On October 3, 2008, President Bush signed into a law the Economic Stabilization Act. This $700 billion law was touted as the only way to rescue the US economy from certain collapse. Instead, President Bush and Congress have likely only delayed the inevitable. The law does nothing to resolve the underlying problems that are threatening our economy.
Candidates from both parties have been quick to condemn Wall Street greed for the implosion of a growing number of banks and investment firms. These companies made billions of dollars in the subprime lending market for years before the bubble of inflated real estate prices began to burst. If we look deeper into the history of subprime lending, an industry in which I worked at one time, we find that while greed certainly played a role, it is not the only factor in the crisis.
Subprime lending as we know it today did not exist prior to 1977. In that year, Congress passed the Community Reinvestment Act, which was signed into law by Jimmy Carter. The law was intended to prevent racial discrimination in lending and to prevent the “redlining” of low-income neighborhoods. Activist groups used the law to challenge regulatory approval for new bank ventures when banks did not comply satisfactorily with the CRA.
The act was significantly strengthened by President Bill Clinton in the 1995. His administration stepped up enforcement of the act by setting performance-based goals. The Clinton Administration also encouraged banks to relax rules for income verification of borrowers and provide for lower down payments. The new CRA also allowed banks to bundle mortgages into securities, which could then be sold to other banks instead of being held by the original lender.
The Clinton Administration also pressured Fannie Mae and Freddie Mac, quasi-governmental companies, to buy more of these mortgage backed securities. In 1999, Fannie Mae CEO Franklin Raines, now an Obama advisor, told the NY Times “there remain too many borrowers whose credit is just a notch below what our underwriting has required who have been relegated to paying significantly higher mortgage rates in the so-called subprime market.'' Fannie Mae further reduced the credit requirements of the mortgages that it purchased as it increased its share of the mortgage market.
The US government directly encouraged the banks to make risky loans with the implicit guarantee that they would be bought by Fannie Mae and backed by the government. Community groups pressured banks to lend more money to low-income borrowers under the threat of bad publicity. Banks did not resist when they found that money was too easy to make in the subprime market in a time of rapidly rising real estate values. By 2007, Fannie and Freddie owned or guaranteed about 40% of the US home loan market. Many banks were heavily invested in Fannie and Freddie stock as well as mortgage backed securities.
The fundamental flaw of the Economic Stabilization Act is that while it includes money for the US Treasury to buy bad mortgages from troubled banks. What it does not do is to remove the impetus that sparked the subprime frenzy in the first place. The Community Reinvestment Act is still law and many of the same people, in both government and banks, are still wielding power.
The Democratic Party is heavily involved in the crisis due to their goal of providing more affordable housing for low-income families. Chris Dodd, chairman of a senate committee that oversees banks, resisted attempts to reform Fannie and Freddie in 2003 and 2005. Dodd also received the most money of any congressman from Fannie and Freddie employees and PACs. Barack Obama, the second highest recipient, includes former Fannie and Freddie CEOs, Jim Johnson and Franklin Raines, among the economic policy advisors to his presidential campaign. Obama also worked with ACORN, one of the community activist groups that pressured banks to lend more money in low-income areas or be harassed under the CRA.
On the other hand, the Republicans did halfheartedly attempt to reform the system. President Bush noted as far back as 2001 that the size of Fannie and Freddie was “a potential problem.” In both 2003 and 2005, Republicans introduced the Federal Housing Enterprise Regulatory Reform Act. In both cases, Democrats threatened a filibuster over the ability of the GSEs to contribute to groups like ACORN. In spite of a Republican majority in both houses, the bill went nowhere.
With the Democrats virtually certain to regain control of both houses of Congress and likely to capture the White House as well, it is highly unlikely that there will be any meaningful reform to the CRA. If the government continues to pressure banks to make loans to people who cannot repay them, then we will certainly revisit the mortgage crisis. More bailouts will be required until the Treasury has no money left. Higher taxes to generate revenues would likely cause the economy to slow further.
As in Ayn Rand’s Atlas Shrugged, the government and the community activists essentially became parasites that attached themselves to the financial sector, which willingly went along with the scheme. Money was sucked from the banks until the bubble burst and they started to fail, resulting in the present crisis.
To further complicate the situation, two other bailouts are already appearing on the horizon. Medicare is projected to be bankrupt by 2019. Social Security will follow it into insolvency in 2041. Either large tax increases or large benefit cuts will be required to keep the programs solvent. These bailouts will be on top of additional spending proposed by congress for programs such as universal health care.
If we are to avoid an economic collapse, there must be fundamental change in the attitudes of Americans. We should, to paraphrase a great president, ask not for handouts from our government, but ask that our government put a stop to spending on programs not authorized by the Constitution. We must return to the days before the New Deal and the Great Society when Americans did not look to the government to provide for their financial security.