The Unbearable Stupidity of Populist Protectionism.

First the House version of the stimulus bill included a "buy American" provision. Then the Senate voted to limit bailout-supported firms' ability to hire H1B workers. At this rate, I may soon be deported from the country to make room for a US citizen to take my job.

For those of you that don't know, H1B is a work visa program for skilled foreign workers. It is the visa I - and any of your foreign friends in the US (unless they are students, illegal or have a Greencard) - live and work on in the US.

Apart from the obvious personal discomfort that seeing something like that creates – not that I am working at a bailed-out bank, but it is a troubling trend for anyone on an H1B visa - there are two big mistakes in a step limiting H1B visas or immigration to protect the US economy.

The first problem is well outlined and discussed in today’s column by Friedman. Given that intellectual capital is the greatest competitive advantage of the US, putting protective measures on it’s inflow is counter-productive. There is something terribly non-sensical about collecting some of the brightest minds from around the globe, bringing them to US universities, and then not allowing them to participate in the US labor market. On previous occasions I took that a step further and argued that immigration is necessary not just to sustain America’s competitive advantage but also to bring it back to fiscal soundness, given the rapidly deteriorating demographic profile of the country.

The second problem I have with the logic of labor protectionism is that I think it’s a symptom of a broader flaw in thinking about recession and unemployment and specifically about the obsession about unemployment common in the public debate about the economy. Surely, increasing unemployment is not a good thing. And understandably, it is the most poignant way to describe a recession. It is personal, it is sad, it has troubling consequences. I think it is for those reasons that when it comes to debates like the one right now about the stimulus package the language used is more often about jobs than it is about output or production. However, as the economy is concerned, unemployment is a symptom or a proxy of a recession, not the equivalent of a recession. Higher unemployment is a result of a contraction in economic activity. And yes, it feeds on itself, but it is primarily caused by shrinking demand.

Bringing this back to my point about foreign workers: I think this obsession about jobs (as opposed to output) leads to the understandable yet mistaken belief that employing more Americans is good given the swelling ranks of the unemployed. Or, to use the words of Charles Grassley, the Senate Finance Committee ranking member:

"With the unemployment rate at 7.6 percent, there is no need for companies to hire foreign guest workers through the H1-B program when there are plenty of qualified Americans looking for jobs."

And yet, hiring Americans in place of foreigners still does not create a job. As economic activity goes, the nationality or immigration status of the worker makes no difference. If I were to be fired today and some US citizen were to replace me, it would do nothing to unemployment or the economy. Even though an unemployed American was hired, no job was created, nothing was added to the economy. And as secondary economic effects go, my income is as likely to be spent – and generate economic activity – as anyone else’s. So nothing has changed there either.

That's why the whole idea of labor protectionism doesn’t make sense to me: it doesn’t matter who gets the job. What matters is that a job is created – which can only happen when the economy expands. Of course, the only reason why the idea makes sense is political: Americans vote for American senators, so if it otherwise doesn’t make a difference who gets a job, they would prefer to favor their constituents. This, however, should not be confused with being beneficial for the economy.

Or, viewed as irrelevant to its long term prospects.

The New Bubble: US Government Debt.

This just came accross my email: TREASURY THREE-MONTH BILLS TRADE AT NEGATIVE RATE OF 0.01%.  Things are so bad that people are willing to pay the government to lend it money.  Imagine if a bank paid you for your credit card balance.  This even though there is no entity in the world with so many unfunded liabilities and future debt.  Crazy crazy world.

Homeland, Part 3, Where I Get All Wonkish.

As a follow up to the previous posts (1, 2) about Homeland Security, it may be helpful to explain why I care so much about immigration reform in the US, or more precisely, why Americans should care more about immigration reform in the US.

To put it bluntly:  because this country needs more young people to survive.  Yes, seriously.  Bear with me.

