In the last few months we've seen the government bailout of Bear Stearn to the tune of $29 billion, Freddie Mac and Fannie Mae to the tune of $200 billion, money markets to the tune of $50 billion , and a wholesale bailout of the mortgage industry for $700 billion . That's almost a trillion dollars in government bailouts so far this year--from a government that doesn't have a trillion dollars!

Of course--and unfortunately--this being a presidential election year, this is being used for extensive political reasons. Obama is using the situation as proof that deregulation doesn't work and that big government is the answer and Republicans are the problem. Meanwhile, McCain hasn't--so far--assigned any substantial blame other than a lack of oversight at the SEC . However, it has been pointed out that Bush proposed significantly more oversight for Fannie Mae and Freddie Mac back in 2003 and that Democrats in Congress actually opposed that additional regulatory oversight.

I have a very serious interest in determining what happened. If, as Obama claims, this is all due to a lack of regulation, then that's a good argument for more regulation and I'd be interested in learning who effectively dropped the ball. I'm a Republican, not an anarchist. That means while I do prefer the minimum amount of government and regulation necessary, that doesn't mean I advocate for no government and no regulation. So I really don't care whose "fault" this is. I just want to know what happened so I can form a personal opinion of what needs to be done to fix it and make sure it doesn't happen again.

As one tries to research what has actually happened, how we got here, what we can do to fix it and make sure it never happens again, one finds it's extremely difficult to find the answer. There is so much partisan commentary being published on the topic that trying to find the facts becomes surprisingly difficult. In fact, I've found that in my efforts to do research for this article that about the only thing you can do is read the partisan commentary on both sides and start Googling specific claims and accusations cited on both sides and research to what extent those claims are true. As you do so you start getting a feel for what actually happened.

It seems that the first step is to try to define what exactly is actually happening now that is causing the crisis. From there we can work backwards as to how it happened.

What is Causing the Financial Crisis?

The financial crisis has been caused by a combination of primarily three situations happening simultaneously:

1. Subprime Defaults. A significant increase in the number of foreclosures in the subprime mortgage market.
   
2. Credit Default Swaps (derivatives). The increase in foreclosures caused a much larger change in the value of hard-to-value financial derivatives known as credit default swaps.
   
3. Failure of Freddie Mac/Fannie Mae. The failure of these two giants became the trigger that unleashed the rest of the crisis.

The simplest explanation is that the current financial crisis is being caused by a large number of people not paying the mortgage on their homes. But that's not the whole story. While the number of foreclosures has increased, the number of foreclosures is still small relative to the large number of outstanding mortgages. However, when combined with the credit default swaps, it created the perfect economic storm.

Culrpit #1: Subprime ("Main Street")

People aren't paying their mortgages either because they can't or, in their judgment, it doesn't make financial sense to do so. As people stopped paying their mortgages, companies in the financial industry that were invested in these securitized mortgages were exposed to huge losses--some of the losses real, some triggered by a "run on the bank" due to fears of further losses.

First, we have the group of people that can't pay their mortgage. While some of those may be because of lost jobs, etc. that's true at any point in time and, so far, we haven't really had a serious unemployment problem any worse than any other business cycle. So it doesn't seem like typical business cycle basics are the cause of this crisis. Rather, it seems that the group of people that can't pay their mortgage are mostly those that took out adjustable rate mortgages (ARMs)--who were also often subprime borrowers with either inadequate or unproven income. As their adjustable rate mortgages reset to higher interest levels, they could no longer afford the payment.

The second group of people are those that can afford their payment but choose not to pay because, in their estimation, it does not make sense to do so. If someone has financed a house for $400,000 and its value has dropped to $300,000 and their payment has gone up, many people will conclude that even though they may be able to afford the new higher payments, it doesn't make financial sense to pay such a high payment on a house that is now worth far less than what they owe. Rather than accept the loss some of these people will simply abandon their home and walk away from their loan. This is especially true if the homeowner put down very little (or none) of their own money as a down payment so they really have none of their own money invested in the property. The only thing they lose by abandoning their house and mortgage is a hit on their credit report--but they lose nothing. Compared to the loss of value of their home they may consider that to be the better of the two options.

In my opinion, though, it all comes down to subprime lending. This was the first real news we got back in 2007 that there was an impending financial crisis--everything else has come as a consequence of that.

