The narrative about how The Financial Crises unfolded. The FCIC Report In June 2005,The Economist, run an article about the imminent demise of the housing market. Moreover, in that same month, Alan Greenspan told the Joint Economic Committee about the possible dangers of a housing crisis that could have a negative effect in the mortgage market. However, at the same time; Greenspan felt the economy was running on a safe track, and that if anything happened, the financial sector was strong enough to contain any type of market disruptions. In that period of 2005, Herb Sandler, a top executive at Golden West Financial Corporation, told Fed officials, the FDIC, the OTS, and the OCC, that it was a mistake to rely on AAA-ratings given by these rating agencies. Much of the work that rating agencies were doing was thanks to law passed in 2000 by congress to lift the ban on over-the- counter derivatives. In 2006, housing prices started to take a nose dive, and along with them the value of large portfolios derived from nontraditional mortgage products that were traded and held by major financial institutions. Consumer advocates started issuing warnings to Fed Officials such as Ben Bernanke about the dangers of nontraditional loans. In March of 2007, Bernanke told congress that if there was a problem in the subprime market, it would most likely be stopped, and that there was a very small change of such problem spreading to other parts of the economy. However, in 2007, the economy was slowing down, a sign that the housing bubble was deflating. In 2008, tragedy struck. Major financial Intuitions failed, such as; the epic fall of Lehman Brothers, the largest bankruptcy in US history. Others like AIG, Bear Sterns, Freddie, and Fannie Mac were rescued by the government for fear of contagion, or as they government likes to put it “too big to fail”. Moreover, the decisions of the government to rescue certain firms created a great level of uncertainty that translated into a financial panic. Close to 11 trillion dollars were lost in retirement accounts, household equity, and life savings accounts. This financial crisis did not happened over night; it had been cooking for years, as far back as the 1990’s and developed over the course of the Bush and Clinton administrations. In October 2008, the Trouble Asset Relief Program (TARP) was sing into law by President George W. Bush before he left office. In 2009, when the Obama administration took office, the $700 billion in TARP funds were distributed to firms affected by the subprime crisis. These firms include AIG, J.P. Morgan, Wells Fargo, and Bank of America among others. Up to this point, the financial shock was contained, however; massive layoffs kept mounting, and soon the unemployment rate went up to around 10%. Today, the US economy is still trying to recover from one of the greatest financial crisis since the Great Depression of 1929. Thomas Sowell, The Housing Boom and Bust Thomas Sowell, an economist at Stanford Universality, narrates, from his own perspective, how the financial crisis started. In 2002, President George W. Bush said he wanted 5.5 million people to own a house by 2010. In 2003, Barney Frank believed that Freddie and Fannie Mae were doing a great job increasing home ownership in the US, and that those in the opposition were simply “exaggerating a threat to safety”. Moreover, the Department of Housing and Urban Development (HUD) was pushing Freddie and Fannie Mae to get deeper into the subprime mortgage business in order to increase home ownership. In 2005, The Economist issued the same warning about the dangers of a collapse which is also reported in the FCIC report. In the same year, Peter J. Wallison from the American Enterprise Institute, pointed out the questionable practices of Freddie Mac, and Fannie Mae in regards to the purchasing of exotic mortgage products, and warned of the potential huge losses that these two companies pose to the economy if they continue purchasing bad loans. The head of the FDIC also warned congress about the high levels of bad loans that were being traded in market. Another contributor the housing bust was many building codes passed into laws which in turn made housing prices high, and forced home buyers to take risky loans in order to afford a house. Also, these borrowers had to commit more of their income in order to keep up with rising cost of owning a home. The idea for these laws was coming from individuals, groups, and communities with the excuse of protecting the environment. Thus, politicians saw a political gain advantage and help this groups pas laws on building restrictions. In 2006 housing prices started falling considerably in places where prices had the highest jumps such as California, Nevada, Arizona, and Florida. These were place were many building codes were made into laws. By 2007, foreclosures shot up to 87% around the country. The state of California was one of the epicenters for foreclosures. In San Francisco prices were down 31%, in Los Angeles prices fell 28%, and 27% in San Diego. In 2008 most houses for sale in around the San Francisco area were foreclosures.By the end of 2008, the S&P reported that in October of 2007 to October of 2008, the house-price index had the deepest decline not seen in twenty years, large financial institutions collapse, TARP was enacted to help companies avoid bankruptcy, and