How government regulations, guarantees, and special-interest tax policy systematically undermined the free-market economy and created the current financial crisis.

Government regulations and special-interest tax policies enacted over the past 80 years, although created with the best of intentions, have systematically weakened the US economy to the point of near collapse by paralyzing the 'invisible hand' that normally would keep abuses in check and prevent corporate greed from taking down the financial system. Many people would say that in fact the current crisis was caused by the lack of proper government oversight, and would recommend increased government regulation. As Obama said on Letterman (9/22/09): "Because of the lack of regulation, for example, we ended up having to pony up hundreds of billions of dollars to banks. And that if we had some good regulations in place, we wouldn’t have had to do that."

[This article is rife with errors.  Sorry.  I have to get back to this and fix it.  But I'll leave it up for now.]

I will show that this view is false, and really what is needed is to greatly reduce regulation, government guarantees, and special-interest tax policy. If the free market is allowed to function freely, then the country can enjoy a robust, competitive, and safe banking system. If the over-regulation is allowed to continue, then we are setting ourselves up for another, even greater, financial crisis down the road. And the worst part is that the taxpayer will again have to bail out the 'Too big to fail' greedy corporations that created the mess.

The Stages of the Crisis

The events leading up to the financial crisis can be divided into four stages. First was the housing bubble, which occurred over the last 10 years or so, inflating the value of real estate around the country to unsustainable levels. The second stage began when the bubble burst, resulting in fast dropping home values and many foreclosures. The third part was the ensuing 'credit crisis', in which banks, saddled with uncertain mortgages and mortgage-backed assets, stopped lending to businesses and individuals. The entire economy was under grave threat, and so the Treasury had to step in (the fourth and final stage) and loan $1 trillion to commercial banks, investment banks, AIG, and other companies to clean up the toxic assets to keep the economy afloat.

The first stage, the housing bubble, was caused by government policies, including the long-standing mortgage interest tax deduction, institutions such as Fannie Mae and Freddie Mac, and other factors which I will review. The foreclosure crisis was the inevitable result, but was made worse by FDIC bank regulations. The 'credit crisis' as well occurred only because of inappropriate FDIC solvency regulations that strongly discouraged banks from lending. Finally, the huge government bailout of investment banks and AIG was necessary to allow banks to resume function without requiring a nationwide FDIC takeover, which would have been huge and unprecedented, and perhaps impossible. Just as important, it was done to protect state and federal pension funds, which also presented a tremendous liability to government if they dropped in value. The thread that connects all the stages are the AAA rated mortgage bonds, the government insured 'toxic waste' that flowed through the system, and as I will show, also a consequence of government policy.

The Housing Bubble

The housing bubble was caused by government policies that funneled too much money into the housing market, increasing prices, speculation, and risk, and creating a huge and unsustainable market in real estate. The worst part was that much of the money was government insured, meaning that any fall in value would be borne by the taxpayer.

The first culprit is the long-standing mortgage interest tax deduction, which encourages people to buy instead of rent. So many people who perhaps should have rented a property were encouraged to buy a new one. Without the deduction, certainly fewer bad mortgages would have been sold. National Association of Realtors lobbies for the deduction, claiming that home values could fall as much as 15% in some areas. Clearly it was a significant contributor to the bubble.

Just as importantly, Freddie Mac and Fannie May (and the Community Reinvestment Act) created huge markets for bad loans. Under pressure from Congress (Barney Frank in particular), they gladly bought up poor quality mortgages in the name of the public good - getting more people to own homes. Currently they own or guarantee about half of the total national $14 trillion mortgage market. By purchasing the mortgages they added fuel to the fire - putting more money back in the hands of the banks to make more loans. Freddie and Fannie funded their operations by selling AAA loans to the public, which carried an implicit government guarantee that was part of the basis for their high rating.

The big investment houses - JP Morgan, Lehman Brothers, and Bear Stearns - also got in on the game. For the 'non-conforming' mortgages that the public sector would not take (either because they were too big or the buyer had insufficient equity), the big boys bought them up, diced and sliced them, insured them internally or though AIG(FP), put on a 'AAA' sticker, and sold them to pension funds and foreign banks, and often right back to the banks that originated them. Although taking on a huge liability, they made lots of money from fees, perhaps believing that government would bail them out in the event of failure. And it did - at least for Lehman Brothers. (Bear Stearns was allowed to fail.)

Another big contributor to the housing bubble and subsequent mortgage crisis was the Federal Home Loan Bank (FHLB), a little-known but huge mortgage lender, funneling money through its network of member banks. Its assets of $1.3 trillion make it the largest borrower in the country, second only to the Federal Government. (It borrows money by selling tax exempt bonds to the general public.) This represents almost 10% of the total $14 trillion national mortgage market.

