April 18

It’s a Wonderful System

We are living the movie “It’s a Wonderful Life.” You might recall the movie; it’s about this wonderfully naïve George Bailey (imagine Ben Bernanke), who upon the death of his father (Alan Greenspan, even though he retired) is selected by the board of directors to run the family business. The family business in the movie is the Bailey Savings & Loan (The Federal Reserve). Its job is to help keep the people happy and prosperous by keeping the money flowing. Bailey’s job is to ensure that the inhabitants of Bedford Falls, New York (the United States) have affordable homes and can live and enjoy the American Dream. Yet, every time George turns around there is another disaster!

George has visions of seeing the world and doing great things, yet, he is encumbered by the death of his father, the Great Depression, World War II and just plain incompetence. Our current economic situation is brought about by the retirement of Alan Greenspan, which parallels the death of George Bailey’s father. The situation is perpetuated by the 1999 creation (by Congress and the Clinton Administration) of sub prime loans to be bought by Fannie Mae and Freddie Mac. It continues with the systematic failure of the Credit Default Swaps’ transformation from an insurance product to a speculative event while the SEC, Federal Reserve and the US Treasury miss all the danger signals (Warren Buffet, however, saw the danger and describes it in the Berkshire Hathaway annual report). http://www.berkshirehathaway.com/qtrly/2ndqtr08.pdf

George has visions of transforming the world by making home ownership available to everyone. At first, despite doubts, it works; many homes are bought through the easy credit terms of Bailey Savings & Loans. However, through an almost unbelievable combination of naïveté, poor accounting and woefully inadequate regulatory oversight, the Bailey Savings & Loan becomes insolvent. Here is how it comes down: Hard times hit and George Bailey’s well meaning, but bumbling uncle, played by the American Government (most notably Congress and the Executive Branch), boasts and brags to the wealthiest man in town, Mr. Potter (imagine Warren Buffet) when he should have been concentrating of making a deposit. The uncle (American Government), of course, loses the deposit creating a crisis in the Savings & Loan (Federal Reserve). The townspeople (played by the American taxpayers) bail out the Bailey Savings & Loan and the credits roll.

So besides making fun of everyone, how does this scenario follow real life? Let me give an account of how the sub prime debacle took down the financial industry. It all started with good intentions by well-meaning politicians looking out for the best interest of our country.

The executive branch and Congress has had its hand in meddling with housing and the mortgage market for decades. In 1938, at the height of the depression, Fannie Mae was created as a government sponsored enterprise (GSE). Banks were not lending money for mortgages due to the total lack of liquidity that existed during the Great Depression. For the next thirty years. Fannie Mae did a great job and created what we now call the secondary mortgage market, which many credit for bringing home ownership from approximately 40% in 1938 to 63% in 1968.

By 1968, politics has come into play and the US debt was soaring. The Johnson Administration was fighting the Vietnam War, while at the same time spending for the Great Society. To lower the national debt, the government sold Fannie Mae to the public, with the promise that if the agency ran into trouble, the government would bail it out (it was not that simple in the fine print). In 1970, the Nixon administration and the Democratic Congress passed the Emergency Home Finance Act of 1970, which created a second GSE nicknamed Freddie Mac. The intent was to create competition in the mortgage market. In its infinite wisdom, the federal government decided that it was sufficient that neither company be required to disclose their finances to the same degree as other private companies. At that time Fannie Mae and Freddie Mac came under the purview of the Housing and Urban Development (HUD) Agency. The GSEs had a line of credit from the US Treasury and were exempt from SEC oversight and state and local taxes. To me, the lack of oversight by any of three entities: US Treasury, Federal Reserve Bank or the SEC is the first major mistake in a long line of mistakes that brought our economy to its knees.

Now we enter into the next misstep. In 1977, with good intentions, President Carter signed the Community Reinvestment Act (CRA) into law.  The purpose of this act was to “require each appropriate Federal financial supervisory agency to use its authority when examining financial institutions, to encourage such institutions to help meet the credit needs of the local communities in which they are chartered consistent with the safe and sound operation of such institutions.” However, the terms were so loose that no one knew what this meant.

