Democracy and the Financial Crisis - by Ohmyrus

According to a Congressional report by Darrell Issa, government intervention in the housing market is the main cause of the Financial Crisis.

The report explained how the Clinton administration in 1995 issued a National Homeownership Strategy, which weakens Fannie Mae and Freddie Mac's lending standards and insisting that banks 'work collaboratively to reduce homebuyer downpayment requirements.'

Clinton complained that in 1989 only 7% of mortgages had less than a 10% downpayment. It wanted that figure to be raised to 29%! Generally speaking, the businessman should be left alone to make their business decisions because he knows what's best for himself. The 'invisble hand' of Adam Smith ensures the optimum allocation of resources. Only in rare occasions where there is a market failure in the proper allocation of resources, should the government intervene. Why did the government intervene in this case?

It must be remembered that in a two party democracy, one party is fighting for the losers of society and the other is fighting for the winners. In the case of America, the Democratic Party is the party for losers. It tries to win votes from the bottom half of the income divide by promising to bring material goodies to their voters. This is normally done by redistribution policies ie taxing the top half and spending the money on the bottom half.

The Republicans, the party for the winners of US society, strives to cut taxes and minimise the transfer of wealth from their voters to their political opponents' voters.

So government intervention in this case, was not to make the economy more efficient or more prosperous but to win votes and hence power for the votrepreneurs (politicians) . Power comes with its perks and in Clinton's case, his chief perk seems to be access to loose women.



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But banks were reluctant to give loans to poorer people because they were higher credit risks. So Clinton toughened the Community Reinvestment Act forbidding banks to expand if they do not lend more (in effect) to Clinton's voters - the lower income groups, especially minorities.

The result was that banks ended up making a flood of mortgages they formerly refused to touch with a 100 foot pole. This fueled a housing boom. Many of these mortagages carried little or no downpayment. That's why they are called sub-prime mortagages. Voters thus were bribed for their votes by giving them housing they could not afford. But there is no FREE LUNCH. Someone has to pay. Let's see who.

The banks, of course, did not want to pay for the lunch given away by the votrepreneurs ie they did not want to hold on to these dubious mortgages. So Fannie Mae and Freddie Mac were told to buy up these dud mortages and repackaged them as Mortgaged Backed Securities. The Glass Steagal Act was also repealed to allow banks to do Investment Banking. This allowed them to repackage these dud mortgages into securities and sell them off to anybody who is willing to assume the risks of defaulting mortgages. Somebody else can carry the risks. Hey! Somebody has to be the sucker.

Private investors, fund managers, banks, pension funds bought them and eventually were made suckers when the property market crashed. But the biggest owners of Mortgaged Backed securities were Fannie Mae and Freddie Mac.

These two are government sponsored enterprises which Congress oversees. Bad deal for their shareholders. What this means is that Congressional leaders will want the two companies to behave in a manner that maximizes their votes instead of maximizing profits for the shareholders. So they ended up owning tons of these risky mortgaged backed securities at very high leverage. If things go belly up, which they eventually did, the shareholders loose their pants. But they are not the only ones to go trouserless.

You see, while Congress did not explicitly guarantee Freddie and Fannie's debts, there is an implicit guarantee. This means that taxpayers will loose their pants in the event that they go belly-up, which they did. Bad deal for taxpayers too. Now you know who the biggest sucker is.

So the bottom line is that the votrepreneurs (politicians) have arranged things in such a manner that taxpayers paid to vote them into office. But don't blame the votrepreneurs, its the system.

While the above description was basically what happened, the whole affair is a lot more complicated and its not just votrepreneurs that should be blamed. A host of characters also must share some of the blame for the financial crisis.

In no particular order, the first on the list is Alan Greenspan, former head of the Federal Reserve. Let's call him the Fedhead. Well, Mr Fedhead kept interest rates too low for too long. This flood of money encouraged speculation in the property market. Everytime, it looks like there might be a recession, the Fedhead turned on the money taps.

This encouraged people to suffer the delusion that recessions have been banished forever from Wonderland. Soon businessmen and consumers were lulled into complacency and they put on more debt. Actually, recessions are healthy for the economy. It weeds out badly run companies and redeploys capital and workers more efficiently.

