(Adapted from the book Capital Offense: How Washington’s Wise Men Turned America’s Future over to Wall Street.)
Many on the right still contend that Fannie Mae and Freddie Mac, the giant, quasi-governmental lending institutions, were the real cause of the 2008 financial crash. They insist that most of what went wrong can be laid to government housing policies, in other words. During the subprime mania, Fannie and Freddie ended up buying more subprime mortgage-backed securities than any other institution, abetted by the Bush administration, which gave them low-income credits to do so. This is what really drove the mania, many Republicans say. Indeed, the Financial Crisis Inquiry Commission appears to be headed into a raucous final few weeks of disagreement over this issue, with Republican members pledging not to support a final report that lays most of the blame on reckless deregulation and Wall Street.
Unfortunately for the blame-the-government crowd, the facts don’t bear out their conclusions. Yes, Fannie and Freddie are government sponsored, but they’re run by shareholders looking for a substantial return. And the prime force that was driving them and just about everyone else in the world to take risks was Wall Street, which kept looking for higher returns. Indeed, Fannie and Freddie didn’t go nearly as far out on a limb as other lenders, and they hadn’t actually created derivative products themselves.
Beyond that, the seeds of the financial crash of 2008 were planted decades before the subprime securitization market took off. Some of the books that came out after the financial disaster would encourage another myth -- that the super-complex subprime securities known as “collateralized debt obligations,” or CDOs, were unique. And that therefore the subprime mortgage crisis was also a unique disaster. “The collateralized debt obligation may well go down in history as the worst thing anyone on Wall Street has ever thought up,” wrote David Faber of CNBC in one quickie book, And Then the Roof Caved In.
But Faber’s description slighted a long lineage of such complex derivatives and structured finance products going back to the early 1990s. Such problems were so prevalent that Brooksley Born, then head of the Commodity Futures Trading Commission, called them “the hippopotamus under the rug.” The key to many successful derivatives trades was just as much deception back then as it later became during the subprime craze. “Quants” on the street -- many of them former physicists or other math geniuses -- were always finding complex new ways to repackage assets. The schemes usually followed the same theme: The key was to take junk or crap -- risky but very high-yielding bonds or securities denominated in pesos or Thai baht or Malaysian ringgits -- and disguise them well enough so that pension investors or insurance companies or others thought they were buying investment-grade stuff denominated in dollars. This was merely an augury of what these same firms later did by euphemizing poor credit risks as “subprime borrowers.”
Mini-blowups began happening in the the’90s, but the warning signs were ignored. Tempted by the high yields, state, county, and local investment funds that were supposed to be playing it safe began indulging in highly risky derivatives trades under cover. The temptation of showing great returns to one’s board of directors, looking like a market whiz, was just too great. And one by one, they began going up in smoke. At one point, 18 Ohio towns lost $14 million. City Colleges of Chicago lost almost its entire investment portfolio -- $96 million. In 1995, the Wisconsin Investment Board abruptly announced a $95 million loss, $60 million of which was linked to investments in the Mexican peso. These state and local funds had no business investing their citizens’ money in high-risk currency trades; in fact, most were banned by law from indulging in such speculation. But somehow they felt they could do it if they were packaged as derivatives.
Some of these scandals were so astonishing in scope and criminality that they should have raised at least a few warning flags back in Washington. Orange County, California, under its treasurer, Robert Citron -- a college dropout who consulted psychics and astrologers about interest rates -- had lost a billion dollars and filed for bankruptcy in 1994. Again, it was a case of a Wall Street firm, Merrill Lynch, knowingly selling Citron investments that were so complex he simply could not comprehend them. But no one did anything. As the speculative collapses continued, there were no rules in place to stop them -- no requirement as there was on exchanges for mark to market or paying margin on a daily or intra-daily basis.
As the years went by, the only change that occurred despite the regular blowups was even more deregulation. No wonder that the subprime securitization mortgage market later took off the way it did, leading to the bizarre world of CDOs. After all, at the start, CDOs were only the latest, “improved” version of a model long in the making, the process of turning dubious or bad assets into better-seeming securities while the adults weren’t watching, while central bankers were no longer getting their hands dirty with worrying about exposure. It was a process that was possible only with derivatives, when buyers were increasingly distant from the underlying asset, and when no one was monitoring production.
In his public comments, Fed Chairman Alan Greenspan kept saying again and again that derivatives were just diffusing risk through the system, parceling it out in little pieces, making everyone individually safer. That was true, but this process was also infecting the entire system with risk, and thereby making the total risk greater. Trade by trade, instrument by instrument, through CDOs and credit default swaps and the rest, every major market player was becoming systemically linked up with everyone else.
After 20 years of free-market fervor, the world of the mid-’00s had become one of overleveraged banks too big to regulate and trillions of dollars worth of derivatives bets that no one had track of -- which in turn were helping to accelerate huge flows of capital coming in from abroad -- and a Fed and government regulators who weren’t aware or weren’t watching.
And that was the real cause of the crisis, whose aftereffects continue to drag on the economy today. Fannie and Freddie were, like almost every other big player, both culprits and victims, but just two of many.