In 2008, there was a financial collapse in the United States. It happened under a Republican President, George W. Bush, and naturally, he attempts to explain in a book that he later wrote about his presidency titled “Decision Points”. I’ll give you some quotes here, and then some commentary.
George W. explains:
“‘Wall Street got drunk, and we got the hangover.”
That was an admittedly simplistic way of describing the origins of the greatest financial panic since the Great Depression. A more sophisticated explanation dates back to the boom of the 1990s. While the U.S. economy grew at an annual rate of 3.8 percent, developing Asian countries such as China, India, and South Korea averaged almost twice that. Many of these economies stockpiled large cash reserves. So did energy-producing nations, which benefited from a tenfold rise in oil prices between 1993 and 2008. Ben Bernanke called this phenomenon a “global saving glut.” others deemed it a giant pool of money.
A great deal of this foreign capital flowed back to the United States. America was viewed as an attractive place to invest, thanks to our strong capital markets, reliable legal system, and productive workforce. investors bought large numbers of U.S. Treasury bonds, which drove down their yield. Naturally, investors started looking for higher returns. One prospect was the booming U.S. housing market. Between and 2007, the average American home price roughly doubled. Builders constructed homes at a rapid pace. Interest rates were low. Credit was easy. Lenders wrote mortgages for almost anyone—including “sub-prime” borrowers, whose low credit scores made them a higher risk.
Wall Street spotted an opportunity. Investment banks large numbers of mortgages from lenders, sliced them up, repackaged them, and converted them into complex financial securities. Credit rating agencies, which received lucrative fees from investment banks blessed many of these assets with AAA ratings. Financial firms sold numbers of credit default swaps, bets on whether the mortgages underlying the securities would default. Trading under fancy names such as collateralized debt obligations, the new mortgage-based products yielded the returns investors were seeking. Wall Street sold them aggressively
Fannie Mae and Freddie Mac, private companies with congressional charters and lax regulation, fueled the market for mortgage-backed securities. The two government-sponsored enterprises bought up half the mortgages in the United States, securitized many of the loans, and sold them around the world. Investors bought voraciously because they believed Fannie and Freddie paper carried a U.S. government guarantee.
It wasn’t just overseas investors who were attracted by higher returns. American banks borrowed large sums of money against their capital, a practice known as leverage, and loaded up on the mortgage-backed securities. Some of the most aggressive investors were giant new financial service companies. Many had taken advantage of the 1999 repeal of the Glass-Steagall Act of 1932, which prohibited commercial banks from engaging in the investment business.
At the height of the housing boom, homeownership hit an all-time high of almost 70 percent. I had supported policies to expand homeownership, including down-payment assistance for low-income and first-time buyers. I was pleased to see the ownership society grow. But the exuberance of the moment masked the underlying risk. Together, the global pool of cash, easy monetary policy, booming housing market, insatiable appetite for mortgage-backed assets, complexity of Wall Street financial engineering, and leverage of financial institutions created a house of cards. This precarious structure was fated to collapse as soon as the underlying card—the nonstop growth of housing prices—was pulled out. That was clear in retrospect. But very few saw it at the time, including me.
Personally, I think the fact that if lenders to homeowners had not been able to shift the risk to others, there would not have been a house of cards that eventually collapsed. However, the ability to sell the loans (with the promised repayments) in bundles to investors – investors who trusted the AAA ratings that these bundles often got, meant that the lender didn’t really have to care whether the loan was repaid. The three companies who gave ratings had a conflict of interest.
The question arises as to why the credit (interest rates) was so low. We know one reason was the fear of the head of the Fed (Ben Bernanke) of the danger of deflation.
But lets avoid detours, and go back to Bush, and then note the ironies here.
In mid-2007, home values had declined for the first time in thirteen years. Homeowners defaulted on their mortgages in increasing numbers, and financial companies wrote down billions of dollars in mortgage related assets…
Early in the afternoon of Thursday, March 13, we learned that Bear Stearns, one of America’s largest investment banks, was facing a liquidity crisis. Like other Wall Street institutions, Bear was heavily leveraged. For every dollar it held in capital, the firm had borrowed thirty-three dollars to invest, much of it in mortgage-backed securities. When the housing bubble popped, Bear was overexposed, and investors moved their accounts. Unlike the run on First National Bank in Midland, there were no paper sacks.
