Exactly. The demonstrative effect here can not be understated. When economists mention the CRA, they aren’t saying Carter caused the collapse in 2008, or whatever party loyalists hear when they see that. The CRA is instantly dismissed as unimportant, as 1977 was a long time ago, and this couldn’t have happened because of just that. That is because it wasn’t solely the reason. The revisions in the 1990′s are key to understanding the role of congress and it’s compounding errors in addition to the existing monetary policy.
Basically, in 1977, congress forced banks to make more risky mortgages by government decree. In order to mitigate risk, mortgage backed securities were invented at this time. Soon after in order to move risk from risk-averse firms to less risk averse firms, credit default swaps were contrived. Psuedo-government GSE’s(1) then bought mortgages and pushed these mortgage backed securities. Now rife with cronyism and spending big on lobbying to the top recipients, in order of total career amounts: Dodd of CT, Obama of Illinois, Kerry of Massachusetts, Clinton of New York.
So now we get to where there were extensive calls for greater regulation and better oversight, starting around 2001. The danger was laughed off, largely by people who were receiving big contributions from the lobbyists. Obama led the fight against “regulating” Fannie and Freddie, in perhaps the best example of regulations never being in effect to protect you and your money
When the GSE’s that had financed the securities and the mortgages collapsed … a fuckton of people who had trusted that the government sponsorship of these agencies made then extremely safe, realized they had lost a lot of money.(5, warning: this citation makes my heart hurt).
When they then decided to get out of the risky securities, even at a loss, marking to market then caused everyone else to mark their equities down too — which caused them to lose value, which those people to sell as well, in a vicious cycle. Go ahead. Check out the Google groups link. hundreds and hundreds of people saying they are literally crying because they lost 20k in a weekend. Retirees who thought that a GSE could not fail. Well no one told them but it can’t fail and didn’t fail. No one failed. Well OK Lehman … but shareholders took the brunt in all these “failures”. Failures in which companies like AIG and Fannie continue on. Wiping out shareholders once and then next year when the bill comes due, all of us.
This caused the credit rating agencies to finally fucking down rate these abominations(6), which then triggered the CDS cascade effect. Firms which had sold credit default swaps found themselves with demands that they pay cash for these securities that no one wanted any longer. This was “the illiquidity crisis”.
The crisis and the panic in the markets over who did and didn’t have exposure to mortgage backed securities and associated credit default swaps made it impossible to evaluate who will and who might not fail.(7)
Now, with no reassurance that they would ever be paid back, lenders stopped issuing loans in the commercial credit and interbank market. This is ongoing, and if it continues, could at any pretty much any time cause payrolls to fail and retail business to become frozen. Namely food. The supply chain from port to shelf is 3 days. 3 days of a completely illiquid market and people begin to feel hunger pangs. American people. Not many really get how interwoven the entire financial system is … but Icelanders figured it out earlier this month.
The real question here is, and it gets a lot deeper than “OMG WTF” is what’s the appropriate counterfactual when comparing against actual history? Suppose that a privately contrived subprime mortgage could have somehow legally existed in the absence of the 1995 revision. Would banks or securities experts have figured it out anyway?
Even if not, there is another important point. Private mortgage-selling companies seem to have originated subprime mortgages, financed by Wall Street securitization, on their own. I don’t think every subprime mortgage (or normal mortgage) has to be backed by Fannie Mae or Freddie Mac. I think mortgages over a certain dollar figure were never allowed to be backed by the GSEs. But those mortgages existed. Perhaps such subprime mortgages exist too. My loan for 176 in 2001 was a Fannie loan by force. I didn’t want that but was forced to accept it.
So IF this was so, there is some bad paper that the GSEs were not DIRECTLY responsible for. I don’t know how this breaks, numbers-wise. I mean, I don’t know what proportion of the bad paper is directly due to the GSE’s. I don’t think anyone does, but Habbard and Meyer claim it was 90%, via their admission the Fed now controls 90% of US mortgages. (8)
There is an underlying reason why the 1995 revision and the GSE’s behavior probably fanned the flames of private behavior. If the initial experiments under the revisions, from about 1996 to 2001, were viewed as successful and safe, then they had what’s called the demonstration effect to everyone else. When the government says to banks: “Go and make Alt-A loans to the riskiest borrowers” and no shit hit the fan, right away at least, it could well have changed operating procedure about what kind of loans are safe.
And of course, I think it is important to remember that events following the dot-com bubble that poured fuel on the fire. This aspect of the crisis stems from when The Fed took interest rates down near zero, which makes assets (like houses) rise in Federal Reserve Note value and also makes it nearly free to finance them from a lender perspective.
Once a bubble gets going, everyone becomes trapped in the bubble. The largest problem with bubbles is that there are always “real” reasons why assets can appreciate. All of us find ourselves not knowing for sure whether someone saying, “this is a bubble” is correct. When a trend in assets reflects real factors, it is sensible to get on board. Even when you know it’s a bubble, it makes financial sense to get on board if other people think the bubble is “real”. That was my plan of attack at the time and it worked.
Austrians allow for game theory and admit it’s role in economic issues such as spontaneous order. (9) Games frequently have many equilibria involved.(10) If there exists a “strategic uncertainty”, meaning the players aren’t certain how other players behave … Multiple equilibria, both the beneficial and harmful, increases.
In summary, I think we can point to several events that facilitated the bubble. The CRA revision … the dot-com bust, the Fed slashing rates to unnatural levels, interest rates and money freed up to lend unnaturally; and “new operating procedure” that made financials view subprime/Alt-A and mortgage securitization as some kind of normal and customary thing. It isn’t. It has existed for 30 years in all of humanity’s history.
Once a bubble is established, it takes on a life of its own. At that point, everyone is to blame. With the sole exception of those who argue against the establishment of bubbles time and again. Austrians.
- GSE’s: http://www.lewrockwell.com/paul/paul282.html
- Cronyism involving FRE and FNM bosses:http://directorblue.blogspot.com/2008/09/root-cause.html