WHAT CAUSED 'THE GREAT RECESSION'?

What caused "The Great Recession," was not a failure of capitalism, nor was it necessarily greed, although that played a subservient role. However, government tinkering with free markets created an environment in which "greed" would flourish. Absent of the government interference, "greed" would not have had nearly the appeal, enticement, or the temporary payoff.

This article will identify the root causes of what is coming to be known as, The Great Recession. Certainly, this economic downturn, thus far, isn't anything nearly as dire, statistically, as The Great Depression, which sported 25% unemployment. However, this is easily the worst recession since the early 80's, and could end up being worse than that one if trends continue and the government doesn't get out of the way.

1) The Community Reinvestment Act, passed by the Carter Administration, then strengthened by future administrations, especially the Clinton Administration, was the genesis of the current economic bloodbath.

Under CRA, banks were forced to consider criteria unrelated to credit worthiness. Like many Utopian, liberal, and socialist policies, the intent was perhaps magnanimous. Well, you know what the road to Hell is paved with.

The CRA, passed by Jimmy Carter and a Democrat Congress, was designed to force banks to make mortgage loans to "all segments of their communities, including low- and moderate-income neighborhoods. Community organizations, like President Obama's own precious ACORN, the Association of Community Organizations for Reform Now, which describes itself as, "the nation's largest community organization of low- and moderate-income families, working together for social justice and stronger communities," lobbied the U. S. Congress to pass the Act in order to reduce what these "do-gooders" perceived as discriminatory credit practices against low-income neighborhoods.

2) Fannie Mae & Freddie Mac (FNMA - Federal National Mortgage Association & FHLMC - Federal Home Loan Mortgage Corporation), two quasi-government/publicly traded agencies that carried the implied (turning out to be true) ultimate backing of the federal government, played a major role in the meltdown. As evidenced in Forbes, in an article aptly entitled, The Government Did it:

"The government has promoted bad loans not just through the stick of the CRA (Community Reinvestment Act) but through the carrot of Fannie Mae and Freddie Mac, which purchase, securitize and guarantee loans made by lenders and whose debt is itself implicitly guaranteed by the federal government. This setup created an easy, artificial profit opportunity for lenders to wrap up bundles of subprime loans and sell them to a government-backed buyer whose primary mandate was to "promote home ownership," not to apply sound lending standards."

The 1992 Housing Bill set quotas or "targets" that Fannie and Freddie were to achieve in meeting the housing needs of low- and moderate-income Americans. In 1995 HUD raised the primary quota for low- and moderate-income housing loans from the 30% set by Congress in 1992 to 40% in 1996 and to 42% in 1997.

By the time the housing market collapsed, Fannie and Freddie faced three quotas. The first was for mortgages to individuals with below-average income, set at 56% of their overall mortgage holdings. The second targeted families with incomes at or below 60% of area median income, set at 27% of their holdings. The third targeted geographic areas deemed to be underserved, set at 35%.

In 2003, when the Bush administration proposed much tighter regulation of the two companies, Barney Frank, was adamant that "these two entities, Fannie Mae and Freddie Mac, are not facing any kind of financial crisis." When the White House warned of "systemic risk for our financial system" unless the mortgage giants were curbed, Frank complained that the administration was more concerned about financial safety than about housing.

3) Artificially Low Interest Rates: This is also known as loose or "easy" monetary policy. Following the 2001 recession, which was brought on when a speculative bubble primarily in technology stocks (especially dot-coms) burst, investment collapsed. But unlike previous recessions since the end of World War II, consumption and the housing industry remained stubbornly strong at the trough of the recession. Federal Reserve Chairman Alan Greenspan held interest rates too low for too long, and in the process overstimulated the economy.

The Fed's over-reaction to the 2001 recession, caused the Fed to continue a prolonged reduction in interest rates overstimulating a housing market that was already booming -- triggering six years of double-digit increases in housing prices during a period when the general inflation rate was low. Individual investors, seeing the value of their homes go up every year (Real Estate never goes down, right?) took advantage of the generous home equity lines of credit being offered on their increasing equity.

The Federal Reserve, under Greenspan, slashed interest rates from 6.5% in January 2001, to a low of only 1% in June of 2003.

4) Leverage/Securitization: In 1992, HUD (Department of Housing and Urban Development) pressured Fannie & Freddie to purchase and securitize large amounts of these loans forcing unnatural amounts of liquidity with gave the banks more capital to make even more risky loans. Why would banks even care if the loans were paid back when they could originate the loan, collect their fees and commissions, peddle it off to Fan & Fred, then make another loan?

Fannie and Freddie, the two semi-government evil twins could then issue mortgage backed securities that paid attractive interest rates compared to other "safe" long-term, fixed income investments.

In 1994, 4.5% of the mortgage market was "subprime" and 31% of those subprime loans were securitized. By 2006, 20.1% of the entire mortgage market was subprime and the loans that were securitized had ballooned to 81%. The Congressional Budget Office now estimates that GSE (Government Sponsored Enterprises) losses will cost at least $240 billion in fiscal year 2009. I think that number may need to be increased as things have gotten even worse since those numbers were crunched.

Wall Street, smelling an anomaly in the markets (high returns/no risk) since the government was blessing and guaranteeing these "junk" loans, leveraged them as high as 30-1! As soon as the defaults started coming in, and the value of the securities declined, financial institutions all attempted to unwind their positions at virtually the same time, creating a modern day, highly technical and electronic version of the old "run on the bank". The feces had hit the proverbial fan.

So where is evil "greed" on the list of causes? It wasn't a root cause of the problem. Absent of government's well-intentioned, yet ill-advised, regulation, "greed" wouldn't have held such as attractiveness.

Wall Street would have seen no value in highly leveraging mortgage backed securities that had been made virtually risk-free by the government. These are not stupid, or necessarily greedy people. Any investment vehicle promising (in the real world, impossible) high returns and absolutely no risk is going to have popular appeal to say the least.

Market fluctuations, economic fluctuations, including mild recessions, are inevitable and healthy. The government cannot outlaw recessions, but they can make them worse, or God forbid, turn them into depressions as in the 1930's. This current, deep recession was not caused by natural causes. It was caused by the government.

Unfortunately, some of the same people complicit in the cause are now trying to find the cure. If left alone, markets and economies in a "free market" system will recover on their own. We have not had free markets, and we have not had unbridled "laissaz-faire" capitalism, as some report.

What we have had is the strong arm of the federal government forcing banks to make loans to people that couldn't pay them back. The intentions were noble. The results have been, and will continue to be -- disastrous.

What we need are politicians who understand what Ronald Reagan did, which was government is not the solution to our problems. It is the problem. Perhaps then we would have The Great Communicator's American vision of a Shining City on a Hill.

It is no wonder why President Reagan said that the most terrifying words in the English language are, "I'm from the government and I'm here to help."

Further Reading:

Obama's New Deal II, is the Raw Deal Too