Fear and Loathing in Washington, aka The Cover Up

Senator Tom Harkin (D-Iowa) has introduced a bill to treat all over-the-counter derivatives as futures contracts, requiring them to be to be traded on regulated futures exchanges. He seems to prefer to do more when he recently said, "Shouldn't we just outlaw all of these fancy little things?"

This legislation reflects the concern often expressed recently about the complexity of sophisticated new financial instruments, such as credit default swaps. Much has been implied that these are a significant cause of the financial crisis.

Nothing could be further from the truth, and focusing on an incorrect cause deflects attention from the real problem and risks repeating the same mistakes in the future.

Banks and other financial institutions are suffering from enormous losses in the most traditional investment for banks: mortgage loans. As the bubble in housing prices has burst, housing prices have collapsed - and due to the high percentage of a home's purchase price that a mortgage typically represents, the mortgage holder faces severe losses. The traditional arrangement where the mortgage provides 80% of the purchase price illustrates that home buying is really a leveraged buyout (LBO), involving a home instead of a business.

Securitization facilitates the spreading of mortgage loans widely, but doesn't change the basic calculus that the lenders, or investors in loans, suffer if housing prices drop significantly.

So the real question is: why did so many lenders and investors pour money into the housing market, both driving up home prices and lending against the value of those inflated home prices?

For any given investment, people make mistakes all the time and suffer losses - but don't produce an economic crisis. But something more profound and fundamental needs to occur to produce a financial crisis of the depth and breadth across the globe that we are currently witnessing.

The main culprit was the extraordinarily accommodating monetary policy that the Federal Reserve pursued beginning in 2002, reducing its base interest rate to 1.00% - an unprecedented low level. The purpose of such low interest rates was to encourage borrowing, and boy did it ever. Banks could borrow at low rates, and pass on the low interest rates to borrowers.

That's why the Fed lowers interest rates. Alan Greenspan and other Fed officials can't escape that fact.

Such low interest rates, for such a long period of time, encouraged lenders to offer, and borrowers to accept, mortgages with ever more aggressive terms. Mortgages with low interest rates for the first year before later resetting to higher rates became more common.

As example, imagine a family can afford to pay $2,000 a month in mortgage payments. At a 6% interest rate, the size of the mortgage loan would be $333,000. But at a 3% rate, the mortgage loan that monthly payments of $2,000 support is $474,000. And that higher borrowing capacity allowed buyers to offer sellers higher prices as they bid for homes - in this example, the buyer could increase the price by $141,000 and still "afford" the house.

This higher borrowing capacity as a result of low interest rates directly fueled the bubble in home prices.

Of course, once the interest rate reset, the mortgage became unaffordable. And as this happened across the economy, housing prices began to drop. Then, lenders and investors realized their mistake and stopped making such loans, further contracting home prices.

Illustrating this was an economy-wide problem, a similar phenomenon developed in leveraged buyouts of corporations and commercial real estate. Large losses have arisen in those markets too, but are dwarfed in size by the housing market.

Alan Greenspan, the architect of this low interest rate policy, elected to blame banks and investors for not exercising greater discretion in their lending and investment decisions. And some banks, and some investors, elected not to participate in this frenzy and are doing well today. But Greenspan should understand market participants react to signals, and there was no bigger green light flashing "Go" then the extraordinary low interest rates that the Fed pursued.

Back to Washington, you will be hard pressed to find politicians who bemoaned low interest rates at the time. The Wall Street Journal editorial pages did, so it isn't as if this problem wasn't recognized at the time.

Moreover, low interest rates facilitated an important public policy goal - promoting home ownership. Fannie Mae, Freddie Mac, and other government sponsored entities (GSE) were pushed by activists and Congress to expand lending for subprime mortgages to increase home ownership among less creditworthy borrowers who in the past couldn't qualify for a mortgage.

This added fuel to fire, with the blame squarely on the shoulders of the primarily Democratic politicians who pushed these policies and defended the GSEs against primarily Republican efforts to regulate them to limit the scope of their activities.

So the assault on sophisticated financial instruments represents both the fear of the new, as well as an attempt to deflect scrutiny from the real causes of this crisis.

If this history isn't understood, we are doomed to repeat it.