How the Democrats Created the Financial Crisis: Kevin Hassett

Commentary by Kevin Hassett

Sept. 22 (Bloomberg) -- The financial crisis of the past year has provided a number of surprising twists and turns, and from Bear Stearns Cos. to American International Group Inc., ambiguity has been a big part of the story.

Why did Bear Stearns fail, and how does that relate to AIG? It all seems so complex.

But really, it isn't. Enough cards on this table have been turned over that the story is now clear. The economic history books will describe this episode in simple and understandable terms: Fannie Mae and Freddie Mac exploded, and many bystanders were injured in the blast, some fatally.

Fannie and Freddie did this by becoming a key enabler of the mortgage crisis. They fueled Wall Street's efforts to securitize subprime loans by becoming the primary customer of all AAA-rated subprime-mortgage pools. In addition, they held an enormous portfolio of mortgages themselves.

In the times that Fannie and Freddie couldn't make the market, they became the market. Over the years, it added up to an enormous obligation. As of last June, Fannie alone owned or guaranteed more than $388 billion in high-risk mortgage investments. Their large presence created an environment within which even mortgage-backed securities assembled by others could find a ready home.

The problem was that the trillions of dollars in play were only low-risk investments if real estate prices continued to rise. Once they began to fall, the entire house of cards came down with them.

Turning Point

Take away Fannie and Freddie, or regulate them more wisely, and it's hard to imagine how these highly liquid markets would ever have emerged. This whole mess would never have happened.

It is easy to identify the historical turning point that marked the beginning of the end.

Back in 2005, Fannie and Freddie were, after years of dominating Washington, on the ropes. They were enmeshed in accounting scandals that led to turnover at the top. At one telling moment in late 2004, captured in an article by my American Enterprise Institute colleague Peter Wallison, the Securities and Exchange Comiission's chief accountant told disgraced Fannie Mae chief Franklin Raines that Fannie's position on the relevant accounting issue was not even ``on the page'' of allowable interpretations.

Then legislative momentum emerged for an attempt to create a ``world-class regulator'' that would oversee the pair more like banks, imposing strict requirements on their ability to take excessive risks. Politicians who previously had associated themselves proudly with the two accounting miscreants were less eager to be associated with them. The time was ripe.

Greenspan's Warning

The clear gravity of the situation pushed the legislation forward. Some might say the current mess couldn't be foreseen, yet in 2005 Alan Greenspan told Congress how urgent it was for it to act in the clearest possible terms: If Fannie and Freddie ``continue to grow, continue to have the low capital that they have, continue to engage in the dynamic hedging of their portfolios, which they need to do for interest rate risk aversion, they potentially create ever-growing potential systemic risk down the road,'' he said. ``We are placing the total financial system of the future at a substantial risk.''

What happened next was extraordinary. For the first time in history, a serious Fannie and Freddie reform bill was passed by the Senate Banking Committee. The bill gave a regulator power to crack down, and would have required the companies to eliminate their investments in risky assets.

Different World

If that bill had become law, then the world today would be different. In 2005, 2006 and 2007, a blizzard of terrible mortgage paper fluttered out of the Fannie and Freddie clouds, burying many of our oldest and most venerable institutions. Without their checkbooks keeping the market liquid and buying up excess supply, the market would likely have not existed.

But the bill didn't become law, for a simple reason: Democrats opposed it on a party-line vote in the committee, signaling that this would be a partisan issue. Republicans, tied in knots by the tight Democratic opposition, couldn't even get the Senate to vote on the matter.

That such a reckless political stand could have been taken by the Democrats was obscene even then. Wallison wrote at the time: ``It is a classic case of socializing the risk while privatizing the profit. The Democrats and the few Republicans who oppose portfolio limitations could not possibly do so if their constituents understood what they were doing.''

Mounds of Materials

Now that the collapse has occurred, the roadblock built by Senate Democrats in 2005 is unforgivable. Many who opposed the bill doubtlessly did so for honorable reasons. Fannie and Freddie provided mounds of materials defending their practices. Perhaps some found their propaganda convincing.

But we now know that many of the senators who protected Fannie and Freddie, including Barack Obama, Hillary Clinton and Christopher Dodd, have received mind-boggling levels of financial support from them over the years.

Throughout his political career, Obama has gotten more than $125,000 in campaign contributions from employees and political action committees of Fannie Mae and Freddie Mac, second only to Dodd, the Senate Banking Committee chairman, who received more than $165,000.

Clinton, the 12th-ranked recipient of Fannie and Freddie PAC and employee contributions, has received more than $75,000 from the two enterprises and their employees. The private profit found its way back to the senators who killed the fix.

There has been a lot of talk about who is to blame for this crisis. A look back at the story of 2005 makes the answer pretty clear.

Oh, and there is one little footnote to the story that's worth keeping in mind while Democrats point fingers between now and Nov. 4: Senator John McCain was one of the three cosponsors of S.190, the bill that would have averted this mess.

