“I hope next year we’ll have abolished Fannie and Freddie…it was a great mistake to push lower-income people into housing they couldn’t afford and couldn’t really handle once they had it. I had been to sanguine about Fannie and Freddie.”, Barney Frank (D-Mass.), former chair of the House Financial Services Committee (In an interview with Larry Kudlow on CNBC, August 2010)

“By 2010, many of the strongest supporters of affordable-housing as enforced by HUD had recognized their error. Barney Frank has taken a lot of criticism for his unqualified support for the affordable-housing goals during much of his career in Congress, but at least he had the courage and intellectual honesty to admit in the end that he had erred. As we will see, others have not.”, Peter J. Wallison, Hidden in Plain Sight 

“(In this book), I will show that the 2008 financial crisis would not have occurred without the government’s housing policies, which fostered the creation of 31 million NTMs (nontraditional mortgages). Three-quarters of these deficient mortgages were on the books of government agencies, and their failure in unprecedented numbers caused housing prices to fall throughout the United States….The sudden decline in housing values immediately affected the value of mortgages, particularly those…with a value of approximately $2 trillion….that were held by private financial institutions, such as banks, in the form of PMBS. This process would not have been as frightening, and might not have induced a panic, were it not for mark-to-market accounting, which required financial institutions to take substantial asset write-downs and operating losses that sharply affected their earnings and their capital positions…..Ultimately, there was nothing exceptional about the government actions that led to the crisis. They were disastrous to be sure, but also expected when the government controls the distribution of an important good like housing.”, Peter J. Wallison, Hidden in Plain Sight

Part Three: Key Excerpts from the Introduction of Peter J. Wallison’s: Hidden in Plain Sight: What Really Caused The World’s Worst Financial Crisis And Why It Could Happen Again:

“Although the Bear rescue temporarily calmed the markets, it created substantial moral hazard. Market participants now believed that the government had established a policy of rescuing large failing financial institutions. This perception substantially affected subsequent decisions. Firms with weak cash or capital positions did not take the opportunity to raise as much new equity as their parlous condition required: with the government likely to protect creditors, there was little reason to dilute shareholders further in order to foster creditor confidence.”

“Potential acquirers for Lehman, noting the $29 billion support that JPMorgan Chase received from the Federal Reserve, were probably unwilling to buy a firm even larger than Bear with no financial support or risk-sharing from the U.S. government. Yet, the U.S. treasury secretary was telling anyone who would listen that there would be no government risk-sharing. Most specifically, the Reserve Primary Fund, a money market mutual fund, decided to retain Lehman Brothers commercial paper in its portfolio, probably assuming that if Lehman went under, its creditors, like Bear’s, would be bailed out.”

“Paulson and Bernanke seemed not to recognize any of this. They apparently thought that during the relatively calm period after the Bear Stearns rescue, financial firms were taking adequate steps to prepare themselves for future challenges….improving their liquidity positions and selling shares to shore up their capital…..In addition, Paulson’s insistence, with Bernanke’s apparent concurrence, that no government funds would again be employed for a Bear-like rescue, probably discouraged other potential buyers. Thus, the key government decision makers had very different perceptions of reality than market participants.”

“Despite the fact that both Paulson and Bernanke had extensive financial experience (Paulson in particular had been a chair of Goldman Sachs), neither seemed to understand that their strategy was both discouraging actions by weakened firms that would improve their capital position and making a buyer for Lehman more difficult to find. The moral hazard created by the rescue of Bear Stearns, plus the fact that the U.S. government had been willing to share JP Morgan’s risk of acquiring Bear, trumped all.”

“Also during this period, the biggest banks were compelled to take back onto their balance sheets hundreds of billions of dollars in mortgage-backed securities, largely based on subprime loans, that the Federal Reserve had allowed them to park in off-balance-sheet asset-backed commercial paper (ABCP) conduits. By 2007, the commercial paper issued by these conduits was the largest money market instrument in the U.S. financial markets; the second largest were Treasury bills, with about $940 billion outstanding. The failure of these ABCP conduits is a major reason that the financial crisis was so severe, but it had little media coverage either at the time it occurred or since.”

“One of the characteristic activities of banks is maturity transformation…turning short-term deposits into long-term assets like loans…..This was one of the reasons for the establishing the Federal Reserve System, which was intended to be a lender of last resort for solvent banks that needed cash in these circumstances. The theory was the Federal Reserve would accept or “discount” (hence the “discount window”) illiquid bank assets such as loans or securities in exchange for cash. When the cash crunch was over, the bank could redeem its assets from the Federal Reserve for the cash it received, plus interest. It turns out, however, that banks are reluctant to use the discount window, especially during periods of liquidity shortage, because it signals a weakness to the market.”