Medicare, the health care program for people over 65, is a good case in point.  The vast majority of the funding for the benefit that covers hospitalization (known as Part A), comes from payroll taxes.  You may know know this, but every month a small percentage of your paycheck goes to the Medicare trust fund.  As a rational prudent person you may live happily thinking that all the money you're putting aside for Medicare is sitting somewhere - in that Trust - waiting for you to turn 65.  Except that is not the case at all.  The money you're paying now is being used to pay for Medicare expenses of your grandparents (which makes sense if you think about the fact that when the program was established they didn't want to wait around for a generation of people to earn their Medicare bucks before turning 65, but I digress).  That wouldn't necessarily be a problem, if it wasn't for the baby boomers - the massive generation born after WW2, which is about to go all senile on us any minute now and in the process planning to deplete the Medicare Trust fund by 2019.  In short:  forget about ever seeing any of that money back and be prepared to pay for hospital bills on your own!  Or, in the slightly more sophisticated language of the KFF:

Over the longer term, an aging population, a decline in the number of workers per beneficiary, and increasing life expectancy will present fiscal challenges for Medicare. From 2010 to 2030, the number of people on Medicare is projected to rise from 46 million to 78 million, while the number of workers to support beneficiaries is projected to decline from 3.7 workers per beneficiary to 2.4 workers per beneficiary.

And Medicare is just one example.  Social security is another headache or, in government budget speak, unfunded liability.  Combined and rounded up, all these babies add up to about $57 trillion, a figure so large that the only thing you can do about it is pray that you never have to worry about it, or that you die before you do.  

Or, as I suggest, start taking steps to systematically replenish what one might euphemistically call the deteriorating demographic profile of the country, ie, import young smart labor (alternatively we could start adopting massive quantities of babies from around the world, but seriously, how many Brangelinas are there out there?).  

I hope that helps put a slightly less self-serving spin on my interest in immigration reform.  This country needs it, desparately.

Do-Over.

Because one mortgage-related bubble per decade is clearly not enough, why not create another one?

That seems to be the thinking behind the recent proposal to guarantee low 4.5% rates on all new mortgages.

The strange logic of encouraging the creation of another asset bubble aside, where does the government get the dough?  The taxpayer (or actually China).  And here's the real kicker: as WaPo explains, the government could actually make a buck or two:

"One possibility is for the Treasury to raise money by issuing bonds to the public at 3 percent interest. This could allow the government to turn a profit because it would be buying securities that pay 4.5 percent."

OMG, brilliant.  Finance for dummies:  borrow at 3%, lend at 4.5%, earn 1.5%.  Love it!

Except, wait a minute!  Why not borrow at 3%, lend at 28%, earn 25% - and buy everyone a home, no mortgage mess necessary?  Because anyone with half a brain knows that leanding at 28% (to Argentina, in case you were wondering where you can earn that kind of rate)  has enormous risks associated with it, so the math doesn't exactly work that way.  

I'm not saying I know what to do with this mess, but this sort of misleading pseudo finance isn't doing anyone any good.  That WaPo doesn't quite get it is not terribly shocking; I just hope that the folks at the Treasury do.

Blue-State Fox.

"I think—you know, I pay very close attention to what the independent media are saying and what bloggers and others are saying, and I think what—a sort of disturbing trend is that we have sort of blue-state Fox emerging, where people are, you know, sort of treating Obama in a different way than they would treat Bush or anyone else in power. And I think—remember, when Bush first took power, there was a tremendous outcry over all of these old Reagan hands that were being brought back in and the neoconservatives and others.   I mean, I think the time is now to call the question on the involvement of some of these people, that this is the precise moment when this kind of journalism matters, when we have to remind people of the history and the previous policies implemented by the people that are at the center of Obama’s foreign policy team right now, because we’re going to be living with these people for the next four years running the show. And I think it’s incredibly important to be all over this right now, before they’re named."

