering an era where the financialservices 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 solucky. The events of the last several months presage a return to the1930s, with a new surge of direct federal involvement in the economy.If we fail to beat back these new controls, future historians may markthis time as the beginning of a long winter of statism and stagnation.

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