President Bush, his Securities and Exchange Commission appointees, other free-enterprise dogmatists who have stood in the way of regulating risky and opaque financial manipulations, and greedy Wall Streeters deserve the blame heaped on them for the financial meltdown that has so severely shaken America.
But the pretense of many Democrats that this crisis is altogether a Republican creation is simplistic and dangerous.
It is simplistic because Democrats have been a big part of the problem, in part by supporting governmental distortions of the marketplace through mortgage giants Fannie Mae and Freddie Mac, whose reckless lending practices necessitated a $200 billion government rescue last month. It is dangerous because misdiagnosing the causes of the crisis could lead both to regulatory overkill and to more reckless risk taking by Fannie, Freddie, or newly created government-sponsored enterprises.
Fannie and Freddie aside, it's worth pointing out that many, if not most, of those greedy Wall Street barons are Democrats. And that the securities and investment industry has given more money to Democrats than to Republicans in this election cycle. And that opposing regulation of risky new financial practices by private investment banks and others has been a bipartisan enterprise, engaged in by the Clinton and Bush administrations alike.
But the roles of Fannie and Freddie are my focus here. Powerful Democratic (and some Republican) advocates of affordable housing, including Senate Banking, Housing, and Urban Affairs Committee Chairman Christopher Dodd, D-Conn.; Sen. Charles Schumer, D-N.Y.; and House Financial Services Chairman Barney Frank, D-Mass., have been the GSEs' most potent and ardent champions in recent years. Meanwhile, the agencies and their employees have orchestrated a gigantic lobbying effort (costing more than $174 million between 1998 and 2008). They have also made campaign contributions of more than $14.6 million between the 2000 and 2008 election cycles, with some of the largest going to Dodd and Barack Obama.
A leading illustration of this Democrat-GSE symbiosis came in summer 2005. The Senate Banking Committee adopted a bill to impose tighter regulation on Fannie and Freddie, with all Republicans voting for it. But the Democrats voted against it in committee and killed it on the floor.
Also in 2005, Fannie and Freddie began buying vast amounts of subprime and "alt-A" mortgages with, in many cases, virtually no down payments, that had been taken out by people with low credit scores and low incomes relative to their monthly payments. To finance more and more affordable housing, as leading Democrats, and some Republicans, had urged, the GSEs dramatically lowered their traditional underwriting standards.
Between 2005 and 2007, Fannie and Freddie "sold out the taxpayers" by financing almost $1 trillion in such highly risky mortgages, according to "The Last Trillion Dollar Commitment: The Destruction of Fannie Mae and Freddie Mac," a carefully researched essay posted on the conservative American Enterprise Institute's website by Peter Wallison of AEI and Charles Calomiris of Columbia Business School.
They base their trillion-dollar figure, which is much higher than most published estimates, on detailed analysis of what they call "accounting practices that made it difficult to detect the size of those exposures."
Fannie and Freddie appear to have played a major role in causing the current crisis, in part because their quasi-governmental status violated basic principles of a healthy free enterprise system by allowing them to privatize profit while socializing risk. That is, their special privileges as GSEs -- created decades ago to promote homeownership by buying mortgages from banks, which could then use the cash to make more loans -- enabled them to lend at high rates to reap enormous profits for their private stockholders and executives and to borrow at low rates based on the government's implicit promise to rescue them from any failure, as it has now done.
Unbeknownst to the investment banks, the experts at Fannie and Freddie knew very well that their bosses were taking reckless risks.
Many conservatives have gone so far as to blame Fannie, Freddie, and their Democratic sponsors for the entire meltdown. Some (not including Wallison and Calomiris) also blame the Community Reinvestment Act of 1977, which forced banks to lend and invest more in minority and low-income areas.
This accusation has spurred furious rebuttals by Democrats and their media friends. Some have been well reasoned. Some -- especially a July 14 column by New York Times columnist Paul Krugman, who was awarded the Nobel Prize in economics this week -- have been flat-out incorrect.
