Root of Economic Crisis
by Tom Tripp
Issue 135 - July 8, 2009

Stories about the worldwide financial meltdown keep proliferating; unfortunately most of these articles begin at square two. This results because addressing the ugly secondary causes and effects that are most apparent to the average spectator - then sensationalizing them - is what the media do best. By uniformly and disingenuously indicting capitalism and Wall Street the statist media mavens distort both the politics and economics of the circumstances. What these efforts do not explain, or even investigate, is the root of the meltdown. Readers and viewers of the mainstream press are thus denied a fundamental understanding of the circumstances in which we now find ourselves.

As primary blame is assessed against the wrong parties—the aforementioned capitalism and Wall Street—for the wrong reasons, the Democrats in Washington further skew the system with wild-eyed and unconscionable fiscal “solutions” that will inevitably force on the next two generations even more damaging taxes and spending. The reaction against capitalism causes the wrong remedies (more regulation, micromanagement of debt enterprise, and the inappropriate insertion of political judgment [often spelled ‘corruption’] in economic matters) that does little to prevent this circumstance recurring (perhaps a futile thought). This invalid assessment of the genesis of our fiscal problems is almost uniformly repeated throughout the popular media and cannot rightly remain unchallenged.

The financial fiasco through which we are now plowing germinated and was fostered over a period of thirty years by political maneuverings and the political, social, intellectual, and economic corruption resident in our national government. It was not created by the ill-effects of capitalism, or Wall Street, or private greed, although it was abetted by all three.

Robert Samuelson, essayist for Newsweek, in a recent article in the Claremont Review of Books discusses bank regulations enacted after the failure of a massive number of institutions during the Great Depression. Mr. Samuelson notes that the intention of the 1930s laws was to ensure “Banks…would be strictly regulated and examined; banks engaging in shoddy or fraudulent practices would be shut.” Although this seems a simple solution to bad practices, and it worked for a number of decades, what is not addressed is what actually happened by the 1990s: the regulators themselves distorted and were caused to distort their financial oversight obligation because of imposed politically-correct goals. The fox was installed in the hen house.

When the subprime mortgages blew up in our faces no one explained how we came to have so many of them, or how we had them at all considering the Depression-era regulations (that were repealed during the Clinton Administration). As a matter of financial probity, subprime mortgages shouldn’t even exist. What these mortgages were not was a product of Main Street or Wall Street avarice or mortgage industry stupidity (does anyone really believe banks voluntarily loaned money they knew had little likelihood of repayment?). They were a product of pure economic distortion and politicians who dismissed, out of equally pure ignorance, their responsibility to the whole population, not just some politically useful segment thereof. Without this part of the story—the base from which everything else sprang—those not studied in this circumstance cannot learn the prime lesson that has unfortunately been left out of most discussion.

What happened in America in this era was the idea that home ownership was a right, and that black citizens in particular were being denied that right through rank discrimination, founded in unfair banking fundamentals. This allegation became a mantra, and was used in a Democrat political maneuver that bore abundant electoral and social leverage. When the banking fundamentals were pushed to the back of the bus in the Clinton Administration the system incrementally headed for a cliff—at which it arrived and plunged over in 2008.

The genesis of federal action addressing discrimination in home ownership was the Community Reinvestment Act of 1977 (CRA). By means of this legislation it was intended that blacks not be discriminatorily or frivolously denied the ability to buy a home. Though this statute was enacted to stop racial bias, it morphed from ensuring an equal right to earn a home into a new entitlement—simply a right to a home. But, in 1977 even the Democrats did not throw caution to the wind. The CRA required loans be made fairly yet “consistent with safe and sound lending practices,” a prerequisite that does not describe subprime loans.

Safe and sound lending practices were gutted in the politically-correct, election-rich era of Bill Clinton. What flowed from this single act were myriad consequences:

1. Local banks and mortgage lenders were required through various regulatory mechanisms to make loans to unqualified (subprime) borrowers or lose their ability to expand or enter new markets, or to sell their conforming mortgages in the secondary market—meaning severe curtailment of their lending business. Forcing banks to comply with politically correct views was partially effected through oversight legislation enacted in the wake of the savings and loan debacle of the 1980s. As a result of that era’s financial legerdemain banks were now required to report on the gender, race, and income of loan applicants. Gathering these statistics didn’t make bank operations more sound, but they were useful in electioneering. If any bank’s lending data did not meet the expectations of political operatives (partnering with community activist groups such as ACORN) a complaint could be filed against that bank. These grievances had dire consequences for lending institutions because the regulators who would review them were often in league with the complainants. In this atmosphere the political corruption of the economic side of banking became endemic and intimidation was at its highest level. Subprime loans became the rule. Although bankers and mortgage brokers made the loans, in media assessment of what happened there is almost uniformly no mention of the politically corrupt genesis and oversight of this sector of the lending industry. Most of the articles note how many loans were made and how efficient subprime lending became because the financial community greased the wheels. These assertions make the authors complicit in indicting capitalism instead of cronyism. Without a full understanding of the political corruption that caused the lending assembly line to seem to work, the public is yet again misled. It is inconceivable that American bankers would engage in such risky loan practices voluntarily and coincidentally—but no one mentions this seemingly chance occurrence or seeks the genesis of the coincidence.
2. The secondary lenders, primarily Fannie Mae and Freddie Mac (both of which were profitable private institutions at that time, though carrying implicit government backing, which was later realized), were forced to buy these highly risky loans under Congressional threat of legislation that would eliminate their business or explicitly deny any government guarantee of their loans. The local originating banks, that were skeptical of their own newly formulated and closely supervised lending practices, were delighted to dump these risky subprime loans on Fannie and Freddie.
3. Because these loans looked no better to Fannie and Freddie than they did to the prime lenders, both institutions packaged and placed them throughout the market as quickly and as effectively as they could. At each step the intent was to spread the risk, but as the risk-bearing base was broadened, it appeared the system could stand even more risk, thus the worthless paper increased in size as it decreased even more in value.
4. The final straw that broke the supposed solidity of the whole mechanism was the explicit backing of Fannie and Freddie’s solvency by the deepest pocket of all—the United States Treasury. While that backing was only implicit, those who think government is the only solution to all problems made it formal after great numbers of subprime loans went sour. It was claimed the market could not absorb this mess. Actually, it was the political class that could not stomach it. With the intrinsic psychosis of each politician that he must appear capable of fixing anything came the insertion of the government into all phases of the financial fiasco. That the political class had caused the mess they now claimed only they could fix was completely ignored in the mainstream media. Blaming the victim became the rule.

