Critical Review, Causes of the Crisis

Journal of Politics and Society

Volume 21 Numbers 2-3. 2009.

Review & Article by GlobalMacroForex

This political journal has compiled essays from a variety of academics and finance professionals, outlining how the government (and not free market capitalism) caused (and prolonged)the 2007-2008 financial crisis .

Some of their points include:

·      Bill Clinton’s Community Reinvestment Act

·      Fannie Mae and Freddie Mac

·      Basel I and Basel II banking laws

·      Government dictated oligopoly of the rating agencies

·      Federal Reserve interest rates

·      “No-recourse” default regulation

·      Arbitrary bailouts

Let’s dive right i

Community Reinvestment Act

The Community Reinvestment Act, which was first enacted in 1977 to prevent redlining racism in mortgage-lending banks, required commercial banks to prove they were making active efforts to lend to the underprivileged in their communities.  The Act was reissued and revamped in 1995 under Bill Clinton to allow investment with the Housing and Urban Development (HUD) agency of the federal government. 

While some critics argue that subprime lending demonstrates horrible banker greed, Journal of Politics and Society editor Peter J. Wallison argues it was in fact by government decree that banks had to lend to subprime borrowers to meet certain quotas.

Fannie Mae & Freddie Mac

Government-sponsored enterprises (GSE) are private companies that receive directives and subsidization from the government.   The Federal National Mortgage Association (Fannie Mae) and Federal Home Loan Mortgage Corporation (Freddie Mac) under directives from Housing and Urban Development (HUD) were created to help poor Americans acquire a home.  However, the two GSE’s abused their original “mission” by buying worthless loans at high prices so bankers could profit from flipping the loans. 

Fannie Mae and Freddie Mac had purchased 40% of all subprime loans.   This artificial government buyer created an incentive for banks to originate these loans to questionable borrowers, then repackage the loans through securitization because the GSEs would buy them.

In a securitization, the banks put multiple loans together and sold bonds with the proceeds.

In addition, the Basel banking ratios were lower for GSE bonds – a further incentive for banks to buy back these securitized loans.

Perverse Basel Incentives

The Basel regulations were designed at an international level to regulate bank risk.  All commercial banks were required to hold 8% of capital against their assets.  Then the Basel regulations linked the required capital to how risky the assets were.  This was done by giving them a “risk weighting.”  For example, US Treasury securities were risk-weighted 0, meaning no capital was required to be held because Treasuries were considered default free

Under Basel I and starting in 2006 with Basel II, regular mortgages were given a 50% risk weighting, meaning for each $100 value of mortgages, banks had to hold $4 in capital:

($100 x . 08 total capital x .5 risk weight) = $4 Capital

On the other hand, if a regular mortgage were bought from a government-sponsored enterprise, the risk weight went down to 20%, meaning only $1.6 in reserves would be required:

($100 x . 08 total capital x .2 risk weight) = $1.6 Capital

This provided a strong incentive for banks to buy back loans from the GSEs.

Banks received the benefit of the lower Basel capital risk weighting regardless of the credit score of the borrower or down payment percent of the total loan.

In addition under Basel rules, banks could escape capital minimums by creating off-balance sheet entities with “Structured investment vehicles,” or SIV.  These SIVs could be funded by debt or preferred stock,

This even further reduces the bank’s required risk-adjusted capital because they’ve sold the assets “off the balance sheet” even though they still technically own them.  Citigroup created 4 of these SIVs.

Rating Agencies are quasi-government

Rating agencies give ratings to these bonds to let investors know how risky they are.

 “Although rating agencies, like the government-sponsored enterprises, are privately owned, they are usually called ‘agencies’ rather than companies for good reason.”

Lawrence J White’s paper argues these rating agencies had immense privileges, making them unofficial arms of the US Government.  Many institutional investors can’t buy bonds that aren’t rated by these agencies.  So in effect, the SEC gave Moody’s, Standard & Poor’s, and Fitch oligopoly status.  No competitor could take advantage of their mistakes.

They made mistakes with their mathematical models, by assuming that the default rates on homes would follow a Gaussian curve/standard normal curve.

This assumes default rates were normally distributed, when in fact many borrowers would default all at once if their Adjustable Rate Mortgage interest rates went up or home prices fell.

n addition, Rating agencies permitted the securities to be divided into tranches with different ratings on the same underlying assets.  This created the false perception of low risk when all the assets were tied in value.

Under this approach, bonds were given ratings based on how soon it would have to take losses in the event of massive default.  So an “AAA’ bond and a “BB” bond were tied to the same underlying assets.[HAS1] 

Federal Reserve Easing & Default Laws

Adjustable-rate mortgages (ARMs) were created whose interest rate changed (or “floated”) based on the interest rate set by the Federal Reserve.  By printing so much and driving rates down to 1% in 2003 then hiking them, the Fed caused borrowers to default in record numbers when their ARMs reset in 2006.

In addition, many states (including California) had “No-recourse” laws entitling mortgagors to suffer little to no consequences of default. Once the ARMs rates went up, these mortgagors lost little by default.   This created a feedback loop wherein more borrowers defaulted, which pushed up interest rates even higher.

Arbitrary Bailouts

The government rescue efforts lacked any type of consistency.  Instead of reassuring the markets, it created havoc and pandemonium by arbitrarily bailing out some but not others.  What was the rationale for intervening with Bear Stearns, then not with Lehman, and then again with AIG?  One can only conclude that these bailouts were the result of which groups were politically connected and were not related to the actual fundamentals of the situation.  This chart from the Critical Review by John Taylor shows how Ben Bernanke’s actions with Lehman brothers only destabilized the market further,