speculators, politicians, and financial disasters

8/14/2019 Speculators, Politicians, And Financial Disasters

1/6

[13]

Fueled by easy credit, the real-estate markethad been rising swiftly for some years. Mem-bers of Congress were determined to assure thecontinuation of that easy credit. Suddenly, theparty came to a devastating halt. Defaults multi-plied, banks began to fail. Soon the economic trou-bles spread beyond real estate. Depression stalkedthe land.

The year was 1836.The nexus of excess speculation, political mischief,

and financial disasterthe same tangle that led toour present economic crisishas been long anddeep. Its nature has changed over the years as Amer-icans have endeavored, with varying success, to learnfrom the mistakes of the past. But it has always beenthere, and the commonalities from era to era arestark and stunning. Given the recurrence of thesethemes over the course of three centuries, there isevery reason to believe that similar calamities willbeset the system as long as human nature and human

action play a role in the workings of markets.

Let us begin our account of the catastrophiceffects of speculative bubbles and politicalgamesmanship with the collapse of 1836. Thanks toa growing population, prosperity, and the advancing

frontier, poorly regulated state banks had been mul-tiplying throughout the 1830s. In those days, char-tered banks issued paper money, called banknotes,backed by their reserves. From 1828 to 1836, theamount in circulation had tripled, from $48 millionto $149 million. Bank loans, meanwhile, had almostquadrupled to $525 million. Many of the loans wentto finance speculation in real estate.

Much of this easy-credit-induced speculationhad been caused, as it happens, by President An-drew Jackson. This was a terrific irony, since Jack-son, who served as President from 1829 until 1837,hated speculation, paper money, and banks. Hiscrusade to destroy the Second Bank of the UnitedStates, an obsession that led him to withdraw allfederal funds from its coffers in 1833, removed theprimary source of bank discipline in the UnitedStates. Jackson had transferred those federal fundsto state banks, thereby enabling their outstandingloans to swell.

The real-estate component of the crisis began to

take shape in 1832, when sales by the governmentof land on the frontier were running about $2.5million a year. Some of the buyers were prospectivesettlers, but most were speculators hoping to turn aprofit by borrowing most of the money needed andwaiting for swiftly-rising values to put them in theblack. By 1836, annual land sales totaled $25 mil-lion; in the summer of that year, they were runningat the astonishing rate of $5 million a month.

While Jackson, who was not economically so-

Speculators, Politicians, andFinancial Disasters

John Steele Gordon

John Steele Gordon is the author of, among otherbooks,An Empire of Wealth: The Epic Story of Ameri-can Economic Power (2004). His Look Whos Afraid ofFree Trade appeared in the February Commentary.

CommentaryNovember 2008


2/6

phisticated, did not grasp how his own actions hadfueled the speculation, he understood perfectly wellwhat was happening. With characteristic if ill-ad-vised decisiveness, he moved to stop it. Since mem-

bers both of Congress and of his cabinet were per-sonally involved in the speculation, he faced fierceopposition. But in July, as soon as Congress ad-journed for the year, Jackson issued an executiveorder known as the specie circular. This forbadethe Land Office to accept anything but gold andsilver (i.e., specie) in payment for land. Jacksonhoped that the move would dampen the specula-tion, and it did. Unfortunately, it did far more: peo-ple began to exchange their banknotes for gold andsilver. As the demand for specie soared, the bankscalled in loans in order to stay liquid.

The result was a credit crunch. Interest ratesthat had been at 7 percent a year rose to 2 and even3 percent a month. Weaker, overextended banksbegan to fail. Bankruptcies spread. Even severalstate governments found they could not roll overtheir debts, forcing them into default. By April1837, a month after Jackson left the presidency, thegreat New York diarist Philip Hone noted that theimmense fortunes which we heard so much aboutin the days of speculation have melted like thesnows before an April sun.