those troubled firms lined up to get funds from the government. In an interview with 60 Minutes, Alan Greenspan, when he was no longer chairman of the Fed, admitted that he had no idea about the magnitude of the financial crisis until very late in 2006. An unregulated Free Market The FCIC report gives a sense that the market was unregulated. As the commission report rating agencies were being left lose when it came come to rating highly risky mortgages. As these agencies, where giving this risky investments AAA ratings. It seems as if the SEC was completely out of the picture. Perhaps there were conflicts of interests within the rating agencies. They were advising firms on how to structure debt, and at the same time they were rating their own work, and the agencies were giving firms positive rating in order to secure their business. Furthermore, the report points out high rank official within the Fed such as Greenspan, and Bernanke failed to exercise their power to regulate the market. Excessive Regulation Mr. Sowell points out, the intricate involvement of Government Sponsor Agencies or GSA’s along with government officials pushed for excessive regulation from the government. TheGSA’s Freddie Mac and Fannie Mae were loading heavily on exotic mortgage due to the pressure put on them by HUD. Moreover, they had Barney Frank and President George W. Bush standing up to defend their business practices and to encourage more home ownership. Government Bureaucrats Contrasting both perspectives, the FCIC’s and Mr. Sowell’s, the most obvious fact that comes out to light in both opinions about the financial crisis is that high ranking officials within the government had no clue about the real damage that a bursting of the housing bubble posed to the economy. Perhaps one can argue that every crisis is different, but as both narratives show, there were warning sings everywhere. The lack of commitment and hard work from government bureaucrats shines thru their un wiliness to dig deeper into the financial matters that pose a threat to the economy. In both accounts of the financial crisis, Mr. Sowell’s and the FCIC’s former Federal Reserve Alan Greenspan comes out as the main culprit. Not only does he admit about not being aware of the real dangers that these exotics mortgages, but he failed to push for a more aggressive investigation into the subprime market given the fact that others industry leaders, and some officials in the government were questioning such business models within the housing market. Politicians enact flawed laws The FCIC report points to the passage of the law that banned restrictions on the trading of over-the – counter derivatives, as one of the laws that help feed “the madness” in Wall Street. As rating agencies were rating these securities, they also experience conflict of interest. This problem was due to the fact that rating agencies were advising client on how to structure debt and at the same time they were rating their own work. Therefore, an assumption can be drawn that high level executives were giving kickbacks to rating agencies for their work. On the other hand, Mr. Sowell many laws on buildings codes that restricted the construction of houses in some localities was the work of irresponsible politicians guided by the greed of political gain.In the 1970’s, there were numerous laws that put restrictions on land. The motive for these restrictions was the need to preserve green areas, farmland, and saving the environment. As housing prices kept rising in this localities, home buyers loaded up on debt by taking out nontraditional loans that allowed them to buy expensive properties. According to Mr. Sowell by 2006 more than half of all subprime loans were “stated income” loans or “liar loans”. Borrowers that carried these loans were committing more than 40 percent of their incomes for the mortgage. Therefore; all of this laws that allowed people to charge higher prices for homes and at the same time foster conditions for abusing borrowers by making them sing into loans that they would never be able to pay. Thus, both narratives give u a slightly different taste. The FCIC report points toward greedy executives corrupting politicians where as Mr. Sowell perspective goes to toward politicians enacting laws that benefit their purpose at the expense of the public The cause of The Financial Crisis The FCIC Report Unregulated Free Markets When it comes to identifying the main cause of the financial crisis, the FCIC report and Mr. Sowell’s have two very different culprits. The FCIC report blames Wall Street firms for playing a big role in the crisis, and Mr. Sowell points to government policies for the financial collapse. According to the FCIC report, one of the key factors in the collapse of the housing market started with lax regulation practices. The report points out to more than three decades of deregulation promoted by former Fed chairman Alan Greenspan whom had the idea that financial institution could check on themselves to make sure they complying with the rules. The lack of regulation facilitated the work of private entities in the shadow banking industry as well as the over the counter derivatives markets. Furthermore the FCIC reports that financial institutions were allowed to choose their own regulators. These people entrusted with regulating the markets opted to avoid executing their