Abso-freaking-lutely.  Jeremy Scahill on Democracy Now!, his piece on the topic here.  Incidentially, their review of potential Treasury Secretary suspects, here, is pretty critical of Geithner, who seems to be getting the job:  

Geithner, I think, yeah, maybe he would be marginally better, but if you look at the deal he initially did with Bear Stearns and JPMorgan, there are a lot of critics of that who say he was had. He was negotiating with Jamie Dimon, who sits on the board of the New York Federal Reserve Bank along with Geithner. And he’s—Geithner is considered to have been hoodwinked in that deal, because the New York Federal Reserve ended up mainly getting worthless subprime mortgage securities in return as collateral for the nearly $30 billion it put up. It’s already recorded a paper loss of $2.7 billion. And he outsourced the management of the collateral to BlackRock. Now, it’s probably just a coincidence that also as part of the—one of Geithner’s main advisers is John Thain, who was CEO of Merrill Lynch before it was swallowed up by Bank of America, and it’s probably just a coincidence that Merrill Lynch owns a 49 percent stake in BlackRock. And what this really represents is, you know, the old boy network. The Federal Reserve Banks are in many ways just Wall Street clubs. And so, I think Geithner himself would not be that good of an appointment, you know.

Well, at least he's good looking.

A Fall to Remember

Click to see legibly:

How it all happened:  Intrade prediction market for odds of Obama's presidency, overlayed with key economic and campaign events.  

Everyone can make their own conclusions, but one thing is for sure: what an eventful 2 month period!

ps.  Please comment if you can think of major events I am missing on the chart.

The Misbehaviors

Capitalism, it turns out, is dead.  According to the narrative that is rapidly growing roots in the collective consciousness, free markets are not the magic they were cranked up to be.  At least Alan Greenspan seems to have concluded that.  

On the back on that admission, David Brooks' column in NYT echoes a theme I have written about a few weeks ago here, but goes a step further and takes it to the level of policy.

My sense is that this financial crisis is going to amount to a coming-out party for behavioral economists and others who are bringing sophisticated psychology to the realm of public policy.

As I continue thinking along that path of reasoning, I have to wonder what will this shattering of the market axiom mean for all of us?  After the crash of 1929 and the Depression we saw the economic philosophies of Marxism rise to prominence in many countries around the world.  Have we come full circle?

Growing up in post-Communist Slovakia, I was a part of a young generation that was never fully indoctrinated with the theories of Marxism and Leninism.  Anxious to be as western as possible, we embraced the ideas of the free market like a religion.  Capitalism was cool, it was the only way to be.  Today, as I listen to Greenspan, and read more about behavioral economics, I am increasingly aware that what may have previously seemed like an axiom was really just a doctrine.  Maybe it is right, maybe not, but still nothing more than a doctrine. 

  

READ: Earth to Kristol: What Planet Do You Live On?

Sometimes opinion pieces are so infuriating that I hesitate if they are even worthy of a response and today's op-ed from Kristol fits right into that category.  

Here's a bon mot that made my jaw drop in disbelief this morning and wonder if we actually live in the same country or on the same planet:

"...as Sept. 11 did not result in a much-feared (by intellectuals) wave of popular Islamophobia or xenophobia, so the market crash has resulted in remarkably little popular hysteria or scapegoating."

Really?  Even though I have no statistics to definitely prove that the opposite is that case, I have heard enough anecdotal material to be astonished by Mr. Kristol's apparent lack of hesitation to make big sweeping statements like this and expect his readers to simply accept them as the truth.

As for the Islamophobia claim, apart from numerous reported cases of discrimination and hate crimes, it is clear that the country suffers from a serious and mostly unrecognized fear of Islam, most vividly displayed by the fact that the accusation the Barrack Obama is a Muslim is exactly that - an accusation.  And even those defending him are more focused on proving that he is not a Muslim than they are on the irrelevance of the claim.  It's amazing that it finally took Colin Powell to say the words that not even the most liberal supporters of Obama dare speak:  

“The really right answer is, what if he is? Is there something wrong with being Muslim in this country? No, that’s not America.”  

Tip of the hat to Andrew Sullivan for that one.  