The longest depression in American history hadset in. Recovery would not begin until 1843. InCharles DickenssA Christmas Carol, published thatsame year, Ebenezer Scrooge worries that a notepayable to him in three days might be as worthlessas a mere United States security.

Modern standards preclude governmentofficials and members of Congress from thesort of speculation that was rife in the 1830s. Buttodays affinities between Congressmen and lobby-ists, affinities fueled by the largess of political-ac-tion committees, have produced many of the sameconsequences.

Consider the savings-and-loan (S&L) debacle ofthe 1980s. The crisis, which erupted only twodecades ago but seems all but forgotten, was almost

entirely the result of a failure of government toregulate effectively. And that was by design. Mem-bers of Congress put the protection of their politi-cal friends ahead of the interests of the financialsystem as a whole.

After the disaster of the Great Depression, threetypes of banks still survivedartifacts of the Demo-cratic partys Jacksonian antipathy to powerful banks.Commercial banks offered depositors both checkingand savings accounts, and made mostly commercial

loans. Savings banks offered only savings accountsand specialized in commercial real-estate loans. Sav-ings-and-loan associations (thrifts) also offeredonly savings accounts; their loan portfolios were al-

most entirely in mortgages for single-family homes.All this amounted, in effect, to a federally man-dated cartel, coddling those already in the bankingbusiness and allowing very few new entrants. Be-tween 1945 and 1965, the number of S&Ls re-mained nearly constant at about 8,000, even astheir assets grew more than tenfold from almost $9billion to over $110 billion. This had something todo with the fact that the rate of interest paid onsavings accounts was set by federal law at .25 per-cent higher than that paid by commercial banks, inorder to compensate for the inability of savingsbanks and S&Ls to offer checking accounts. Sav-

ings banks and S&Ls were often called 3-6-3 in-stitutions because they paid 3 percent on deposits,charged 6 percent on loans, and management hitthe golf course at 3:00 p.m. on the dot.

These small banks were very well connected. AsDemocratic Senator David Pryor of Arkansas onceexplained:

You got to remember that each community hasa savings-and-loan; some have two; some havefour, and each of them has seven or eight boardmembers. They own the Chevy dealership andthe shoe store. And when we saw these people,we said, gosh, these are the people who are

building the homes for people, these are thepeople who represent a dream that has workedin this country.

They were also, of course, the sorts of peoplewhose support politicians most wanted to havepeople who donated campaign money and had sig-nificant political influence in their localities.

The banking situation remained stable in thetwo decades after World War II as the Federal Re-serve was able to keep interest rates steady and in-flation low. But when Lyndon Johnson tried tofund both guns (the Vietnam war) and butter (theGreat Society), the cartel began to break down.

If the governments first priority had been theintegrity of the banking system and the safety ofdeposits, the weakest banks would have been forcedto merge with larger, sounder institutions. Mostsolvent savings banks and S&Ls would then havebeen transmuted into commercial banks, whichwere required to have larger amounts of capital andreserves. And some did transmute themselves ontheir own. But by 1980 there were still well over4,500 S&Ls in operation, relics of an earlier time.

[14]

Commentary November 2008


3/6

Why was the integrity of the banking systemnot the first priority? Part of the reason layin the highly fragmented nature of the federal reg-ulatory bureaucracy. A host of agenciesincluding

the Comptroller of the Currency, the Federal Re-serve, the FDIC and the FSLIC, state banking au-thorities, and the Federal Home Loan Bank Board(FHLBB)oversaw the various forms of banks.Each of these agencies was more dedicated to pro-tecting its own turf than to protecting the bankingsystem as a whole.

Adding to the turmoil was the inflation that tookoff in the late 1960s. When the low interest ratesthat banks were permitted to pay failed to keeppace with inflation, depositors started to look else-where for a higher return. Many turned to money-market funds, which were regulated by the Securi-ties and Exchange Commission rather than by thevarious banking authorities and were not restrictedin the rate of interest they could pay. Money beganto flow out of savings accounts and into these newfunds, in a process known to banking specialists bythe sonorous term disintermediation.

