It's a pleasure to be here this evening, and an honor to have an opportunity to debate an issue of great importance with Judge Posner. The question central to this debate--whether the current crisis is a failure of capitalism or a failure of government policy--is important simply because, as in medicine, the diagnosis determines the prescription. If the diagnosis is that we have a failure of capitalism on our hands, the prescription is to add significantly to the government's ability to control our financial system through regulation. If, on the other hand, the problem is more mundane--as I think it is--then the prescription is not sweeping new regulation of financial institutions that have not previously been subject to government regulation.
In my view, the current crisis is not--as many have said--a crisis of capitalism. It is in fact the opposite: a demonstration that well-intentioned government intervention in the private economy can have devastating consequences.
An essential element of the "crisis of capitalism" argument is that the capitalist system is inherently unstable, and needs extensive government controls in order to keep it operating without debilitating collapses. Judge Posner's argument is of a piece with this outlook. He sees the current crisis as an example of what happens when capitalism is not adequately controlled.
The key question is this: we have had an enormous housing bubble--now deflating. But we have had housing and other asset bubbles in the past. Why did this particular bubble cause a world-wide financial crisis?
Judge Posner's argument does not provide an answer. He points to low interest rates induced by the Fed, to people disregarding warnings, to herd behavior, to young and inexperienced traders, to the pressure to produce profits when others are also riding a bubble, and of course to Wall Street's system of compensation. These are familiar elements of all asset bubbles. They don't explain why this bubble was different--why it is the first bubble in 70 years to result in a world-wide collapse.
As you have just heard, Judge Posner also argues that it was deregulation of both banks and those that competed with them that was responsible for the collapse. Without adequate regulation, the banks--under competitive pressures from the "near banks"--took too many risks and were driven to insolvency. This would be a plausible argument for differentiating this bubble from those in the past.
The flaw in this argument, however, is that he does not and cannot point to any particular deregulation that might have been responsible. Yes, I heard him argue that allowing money market mutual funds to sprout up--thus offering competition for bank deposit accounts--was the deregulation that caused this mess. The idea, apparently, is that when banks had to pay market rates for their raw materials--money--they were then required to take more risks in order to be able to pay for this new cost.
Frankly, I'm puzzled by this argument. It's a throwback to the ideology of the '30s--the Depression era--when the theory was that competition was "ruinous." We know now that competition creates efficiency and low prices. It is only "ruinous" to inefficient operators and bad business models.
As we all know, Judge Posner has been one of the strongest advocates of this approach in his analysis of antitrust law. I regret to see him turning away--with his analysis of the financial crisis--from a lifetime of achievement in bringing economic analysis into legal decisions.
There is one further fact that also raises serious questions about Judge Posner's argument: the current crisis is by far the worst since the Depression era. But then there was none of the competition that Judge Posner claims has caused the banks to take excessive risks. The banks at that time had almost the entire financial system to themselves, yet a worldwide banking and financial crisis still occurred. In fact, recent academic studies show that there have been 15 banking crises in the US since 1800, but only 2--the Crisis of the '30s era and this one--have caused a world-wide financial collapse.
Well, if deregulation and excessive competition between banks and others did not cause the current crisis, what did?
The commonly accepted cause of the Great Depression is government policy--particularly the actions of the Federal Reserve in tightening rather than loosening the money supply and credit. It is my view that US government policy is again responsible for a world-wide financial collapse.
Let's begin with some numbers that are not well known--even now. There are 25 million subprime and other non-prime mortgages outstanding, with an unpaid principal balance of over $4.5 trillion. When I speak of subprime mortgages I'm referring to mortgages made to people with blemished credit and low scores on the measures that are used to estimate credit quality. When I speak of other nonprime mortgages--also known as Alt-A--I am talking about mortgages that have adjustable rates, no or low downpayments, negative amortization, or were made to people who did not have to state their income or their income was not verified. Many of these people were not intending to live in the home they were buying, but were investing or speculating in housing.
25 million subprime and Alt-A loans amount to almost 45 percent of all single family mortgages in the United States. These subprime and Alt-A mortgages are defaulting at unprecedented rates. As these mortgages decline in value so does the capital and the financial condition of every bank and financial institution that is holding them. This includes not only US banks and financial institutions but banks and other financial institutions around the world. More than any other cause, the sharp decline in the value of these mortgages accounts for the world-wide financial collapse we are now experiencing.
Financial institutions around the world invested in these mortgages--usually in the form of mortgage-backed securities--because they believed that Americans always pay their mortgages. This was certainly true when almost all mortgages were prime--made to people with jobs and downpayments and at fixed interest rates for 30 years. Even in the worst downturns, foreclosure rates rarely reached 4%. Some projections of foreclosure rates in the current downturn are 30%.
The boom in subprime mortgages is something entirely new. They always existed, but were a small part of the total mortgage pool. There was good reason for this--they are very risky.