As for the latter statement, has Mr. Kristol talked to anyone anywhere? Was he paying any attention at all when the bailout package was first turned down in the House because the members were bombarded by letters from their constituents infuriated by the idea of bailing out Wall Street, which they singularly blamed for the mess we're in?  So much for no scapegoating. 

As for no hysteria, not to belabor the point, but has he talked to anyone anywhere?  At work, I interview and survey businesses around the country constantly to understand various trends and most recently I have been on the phone with dozens of them talking about the impact of the slowing economy and the financial crisis.  While the real-time impact on current profits may not yet be catastrophic, business owners are extremely nervous; nervous, as in hoarding cash and not planning any major purchases for the foreseeable future.  My favourite example was a dentist in Iowa who decided not to purchase a piece of equipment for his practice because of the volatility on the stock market.  A dentist - one of the most economically resilient professions - in Iowa - pretty removed from Wall Street.  

So before making any more sweeping statements for international circulation, can Mr. Kristol do me a solid, get his head out of his ass and talk to, say, 5 people?  It may not be super scientific, but it's a good baby step in the right direction.

READ: Lessons - Follow Up

A few days ago I wrote about a greater need for integration of economics and psychology to understand (and prevent) situations like the current financial crisis.  On Friday, Ezra Klein had a similar post inspired by a New America Foundation event he attended.  Is behavioral finance the next big thing?

READ: R.I.P. Good Times

It's one thing to see the data in the New York Times.  It's another to get an email which originated at one of the largest venture capital funds in the world with the following message:

"We are in a serious economic downturn and this is just the beginning. Immediate, decisive and swift action is required, along with frugal, day-to-day management of expenses and our business is required."

The email I am talking about details a mandatory meeting with a hudred CEOs where the following were some of the messages delivered while the conference room screen was apparently showing the image above:

We are in drastic times. Drastic times mean drastic measures must be taken to survive. Forget about getting ahead, we’re talking survive. Get this point into your heads. 

We are in the beginning of a long cycle, what we call a “Secular Bear Market.”

This is a global issue and not a ‘normal’ time.

There is significant risk to growth and your personal wealth.

A “V” shaped recovery is unlikely [√]

Cuts in spending will accelerate in Q4/Q1. Look at eBay—this is just the beginning.

This is a different animal and will take years to recover.

In other words, CEOs are being told to assume the business equivalent of the fetal position.  

This is a beast that feeds the beast.

READ: Are We Done Yet - Update

For a moment it seemed like my prediction of further challenges ahead was, in fact, picking the bottom of this mess.  Surely everyone rejoiced on Monday when the market saw the largest point increase ever.  Alas it turns out we are indeed not done.  Surely enough, the news is now coming out about the real economy going down, the market is down some 5%, and I think it is likely to be worse in October since the downturn probably accelerated in the back end of the month which means more bad news can be expected.  

So for those that saw Monday as a huge relief, hold it.  On a related note, this chart helps put Monday's gain in perspective and demonstrates an interesting point.  Namely it shows that the largest % gains in history occured during the depression which isn't necessarily to say that we are experiencing a second great depression.  Instead it helps to point out that large gains should not be interpreted as a guarantee of things getting better.  

READ: Lessons

As I go into work every day fearful of what will happen next, I am truly envious of scholars in just about every branch of academia. Instead of worrying about the impact of this crisis on their livelihood (unless they invested their retirement savings in the stock market, oops), they benefit from the endless material that a spectacular meltdown like this provides for further study and analysis. Those in finance and economics are reconsidering how we think about risk (and some are being propelled from the outskirts of economic theory right to the forefront); political scientists are exploring the role of the government and regulation in causing, preventing and resolving situation like this; sociologists can study the impact of the decline in the housing market on communities around the country. In other words everyone worth their academic post can find something in this mess worth pondering about, at least for a few moments.