While the argument can be made that adjustable rate mortgages are to blame, I don't think that's the case. A financially responsible person with adequate means can look at market conditions and conclude that, in some cases, it might make sense to take an ARM loan over a conventional one, or an interest-only loan. Perhaps interest rates are extremely low and you're only going to be in the home for a couple of years--this allows you to live in a house, pay only the interest, but hopefully reap the benefits of a house that is increasing in value. Or perhaps you plan on living there for a long time but it makes sense to take advantage of a low initial rate to give you a year or two during which you can make large payments to quickly reduce the principal of your loan and then refinance to a fixed-rate of a much-reduced value since you'll have been applying relatively large amounts to principal for the initial period of the ARM.

While I personally would never gamble with an ARM, there is nothing inherently evil about an ARM for someone that 1) has good credit so it's clear that they're willing to meet their financial responsibilities even if it turns out they made a bad financial decision. 2) has sufficient income to cover those responsibilities.

Adjustable rate mortgages are the most common type of loans in the UK, Ireland, and Canada, and also common in Australia and New Zealand . In many countries a true fixed-rate mortgage isn't even available, normally because interest and inflation rates are so volatile that no bank would be willing to extend credit for 30 years at a fixed rate.

So the underlying problem isn't adjustable rate mortgages--it's the fact that these mortgages were marketed to people that didn't meet both (or perhaps met neither) of the above requirements, thus subprime. Indeed in the third quarter of 2007, a full 55% of the foreclosures were from subprime loans even though those subprime loans constitute only about 13% of all outstanding loans . In other words, 13% of the loans are causing 55% of the problem.

Based on the numbers from the previous link, subprime borrowers are generally five times more likely to default than prime borrowers. While an ARM loan does increase the risk of default by both prime and subprime borrowers, the single biggest factor is still the subprime rating of a client. And giving a subprime client an ARM loan is just a financially lethal combination. That's why these subprime ARM borrowers, while only accounting for 6.8% of outstanding loans, are currently responsible for 43% of the foreclosures.


Update 4/18/2009: An article seven months later highlights that subprime was indeed the trigger since, as the article points out, Canadian banks have remained profitable by having avoided sub-prime.


One place where none of this banking drama is taking place is Canada...

In fact, since the financial crisis began, American taxpayers have provided more than $300 billion dollars to more than 450 companies. During that same period, from their government, Canadian banks have not received one penny.

One reason: Take those infamous subprime mortgages given to risky homebuyers. They crippled banks in the U.S., where at peak, 25 percent of loans were subprime. In Canada? Three percent.

"Our U.S. subsidiaries did not do any subprime lending. Nothing. Zero," Clark said. "We just said, 'Stay away from this stuff. We know where this is going.'"...

One reason why Canada is the only industrialized nation in the world without a single bank failure in the current economic downturn.



So to try to figure out what caused the crisis we must evaluate what caused traditional fiscally conservative mortgage requirements to be thrown out the window and loans extended to applicants that would have traditionally been turned down due to a lack of income or lack of creditworthiness.

When/Why Did Lenders Lend to Subprime

The main necessary legal changes were made in 1982 in the form of the "Alternative Mortgage Transaction Parity Act of 1982" . This act allowed lenders to provide alternative mortgage instruments with variable rates, terms, etc. This was implemented to make sure that credit remained available during volatile economic times, the law itself being enacted within a few years of inflation rates hitting nearly 14% and mortgage rates of nearly 16% . In conditions such as these, federal and state regulations creating limits on the maximum interest rate and types of loans had the potential not of protecting consumers but of forcing banks to stop loaning money. When inflation approaches the maximum fixed interest rate and government tells banks they can't charge a higher interest rate, banks will simply stop loaning money. Thus the AMT Parity Act of 1982 addressed this problem by decreasing regulation to allow market forces to operate as much as possible within the market that actually existed.

Interest rates, however, actually followed a downward trend from a peak of about 15.80% in December 1981 and continued down until they hit 6.60% in December 1993 . Then they started going back up until hitting a maximum of 8.09% in April 1995. This led to a decrease in demand for traditional "prime" loans and drove lenders to start looking at adjustable rate mortgages as a way to loan money to people that wouldn't otherwise be able to afford it . Indeed, subprime lending became popular in the mid-1990's .

However, these loans were generally not held by the original lender or broker but rather sold on the secondary market. These loans were often purchased by Freddie Mac and Fannie Mae, or purchased directly by other investors. At that point the original lender has no risk: The purchaser of the mortgage (Fannie Mae, Freddie Mac, or some other investor) paid the original lender the full amount they loaned and now the party holding the mortgage held the risk. The sale of mortgages typically happens so fast that they'll reach the final investor before the first payment is even due--so the original lender or broker has virtually no risk of losing the money they loaned you as long as they sell your mortgage to someone else before you even make your first payment.

