How Lack of Government Regulation Caused Financial Meltdown

The financial meltdown that hit Wall Street and the global financial markets was due to the lack of regulations – that is, a lack of regulation ON government.

It doesn’t take the most competent forensic expert to put the crime scene squarely at the doorstep of the quasi-government banking institutions Fannie Mae and Freddie Mac. These two Government Sponsored Enterprises (GSEs), one of which was founded back during FDR’s New Deal, are at the epicenter of the runaway financial meltdown that has enveloped the globe. Without a doubt, they have wielded too much financial political muscle with too little Congressional oversight.

Paulson Bailout cartoon

Some political leaders in 2003, mostly Republicans, attempted to rein in Fannie and Freddie, which handle a majority of the $12 trillion mortgage market. The “New York Times” called these reforms “the most significant regulatory overhaul in the housing finance industry since the savings and loan crisis a decade ago.” But the Democrats, especially Massachusetts Rep. Barney Frank, blocked the bill, fearing that it would inhibit loans to low-income households. Calling Fannie and Freddie financially sound just a few years ago, many of the Congressmen opposed to stronger financial regulation were on the receiving end of political contributions by these two state corporations.

In fact, both of these taxpayer-backed corporations together spent nearly $200 million to lobby Congress and financial political action organizations. Much of the money went to affordable housing advocates, political groups, lobbyists, politicians, and anyone who supported Fannie and Freddie’s excesses. Running wild, these institutions were given all sorts of political and financial preferential treatment. For instance, banks are required to retain 10 percent of their capital, but Fannie and Freddie needed to keep only 2.5 percent of their capital, giving them a competitive advantage and the ability to buy even more questionable mortgages. Both corporations are even exempt from filing requirements with the U.S. Securities and Exchange Commission.

So when did this all start?

It appears that the trail of bread crumbs leads back to 1977 when President Jimmy Carter helped pass the Community Reinvestment Act, which required banks to provide loans to people in low-income areas regardless of borrowers’ credit worthiness or job history. In short order, banks were successfully sued over charges of racism and redlining when they hesitated to lend to people considered incapable of paying back the loans. Ironically, when banks were reluctant to lend to high-risk borrowers, they were often condemned as racists, yet when they were finally cowed into making loans to unqualified borrowers, many mortgage lenders, including Countrywide, were sued for “predatory lending practices.”

Under the lobbying pressure of Fannie and Freddie, Congress was persuaded to mandate these two government chartered corporations to open up the subprime home loan floodgates by the mid-1990s. Subprime loans were now available to anyone with a pulse, regardless of bad credit history and low income. Next, Fannie and Freddie leveraged their advantages, bundling the loans into mortgage-backed securities and selling them around the world. Soon other banks followed suit, determined to remain competitive with the GSEs. Underwriting standards became almost nonexistent in a rush to sell loans to a huge segment of society that could never before qualify for a home loan.

But lowering underwriting standards, disregarding credit history, and promoting “no documentation” loans with no down payment were only part of the problem. Another piece of the puzzle involved “moral hazard” – a situation in which people engage in risky behavior because they feel protected. As government-subsidized corporations, Fannie and Freddie would not be permitted to fail. The federal government would always come to their rescue, by cranking up the money printing press or increasing taxes. These two government-chartered corporations would never have to bear the full consequences of their actions, since the federal government was always there to bail them out. With such unlimited guarantees, Fannie and Freddie threw open the doors to bad, high-risk loans by privatizating rewards and socializing risk, the essential feature of a mixed economy.

Although some pundits have tried to pin the blame for this mess on laissez faire markets and libertarian ideology, we got into this situation because quasi-government corporations had little fear of financial failure or of greater congressional restraints. Fannie and Freddie got special political treatment and ran recklessly across the political and economic landscape. In essence, the current financial crisis is the result of an unfettered fusion of big business with big government – once known as mercantilism. And when that happens, the out-of-control actions of the corporate state often threaten to sink the ship of state as well as everyone still clinging to the lifeboats.

The 2008 financial meltdown could not have occurred without the interjection of politics into the mortgage industry. A truly free market would have no need of a bailout, nor would it have expected one.