Let them fail

Unless you are living in a lead-lined cave you have heard the reports on the coming end of the world. By this time next week, civilization will have collapsed and we will all be bartering for water, food, and handgun ammunition as we struggle to stay alive. We are in the midst of the worst financial disaster since the Great Depression. In fact, this one might be worse! Forget the Savings and Loan collapse, the stock market crash of 1987, and the dismal 1970’s. This one dwarfs them all.

Well, not really, but it does sell newspapers, and we all know that newspapers need to do something to increase their readership before they become completely irrelevant. Doom and gloom is also a useful tool for the media, which is completely in the tank for BO.

While there has been considerable hyperbole from a media more concerned with sensationalism than responsible reporting, and many are seizing on the events to further their own political agenda, there is a real problem which has been years in the making. It deserves our attention to understand how we got here, what we should do at this point, and what we can learn for the future.

With a crucial election 42 days away, the political blame game is in full swing.

I could make a pretty good case that the roots of the problem go back to Jimmy Carter’s programs, primarily the “Community Reinvestment Act,” to encourage home ownership by pressuring mortgage companies to lower their lending standards for lower income people who would not otherwise qualify for a loan.

Clinton expanded those programs in 1994, and Alan Greenspan’s policy encouraged further reducing the lending standards, resulting in mortgage companies lending billions of dollars to people who didn’t have the financial means to repay the loans. By this time, not all of them were lower income. Instead of letting mortgage brokers decide who to lend money to, and what rates to charge, the government stepped in with their VHA loans and government-chartered organizations run by former top Clinton White House officials. These government intrusions were the driving force behind the sub-prime lending spree, where millions of loans were made to people without documenting their ability to pay the loans back.

I’m sure you heard the advertisements for loans with no money down, no income verification, and no credit check. “You can buy a house with no money down one day after filing for bankruptcy!”

Many people took out adjustable rate mortgages when interest rates were at historic lows, leaving no direction for their payments to adjust other than up. There is no justification for that kind of foolishness, but people did it because of the teaser rates which permitted them to buy a much more expensive house than they could afford.

No money down, interest only loans also flourished. In this kind of loan, you never gain any equity, unless the value of the house increases. If the value of the house decreases, the homeowner is in a slippery, slimy hole, where selling the house would not generate enough money to pay off the loan.

Safeguards such as 20% down payments, qualifying ratios, credit requirements, and income documentation protect the buyer from being forced into default and foreclosure, and they protect the lenders from loosing their principal. These safeguards were thrown to the wind, both to meet government mandates on lending fairness and based on pure greed. With real estate prices soaring, everyone wanted in on the game, and the loans didn’t look risky as long as interest rates stayed low and real estate values kept going up.

Government organizations such as Fannie Mae and Freddie Mac rated pools of sub-prime mortgages as AAA and sold them to money-market funds and Wall Street investment bankers.

The borrower had no skin in the game – they paid nothing down and had little or no equity at risk.

The broker had no skin in the game – they made the loan and sold it in a pool of other sub-prime loans rated as prime-quality low-risk paper.

The investment bankers who bought the pools were making money hand over fist, so they were not concerned about the actual quality of the loans.

With loads of money available to for loans at low interest rates, and with lenders willing to offer unrealistic “teaser” rates which allow people to qualify for a much bigger loan, people wanted more and more expensive houses, and the surge in demand drove prices way up, forming the self-sustaining real-estate bubble of the 2003-2006 period.

Near the end of 2006, the bubble popped.

Interest rates started to creep up. Adjustable rate mortgages started to adjust upwards. Real-estate prices started to fall, and buying houses no longer looked like a fail-safe ticket to riches. For the first time in years, there were more houses on the market than buyers to purchase them, and people stuck with a house they couldn’t afford were forced to sell at a loss to downsize to a house they could afford.

There were some feeble attempts to tighten up the standards and institute responsibility in Fannie Mae and Freddie Mac. Bush introduced several measures in 2003 which might have helped, but he didn’t push them hard enough to get them passed.

In 2005, Alan Greenspan warned of a coming crisis: “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.''