How did it happen that almost half the mortgages in the US turned out to be very risky and are defaulting at unprecedented rates? My explanation is US government policy. Since the beginning of the 20th century, the US has had a policy of fostering home ownership. One of the ways Congress chose to carry out this policy was through providing tax advantages to homeowners. Another way was through forcing companies over which it had control to make loans they would not otherwise have made.
Here we come upon Fannie Mae and Freddie Mac and the Community Reinvestment Act. I'll start with the CRA. This law was first adopted in 1977 and applied to all insured banks. Originally, the CRA just required banks to show that they were making efforts to lend to all groups in their communities. In 1993, however, the Clinton administration revised the CRA regulations to make them more like a quota system than a process system. The new regulations said that banks had to have made the loans, not just tried to find suitable borrowers.
Many of the communities served by banks contained borrowers who had blemished credit or no money for downpayments, or did not have steady jobs or incomes. That did not excuse banks from making mortgage loans to these groups. They were directed to use "flexible underwriting standards."
The bank regulators were supposed to enforce these rules. In effect they were co-opted. Loans they formerly would have criticized, they now had to consider good loans. Here's a comment by the chairman of a local bank in Colorado about CRA:
Under the umbrella of the Community Reinvestment Act (CRA), a tremendous amount of pressure was put on banks by the regulatory authorities to make loans, especially mortgage loans, to low income borrowers and neighborhoods. The regulators were very heavy handed regarding this issue. I will not dwell on it here but they required [our bank] to change its mortgage lending practices to meet certain CRA goals, even though we argued the changes were risky and imprudent.
But CRA did not produce a large number of subprime loans--certainly not enough to cause the current crisis. What it did was start the process of degrading the quality of mortgage loans. The flexible underwriting standards that the government wanted the banks to use really meant lowering down payments, not insisting on income, a steady job, or unblemished credit. The low quality mortgages that were required by CRA--and approved by bank regulators--gradually spread to the rest of mortgage market.
The vehicles for spreading these nonstandard and flexible terms were Fannie Mae and Freddie Mac. They were and still are the 800 pound gorillas of the housing finance market. In fact, writing or speaking about housing policy in the US without noting the central role of Fannie Mae and Freddie Mac is like describing Hamlet without the Prince of Denmark.
So let me explain what they are. Fannie and Freddie are--or were until they were taken over last September because they were insolvent--shareholder owned companies that were chartered by Congress to perform a government mission. The reason Fannie and Freddie were so important is that they had access to enormous amounts of money. This is because they were seen in the markets as backed by the government. There were many reasons for this, but the fact that they were chartered by Congress to perform a government mission was probably the most important. Their government backing enabled them to raise funds cheaply--paying only a little more than Treasury itself--and in virtually unlimited amounts. In addition, their capital requirements were set by statute at a very low level, so they were able to attain leverage of 75-100: 1. These advantages enabled them to dominate the mortgage finance market, and by 2003 they were buying about 57 % of all mortgages made in the US.
Initially, their mission was to maintain a liquid secondary market in mortgages. This meant that they would buy mortgages from banks and other lenders so that these lenders could make new mortgage loans. But in 1992, Congress amended their charters to give them a second mission--promoting affordable housing. Congress also gave the Department of Housing and Urban development the responsibility for seeing that Fannie and Freddie performed their missions, and for this purpose HUD developed what were called affordable housing regulations.
These were gradually tightened over the years. Initially, in the early 1990s, 30 percent of their mortgage purchases had to be low and moderate income borrowers (LMI). By 2005, 55% had to be LMI, and 25% had to be to low or very low income borrowers. The real work in reducing the quality of mortgage loans was therefore done by Fannie and Freddie, operating under the lash of the HUD's affordable housing regulations.
By the time they were taken over by the government in September 2008, they held $5.3 trillion in mortgages that they either held in portfolio or had guaranteed. Thus, when Fannie and Freddie started to reduce the quality of the loans they would buy from banks and others, it had a real impact on what kinds of loans the market produced.
Their initial steps were modest, and the subprime and Alt-A loans they bought were generally of high quality within that group. But by 1998 Fannie was offering a mortgage with a 3% down payment and by 2001 a mortgage with no down payment at all. By 2003, Fannie and Freddie had bought about $600 billion worth of subprime and Alt-A loans.
But in 2004, they started on what can only be called a binge. Between 2004 and 2007, they bought about $1 trillion in subprime and Alt-A loans, and they now hold or have guaranteed as mortgage-backed securities a total of $1.6 trillion in mortgages--about 10 million loans. This amounted to about 40 percent of the portfolio of mortgages they held or had guaranteed at the time they were taken over by the government.
As a result of CRA, but mostly Fannie and Freddie, home ownership rates rose. From the 1960s until about 1995, the homeownership rate in the US had remained at about 64%. But after 1995 it began to rise. By 2000 it had risen to about 67.3%, and by 2004 it reached 69.2%.
So the policy of increasing home ownership did work, but the unintended consequences were disastrous. Fannie and Freddie's own losses will probably cost the taxpayers about $400 billion dollars, perhaps more. But the other costs are worse, and include the world-wide financial crisis we are now experiencing. The cost to US taxpayers is or should be a huge scandal. But the losses that came from the sale throughout the world of mortgage backed securities not guaranteed by the US government through Fannie and Freddie have been the principal cause of the weakened financial system world-wide. This is probably more than $2.5 trillion in poor quality loans.
