Deciphering the Financial Crisis

As we draw nearer to the upcoming election, one issue has arisen to eclipse all others: the financial meltdown. Frighteningly, neither John McCain nor Barack Obama seems to have the slightest clue as to what really caused it, or how to fix it. Neither man has done his homework. How will we know who to choose to lead us back from the brink of economic disaster?

The implications of this crisis will continue far beyond November 4th, and we can realistically expect years of economic hardship before any semblance of prosperity returns to our nation. Bad luck for us. We’re pissed off, the lowest cogs in a complex machine we don’t understand.

So what happened? How did we land in this mess?

It can be said that what happened was due to greed, and that is 100% true, but greed must have an enabler. It must be understood right here that the enabler in this situation was not the the original program and legislation, but subsequent legislation that created a way for the prospect of profit to appear in a market where it should not have been. The original intention of the Community Reinvestment Act and the laws surrounding it were and remain noble. It should not be discarded because of its role in this crisis.

A 1961 study by the U.S. Commission on Civil Rights found that banks were engaged in discriminatory acts against African American borrowers. Institutions required  that black Americans make larger down payments and gave them less time to pay their loans back. Most nefarious, however, was the practice of redlining, when a lending institution simply refused to extend credit into certain neighborhood. This 1968 Civil Rights Act (commonly known as the Fair Housing Act) addressed discriminatory housing practices, but provided no framework from which the Federal Government could work to effectively combat them.

It wasn’t until the 1970’s that Congress passed legislature that began to work towards compliance with the Fair Housing Act. In 1974 the Equal Credit Opportunity Act allowed for credit applicants to seek civil punitive damages against lending institutions that discriminated against them. The 1975 Home Mortgage Disclosure act required banks to give the Federal Government personal information about the race, gender and demographics of their customers. Then, in 1977, President James Earl Carter signed into law the Community Reinvestment Act. (Please note that both the Community Reinvestment Act and the Civil Rights Act are referred to as the CRA. From this point forward, when I refer to the CRA I will be referring to the Community Reinvestment Act).

The CRA dealt primarily with redlining, trying to ensure that residents of poverty-stricken and low-income neighborhoods were not denied credit. At the same time, it was only a directive and provided little means for the redress of grievances against lending institutions. Slowly community advocacy groups formed as a means to communicate resident’s concerns. The failure of numerous savings and loan companies in the 1980’s spurred the passage of FIRREA (Financial Institutions Recovery and Reform Enforcement Act) in 1989. FIRREA increased oversight of CRA guidelines and expanded the degree with which the Government could asses a bank’s compliance by creating a four-tier rating scale of Outstanding, Good, Needs Improvement, and Substantial Non-compliance. Public disclosure of CRA ratings and other information gave greater leverage to advocacy groups, but the Federal Government still had little means of enforcement. In 1994, the Riegle-Neal Interstate Banking and Branching Efficiency Act repealed restrictions on interstate banking practices. The Government began to use CRA compliance ratings as one method of determining an institutions eligibility when applying to open interstate branches. Eventually CRA ratings would be examined any time a bank required Federal approval for an expansion or other action. The Feds now had leverage to begin CRA compliance enforcement.

The CRA is the first loose brick of Wall Street that contributed to its collapse. We will come back to it, but first must examine another component.

Government Sponsored Enterprises (GSE’s) are financial entities created by Congress to provide transparency, oversight, stability, and stimulus to three specific areas of the credit market: agriculture, finance, and education. In 1916 Congress created the first GSE, the Farm Credit System. In 1932, during the Great Depression, it created the 12 Federal Home Loan Banks to stabilize the housing market by offering liquidity in the form of low-interest loans to banks operating in the home mortgage market. The two most well known GSE’s are undoubtedly the Federal National Mortgage Association and the Federal Home Loan Mortgage corporation, also known respectively as Fannie Mae and Freddie Mac. Fannie Mae was created in 1938 as part of the New Deal, and Freddie Mac in 1970 to compete with Fannie Mae and bolster the market. Fannie Mae and Freddie Mac are separate from the Federal Home Loan Banks.