Why would FHLB (which is considered at-risk in many parts of the country) continue to make such bad loans? And why would investors buy their bonds to fund the loans? The reason is that the bonds are tax exempt, both federally and locally. Also they sport an implicit government guarantee. Even though the FHLB denies this, it's the basis of their AAA rating (according to Moody's), and furthermore the Treasury has opened a line of credit for them (though they have not yet used it). The average investor buys FHLB bonds not because of an interest in the mortgage market, but because they are considered safe and tax exempt. However this money can be used only for buying homes. Thus they unwittingly provided the leverage the banks needed to put themselves out of business. When WaMu failed, by far its largest creditor was FHLB, with $83 billion in loans.

While there is nothing wrong with leverage in principle, it should be done with private funds, not government-guaranteed funds. Regulation that fails to take this into account cannot work.

With so much extra money in the housing market, banks had to put it somewhere. As opportunities for prime mortgages ran out, they had no choice but to consider qualified subprime borrowers, and after those ran out, there was no choice but to fudge the applications. Banks also turned to independent mortgage companies, more often than not unscrupulous and aggressive 'predatory lenders'. These lenders sold high interest mortgages to people who couldn't afford them (so-called "Liar's Loans", because the buyers were encouraged to lie about their income, job, and assets). They also offered risky low-down-payment loans, among other types of dubious practices. But the banks didn't care because they could easily sell the mortgages to others.  However, the supply of even poor quality borrowers was not limitless.

By selling off their mortgages to Freddie, Fannie, and the big investment banks, mortgage lenders had no 'skin in the game'. They had nothing to worry about. If the investment failed, no problem - the taxpayer would be on the hook for repayment. And that's exactly what happened. The lenders' only mistake was not getting rid of the mortgages fast enough. When the mortgage crisis hit, some banks still had sufficient toxic assets on their books to take them down. For example, WaMu had sold off hundreds of billions in mortgages, but still had about $20 billion in bad assets when it failed.

Of course lenders were not forced to lend, but the environment created such a great opportunity. Should they have given the money back? Of course they should. But they didn't. Certainly this behavior was illegal, but the incentive was irresistible.

The additional funding also fueled speculation, as investors got cheap money for second properties (both for rental and for flipping). This inflated the market still further, making mortgages even more unaffordable and risky.

In this way, government's pro-homeownership policies contributed greatly to the real estate market bubble. Furthermore, if the government didn't guarantee the mortgages, then at least the taxpayer would not have had to pay for the damage from the collapse.

The Bubble Bursts

In this fragile market in 2007, defaults became more commonplace. The loss of a job or an unexpected expense, and a payment was missed. The foreclosures started. The supply of even unqualified borrowers to support the market had run low.  Housing prices starting falling, and many homeowners dropped underwater (i.e. the mortgage was greater than the value of the home). They chose just to walk away. The wave of foreclosures grew.

If instead these people had rented a property, and either the rent increased or they lost their job, the situation would be much more fluid. They could move to another cheaper property, or move to where the jobs are. Rental prices would also go down as they do in a poor economy, making rentals more affordable. Instead, many homeowners were trapped in a sinking ship. The unintended consequences of well-intentioned government policy.

As real estate prices fell, banks could sell foreclosed homes only at a loss, causing a significant drop in mortgage bond values. If not for the artificially induced bubble, many of these homes could be re-sold, thereby retaining the value of the bond, and thus not presenting such a risk to the banks and funds that owned them.

To make matters worse, many foreclosed homes sat empty while waiting for a new buyer. In additional to the loss of potential income on the asset, this increased neighborhood blight and inflated local rental prices - making the situation even worse. The reason? FDIC regulations discourage banks from renting out their property, as it is outside their customary line of business.

Grade Inflation: AAA Junk Bonds

The ensuing credit crisis resulted from the fact that the AAA rated bonds were now of dubious value, threatening the solvency of banks and pension funds across the country and around the world (due to FDIC and other regulations). How did these bonds get AAA rating in the first place? Fannie Mae and Freddie Mac bonds get AAA rating because as Government Regulated Entities (GREs), they get an implicit government guarantee. The rating agencies believe that the mission of these agencies (increasing homeownership) is so important, that the federal government will step in and bail them out if they fail. Of course that's exactly what happened. It's the same for FHLB. Although the FHLB web site denies that the bonds are backed by the government, the agency still receives AAA from Moody's, despite the fact that 6 of its 12 banks are considered to be at-risk, because as a GRE there is an implicit government guarantee. In fact, the Treasury in 2008 opened a $1 trillion line of credit to FHLB, although this credit has not yet been tapped.

