Was It Wall Street or the Government?

A recent Securities Exchange Commission (SEC) investigation into Fannie Mae and Freddie Mac, the two government sponsored enterprises (GSEs) that were integral to the housing boom and bust, now formally argues that these two organizations committed massive fraud, which underrepresented their exposure to subprime mortgages and contributed to the economic meltdown.

The Wall Street Journal expounds how this investigation blows holes in the argument, often proffered by anti-capitalist Democrats, that Wall Street is solely to blame:

Democrats have spent years arguing that private lenders created the housing boom and bust, and that Fannie Mae and Freddie Mac merely came along for the ride. This was always a politically convenient fiction, and now thanks to the unlikely source of the Securities and Exchange Commission we have a trail of evidence showing how the failed mortgage giants turbocharged the crisis. 

That's the story revealed Friday by the SEC's civil lawsuits against six former Fannie and Freddie executives, including a pair of CEOs. The SEC says the companies defrauded investors because they "knew and approved of misleading statements" about Fan and Fred's exposure to subprime loans, and it chronicles their push to expand the business.

And while the GSEs were somewhat independent from the legislature and the bureaucracy, the paper trail seems to go further back. At least some of the incentive for the alleged fraud was directly caused by government's social policy of getting every American his or her own house - regardless of the ability to afford it.

The Beltway story of the crisis claims that Congress's affordable housing mandates had nothing to do with it. But the SEC's lawsuit shows that Fannie degraded its underwriting standards to increase its market share in subprime loans. According to the SEC suit, for instance, in 2006 Fannie Mae adjusted its widely used automated underwriting system, "Desktop Underwriter." Fannie did so as part of its "Say Yes" strategy to "provide more 'approve' messages . . . for larger volumes of loans with lower FICO [credit] scores and higher LTVs [loan-to-value] than previously permitted."

Unfortunately, this is what happens when the government meddles in private-markets for social engineering purposes - prices (and risk) get mispriced, bubbles are grown, and then busts bring the economy down. And while this does not fully absolve Wall Street (fraud did occur and non-criminal stupid decisions were made) or the consumer (the role that greedy homeowners played in buying too much house or refinancing to buy flat-screen TVs and BMWs is unfortunately overlooked), it does shed light on the harm government can do. Sometimes trying to help people ends up with a worse outcome than doing nothing, especially if all potential consequences are not considered from the outset.

The Power of Lobbies

It is a common political pastime to disparage so-called “special interests.” Their association with the Big “You Fill in the Blanks” [Business, Insurance, Auto, Pharma, etc.] and their alleged corrupting influences on politics has made them an unremitting target of popular umbrage. Following the Citizens United decision, President Obama distinctively claimed that it was “a major victory for big oil, Wall Street banks, health insurance companies and the other powerful interests that marshal their power every day in Washington to drown out the voices of everyday Americans.” However, a year after this infamous and contentious Supreme Court ruling, there has yet to be considerable, if any, focus on a key aspect of the special interest world.


The overlooked reality is that no lobby or special interest has any power save what is given to it by the government. Merriam-Webster defines a special interest as “a person or group seeking to influence legislative or government policy to further often narrowly defined interests.” Special interests gain clout not through their own power over a specific industry or market, but by influencing legislators or regulators to grant them undue sway. The real power lays with the government officials, who possess the ultimate command of coercion.

Surprisingly, this fact is frequently disregarded when populists want to attack special interests. However, if one takes a look at the industries where powerful lobbies exist there is an eerie correlation with government involvement. Seemingly, special interests would lose much of their influence if the government ceased arbitrarily meddling in private markets.

To be clear, this is not a claim that the problem of every special interest is rooted in government. For instance, simple vote- or seat-buying [Mr. Blagojevich] is often initiated by special interests and is unquestionably and inarguably wrong. There is little controversy that such behavior is unconscionable and must be eradicated. This is, of course, not a flaw in government as an institution but in government officials as corrupt individuals.

Nor is it a claim that government can have no constructive role in the private sector. Certain regulations and oversight are, at times, necessary. For instance, when non-legislatively caused monopolies exist and they are able, through illegal or unjust means, to deter competition (or in other words, cause severe distortions of the market) the government may have a limited role to play in deconstructing the firm’s market power.

Nevertheless, far too many of the problems (and there are many problems) in the private sector are the result of a conferral of power from the government to an undeserving group or individual. Critics miss the point when attacking lobbies, who like any other group or individual, are solely aiming to maximize their self-interest. Instead, the vitriol should be directed towards the regulators and politicians who continue to write laws and regulations that arbitrarily interfere in a world where the government does not belong. [To parallel, who is at fault when a demanding child is given one-too-many sweets– the relenting parent (who ultimately has the power) or the whining kid?]

Our government and our society need to change their outlook in this regard. If industries know that government will stand at arm’s length from the daily hubbub of a market and instead, solely create guiding rules (I.e. enforcement of contracts, prevent of abuse or fraud, etc.), the power of special interests will be severely limited if not eradicated. However, this is unfortunately not the case. Far too often, a tweak in a law can make or break a company’s bottom line. Right or wrong, this necessitates a strong response from an industry.