How did this happen? Again, Fannie and Freddie are at the heart of the problem. Fannie and Freddie's funding advantages allowed them to drive all private sector competition to the edges of the market. This meant that banks and investment banks were relegated to two kinds of mortgages--jumbos, that were too large for Fannie and Freddie to buy, and junk, which until the early 2000s Fannie and Freddie wouldn't buy. For this reason, the subprime and Alt-A market was relatively small and handled mostly by the commercial and investment banks through structured mortgage backed securities. This involved the issuance of securities backed by pools of mortgages, but issued with different levels of potential loss absorption, or tranches.
However, in 2003, Fannie and Freddie started buying--in large amounts--the AAA tranches of the MBS that Wall Street was creating. These purchases doubled in 2003 to $82 billion and doubled again in 2004 to $180 billion. In 2004, for reasons that are a matter of conjecture, they decided to buy large amounts of subprime and Alt-A loans directly. Their chairmen--Franklin Raines for Fannie and Dick Syron for Freddie--went to meetings of mortgage brokers and mortgage bankers and said, essentially, send us the mortgages of people with blemished credit--we want these people to have a shot at home ownership.
When someone with virtually unlimited funds asks for something like this, the result is obvious--there was a huge frenzy to produce subprime and Alt-A loans. In 2005, they started to buy vast quantities of subprime and Alt-A loans directly from the brokers and mortgage bankers. Countrywide Financial and the famous Angelo Mazilo was an important supplier.
Still, they continued to buy from Wall Street--a total of $609 billion between 2002 and 2007. The Wall St firms would never have been able to develop such large distribution networks if they hadn't had ready buyers in Fannie and Freddie.
The housing bubble continued to inflate, but now it was filling up with subprime and Alt-A mortgages. In 2006, almost half of all mortgages made in the US were these junk loans. They were either on Fannie and Freddie's balance sheets or on the balance sheets of banks and other financial institutions around the world. And today they are defaulting at unprecedented rates. Estimates run to 8.8 million foreclosures, with the vast majority subprime and Alt-A loans. In the end, including the AAA tranches that they bought from Wall Street, Fannie and Freddie bought or guaranteed 54% of all subprime mortgages that were made in the US between 2005 and 2007--and 60 % of all the Alt-A loans.
Why did they do this and what was its affect?
It was obviously a disastrous policy, and eventually destroyed two companies that had solid gold franchises. The conventional wisdom--what we read in the media all the time--is that they were trying to compete for market share with Wall Street. But the numbers say the conventional wisdom has it backwards.
As I noted a moment ago, Fannie and Freddie actually bought most of the subprime and Alt-A mortgages sold in the US between 2005 and 2007. In other words, they always had the dominant market share, even when they were dealing with junk loans. They bought many of these mortgages through buying the AAA tranches Wall St was creating.
So the correct way to look at this is that Fannie and Freddie were the enablers. They first stimulated the development of a subprime and Alt-A market on Wall Street by buying huge amounts of AAA tranches. Then, in late 2004, they began to buy these junk loans in large amounts themselves, competing for product with Wall Street. Thus, Wall Street was fighting to maintain its market share against encroachments by Fannie and Freddie, not the other way around.
In fact, Wall Street didn't have a chance. Because of their government backing, Fannie and Freddie were unstoppable; they could take whatever share they wanted of any market they chose to enter. In any event, the fight between Wall St and Fannie and Freddie drove down the price of junk mortgages, drove up the housing bubble, and filled it with of unprecedentedly low quality mortgages. It also produced something like $2.5 trillion dollars in these low quality mortgages that Fannie and Freddie didn't buy, but which were spread around the world in the form of mortgage-backed securities. It is these instruments that are the underlying cause of the financial crisis.
If they weren't just going after market share, then, why did they binge?
The best answer is that they were trying to retain support in Congress that would prevent new and tougher regulation. In 2003 and 2004 both companies had accounting scandals; they were found to have been manipulating their financial reports--to smooth earnings and to make the numbers management needed for bonuses. At the time, there was a Republican Congress and a hostile Republican administration. Strong legislation had been proposed, and had passed the Senate Banking Committee in 2005. Alan Greenspan was warning that they could cause a financial meltdown if they were not curbed. Fed economists had recently done a study that showed they didn't even reduce interest rates. Without that, there was very little reason for their existence.
In these circumstances, they hoped to curry favor with their supporters in Congress by showing that they could boost homeownership rates, especially in low income communities. The strategy worked; there was no new regulation of Fannie and Freddie until September 2008. But by then it was too late.
Accordingly, this is a story about how a well-intended government policy caused a substantial decline in the quality of US mortgages and ultimately the financial crisis we are living with today.
Peter J. Wallison is the Arthur F. Burns Fellow in Financial Policy Studies at AEI.