The story behind the AAA ratings for investment bank Mortgage Backed Obligations (MBOs) is a bit more complicated. The reason is that the ratings agencies make lots of money from the companies and instruments that they rate. It's a fundamental conflict of interest. (This is not the case with stocks, where the investor buys the ratings recommendations from an independent rater such as Morningstar. In the case of bonds, investors get ratings for free. There is no recourse if the ratings are bad.) How did this conflict of interest occur? Surprisingly it is also due to government regulation. In the 60's, after investors got burned by poor quality ungraded bonds, the government chartered a monopoly for the 3 agencies - Moody's, S&P, and Fitch, requiring that all bonds must get rated. So now the agencies could charge companies for the right to get their bonds on the market. These agencies all started in the early 1900's as investor-subscription services, and were originally accountable only to investors. But after this new regulation, their business model changed, and they started charging fees to bond issuers. Abuses started to occur, such as shopping around for the best rating, and paying for a higher rating. One can imagine the huge incentive to make the huge market of poor quality mortgage-backed investments appear to sparkle with a triple-A rating. This is what happened with CDOs and MBSs. This is also what happened with AIG. In fact the ratings agencies never even investigated the loan files. When they finally did, according to Fitch, "There was the appearance of fraud or misrepresentation in almost every file."

Any other company that committed such a mistake would be out of business by now.  Although it's likely that the malefactors will be prosecuted, the business are too important for the government to be dismantled.  As a result, it is unlikely that any lessons will be learned, except that they can survive after committing fraud.

Credit Default Swaps were an integral part of the process. A new and little known financial instrument in 2000, by 2005 they had become the 'special sauce' for subprime loans, making them palatable to banks and pension funds. Basically they are insurance on bonds, purchased for a fee, and in this case turned low-rated securities into AAA (the insured bonds inherit the rating of their AAA insurer - in this case AIG). They became a huge part of the bond market. Common sense would suggest that such a product is a bad idea. You can't insure an entire market, because if the market goes down all at once, then there's a huge hit. For example, most insurance companies don't cover flooding, because floods tend to affect a large number of customers all at once. This presents a huge liability, potentially crippling the company. On the other hand, car accidents are much more predictable and easy to insure. You don't know where an accident will happen, but you have a pretty good sense of frequency based on historical data. So CDS should not exist on a large scale, but they did, because they turned junk into gold. AIG remained a AAA rated company despite their huge liability.

As CDS became more popular, AIG realized that the entire financial system was in fact dependent on them. They could sell more and more, secure in the knowledge that even if the market turned, the government would have to bail out the company to avoid financial catastrophe. As Obama said on Letterman (9/22), "People were taking wild risks, expecting that maybe taxpayers would come back and bail them out after the fact because we couldn’t afford to let the whole financial system to go under."

Thus bonds were cleaned by this financial laundry service. The fundamental market principle of 'risk/reward' was decoupled. These were seemingly very low risk investments with high interest rates. They basically sold themselves.

Banks and pension funds bought them up like candy.

The Credit Crisis

In the face of obvious trouble, the rating agencies finally started to downgrade bonds. People began to realize that the "Emperor has no clothes." The bond market froze up because no one knew how much the troubled assets were worth.

As a bank's assets falls below AAA, its capital reserve requirements increase. If it cannot meet these requirements the bank is deemed insolvent by the FDIC. The agency would have to step in and resolve the situation, either by orchestrating a merger, or selling off the bank's assets (into a troubled market) and restoring it's depositors. As a result the credit markets froze up, since banks didn't know if their assets would fall below AAA, and if they did, whether they would be able to sell them into a troubled market to raise capital.

The credit markets are essential to the daily function of industry big and small, as well as consumer spending. Having frozen up, the economy was brought to the brink. There was a level of crisis and fear not experienced since the Great Depression.

Ironically it was the FDIC reserve requirements that caused the problem -- ironic because the FDIC was created to prevent public panic. Without the regulations, banks could continue to lend, and the problem would not have been nearly so bad. Furthermore, the crisis created panic in Washington. Something had to be done, and fast.

The Bailout

The federal government, fearing economic collapse and bank runs on a wide scale, decided it had no choice but to maintain the AAA ratings of bonds at all costs. If it didn't, then the banks would fail, and the FDIC would have to resolve bank failures on a scale never before seen. They would have to sell their assets in a depressed market AND make their depositors whole. It would have been an impossible task. FDIC insurance fund is far to small to take on such a huge problem.

The additional irony is the utter powerlessness of the FDIC. The very organization that is supposed to rescue banks in times of crisis itself had to be rescued.

Pension funds were in a similar situation. Lower bond ratings would require costly state intervention.

