No single government decision in the last two decades caused the steep descent into the present economic quagmire. But working hand-in-hand, both political parties gave Wall Street everything it wanted. In effect, Washington D.C. let the foxes guard the chickens!

Once a god, Alan Greenspan "Made a Mistake"
In subdued testimony before Congress on October 23rd, the 18-year Chairman of the U.S. Federal Reserve Bank said that he had put too much faith in the self-correcting power of free markets and had failed to anticipate the self-destructive power of wanton mortgage lending. He also said his belief in deregulation had been "shaken."

President Ronald Reagan originally appointed Greenspan to his high position. Greenspan retired in 2005 after serving under three different U.S. presidents. He was replaced by the current head of the central bank, Ben Bernacke.

Here are major milestones along the road into the quagmire.
1. Ronald Reagan
Ideologically, the popular Reagan set the stage during his presidency from 1980-88. He introduced "Reaganomics," which included deregulation, in general, and tax cuts that were implemented in 1981.

George H.W. Bush followed Reagan into office in 1989 and Bush carried on Reaganomics, with one exception. While he was elected to office on a pledge to "read my lips, no new taxes," he did raise taxes in a compromise with the Democratically-controlled Congress. This reversal of position helped Bill Clinton defeat the first Bush in 1992.

2. Bill Clinton
Clinton (1992-2000) led several landmark steps contributing to the current economic quagmire. First, he signed into law a bill spearheaded by Senator Phil Gramm. The Gramm-Leach-Bliley Act removed Depression-era laws separating banking, insurance and brokerage activities. This Act was a dream come true for Wall Street. Phil Gramm, a Texas Republican and a big proponent of deregulation, was the chairman of the U.S. Senate Committee on Banking, Housing, and Urban Affairs between 1995 and 2000.

Meanwhile, in the mid-1990s, Clinton's top housing official, Henry Cisneros, the head of the Department of Housing and Urban Development (HUD), was loosing mortgage restrictions so first-time buyers could qualify for loans they could not get before.

Under the Clinton HUD, families no longer had to prove they had five years of stable income to get a mortgage loan. Three years would do. And in another change championed by the mortgage industry, lenders (e.g., banks) were allowed to hire their own appraisers rather than rely on a government-selected panel. This saved borrowers money but also made inflated appraisals easy—and more likely. A later HUD inquiry found appraisal fraud that actually imperiled the federal mortgage fund.

3. Derivatives—Financial Voodoo for the Few
In the 1970s the wizards of Wall Street and their advisors introduced a set of financial instruments called derivatives. They were theoretically designed to lower risks for buyers and sellers, including those in recent times involved in Mortgage-Backed Securities (bonds). The primary use of derivatives is called hedging.

In some respects, derivatives were (and are) insurance-like contracts designed to protect, say, bond investors, from default by the bond issuers. The name, derivative, is used because the value of a specific instrument is based on (derived from) something else.

The last few years, the complexity and prevalence of derivatives has escalated so that today there are futures, swaps, options, and other exotic hedges available to the wise and un-wise. All together, derivatives have accelerated and deepened the current economic crisis.

A very thin layer of people know how derivatives work, or don't work. For example, there were two people who won a Nobel Prize in 1997 for figuring out a new way to price derivatives. These two co-founded Long-Term Capital Management, one of the early, highly-leveraged, hedge funds. It went bankrupt in 1998 and raised a lot of eyebrows. The eyebrows returned to normal; the derivatives went on.

In 2000, a well-orchestrated financial services industry persuaded Congress to allow a huge, unregulated market in derivatives, which are traded privately. Their estimated market value on October 13, 2008 was $531 trillion. And losses from derivatives, in association with Mortgage-Backed Securities, are what helped bankrupt giant Lehman Bros in September. Losses on derivatives also led to the government bailout of another giant, the insurer, AIG, in recent weeks, a bailout that is not yet finished.

