Thursday, September 25, 2008

Bringing Back Welfare As We Knew It: My Indignant Take on the Wall Street Bail-Out



Bill Clinton’s 1996 "welfare reform" made him (and his wife) the enemy of the left and a hero to moderates and conservatives who apparently believed that single black mothers on welfare were the greatest threat to American taxpayers. Of course, AFDC payments constituted only 1% of the federal budget, and a majority of welfare beneficiaries were (and still are) white. Nevertheless, the "welfare queen" became a rallying cry for opponents to welfare. Welfare recipients, according to the royal rhetoric, are lazy, make bad choices, have ample opportunity for economic advancement, and are incentivized to idleness and pathology by governmental subsidies. The Personal Responsibility and Work Opportunity Reconciliation Act of 1996 required recipients to work, curtailed benefits to unmarried individuals (under the false assumption that marriage ends poverty), and placed a lifetime limit on benefits. By contrast, the unconditional bail-out for Wall Street, as it currently stands, marks a return to welfare as we knew it.

Earlier this year, I wrote a column questioning why the Bear Stearns bail-out failed to trigger a discourse concerning the pathology of Wall Street’s "welfare kings." See (http://www.blackprof.com/?p=2002). Although some liberal commentators have attempted to blame the present financial unrest on "deregulation," most financial experts believe that reckless investment decisions created this havoc. Historically low interest rates in the early in 2000s made it very easy for banks to obtain money to lend (at a profit). The wide availability of credit increased demand for housing which caused rapid price appreciation. Banks, wanting to fatten their coffers, engaged in reckless lending, using "creative" products such as adjustable rate mortgages and no-income verification loans to finance home purchases for individuals with poor credit ratings or "A-credit," but insufficient income. Homeowners used their homes as ATM cards, dipping into their equity to purchase cars and other consumables. Investment banks purchased mortgages, bundled them together as securities, and sold them as assets to investors wanting a fixed return.

Ultimately, market fundamentals could not sustain this excess, and the Federal Reserve began raising interest rates to bring the market back to reality. Adjustable rate loans caused payment shock for borrowers, and foreclosures soared. Suddenly, mortgage-backed securities became risky and unstable assets, and financial institutions that held these securities or traditional mortgages began to suffer huge losses. Lenders refused to extend credit to holders of these assets or to purchase them due to their risk. Essentially credit dried up. Foreign sources of money also ran from the United States, exacerbating the unavailability of credit. Bear Stearns, Lehman Brothers, and other venerable Wall Street institutions hit the dust. And the story continues to unfold.

In response to recent events, the Bush administration has requested $700 billion to allow the Secretary of Treasury to purchase mortgage-backed securities from troubled financial institutions. The companies would receive "market value" for the securities (whatever that is) and would presumably have a better credit rating without the risky assets. In addition to infusing capital into troubled firms, this plan, if successful, would help stabilize financial markets, attract foreign and domestic sources of credit, and prevent steep economic decline. Because a private-sector solution to this madness seems out of reach, governmental intervention is necessary.

Still, we need to label this intervention honestly: it is a handout to people who engaged in highly irresponsible behavior. Not only was their behavior reckless, but they, as financial professionals, had greater knowledge of the risks and consequences of their behavior than the average homeowner, who lacks sophistication concerning financial markets and lending parameters. Although many commentators have bashed "sub-prime" borrowers, which I view as the new "welfare queens" (http://www.blogger.com/(http://www.blackprof.com/?p=2002)) they have not similarly critiqued the companies which had the capital and power to create the current situation – and the financial expertise to avoid it!