Once the loans were sold off by the mortgage lender or broker, it no longer mattered to them whether or not the debt was ever repaid because they already made their money at the moment they sold the loan package to investors. Indeed, the lenders were essentially loaning out money that didn't belong to them but to investors. With little of their own money at stake lenders had less incentive to verify the borrower's ability to pay. In addition, the growing investment market for mortgage-backed securities (based on the assumption that housing prices would continue to increase) meant there was more and more demand for mortgages. Further, this exploding securities market lead to more and more demand for higher and higher yields which could only be satisfied by lending to more and more high-paying subprime borrowers that would be willing to pay higher interest rates .

Thus lenders were rewarded not for the quality of the loans nor whether the borrowers could ever be expected to repay them, but were instead rewarded for the simple quantity of loans that were made, packaged, and sold to the investors. Increasingly lax requirements and loans being made to sub-prime borrowers was a logical result of all of this since the lenders (or mortgage brokers) selling loans to the customer didn't make money by identifying good candidates for credit but by making as many loans as possible regardless of risk.

The Collapse of Sub-prime Lending

So much of the lending in the last 10 years was based on the obviously flawed presumption that house prices would continue to increase at absurd rates. As long as that continued to happen it really didn't matter who you loaned money to. If you loan $100,000 to someone for a house and they can't pay it, you foreclose, reposses the house, and sell it for $130,000 by the time it's all done. If the consumer pays on time, the bank wins. If the consumer stops paying, the bank wins. There was no risk... or so it seemed at the time.

But no bubble lasts forever and when housing prices stopped their seemingly unstoppable march upwards in 2006 and even started to fall, people got nervous. Then some of those ARMs started resetting and subprime borrowers that could no longer afford them and couldn't sell their house without losing money simply stopped paying. The foreclosures began which put even more houses on the market which caused even further decreases in prices which led even more people to stop paying their mortgage. A vicious cycle ensued.

The real underlying problem was loaning money to subprime borrowers who had no business buying a house, but the problem was invisible as long as real estate prices continued to rise. Once they stopped rising and then started falling, the real underlying problem was painfully obvious: subprime lending.

Culrpit #2: Financial Derivatives ("Wall Street")

The next factor that contributed to the current crisis is the rapid increase in the use of more complex financial derivatives over the last two decades known as credit default swaps.

Credit Default Swaps for Municipal/Corporate Bonds

A credit default swap is a type of financial derivative which effectively amounts to insurance against something happening and can be used to insure a party that would be negatively effected by that "something" happening.

Originally credit default swaps (CDS) were used to insure the risk of municipal bonds. A pension might buy $10 million in municipal bonds and would then buy CDSs to protect that investment. If the bond was repaid as planned, the pension fund would get their money back and simply be "out" the money they spent on the CDS--much like buying homeowners insurance and not ever filing a claim. But if the municipal bond was not paid back, then the issuer of the CDS would pay the pension fund the money they lost. In theory, as long as the pension bought a CDS for each bond it purchased, there was no risk of the pension losing money. Municipal and corporate bond defaults were so unlikely at that time that, really, CDS were a cash cow for those who sold them.

Credit Default Swaps for Mortgage-Based Securities

More recently, however, banks started issuing bonds based on mortgages. Like municipal bonds, parties started trading in CDSs to insure the risk of those bonds. A credit rating agency would assign a risk grade to the mortgage-backed bond; that rating was usually quite optimistic since there was little perceived risk in a constantly-expanding housing market. An investment bank would then look at that relatively low credit risk and sell CDSs to insure those bonds. In the originally good market there was very little risk. Investment banks just racked up more and more income selling CDS and made healthy profits--as did those investors (and pension funds, etc.) that had invested in the investment banks.

However, when mortgages started to fail the investment banks that had sold CDS's had to start reimbursing the holders of CDS's for their increasing losses. This was the financial equivalent of "Hurricane Katrina of the Gulf States" or "The Next Big Earthquake in L.A." They had effectively been collecting insurance premiums for years and now it was time to pay the claims.

But to make matters worse, not only was the holder of the mortgages allowed to purchase CDS's for those mortgages, third parties could too. For example, 10 people could obtain mortgages. Those would be packaged together and sold as a bond. Investor "A" could buy that bond (essentially providing the money for the 10 loans) and buy a CDS from Investment Bank "Z" to insure the bond so that they would be protected if the mortgages weren't repaid and the bond defaulted.

