Learning From Public Policy Mistakes Of The GFC

In the Financial Times at the end of March, the former Federal Reserve Chairman Alan Greenspan wrote “With notably rare exceptions (2008, for example), the global ‘invisible hand’ has created relatively stable exchange rates, interest rates, prices, and wage rates”.

That statement is mundanely true. But as it came from Greenspan, it was not well received.

Left-leaning blogs have had great fun: “With notably rare exceptions, the levees protecting New Orleans have held fast in the face of major hurricanes”.

The Nobel winning economist-turned-polemicist Paul Krugman wrote he “didn’t know quite how to respond”.

The Global Financial Crisis still looms large.

Our understanding of the crisis will shape debate about the role of government and the fragility or robustness of markets for decades.

So it’s important to get it right – to pinpoint exactly what went wrong in the US housing market and what caused it. The particulars are important.

Those particulars make it hard to shove the crisis into a morality play of deregulation and rampant greed.

We know a lot more about the crisis than we did in 2008 and 2009.

The US government’s Financial Crisis Inquiry Commission reported this January. While its majority report largely fails to interrogate the structural origin of the housing bubble, a dissenting report released as an appendix is much more interesting.

Written by Peter Wallison of the American Enterprise Institute, the dissent rigorously documents the deliberate erosion of lending standards by successive American administrations.

As Wallison writes, in the early 1990s lending standards were seen as a barrier to home ownership for low and middle-income families.

The solution was the Housing and Community Development Act of 1992, which intended to give those families better access to mortgage credit through the government-sponsored enterprises Fannie Mae and Freddie Mac.

Fannie and Freddie had been, until then, conservative and relatively benign, trading mortgages on the secondary market since the Great Depression. But with the 1992 Act they now had a new mandate, a social mission.

Over the next 15 years the Government ratcheted up the affordable housing goals.

The result of these goals was spectacular.

By 2008, “non-traditional” mortgages (loans made to those with blemished credit, or lacking documentation, or with negligible down-payment) made up a massive 58 per cent of the total US mortgage market.

And US government entities – primarily Fannie and Freddie – were either directly holding or guaranteeing 71 per cent of those non-traditional loans.

This was a successful program, under its own terms. It boosted homeownership rates substantially. But the housing bubble it created eventually burst.

The received wisdom on this boom in non-traditional mortgages has focused on fraud by lenders, the naivety of borrowers, and the greed of investment bankers who packaged them into complex and inscrutable investments.

This tale has been reinforced by bookstores full of hastily-written financial crisis porn, rich with anecdotes about fast-living financiers and lazy lenders.

Yet in a market engorged by government affordable-housing goals, these bankers no more epitomise the ‘invisible hand’ than the US Congress does.

So three years after the crisis, the policies which caused the housing bubble are starting to get their due recognition.

As are the mistakes made in 2008, while the bubble was collapsing.

If the erosion of lending standards was the long-term cause of the crisis, then the actions of the US government in 2008 was the short-term one – badly deepening the crash and impeding the recovery.

Since the 1980s, the US government had slowly built an expectation it would bailout big firms if they got into trouble. This expectation was never explicit. You wouldn’t want to bet the company on it. But it was there.

Still, the bailout of the investment bank Bear Sterns in March 2008 came as a surprise. Sure, Bear Sterns was deeply involved in non-traditional mortgages, but it was only a mid-sized firm. If Bear Sterns was “too big to fail”, so were dozens of others.

When the Federal Reserve stepped in to save Bear Sterns, it was massively expanding the government’s implied support net.

In retrospect, many participants have blamed the failure to bailout Lehman Brothers in September for the crash. And it is true that the market only truly sunk after it became clear Lehman would be left to fail, and investors realised government help was not guaranteed.

But Lehman’s actions in the week after the Bear Sterns bailout reveal the real problem in 2008.

Bear Stern’s near collapse in March should have inspired all participants to stop and reassess the quality of the mortgage-backed securities they were holding.

Instead, Lehman doubled-down, packaging all their riskiest assets into a special fund with one purpose – as collateral to borrow money from the Federal Reserve. In other words, instead of limiting their risk, they increased it.

For Lehman and other firms, maximising the chances for a bailout became the main game. Not cleaning balance sheets and taking a financial hit. As a former director of the Federal Reserve Bank, Vince Reinhart, has argued, the question becomes less “how do we get out of this mess?” and more “how much money will the government pony up first?”

Expectations changed again in September with Lehman’s collapse. The US economy froze. The global panic began. Governments initiated an unprecedented series of interventions and stimulus packages.

And the name of the Lehman Brothers fund specifically designed to take advantage of Federal Reserve largesse and the banking sector’s new claim on taxpayer dollars?

The “Freedom” fund.

Memory of the Great Depression shaped economic policy in the second half of the 20th century. The Great Recession will shape the next 50 years.

So let’s not let our understanding of its causes slip into a vague haze of myth and cliché. The crisis was caused not by greed, or deregulation, or neo-liberalism. It was caused by a web of public policy mistakes – if well-intentioned ones – and their unintended consequences.