I was surprised by the sudden crisis. My focus had been kitchen-table economic issues like jobs and inflation. I assumed any major credit troubles would have been flagged by the regulators or rating agencies. After all, I had strengthened financial regulation by signing the Sarbanes Oxley Act in response to the Enron accounting fraud and other corporate scandals. Nevertheless, Bear Stearns’s poor investment decisions left it on the brink of collapse. In this case, the problem was not a lack of regulation by government; it was a lack of judgment by Bear executives.
My first instinct was not to save Bear. In a free market economy, firms that fail should go out of business. If the government stepped in, we would create a problem known as moral hazard: Other firms would assume they would be bailed out, too, which would embolden them to take more risks.
Hank shared my strong inclination against government intervention. But he explained that a collapse of Bear Stearns would have widespread repercussions for a world financial system that had been under great stress since the housing crisis began in 2007. Bear had financial relationships with hundreds of other banks, investors, and governments. If the firm suddenly failed, confidence in other financial institutions would diminish. Bear could be the first domino in a series of failing firms. While I was concerned about creating moral hazard, I worried more about a financial collapse.
“Is there a buyer for Bear?” I asked Hank.
Early the next morning, we received our answer. Executives at JP Morgan Chase were interested in acquiring Bear Stearns, but were concerned about inheriting Bear’s portfolio of risky mortgage-backed securities. With Ben’s approval, Hank and Tim Geithner, the president of the New York Fed, devised a plan to address JPMorgan’s concerns. The Fed would lend $30 billion against Bear’s undesirable mortgage holdings…
Many in Washington denounced the move as a bailout. It probably didn’t feel that way to the Bear employees who lost their jobs or the shareholders who saw their stock drop 97 percent in less than two weeks. Our objective was not to reward the bad decisions of Bear Stearns. It was to safeguard the American people from a severe economic hit. For five months, it looked like we had.
“Do they know it’s coming, Hank?”
“Mr. President,” he replied, “we’re going to move quickly and take them by surprise. The first sound they’ll hear is their heads hitting the floor.”
It was the first week of September 2008, and Hank Paulson had just laid out a plan to place Fannie Mae and Freddie Mac, the two giant government sponsored enterprises, into government conservatorship.
Of all the emergency actions the government had to take in 2008, none was more frustrating than the rescue of Fannie and Freddie. The problems at the two GSEs had been visible for years. Fannie and Freddie had expanded beyond their mission of promoting homeownership. They had behaved like a hedge fund that raised huge amounts of money and took significant risks. In my first budget, I warned that Fannie and Freddie had grown so big that they presented “a potential problem” that could “cause strong repercussions in financial markets.”
In 2003, I proposed a bill that would strengthen the GSEs’ regulation. But it was blocked by their well-connected friends in Washington. Many Fannie and Freddie executives were former government officials. had close ties in Congress, especially to influential Democrats like Congressman Barney Frank of Massachusetts and Senator Chris Dodd of Connecticut. “Fannie Mae and Freddie Mac are not facing any kind of financial crisis,” Barney Frank said at the time.
I should point out here that the main law that was passed after the disaster was the “Dodd-Frank” law – oddly enough, two people that Bush mentions as being culpable were then put in charge of writing a law to prevent the future collapse.
By the summer of 2008, I had publicly called for GSE reform seventeen times. It turned out the eighteenth was the charm. All it took was the prospect of a global financial meltdown. In July, Congress passed a reform bill granting a key element of what we had first proposed five years earlier: a strong regulator for the GSEs. The bill also gave the treasury secretary temporary authority to inject equity into Fannie and Freddie if their solvency came into question.
Shortly after the legislation passed, the new regulatory agency, led by friend and businessman Jim Lockhart, took a fresh look at Fannie’s and Freddie’s books. With help from the Treasury Department, the examiners concluded the GSEs had nowhere near enough capital. In early August, both Freddie and Fannie announced huge quarterly losses.
The implications were startling. From small-town banks to major international investors like China and Russia, virtually everyone who owned GSE paper assumed it was backed by the U.S. government. If the GSEs defaulted, a global domino effect would follow and the credibility of our country would be shaken.
With Hank’s strong advice, I decided that the only way to prevent a disaster was to take Fannie and Freddie into government conservatorship. It was up to Hank and Jim to persuade the boards of Fannie and Freddie to swallow this medicine. I was skeptical that they could do so without provoking a raft of lawsuits. But on Sunday, September 7, Hank called me at the White House to tell me it had been done. The Asian markets rallied Sunday night, and the Dow Jones increased 289 points on Monday.
