Causes Of Current Financial Crisis: No Denying This Reality

It’s not denial. I’m just selective about the reality I accept.
–Bill Watterson, author

I have a very highly developed sense of denial.
–Gwyneth Paltrow, actress

Denial ain’t just a river in Egypt.
–Mark Twain, author

There’s no doubt that hubris, greed, and recklessness helped bring about the worst financial crisis this century. But other factors have also played a major role, including ignorance and denial. In fact, it is hard to think of a circumstance where a failure to acknowledge reality was more evident than in regard to the systemic threat posed by the government-sponsored enterprises, especially Fannie Mae (FNM) and Freddie Mac (FRE). While many of those who deluded themselves and others might now claim differently, there is, of course, a public record of their otherworldly views on the matter. I note, for instance, an October 2008 Wall Street Journal commentary, “What They Said About Fan and Fred” [bold highlighting mine]:

House Financial Services Committee hearing, Sept. 10, 2003:

Rep. Barney Frank (D., Mass.): I worry, frankly, that there’s a tension here. The more people, in my judgment, exaggerate a threat of safety and soundness, the more people conjure up the possibility of serious financial losses to the Treasury, which I do not see. I think we see entities that are fundamentally sound financially and withstand some of the disaster scenarios. . . .

Rep. Maxine Waters (D., Calif.), speaking to Housing and Urban Development Secretary Mel Martinez:

Secretary Martinez, if it ain’t broke, why do you want to fix it? Have the GSEs [government-sponsored enterprises] ever missed their housing goals?

* * *

House Financial Services Committee hearing, Sept. 25, 2003:

Rep. Frank: I do think I do not want the same kind of focus on safety and soundness that we have in OCC [Office of the Comptroller of the Currency] and OTS [Office of Thrift Supervision]. I want to roll the dice a little bit more in this situation towards subsidized housing. . . .

* * *

House Financial Services Committee hearing, Sept. 25, 2003:

Rep. Gregory Meeks, (D., N.Y.): . . . I am just pissed off at Ofheo [Office of Federal Housing Enterprise Oversight] because if it wasn’t for you I don’t think that we would be here in the first place.

And Freddie Mac, who on its own, you know, came out front and indicated it is wrong, and now the problem that we have and that we are faced with is maybe some individuals who wanted to do away with GSEs in the first place, you have given them an excuse to try to have this forum so that we can talk about it and maybe change the direction and the mission of what the GSEs had, which they have done a tremendous job. . .

Ofheo Director Armando Falcon Jr.: 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’s engagement in improper conduct, it is about Freddie Mac. Let me just correct the record on that. . . . I have been asking for these additional authorities for four years now. I have been asking for additional resources, the independent appropriations assessment powers.

This is not a matter of the agency engaging in any misconduct. . . .

Rep. Waters: However, I have sat through nearly a dozen hearings where, frankly, we were trying to fix something that wasn’t broke. Housing is the economic engine of our economy, and in no community does this engine need to work more than in mine. With last week’s hurricane and the drain on the economy from the war in Iraq, we should do no harm to these GSEs. We should be enhancing regulation, not making fundamental change.

Mr. Chairman, we do not have a crisis at Freddie Mac, and in particular at Fannie Mae, under the outstanding leadership of Mr. Frank Raines. Everything in the 1992 act has worked just fine. In fact, the GSEs have exceeded their housing goals. . . .

Rep. Frank: Let me ask [George] Gould and [Franklin] Raines on behalf of Freddie Mac and Fannie Mae, do you feel that over the past years you have been substantially under-regulated?

Mr. Raines?

Mr. Raines: No, sir.

Mr. Frank: Mr. Gould?

Mr. Gould: No, sir. . . .

Mr. Frank: OK. Then I am not entirely sure why we are here. . . .

Rep. Frank: I believe there has been more alarm raised about potential unsafety and unsoundness than, in fact, exists.