However, this isn't really insurance and insurance regulations don't apply. They were simply contracts based on a company estimating risk and trying to make a profit off of it. That being the case, investors "B", "C", "D", and "E" could also buy CDS's from Investment Bank "Z" (or bank "X" and "Y") on the bond held by investor "A" even though those additional investors didn't buy the bond itself. They were basically gambling on whether or not someone else's bond failed. So when the homeowners eventually stopped paying their mortgages and the bond failed, investment banks not only had to pay up to investor "A" that held the bond, but also had to pay investors B, C, D, and E! So a $250,000 default could easily turn into a loss of millions of dollars for the sellers of CDS's--it just depended on how many CDS's they had sold on that bond issue.

This is akin to a homeowner buying homeowner's insurance on his house--and all the other neighbors also buying insurance on that same house. They all pay premiums but if that one house burns down the insurance company (or companies) have to pay all of the people that had taken out insurance on that one house. Again, this isn't illegal because CDS aren't insurance and aren't regulated as such. CDS's are simply contracts between parties and based on the confidence of each party that both sides will live up to their contractual obligations. And CDS can be issued on other CDS's.

Credit Default Swaps & Derivatives Self-Destruct the Market

Bear Stearns, Lehman Brothers, AIG, Freddie Mac, Fannie Mae--all institutions that have been rescued by the government or allowed to go bankrupt this year--were all exposed to losses due to credit default swaps and other related financial derivatives . And, lest we forget, financial wizard Warren Buffet in 2003 called derivatives "financial weapons of mass destruction." Mr. Buffet essentially foresaw this contingency back in 2003 .

So the problem is clear enough, but it is made worse by the fact that many private investors, retirement accounts, and pensions may be invested in companies that sell these CDSs and which are being devastated by having to pay all those "claims" from CDS they had sold. Likewise, pensions/investors/retirement accounts may have actually bought mortgage-backed securities and CDS's to insure those securities; now that the mortgage-backed securities are failing, they are trying to "file claims" based on the CDS's they hold and finding that the CDS's they bought are not paying their claim... because the company that sold the CDS has gone bankrupt or doesn't have enough liquidity (cash) to pay the claim. So retirement accounts, pensions, and individual investors stand to lose a lot of money as Wall Street companies suffer huge losses or go bankrupt.

And, additionally, if banks that make day-to-day credit available for the financial markets are brought down by CDS losses, all of a sudden a huge chunk of the credit market disappears and there's no money available to borrow.

Culprit #3: Fannie Mae/Freddie Mac ("Politicians")

The whole cascading problem of CDS's began, however, when the government took over Freddie Mac and Fannie Mae. Fraud and mismanagement at these two companies, along with their growing exposure to the sub-prime market and its related losses, were leading to a situation where the companies would not be able to pay their bonds. Trillions of dollars of CDS's had been issued to guarantee bonds issued by these government-sponsored entitites. Since there was an implicit understanding that the government would bail out these two companies if they got in trouble, lots of CDS's were issued to guarantee Freddie Mac/Fannie Mae bonds since so many sellers thought the bonds of these companies could never fail.

But when the government took over the two companies and put them in a conservatorship on September 7th, 2008 , that was essentially a de facto bankruptcy. This was a "CDS event" which meant those that had purchased CDS's to insure against a default of Freddie Mac/Fannie Mae defaults were within their rights to demand a payout. Even though the government's bailout actually made it far less likely the actual bonds would be defaulted on, the very fact that the two companies had essentially gone bankrupt was enough to put the bonds into technical default and cause the trillion-dollar CDS cascade to begin .

The first casualty happened just a week later: Lehman Brothers investment bank declared bankruptcy on September 15th, 2008 and became the largest bankruptcy in U.S. history with over $600 billion in debts. While Lehman Brothers had already started a steady march downward due to exposure in the sub-prime market, the final collapse happened promptly after the Freddie Mac/Fannie bankruptcy which triggered the CDS's. This may have been caused because Lehman Brothers had issued CDS's insuring Freddie Mac and Fannie Mae or it may simply have been because investors feared they had and no-one really knew. In either case it is not a coincidence that this company failed within a week of Freddie Mac's and Fannie Mae's collapse.

The failure of Lehman Brothers was itself a CDS event since other parties had issued CDS's to ensure against the default of Lehman Brothers--when Lehman Brothers went bankrupt, the CDS's that "insured" them were triggered continuing the cascade .

