The AHI’s headquarters hosted a standing-room only crowd of more than 150 persons on Saturday afternoon, 1 November. They attended the presentations of AHI co-founder James Bradfield and AHI board member Carl Menges on “Turbulence in the Financial Markets.”
Mr. Menges, a retired Wall Street executive, began by underscoring the severity of the global credit crisis, calling it an event “the likes of which the financial world has never seen before.” The current crisis, he argued, derived largely from two sources: 1. “Government policies that encouraged mortgage lenders to lend to financially unworthy and unqualified borrowers” 2. “A super aggressive financial industry that overreached all sensible, prudent, and risk-appropriate banking and investment practices.” The list of the culpable proves long: federal regulators, mortgage lenders, home-buyers, financial intermediaries, security rating agencies, insurance companies, banks, managers of investment funds, and, most importantly, quasi-federal agencies like Freddie Mac and Fannie Mae, who “indiscriminately brought trillions of dollars of mortgages from the originators without prudent credit/risk analysis to keep a continuous supply of liquidity in the system.”
Mr. Menges sketched the history of such GSO’s (government-sponsored organizations). President Carter’s signing of the Community Reinvestment Act (1977) speeded travel on a road to hell paved with good intentions by forcing banks to provide billions of dollars of credit to persons who could not afford the homes they were buying. Bear Stearns, whose rapid collapse stunned the financial world, honed the practice of “securitizing” loans made under the Community Reinvestment Act. The investment community, seeking high-yielding securities and thinking that housing prices would continue to rise interminably, gobbled up bundles of these toxin-laden mortgages.
The five big investment banks (Goldman-Sachs, Merrill-Lynch, Morgan-Stanley, and Bear Stearns), according to Mr. Menges, pursued these new securities with gusto after the Securities and Exchange Commission in 2004 loosened the capital rules for borrowing. The insurance industry, most notably American International Group (AIG), responded by offering insurance policies to the holders of these new, opaque securities. These insurance policies– called Credit Default Swaps–“drive their value from the underlying security and were sold “without any credit or collateral; security, no oversight or regulation.”
Professor Bradfield began by stating that the economic history of the United States since its founding has been growth with turbulence. Some of these turbulent episodes have resulted in precipitous and deep destruction of liquidity. The most severe episode is the Great Depression of the 1930s. During the financial panics prior to and including the Depression, the Federal Reserve System exacerbated the destruction of liquidity by acting as a bank would; the Fed called in problematic loans, thereby accelerating the destruction of liquidity. Following the Depression, the Fed began acting as a monetary authority, rather than a bank. In each of the panics since the Depression the Fed acted to increase liquidity, as it is doing now. As a consequence, the panics have been less severe than they would otherwise be. Bradfield agreed with Menges that the unusual severity of the current situation raises the question of how effective the Fed can be in bringing timely relief .
Bradfield contended that the primary cause of the current crisis is the persistence of the Federal Government in using Fannie Mae, Freddie Mac, and other similar Governmental Sponsored Enterprises, to induce banks and other financial institutions to originate, and then securitize, mortgaged loans that private markets, left to their own, would have rejected.
Bradfield rejected the argument that deregulation was a major cause of the current crisis. He emphasized that a necessary condition for free markets to regulate themselves is the absence of governmental interference in setting prices, including the prices of securities, such as mortgages. The function of prices is to transmit information. In markets for mortgages, prices be must free to transmit information about the ability (or lack thereof) of prospective borrowers to meet contractual obligations. Governmental interference, through such agencies as Fannie Mae and Freddy Mac, distort the ability of prices to transmit correct information, with the result that individuals make decisions and take risks that are based on distorted, and thus incorrect, information.