By 1980, with inf lation roaring above 12 per-centthe highest in the countrys peacetime histo-rythe banks were bleeding deposits at a prodi-gious rate. The commercial banks could cope; theirdeposit base was mostly in checking accounts,which paid no interest, and their lending portfolioswere largely made up of short-term loans whoseaverage interest rates could be quickly adjusted, notlong-term mortgages at fixed interest. But to thesavings banks and S&Ls, disintermediation was amortal threat.

Rather than taking the political heat and forcingthe consolidation of the banking industry intofewer, stronger, and more diversified banks, Wash-ington rushed to the aid of the ailing S&Ls withquick fixes that virtually guaranteed future disaster.First, Congress eliminated the interest-rate caps.Banks could now pay depositors whatever ratesthey chose. While it was at it, Congress also raisedthe amount of insurance on deposits, from $40,000to $100,000 per depositor.

At the same time, the Federal Home Loan BankBoard changed the rules on brokered deposits.Since the 1960s, brokers had been making, on be-half of their customers, multiple deposits equal tothe limit on insurance. This allowed wealthy cus-tomers to possess insured bank deposits of any cu-mulative sizean end-run around the limit thatshould never have been tolerated in the first place.Realizing that these deposits were hot money,likely to chase the highest return, the Home Loan

board forbade banks to have more than five per-cent of their deposit base in such instruments. Butin 1980 it eliminated the restriction.

With no limits on interest rates that could be

paid and no risk of loss to the customers, the reg-ulators and Congress had created an economicoxymoron: a high-yield, no-risk security. As moneyf lowed in to take advantage of the situation, thevarious S&Ls competed among themselves to offerhigher and higher interest rates. Meanwhile, how-ever, their loan portfolios were still in long-termhome mortgages, many yielding low interest.

As a result, they went broke. In 1980 the S&Lshad a collective net worth slightly over $32 billion.By December 1982 that number had shrunk to lessthan $4 billion.

To remedy the disaster caused by the quick f ixesof 1980, more quick fixes were instituted. TheFHLBB lowered reserve requirementstheamount of money that banks must keep in highlyliquid form, like Treasury notes, in order to meetany demand for withdrawalsfrom 5 to 3 percentof deposits. With the proverbial stroke of thepen, the journalist L.J. Davis wrote, sick thriftswere instantly returned to a state of ruddy health,while thrifts that only a moment before had beenamong the dead who walk were now reclassified asmerely enfeebled.

For good measure, the Bank Board changed itsaccounting rules, allowing the thrifts to showhandsome profits when they were, in fact, goingbust. It was a case of regulators authorizing thebanks they regulated to cook the books. Far worse,the rule that only locals could own an S&L waseliminated. Now anyone could buy a thrift. High-rollers began to move in, delighted to be able to as-sume the honorific title of banker.

And Congress, ever anxious to help the Chevydealers and shoe-store owners, lifted the limits onwhat the thrifts themselves could invest in. Nolonger were they limited to low-interest, long-term,single-family mortgages. Now they could lend upto 70 percent of their portfolios for commercialreal-estate ventures and consumer needs. In short,

Congress gave the S&Ls permission to becomefull-service banks without requiring them to holdthe capital and reserves of full-service banks.

Now came the turn of state-chartered thrifts,whose managers understandably wanted to enjoythe same freedoms enjoyed by federally-charteredS&Ls. State governments from Albany to Sacra-mento were obliging. California, which had thelargest number of state-chartered S&Ls, allowedthem to invest in anything from junk bonds to

[15]

Speculators, Politicians, and Financial Disasters


4/6

start-up software companiesin effect, to becomeventure-capital firms using government-guaran-teed money. The consequence, as predictable asthe next solar eclipse, was a collapse of the S&Ls

en masse. Between 1985 and 1995, over a thousandwere shut down by the government or forced tomerge. The cost to the public is estimated to haverun $160 billion.