The fact that this problem has intensified during a presidential election makes things even more dramatic. Democrats and Republicans are rightfully calling for more conditions placed on the receipt of federal money (and this seems inevitable). Hillary Clinton has even proposed that the government purchase individual mortgages and reiussue them to distressed homeowners under more favorable terms; a similar course of action took place during the Great Depression. But neither side can claim "clean hands" on this issue -- although Democrats have tried to do so. Liberals, in particular, have blamed the current mess on "deregulation," citing to several pieces of legislation, but most often, the Gramm-Leach-Bliley Act of 1999. That legislation allowed commercial banks, investment banks, and insurance companies to consolidate. This statute, however, did not create financial chaos; risky investments did. Countrywide and Washington Mutual are strictly commercial banks. The former has already folded into Bank of America, while the latter is on life support. Bear Sterns and Lehman Brothers were strictly investment banks, and they have both died. AIG is exclusively an insurer, but it too needed a federal rescue. On the other hand, JP Morgan Chase is a consolidated investment and commercial bank, but it is among the strongest of the remaining financial institutions in the country. Furthermore, Bill Clinton signed the legislation into law, and Robert Rubin (former head of Goldman Sachs, now Chairman of Citicorp), his Secretary of Treasury, lobbied for it. Democrats also voted for the measure in large numbers.

Recently, Obama called Rubin for "advice" on the economic crisis, and he initially chose James Johnson, a former managing director of Lehman Brothers and Vice President at Fannie Mae, to head his Vice President vetting team. Johnson resigned after the Republicans politicized his connection to Fannie Mae and his receipt of millions of dollars in "loans" from the troubled company. In the past, Democratic Senators Charles Schumer and Christopher Dodd have both rejected stricter regulation of financial institutions, as has Representative Barney Frank. All of these men sit on congressional banking and finance committees. And Fannie Mae employees gave Dodd, Obama, and Clinton most of their campaign contributions this year. No one is innocent.

McCain has "suspended" his campaign, but, ironically, this move is just a campaign strategy designed to delay having a presidential debate during this chaos. Polls have begun to shift towards Obama during the turmoil, proving the old maxim that "it’s the economy stupid." Statistical data indicate that voters tend to blame the incumbent’s party for economic distress. Obama says the show must go on and that presidents have to "multi-task." That’s a great response to McCain’s gimmick. But at the end of the day, both candidates, as leaders of their respective parties, need to endorse the solution. Because it is an election year, expect to hear emotional (and nauseating) appeals to bipartisanship – so that neither side will become vulnerable to charges of "playing politics" with the solution.

Ultimately, both candidates will ceremoniously help craft and endorse the legislation, which will likely have some conditions placed upon the Secretary of the Treasury and the companies that receive governmental assistance. But I do not expect "the people" to benefit directly from the legislation, in terms of mortgage-payment assistance or reissuance with more favorable terms. Nor do I expect that the "conditions" in the law will involve things like job training for financial professionals, a lifetime limit on the receipt of subsidies, or other similar conditions that were all placed in welfare reform legislation. Welfare as we knew has made a triumphant return.

13 comments:

Avatar said...

Its all about the Federal Reserve System.

Darren Lenard Hutchinson said...

The Fed certainly had a lot to do with this. In some ways, it was important to lower interest rates after 9/11, but things got out of hand.

Findalis said...

This problem is caused by both parties equally. The freeing up of money in the late 90's, early 2000's and the use of sub-prime mortgages to people with less than stellar credit, has led to this crises.

Another factor in this mess we are in goes to the homeowners themselves. People who have combined incomes of $30,000-$75,000 a year bought homes worth $500,000 and up with sub-prime mortgages.

The third factor was the real estate market itself. Pushing up the price of homes to 200%+ their actual value to make easy and fast sales.

The last factor was and is the culture of buying on credit which has become living on credit. Too many people have maxed out their credit cards that they have no disposable income left.

We need to get back to financial basics: Save for a house, home prices going back to a decent level, and giving up living on credit. And banks have to go back to doing business the old-fashioned way, they wouldn't be in this mess if they did.

Darren Lenard Hutchinson said...

Findalis - I agree. During the whole real estate run, the savings rate dropped to zero and then went negative, which meant the average American was a net borrower. I agree that we must tighten spending and the extension of credit. But this is not the dialogue taking place in Washington.

Anonymous said...

There might be a little more to this than meets the eye, apparently there was a partisan discussion in the congress 4 years ago.

http://www.youtube.com/watch?v=_MGT_cSi7Rs

Hopefully, I can find more about this debate.