Paul Krugman, columnist for the New York Times, contends that “…government officials should have realized that we were recreating the kind of financial vulnerability that made the Great Depression possible—and they should have responded by extending regulation and the financial safety net to cover these new institutions.” The problem is the regulators, or some of them, did realize this—they just didn’t quite understand either the timing or the magnitude of what they were causing because of their wholesale inexperience. Most important to understand is these regulators weren’t vocal because the political class forced them to turn a blind eye. Krugman’s misanalysis of what might have happened absent political corruption serves no one.

Making unrealistic loans under the guise of the CRA was forced on the masters of the universe resident in Wall Street against both their will and their experience. It is implicit from the results that these loans were not made freely. When the stark nature of the consequences of these loans is understood, including the fatal consequences to any bank that did not comply with the political instructions from activists both inside and out of Congress and the regulatory agencies, the truth of the matter becomes clear: the mortgage lenders weren’t greedily seeking to make unrealistic loans, they were being politically blackmailed into doing so. To not directly address this foundation is to miss too much of the meltdown.

When alarm bells began to ring it was obvious the Democrats were not going to kill what they saw as a golden political opportunity. Here is Harry Reid (D-NV), then minority leader, later majority leader of the U.S. Senate, in July, 2005:

While I favor improving oversight by our federal housing regulators to ensure safety and soundness, we cannot pass legislation that would limit Americans from owning homes and harm our economy in the process. (Read that sentence again—it does say what you think it does.)

Cong. Barney Frank (D-MA) September, 2003, then ranking minority member, later chairman of the House Financial Services Committee: “Fannie Mae and Freddie Mac are not facing any kind of financial crisis….The more people exaggerate these problems, the more pressure there is on these companies, the less we’ll see in terms of affordable housing.”

It is unfortunate that some analysts speculate on what might have been in this era, as those in the chattering class do while looking for scapegoats, when it is self-evident everything that happened was intentional. The suggestion that things might have been different if regulators did this or bankers did that again leads the public away from understanding the premeditated political causes and effects.

What supported the quick hand-off of subprime loans from originating banks to Fannie and Freddie to the market at large was everyone’s realization that they had to get rid of what they were forced to create as quickly as possible. As well, when the messy loans arrived on Wall Street they were heavily disguised; no one knew the underlying value of anything they were buying from Fannie and Freddie; what they did know is that the federal government guaranteed these instruments and that’s all they really cared about. What Wall Street did is what any sound investor does—spread the risk as far as possible and use the government as a backstop.

Although big profits were made and bankers and investment types did consider themselves rather smart at that, they were so long misled by government regulators, sycophant executives at Fannie and Freddie, pliable conspirators at bond rating agencies, and Congressional toadies, that their reactions, while never excusable, are more than understandable. Should they be held accountable because they didn’t do their own due diligence, yes. Should the system be indicted because the bad guys in this case were on the inside, no. Unfortunately the bad guys are the weak link, as always, in the whole episode and are equally as often on the inside.

Without the root cause—subprime loans forced on banks through politically-correct machinations—there would not have occurred the predictable fall from grace. The myriad additional factors needed to square this era’s economic circle, and which this article cannot succinctly offer, can be found in full at “Good Intentions Hijacked” here.

Mr. Samuelson, in his Claremont article suggests: “There is, it seems, no self-evident ‘happy medium,’ no utopian mix of market power and government power that will achieve perpetual expansion [of any capitalist economy].” The fact is that the U.S. was not harmed by the interplay between market and government power but through corrupt political power wielded by those who think they are not only smarter than the market, but more powerful, and worst of all, more important.

“The financial meltdown has led to an intellectual meltdown” Samuelson contends. I would say it is much more simple than that—a meltdown of integrity and honesty, an old paradigm surely, proving once again the only protection for the citizen is a vigilance that results in less government, less political power to intimidate, and fewer regulatory mechanisms to distort. The present crisis is the result of political blackmail launched against normally rational bankers and cautious regulators, political interference that allowed a dislocation to become the worst financial calamity since the Great Depression of the 1930’s.

Tom Tripp is a director of the American Conservative Union Foundation