Then American Insurance Group (AIG), which also had huge exposure to credit default swaps, started spiraling down until it was ultimately rescued by the government with $85 billion on September 18th .

But regardless of the ultimate casualties, the whole cascade of credit default swap triggers seems to have begun with Freddie Mac and Fannie Mae having technically gone bankrupt when the government took them over on September 7th, 2008. Things had been festering due to the sub-prime meltdown but it wasn't a threat to the overall economy until the Freddie Mac/Fannie Mae bailout caused all the CDS's to be triggered--within three weeks Lehmans Brothers, AIG, Washington Mutual, and Wachovia all failed or were bought out in fire sales... and it remains to be seen what other companies will fail in coming weeks.

The $700 Billion Bailout

As of this writing, politicians in the House and Senate have announced that they have reached an agreement for a $700 billion bailout . This bailout essentially consists of the government buying the assets that are causing uncertainty and potential risk to the market.

The whole purpose of the bailout is to prevent the issuers of CDS's from having to make the payouts that would be required under the contracts and which, if allowed to occur, would bankrupt those companies as well as many pension funds, retirement accounts, and individual investors that are invested in those markets. The total amount of bad mortgages may only be a few hundred billion dollars, but if those debts were allowed to go bad then there would be a cascading effect as trillions of dollars of CDS's were activated and caused other companies to fail, and so on.

The bailout isn't so much of the mortgage industry but of the derivatives industry that has been built on top of it. The collapse of the mortgage industry would be tough but survivable--but the trillions of dollars of defaults caused by CDS's would provoke an economic catastrophe all across the economy. Essentially, the hundreds of billions of bad mortgages would be a significant hit to a $13.8 trillion dollar economy. However, the activation tens of trillions of CDS's would potentially create liabilities that are many times the gross domestic product of the country. It would make credit extremely scarce and could wipe out the investments, retirement accounts, and pensions of millions of people around the country. And--as has been said by President Bush, Democrats, and Republicans--this would be an economic crisis of epic proportions that could easily rival, if not surpass, the Great Depression. The United States--in fact the entire world--simply doesn't have enough wealth to settle the tens of trillions of dollars of CDS's.

The interesting point is that the assets in question are not worthless. At the end of the day, every mortgage represents a very real physical asset: a house. Even if the loan was for $300,000 and the house is only worth $200,000, it's not a total loss. And, given a few years, it may very well be worth more than the loan value. That's why politicians are suggesting that the government might even eventually make money off the whole thing.

Was the Bailout a Good Idea?

Given the scenario described above it's clear that something had to be done. The CDS's could not be allowed to fail and cause a cascading multi-trillion dollar meltdown. Regardless of who is to blame, there should be no doubt that this crisis is very real and can and will effect the entire economy, from Wall Street to Main Street, and everywhere and everyone in between. The question is not whether or not government should act but how it should act.

It seems, however, that the proposal of the House Republicans was a much better alternative. The House Republicans proposed that rather than purchasing all the questionable assets for hundreds of billions of taxpayer dollars, the government should simply sell insurance to the financial industry to insure the repayment of the loans making up the mortgage-backed securities. Thus the financial industry would pay a premium to insure those securities and the government would use those premiums to pay for any defaults. Since the government would be insuring the mortgages, the mortgage-backed bonds would not default and there would be no triggering of a cascading meltdown caused by under-funded credit default swaps.

Given that the House Republicans plan would have achieved the exact same result without spending hundreds of billions of taxpayer dollars, I'm quite baffled as to why their plan was not implemented. Apparently it is included to a certain degree in the final plan as an "option," but I do not understand why it was not the entirety of the plan. I don't see any particular benefit in the government purchasing hundreds of thousands of loans that may or may not fail--it should only be necessary to repay (i.e. insure) those loans that do fail if they fail and when they fail.

The only legitimate reason that occurs to me is if politicians thought that having the government announce such a huge bailout would further reassure world markets that there was nothing to fear. NOTE: After I wrote the previous sentence, but before I published this article, I found out that I was exactly right. Regarding the $700 billion figure, a Treasury spokeswoman told Forbes that "It's not based on any particular data point. We just wanted to choose a really large number." .

I personally believe that the House Republicans plan would have been sufficient and would have cost far, far less than the plan that apparently will be passed this week; and would have accomplished the same thing without the need to effectively nationalize huge swaths of the financial industry.

Edit September 29th, 2008 at 12:30pm: The House of Representatives has voted against the bailout and the Dow Jones as dropped about 600 points. Again, it's clear that something has to be done but I hope that the rejection of the bailout opens the opportunity to craft a bailout plan that is much more in line with the House Republicans proposal.