fiduciary duties. For example, the Security Exchange Commission along with the FDI failed to supervise the capital reversed of bank engaged in the trading of derivatives tied to the housing market. These banks were so highly leveraged that if the market turned down a couple of percentage points, they would not have sufficient capital to cover losses. For example some investment banks had leverage ratios of 40 to 1 which mean that for $40 in assets, there is $1 of capital. Clearly, these banks had poor liquidity management. They did not have sufficient capital to cover their deposit demands. As Bank Management dictates banks need to protect from large deposit outflows. Management at the banks did not care to look into the issue. Perhaps, they were relying on their deposit insurance to make wild bets without proper capital in case of a failure. They were also affected by the principal agent problem, in which they had huge monetary incentives to overlook their liquidity problems. As time went by changes were implanted but given the magnitude and power of financial institutions regulations got diminished. According to the FCIC report, Wall Street firm spent a total of $2.7 billion lobbying regulators and political groups. Also individuals and political action groups gave more than $1 billion in campaign contributions. Thus, as the report shows there was a much unregulated market that prevented regulators to establish a market free of obstacles to its sound operation. Government Bureaucrats The FCIC report points out to incompetent Government bureaucrats as the cause of the financial turmoil. During the 1990’s, there was a larger influx of capital from China and other oil-rich countries as they were trying invest in the US and Europe as way to load their big cash surplus. This led to low interest rate and easy credit which allowed for investment in risky mortgages. By the end of the 1990’s and early 2000’s a housing bubble formed. All of these factors were let unchecked by the Federal Reserve as they were had the power to warn about the possible effects of interest rate, and also; establish reasonable mortgage-lending practices. Due to the lack of oversight by the Fed, financial institutions invested heavily on mortgage related securities. Furthermore these firms were relaying on billions of dollars on overnight borrowing that were back by mortgage securities. On top of that, rating agencies were giving these exotic mortgages AAA ratings. Therefore, the FCIC reports concludes that the failure of the Fed to address monetary policy along with the flow of capital from overseas created a housing bubble that led to poor lending standards. Some of these nontraditional loans were done based on the idea that housing prices will keep on rising. Institutions that were doing these loans could not be held accountable since they relied in the originate-to-distribute model that allowed for the securitization of these loans, and then, these bad loans could be sold to other financial institutions. The Federal Reserve wasn’t diligent enough to recognize the adverse consequences that the housing bubble could have on the financial system, and acted too late contained its negative effects. Politicians and Flawed Laws The FCIC commission reports that Politicians were also responsible for creating laws that created conditions for private organizations to abuse market conditions. In 2000 both houses of congress enacted a legislation to remove regulation by Federal and state governments of over-the-counter or OTC derivatives. The commission points out that the enactment of such legislation was a key to the cause of the financial crisis. All types of business entities use derivatives to hedge against or speculate about changes in commodities, stocks, etc. However, as useful as this method might be, if left unchecked it can get out of hand. The derivatives market grew out of control to the tune of $673 trillion that firms involved in this market had no adequate collateral, their leverage was out of hand, capital was insufficient to cover their positions, had inaccurate estimates of risk, lacked transparency in their transactions, and reports on how these firms were interconnected thru derivatives. The way OTC derivatives worked was as follows: credit default swaps (CDS) were sold to insure against default from top-rated tranches of CDOS. CDOS or Collateralized Debt Obligations were created by taking lower rated tranches out of Mortgage Back Securities (MBS) that contain hundreds of subprime mortgages all bundled together. Lower tranches in MBS had low ratings but had the potential to earn more. The CDOS created out of the lower tranches of MBS had AAA ratings, even though; they were created out of the riskiest tranches in MBS. Add to CDOs, CDO-square which follow the same idea for creation as CDOs. Therefore; CDS allowed the sale of AAA CDOs by telling investor of their low risk, but at the same time increased the risk of seller of the CDS to a potential collapse in the housing sector. Furthermore, CDS allowed for the creation of Synthetic CDOs that contained credit default swaps, and thus; allowed investors to bet on the performance of the housing sector. Years later, when the housing sector collapsed, derivatives did a lot of damage especially to AIG who had sold $79 billion of theses sophisticated investment instruments, and who had