So in addition to bailing out Freddie Mac and Fannie Mae, the government also had to bail out AIG and other Wall Street investment banks to maintain their high credit ratings and the ratings of the bonds they insured.

Without the FDIC regulations, AIG could have been allowed to fail, and banks could continue to service their customers. Perhaps it would be necessary to limit withdrawals temporarily until the bond market resumed functioning. Worst case if bankrupt, the bank could slowly wind down and distribute the proceeds to its customers. Losses from troubled assets were generally only a fraction of total deposits, so depositors would receive most of their funds.

(The FDIC is often justified as necessary to prevent bank runs. But bank runs can be prevented in other ways, such as by allowing banks to limit withdrawals in crisis situations. This may not prevent a bank failure, but it would prevent a panic and allow an orderly wind-down.)

It was not only the FDIC, but other government regulations which contributed to the crisis. The insurance companies in New York State are themselves self-insured. By state regulation, if any insurance company fails, then all other companies have to bail it out and restore their customers. Thus, AIG could not be allowed to fail. If it did, all the other insurance companies would have to bear the cost. With a company as big as AIG, this could destroy them. So for their own survival, business in NYS supported the bailout of AIG.

(Similarly, FDIC is funded by insurance payments from member banks. Recently the FDIC raised their insurance premiums, which hit small community banks harder, even though they were among the healthiest. This further helps the big banks at the expense of the small ones.)

Despite the bailout, the problem is far from resolved. Banks are still holding onto assets of dubious value and could still face a future crisis.

As well, now that subprime lenders are gone, the FHA (Federal Housing Agency) has stepped in to insure the riskiest mortgages.   Because the FHA has very low standards with regard to approval, it is now supporting about 30% of loan applications.  The worst part, of course, is that if the borrower defaults, the American taxpayer must pay the bill.  It is estimated that the cost could be half a trillion dollars.  Thus the housing market remains artificially inflated, and when it falls again, another crisis will ensue.

Conclusion

Thus we see that a combination of government regulations, institutions, guarantees, and policies were the cause of the financial crisis. The free market was not allowed to function normally because the 'invisible hand' of the market was slowly being paralyzed, to the point in 2008 where it could no longer function at all.

Only by retracting these policies can we avoid a future crisis. Obama draws the opposite conclusion from the same facts: "We had too little government, too little regulation." Most people share Obama's belief. The reason, I suspect, is simply that most people don't realize the depth of the corrupt state of affairs leading up to the crisis. In part this is because we are so used to certain policies that we don't even question them, such as FDIC, the conflict of interest with ratings agencies, and the mortgage tax deduction. Furthermore, some of these policies are favored by many for their own self interest. However, people need to be advised of the dangers posed by these policies, and they must be retracted or phased out. Only in this way can we avoid future crises and catastrophes.

We must also recognize that to a great extent these problems are our own fault. We Americans demand insurance for our bank deposits, tax deductions for our mortgages, and security with our pension funds. But this requires a government guarantee, which ultimately leaves the taxpayer on the hook. We need to take responsibility for where we put our money, just like we do with real estate and the stock market. We don't expect the government to bail us out for a bad stock pick. We should not expect the government to bail us out 100% if our bank fails. Or if our pension fund fails. Banking regulation must be replaced with consumer education. In fact, even if WaMu deposits were not insured, depositors would still get back around 90% of their assets. They estimated write offs of $19 billion, but total deposits were $189 billion.

Common Criticisms

I will now address some of the most common criticisms of this thesis.

First of all, I fully acknowledge that some level of regulation is necessary. For example, anti-monopoly regulation is critical, and breaches of fiduciary duty should be strongly prosecuted.

A common argument for regulation is that it is required to counteract the level of greed on Wall Street, and it's apparent focus on short term gain over of long term viability. But there will always be greed and short-sightedness on Wall Street (and everywhere else). Furthermore, people will always make mistakes, and even smart regulators can't prevent that from happening. The best we can do is ensure that these people are not gambling with our money or government-guaranteed funds. And the only way to do that is to take responsibility for how we invest our money and to end government guarantees.

One might be tempted to blame China for it's role in lowering interest rates (by purchasing Treasuries), thereby making it 'too easy' to purchase homes. Certainly this contributed, but it was only the housing market that ballooned during this time: no other segment of our economy enjoys such deeply entrenched government policies. (China wisely stayed out of the real estate market in the US.) It would also be a mistake the blame the Democrats. Republicans as well encouraged the 'ownership society'.

Finally, while it could be argued that previous economic crises occurred in times of low regulation, these were also times of limited consumer knowledge and power. If the consumer is educated and takes responsibility for their financial choices, this will in itself provide the necessary regulation to keep businesses competitive and robust.