Financial meltdown blame game: Fannie/Freddie or derivatives?

The big political argument over the financial meltdown basically goes like this. Democrats point to the rise of incredibly complex financial instruments, in particular the species of derivatives called credit default swaps (CDSes), as ground zero for the disaster. Republicans prefer to point their fingers at Fannie Mae and Freddie Mac for making it too easy for people to get mortgages.

It’s easy to see how these preferences arise. Democrats can argue that CDSes became a problem because the Republican Congress (with limited Democratic help) chose not to regulate them, in keeping with the party’s decades-long deregulation fever. Republicans can argue that subprime mortgages backed by Fannie and Freddie became a problem because Democrats pushed to make home ownership more widely available to people who couldn’t really afford it.

These arguments have become a political shorthand, but responsible voters should take some time to sort them out. A couple of places to start: this point-counterpoint style debate between two pundits lays out some of thepolitical faultlines. This news analysis from McClatchy offers some factual background.

My take: Sure, Fannie and Freddie became a big mess, and you can’t let them off the hook. But the subprime mortgages were mostly originated by private banks, not F&F. And if the financial system’s only problem were subprime mortgages, you could simply buy up the worst of them for a few hundred billion and call it a day. That’s not why the banks got into trouble. It was the CDS market that took those mortgages and turned them into something “toxic.” By securitizing the risk involved in the mortgages and transforming it into a market theoretically worth tens of trillions of dollars but actually worth, well, who knows?, the CDS peddlers and purchasers pushed the entire financial world into the unknown. Specifically, they now have no idea what their credit-default swaps are worth.

That is why the banks stopped trusting each other. It’s the uncertainty over how to value these CDSes that seems to have caused the credit freeze that is the heart of today’s crisis. (That’s why Paulson originally wanted a bailout that would buy them — he trhought he could resolve the uncertainty — but that approach apparently proved unworkable.)

The uncertainty over subprime mortgages is old-fashioned and reasonably known: some percent of mortgage holders will pay up, some others won’t. Banks and insurance companies know how to handle that kind of risk. It was the effort to engineer new kinds of securities based on that risk that pushed us over the edge. The CDSes were supposed to reduce risk, and they ended up magnifying it inconceivably instead. And here we are, wishing that someone had had the forethought to regulate this marketplace, instead of keeping hands off, as Alan Greenspan and Phil Gramm wanted.

I can’t see how either candidate would be able or willing to go this far into the weeds during tonight’s debate (and it isn’t even that far!). But this is what voters really need to understand.

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  1. grant

    I agree with your points about F&F and “subprime” (although really the problem has never really been about subprime mortgages per se, IMO: these were just the first things to go as the housing bubble burst).

    So far as CDSes go, my understanding (based on wikipedia and NPR’s Planet Money podcast), is that non-regulation of CDSes was tacked on to an omnibus spending bill in late 2000, which passed unanimously in the Senate and overwhelmingly in the House ( You can maybe point to chicanery by the Republican-led Congressional leadership jamming it in at the end of a session, but I think it’s more likely that stuff like this was unobjectionable at the time … After all, the economy was riding high under the sage guidance of Alan Greenspan.

    Despite Warren Buffet’s dire warning around 2002, I don’t know of any political efforts on either side of the aisle to regulate the CDS market (though these may exist).

  2. smrstrauss


    Well yes there was that legislation in 2000. But who was in charge of our Treasury and who appointed the head of the Federal Reserve Board in the years 2001-2008? A Republican administration.

    During that period of time Sub-prime backed mortgage paper swelled, credit default swaps increased, Auction-rate securities increased (and were used as the basis for money market funds, some of which have defaulted). The SEC allowed Wall Street firms to practice what was called “voluntary regulation.” The Federal Reserve Board failed to find out that some banks had leverage of 33-to-1. The SEC failed to find out that some investment banks and insurance companies were holding suspect assets in “off balance sheet” companies.

    And no one in the US Government paid much attention to credit default swaps or derivatives in general. They had the attitude that the derivatives and the situation in general would take care of themselves and itself. Laissez Faire, I suppose.

    Who is responsible for that? Not the Democrats. They were not in charge of the executive branch, the Fed, the SEC, and not even Congress until 2006. However, the Democrats did call repeatedly for tighter regulation of commercial mortgage companies, and the Republicans turned them down.

  3. Fannie and Freddie do share some of the blame for the mortgage and housing bust. They recorded $14 billion of losses in the 12 months ended June 30 largely because they lowered their credit standards and purchased or guaranteed dubious home loans. But they weren’t the leaders in lowering the credit standards.

    But as you have pointed out, that is overshadowed by the market for derivatives and especially, CDSes. This is a $US60 trillion market for credit enhancement, entirely unregulated, based on instruments that fewer than 500 people on the planet understand. All that’s left is for the conspiracy theorists to ask, why was Lehman Brothers the sole investment house hung out to dry right before the Calvary arrived? And surely in some backroom deal there was dark laughter over those silly Icelanders and how they were getting taken for a ride.

    There was an October surprise, and we finally know who the terrorists are. Meanwhile, the Commodity Futures Modernization Act of 2000 is still law, the Glass-Steagall Act of 1933 is still repealed, and Generalissimo Francisco Franco is still dead.

  4. IanRae

    >But who was in charge of our Treasury and who appointed the head of the Federal Reserve Board in the years 2001-2008? A Republican administration.

    Republicans weren’t in charge of Iceland, Scotland, or other European countries. If deregulation is the crime then it was one practiced internationally.

    The other factor not being mentioned is complexity. A year ago the Economist magazine mused about the frightening complexity of CDS instruments, and of the tangled chains of cross-investments between banks. The system had reached a point where no one really understood who owned what risk.

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