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.