Some have called them the Nine Words of Reagan: “Government is not the solution; government is the problem.”
I still hear this in the Libertarian/Tea Party catechism. A recent post on Patheos, The Silence Before the Restoration, writes poignantly about the emptying of the “Inland Empire” just east of Orange County in California due to housing foreclosures, and takes a swipe at “a body of sclerotic political ideas, translated decades ago into policies that are now failing on a colossal scale.“
To me, this means the disastrous neoconservative ideology of Reagan and the rigid ideologues who follow in his footsteps, including modern Republicans, Conservatives, Tea Baggers, and Hung-Dog Democrats. For those worthies, it means the New Deal crafted under Franklin Roosevelt, particularly Social Security. The article above does nothing to clarify what the author means, but based on her previous writings, I think she is probably referring to the New Deal. It doesn’t really matter, though.
What bothers me deeply about this kind of discussion is the shallowness and the fact that it stops at finger-pointing.
I can’t claim to be an expert on the 2008 financial collapse that led to the “Silence” the above author bemoans, but I do know a little bit about it, just from reading and putting stuff together. Let’s walk through it, because I think it leads to an interesting place.
Let’s begin with the collapse itself.
First, the widely-accepted trigger for the collapse was the unravelling of the “subprime mortgage” bubble. A few pieces of background are needed to grasp this.
First, mortgages have always been considered “safe” loans because they are backed by collateral, namely the house. If you default on your mortgage, the bank forecloses and sells your house to pay off the remainder of the loan. Since the bank only needs to recover the balance on the loan, they sell at “foreclosure” prices — a fraction of the actual market value — so banks have rarely had to worry about getting stuck with a property for very long once the paperwork clears.
Second, if you look at the payment schedule, you’ll notice that you don’t really start paying off the loan until about halfway through. The interest is “amortized,” meaning that your first mortgage payment to the bank is almost 100% interest — you might pay back a few dollars of your debt, but the rest of the fixed monthly payment is pure interest. By halfway through the loan, you’re paying about 50% interest, and 50% on the loan with each payment. By the last payment or two, you are paying almost no interest, you’re just paying back the loan.
What this means is that bank has made most of its profits from the loan within the first few years. After that, the loan isn’t worth nearly as much to them. So within a few years after initiating a new mortgage, banks are happy to sell the mortgage to some other bank or holding company. The buyers like these loans because even though they don’t make as much money, they are quite a bit safer than the original mortgage — if you haven’t defaulted in the first couple of years, odds are (or at least used to be) that you never will.
Third, in 1933 the Glass-Steagall Act was passed to address some of the banking excesses that resulted in the Great Depression. Among other things, this separated commercial banks from investment banks. In 1999, the Gramm-Leach-Biley Act repealed this provision of Glass-Steagall, removing any legally enforceable conflict-of-interest between investment banks and commercial banks. This opened the door to the subprime mortgage scam.
Here’s how the scam worked. A bank would make a “subprime” loan on a house or commercial property, meaning a loan way beyond the applicant’s demonstrated ability to pay it back. In the past, no bank would have done this, because they would be all but asking for a default, which is a stupid thing for a bank to do. But these banks didn’t intend to keep the loan for very long: they gambled that the applicant would make at least the first six months to a year of payments before they defaulted, during which the bank would collect almost pure interest on the loan. Then they’d sell the loan to someone else, and let them pick up the pieces if (when) the applicant defaulted.
Yes, that’s fraud. But it only starts there.
Prior to 1999, this would not have worked, because the only buyers interested in mortgages were other commercial banks of one sort or another, and they understood mortgages quite well. They weren’t stupid enough to buy second-hand subprime mortgages. And they bothered to ask.
After 1999, however, the banks could bundle all of these mortgages together as investments and sell them in blocks to investment speculators — who, when it came to mortgages (or even investments) were well-known to be idiots. All that the investors understood, when they even knew what they were buying, was that “mortgages are safe.” After all, if someone defaulted on a mortgage, they’d lose their house, and no homeowner would want that, right? And banks didn’t offer loans to people who couldn’t pay them back, right?
Well, a lot of the buyers weren’t real homeowners: they were “flipping” houses. I knew a couple doing that. The idea is to buy a fixer-upper with no money down, even though you already have a mortgage (or rent) and no sane bank would lend you the money. Then you add a bunch of cheap, cosmetic fixes to the house and immediately resell it for a substantial markup. As a flipper, you could care less if the thing wouldn’t sell and you had to let the bank take it. So every assumption the investor made was wrong.
The ratings agencies colluded with the investment bankers, and offered triple-A ratings to these junk mortgage bundles. That’s also fraud, since from what I’ve read, they should have known (and did know) better. So even if the idiot investors decided to check up, the ratings told them everything was just fine. No worries man. These are safe investments.
