Democracy Reform

Sir Winston Churchill once said that democracy is the worst form of government except for all the rest. He is right. Its the best form of government but it also has its flaws. I think that its flaws endanger democracy and needs to be fixed. This blog is for like minded people who want to see democracy improved. I invite people to sumbit essays. I will publish even those I do not agree with so long as I find them interesting.

Wednesday, September 24, 2008

The Political Roots of the Financial Crisis

In the midst of the worst financial crisis since 1929, people are asking, "Who's fault is it?"

It is human nature to find someone to blame. We all want to know who the culprit is. Some blame greedy and incompetent executives who over leveraged their firms and drove them to the ground. One favorite target are the speculators who shorted financial instruments.

All these could have parts to play in the debacle. But commentators have so far over looked one important point - the political system that contributed to the debacle.

The current crisis is at its heart a housing crisis. Housing prices rose as a result of easy loans made by banks and other financial institutions. Loans were made to people who could not afford to buy property. These are called "sub-prime" mortgages.

Banks knew that they could not pay but felt that they could get away with it by pooling these mortgages into Mortgaged Backed Securities or Collaterized Debt Obligations. These were sold off by investment banks like Merrill Lynch or Lehmen Brothers to investors who assumed the risk of default in exchange of a higher rate of return.

This blew the housing bubble even higher. As housing prices grew, there was no problem. Buyers of property could always sell off their property to pay off their mortgages. But as in all bubbles, it has to pop sometime.

Sub-prime mortgages started to go sour. The problem was that instead of flogging all these sub-primes to gullible investors, Citibank, Merrill Lynch, Lehmen Brothers kept much of them in their own books. I guess they believed in their own marketing hype. Since they were highly geared, they became insolvent. Unfortunately, the biggest buyer of sub-prime mortgages were Fannie Mae and Freddie Mac. That's where the politics come in.

Politics in democracies is mostly about competition between the winners and losers of society. Generally, there are two main parties. One fights for the winners and the other the losers. Both parties behave like business companies and their customers are the voters.

The party of the losers (in the case of the USA, the Democratic Party) tries to transfer income from the winners by taxing them and spending the money on their customers - the losers. The Republicans, try to win votes by cutting taxes and thereby helping their customers, the winners to keep their winnings.

So it came to no surprise that it was the Democrats who took the lead to help lower income groups to own property. After all, they were their number one customers. The first seed of the bubble was planted during the Carter administration when Congress passed the Community Reinvestment Act.

Prior to the Act, banks typically targetted lending money to folks from the better neighborhoods, a process called "redlining".

This Act lacked teeth till it was strengthened under the Clinton administration. What is does basically is to pressure banks to make loans to people they normally would not want to. It was to address the so-called problem of banks preferring to loan to people with higher incomes. Banks who wanted to expand or merge must have a good CRA rating. To achieve this, they must meet certain quotas that includes lending to the Party of Losers' preferred borrowers. For a while, Countrywide Financial was regarded as a role model. Of course, we all know what happened - it went bust and had to merge with another bank.

Next we have Freddie Mac and Fannie Mae which were set up by Congress to help Americans to buy homes - a noble idea. Under an implicit and now explicit guarantee by Congress these two giants were able to borrow money at lower rates than banks could which they then use to buy mortgaged backed securities thereby lowering mortgage costs. Trouble was that the two giants were permitted to have 50 times leverage instead of 10 times for banks. In other words, Freddie and Fannie could lend out $100 for every $2.5 in capital. The rest - $97.5 can be borrowed!

Another outrageous rule change during the Clinton administration was to allow Freddie and Fannie to buy sub-prime mortgages. This fueled the bubble even further. In 2005, Alan Greenspan warned Congress of the monster they have created. The Senate Banking Committee passed a Reform Bill to curb the activities of Freddie and Fannie. Senator McCain was one of the sponsors.

But Senators Obama, Clinton and Dodd and others protected Fannie and Freddie and killed the Reform bill. They of course knew that stopping the two monsters would be unpopular with their constituency - the losers and hurt their political careers. Of course, donations from Franklin Raines, ex-CEO of Fannie to Obama and Dodd may have something to do with it.

But don't blame them. Its all the fault of the system. If they did not behave like that they won't be elected. Someone else would and the same thing will happen. If this financial crisis teaches us something, it is that democracy needs to be reformed so that votrepreneurs don't need to behave irresponsibilly to get elected.

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