The Senate Banking Committee passed the first-ever reform bill for Fannie and Freddie. The bill would have required the companies to eliminate their investment in risky assets. It may have already been too late to avert disaster entirely, but it would have reduced the scope significantly. However, the bill did not become law. Senate Democrats voted the bill down in a party-line vote. Many of the senators who opposed reforming Fannie and Freddie, including Barack Obama, Hillary Clinton, and Chris Dodd, received huge campaign contributions from those institutions over the years. BO ranks second only to Dodd in lifetime contributions from Fannie and Freddie. Dodd, the Senate Banking Committee chairman has raked in more than $165,000, while BO got $125,000. Clinton is the 12th ranked recipient, with $75,000. This profit found its way back to the Senators who killed the fix.

Clinton and Obama cronies, including Obama advisors Franklin Raines and Jim Johnson, and Clinton administration official Jamie Gorelick and Rahm Emanuel raked in huge bonuses while they cooked the books to create the illusion that Fannie Mae and Freddie Mac were sound, when in fact they were steering it directly towards collapse. All told, Clinton and Obama cronies looted Fannie and Freddie to the tune of over $100 million, money which the taxpayers will now be asked to cough up. To be completely clear, your money taken from you by the government is going to pay Clinton’s and Obama’s buddies for creating this crisis.

One footnote which is worth keeping in mind while Democrats point fingers between now and election day: Senator John McCain was one of three cosponsors of S.190, the bill which would have attacked this problem before it got so completely out of control.

Today, the house of cards is collapsing and the results of the mortgage crisis are being felt in many other circles. Financial companies not directly in the mortgage business held mortgage securities that are now failing. These contracts, rated AAA by government regulators, and thus assumed to be safe investments, are now worthless or reduced to some fraction of their face value. This explains the wave of bank failures. AIG, an insurance company, was caught in a double-whammy. At the same time that they are facing billions of dollars in claims from two hurricanes, a significant portion of their assets have been rendered worthless, leaving them unable to pay their obligations.

Government tampering, under both parties, led to the current crisis. Today, politicians of both parties want more government tampering as a “solution” to the crisis. What they propose amounts to using our money to buy the failing loans which no one in their right mind would buy, and placing huge portions of the financial industry under government control. That is the wrong answer. We need to get government out of the way and let failing businesses fail. Bailing them out sends a really dangerous message. It encourages foolish risk-taking by assuring that businesses can reap the potential reward of excessive risk, but government will bear the cost of the down-side of that risk.

Think of it this way: you are offered the chance to flip a coin. If the toss comes up heads, you win $100,000. Tails costs you $200,000. Since you don’t have that kind of cash on hand, they will take your house, cars, bank accounts, retirement savings, and all of your property. That won’t quite cover it, so you and your entire family will become indentured slaves until the debt is paid. Sound good? No way! It is a foolish risk and you wouldn’t touch it with a ten foot pole. Now imagine that if you loose, we’ll go out and force a bunch of people you don’t know to pay your debt. It still is a bad risk, but you no longer care so much about the downside, because it doesn’t affect you directly. You would be a lot more prone to accept the risk because you would benefit from the upside.

If we set the precedent that taxpayers will bail out businesses who take excessive risks, we can expect more of the same in the future. I understand that allowing these businesses to fail involves significant amounts of pain. But bailing them out is not pain-free either. It is simply a shell-game. When the government buys a bad loan, it doesn’t make it into a good loan. It simply makes it a bad loan that we, the taxpayers are responsible to cover, and moves the industry from the private sector with government tinkering to complete government control. A look at the history of centralized control of the economy indicates that government doesn’t do things better than the private sector, it does things worse. The solution is not to socialize the mortgage and financial industry, but to get rid of government intrusion, letting successful companies survive and flourish and unsuccessful companies fail. None of us should be happy to see hundreds of billions of our dollars used to prop up failing businesses in huge government power grabs. It is politically expedient to protect people from the pain of reckless risk-taking, but in the long term, the failure of poorly-run businesses is just as important as the success of well-run enterprises.

I say let Fannie Mae, Freddie Mac, AIG, Lehman, Bear Sterns, and the rest of them fail, let the chips fall where they may, and get the government out of the way so that the industry can rebuild in a more sound way, recognizing that there are consequences for excessive risks.