Understanding the Mortgage Crisis
It’s a truism of this time, though one often doubted, that globalization is fundamentally good for healthy, successful economies. But unchecked and unscrutinized, globalization also can impose terrible costs, as we see clearly in this week’s U.S. government bail-out of Fannie Mae and Freddie Mac. Globalization set much of the stage for the meltdown, as our government’s systematic failure to regulate excesses in the financial system raised the curtain. Globalization produces enormous benefits — cheaper prices for electronics, garments, autos, and IT, to name but a few standard goods now produced through global networks. It also accelerates medical advances by increasing the demand for treatments. It promotes higher incomes and standards of living across much of developing world. And it also generates enormous new pools of saving and capital that have left the world awash in liquidity. All that capital creates inflationary pressures that found their way into asset markets, producing price bubbles in housing markets around the world. All that capital also seeks as high returns as possible, so that much of it found its way to our capital markets, where billions went into subprime mortgages and many tens of billions more into the leverage for financial institutions to buy the securities based on those mortgages and the derivatives based on those securities.
The sub-prime collapse was utterly predictable and could have been avoided entirely. Instead, the thoughtless, deregulatory prejudices of the Bush Administration allowed the excesses and distortions to grow until there was way no choice but to take over the two giants of the mortgage market, Fannie Mae and Freddie Mac. The Bush White House’s reckless approach to regulation is only part of the story. At any point, the Treasury or the Federal Reserve Bank could have stepped in or at least urged the Congress to do its duty. But we live in an era in which conservatives and some liberals live in exaggerated awe of unregulated markets. It’s been part of this cultural moment, and one aggressively supported by the economy’s most powerful and influential financial institutions.
Finally, the government’s takeover of Fannie Mae and Freddie Mac, which originate or buy 80 percent of mid-level mortgages in this country, became unavoidable. Their complete collapse would have stalled out the national mortgage market and sent housing prices falling further. In addition, foreign central banks hold tens of billions of dollars in Fannie Mae and Freddie Mac securities, creating a new and serious foreign policy dilemma for the Bush Administration. While the White House has remained steadfastly unmoved by the difficulties and interests of American homeowners, it could no longer stand by unconcerned about the difficulties and interests of our economy’s central financial institutions and those facing allied governments. Yet the takeover will do little about the declining value of securities held by them, unless taxpayers pick up the tab.
Make no mistake. This is the most serious financial problem U.S. markets have faced since the Great Depression. It requires responses comparable to those undertaken in the 1930s, namely to fashion new regulatory standards and rules to protect the economy from distortions and excesses in financial markets, made more serious and more likely by the globalization of capital. Our government should have no interest in protecting financial institutions from their own bad decisions. If they choose to invest 30 percent of their capital in risky markets, they can do so. But they cannot be permitted to do so with 90 percent leverage, because if and when those loans default, they create enormous losses for other institutions, producing a cascading effect that squeezes the normal flow of credit that our businesses and credit depend upon. We will need a new regulatory system to protect our economy from those cascading losses.
The Bush Administration is not up to this task, so if will have to come from the next president and his administration. They’ll need the support and backing of Wall Street as well as the American people, which will require difficult political work and unusual political leadership. That’s part of the challenge that President Obama — or perhaps president McCain — will face next January.