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Reflections on a House Divided

Part II: Who Done it?


Feeding the hand that bites you

In the previous article on the financial crisis-  Who Done it?  - posted on this site, there was a passage concerning measures that contributed to the failure of the mortgage industry, and which were promoted largely by the Democrats. It read:

□ Creation of an institution - Freddie Mac - which in essence acted as a form of insurance for the sub prime market - similar to FDIC in the banking industry - but without the safeguards and oversight that constrain abuse in the latter program. Doing so - within FDIC - by controlling the level of financial risk that its member institutions are allowed to incur in regards to their investments.

As written, this passage is partially in error. Freddie Mac was created in 1970 and its intended purpose at that time was to serve as a counter-weight to FannieMae - so that the latter company would no longer have  a virtual monopoly in the secondary mortgage market . However, in the 1990s elements of the role, structure and regulatory framework of Freddie Mac were altered significantly, such that it was then true that it

in essence acted as a form of insurance for the sub prime market - similar to FDIC in the banking industry - but without the safeguards and oversight that constrain abuse in the latter program.

And, it is also true that those changes were brought about largely by Democrats --

The Democrat-led Congress of the early 1990s eased capital limits on the two mortgage lending giants, letting them use enormous leverage 2.5% of assets at Fannie and Freddie, vs. 10% for banks to expand lending to low-income, minority communities.

Regulator Reined In

Congress, with the passage of the Federal Housing Enterprises Financial Safety and Soundness Act of 1992, also created a regulator for Fannie and Freddie but made sure that, from the very beginning, it would essentially be neutered.

That regulator, the Office of Federal Housing Enterprise Oversight, an arm of the Department of Housing and Urban Development, was unique among financial regulators in that it had to go back each year to Congress for its budget.

This assured its total dependence on Congress a less-than-ideal situation for a regulator.
Congress Pushed Fannie, Freddie In Wrong Direction During 1990s

The potential for abuse caused by this measure was deepened and extended by actions later taken by then Pres Clinton - who was able to use his executive authority effectively enough to get around a
congress which was increasingly Republican in character from 1994 on --

Clinton, bypassing Republicans in Congress, had HUD rewrite the rules for Fannie and Freddie to let them get involved in the sub prime market for the first time.

Robert Rubin's Treasury got involved too, reworking its own rules to crack down on banks that didn't make enough loans to distressed, minority neighborhoods.

That year, Fannie Mae bought an estimated $18.6 billion in sub prime loans from banks. By 2004, that amount had exploded to $175 billion, or 44% of the total
Congress Pushed Fannie, Freddie In Wrong Direction During 1990s

The stage for the current crisis was then set - the accident waiting to happen.

Reading:
September 19, 2008 Just the Facts: The Administration's Unheeded Warnings About the Systemic Risk Posed by the GSEs

(C) David Aronin 2008  
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