not put capital aside as protection for the protection it was selling. When hell broke loose, the government ended up spending $180 billion to recuse AIG because of fears of a trigger effect due to contagion to other business entities. Thus as one can see the work of a couple of Government bureaucrats can do quite some damage. Thomas Sowell, The Housing Boom and Bust Excessive Market Regulation Mr. Sowell’s account for the cause of the financial crisis differs in that Wall Street was not the cause of the financial crisis but the excessive meddling of the government. Mr. Sowell tells that the market was far from being unregulated, but heavily regulated by the Government. Such regulation fostered the perfect environment for reckless behavior on the part of firms involved in the financial mess. As far back as 1989, the administration of President H.W. Bush thru The Department of Justice demanded access to loan records from several Atlanta banks. The administration was alleging possible racial discrimination from banks against customer with a certain racial background when these customers applied for loans. In 1992 a bill was signed into law asking banks to make housing loans to people in “underserved areas”. Furthermore, during the Clinton administration former Attorney General Janet Reno threatened banking institutions with legal actions, if they denied loans to their customers based on race. The majority of the people applying for loans had sketchy credit histories and an unstable financial situation. Thus, the reason why banks were hesitant to make housing loans under traditional standards, but not because of race. Nonetheless, the government forced banks to make loans to the “underserved population”. In order for banks to have people qualify for housing loans, they created exotic types of mortgages such as low-down payment, no-down-payment, and interest only mortgages among others types which are considered risky mortgage loans. Furthermore, pressure was put on Freddie Mac and Fannie Mae, also known as “government-sponsored enterprises”, to buy these nontraditional house loans. As soon as Banks knew that there was a way to pass on the risk on the GSEs, they were willing to create more risky loans, even lower there criteria to make borrowers qualify to get these nontraditional loans. At the first, it was only required for Freddie and Fannie to buy a small portion of these bad loans. However in 1996, the Department of Housing and Urban Development, an agency commanded by any administration currently in power in Washington, that exercises control over Fannie Mae and Freddie Mac started demanding these two GSEs loan quotas of 40 percent, and later 53 percent. For Fannie and Freddie, it wasn’t so difficult to meet such quotas because there were market and political incentives for them to do so. Since these GSEs offered high risky investments they could also make higher profits, and if there were any losses they could use taxpayers money to make up for them. Furthermore, Fannie and Freddie could borrow at low interest rates because they were sponsored by the government, and thus; they could use sponsorship of the government as collateral to borrow money. As Mr. Sowell shows it all this excessive regulation turned into a vicious cycle of reckless behavior from the people enchased of running these GSEs and from people at the head of major financial institutions. Government Bureaucrats Following with the analysis from Mr. Sowell’s book, when it comes to Government bureaucrats who lack intelligence, and not corruption, Barney Frank and Christopher Dodd take the tile. In 2003 Barney Frank came out to defend Freddie Mac and Fannie Mae practices by saying that those who were criticsing these GSEs were exaggerating such allegations. Mr., Frank believed that the Federal Government still needed more in terms of pushing for more affordable housing. He wanted Freddie and Fannie to get deeply involved in low-income housing and provide subsidies if needed. Also, he expressed concern for the criticism about lower lending standards, and told that such criticism could jeopardize affordable housing. Furthermore, he dismissed fears about these two GSEs engaging in risky operations that could pose a problem to the federal government because of a possible bailout. Barney Frank became chairman of the House Committee on Financial Services in 2006. However, in January 2009, Mr. Frank’s assertions were proven wrong when Fannie and Freddie had to receive bailed out money for about $238 billion. During the bailout period, One United Bank of Massachusetts wasn’t eligible for bail out money, however; Mr. Frank somehow arranged for One United Bank to receive up $12 million. Congressman Barney Frank wasn’t alone in his arcane assertions, Senate Chairman Christopher Dodd of the Senate Banking Committee, back in 2004; told that Fannie and Freddie were a success story and warned that restricting their business practices could do a lot of harm to these “great engines of economic success”. Later and article published in the Wall Street Journal found that Fannie and Freddie had been donating to about $5 million since 1989 to members of congress. One of those members was Senator Christopher Dodd with $16500. Politician and Flawed Laws Continuing with the review of Mr.Sowell account on the financial crisis, he points out the community Reinvestment Act