Sunday, July 11, 2010

Leadup to the Current Crisis: The Old Financial Order

So, at last we get to the question of how we got to where we are now. This is only an Enlightened Layperson's opinion and analysis, with no claim to special expertise. My main sources are Zandi, Krugman, and Wikipedia.

Any attempt to understand how we got here has to start in the 1930's because that is where the modern system of financial regulation began, and discuss how the finance system outgrew it. Roosevelt's financial reforms, it must be emphasized, were wildly sucessful; they tamed the boom-and-bust cycle that had troubled the economy until then and largely kept it at bay for another 50 years. Best known was the FDIC, which ensured bank deposits and put an end to bank runs.

In exchange for protection, banks were subject to tighter regulation, including requirements to hold a certain amount of their deposits in cash (actually, this existed even before) and restriction from certain risky activities. Presumably, this includes (or should include) close regulatory oversight in general, but particularly it included the Glass-Steagal act, which (it has been endlessly repeated) separated commercial banks from investment banks and insurance companies. Or, translated into terms a person ignorant of finance, like me, can understand, the Glass-Steagal act forbade any financial institution that accepts deposits from investing and trading in stocks, financing mergers, or underwriting (financing) issuance of stock. Or, more simply put, anyone taking deposits had to stay the hell out of the stock market, which was considered too dangerous. It was also driven by a fear that combining the functions would lead to conflict of interest. Another financial reform was the founding of the Securities Exchange Commission (SEC) to oversee the formation and exchange of securities and prevent secrecy and fraud.

An underappreciated financial reform was the development of the fixed rate mortgage by the Federal Housing Authority (FHA). Before that, most home mortgages were short-term, for a period of three to five years, required a 40-50% down payment, and featured balloon payments, i.e., the borrower first paid off the interest and then had to pay the principle in a lump sum. The FHA developed a mortgage requiring only a 20% down payment, with fixed and unchanging payments over a period of 30 years. This proved wildly popular, both with buyers, many of whom were able to afford a home for the first time, and with banks, which found the fixed rate mortgage to be one of the safest and most reliable of all loans.

And then, of course, there is the Federal National Mortgage Association (Fannie Mae). Fannie was founded in 1938, not to issue mortgage loans directly, but to buy them from banks in order to encourage banks to keep issuing more. Originally, Fannie was allowed to buy only mortgages that were insured by the FHA. Fannie Mae was (semi) privatized in the 1960's and the Federal Home Loan Mortgage Corporation (Freddie Mac) created to compete with it.

The background of the current, crisis, then, is the story of house the finance system gradually outgrew these reforms and morphed into something new, outside the established regulatory system.

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