The Role of the U.S. Government

Like millions of Americans watching events unfold on Wall Street this past week, millions of Chinese were also watching, undoubtedly scratching their heads and wondering how such a highly developed country with such sophisticated capital markets could possibly find itself in such a financial mess.

In the months ahead, Republicans and Democrats will take turns blaming each other for “falling asleep at the switch,” and everyone will blame the greedy bankers for putting the interests of Wall Street ahead of those of the ordinary citizens on Main Street. Blue ribbon panels will be formed to analyze the causes of the worst American financial crisis since 1929, and the U.S. Congress will hold hearings to decide what to do. The end result will likely be a new set of regulations and legislation designed to curb the “excesses” on Wall Street. If the past is any guide, the “cure” prescribed by Congress will be worse than the disease.

It’s very easy to get tangled up in the inner workings of the subprime mortgage market, as well as the technical jargon surrounding the sophisticated financial instruments that have become such a big part of the capital marketplace. One would be forgiven for concluding to that only someone with a doctoral degree in economics from Harvard or Tsinghua can possibly understand what has transpired. In actuality, though, the fundamental reasons for this crisis are relatively straightforward and easy to understand, and China would do well to analyze them very closely. Capital markets are still at an early stage of development in China, but they will be increasing in sophistication in the years ahead. By studying this most recent and painful experience of the United States, China can perhaps avoid some of the pitfalls that are currently crippling the U.S. financial system.

As much as the politicians would like to shift the blame, the truth is that there is plenty to go around. The U.S. Congress and government deserve quite a bit of it for encouraging banks and savings and loan organizations to make mortgage loans to unqualified borrowers, as well as for the loose money policy followed since the dot-com crash. Wall Streeters and the financial experts are also at fault. In their pursuit of higher profits, U.S. banks and other lending institutions forgot the most fundamental rule in lending: “Know your customer.” And, otherwise astute investors forgot the cardinal rule of investing: “Never invest in something you don’t understand.”

Given the far-reaching implications of “Meltdown Monday” (the name given to Monday, September 15th, the day when Lehman filed for bankruptcy, Merrill Lynch agreed to be acquired by Bank of America, and AIG teetered on the edge of bankruptcy), MTD will discuss the lessons that China might learn in three parts. Today’s post discusses the U.S. government’s role in creating the crisis, while Parts II and III will discuss how Wall Street firms became so interested in making more money that they took on higher and higher amounts of leverage and began creating increasingly complex financial instruments to further hype investment returns.

There is an old saying, “The road to Hell is paved with good intentions.” That about sums up what the U.S. Congress did in 1977 when it passed the Community Reinvestment Act (CRA), a law requiring banks to make loans throughout their entire market area and prohibiting them from targeting only wealthier neighborhoods. CRA was passed to provide credit and home ownership opportunities to less qualified borrowers, despite considerable opposition from the mainstream banking community. As a result of the law, the record of each lending institution in making loans available to less qualified borrowers is taken into account when government regulators consider a bank’s application for deposit facilities or certain other approvals.

The Clinton administration strengthened the enforcement of CRA in 1995, and this lead to a substantial increase in the amount of subprime loans to low- and moderate-income borrowers. (Subprime loans are those loans made to borrowers who do not qualify for market interest rates due to various risk factors such as income level, size of the down payment made, credit history, and employment status.) The Clinton administration’s revisions to the law also allowed the securitization (combining a group of loans in one package and selling that package to a broad group of investors) of CRA loans containing subprime mortgages. The first public securitization of CRA loans started in 1997 by Bear Stearns. (Due to its participation in underwriting subprime loans, Bear Stearns was one of the first casualties of the current financial crisis.) As a result of these measures, the number of CRA mortgage loans increased by 39 percent between 1993 and 1998, while other loans increased by only 17 percent.

In the interest of providing affordable housing to every American family, the U.S. Congress unwittingly created a growing pool of future bad loans. To his credit, President Bush recognized the growing problem in 2003 and recommended that supervision of two of the primary agents guaranteeing subprime loans, Fannie Mae and Freddie Mac, be moved to a new agency under the Treasury Department. Unfortunately, the changes were generally opposed along political lines. Representative Barney Frank, a Democrat, claimed, “These two entities — Fannie Mae and Freddie Mac — are not facing any kind of financial crisis, the more people exaggerate these problems, the more pressure there is on these companies, the less we will see in terms of affordable housing.” Representative Mel Watt, a fellow Democrat added, “I don’t see much other than a shell game going on here, moving something from one agency to another and in the process weakening the bargaining power of poorer families and their ability to get affordable housing.”

If Congress started the fire that eventually consumed a large part of Wall Street this week, the loose money policy followed by the Federal Reserve System over the past eight years fanned its flames. An editorial in The Wall Street Journal on Tuesday, “Surviving the Panic,” summarized the underlying cause of the crisis:

The current panic is the ugly aftermath of the credit mania that took flight in the middle years of this decade. As students of economic historian Charles Kindleberger know (“Panics, Manias, and Crashes”), financial manias throughout history have shared one trait: the excessive expansion of credit. This bubble was no different.

Following the dot-com crash and the tragic events of 9/11, the Fed did what it always does in times of crisis—it pumped more money into the U.S. economy to avert a recession, giving banks more and more money to lend. With an increased supply of low interest rate loans available, investors started buying more assets—stocks, real estate, commodities etc.—causing the prices of all of these assets to go up. The more money investors invested, the more the prices went up and the more profits the investors made. That’s how bubbles are created.

Chinese investors understand this dynamic quite well. As foreign currency poured into China from foreign direct investment and export sales over the past five years, the Chinese government began buying the foreign currency with yuan, pumping more and more money into China’s economy. Chinese banks and investors then did the same thing that American banks and investors did—they made more loans and bought more assets. That is why real estate prices soared all over China, and the Shanghai Index topped 6,000 in November, 2007. It was only when the Chinese government began to restrict loans and take other measures last year to cool the economy that the air began to be let out of China’s “bubble.” If China’s capital markets had been as developed as those in the United States, China might be experiencing the same fate that the U.S is facing today. That is why it is so important for China to learn from the U.S. experience.

With Congress encouraging loans to less creditworthy borrowers, and a greater supply of money for loans available, mortgage lending increased, creating the recent bubble in U.S. home prices. In 2007, mortgage loans in the United States totaled $14.7 trillion, with the value of U.S subprime mortgages estimated at $1.3 trillion. Approximately 16 percent of subprime loans with adjustable rate mortgages were 90-days delinquent or in foreclosure proceedings as of October 2007, roughly triple the rate of 2005. By January 2008, the delinquency rate had risen to 21 percent and by May 2008 it was 25 percent. The U.S. government’s efforts to enable every American to own their own home, combined with a flood of cheap money, were the underlying reasons for the looming financial crisis. With over ten years of bad loans coming home to roost, the stage was set for Meltdown Monday.