“One of the ways that banks are supposed to be able to withstand losses and withdrawals is to hold sufficient capital to allay depositors’ fears about the banks’ solvency and their ability to supply sufficient cash to meet withdrawals. That’s why the banks are required to hold capital. However, the ABCP conduits, which were not on the banks’ balance sheets, had no capital; they attracted short-term investors, mostly money market funds, because they were back by liquidity guarantees from the associated banks. In other words, the Federal Reserve had permitted some of the largest U.S. banks to ignore the Basel capital requirements so they could engage in the risky but profitable business of maturity transformation, using short-term funding to support long-term assets. Former Treasury Secretary Geithner confirmed all this in his 2014 book Stress Test when he noted that Citibank “had stashed….$1.2 trillion in assets off its balance sheet in ways that allowed it to hold virtually no capital against losses on those assets….(and) financed some of its off-balance-sheet securities by issuing asset-backed commercial paper if no one else wanted it. When markets ran from asset-backed commercial paper….the market shrank 30 percent in the second half of 2007…Cit had to shell out $25 billion to made good on its assurances.” Although $1.2 trillion is far larger than Citi’s actual contribution to this activity, what Geithner didn’t say is that the Federal Reserve (and probably the New York Federal Reserve Bank, which he headed) had permitted this evasion of the capital requirements otherwise applicable to banks.”

“When the mortgage markets began to weaken in 2006 and 2007, many money market mutual funds refused to renew their loans by rolling over the commercial paper they had previously acquired. The only alternative for the banks was to take much of this paper back on to their balance sheets, with an immediate adverse effect on their capital. So as the financial crisis approached in September 2008, the largest U.S. banks were already weakened and strapped for cash.”

“Thus, when Lehman Brothers was required to file for bankruptcy on September 15 (2008), chaos ensued. Market participants, investors, and creditors who had assumed that the government would not allow any large financial institutions to fail now had to reevaluate all their counterparties. This outcome was not conducive to calm reflection.”

“Uncertainty about the financial condition of many firms caused investors and creditors to seek cash. In turn, financial institutions, including the biggest banks, afraid of rumors that they were not able to meet the withdrawal request of creditors and depositors, hoarded cash, not willing to lend to one another even overnight. This caused a virtual collapse of liquidity and the market panic that we know as the financial crisis.”

“Filling out the details about how the government’s housing policies led to the crisis will be the principal focus of the balance of this book. I will show that the 2008 financial crisis would not have occurred without the government’s housing policies, which fostered the creation of 31 million NTMs (nontraditional mortgages). Three-quarters of these deficient mortgages were on the books of government agencies, and their failure in unprecedented numbers caused housing prices to fall throughout the United States.”

“The sudden decline in housing values immediately affected the value of mortgages, particularly those…with a value of approximately $2 trillion….that were held by private financial institutions, such as banks, in the form of PMBS. This process would not have been as frightening, and might not have induced a panic, were it not for mark-to-market accounting, which required financial institutions to take substantial asset write-downs and operating losses that sharply affected their earnings and their capital positions.”

“Ultimately, there was nothing exceptional about the government actions that led to the crisis. They were disastrous to be sure, but also expected when the government controls the distribution of an important good like housing. Daily, we see how difficult it is to stop government spending. Equally if not more difficult is preventing the government, once it controls an activity, from using it to provide benefits to favored constituencies and then charging the taxpayers for the inevitable losses.”

“As this book is written, there is a debate in Washington about the reform of the housing finance system. Fannie and Freddie, which were driven into insolvency by the government’s policies, will probably not survive. But, as shown in Chapter 14, many participants in the debate want to erect another government-controlled system in their place. If this $11 trillion plaything is not taken out of the government’s hands, another financial crisis awaits us in the future.”

“By 2010, many of the strongest supporters of affordable-housing as enforced by HUD had recognized their error. In an interview on Larry Kudlow’s CNBC television program in late August, Representative Barney Frank (D-Mass.)….the former chair of the House Financial Services Committee and the previously loudest congressional advocate for affordable housing…conceded that he had made a mistake: “I hope next year we’ll have abolished Fannie and Freddie…it was a great mistake to push lower-income people into housing they couldn’t afford and couldn’t really handle once they had it.” He then added, “I had been to sanguine about Fannie and Freddie.” Barney Frank has taken a lot of criticism for his unqualified support for the affordable-housing goals during much of his career in Congress, but at least he had the courage and intellectual honesty to admit in the end that he had erred. As we will see, others have not.”

“Chapter 3 discusses the report of the Financial Crisis Inquiry Commission, of which I was a member and from which I dissented, and details why other explanations of the crisis are deficient.”

“Chapters 5 through 8 explain how the affordable housing goals forced a decline in mortgage underwriting standards that spread to the wider market, show that this was a deliberate policy of the Department of Housing and Urban Development under both the Clinton and George W. Bush administrations, and make clear that Fannie and Freddie led the market into perdition because of the goals and not for profit or market share.”

“Finally, chapters 13 and 14 show how the bumbling of government officials made a bad situation considerably worse, and why the false narrative about the causes of the crisis has both saddled the financial system with the Dodd-Frank Act and made it likely that the same mistakes in housing policy that were responsible for the crisis will be repeated in the future.”

Posted on February 4, 2015, in Postings. Bookmark the permalink. Leave a comment.

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