The economy is like a forest. From time to time, there is a fire. Forest fires are simply a part of nature. So forest rangers should not try to put out fires. The fire burns away at the dead wood that collect at the forest floor and opens up clearings for new trees to grow. Similarly, a recession forces poorly run companies to go bust, creating space for younger, newer companies to emerge.

If park rangers keep putting out fires everytime lightning strikes, dead wood will collect on the floor. One day, there will be a fire too strong to control and the whole forest will burn down. So it is the same in the economy. The Fedhead kept 'putting out the fire' and thus allowed inefficiently run companies to survive. Complacency set in and these companies piled on more and more debt. The consumers also put on more debt like the forest accumulates tinder.

Then one day we get a severe recession and global crisis that they cannot control - like now. It is better for the Fedhead to allow frequent but smaller recessions to take place than having a huge one like what we have now.

The next on the blame list are the bankers and fund managers. These guys 0n Wall Street get huge bonuses by gambling with other people's money. They system goes like this - heads we win but tails you lose. In the case of bankers, they geared up their companies to make risky loans or buy risky assets. When the going was good, the banks reported fat profits and the executives collected fat bonuses. Shareholders also win.

This encouraged them to take on risky behavior - since they do not generally suffer personal bankruptcy if their banks go bust. The more they leveraged their banks, the more money they made. When the banks go bust, they still get to keep their bonuses earned in previous years. But you, the shareholders get wiped out.

In this current financial crisis, while initially banks were initially reluctant to retain mortgaged backed securities in their books, prefering to sell them, they eventually did so. They wanted to enhance their earnings and hence their bonuses. If the mortgages default, its the sharholders to bear the loss while they get to keep all their bonuses during the good years.

Its the same with hedge fund managers. These guys collect money from their clients to buy financial assets like stocks, derivatives, mortgaged back securities etc. They also used leverage. If they market goes in the right direction, they make more money for their clients who will pour in more money into their funds. During good times, they collect fat fees from their clients.

But when the market crashes, their clients often get wiped out. But they also get to keep their fat fees earned during the good years. In a nutshell, bankers and fund managers gamble with other people's money. They get to grow rich during good times and suffer no losses during bad times, prompting them to take huge risks with other people's money.

The nature of the financial markets is that crashes are inevitable and their shareholders or clients will one day be wiped out given the high leverage. Heads we win and tails you lose. Sooner or later, you are going to lose. But they won't go to jail in a paddy wagon like Bernie Maddoff. Instead, they can sail to Bermuda in their yachts.

That is why I cannot understand why Bernie Maddoff ran a Ponzi scheme. Not only is he a crook, he is a stupid crook. Doesn't the clown know that Wall Street gives you ample opportunity to cheat people the legal way?

The next one on my blame list are the credit rating agencies. There are three large rating agencies - Moody's, Standard and Poors and Fitch. These guys are supposed to give their opinion on various financial instruments. Unfortunately, they get paid by the guys whom they are supposed to rate! This is one time when competition is bad for you. If one agency gives you lousy ratings, you go elsewhere. In the end, risky assets like Mortgaged Backed Securities got high ratings. Its like your boss asking you what you (honestly) think of him.

While the blame for this financial crisis can be spread fairly wide, the largest share of the blame must fall on the votrepreneurs (politicians) and the political system that produced them. After all, it was they who encouraged the growth of sub-prime lending so that they can win votes. That was how this mess got started.

We need to reform the system in such a manner that the personal interests of the political class coincides with the nation as a whole. Unfortunately, the current system makes it worthwhile for the votrepreneurs to behave irresponsibly and betray the very people they were elected to serve.

What can be done about it? The key is to empower the taxpayers whose money is used to bribe voters so that votrepreneurs can win office. Paying taxes is the chief contribution an average citizen makes to his country. Those who pay more taxes must have more say as to how that money is to be spent. That is why America's Founding Fathers restricted the vote to those who paid taxes. They understood the linkage between taxation and representation. That was why their complaint was, "Taxation without Representation is tyranny."

Today, all too often we have Representation without Taxation and it is also tyranny.Those who pay little or no taxes have more power to decide how to spend taxpayers' money than those who paid most of the taxes. The result is to make everyone poorer. In my earlier article, Lessons from the Ancients, I have proposed some solutions that can empower the taxpayers without sacrificing the one-man-one-vote system. Its time for reform or America will go the way of hyper-inflation and economic decline leading to the collapse of democracy itself.