Free-Market Ideology Caused the Sub-Prime Mortgage Debacle

Today the Plain Dealer reprinted this important op-ed by Robert Kuttner in the Los Angeles Times, arguing that the "deepening calamity" of the sub-prime mortgage crisis "results from the failed fantasy that markets can regulate themselves." Kuttner connects mortgage lending abuses in the 1990s to the deregulation of financial markets sought by free-market economists since the 1970s. That deregulation scaled back the "dynamic system of managed capitalism" that had been created in response to the stock market crash of 1929, a product in turn of the laissez-faire 1920s:

In the sub-prime [mortgage boom], unregulated mortgage lenders threw away underwriting rules and made teaser loans to people with sketchy credit histories. ...

But in the Alice-in-Wonderland world of financial deregulation, a Wall Street bank could turn the loan into a bond; a credit rating agency using obscure alchemy could bless the bond with a triple-A rating, and some consenting adult could be found to buy it. ...

The whole daisy chain was unregulated and opaque -- to investors, to regulators, even to the investment bankers who orchestrated it. Nobody really knew what these bonds were worth if they ever had to be sold. Now we are finding out.

Had regulators simply required all mortgage lenders to use prudent underwriting standards, the sub-prime crisis never would have happened. ... Congress, in a rare bout of pro-consumer regulation, passed a law in 1994 requiring exactly that. But the Federal Reserve, a devout believer in the magic of markets, refused to issue regulations.

This is an important point and deserves more attention. The lending industry and to some extent the federal regulators are largely treating the crisis like it is just some bad thing that happened, like the wind and the rain, with nobody really to blame. But there are people to blame. Unregulated lenders fudged the rules to generate a wave of unsustainable loans, and Wall Street entities hid behind the complexity of newly created complex investment vehicles to get away with massive conflict of interest and deception. Rating agencies were paid by the very investment banks who sold ostensibly safe but highly risky investments based on the rating agencies' approval. (42% of Moodys' income from 2002 to 2005 was from rating residential mortgage backed securities and similar exotic instruments.) Everybody made money on each step of the transactions until the bubble burst. It was a bonanza built on lack of oversight and lack of transparency.

Last Thursday Cuyahoga County Treasurer Jim Rokakis gave a presentation to the Cleveland Heights Democrats that tied the mortgage crisis in Ohio specifically to opposition by Republican-led state government to regulating the lending industry. When the state wouldn't step in to crack down on abusive lending practices, he said, the City of Cleveland passed its own predatory lending ordinance in 2001. Within two weeks the General Assembly, after having ignored the subject for years, passed a law that forbid Ohio cities from regulating lenders. (House Speaker Chuck Blasdel (R-East Liverpool) was awash with campaign contributions from the financial industry. Read all about it in this Free Times article by Charu Gupta.) The legislature took no action against abusive lending until 2006, when it finally passed a predatory lending law. During the intervening time, Rokakis reported, foreclosures in Cuyahoga County mounted from about 3,500 in 1995 to over 7,000 in 2000 to over 13,500 in 2006. This year the county is on a pace to exceed 17,000.

The lending industry likes to blame our high foreclosure rate on Ohio's struggling economy (although they never explain why they were so intent on writing loans here if it is so bad). The real explanation, Rokakis said, is that the sub-prime loans were often issued with no down payment, no credit check, no proof of income, and incredibly low initial "teaser" rates following by rate resets. Many of the loans now going into foreclosure were issued in amounts far in excess of the value of the home, often 175%. Ameriquest, a major sub-prime lender, reportedly had an "art department" to fabricate documents in order to facilitate loan approval.

That is a picture of an unregulated market at work. The charade came to an end when the booming real estate markets in California and Nevada slowed, so that poor-performing Ohio sub-prime loans could no longer be buried in mortgage pools with high-performing loans from out west. Gradually it became apparent that the book values of mortgage-backed investments were grossly inflated. Hedge funds were in trouble as of late 2006 and early 2007. Since the last quarter of 2006, over 180 loan-issuing entities have gone under. This past summer the credit crunch hit and major banks began to write off billions of dollars worth of mortgage-related assets. There has been about $500 billion in mortgage-related investment losses already, and another $880 billion in adjustable rate mortgages will reset in the next year or two, with perhaps half of those going into default. Two million or so families will lose their homes.

As Kuttner says, free-market ideology is a major culprit in this disaster. Markets do not regulate themselves, and when rules and disclosure requirements are scaled back or missing we get the same deceptions, insider self-dealing, inflated valuations, and unsustainable speculation that led to 1292 market crash. As Rokakis said, this is already the worst housing crisis since the Great Depression, and it's going to get worse before it gets better. And, I might add, it's going to take Democratic control of state and federal regulatory authorities to get tighter regulations in order to head off the next wave of abuses.