Now you’d think that the investment bankers would be a little leery, since their clients would be left holding the bad mortgages at the end. That’s where something called a “default credit swap” entered the picture. This is a kind of futures market that spreads the risk of a default. It works reasonably well if defaults are just the normal random business failures, personal bankruptcies, and so forth. But when the risk consists of everyone swan-diving into a live volcano, it doesn’t really matter how much you spread the risk — everyone is going to get burned. Because these default credit swaps were explicitly “deregulated” by the Republican Congress in 2000, there was no oversight and no transparency to the default credit swap markets, so no one could see that people were beginning to bet in large numbers that these triple-A junk mortgages were going to tank.
Then we find out that firms like Goldman-Sachs were actually going a step further and betting on the defaults. There’s an investment process called “selling short,” which is a way of making money (usually lots of money, very quickly) if the bottom falls out of the market, and these firms were simultaneously advising their clients to buy triple-A rated junk mortgage bundles, and then betting against their own clients by selling short on those same bundles. That’s also fraud.
When it all came apart in late 2008, the entire financial industry ran to the government, screaming, “Too big to fail! Too big to fail!”
Meaning, “If you let us go down, the US economy won’t dig out of the rubble for a thousand years.” The government — first Bush/Cheney, then Obama/Biden — didn’t have many options because these con artists were right. They really were too big to fail. So the taxpayers paid off much of the investment loss that would otherwise have sunk all the big investment firms/commercial banks that got caught up in this, which would have crashed the economy completely. Even with the bailouts, some of them went under. The economy shuddered, but it didn’t (quite) capsize.
This is why people think there should have been some nice, long jail terms coming out of the mess. Instead, most of the crooks got huge bonuses. Mission Accomplished.
I’ll be the first to admit that the above is an oversimplification of an extremely complex collapse, and I’m quite sure the details aren’t entirely correct. There was certainly fraud and collusion on a huge scale, a lot of utterly inappropriate deregulation of the banking industry, and a whole lot of people who fell asleep at the wheel. If my intent was to point fingers, I’d need to track down all of those details to truly identify the guilty. I’m not sure that’s even possible.
But I’m going to steer away from the finger-pointing to follow a more interesting thread. How did we ever get into this mortgage and credit mess in the first place?
That takes us back to Fannie Mae and gasoline.
In 1938, the New Deal founded the Federal National Mortgage Association (FNMA or “Fannie Mae”). Its purpose was to allow ordinary people to buy new homes, by providing federal backing for loans on new housing. Prior to FNMA, it was extremely difficult to get a mortgage on a new house, as is the case in most non-US countries to this day: if you wanted to own property, you needed to save up cash to buy it. Otherwise, you rented. Or lived under a bridge.
In Germany and much of Europe today, many people own property passed down from parents and grandparents, yet most of those people rent out their own properties, and live in places they rent from others — the property they own isn’t where they need to be. Real estate sales are rare (relative to US sales) and landlords are all VERY fussy about their tenants, many of whom live in their rented homes for twenty or thirty years (or longer). It was difficult for my friends, who worked in Tübingen for two years, to find a landlord who would rent to them on such a short-term basis.
Fannie Mae changed that pattern in the US, and had a number of entirely unintended consequences. Perhaps unforeseeable as well, though it seems pretty obvious in retrospect.
First, it funneled an unprecedented amount of money into the banking industry, increasing its status, wealth, and power over Congress. On average, a 30-year mortgage costs the buyer about three times the cost of the property. So when you buy a $150,000 house, you end up paying nearly a half-million dollars before the mortgage company turns over the deed. This created a housing “shadow economy” twice the size of the housing market itself, and every last dollar of that shadow economy belonged to the banks, and was drawn from the future earnings of the homeowner. In addition to vastly expanding the banks, it put a crippling drain on personal income.
Second, it created a “housing construction industry” that opened job opportunities for countless unskilled, semi-skilled, and skilled workers, which became so large that now the entire US economy is partially measured in terms of “new housing starts.” We have to keep building new houses simply to keep the economy going — even if no one wants or needs the houses. Otherwise the economy falters, the markets tumble, and people run around screaming about the end of the world.
This has changed the nature of construction. A friend recently asked me if I knew why all new restaurants were under 5000 square feet in size. I didn’t, so he explained. If a public building is more than 5000 square feet in size, building codes require a sprinkler system in case of fire. That costs money. So they keep the size under 5000 square feet, and they design the restaurants to burn right down to the concrete pad in the case of fire, at which point they scrape and rebuild. The buildings are additionally designed to last only 25 years, after which they expect to scrape and rebuild with or without a fire. New restaurants are designed as “throwaway buildings.”
