Christopher Shays Blames Fannie and Freddie

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On Friday afternoon, October 24, I received an email from Christopher Shays’ constituent services asserting the need for Congressional hearings on malfeasance at Fannie Mae and Freddie Mac, for which Congressman Shays blamed the entire financial crisis that has spread from the United States to all parts of the world.  This is an assertion that I have heard repeated several times by John McCain and other Republicans during the past three months. 

While I agree that there was mismanagement at Fannie and Freddie, it was not the main cause of the current financial crisis.  The securitization of subprime loans started on Wall Street, at companies like Bear Stearns.  The creation of credit default swaps to “insure” these mortgage-backed securities started when J.P. Morgan suggested the idea to AIG.  If Fannie and Freddie had never bought, securitized or insured any subprime loans, their revenues would gone down but unregulated mortgage brokers would have just sold their loans to Wall Street firms.

The primary cause of the current financial crisis is deregulation ideology.  In 1994, Congress passed the Home Ownership and Equity Protection Act (HOEPA) giving the Federal Reserve the power and duty to regulate the mortgage lending industry, to require adequate disclosure and prevent predatory lending.  However, Federal Reserve Chairman Alan Greenspan, a lifelong Republican, was reluctant to regulate mortgage lending.  Dr. Greenspan publicly encouraged people to make use of adjustable rate mortgages, which he said would lower the cost of home ownership.

When, in July 1998, the Commodity Futures Trading Commission proposed to regulate OTC financial derivatives such as swaps, SEC Chairman Arthur Levitt objected.  Less than two months later, we almost had a world-wide financial crisis when highly-leveraged LTCM collapsed but was saved by several commercial and investment banks at the instigation of the Treasury and the Federal Reserve.   

Unfortunately, our government leaders learned nothing from the LTCM near-disaster in 1998.  Alan Greenspan persuaded Congress to pass legislation removing from the CFTC the power to regulate financial derivatives.  The OTC derivatives market remained unregulated, providing a means for banks and other financial institutions to skirt capital requirements and increase their leverage.  In 2000, the Federal Reserve established an advisory committee chaired by Walter Shipley, former CEO of Chase Manhattan Bank.  The Shipley panel recommended specific changes in regulatory oversight to improve risk management and to require better disclosures for all financial institutions.  However, Fed Chairman Greenspan chose to ignore the recommendations of the Shipley committee.  Last week, Alan Greenspan admitted to a hostile Congressional Oversight Committee that his deregulatory philosophy had a flaw.  Thanks a lot, Mr. Greenspan.  Ten years too late!

Deregulation ideology continued to prevail in this decade. In 2003, the Federal Government preempted authority from the states when several state Attorneys General tried to investigate and rein in deceptive and fraudulent peddling of subprime mortgages.  In 2004, the SEC held a basement hearing with only representatives of five major investment banks, including Goldman Sachs – led by Hank Paulson, now Treasury Secretary – in attendance, and agreed to relax capital requirements on those banks, and allow them to operate at higher leverage.  Meanwhile, the unregulated credit default swap market grew from $900 billion in 2000 to $62 trillion in 2007, or four times U.S. GDP, threatening the entire global capitalist system.[i]

Treasury Secretary Hank Paulson has been consistently behind the curve in dealing with this financial crisis.  Nationalizing Fannie Mae and Freddie Mac in the waning days of summer (September 7, 2008) was the right thing to do.  However, allowing Lehman Brothers go bankrupt on September 15, 2008 turned out to be a huge mistake. In addition to many thousands of creditors holding its bonds, Lehman had made derivatives deals with 8000 firms, and other firms held credit default swaps with notional value of hundreds of billions that were triggered by the Lehman bankruptcy.  The entangling counterparty risk was enormous, affecting financial institutions as well as individuals all over the world.  Financial institution lost all trust to lend to each other, and the credit crisis reached disaster proportions.  Swap sellers sold equities to raise cash to pay swap buyers, driving down global stock markets.  Now all the Kings’ horses and all the Kings’ men are having great difficulty putting Humpty Dumpty back together again. 

Mr. Shays is proud to say that he is a member of the House Financial Services Committee.  What was Mr. Shays doing to provide oversight and regulatory guidance during the years 2000-2006 when the Republicans controlled Congress as well as the White House, and the credit default swap market was growing out of control?  Did Mr. Shays heed Warren Buffet’s warning that unregulated credit default swaps were weapons of mass destruction?  Did Mr. Shays stand up in the House and urge adoption of the Shipley Committee recommendations on risk management and disclosures of financial institutions?  Was Mr. Shays warning about the dangers of increased leverage at investment banks and hedge funds?  Did Mr. Shays request any hearings in 2003 on the subprime mortgage concerns of the state Attorneys General?  The answer to all these questions is no.

I plan to vote for Jim Himes.  He understands the financial world and the need for regulatory reform.


[i] https://westonpolicy.wordpress.com

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