Who's Fault Is It?

There has been a lot of political finger-pointing. Some Republicans accuse Democrats of strengthening the Community Reinvestment Act (CRA) which required banks to make questionable loans to persons that might not normally qualify for the loans--this in the interest of making sure banks do not discriminate. Freddie Mac and Fannie Mae participated in this effort and, beyond that, there is absolutely no question that Freddie Mac and Fannie Mae--very likely the primary cause of the immediate meltdown--were fraudulently operated by corrupt CEOs who had a vested interest in concealing losses in order to increase their bonuses. Meanwhile, Democrats accuse Republicans of not sufficiently regulating the market and essentially making this out to be a failure of the free market system and an indictment of deregulation.

So who's right? To some extent everyone. And no-one.

Community Reinvestment Act (CRA)

The Community Reinvestment Act (CRA) was a Democratic invention of the Carter Administration and which was strengthened by President Clinton. The purpose of CRA was to make sure banks didn't discriminate--a good idea, in theory, if properly implemented.

But President Clinton, in 1995, pushed to have the evaluation of CRA compliance based not on subjective assessment but based on strict numeric analysis. That meant that, essentially, if a bank wasn't loaning the "right" amount of money to minorities and low-income clients, etc. that they would be found to be in violation--even if the reason minorities weren't receiving the same amount of loans was because they weren't credit-worthy . This obviously lead to the beginning of the sub-prime market as most (if not all) of these CRA-driven loans were not made to prime borrowers that would normally be accepted by Freddie Mac and Fannie Mae. It all began with the first securitization of CRA loans in October 1997 and snowballed from there.

Banks would normally have not been inclined to lend money to uncreditworthy borrowers but the government essentially compelled them to. In the exploding housing market with constantly-increasing house prices it turned out that even these high-risk borrowers were not defaulting because even if they couldn't afford the mortgage they could just sell their home. At a profit. At that point the free market took over. It figured that if these highly-profitable sub-prime securities weren't defaulting, heck, they might as well start getting into the market as well. And it worked fine for a number of years... as long as home prices continued to increase.

The Community Reinvestment Act was an ostensibly noble effort to help the poor in our economy. But despite their presumably good intentions, it should be painfully obvious--especially today--that forcing banks to lend money to people that have bad credit or insufficient income is not a good idea. While it is impossible to know whether or not banks would have dared to have made these bad loans had they not been compelled to by the government, it seems pretty unlikely--after all, that was the whole reason for the CRA! The mortgage industry was pretty darned stable for decades but after about a decade of government-compelled loans to people that couldn't afford them, everything came crashing down.

The free market definitely loaned to more sub-prime borrowers than the government required, but that's only because it seemed that the government-required high-risk loans were very profitable. Government regulations instituted by the Clinton administration in 1995 forced banks to make loans to sub-prime borrowers which were the seeds that convinced the free market that doing so was actually a good idea.

The Democrats wanted the market to loan more money to people of limited means and that's exactly what the market did. Yes, the market did loan to more sub-prime than the government mandated with a profit motive, but what did they expect?

This is definitely a failure of policies that were championed by the Democratic party and was caused not by a lack of regulation but rather over-regulation of the mortgage industry.

Update 2/16/2009: In an interview, Bill Clinton said: "Some of the conservatives said that I was responsible because I enforced the Community Reinvestment Act, and they said that's what made all these subprime mortgages be issued. That's also false. The community banks, the people that loan their money in the community instead of buying these esoteric securities, they're doing quite well. " I don't know if community banks are doing quite well or not, but that doesn't change the validity of anything stated above. Very few community banks actually extend mortgages--they are brokers who turn around and sell the mortgages to those that buy "esoteric securities." If community banks that made bad loans are doing well, it's because they sold those bad loans to entities that are now doing poorly.

Lack of Regulation in Credit Default Swaps (Derivatives)

While there was too much regulation in the mortgage industry (in the form of the Community Reinvestment Act described above), there was arguably not enough regulation of the derivatives market--including credit default swaps.

The potential risk posed by the mis-use of derivatives was known at least as far back as 1994 when Congress asked whether derivatives could "topple a major financial institution or even threaten the financial system" , and the House Banking Committe issued a 900-page report on the derivatives market back in 1993 . Even back then there was a significant discussion about the need (or not) for more regulation in the derivatives market.