* * *

Senate Banking Committee, Oct. 16, 2003:

Sen. Charles Schumer (D., N.Y.): And my worry is that we’re using the recent safety and soundness concerns, particularly with Freddie, and with a poor regulator, as a straw man to curtail Fannie and Freddie’s mission. And I don’t think there is any doubt that there are some in the administration who don’t believe in Fannie and Freddie altogether, say let the private sector do it. That would be sort of an ideological position.

Mr. Raines: But more importantly, banks are in a far more risky business than we are.

* * *

Senate Banking Committee, Feb. 24-25, 2004:

Sen. Thomas Carper (D., Del.): What is the wrong that we’re trying to right here? What is the potential harm that we’re trying to avert?

Federal Reserve Chairman Alan Greenspan: Well, I think that that is a very good question, senator.

What we’re trying to avert is we have in our financial system right now two very large and growing financial institutions which are very effective and are essentially capable of gaining market shares in a very major market to a large extent as a consequence of what is perceived to be a subsidy that prevents the markets from adjusting appropriately, prevents competition and the normal adjustment processes that we see on a day-by-day basis from functioning in a way that creates stability. . . . And so what we have is a structure here in which a very rapidly growing organization, holding assets and financing them by subsidized debt, is growing in a manner which really does not in and of itself contribute to either home ownership or necessarily liquidity or other aspects of the financial markets. . . .

Sen. Richard Shelby (R., Ala.): [T]he federal government has [an] ambiguous relationship with the GSEs. And how do we actually get rid of that ambiguity is a complicated, tricky thing. I don’t know how we do it.

I mean, you’ve alluded to it a little bit, but how do we define the relationship? It’s important, is it not?

Mr. Greenspan: Yes. Of all the issues that have been discussed today, I think that is the most difficult one. Because you cannot have, in a rational government or a rational society, two fundamentally different views as to what will happen under a certain event. Because it invites crisis, and it invites instability. . .

Sen. Christopher Dodd (D., Conn.): I, just briefly will say, Mr. Chairman, obviously, like most of us here, this is one of the great success stories of all time. And we don’t want to lose sight of that and [what] has been pointed out by all of our witnesses here, obviously, the 70% of Americans who own their own homes today, in no small measure, due because of the work that’s been done here. And that shouldn’t be lost in this debate and discussion. . . .

* * *

Senate Banking Committee, April 6, 2005:

Sen. Schumer: I’ll lay my marker down right now, Mr. Chairman. I think Fannie and Freddie need some changes, but I don’t think they need dramatic restructuring in terms of their mission, in terms of their role in the secondary mortgage market, et cetera. Change some of the accounting and regulatory issues, yes, but don’t undo Fannie and Freddie.

* * *

Senate Banking Committee, June 15, 2006:

Sen. Robert Bennett (R., Utah): I think we do need a strong regulator. I think we do need a piece of legislation. But I think we do need also to be careful that we don’t overreact.

I know the press, particularly, keeps saying this is another Enron, which it clearly is not. Fannie Mae has taken its lumps. Fannie Mae is paying a very large fine. Fannie Mae is under a very, very strong microscope, which it needs to be. . . . So let’s not do nothing, and at the same time, let’s not overreact. . .

Sen. Charles Schumer (D., N.Y.): I think a lot of people are being opportunistic, . . . throwing out the baby with the bathwater, saying, “Let’s dramatically restructure Fannie and Freddie,” when that is not what’s called for as a result of what’s happened here. . . .

Sen. Chuck Hagel (R., Neb.): Mr. Chairman, what we’re dealing with is an astounding failure of management and board responsibility, driven clearly by self interest and greed. And when we reference this issue in the context of — the best we can say is, “It’s no Enron.” Now, that’s a hell of a high standard.