In 1989, under the first Bush Administration, congress amended the CRA to require public release of these examinations.  With community groups becoming more organized and more informed, these groups started to make more demands and protesting in ever-increasing numbers of applications from deposit and lending institutions. New guidelines issued concurrently with this amendment appeared to emphatically demand documentation, as the deposit and lending institutions had to show compliance through day-to-day operations.  Under the Clinton Administration, The Federal Housing Enterprises Financial Safety and Soundness Act of 1992, played a key role in bringing Fannie Mae and Freddie Mac into the subprime mortgage business. The Office of Federal Housing Enterprise Oversight was created as a regulatory office within HUD: to…”ensure that Fannie Mae and Freddie Mac are adequately capitalized and operating safely.” This office is authorized to act without HUD oversight on a range of regulatory issues.  It also established HUD-imposed housing goals for the financing of affordable housing and housing in inner cities, as well as housing in rural and underserved areas. Due to the nature of the legislation credit risk was not linked to these goals. So, the road to ruin was founded on good intentions. In an effort to address the above problems, Congress passed The Federal Housing Enterprises Financial Safety and Soundness Act of 1992.   For the first two years, the 1992 Act established these goals. In 1995, HUD set the goals in place.  The 1992 Act mandated that a certain percentage of loans purchased by the two GSEs had to be written in low- and moderate-income, underserved, and special affordable areas.  In other words, the 1992 Act forced Fannie Mae and Freddie Mac to buy sub prime loans in considerable numbers. The 1992 Act required Fannie Mae and Freddie Mac to enter the sub prime mortgage business and it was done purposefully and with great fanfare.

The alarms sounded for the next ten years. In 1999 in a New Times article dated September 30th, Steven A Holmes warned. “In moving, even tentatively, into this new area of lending, Fannie Mae is taking on significantly more risk, which may not pose any difficulties during flush economic times. But the government-subsidized corporation may run into trouble in an economic downturn, prompting a government rescue similar to that of the savings and loan industry in the 1980’s.

”’From the perspective of many people, including me, this is another thrift industry growing up around us,’’ said Peter Wallison a resident fellow at the American Enterprise Institute. ‘If they fail, the government will have to step up and bail them out the way it stepped up and bailed out the thrift industry.’

“In July, the Department of Housing and Urban Development proposed that by the year 2001, 50 percent of Fannie Mae’s and Freddie Mac’s portfolio be made up of loans to low and moderate-income borrowers. Last year, 44 percent of the loans Fannie Mae purchased were from these groups.

“The change in policy also comes at the same time that HUD is investigating allegations of racial discrimination in the automated underwriting systems used by Fannie Mae and Freddie Mac to determine the credit-worthiness of credit applicants.”

Under the Clinton administration Fannie Mae and Freddie Mac were already targeting 44% of their capital to buy sub prime mortgages. With 20/20 hindsight, it is obvious that we were already far down the road of financial ruin in 1999. The housing boom masked this disaster but as this article states, the warning bells were ringing, unfortunately those in the position to do something about it, were not listening!

Four years later, the current Bush administration proposed a new regulatory agency under the aegis of the Treasury Department amid investigations of mismanagement, questionable accounting practices and charges of outright fraud. Despite Republican control of Congress, the legislation failed.

The New York Times reported on September 11, 2003,

”The regulator has not only been outmanned, it has been out-lobbied,” said Representative Richard H. Baker, the Louisiana Republican who had proposed legislation similar to the administration’s proposal and led a subcommittee that oversaw the companies. ”Being underfunded does not explain how a glowing report of Freddie’s operations was released only hours before the managerial upheaval that followed. This is not world-class regulatory work.”  The same article contains the now famous quotes from two Democrats:

”These two entities — Fannie Mae and Freddie Mac — are not facing any kind of financial crisis,” said Representative Barney Frank of Massachusetts, the ranking Democrat on the Financial Services Committee. ”The more people exaggerate these problems, the more pressure there is on these companies, the less we will see in terms of affordable housing.”  Representative Melvin L. Watt, Democrat of North Carolina, agreed.

”I don’t see much other than a shell game going on here, moving something from one agency to another and in the process weakening the bargaining power of poorer families and their ability to get affordable housing,” said Representative Watt.