The derivatives market is a tough thing to regulate, though, because it is extremely complex and is essentially made up of contracts between private parties. If I say, "Give me $5 and I'll insure your $50 investment in food is covered for your BBQ tomorrow if it rains" then that's a private decision between you and me. We have the right to engage in any contracts we want to; if it then rains and I don't give you the $50 I owe you, again, that's between you and me. The government is rightfully shy to get in the way of the right for two parties to engage in contracts between themselves.

Added to that, derivatives are extremely complex and politicians have time and time again realized that they simply do not know enough about them to regulate them. It would be like having politicians create regulations that state exactly how certain computer programs must be written when they certainly don't know anything about computer programming. Indeed, ill-advised regulations can be more damaging than no regulations at all. And that's essentially the view politicians have taken over the last two decades.

Further, the potential for a massive derivatives crisis effecting the entire economy had been looked at as theoretical. In the cases where derivatives had caused problems, the market looked after itself. In 1998, many banks even got together to bailout another bank, Long-Term Capital Management, to prevent a massive failure in the derivatives market . So it seemed that when there was a crisis caused by the market, the market was able to bail itself out.

It seems clear, especially now, that more regulation of the derivatives market is necessary. However, at the time it was not clear that regulation was necessary, it was not clear whether regulation would cause more or less problems, and it seemed that the market could bail itself out of any problems that might come along.

In any case there was certainly no deregulation of the derivatives market by Republicans... there was simply a lack of regulation in a relatively new and complex market that few politicians even understood. Republicans or Democrats. As has been said, the 21st-century economy was operating under 20th-century regulations. Regulations hadn't caught up with modern financial products. That is completely true.

Update 2/16/2009: In an interview, Bill Clinton said: "I think that the only thing that our administration did or didn't do that we should have done is to try to set in motion some more formal regulation of the derivatives market." Clinton's statement confirms exactly what I previously wrote in the above paragraphs back in September.

Freddie Mac and Fannie Mae Fraud

As was explained above, the collapse of Freddie Mac and Fannie Mae seem to have been the triggering event for pretty much the entire economic crisis that has unfolded over the last few weeks. The collapse of these companies were due to increased exposure to the sub-prime market (as compelled by the Community Reinvestment Act and the resulting explosion in the housing market, as described above) and by outright fraud by the CEOs of the companies.

The fraud that was perpetrated at Freddie Mac and Fannie Mae really warrants an article of its own.

But, briefly, Jim Johnson (Former CEO of Fannie Mae) deferred $200 million in expenses at Fannie Mae in order to increase his own bonus; he also personally received preferential mortgage terms from the CEO of Countrywide at the same time that Fannie Mae was the largest purchaser of Countrywide mortgages . Franklin Raines also was CEO of Fannie Mae, received preferential mortgage terms from Fannie Mae's client Countrywide, also received a $3 million loan, and was eventually prosecuted--he gave up over $6 million to settle the case .

During this time, certain politicians--particularly those involved in the banking and housing committees--received preferential mortgage terms from Countrywide .

Freddie Mac and Freddie Mae are now under investigation by the FBI for fraud.

Back in 2003, reports were made by outside investigators that Freddie Mac "manipulated its accounting to mislead investors, and critics have said Fannie Mae does not adequately hedge against rising interest rates." As a result, President Bush recommended "the most significant regulatory overhaul in the housing finance industry since the savings and loan crisis." .Rather than Republicans promoting deregulation, this was an instance of Republican President Bush recommending more regulation.

And, interestingly, this was a case where Democratic congressman were actually opposed to such regulation. Ranking Democrat on the Financial Services Committee, D-Barney Frank of Massachusetts, said "These two entities -- Fannie Mae and Freddie Mac -- are not facing any kind of financial crisis. The more people exaggerate these problems, the more pressure there is on these companies, the less we will see in terms of affordable housing." Another Democrat, Melvin Watt from North Carolina, agreed "I don't see much other than a shell game going on here, moving something from one agency to another and in the process weakening the bargaining power of poorer families and their ability to get affordable housing".

Five years before the current crisis, it appears that President Bush was advocating for more oversight of a "broken" Freddie Mac/Fannie Mae while Democrats were arguing against it, claiming that the two entities--later subject to a $200 billion bailout--were "not facing any kind of financial crisis."

So while Bush (and, in 2005, John McCain ) were sounding the warning bells about Freddie Mac and Fannie Mae, Democrats were resisting regulation--all the while receiving preferential treatment from the industry.