However, while we're still deep in the middle of it all, I can also see how it is incredibly demoralizing to some: Markets are supposed to be perfect.. Regulation is supposed to prevent this.. 10% drops and gains in the stock market are supposed to be extremely unlikely.. People are supposed to be rational. In other words, imagine your whole professional life is predicated on certain assumptions and overnight those assumptions turn out to be shaken, if not crumbling down. A perfect case in point is this blog entry:

We should ditch the assumption - which in a sense is mere courtesy - not only that others are rational but even the weaker assumption that they are nearly so. Perhaps we should indeed regard them merely as “empty suits.”

Apart from making that substantive point about ditching a widely-held assumption, I was quite moved by the sense of helplessness and confusion embedded in the final words of that entry:

All of which leaves me genuinely puzzled. Were banks risk managers really that bad? Are bosses an order of magnitude stupider than even I had thought? Or is something else happening? Help me.

I can relate to this sense of confusion, anger and frustration. I encounter it quite often in my job: when common sense logic and endless analytical work is telling you one thing and the market is telling you the complete opposite. When you spend days, weeks, months and sometimes years being right about something fundamentally but still lose money in the market. Problem is that quite often the market is not driven by logic or common sense, but rather by pure emotion. It can be anywhere from humbling to outright insulting to see that your analysis is correct albeit sometimes completely irrelevant.

Market fundamentalists often respond to this observation by saying that eventually, in the long run, the market gets it right - emotions give way to underlying fundamentals and the prices correct. However, that long run can be painfully long, especially for those who are evaluated on their daily, weekly, monthly, quarterly and - if they're lucky enough to be still around - annual performance. (Which is why people often find it easier - and more lucrative - to predict emotions rather than to predict fundamentals, but there I really digress.)

So how is that related to the frustration expressed in the blog post and this meltdown? Perhaps the answer to the deep questions underlying this whole crisis cannot be found in any one of the academic fields I mentioned above because all of them either simplify or altogether ignore the role of psychology and the human element in their analysis. In other words, the assumption that people are rational is not necessarily flawed; maybe people are just much more complex that we give them credit for in standard economics analysis and until we can somehow break down the artificial barrier between economics and psychology we will never quite get it.

Surely enough, this idea is not at all novel. In its origins, classical economics was indeed quite interested in understanding the link between human psychology and economic decision-making and more recently there has been a resurgence in behavioral finance and economics. However, much like the idea of a Black Swan, it sits very much on the fringes of academia. Perhaps thanks to this situation it will finally get more respect and airtime in those Econ 101 classes.

Until then, I have found myself a new interesting read which may contain some good insights applicable to this situation: Almost Certain Loss: The Psychology of Pyramid Schemes.

READ: Are We Done Yet?

When people who are normally completely uninformed about the market start talking about it and asking me about my fund's performance it is a sign of how bad things are.  Indeed, unless you've been living in an underground shelter, you know that the market has been dropping like a rock.  So what's the 411?  Well, by at least one measure I have no reason to complain - I still have a job.  Other than that, every day feels like a new chapter in some unlikely science fiction novel.  If you think Lehman going out of business is big and sad news, imagine your whole country going bankrupt.  One day you may be stunned by a $700 billion bailout in the US, but only until you find out the UK - with a much smaller economy and banking system - is ready to plow 500 pounds to rescue it's system (albeit with significantly less politicking and posturing).  

So, are we done yet?  Can it get any worse?  In short: yes, it can.  

The next shoe to drop will be a precipitous drop in consumer spending.  We already saw hints of this in the August consumer credit report, that is before we even saw the true nature of the credit beast unravel during the events of September.  The 29% drop in car sales in September gives us a slightly more accurate view of the more recent trends, but even that probably doesn't fully capture the massive shake up in consumer confidence that has occured in the second half of September and early October.  Why does any of this matter?  Until now, the actual economy hasn't really suffered that much - we have yet to see a quarter of negative GDP growth and unemployment is still in single digits.  People are still holding on to the illusion that this is no Great Depression.  However, with a drying up in consumer spending, that could change very quickly.  Remember that in the last few recessions, it was the continued strength in consumer spending that has buffered the downturn in the economy - even if at the time we didn't fully appreciate the extent to which that was probably supported by a dramatic expansion of consumer credit.  

