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Boulton: Lack of regulation not to blame for financial collapse

Boulton: Lack of regulation not to blame for financial collapse

March 19, 2009
March 19, 2009

The other day I read with dismay the Idaho Statesman’s front page article about how the majority of new mortgages recently insured by the FHA (Federal Housing Administration) have gone in default before even a second monthly payment is made. This is criminal fraud by both real estate ‘professionals’ and new home buyers involved with collusion by the mortgage banking industry. I know they really can’t make a living in under current conditions in the housing market but that doesn’t justify their behavior. What this also points out is the fact that today’s economic crisis was brought about by several million irresponsible Americans looking for a free lunch – not ‘Wall Street’, an entity that no longer exists in its traditional sense.

What Wall Street did over the past thirty years, in conjunction with the US Government’s effort to maximize the extent of home ownership amongst the American population, was to develop ways the broad international capital markets could be tapped by the average home buyer by using statistics to reduce the risk and uniqueness of the average home mortgage. In retrospect, the investment banking industry was perhaps too successful in accomplishing this goal for which it was well paid.

The core premise was that if passive investors (everything from IRAs to fiduciary endowment funds) owned pieces of thousands of mortgages, the risk of owning them would be reduced to the average mortgage default rate that has prevailed for decades. This both commoditized and reduced the investment risk to a quantifiable number – like around 2.5% of the total portfolio which can be compensated for in the price of each mortgage pool. Outside of the fees generated for doing this, the process did not produce investment products one could get instantly rich from owning them. It was a risk reduction strategy that was enhanced by the use of various derivative contracts like mortgage default insurance to reduce the investment risks inherent in warehousing mortgages in passive portfolios to almost nil – a concept every regulatory agency signed off on with minimal reservation.

So why did it blow up like it did? The key to understanding this is in recognizing that the whole structure of financing mortgages was based on the long standing default rates amongst American home owners and that everyone came to believe that home prices would never collapse. Ergo, even if mortgages did go into default, or when it became necessary to refinance one’s mortgage, housing prices would have risen high enough to bail everyone out, thereby turning mortgage lending into a defacto risk less proposition.

Unfortunately home prices in several parts of the United States had risen to the point where less than 10% of potential home buyers could afford a traditional mortgage granted after a thorough due diligence process -- adherence to traditional lending standards. Under these conditions, particularly in the locales most affected by unaffordability, no one in the real estate or independent mortgage banking industries could make a living. From their perspective the solution was to resort to ‘kamikaze’ lending practices (liar loans, ‘pay what you can loans’, et al) where most mortgages written would result in guaranteed defaults and ultimately, automatic foreclosures that would in turn weigh upon the market by working to produce an oversupply of homes for sale followed by an inevitable decline in home prices to exacerbate the problem.

Even with the participation of significantly large publicly traded mortgage firms like Countrywide Mortgage, the massive home grown exercise in financial fraud by buyers, real estate brokers, and independent mortgage bankers would never have led to the problem without the connivance of the federal government agencies Fannie Mae and Freddie Mac. Under congressional dictate to maximize home ownership rates amongst Americans, these agencies bought and resold these fraudulent sub-prime mortgages, or held them for their own account to where they represented close to half their $5 trillion portfolios.

Despite this and ample warnings that something foul was going on at these two federal agencies, starting with the fact that neither could produce accurate financial statements after roughly 2002, members of Congress blocked every effort to reform their operations and subsequent attempts to get the only regulatory body that legally could control them to clamp down. The SEC tried but was precluded by law from even forcing Fannie and Freddie to produce honest financial statements.

Because of this, everyone else was basically stuck and investment professionals couldn’t arbitrarily eschew purchasing securities resold by Fannie and Freddie because they carried an implied government guarantee. Thus America’s banking industry was sandbagged by these two federal agencies until they were directly taken over by the US Treasury. At this point everyone was screwed with a lot of black holes that no one could tell what they might be worth and because of all the inter-related contra-party contracts between financial institutions, no one knew if it was possible to collect what they were promised when these contracts were entered into. Thus by standard accounting rules, every financial institution in the world was technically insolvent and the extension of credit froze up accordingly.

So if you want to know who is to blame, you have lots of candidates available by just looking down the street at your neighbors. This was not a problem that ‘better’ regulation of ‘Wall Street’ would have prevented. Instead it was brought to you by both the Clinton and Bush Administrations’ housing policies, aided by a violation of their fiduciary responsibilities by Fannie Mae and Freddie Mac, and ubiquitous fraud committed by prospective home buyers, real estate agents, and independent mortgage bankers who have never been rigorously regulated – particularly by comparison to the very extensive regulation every one in the investment industry is subject to. I know, I was a general securities principle for years and constantly was subject to myriad compliance audits.

Craig Boulton has written a number of books on finance, economics and political economy. He has written for Cato, and is a chartered financial analyst with more than 20 years of experience in the investment industry. He's also a combat veteran.

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