1999 Deregulation of Banking Industry

The Gramm-Leach-Bliley Act in 1999 allowed banks to get back into investment, commercial banking, and insurance industries--something which had been prohibited since the Great Depression by the Glass-Steagall Act. This change was proposed by Republicans but eventually was passed by overwhelming bipartisan majorities (90-8 in the Senate and 362-57 in the House) and was signed by President Clinton.

Democrats have been attempting to point to this deregulation as a cause of the current crisis and blaming Republicans. This is absolutely absurd. The deregulation covered in the Gramm-Leach-Bliley Act simply allowed banks to enter other industries. It had nothing to do with sub-prime lending nor with credit default swaps, both of which could have occurred even without the passage of the 1999 change. It just happens to have been the most recent change to banking laws prior to the current crisis and it was championed by Republicans so it becomes a convenient target.

But the Gramm-Leach-Bliley Act was passed by overwhelming bipartisan majorities and signed by President Clinton at then-Treasury Secretary Robert Rubin's urging .

It's clear that the Gramm-Leach-Bliley Act of 1999 had nothing to do with the current crisis; but even if it did, it was an overwhelming bipartisan decision. It is folly for the Democrats to point to this and try to blame Republicans. If the Democrats thought this Clinton-era deregulation was a bad idea it sure wasn't evidenced by their votes.

Update 2/16/2009: In an interview, Bill Clinton said: "They're wrong in saying that the elimination of the Glass-Steagall division between banks and investment banks contributed to this. Investment banks were already...banks were already doing investment business and investment companies were already in the banking business." Clinton's statement confirms exactly what I previously wrote in the above paragraphs back in September.

On balance it seems to me that if anyone is to blame, it's the Democrats. The Democrats are the ones that pushed for more application of the Community Reinvestment Act which is definitely the original cause of the sub-prime crisis. The Democrats are the ones that were actively involved in the fraud at Freddie Mac and Fannie Mae and which eventually led to their bankruptcy and the triggering of the CDS's which has caused the current financial meltdown. And the Democrats are the ones that resisted more regulation of Freddie Mac and Fannie Mae at a time when their Democrat CEO was engaging in fraud.

If Republicans are at fault for anything, it's that they didn't pass any regulations regarding the CDS's... but then, neither did Democrats.

What Should Be Done to Fix It?

I'm sure there will be changes in regulations--some of the changes will probably be necessary while others will be "tacked on" as special interests use this crisis as an opportunity to get their ideas into regulations.

It seems that only three major changes or new regulations need to be implemented to prevent this kind of thing from happening in the future:

1. No Sub-Prime Lending. Obviously the mortgage industry needs to go back to its conservative traditions and only loan money to those that can reasonably be expected to pay it.
   
2. No Government-Mandated Lending. Government regulations, such as the Community Reinvestment Act, should be repealed. Regardless of any good intentions there may have been, forcing banks to lend money to people that can't afford the loans is bad, bad policy and is what led to the sub-prime fiasco in the first place .
   
3. Limit Credit Default Swaps. In light of the current crisis, it seems clear to me that CDS's should only be issued to investors that actually hold the bond that those CDS's are designed to insure, and that only parties that can demonstrate they have the financial assets to truly insure those bonds should be allowed to sell CDS's. This will require debating and a lot of legalese to define as it does interfere with the right of two parties to engage freely in contracts. But much of the crisis today would be eliminated if these two regulations had been implemented in the past. Update 3/24/09: Almost six months after I wrote this article and made the previous recommendation, Wall Street financier George Soros made the same recommendation: "Only those who own the underlying bonds ought to be allowed to buy them [CDS's]."

Free Market Didn't Fail, Massive New Regulation Not Required

In conclusion, it seems to me that deregulation is not what caused this crisis. Nor is it necessary to set up entirely new governmental agencies with massive and invasive power in the markets. We simply need to respect traditional, conservative investing techniques.

Government should stop interfering in the market with things such as the Community Reinvestment Act. And government should start implementing regulations in the derivatives market to make sure that CDS's are only issued to those that have a stake in the bond being insured, and making sure that those that issue CDS's actually have the financial strength to be able to pay the "claim" when a CDS is triggered.

I don't think the current crisis is a condemnation of deregulation but rather a testament to the results of having the wrong regulation. The current crisis is certainly a mess but we aren't going to improve things by adding the wrong kinds of regulation. Keep it simple. Just legislate that those who receive loans have to be in a financial situation that makes it reasonable to believe they'll actually pay it back, and add a few regulations to make sure that derivatives are used to manage risk rather than engage in speculation--that is to say, gambling.