was a flawed law enacted by politicians that cause damaged to banks and benefited government bureaucrats and private groups such as Acorn and HUD. The main purpose to the CRA was to direct Federal financial agencies to encourage banks to help less credit worthy borrowers get loans in the communities where such banks were established. If banks decided not comply with the CRA requirement, regulator could deny banks request to open new branches or conduct business transactions such as mergers. Government officials used the CRA to put pressure on banks to lend to who they wanted to. During the Clinton and George W. Bush administration pressure grew not just to lend to the people in the communities they were established, but to lax lending qualifications in general. Private organizations such as Acorn saw the opportunity in the CRA to extract millions of dollar from banking institutions. ACORN’s tactic was to charge bank about not living up to their responsibilities within the community. Therefore, because regulators could look at bank’s CRA record, banks had to pay large sums of money to ACORN in order to have such allegation removed. Also the HUD started taking action against mortgage lenders that turned down a large percentage of people applying for a mortgage loan. Thus, lenders had no choice but change their lending standards in order to qualify more borrowers. The Blame Game in The Financial Crisis The FCIC Report The FCIC blames the free unregulated market for the financial crisis. The commission points out that the Federal Reserve led by Alan Greenspan, successive administrations, Congress, pushed by powerful Wall Street leaders allowed for more than three decades of deregulation with the idea that the market could self-regulate. Moreover, the Federal Reserve failed to contain the flow of risky mortgages by not setting reasonable mortgage lending principles. Financial institutions trade securities that were not examined carefully about their potential risk to the economy. Firms also were heavily leveraged and depended on overnight borrowing to finance their operations. At the same time, they were using their subprime mortgage securities as collateral to attract funding. Top executives at these firms were motivated to take such extreme risk due to the high compensation packages that rewarded their reckless actions. Furthermore rating agencies were facilitating the sale of risky mortgages securities by assigning AAA ratings. As this all shows, federal agencies such as the Federal Reserve, the Federal Reserve Bank of New York, and the Treasury Department were not at their posts. Also the FCIC report concludes that even though, Freddie Mac, and Fannie Mae had deep flaws in their business practices, and contribute to the crises, they were not primary cause. The GSEs “followed rather than led Wall Street and other leaders in the rush for fool’s gold”. The mortgage related securities purchased by the GSEs were of high quality and these purchases were not representative of the overall mortgage securities market. Furthermore, the commission adds, the value of the securities purchased by the GSE’s held their value and did not contribute to the crisis. Also the commission points out that the indolent of the HUD in respect to the goals placed on Freddie Mac and Fannie Mae to reach affordable housing to low income people, only contribute marginally to the involvement of the GSEs in risky mortgages. The Community Reinvestment Act was not a major factor in the crisis either. According to the commission many lenders were not subject to the CRA, and those that were only represented 6% of all the high cost loans made. Those CRA regulated lenders’ loans that were required to lend in the communities they were established were only half as likely to default as similar loans made by other lenders not subject to the CRA. The commission adds, rather than blaming these acts, and policies; government entities such as the Federal Reserve and other regulators failed to exercise their authority to oversee the markets. Thomas Sowell, The Housing Boom and Bust On the other hand, Mr. Sowell blames politicians and their flawed policies saturated the market with too much regulation. Administration from both parties such the Clinton and the Bush administration pushed for higher rates of home ownership. The HUD put tremendous pressure on Fannie and Freddie by setting loan quotas to accept risky loans. Also, the HUD had indirect regulatory power over banks thru the Community Reinvestment Act. The HUD required banks to report regulator their approval and denial rates on loans. If the regulator saw unsatisfactory approval rates, they could charge bank with not meeting their CRA requirements. Therefore; in reality government agencies were requiring lower lending standards in order to meet political goals. As for Wall Street firm, they did what any business would do which is to serve the needs of their customer by creating investment vehicles that would allowed to bring in profits for their customers and their firms, but in many cases neither the creators nor purchasers of the securities, along with rating agencies were aware of the financial records of the home buyers. These institutions were dealing with problems of their own such as liquidity problems and principal agent problems that in the end contributed in part to the financial crisis.