Socialising risk, privatising rewards

If Congress does not act, American taxpayers will continue to be exposed to the enormous risk that Fannie Mae and Freddie Mac pose to the housing market, the overall financial system, and the economy as a whole. Sen. John McCain, May 25, 2006

Sarah Heath was just a little girl of eight when Joe Biden (D-Delaware) for the first time, slid himself into one of the many rich soft leather seats that furnish the United States Senate. Thirty-six years later, Sarah Heath is now married to Todd Palin, has five children, is a proud hockey mum, ran a small town and now, as Governor, runs the largest state in the union.

Sen. Biden, the consummate Washington insider, is still glued to the same leather chair.

It’s judicious to study Friday’s Vice Presidential debate and look behind the cute comments of the Democratic candidate for Vice President and understand why the Republican candidate kept her powder dry.

When asked about the financial disaster by the moderator Ms Gwen Ifill, Senator Joe Biden was quick to apportion blame to the Bush Administration: “… it's evidence of the fact that the economic policies of the last eight years have been the worst economic policies we've ever had. As a consequence, you've seen what's happened on Wall Street”.

He droned on blaming President George W. Bush for policies of “excessive deregulation”.

The Governor of Alaska, in reply, softly mentioned that it was Sen. John McCain who three years ago warned the Senate about an out of control Fannie Mae. A Fannie Mae that needed more oversight. She didn’t labour the point. Even though it’s a very valid point to labour. I am confident that her running mate, Sen. John McCain, over the next month, through television advertisements will remind the American public of this. And of Sen. Barack Obama’s undignified role in this crisis.

Sen. McCain’s task will be difficult given the media is doing its utmost to show how politically correct it can be, by not discomforting the first black candidate for the highest office in the United States with any unsavoury questions. Even if such questions unearth evidence of conduct that one would not expect in a Presidential candidate.

In the lead up to Friday’s vote in the House, some representatives on Capitol Hill would have the proverbial working stiff believe that Wall Street’s difficulty is a lack of capital. So they (both Democrats and Republicans) agreed in principle to spoon out hundreds of billions in taxpayer funds to allay those concerns. Others, mainly Democrats, claim the issue is not so much a lack of capital, but rather a lack of “trust”.

Robert B. Reich, the pint sized Secretary of Labor in President Bill Clinton’s administration is one of the more vocal advocates arguing that rebuilding trust on Wall Street is Job #1.

In between writing op-eds and advising a community organiser from Illinois, Reich laments that the most ambitious intrusion of government into the market in living memory - bailouts and nationalisations - will not help Wall Street one jot. The Street's fundamental problem isn't lack of capital. It's lack of trust, he proffers. And without trust, Wall Street suits might as well undo their Ermenegildo Zegna ties and mothball their Hermes hand bags.

Financial markets trade in pledges: that assets have a certain value that financial statements are accurate, that a loan carries a defined risk, and that such risk is reflected in the anticipated return on that investment. Crucially, when a counter party asks for a withdrawal, the funds to realise that withdrawal actually exist. Once a car is out of petrol it doesn’t work. The same goes for investors when they stop trusting the promises made to them. The markets stop functioning.

It turned out that many of these financial promises weren't worth the fancy paper they were written on. Reich asserts that while the subprime mess triggered the collapse of trust, financial markets were in danger of such a free fall even before mortgage-backed loans were shown to be worth far less than anyone assumed. That's because when the market was roaring a few years back, so many financial players were clueless as to what they were buying or selling. Even worse, they didn't care a hoot, as long as they were reeling in the cash.

A suite of financial instruments, such as complex derivatives and collateralised debt obligations erected a mirage of solid value. But it was just a mirage. These securities had sweet little behind them.

The leverage some financial institutions took on board seemed to have no limits. Lehman Brothers, for example, started this year with a gearing ratio of 30:1. Imagine that. Imagine rolling up to your home mortgage provider and stumping up a $100,000 deposit, to be offered a $3m loan. Now that’s my kind of home loan.

Why the former Labor Secretary should even enter the debate on the housing originated sub prime fiasco - given his party’s fingerprints all over the mess in the first place - is incomprehensible.

Since the mid 1990s, Democrats, both in the Clinton White House as well as in Congress, fought tooth and nail against major reforms to bring Fannie Mae and Freddie Mac under closer financial supervision.

A bit of history is in order.