Anonymous said...

Sorry, ken is the above comment

Darren Lenard Hutchinson said...

Ken, I have not listened to the entire video, but I have already said elsewhere that Democrats earlier resisted efforts at more oversight over Freddie/Fannie. Now, any fraud by these two entities could explain their collapse, but certainly not the crisis in the credit markets generally. Federal regulators require certain financial institutions to have "reserve" assets to cover a certain percentage of their mortgage portfolio. This prevents the companies from over-extending themselves, leaving them vulnerable if a substantial amount of their debt goes sour. If Fannie/Freddie "cooked the books" (as they did in the past) then heads should roll.

I would close in noting that the Republicans are not innocent of turning a blind eye either. They controlled Congress and the White House when banks were departing from healthy lending parameters and basically throwing money to consumers. Why didn't they try to tighten lending parameters at all financial institutions - not just at Fannie/Freddie? And why is the Department of Justice only now conducting an investigation? Is it investigating other companies too - or is this just political grandstanding? Tune in.

Darren Lenard Hutchinson said...

Forgot to link to an article on the current investigations of Fannie/Freddie: http://www.bloomberg.com/apps/news?pid=20601087&sid=arkqG4NGI1iw&refer=home

Anonymous said...

Darren,

I am not versed in this, as to why only Freddie and Fannie were , but from what I can tell those institutions did not fall under the same regulations as the others, and were providing guarantee on loans for other institutions, one of the representatives alluded to this in the fragmented video, but I would like to find this discussion and get more context.

I agree with you that republicans have a part in this, but I wish we could slow down this big bail out and unfold what all the factors are that happened. I am glad to see Bush attempting a fix, but am disappointed in this solution.

ken

Anonymous said...

Darren,

I haven't read this, but I will, I suspect this document will explain why Freddie and Fannie are different.

http://www.aei.org/publications/pubID.22514/pub_detail.asp

ken

ken said...

Darren,

Why didn't they try to tighten lending parameters at all financial institutions - not just at Fannie/Freddie? And why is the Department of Justice only now conducting an investigation? Is it investigating other companies too - or is this just political grandstanding? Tune in."

Alright Darren were tuning in now:

Bill H.R. 1461 never became lawbut here was part of the argument for it:

"Currently, Fannie Mae and Freddie Mac are the only two publicly-traded companies in the Fortune 500 that are exempt from regulation by the SEC. The only reason Fannie Mae and Freddie Mac were forced to reveal their accounting errors is because in July 2002, under pressure from Congress and the Administration, the two companies finally agreed to comply with certain reporting requirements of the Securities Exchange Act of 1934. Fannie Mae followed through and registered in 2003, but failed to file a report in the third quarter of 2004, and is now in the process of restating those reports it did file. Freddie Mac simply never lived up to the agreement.

I believe all publicly-traded firms should play by the same set of rules, and am pleased this legislation codifies the 2002 agreement. This legislation should go even further by requiring Fannie Mae and Freddie Mac to comply fully with the Securities Act of 1933 and the Securities Exchange Act of 1934.

Regarding the powers of the new regulator, due to the enormity of the GSEs’ holdings, it seems to me we should go even further in empowering this new office."

As you can see Freddie and Fannie didn't play with the same rules, and they also didn't just now start getting investigated.

http://www.house.gov/shays/issues/floorstatement/octgse.htm

Darren Lenard Hutchinson said...

There are a lot of responses - but they all try to get at "why just Fannie/Freddie." Fannie acted as a guarantor -but other entities "insured" debt as well, such as AIG. My main point is that there is causation all over the place. When venerable entities like AIG, Fannie/Freddie, Lehman Bros., Merrill Lynch, Morgan Stanley, Wachovia, Bear Stearns, and others are all falling in less than a year, we have a deep and wide problem. The Fannie/Freddie situation is just one piece of the puzzle.

Darren Lenard Hutchinson said...

Oh - and thanks for the responses. I'm just only recently getting the blog going. You guys are very helpful, and I appreciate your presence.

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