Even now, despite a relentless torrent of red ink and a taxpayer tab in the tens of billions of dollars, those in charge still seem to be doing their best to think only happy thoughts or to avoid thinking at all. Unfortunately, the economic fundamentals suggest the GSE mess will only grow bigger, as, among others, Mike Morgan, publisher of the Behind Enemy Lines blog, makes clear in “Fannie Mae and Freddie Mac - The Ugly Sequel”:

Fannie Mae recently told us they need another $10.7 billion of taxpayer money, after already receiving about $34 billion . . . that fools like Carney Frank and Dudley Dodd told us would never be needed.

Freddie Mac headlines recently shouted out how great things are because they didn’t lose money . . . if you excluded dividends they were required to pay. So in reality, they lost money. It’s funny, how we crave reality when it comes to TV shows, but we don’t want any part of it when it comes to our financial systems or our futures.

$2 Trillion Problem - Fannie and Freddie guarantee or own more than $2 trillion in mortgages, and that number is growing, as these two “stars” are the last resort in a housing market that is stumbling along like a drunken sailor on a short pier.

With the very best estimates putting more than 20% of all mortgages underwater, you can do some simply math and double that number to 40% or more for Fannie and Freddie.

Ground Zero - I’m at ground zero in my real estate brokerage, and we work with banks and foreclosures every day. On average we are seeing banks recover about 35% of the mortgage value after foreclosing on properties and paying off the attorneys, asset managers, real estate agents, contractors and consultants. And believe me . . . I’m being generous with the 35%.

This means on $2 trillion in mortgages, there will be losses exceeding $1.3 trillion, which is more than enough to pay for Obama’s health care plan, a fleet of jets for Congress, and a few hundred billion for Goldman Sachs’ fees and Bankster Bonuses.

Head You Lose - Tails Goldman Sachs Wins - You don’t think that $1.3 trillion will come from the tooth fairy, do you? Nope. If you’re tuned into this Reality TV show, that $1.3 trillion will come from you, your kids and your grandchildren . . . and their kids and grandchildren.

Geithner Sends Smoke Signals - If you think I’m making this stuff up, you need to put down the beer and chips, and pick up the newspaper. In fact, Tim the Tax Cheat just told us Fannie and Freddie are doomed to be broken up, when he appeared at the House Financial Services Committee hearing. But he made it sound like something good was going to come from this break up. Not so with James Lockhart . . .

James Lockhart, departing director of the Federal Housing Finance Agency, kinda, sorta, winkie winkie told us our $85 billion was gone and it was going to cost a heapin’ pile more to unwind these two kids. Actually, he only told us we were going to lose some of the $85 billion, but this guy has been lying through his teeth, toes and nose since he landed in Washington.

Good Bank - Bad Bank . . . The Sequel - It’s back again, like Ground Hog day. You see, rehashing Good Bank - Bad Bank is nothing more than a pirated copy of Ground Hog day played on a black and white TV with the static. Each time we hear it, it gets worse. But here we are proposing to take the good assets from Fannie and Freddie and leaving the bad assets for “another” entity. First of all, that entity is you the taxpayer. Second, you can rest assured the good assets will go to friends and family of Goldman Sachs. Didn’t you hear? That’s been deemed an inalienable right during this financial crisis.

Sparks but No Kaboom - That’s the big issue. Everyone keeps asking me, what will trigger the next leg down in the financial markets. What will trigger a meltdown? My response is anything from a natural disaster to a war or maybe the reality we are facing with a mortgage market that is one Reality TV scene away from total blackout.

By the way, the $1.3 trillion potential hit in the Fannie and Freddie debacle is probably only a quarter of the total residential and commercial loss that seems to be growing by the day.

No doubt Washington’s funny-money accounting makes it hard for even the non-denialists to stay focused on just how large this festering wound has become and the damage it is doing to our nation’s finances, especially given all the other stuff that is going on. In that regard, the call for greater transparency in the following Wall Street Journal commentary, “Fannie Mae Enron, the Sequel,” makes sense, if only because, as a cynic might say, it would allow us to better see how a once great empire self-destructs — in real time.