I spent the next weekend, September 13 and 14, managing the government’s response to Hurricane Ike…
That same weekend, a different kind of storm was battering New York City. Like many institutions on Wall Street, Lehman Brothers was heavily leveraged and highly exposed to the faltering housing market. On September 10 the firm had announced its worst-ever financial loss, $3-9 billion in a single quarter. Confidence in Lehman vanished. Short-sellers, traders seeking to profit from declining stock prices, had helped drive Lehman stock from $16.20 to $3.65 per share. There was no way the firm could survive the weekend….this time, we weren’t going to be able to stop the domino from toppling over.
… time had run out for Lehman. Ihe 158-year-old investment house filed for bankruptcy just after midnight on Monday, September 15.
All hell broke loose in the morning. Legislators praised our decision not to intervene. The Washington Post editorialized, “The U.S. government was right to let Lehman tank.” The stock market was not so positive. The Dow Jones plunged more than five hundred points.
A panic mentality set in. Investors started selling off securities and buying Treasury bills and gold. Clients pulled their accounts from investment banks. The credit markets tightened as lenders held on to their cash. gears of the financial system, which depend on liquidity to serve as the grease, were grinding to a halt.
I’ve often reflected on whether we could have seen the financial crisis coming. In some respects, we did. We recognized the danger posed by Fannie and Freddie, and we repeatedly called on Congress to authorize stronger oversight and limit the size of their portfolios. We also understood the need for a new approach to regulation. In early 2008, Hank proposed a blueprint for a modernized regulatory structure that strengthened oversight of the financial sector and gave the government greater authority to wind down failing firms. Yet my administration and the regulators underestimated the extent of the risks taken by Wall Street. The ratings agencies created a false sense of security by blessing shaky assets. Financial firms built up too much leverage and hid some exposure with off-balance sheet accounting. Many new products were so complex that even their creators didn’t fully understand them. For all these reasons, we were blindsided by a financial crisis that had been more than a decade in the making.
There is more, but this a blog, not a book. I will however put in some cutting remarks from Thomas Sowell, and from a discussion I started on Quora:
Here is Sowell, who mainly blames, not the Republicans, but the Democrats:
Fact Number One: It was liberal Democrats, led by Senator Christopher Dodd and Congressman Barney Frank, who for years — including the present year — denied that Fannie Mae and Freddie Mac were taking big risks that could lead to a financial crisis.
It was Senator Dodd, Congressman Frank and other liberal Democrats who for years refused requests from the Bush administration to set up an agency to regulate Fannie Mae and Freddie Mac.
It was liberal Democrats, again led by Dodd and Frank, who for years pushed for Fannie Mae and Freddie Mac to go even further in promoting subprime mortgage loans, which are at the heart of today’s financial crisis.
Alan Greenspan warned them four years ago. So did the Chairman of the Council of Economic Advisers to the President. So did Bush’s Secretary of the Treasury, five years ago.
Yet, today, what are we hearing? That it was the Bush administration “right-wing ideology” of “de-regulation” that set the stage for the financial crisis. Do facts matter?
We also hear that it is the free market that is to blame. But the facts show that it was the government that pressured financial institutions in general to lend to subprime borrowers, with such things as the Community Reinvestment Act and, later, threats of legal action by then Attorney General Janet Reno if the feds did not like the statistics on who was getting loans and who wasn’t.
Is that the free market? Or do facts not matter?
Then there is the question of being against the “greed” of CEOs and for “the people.” Franklin Raines made $90 million while he was head of Fannie Mae and mismanaging that institution into crisis.
Who in Congress defended Franklin Raines? Liberal Democrats, including Maxine Waters and the Congressional Black Caucus, at least one of whom referred to the “lynching” of Raines, as if it was racist to hold him to the same standard as white CEOs.
We have an irony here. Supposed Compassion for people who, due to poverty have to rent instead of buy a house, helped lead to the very uncompassionate results of the crash of 2008. Another lesson is that lowering interest rates to encourage people to borrow and invest is not always a good idea.