No matter what Congress said, the companies were in trouble. Furthermore, the executives’ pay was linked to satisfying these HUD goals, not the maintainence and safety of either Freddie Mac or Fannie Mae. In 2004, HUD finally reached the goal that it had stated in 1999 when it increased the availability of sub prime loans to our two GSEs. The percentage of loans written to low- and moderate-income homeowners rose from 50% to 56%. This HUD directive under the current Bush administration brought the risk of a financial meltdown closer.  After scandals with elections violations and the accounting practices of Fannie Mae and Freddie Mac, Congress introduced the Federal Housing Enterprise Regulatory Reform Act of 2005. By this time, the Democrats controlled Congress. The chart at the bottom of this page shows the top 27 political recipients of Fannie Mae and Freddie Mac campaign contributions as compiled by Opensecrets.org on September 11, 2008.  The 2005 bill was sponsored by Sen. Charles Hagel [R-NE] and co-sponsored by Senators Elizabeth Dole [R-NC], John McCain [R-AZ], and John Sununu [R-NH].  The bill was bottled up in the Committee on Banking, Housing, and Urban Affairs and went nowhere. So, Congress and HUD regulations basically set Fannie Mae & Freddie Mac on a collision course with disaster as surely as the one the Titanic was on when it hit an iceberg in the North Atlantic.

The only way to avoid the coming disaster was not to regulate the industry more or to blame Wall Street greed, but to have the proper agency enforcing the proper regulation. With 20/20 hindsight, the safety of the system was more important than increasing Fannie Mae’s and Freddie Mac’s percentage of sub prime mortgages. Alas, the regulations by HUD, which determined the executives’ pay, pushed the GSEs into riskier positions. The only possible conclusion was a government bailout. Without doubt this was a set up for disaster, which was payed for with the taxpayers’ money. The disaster was predicted in 1999 by the New York Times article described earlier.

So, as in the Frank Capra movie, “Its A Wonderful Life”, the little people, you and me the taxpayers, are bailing out George and those well meaning but totally incompetent regulators and politicians in Washington. And the people benefitting are the Warren Buffets of this world who are now buying up our financial institutions with ten percent yields while they wait for the stocks to rise again. By the way, I am not knocking Warren, because he is helping, however, there is no denial that he is truly benefitting from the current disaster. When Frank Capra first introduced America to his movie, it was a box office flop. With time, the community’s unity in the face of struggle caused an upsurge in the movie’s popularity. So, today my reflection is that we are polarized and angry with the system that has harmed our country and view the rescue attempts by the Federal Reserve, the US Treasury and Congress as popularity flops. But maybe with enough time, we shall look back and admire how the country united to fix the system.

The questions we get to ask now are: where are the opportunities? Because with the government committed to spending more than $1 trillion to fix this mess already, there are opportunities. What really does matter? How can I/we learn from what has happened and is happening? What new systems can be built that is filled with integrity, appreciation and concern for both ourselves and for the whole? These are the possibilities that open up for us now.

Where do you want to put your energies? Toward finding fault and blame for events that we cannot change OR toward what is possible and a future that inspires, attracts and welcomes what the planet is calling for now.

All Recipients of Fannie Mae and Freddie Mac Campaign Contributions, 1989-2008

Name Office State Party Grand Total
Dodd, Christopher J S CT D $165,400
Obama, Barack S IL D $126,349
Kerry, John S MA D $111,000
Bennett, Robert F S UT R $107,999
Bachus, Spencer H AL R $103,300
Blunt, Roy H MO R $96,950
Kanjorski, Paul E H PA D $96,000
Bond, Christopher S ‘Kit’ S MO R $95,400
Shelby, Richard C S AL R $80,000
Reed, Jack S RI D $78,250
Reid, Harry S NV D $77,000
Clinton, Hillary S NY D $76,050
Davis, Tom H VA R $75,499
Boehner, John H OH R $67,750
Conrad, Kent S ND D $64,491
Reynolds, Tom H NY R $62,200
Johnson, Tim S SD D $61,000
Pelosi, Nancy H CA D $56,250
Carper, Tom S DE D $55,889
Hoyer, Steny H H MD D $55,500
Pryce, Deborah H OH R $55,500
Emanuel, Rahm H IL D $51,750
Isakson, Johnny S GA R $49,200
Cantor, Eric H VA R $48,500
Crapo, Mike S ID R $47,250
Frank, Barney H MA D $42,350
Bean, Melissa H IL D $41,249


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About the Author

The What is Finology? Project considers the nature of money and it's meaning in our lives. The Finology Fellows are a group of experienced Certified Financial Planner™ Professionals who have a deep and grounded understanding of Finology, the Financial Planning Profession and the nature of how we exchange value.

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