A Crash Course in Crisis Economics*
IV. The Fungibility of Zero-Risk Bets and $55 Trillion FUBARs
Barney Frank now says his biggest blind spot was his limited understanding of the unregulated derivatives that Brooksley Born had been warning the Financial Services Committee about, and the extent to which they intensified the risk of subprime loans and spread it out through the international financial system. From an academic perspective, that’s true. Policy-wise, his more fundamental blind spot was the reason he joined the Financial Services Committee in the first place: his interest in housing, and specifically the federally sponsored mortgage giants Fannie Mae and Freddie Mac.
Fannie Mae was founded by the government in the 1930s to encourage homeownership by lending money to banks so they could extend mortgages to middle- and working-class borrowers. In 1968 it was privatized in a ploy to balance the federal budget that "saved" the government billions by getting the mortgages off its books. No one then believed the government would not guarantee the mortgages it bought; no one ever would. If Fannie Mae ran into cash-flow problems, a federal bailout seemed assured. As Michael Lewis wrote in Liar’s Poker, his definitive book on the advent of mortgage bonds, "To stand up in Congress and speak against homeownership would have been as politically astute as to campaign against motherhood." Or economic growth.
And here we return to Alan Greenspan. Where previous Fed chairmen had focused mostly on reining in inflation, Greenspan gave himself a dual mandate: He’d keep inflation in check while also growing the economy, something he did by holding down interest rates and applying a rather malleable definition to price stability. Fannie Mae, too, had a dual mandate: to help middle- and working-class families buy homes while also making fat profits for shareholders — a toxic combination.
Frank was actually an early skeptic of the rapid growth of homeownership, especially against the backdrop of a fast-widening income gap. But he abided it, and supported Fannie Mae and Freddie Mac over the years because they were the only vehicles he had for affecting housing policy under Republican rule. Then, in 2003, the Bush administration began to mobilize to toughen regulations on Fannie and Freddie in response to a host of accounting shenanigans (shenanigans that came during a stretch that had also seen the collapse of Enron, as well as sundry other big corporate scams). Frank was among the Democrats — who, not for nothing, took thousands in campaign contributions from Fannie and Freddie — seeing the White House’s move as basically a power grab that would have robbed the committee of what they considered their last shred of authority over housing policy.
Frank’s argument, essentially, was that the Bush administration was ginning up accounting irregularities as an excuse to undermine the American Dream. "The more people exaggerate these problems," he said during one of the hearings that ensued, "the more pressure there is on these companies, the less we will see in terms of affordable housing."
What critics who’ve used that sentiment as their basis for blaming Frank for the whole home-loan meltdown fail to acknowledge is that once passions cooled, Oxley and Frank marshaled support for a bipartisan bill regulating the mortgage giants that passed 331 to 90, only to be ignored by the White House. Further, the worst abuses at Fannie and Freddie, and in the larger mortgage business, did not begin until 2004, the year the credit-rating agencies lowered their standards for mortgage-backed securities. At the same time, the SEC relaxed capital requirements on investment banks, allowing them to take on 20 and 30 times their total assets in debt, which just accelerated the chase around the financial world for new bets to make.
Ultimately, there were only so many of those bets to place. And the shrewdest one, that it would all go bust, was also a tricky one to pull off. It’s relatively easy to short-sell a stock whose price you think is going to fall. But betting against the housing market requires an esoteric type of derivative security called a credit-default swap, an area of finance Frank had been putting off figuring out. ("Derivatives also is something we have to look into," he said during a 2003 hearing. "I say that with all the enthusiasm of being told that we’ve got to go back to trigonometry and take a test in it.")
Perhaps as penance, Frank now explains credit-default swaps (cwredit-defawlt swaaahps, when he says it) everywhere he goes. One Saturday morning a few weeks before Election Day, he arrives early to an otherwise deserted Sturbridge hotel for an annual gathering of state selectmen and launches into his lesson just before 9 a.m. He begins with a topic arcane to most, but familiar to anyone in local government: "monolines."
When a city or town decides to float a bond offering to pay for a stadium or an airport renovation or some such, it can usually borrow at lower rates if it buys default insurance from a bank — the monoline — which insures the principal in case of default. Well, credit-default swaps are just like bond insurance, except you don’t need to be an insurance company to sell them, and you don’t need to own any actual bonds to buy them. If you were selling swaps, you could issue infinite insurance policies on the same bond; if you were buying, you could purchase limitless amounts.
The prices charged for swaps were generally based on the historical rate of default for the underlying variety of bond, and mortgage bonds, throughout most of the relevant history, had rarely defaulted. Accordingly, swaps based on mortgage bonds could be had on the cheap, though acquiring them looked like a sucker’s move: It meant taking the very contrarian position that home values were due for a big fall. "They thought they were selling life insurance to vampires!" Frank says. By the time it became clear that housing prices would indeed not hold, the dollar amount pegged to or hedged by credit-default swaps had reached $55 trillion.
In other words, per Frank: "These people insured so much money…that they now owe more money…than there is money!"
It’s a line he’ll repeat over and over, always to roars of laughter, because if you can’t laugh at financial Armageddon, what can you laugh at? But underlying it is a question that’s not so funny: What if someone had told every man, woman, and undocumented worker who signed up for a mortgage after 2005 that the smartest money on Wall Street was betting trillions of dollars that they’d wind up in foreclosure?
Who knows, maybe the market would have worked. And maybe Barney Frank wouldn’t be diving headfirst into the moral-hazard morass that is coming to the rescue of a bunch of guys who vilify him as a left-wing zealot. As it is, as he told the crowd back at that New Hampshire fundraiser, "I’m from the government, and I’m here to help. That used to be a right-wing joke!"