Banks, Bailouts, and Bulls**t: Part II

In Part I of this series of postings we learned how the federal government stepped in to stabilize the American banking and financial systems during the Great Depression. In this posting we will take a look at what happened between that time and the onset of the current financial crisis.

In the fifty years following the Great Depression the United States managed to survive a world war, two undeclared wars in Asia, a few economic recessions, Lyndon Johnson's Great Society, and the Carter Administration. Well, not exactly, because the policies of the last two are coming back to haunt us.

It appears that Lyndon Johnson thought himself to be the second coming of Franklin Roosevelt. As part of his "War on Poverty" initiative, and as an attempt to bolster his failing public image due to the conflict in Vietnam, Johnson sought to make home mortgages "accessible." To facilitate this, he bullied Congress into creating the Federal National Mortgage Association (Fannie Mae). Before proceeding with our review of how the current situation developed, a little history and a brief explanation will be necessary.

A Little History

Fannie Mae began as a program that was part of Roosevelt's New Deal. Specifically, it was created to issue government-backed mortgages in order to assure that affordable housing would be available to prospective home buyers. Johnson, facing huge budget deficits due to spending related to the Vietnam War, wanted the program off the government's payroll, forced Congress to "spin off" Fannie Mae as a public, shareholder-owned (although government-chartered) corporation.

Under the terms of its creation, Fannie Mae would no longer directly issue mortgages but instead would buy mortgages that had been previously issued by other lenders. By doing so, Fannie Mae would free up more money that was to be used to make more mortgages available to the public. How this system worked brings us to the previously mentioned brief explanation.

A Brief Explanation

In our banking system, it is the banks themselves actually "create" money. Banks are able to do this because of something called fractional reserve banking. Under this system banks are allowed, by the Federal Reserve, to make more in dollar-value loans than they have on deposit from their customers. An example will help to explain this concept.

Bank of Your Town has $1 million in deposits. If the fractional rate is 6:1, it can make $6 million in mortgage loans and the bank can then either carry these loans as assets on its balance sheet or sell those loans to Fannie Mae, which will free up the same $1 million in fractional reserve to make more loans (see my previous post, Fannie, Freddie, and the Feds, for a more detailed explanation). Fannie Mae then "bundles" these mortgages into "packages" that become the collateral for securities (such as bonds) that Fannie sells to investors.

And now, back to our review of how the current mess developed.

Initially, Fannie Mae was so successful that Congress created another federally-chartered but publicly-financed organization to compete with it and thus insure that Fannie wouldn't gain a monopoly in the mortgage purchasing business. This new organization was the Federal Home Loan Mortgage Corporation, better known as Freddie Mac.

At first, all was well and both Fannie and Freddie were doing well and returning good dividends to their shareholders. Then the Carter Administration decided that a few changes were in order.

First came the Community Reinvestment Act of 1977 (CRA). Although it was written with the intent of reducing discrimination in lending, it also mandated "oversight" by the federal government to insure that a certain percentage of private lending went to "underserved" communities. The banks and other lending agencies made the requisite loans and, in turn, sold them to Fannie and Freddie.

In 1980 the Carter Administration, in response to pressures from the Savings and Loan (S&L) industry, pushed the Depository Institutions Deregulation and Monetary Control Act. This law removed restrictions that had been placed on the nation's savings and loan operations during the New Deal era regarding what loans, and other related businesses, these institutions could participate in. In return for this concession, and the removal of controls on interest rates that banks or the S&Ls could pay depositors, the Federal Reserve was given authority over all banks.

The S&Ls acted like children in the toy shop; making loans on commercial properties that they would sell to other S&Ls who would, in turn, carry these properties on their balance sheets at inflated prices. This practice, among many others, as well as another round of deregulation in 1986, led to the Savings and Loan Crisis of the late 1980s. The price of resolving this crisis was estimated to be over $160 billion. While all this was going on, banks and mortgage companies continued making CRA-required loans and selling them to Fannie and Freddie.

During the Clinton Administration the number of CRA-related loans became the unofficial political "litmus test" when it came to deciding which banks would receive the go-ahead when it came to mergers and acquisitions with other banks. This unwritten requirement to participate in CRA lending became law in 1998 as an attachment to the Gramm-Leach-Bliley Act, which also repealed the restrictions placed on banks and related financial institutions by the Depression Era Glass-Steagall Act. With these regulations out of the way, it was 1929 all over again. The distinction between commercial and investment banks was gone.

Banks either established, or merged with, brokerage firms and investment bankers. The brokerage firms sold riskier and riskier investments to the investment banks' clients. Mortgages made in compliance with the CRA continued to be sold to Fannie and Freddie who, in turn, began to "cook the books" in order to list "problem" mortgages at full value. By 2002, fully half the mortgages purchased and repackaged by Fannie and Freddie were high-risk CRA loans.

It all came crashing down a few months ago.

The usual amount of blame-shifting and finger pointing will go on for years, and there's plenty of blame, and culprits, to go around. But, in the long run, you can't avoid the fact that all this probably wouldn't have happened if our Congress, regulatory agencies, and other supposed "watchdogs" had done their jobs rather than selling their votes to those that stood to benefit from lax oversight of the financial world.

Maybe our children and grandchildren will learn a lesson from all this. They'll still be paying the bill for our mistakes for a long time after we're gone.