One way that GSE’s invest is by securitizing mortgages. This means that they buy mortgages from banks, pool these bundles of home loans, and then sell them as investments. The value of the security is guaranteed only by the repayment of the principal and interest of the loan by homeowners. Therefore, prepayment of loans can affect the value of a mortgage–backed security (MBS). So can foreclosures. GSE’s also created a secondary market for home mortgages, meaning that MBS’s can be bought and sold in bulk between different financial enterprises. This allowed more liquidity for the investors of securities. Because of their government affiliation, GSE’s generally receive below market interest rates for loans issued to them and high prices for their securities. The Government also exempts them from paying income taxes. While the CRA and the GSE’s are separate, they connect through the government’s desire to expand home ownership in lower-income families. In 1992, the Federal Housing Enterprises Financial Safety and Soundness Act required Fannie Mae and Freddie Mac to direct a certain percentage of their enterprise towards the subprime mortgage market.

President Bill Clinton in 1995 pushed for extensive regulatory revision and expansion of the CRA.  This deregulation streamlined Federal CRA examination techniques and, more importantly, allowed for the first time public sale of CRA related securities. These securities were given a AAA rating by Fannie and Freddie, misleading the public into believing that they carried some sort of guarantee from the Federal Government.

In 1999 Bill Clinton signed into law the Financial Services Modernization Act. It repealed the depression era Glass-Steagel Act which had prohibited institutions from mixing investment, commercial, and insurance interests. Also called the Gramm-Leach-Bliley Act after its sponsors, GLB passed as a compromise bill after an initial defeat. The compromise involved the call of Republican Senator Phil Gramm for transparency in the dealings of advocacy groups (which he felt were strong-arming lenders), versus the Clinton Administration’s mandate that all banks expanding in mixed commercial, investment and insurance holdings be CRA compliant.This compromise allowed the creation of mega-corps like Citi-group. Suddenly the sub-prime mortgage market became very profitable, and the banks themselves, with the approval of CRA auditors and community groups, began lowering their underwriting standards, which led to extremely risky no down payment and no income verification loans.

The next relevant piece of legislature came a year later. The Commodity Futures Modernization Act, aka the “Enron Loophole,” allowed the creation of single-stock futures (futures being investments that allow investors to purchase future deliveries of as-yet unproduced commodities and services). Offering futures that deal only with single stocks instead of blended assets allows speculators to control the markets of essential industries such as oil, energy, and agriculture and also wreak havoc with consumer prices . Evidence points to Republican Phil Gramm as being the contributor of the few lines in the Act which enabled single-stock trading. Bill Clinton signed the CFMA in December of 2000, shortly before leaving the office of President of the United States.

Now enter Democrat Franklin Delano Raines. A Rhodes Scholar, Raines attended Harvard, Harvard Law, and Oxford. A man of ambition. Raines worked for Jimmy Carter as an assistant budget director in the Office of Management and Budget (OMB). After that he joined Lazard LTD. I will let Lazard itself describe what they do; here is a clip from the front page of their website:

“Lazard, one of the world’s preeminent  financial advisory and  asset management firms, operates from 41 cities across 24 countries in North America, Europe, Asia, Australia, Central and South America. With origins dating back to 1848, the firm provides advice on mergers and acquisitions, restructuring and capital raising, as well as asset management services to corporations, partnerships, institutions, governments, and individuals.”

Raines left Lazard in 1990, after becoming a partner. He became Vice Chairman of Fannie Mae where he stayed until 1996. He returned to the White House, this time as Director of the OMB. To briefly describe the job of the OMB, it oversees federal agencies, programs and services ensuring that they meet the requirements of the President’s budget. OMB has a secondary mission also. From their official Government website:

“In addition, OMB oversees and coordinates the Administration’s procurement, financial management, information, and regulatory policies.”

Basically, in Government, you don’t spend without OMB approval. Raines cabinet appointment wielded him immense power and influence in Washington. As we shall see, that influence would serve Raines well.

In 1999 Raines left the Clinton Administration to take control of Fannie Mae as its CEO. Over the next 5 years, Raines stole tens of millions of dollars (purportedly $90 million) in the form of executive bonuses by overstating the earnings of Fannie Mae to the tune of 6 to 9 billion dollars. In 2004, the OFHEO (Office of Federal Housing Enterprise Oversight) and the Securities and Exchange Commission began an investigation of Fannie Mae, Freddie Mac, and Frank Raines. The Congressional hearing on this investigation was taped, and the video of it is widely available on the internet. Here are some transcripts.

Congressmen Richard Baker, R-Louisiana: “It is indeed a very troubling report [by OFHEO regulators], but it is a report of extraordinary importance, not only to those who wish to own a home, but as to the taxpayers of this country who would pay the cost of a clean up of a [government-sponsored] enterprise failure…The analysis makes clear that more resources must be brought to bear to insure that high standards of conduct are not only required, but more importantly, they are actually met.”