Why did Congress take a hands-off approach? Note this paragraph from a front-page story titled: How Congress set the stage for a meltdown.
The bill barring most regulation of derivative trading was inserted into an 11,000-page budget measure (in Congress) that became law as the nation was focused on the disputed 2000 presidential election (Bush vs. Gore). The inserted bill was sponsored by Republican Senators Phil Gramm of Texas and Richard Lugar of Indiana, with support from Democrats, the Clinton administration, and then-Federal Reserve chairman Alan Greenspan. Few opposed it. USA Today Oct. 13, 2008.

Here is an October 22, 2008 observation on derivatives that has caused a bit of a stir: "When unconstrained by good regulations, derivatives can be financial weapons of mass destruction." This quote is from an opinion article in the Wall Street Journal by Darrell Duffle, professor of finance at Stanford University's Graduate School of Business.

4. Congress Protects its Babies
From 2003-2005, during the middle of the George W. Bush administration, there were sporadic attempts by isolated individuals to curb the risky investments being made and encouraged by the two, government-sponsored mortgage giants, Fannie Mae and Freddie Mac. But Congress, along with the Federal Reserve Bank (Greenspan et al) and the administration, looked the other way. Both huge agencies had the implicit backing of Congress; both were able to borrow money at below-market rates; and both had public shares trading on the stock market so they had plenty of investors cheering them on. The agencies boomed, even in the face of accounting scandals in 2003 and 2004. And the executives of the agencies were paid tens of millions of dollars.

Then the house of cards with a foundation of simple mortgages started collapsing.

Short Case History of How Virus Spreads
Author, Thomas L. Friedman, of the New York Times put out a short story titled, "The Great Iceland Meltdown," on October 18. Here is the gist of the story.

Iceland has 300,000 people on about 40,000 square miles of land. In 2007 Iceland was ranked as the most developed country in the world in the United Nations' Human Development Index. In 2002, Iceland began deregulating its banking system (three banks) by freeing it from state ownership. The three banks boomed, based on easy credit and the free flow of money and securities around the world. And the banks wooed savers from Europe by paying 5% or more on savings accounts. Deposits poured in from nearby Britain, apparently around $1.8 billion in round numbers.

Recently, when the world credit market seized, depositors rushed (via the Web) to get their money out of Iceland, but the banking system there had too few reserves to cover withdrawals. So all three banks failed and were nationalized (re-regulated the hard way).

Who was left holding the (empty) bag? Friedman says that British newspapers have reported that more than 120 British municipal governments, universities, hospitals, and charities have deposits stranded in blocked Icelandic bank accounts. This included 15 British police forces from small towns.

What's the message from this brief story? Friedman, author of the best-selling book, The Earth is Flat, says that the story points out that people around the world are all connected these days. When a homeowner in L.A. defaults on his or her mortgage payment, the ripples extend to Iceland and the U.K.
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Said another way, when a virus (Mortgage-Backed Securities) has a dark, warm breeding ground (non-regulation of financial industry) and a catalyst (derivatives), a lot of people around the world end up sick, stuck in an economic quagmire.

Editor's Note: Steve Brandt is Senior Lecturer in Management, Emeritus at the Stanford Graduate School of Business where he was a faculty member for 21 years.



Author's Notes: Intervention, as is now underway by the U.S. federal government, is not a new thing. Over the last 100 years, Washington D.C. has occasionally taken stakes in railways (1917), coal mines and steel mills (1952), a large bank (1984), and even a car company (Chrysler in 1979) and an aircraft company (Lockheed in mid 1970s). In general, the interventions have been short-lived as Americans have not favored government ownership of private enterprise.

This series, by a non-economist, non-banker, is written to try to help readers get their arms around the current, economic mess. Understanding can provide a whiff of relief. The series highlights some of the major peaks of the problem; the series does not attempt to describe the entire mountain range, a task far beyond the author's ability. Part I on Mortgage-Backed Securities can be seen by clicking on Other Stories. Part III in the series, about Money (lobbying) in D.C., is also available in Other Stories.