As Wallison and Calomiris demonstrate, Krugman was egregiously wrong in writing that "Fannie and Freddie had nothing to do with the explosion of high-risk lending." He was wrong again in stating that "they didn't do any subprime lending, because they can't ... by law." He was further wrong in writing that the GSEs were "tightly regulated with regard to the risks they can take."
Others in the don't-blame-Fannie-and-Freddie camp reasonably point out that private Wall Street investment banks and others financed even more of the $3 trillion in substandard mortgages than Fannie and Freddie did, and that these investment banks and many of the mortgage lenders who made (and then sold) the loans were not covered by the Community Reinvestment Act.
Wallison agrees that the 31-year-old law does not appear to have been a major cause of the current crisis. He also notes that although the Clinton administration pushed the GSEs to finance more affordable housing by purchasing subprime mortgages, it was not until 2005 that the GSEs began financing risky loans in huge amounts.
Why did Fannie and Freddie dive into the subprime mortgage market? And were their practices just one facet -- or the most important cause -- of the crisis? The questions are related and the answers debatable.
Freddie and then Fannie had been ravaged in 2003 and 2004 by accounting scandals that led to the departures of top executives, including Fannie Mae CEO Franklin Raines, a former Clinton administration official who had collected $90 million in compensation from 1998 through 2004. The scandals brought warnings from Alan Greenspan, then the powerful chairman of the Federal Reserve Board, that the government should restrain the mortgage giants' growth. Meanwhile, three Fed economists published a study casting doubt on whether Fannie and Freddie had much effect on mortgage interest rates. All of this put the two agencies on the defensive in Congress.
By the time Daniel Mudd succeeded Raines in 2004, according to an in-depth New York Times article on October 5 by Charles Duhigg, "his company was under siege. Competitors were snatching lucrative parts of its business. Congress was demanding that Mr. Mudd help steer more loans to low-income borrowers. Lenders were threatening to sell directly to Wall Street unless Fannie bought a bigger chunk of their riskiest loans.
"So Mr. Mudd made a fateful choice," Duhigg wrote. "Disregarding warnings from his managers that lenders were making too many loans that would never be repaid, he steered Fannie into more-treacherous corners of the mortgage market, according to executives.
"For a time, that decision proved profitable. In the end, it nearly destroyed the company and threatened to drag down the housing market and the economy."
(So much for Krugman's analysis.)
Duhigg added, "The ripple effect of Fannie's plunge into riskier lending was profound. Fannie's stamp of approval made shunned borrowers and complex loans more acceptable to other lenders, particularly small and less sophisticated banks." The banks had little incentive to avoid risky loans as long as they could sell them to the GSEs and others long before any defaults.
Duhigg also implies, however, that Fannie and Freddie joined the junk-mortgage binge, rather than led it, to avoid losing business to private companies such as Bear Stearns, Lehman Brothers, and Goldman Sachs. Other analysts plausibly argue that what started the ball rolling was an August 2004 decision by the big bond-rating agencies, Moody's and Standard & Poor's, to loosen their guidelines for rating mortgage-backed securities.
Wallison and Calomiris disagree. "The most plausible explanation for the sudden adoption of this disastrous course [by Fannie and Freddie] is their desire to continue to retain the support of Congress after their accounting scandals in 2003 and 2004," they argue. In an October 15 Wall Street Journal op-ed, Wallison adds, without qualification, that this was "the source of the financial crisis we are wrestling with today."
But why would investment banks take foolish risks with their own money, as well as that of investors, just because Fannie and Freddie were doing so? In an interview, Wallison theorizes that the companies wrongly assumed that these must be sound investments because the leading experts on the mortgage market -- Fannie and Freddie, with their vast databases and sophisticated computer programs -- thought so. But unbeknownst to the investment banks, the experts at Fannie and Freddie knew very well that their bosses were taking reckless risks.
Perhaps a congressional investigation will someday sort out the extent to which Congress itself -- by pressuring Fannie and Freddie to take such risks -- brought about the current crisis.
This article appears in the Oct. 18, 2008, edition of National Journal.