Then just when the consumer drop becomes apparent we may potentially be served with more news from the banking industry.  Part of the reason why all the recent liquidity measures have seemingly not done much to unfreeze the flow of credit is the growing suspicion that liquidity - while being part of the problem - is not the core of it.  Felix Salmon makes an interesting point to consider:

There's an evolving consensus that we're no longer seeing a liquidity crisis, but rather a solvency crisis. Banks don't just lack cash; they're fundamentally insolvent, with their assets (things like mortgage-backed bonds) worth less than their liabilities (including their deposits). Improving liquidity, through rate cuts or swap lines or discount windows or buying unsecured commercial paper or any other means, can no longer get us out of our present hole. What we need is a recapitalization of the banking system.

The government is slowly realizing this however can it act fast enough - given that only 2 weeks ago they claimed that buying up toxic assets from banks was the only plausible solution?  And what if - in the process of recapitalizations - it turns out that the problem is much bigger that we can, even globally, afford to pay?  Consider what this article says about credit default swaps - the financing instrument du jour - which dwarf the subprime mortgage problem:

So here is a global private market whose products, combined, have a nominal value roughly equal to the total size of the world economy’s output in a year, and apparently no one in any government knows the full market’s shape, distribution, or true vulnerabilities. Gulp.

Last time I wrote about this distaster, after the failure of the bailout package in the House led to a 777 point decline in the DOW, I was worried about what all could happen before it's finally passed and implemented.  Indeed, by the time it was approved, it was almost a moot point as it became clear that the rest of the world in even deeper trouble than the US and that the US employment saw a sharp drop.  5 different steps by the Fed later, it feels like we are perpetually 2 steps behind and 2 days too late.  

Let's just hope we're not a few trillion too short.

READ: Finance Geek Alert

If you've been wondering how the near-collapse of financial markets in the last month originated and why the bailout is needed, or if you're simply a finance geek like me, you need to check out the latest episode of This American Life.  In typical TAL style, the show brings testimonies from people from the gut, heart and brain of the capital markets.   

The guys who made this episode, authered an episode 5 months ago which I consider to be the most comprehensive guide to the subprime mortgage debacle, once again with interviews from the various actors in this tragedy.  Or for some fun subway/bathroom reading, get the full transcript here.  

READ: Well, At Least It Wasn't 666

Perhaps the only good news yesterday was that the DOW dropped 777 points and not 666.  Then it would have seemed like this was some sort of devilish act of wrath.  Like this, it is only a complete disaster.

Many are pointing fingers at the House Republicans or Nancy Pelosi's remarks at the 11th hour (as a sidenote:  Seriously?  Grow the hell up!), while McCain wants have his cake and eat it too by both blaming Obama and Democrats and saying "Now is not the time to fix the blame; it's time to fix the problem."  Whatever John, you've done quite enough.

In reality, the failure of the rescue package can be traced back to the incompetence of the administration which first refused to acknowledge the seriousness of the problems in the credit markets and then tried to bully everyone into a fast approval of a massive package combined with dictatorial powers and a non-sensical unwillingness to compromise on any detail that would make it more palatable to the public (compensation, oversight, size, etc).  Did they really believe that this approach would fly the second time around after the WMD/Iraq disaster?  How could they neglect public opinion 5 weeks before an election that puts many house and senate seats on the line?  Why was there no concerted effort from minute 1 to explain the urgency in simple non-threatening terms and how this trickles down to the average person, before the package became labeled as a "Wall Street bailout", the most absurd misnomer?