The mortgage giants, now taxpayer wards, belong on the federal balance sheet.

When Larry Summers and his White House economic team next take up the future of Fannie Mae and Freddie Mac, one idea up for debate will be shifting the mortgage giants’ bad assets into a government-owned “bad bank.” Fannie and Freddie would be left with clean balance sheets and a new lease on life.

But shifting around bad assets is the least of the Obama Administration’s problems with these two failed “government-sponsored enterprises.” The bigger issue is that all of Fan and Fred’s liabilities, whether kept inside the companies or hidden in a dark corner of the Treasury, are now Uncle Sam’s responsibility. Moving their bad assets into a new Baddie Mae would only preserve the fiction that there is a difference between the government’s obligations and those of Fan and Fred. Not even Barney Frank could believe that any more.

The best long-run solution would be to put the two into run-off mode, paying their debts as they come due and collecting whatever they can from the portfolios they currently hold. Relieving them of their mistakes so they can gamble again on the taxpayer dime would merely re-create the moral hazard that landed them in federal conservatorship. We know how that movie ends.

Mr. Summers has long said that mixing private profit with public risk is bad policy, and we trust he doesn’t want to repeat the mistake. A starting point for permanent reform would be to treat Fan and Fred, in the budget and on the federal balance sheet, as the government-owned creatures that they are. For the moment, despite 80% government ownership, their $85 billion bailout cost (with more losses to come) and their $5.4 trillion in taxpayer liabilities remain off-balance-sheet in the mold of Enron’s special purpose vehicles or Citigroup’s SIVs.

The politicians who created and pampered Fan and Fred like it that way. They know that offering federal “guarantees” looks much cheaper, in the official accounting, than actual outlays. But whether it’s Fan and Fred, or the Pension Benefit Guaranty Corporation or the Federal Housing Administration, these deferred promises seem to come due sooner or later. Perhaps the politicians would be less profligate in issuing such guarantees if they had to admit the cost up front.

Putting Fannie and Freddie on the national books would in an instant increase the national debt held by the public by 75%-to $12.7 trillion, from $7.3 trillion today. The nearby chart shows that this takes debt as a share of GDP to nearly 90%, or nearly double the peak it reached in the 1980s when the political class was hyperventilating even as the Reagan deficits were falling as a share of GDP. Congress would have to add that $5.4 trillion to the increase in the federal debt limit that Treasury Secretary Timothy Geithner is now requesting. But that would be truth-in-budgeting. Wall Street has sold Fannie paper to the world as if it were as taxpayer guaranteed as Treasury bills, and now we know it is.

Even as the companies careened toward failure a year ago, the Bush Administration was desperate to show it would cover all Fan and Fred debt. The Obama Treasury has been no different and has ginned up the two companies to expand their debts amid the housing meltdown by guaranteeing more residential mortgages. The Federal Reserve has bought $543 billion of Fannie and Freddie mortgage-backed securities and has plans to buy up to $1.25 trillion worth by year end. Foreign debt holders get the message. The only people who still might be fooled are the American taxpayers, who are ultimately responsible when the bills come due.

The larger issue is the integrity of the national balance sheet. As government spending soars, the political temptation to use off-balance-sheet vehicles of various sorts will only increase. Barney Frank is even pushing a bill to make the feds guarantee U.S. municipal debt. The danger is that the federal government will itself become the next Enron, with its biggest liabilities hidden from view, officially denied or tucked away in special purpose vehicles like Fannie Mae. Until the next crisis hits.

It’s bad enough that the political class has played this dishonest game with the long-term liabilities of Social Security and Medicare, which are also kept off the balance sheet. But at least those IOUs are held by another branch of the government and can be legislated away by some future Congress. Debt held by the public can’t be repudiated without the U.S. descending into Argentina-ville. It’s time to come clean about the debts our government is racking up, and Fannie and Freddie are a good place to start.

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