From the Quora conversation I started, one person replied:
… the myth started to grow that home and real estate prices will never collapse. When a bubble starts to inflate because of an expansion of the supply of money and credit, which is what the Fed was doing with its 1% interest rate, people lose their objectivity. Manias naturally result, and people began to think that any investment in real estate and housing was safe. This made investors willing to take on risks which looked safe because of all this Moral Hazard created by expansionary monetary policy.
Mortgage lenders were being required to take on more risk, and were thus eager to divest themselves of riskier mortgages. Because housing prices were rising, and just kept going up, more people were willing to invest in taking on that risk, which they perceived to be minimal.
Another respondent says this:
The cause of the failure is a bit more complex than just “bad loans” but bad loans were important to the failure. If I am offered a simple bond, I can look at the bond and determine if it is likely to be repaid. Would I buy a bond offered by GE today? Maybe not. Would I buy a bond offered by Wal-Mart? Yeah, probably. Those are pretty easy to sort out. Would I buy a bond backed by portions of 200,000 different mortgages when I can’t know who is liable for those mortgages? Sheesh, how could I ever figure that one out? How would I analyze that?
Standard & Poor to the rescue. For a fee, they will do all the heavy lifting of analyzing that security and give it a rating. Even better, you don’t have to pay the fee! It’s paid by the guy who is offering to sell you the security. Why did he choose S&P? Because S&P always came back with a good rating of the security. You were assured that it was a good investment by S&P. S&P was incentivized to give all these securities (that are truly incapable of being evaluated) a good rating and so they did. The whole system was rigged to cheat you and it worked. Of course, there are other rating agencies doing exactly the same thing as S&P. If not, there would have been no incentive to give good ratings. My anger is not at the people bundling the mortgages. It is at the rating companies who inflated all the ratings for their own profit. There should have been a law that would have jailed every one of them.
Another respondent weighs in:
HUD, which Congress had made the regulator of Fannie Mae and Freddie Mac in 1992, began to pressure these agencies to set numerical goals for affordable housing, even if that meant buying subprime mortgages. The media cheered the agencies on.”
Banks suddenly found that regulators had the power to refuse their branch expansions or reject a merger if they weren’t making enough loans to otherwise unqualified minority borrowers. So they played along. They made the loans, and Freddie and Fannie bought the loans right back. It was like a game of musical chairs, and the Fed kept the game going in the early 2000s by cutting interest rates.
Every time Republicans in Congress or President Bush talked about reforming housing programs, Democrats like Rep. Barney Frank of Massachusetts and Sen. Chris Dodd of Connecticut threw fits, threatening to gum up Congress and implying that GOP lawmakers were racists. The Republicans backed off.
This opinion also is worth quoting:
Few people expected defaults on the scale that actually ended up occurring, and financial wizardry was employed to create CDOs squared, taking tranches of existing CDOs, and treating them as if they were mortgages to create new CDOs, so there was a whole pyramid ready to collapse when it was discovered to be built on quicksand. Institutions like pension funds and insurance companies had to invest in high-rated bonds, whether the ratings bore any relation to reality or not, and they sometimes didn’t; there were only three rating agencies, and if they were all wrong together, someone with a fiduciary duty to buy high-rated bonds had to do so, even if he might be of the personal opinion that it would be more prudent to buy gold coins and hide them under his mattress.
Now having written all this, I am still confused. I made a causal diagram with nodes and arrows, and questions and gaps arise. Why did people believe the real estate market could only go up, and not down? If one cause was the government threatening banks until the banks made bad loans, why did commercial real estate also suffer from the speculative bubble? Where were the signals that the market is supposed to give as to when to buy and when not to buy? Why did a few people see the crisis coming, but most people did not? Why could bad ideas such as “Option adjustable mortgages” get put into practice, when they didn’t require payments at least cover interest charges, which meant that the total principal could grow over time, and then the borrower could just walk away and abandon his house?
I think we can conclude that something that was often valueless (loans to people that were made without any requirement for credit-worthiness) was made to look as if had value. Perhaps in a very general sense, we should heed Milton Freedman’s observation: “Unless it is politically profitable for the wrong people to do the right thing, the right people will not do the right thing either, or it they try, they will shortly be out of office.” He speaks of politics, but in economics too, we have to keep an eagle’s eye out on counterproductive incentives and lack of transparency and market signals that get buried.
Decision Points – by George W Bush
The Financial Crisis: Facing the Facts – Thomas Sowell (https://www.creators.com/read/thomas-sowell/10/08/do-facts-matter)