Naturally, witnessing the magnitude of the market drop after the bill's failure made everyone uneasy and alarmed.  CNN is now suddenly dedicating prime time minutes to explaining the impact of the credit crisis to the average Joe, something they could have done a bit more of before Joe, Mary and Jane called their representatives to tell them not to expect to be reelected unless they kill the bill.  Meanwhile, much of the $1.2 trillion in market value lost yesterday will hit people's investment and retirement accounts immediately.  That is real money though that can be reversed in a few days.  What can't be taken back is the shock this could create throughout the system.  Will this uncertainty accelerate the "invisible bank run" that Cramer is talking about?  This isn't just some crazy theory, as Washington Mutual and Wachovia have demonstrated.  What all can happen in the two days before we get another vote, if it seemingly took a few days for Lehman to go from troubled to bankrupt?  Did anyone pause to think about that?

READ: How It All Began - Follow Up

In follow up to the previous post, I searched to see what Peter Wallison is up to and there you go - on September 23 he published an article in WSJ which I thought was pretty helpful in undestanding not just the root causes of this mess but also contained some counter-intuitive setting-the-record-straight about which party and which candidate was and was not instrumental in preventing this from happening.  

Blame Fannie Mae and Congress For the Credit Mess

By CHARLES W. CALOMIRIS and PETER J. WALLISON

Many monumental errors and misjudgments contributed to the acute financial turmoil in which we now find ourselves. Nevertheless, the vast accumulation of toxic mortgage debt that poisoned the global financial system was driven by the aggressive buying of subprime and Alt-A mortgages, and mortgage-backed securities, by Fannie Mae and Freddie Mac. The poor choices of these two government-sponsored enterprises (GSEs) -- and their sponsors in Washington -- are largely to blame for our current mess.

How did we get here? Let's review: In order to curry congressional support after their accounting scandals in 2003 and 2004, Fannie Mae and Freddie Mac committed to increased financing of "affordable housing." They became the largest buyers of subprime and Alt-A mortgages between 2004 and 2007, with total GSE exposure eventually exceeding $1 trillion. In doing so, they stimulated the growth of the subpar mortgage market and substantially magnified the costs of its collapse.

It is important to understand that, as GSEs, Fannie and Freddie were viewed in the capital markets as government-backed buyers (a belief that has now been reduced to fact). Thus they were able to borrow as much as they wanted for the purpose of buying mortgages and mortgage-backed securities. Their buying patterns and interests were followed closely in the markets. If Fannie and Freddie wanted subprime or Alt-A loans, the mortgage markets would produce them. By late 2004, Fannie and Freddie very much wanted subprime and Alt-A loans. Their accounting had just been revealed as fraudulent, and they were under pressure from Congress to demonstrate that they deserved their considerable privileges. Among other problems, economists at the Federal Reserve and Congressional Budget Office had begun to study them in detail, and found that -- despite their subsidized borrowing rates -- they did not significantly reduce mortgage interest rates. In the wake of Freddie's 2003 accounting scandal, Fed Chairman Alan Greenspan became a powerful opponent, and began to call for stricter regulation of the GSEs and limitations on the growth of their highly profitable, but risky, retained portfolios.

If they were not making mortgages cheaper and were creating risks for the taxpayers and the economy, what value were they providing? The answer was their affordable-housing mission. So it was that, beginning in 2004, their portfolios of subprime and Alt-A loans and securities began to grow. Subprime and Alt-A originations in the U.S. rose from less than 8% of all mortgages in 2003 to over 20% in 2006. During this period the quality of subprime loans also declined, going from fixed rate, long-term amortizing loans to loans with low down payments and low (but adjustable) initial rates, indicating that originators were scraping the bottom of the barrel to find product for buyers like the GSEs.

The strategy of presenting themselves to Congress as the champions of affordable housing appears to have worked. Fannie and Freddie retained the support of many in Congress, particularly Democrats, and they were allowed to continue unrestrained. Rep. Barney Frank (D., Mass), for example, now the chair of the House Financial Services Committee, openly described the "arrangement" with the GSEs at a committee hearing on GSE reform in 2003: "Fannie Mae and Freddie Mac have played a very useful role in helping to make housing more affordable . . . a mission that this Congress has given them in return for some of the arrangements which are of some benefit to them to focus on affordable housing." The hint to Fannie and Freddie was obvious: Concentrate on affordable housing and, despite your problems, your congressional support is secure.