That same philosophy governs new housing as well. Even as construction materials and techniques have improved, the long-term value of new homes has declined. The brick-exterior, hardwood-floor house my father bought in 1960 for $16,000 will outlast by many decades the $500,000 house my wife’s son is contracting to build this year. My wife calls it “toothpick and mucous” construction. That isn’t far wrong.
Third, easy mortgage credit for new construction combined with the gasoline-powered automobile created The Suburb, and facilitated the decay of inner cities as the middle classes within the cities moved out. The entire suburban landscape of the Inland Empire would not exist without Fannie Mae and the automobile. Since an automobile became a necessity for suburban living (which greatly expanded the automobile industry), banks began to extend easy credit for automobile purchases, which inflated the consumer cost of the automobile and expanded bank profits further. (Eventually auto financing became the most profitable portion of the Big Three automakers, which is in part why the credit collapse in 2008 hit them so hard — they weren’t automobile manufacturers, they were specialized banks with a barely-profitable side business in making automobiles.)
The ready credit for housing and new cars paved the way for consumer credit (unsecured signature loans). There have always been signature loans, but in the distant past, you had to be a person of substantial wealth to be good for a loan at a bank on the basis of your signature. For the common person, debt was a matter of shame and a mark of truly hard times, and banks wanted collateral. Once mortgages and car loans became commonplace, the idea of a signature loan through a “revolving credit account” could take root and grow. Again, this adds a transaction cost to every purchase, and every penny of that goes to the banks.
Manufacturing industries have increasingly turned over their cash management to major banks that provide them with a “line of credit” to purchase parts to make their products. If the banks stop lending, much of manufacturing in the US simply stops.
So it’s easy enough to see where the economic collapse of 2008 came from. It came from overwhelming indebtedness to and entanglement with the banks. When the banks started to fail, the economy’s heart stopped.
Why did we become so indebted? In large part, because the government made it so easy for ordinary people to buy a house, through Fannie Mae. That one act changed the entire shape of US culture and its economy.
But let’s not stop at this pointing finger, either.
Let’s argue for a moment that Fannie Mae really was the miserable, leftist-Liberal, mush-brained idea the Libertarians say it was. Let’s say all of the consequences were foreseeable, and that somehow, in some alternate Libertarian United States, Fannie Mae never happened. What would the US look like now?
The suburbs would not exist, or would be much, much smaller and a great deal wealthier: they would be for the “country club” set, and not available to the middle class at all.
Most inner cities would be far more vital, more middle-class affluent, and safer, because there would never have been an exodus to the suburbs.
Most people would rent, even if they owned property. Rents would, on average, be lower, since the owner would not need to cover mortgage payments with the rental income: they would actually own the property, and the rents would go to property upkeep and a modest “rentier’s income,” as in Europe.
The housing, automotive, and banking industries would each be only a fraction of their current sizes. Other industries would probably have taken their places as economic flagships, though it’s possible that economic activity would have been diverse and decentralized, with no major “industries” that dominated the economic landscape.
Debt would not have gained anywhere near the foothold it currently has, either in the private sector or the government. Credit cards would not exist. Without credit cards, there would likely be no debit cards, automatic tellers, or other retail purchase conveniences. We would still write checks, and withdraw cash from banks.
This doesn’t sound all that bad.
So let’s argue that this really would have been better, both for the country, and for most of us as individuals.
We come at last to the really interesting question: how do we get back to that world? Since that seems to be what the Conservatives want to do.
This is where I become angry with and contemptuous toward Republicans, Conservatives, and Tea Baggers. They haven’t even begun to think this through.
It’s one thing to speculate on what the US would have been like if Fannie Mae had never happened. But Fannie Mae did happen, and the US changed.
We now have middle-class suburbs saddled with crushing debt, and urban decay. We have a financial sector that dominates both the economy and the political process like an ill-tempered, diarrhetic gorilla in a phone booth. We have a housing industry that, when it gets a head cold, sends the entire economy to the emergency room with cardiac arrest.
If we want to go back to a pre-Fannie Mae world, the first thing that has to go is the American Dream of middle-class home ownership. Because that is precisely what Fannie Mae facilitated. That is precisely what drove us into the 2008 collapse.
We need to dump debt. Not the federal debt. All debt. Including mortgages.
I don’t see Conservatives talking about this.
I don’t see Conservatives talking about any relevant issues at all.
They remind me of the old joke about Druids:
Q: How many Druids does it take to change a light bulb?
A: Thirteen. One to change the bulb, and twelve to compose poetry about how much better the old bulb used to be.
Except that Conservatives only provide twelve (bad) poets, and no light bulb.
Themon the Bard 