In her reply, D-California  Congresswoman, Maxine Waters: “[We sat] through nearly a dozen hearings where, frankly, we were trying to fix something that wasn’t broke. Mr. Chairman, we do not have a crisis at Freddie Mac, and particularly at Fannie Mae. Under the outstanding leadership of Mr. Frank Raines, everything in the 1992 act has worked just fine. In fact, the GSE’s have exceeded their housing goals. What we need to do today, is to focus on the regulator, and this must be done in a manner so as not to impede their affordable housing mission, a mission that has seen innovation flourish, from desktop underwriting to 100% loans.”

Congressman Gregory Meeks, D-New York (Meeks’ rant is directed at the OFHEO regulator): “I’m just pissed off at OFHEO, because if it wasn’t for you, I don’t think that we’d be here in the first place and now, the problem that we have and that we’re faced with is, maybe some individuals who wanted to do away with GSE’s in the first place, you’ve given them an excuse to try and have this forum so that we can talk about it and maybe change the direction and the mission of what the GSE’s had, which they’ve done a tremendous job. [There] has been nothing that has been indicated as wrong, you know, with, uh, Fannie Mae. Freddie Mac has come up on its own, and the question that then presents is the competence that, that, that your agency has, with reference to deciding and regulating these GSE’s. And so, I wish I could sit here and say that I’m not upset with you, but I am very upset because, you know, what you do is, you know, you give, maybe giving any reason, to, as Mr. Gonzales said, to give someone a heart surgery when they really don’t need it.”

Congressman Ed Royce, R-California: “In addition to our important oversight role in this committee, I hope that we will move swiftly to create a new regulatory structure for Fannie Mae, for Freddie Mac, and the Federal Home Loan Banks.”

Congressman Lacy Clay, D-Missouri: “This hearing is about the political lynching of Franklin Raines.”

Ed Royce: “There is a very simple solution. Congress must create a new regulator with powers at least equal to those of other financial regulators such as the OCC [Officeof the Comptroller of Currency] or the Federal Reserve”

Meeks vs. the Regulator, part II: “Why should I have confidence, why should anyone have confidence, in you as a regulator at this point?”

Regulator: “Sorry, Congressman. OFHEO did not improperly apply accounting rules, Freddie Mac did. OFHEO did not try to manage earnings improperly, Freddie Mac did. So this isn’t about the agency engaging in improper conduct, its about Freddie Mac.”

Congressman Christopher Shays, R-Connecticut: “ We passed Sarbanes-Oxley, which was a very tough response to that.” [My note: Sarbanes-Oxley is 2002 bill designed to counteract securities market failures as a result of corporate scandals like Enron. It applies to publicly owned corporations only and excluded private corporations like Fannie Mae and Freddie Mac] “And then I realized, Fannie Mae and Freddie Mac wouldn’t even come under it. They weren’t under the 34 act, they weren’t under the 33 act, they play by their own rules, and, and, I’m tempted to ask, how many people in this room are on the payroll of Fannie Mae? Because what they do is, they basically hire every lobbyist they can possibly hire. they hire some people to lobby and they hire some people not to lobby so that the opposition can’t hire them.”

Congressman Artur Davis, D-Alabama, addressing the OFHEO regulator: “A concern that I have, you’re making very specific, what you have correctly acknowledged, broad and categorical judgments about the management of this institution, about the willfulness of practices that may or may not be in controversy. You’ve imputed various motives to the people running the organization, you went to the board and put a 48 hour ultimatum on them, without having any specific regulatory authority to put that kind of ultimatum on them, um, that sounds like some kind of invisible line has been crossed.” [Note: Artur Davis has since apologized for his role in this hearing. He is the only Democrat as of yet to do so.]

Christopher Shays: “Fannie Mae has manipulated, in my judgment, OFHEO for years. and for OFHEO to finally come out with a report as strong as it is, tells me that’s got to be the minimum, not the maximum.”

Congressman Barney Frank, D- Massachusetts, then ranking democrat on the House Financial Services committee (Frank is currently the Chairman of said committee): “I,I,this, you, you seem to be saying well, these are in areas which could raise safety and soundness problems. I don’t see anything in your report that raises safety and soundness problems…but I have seen nothing in here that suggests safety and soundness are at issue. It serves us badly to raise safety and soundness as a kind of general shibboleth [i.e. a phrase distinctive of a specific issue] when it does not seem to me to be an issue.” [In 2003  Frank opposed a proposal by the Bush administration to create a separate oversight agency for Fannie Mae and Freddie Mac.]