In light of the collapse of Fannie and Freddie, both John McCain and Barack Obama now criticize the risk-tolerant regulatory regime that produced the current crisis. But Sen. McCain's criticisms are at least credible, since he has been pointing to systemic risks in the mortgage market and trying to do something about them for years. In contrast, Sen. Obama's conversion as a financial reformer marks a reversal from his actions in previous years, when he did nothing to disturb the status quo. The first head of Mr. Obama's vice-presidential search committee, Jim Johnson, a former chairman of Fannie Mae, was the one who announced Fannie's original affordable-housing program in 1991 -- just as Congress was taking up the first GSE regulatory legislation.

In 2005, the Senate Banking Committee, then under Republican control, adopted a strong reform bill, introduced by Republican Sens. Elizabeth Dole, John Sununu and Chuck Hagel, and supported by then chairman Richard Shelby. The bill prohibited the GSEs from holding portfolios, and gave their regulator prudential authority (such as setting capital requirements) roughly equivalent to a bank regulator. In light of the current financial crisis, this bill was probably the most important piece of financial regulation before Congress in 2005 and 2006. All the Republicans on the Committee supported the bill, and all the Democrats voted against it. Mr. McCain endorsed the legislation in a speech on the Senate floor. Mr. Obama, like all other Democrats, remained silent.

Now the Democrats are blaming the financial crisis on "deregulation." This is a canard. There has indeed been deregulation in our economy -- in long-distance telephone rates, airline fares, securities brokerage and trucking, to name just a few -- and this has produced much innovation and lower consumer prices. But the primary "deregulation" in the financial world in the last 30 years permitted banks to diversify their risks geographically and across different products, which is one of the things that has kept banks relatively stable in this storm.

As a result, U.S. commercial banks have been able to attract more than $100 billion of new capital in the past year to replace most of their subprime-related write-downs. Deregulation of branching restrictions and limitations on bank product offerings also made possible bank acquisition of Bear Stearns and Merrill Lynch, saving billions in likely resolution costs for taxpayers.

If the Democrats had let the 2005 legislation come to a vote, the huge growth in the subprime and Alt-A loan portfolios of Fannie and Freddie could not have occurred, and the scale of the financial meltdown would have been substantially less. The same politicians who today decry the lack of intervention to stop excess risk taking in 2005-2006 were the ones who blocked the only legislative effort that could have stopped it.

Source: Wall Street Journal, September 23, 2008

READ: How It All Began

My question is, where is Peter Wallison and is there an award of some sort we could give him?

Check this out:

Fannie Mae Eases Credit To Aid Mortgage Lending

By STEVEN A. HOLMES
In a move that could help increase home ownership rates among minorities and low-income consumers, the Fannie Mae Corporation is easing the credit requirements on loans that it will purchase from banks and other lenders.

The action, which will begin as a pilot program involving 24 banks in 15 markets -- including the New York metropolitan region -- will encourage those banks to extend home mortgages to individuals whose credit is generally not good enough to qualify for conventional loans. Fannie Mae officials say they hope to make it a nationwide program by next spring.

Fannie Mae, the nation's biggest underwriter of home mortgages, has been under increasing pressure from the Clinton Administration to expand mortgage loans among low and moderate income people and felt pressure from stock holders to maintain its phenomenal growth in profits.

...

In moving, even tentatively, into this new area of lending, Fannie Mae is taking on significantly more risk, which may not pose any difficulties during flush economic times. But the government-subsidized corporation may run into trouble in an economic downturn, prompting a government rescue similar to that of the savings and loan industry in the 1980's.

''From the perspective of many people, including me, this is another thrift industry growing up around us,'' said Peter Wallison a resident fellow at the American Enterprise Institute. ''If they fail, the government will have to step up and bail them out the way it stepped up and bailed out the thrift industry.''

...

Source: New York Times, September 30, 1999