The Democrats lit the sub prime fuse by railroading lenders to spoon out cash to people who could not possibly qualify for a home loan. This came into being via the irresponsible modifications to the Community Reinvestment Act. While President Bill Clinton was not unzipping his trousers for Ms Monica Lewinsky, he applied pressure to US financial institutions to lend to minorities and those in poor neighbourhoods, in a misguided effort to increase home ownership in United States.

One of Clinton’s more appalling changes to the Act was giving Fannie Mae and Freddie Mac extraordinary leverage, allowing them to hold just 2.5 per cent of capital to back their investments, versus 10 per cent for banks.

The Democrats, under Bill Clinton’s Secretary for Housing and Urban Development, Mr Andrew Cuomo (the youngest such secretary in history), made several ignorant and partisan decisions between 1997 and 2001 that gave birth to the current financial crisis.

Cuomo took actions that helped plunge Fannie Mae and Freddie Mac into the subprime markets while disallowing the means to monitor their increasingly risky investments. He turned the Federal Housing Administration mortgage program into a sweetheart lender with shoot-the-moon loan ceilings that required no money down, in time making it a major lender to minorities (code for blacks and Hispanics who earn little, have poor credit histories, but vote Democrat).

The Democrat-manufactured current mortgage crisis involved strong-arming home loan providers to lend with no-doc provisions. Low-doc would have been a godsend in comparison. There was no verification of income. No verification of assets. Little assurance of the ability to pay the mortgage and little or no down payment.

So, with rules like these, who wouldn’t expect that in time, something unpleasant would hit the fan?

Thanks to Cuomo, between three and four million American families are now facing the repo man. Good work Andrew. You too Bill.

Over the years, Fannie Mae’s and Freddie Mac’s holdings of dodgy mortgages grew ever more unsustainable. The ticking bomb of several trillion dollars in Fannie Mae’s and Freddie Mac’s portfolios remained low-risk “investments” so long as home prices continued to rise. Once prices began to tank, the jig was up.

If Fannie Mae and Freddie Mac were better regulated, it’s hard to imagine this disaster ever happening. But they were not better regulated. Why?

Some three years ago, Fannie Mae and Freddie Mac were in all sorts of trouble, notably accounting scandals that led to turnover at the top. Responsible commentators were aghast when they heard the Securities and Exchange Commission’s chief bean counter dismiss Fannie Mae CEO Mr Franklin Raines’ accounting position was a sham.

Soon thereafter, a bill to reform Fannie Mae and Freddie Mac was passed by the Senate Banking Committee, after sailing through the House of Representatives. The bill allowed a regulator the power to crack down on, and to direct the companies to eliminate their investments in risky assets. The bill had three sponsors: one of them was Sen. John McCain.

If that bill had become law, then the world today would be very, very different.

But the bill didn't become law, for a simple reason: Democrats opposed it. Some Republicans, frustrated by the wholesale Democratic opposition, couldn't (or wouldn’t) get their act together to organise a Senate vote on the matter.

That the Democrats could have taken such a reckless political stand was scandalous then.

What was clear to keen observers was that opposing the bill was tantamount to socialising the risk while privatising the rewards. Obviously those hostile to the bill could only act so shamefully because their constituents understood very little of what they were doing.

The public - aided by the overwhelmingly a leftist media - was broadly ignorant then and remains ignorant now as to the true involvement of the Democratic Party in creating the home loan fiasco. In the light of the US$700 billion taxpayer funded bail out, the wickedness of the Democrats in 2005 is indefensible.

Today we know that many Senate Democrats who shielded Fannie Mae and Freddie Mac, including Barack Obama, Hillary Clinton and Christopher Dodd, received mind-numbing sweeteners from them over the years.

Throughout his political career, Barack Obama banked more than US$125,000 in campaign contributions from employees and political action committees (PAC) of Fannie Mae and Freddie Mac, only the Senate Banking Committee Chairman Christopher J. Dodd (D- Connecticut) received a fatter brown envelope. His bulged with US$165,000. Sen. Hillary Clinton (D-New York), not averse to having her own palm greased, scooped upwards of US$75,000 from Fannie Mae and Freddie Mac.

There has been a lot of talk about who is to blame for this crisis. Looking back at three years, where Senate Democrats were drowning in payoffs from Fannie Mae and Freddie Mac, it’s pretty clear who’s to blame.

Oh and another thing. Franklin D. Raines, the former Fannie Mae CEO who was removed from his position in 2004 after Security and Exchange Commission (”SEC”) regulators found a multitude of accounting problems at the mortgage company, has a new job.

He’s advising Barack Hussein Obama.