Congressman Don Manzullo, R-Illinois: “ …Mr. Raines, 1.1 million bonus and a $526,000 salary. Jamie Gorelick, $779,000 bonus and a salary of $567,000. This is, what you stated on page 11, is nothing less than staggering. The 1998 earnings per share number turned out to be 3 dollar and 23 cents and 9 mils,” [meaning that pennies were counted down to minute decimals]” a result that Fannie Mae met the EPS maximum payout goal right down to the penny. Fannie Mae understood the rules and simply chose not to follow them…If Fannie Mae had followed the practices, there wouldn’t have been a bonus that year.”

Christopher Shays addressing Frank Raines: “You have about three percent of your portfolio set aside.” [I believe this addresses the amount of liquidity of an asset an institution is required to keep on hand.] “If a bank gets below four percent, they are in deep trouble. So I just want you to explain to me why I should be satisfied with three percent?”

Frank Raines: “ Because banks don’t, there aren’t any banks that only have multi-family and single-family loans…these assets [securitized subprime mortgages] are so riskless that their capital for holding them should be under two percent.”

This transcript reveals several disturbing things, foremost among them members of Congress bullying and intimidating Federal regulators. We also have Democratic resistance to Fannie Mae and Freddie Mac coming under the regulation and oversight intended to counteract exactly the kind of fraud that allowed Frank Raines and other F&F executives to commit their heinous crimes. Raines took early retirement from Fannie Mae shortly after this hearing. He remains a free man, having paid back less than $5 million of the $90 million he purportedly stole in a settlement with OFHEO and the SEC. Fannie Mae itself paid a whopping $400 million in its settlement.

Lets compare what we know about Republican and Democratic roles in regulation from this hearing with Speaker of the House Nancy Pelosi’s comments during House debate on the bailout:

“When was the last time anyone ever asked you for $700 billion? It’s a staggering number, but only a part of the cost of the failed Bush economic policies to our country. Policies that were built on budget recklessness…and now eight years later, the foundation of that fiscal irresponsibility, combined with an anything-goes economic policy, has taken us to where we are today…[Republicans] claim to be free market advocates, when it’s really an anything-goes mentality. No regulation, no supervision, no discipline. And if you fail, you have a golden parachute, and the taxpayer bails you out…How did it sneak up on us, so silently, almost on little cat feet?”

Pelosi’s accusations seem to indicate the opposite of what my research has revealed. The sale to the public of securitized subprime mortgages happened under Clinton’s watch, not Bush’s, as did the deregulation of depression-era legislation with Riegle-Neil and GLB. During the Bush administration, Republicans called for greater oversight of Fannie Mae and Freddie Mac while executives like Frank Raines robbed them blind. Democrats blocked the proposed regulation, intimidated the regulator, and covered for Raines. In the face of an imminent election, Pelosi made misleading comments obviously designed to bolster her own party and undermine the Republicans.

Scarier yet, in a July interview, Washington post reporter Anita Huslin claimed that Raines had said he had “taken calls from Barack Obama’s presidential campaign seeking his advice on mortgage and housing policy matters.” The McCain campaign took this tidbit and blew it up in a campaign ad that purported that Raines was a “close economic advisor” of Obama’s, an idea for which there is little support, but the fact remains that Raines himself admitted being contacted by Obama’s campaign staff. Shouldn’t Raines be behind bars? Didn’t he receive the same “golden parachute” spoken of by Nancy Pelosi? (For the sake of fairness, I must point out that just as Obama has been linked to Frank Raines, McCain has ties to Phil Gramm.)

The truth is that both parties contributed to this crisis, and both are to blame. But we cannot let ideology stand in the way of reason. Objectivity by Democratic party leaders seems to have flown out the window on this one.

Is this “THE CHANGE WE NEED?”

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1 Comment

  1. I started to respond with a brief outline of the concurrent meltdown in the federal student loan industry but soon found myself mired in an epic analysis that went far afield of your original treatise. You have provided a well-researched assessment of the issue and reading this in light of the circumstances several months post-election only emphasizes the concerns. The partisan blame-game and overreaching proposals of our new administration give me great concern for the immediate future.


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