Financial Meltdown: Where Does the Buck Stop?

By Matt Cover | September 19, 2008 | 7:09pm EDT

In taking over AIG last week, the federal government took control of its first insurance company and engineered its fourth bailout of a major financial institution this year, further injecting itself into the economic life of the nation while catalyzing heated debate on causes and cures.

( – In taking over American International Group (AIG) last week, the federal government took control of its first insurance company and engineered its fourth bailout of a major financial institution this year, further injecting itself into the economic life of the nation while catalyzing heated debate on causes and cures.
Both presidential candidates have said the bailouts of AIG, Fannie Mae, Freddie Mac, and Bear Stearns were necessary measures. Republican John McCain blamed greedy Wall Street tycoons, while Democrat Barack Obama blamed failed Republican economic policies.
According to Sheldon Richman, editor of The Freeman and an economist with the Foundation for Economic Education, government policy is to blame.
“The biggest culprit, I think, is the implicit guarantee the government has always issued to Fannie Mae and Freddie Mac,” Richman said. “Something like 80% of the mortgages these days are held or backed by Fannie Mae or Freddie Mac,” he said, and “they get special treatment from the government like no other lender gets.”
These factors, particularly the government guarantee, have brought about our current financial crisis, said Richman.
Fannie Mae and Freddie Mac have been able to buy bundles of home mortgages, or mortgage-backed securities, in massive quantities without real-world considerations of financial risk, because they could count on the federal government to bail them out if things went south.
“We don’t call them ‘Government Sponsored Enterprises’ for nothing,” Richman said.
Other economists reject this analysis. In a paper published this year by the Brookings Institution, economists Martin Neil Baily, Douglas W. Elmendorf, and Robert E. Litan argue that since “financial institutions are regulated and supervised by a bewildering array of federal and state authorities,” those regulators could and should have acted.
“Despite the limited authority of any specific regulators,” the economists said, “more should have been done to prevent the crisis.”  
But lack of oversight is hardly the problem, Richman said, because “the financial industry is regulated all over the place.” In Richman’s analysis, it is precisely the government guarantee of Fannie and Freddie that is “short-circuiting” the market.”
That guarantee “removes market discipline,” emboldens banks to make bad loans, and encourages Fannie and Freddie to back them. This, Richman asserted, is a “moral hazard.”
“It’s like if I invite you to Vegas and say the winnings are all yours and I’ll cover your losses,” Richman said. “You’re going to have a great old time. On the other [hand], if you go by yourself and you know you’ve got to cover your losses, you’re going to behave differently, and that’s been the problem.”
Providing context, Richman said government policy laid the foundation of this crisis more than 30 years ago when Congress passed the Community Reinvestment Act of 1977. This law forced banks to loan money to low-income borrowers as a way to ensure that financial institutions would “meet the credit needs of the local community.”
Under the Clinton administration, federal regulators began using the act to combat “red-lining,” a practice by which banks loaned money to some communities but not to others, based on economic status. “No loan is exempt, no bank is immune,” warned then-Attorney General Janet Reno. “For those who thumb their nose at us, I promise vigorous enforcement.”    
The Clinton-Reno threat of “vigorous enforcement” pushed banks to make the now infamous loans that many blame for the current meltdown, Richman said. “Banks, in order to not get in trouble with the regulators, had to make loans to people who shouldn’t have been getting mortgage loans.”  
This threat combined with the government backing of Fannie and Freddie set the stage for the current uncertainty, because the “banks could just sell the loans off to Fannie or Freddie,” who could buy them with little regard for negative financial outcomes, Richman said.
However, the most harmful federal policy may not have been backing Fannie and Freddie per se, but bailing them out.
“When the government basically expropriates stockholders, that makes other stockholders nervous and therefore drives down other stocks that are similar,” said Cato Institute economist Alan Reynolds. “Most obviously, Morgan Stanley [going] down after Lehman goes down.”
That nervousness can help drive poor economic policy decision-making. AIG, Reynolds explained, “has just got fabulous assets. It’s a trillion dollar company. It’s just short of cash.” The federal government bailout of AIG has been “draconian.” 
Moreover, Reynolds said, the bailouts have forced these companies into a kind of “quasi-bankruptcy” when no one knew in fact whether the firms were or were not solvent.  
Reynolds called the government’s intervention “capricious” and “whimsical” and said it appears to have “no rules.” No wonder, he said, investors have been scared away from infusing financial institutions with the capital they need to maintain solvency and stave off bankruptcy.  
Economist Robert E. Litan challenged a negative view of government intervention. In bailing out Bear Stearns, Fannie, Freddie, and AIG, he said, “federal policymakers appropriately used their authority to stabilize the markets and protect the American economy from systemic risk and collapse.” 
“We have learned from the past,” he said. “While Depression-era policy makers watched idly while events spiraled out of control, today’s policy-makers have recognized the need for swift action to contain the damage.” 
What this financial crisis really shows, Richman said, is that politicians “don’t know what they’re doing. They don’t understand economics. They think there are no laws of economics, that they can decree whatever they want and that there won’t be consequences.”

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