(Kevin Hassett, director of economic-policy studies at the American Enterprise Institute, is a Bloomberg News columnist. He is an adviser to Republican Senator John McCain of Arizona in the 2008 presidential election. The opinions expressed are his own.)

How Democrats created the financial crisis?

They got beat by the Republicans in elections.

Both parties helped this situation along but if you don't think that 2005 bill blocked by partisan Democrats had a lot to do with this $700b bailout, you're only fooling yourself.

This mess was a long time coming but someone trying to sort it out in 2005 (like they should have) would have helped tremendously.

Then again, who am I fooling?

*puts on liberal hat*

Obama is PERFECT!

*puts on conservative hat*

So is McCain! Yar, partisan politicking rules!

Why shouldn't we blame Republicans when their idealogy is to deregulate everything? Deregulation and the rolling back of Great Depression oversight is what led to the financial crisis in the first place (Republican idea), and obviously both sides agree (Republicans have switched positions) that regulation is the best way out of it.

1933 Glass-Stegall Act regulated the investment banking industry.

1999 the Republican passed the Gramm-Leach_Bily Act (Phill Gram is McCain's economic advisor) which repealed the Glass Stegal Act.

It didnt take long for the deregulated market to collapse.

Who said we shouldn't blame Republicans?

I simply said the Democrats deserve a lot of shit for blocking that bill in 2005.

@ManusJustus:

The point of this article is: Many Republicans saw this coming a few years ago and tried to avert the Crisis. Greenspan warned of exactly what is happening now, and the Democrats ignored him. McCain co-sponsored the bill to help fix the problem before it became a crisis, and the Dems killed it. Democrats, who get a lot of money for their campaigns from Fannie and Freddie blocked the bill that may have staved off this Crisis. You can use generalizations about ideology, but the facts remain.

EDIT: Many republicans also deserve blame for this, several actually sided with the Dems on blocking the bill from what I remember. The point is that the Democrats largely blocked the measure, while Republicans largely supported it.

First of all, the Gramm-Leach-Biley Act is the cause of the financial crisis. It was passed by the Republicans, including McCain, and Phill Gramm is now McCain's economic advisor.

Secondly, the Republicans dominated the Senate, House, and executive branch in 2005. Blaming democrats (specfically here for a symptom on the problem, not the problem itself) would be like blaming your bat boy for your baseball team's low batting average.

No one is arguing that the Republicans were the ones behind deregulation.

In 2005, the Republicans had a slight 232-202 edge in the House. The Republicans largely backed this bill and the Democrats largely blocked it. It failed because of Democratic efforts.

Why is that so hard for you to accept?

This isn't a problem that was caused by the Democrats or the Republicans, this is a problem that was caused by both the Democrats and the Republicans ...

For decades there has been a movement towards making credit easier to access by both the government (through easing regulations) and private industry (by changing underwriting principles) which has resulted in most assets being overvalued. As a result of this, home prices (and other assets) skyrocketed in price and they became (much) riskier investments and the risk of the investment was hidden from the people who were buying them.

Basically, how did we move from a time (or grandparents generation) when you bought a home for 25% down and 35% of your take home income to a time when you can buy a home for -30% down and 60% of your take home income?

This didn't happen over night, it took 50 years and dozens of governments.

Democrats killed the bill in committee, you can pretend that didn't happen all you want, but that doesn't change the facts.

The deregulation law isn't the cause of all this, though it has some effect. The CAUSE of this is the fact that Fannie and Freddie are government guarunteed companies (implicitely, not explicitely), and their CEO's decided to take huge risks because of this. Fannie is a direct product of the New Deal.

Fannie Mae and Freddie Mac both began taking huge risks with their mortgage products some years ago. These mortgage products were highly profitable when they were being payed on. To remain competitave, traditionally careful companies such as Lehman Brothers entered into this business as well. Freddie Mac and Fannie Mae also led the way on securitizing these sub-prime, high risk loans, so other banks had to follow suit to stay competitive. When the economy hit a bump (as it always does from time to time), these formerly lucrative loan products became toxic debt. Because so many banks had invested so heavily in these products, and because they were securitized across the market (both moves lead by Freddie and Fannie, products of The New Deal), the impact of this crisis is very wide. The CEO's of both companies were willing to take huge risks, partially, I believe, because they knew the government would step in if they ran into problems, this removed excessive risk as a deterrent to making foolish decisions. The system in place for both of these giants was designed to privatize profits, but socialize losses, and this system has failed.

Both parties are clearly to blame in this, I'm not denying that, however, the idea that this is soley (or even mostly) the fault of Republicans ignores who actually helped create the mortgage giants Fannie and Freddie, and that Democrats blocked the legislation designed to prevent this current crisis from happening back in 2005 by not letting it leave the Committee.