Republicans have a grand opportunity (and some say a mandate) to make this cultural shift. While so-far largely symbolic, the “repeal and replace” campaign against Obamacare is a prime testing ground. Regardless of whether the “replace” makes it anywhere in the next two years, it should be fundamentally based on the principle of clear, concise rules, that strengthen market forces and avoid noisome government meddling.  Avoiding unwarranted special interest power is as simple as prohibiting unjustifiable government forays into the private sector.

The State of the Perpetual Campaign

“We can’t wage a perpetual campaign.” So said President Barak Obama in a State of the Union address that was arguably another stump speech in a long-line of campaign speeches. The address was mainly an attempt at resetting his presidency to a time, a little over a year ago, when the President was popular and perceived he had a mandate to govern. Rather than drastically alter his direction, Obama emphasized a number of trends that have been unvarying cornerstones of the past year, namely populism, an anti-Washington sentiment, and the call for more government.

His populist stance was evident throughout the speech. While he admirably accepted some responsibility and admitted to gaffes, he largely played to the misgivings of the masses. He continuously bashed Wall Street and banks, targeting bonuses and the bailout. He said, “[W]e all hated the bailout. I hated it….”  Even while appealing to the grand notion of bipartisanship he attempted to separate ‘the people’ from the ‘elite’ by, for instance, offering an end to capital gains taxes, but only for small businesses.

This populism is rather disingenuous and anti-intellectual, as most populism is, and will only serve to foment fault-lines in American politics. All of America is responsible for the economic meltdown, not just Wall Street. By refusing to indict the average citizen for his mistakes alongside Wall Street, Obama is reinforcing a culture that dismisses personal responsibility.

The second major theme was the continued attempt to portray himself as an outsider to Washington. His repeated mantra was “Washington has been unable or unwilling to solve any of our problems.” It is a time-tested tactic for campaigners to portray themselves as outsiders. America habitually wants new visions and ideas and elected Obama a year ago largely based on this successfully transmitted message.

However what worked during his ‘real’ campaign will largely fall on deaf ears now. After a year in office, Obama is Washington. He said this much when castigating his party for their failures, “To Democrats, I would remind you that we still have the largest majority in decades, and the people expect us to solve problems, not run for the hills.”

Obama’s insistence on railing against Washington is interesting to say the least. It shows that he has yet to fully leave the campaign trail. From his perspective, this should be worrying as America has shown that it does not appreciate this politicking. America wants a president that leads not one that is on the campaign-trail.

The final major theme was his insistence on Big Government. Roughly two-thirds of his speech focused on the economy and rightly so. However, his entire approach of a paternalistic big government saturated his rhetoric. While his healthcare discussion was moderated, his language elsewhere continued the same cadence that drove the healthcare issue during the first year.  A prime example of this misguided economic policy was his discussion on college affordability. He stated:

And let's tell another one million students that when they graduate, they will be required to pay only 10 percent of their income on student loans, and all of their debt will be forgiven after 20 years –- and forgiven after 10 years if they choose a career in public service, because in the United States of America, no one should go broke because they chose to go to college.

Now this sounds noble and, on the surface, profound. After all, every America should have access to college and most understand the heavy load from student loans. However, if one spends a few seconds considering the ramifications of the plan the economics simply fail.

For starters, if debt is forgiven it means someone has to cover the costs. There seem to be three options – the taxpayer, the lenders, or the schools. If it falls on the lenders, well they simply will stop lending. No business will be willing to operate at a loss and so such a plan will reduce available loans. If it’s the taxpayers, well we all know the problems there. If the schools have to shoulder the burden it will reduce the quality of education as schools would be forced to cut programs, salaries, and other expenditures. Alternatively, it would give schools incentives to only admit those who could pay their own way, thereby restricting access to universities (particularly the elite) to the rich.

Likewise, Obama’s plan could create a perverse incentive for individuals to get frivolous degrees. Higher education is an investment in one’s future. While many enjoy learning, a higher degree should generally only be pursued if it offers a positive return. Such a program would encourage people to complete degrees that have little bearing on their career paths. While this is certainly noble and learning is a paramount value, it should not be done at the expense of demolishing our education system.

This is but one example of the administration’s warped economic perspective. Obama, while often pure in aims, far too often attempts to correct the symptoms rather than address the underlying problems. It is economically unwise to expand government in order to force changes in the price one pays without addressing the underlying cost of the product. This backward economic principle only serves to grow government and exacerbate problems.

However, despite the many flaws of the address, credit must be given where it is due. Obama did make a number of strong points and called for some positive changes. First he stated, “We need to make sure consumers and middle-class families have the information they need to make financial decisions.” The flow of information is a principal aspect of free competitive markets and should be applauded. Second, he called for off-shore drilling and the construction of nuclear plants (amongst other proposals) both which will create jobs and promote energy independence. Third, Obama invited both parties to offer ideas for healthcare reform. He stated, “But if anyone from either party has a better approach… let me know.” Hopefully this is not mere rhetoric and the Republicans will take advantage.

Obama has work to do. Hopefully, he can step up as a leader, dismiss the big government, partisan, and populist focus of his administration and end his political campaign. He seems to have learned some lessons from the past year, and particularly Massachusetts, but he is not quite there yet.