As the sorry tale of the S&L crisis suggests,the road to f inancial hell is sometimes pavedwith good intentions. There was nothing malign inattempting to keep these institutions solvent andprofitable; they were of long standing, and itseemed a noble exercise to preserve them. Perhapseven more noble, and with consequences that havealready proved much more threatening, was thephilosophy that would eventually lead the UnitedStates into its latest financial crisisa crisis thatbegins, and ends, with mortgages.

A mortgage used to stay on the books of the is-suing bank until it was paid off, often twenty orthirty years later. This greatly limited the numberof mortgages a bank could initiate. In 1938, as partof the New Deal, the federal government estab-lished the Federal National Mortgage Association,nicknamed Fannie Mae, to help provide liquidityto the mortgage market.

Fannie Mae purchased mortgages from initiat-ing banks and either held them in its own portfo-lio or packaged them as mortgage-backed securi-ties to sell to investors. By taking these mortgagesoff the books of the issuing banks, Fannie Mae al-lowed the latter to issue new mortgages. Being agovernment entity and thus backed by the full faithand credit of the United States, it was able to bor-row at substantially lower interest rates, earningthe money to finance its operations on the differ-ence between the money it borrowed and the in-terest earned on the mortgages it held.

Together with the GI Bill of 1944, which guar-anteed the mortgages issued to veterans, FannieMae proved a great success. The number of Amer-icans owning their own homes climbed steadily,

from fewer than 15 percent of non-farm families inthe 1930s to nearly 70 percent by the 1980s. Thusdid Fannie Mae and the GI Bill prove to be pow-erful engines for increasing the size of the middleclass.

It can be argued that 70 percent is about as higha proportion as could, or should, be hoped forin home ownership. Many young people are notready to buy a home; many old people prefer to

rent. Some families move so frequently that homeownership makes no sense. Some people, like Con-gressman Charlie Rangel of New York, take advan-tage of local rent-control laws to obtain housing

well below market rates, and therefore have no in-centive to buy.And some families simply lack the creditworthi-

ness needed for a bank to be willing to lend themmoney, even on the security of real property. Per-haps their credit histories are too erratic; perhapstheir incomes and net worth are lower than bankstandards; or perhaps they lack the means to makea substantial down payment, which by reducing theamount of the mortgage can protect a bank from adownturn in the real-estate market.

But historically there was also a class, made upmostly of American blacks, for whom home own-ership was out of reach. Although simple racialprejudice had long been a factor here, it was, iron-ically, the New Deal that institutionalized discrim-ination against blacks seeking mortgages. In 1935the Federal Housing Administration (FHA), estab-lished in 1934 to insure home mortgages, asked theHome Owners Loan Corporationanother NewDeal agency, this one created to help prevent fore-closuresto draw up maps of residential areas ac-cording to the risk of lending in them. Aff luentsuburbs were outlined in blue, less desirable areasin yellow, and the least desirable in red.

The FHA used the maps to decide whether ornot to insure a mortgage, which in turn causedbanks to avoid the redlined neighborhoods. Thesetended to be in the inner city and to compriselargely black populations. As most blacks at thistime were unable to buy in white neighborhoods,the effect of redlining was largely to exclude evenaffluent blacks from the mortgage market.

Even after the end of Jim Crow in the 1960s, theeffect of redlining lingered, perhaps more out ofhabit than of racial prejudice. In 1977, respondingto political pressure to abolish the practice, Con-gress finally passed the Community ReinvestmentAct, requiring banks to offer credit throughouttheir marketing areas and rating them on their

compliance. This effectively outlawed redlining.Then, in 1995, regulations adopted by the Clin-

ton administration took the Community Reinvest-ment Act to a new level. Instead of forbiddingbanks to discriminate against blacks and blackneighborhoods, the new regulations positivelyforced banks to seek out such customers and areas.Without saying so, the revised law established quo-tas for loans to specific neighborhoods, specific in-come classes, and specific races. It also encouraged

[16]



5/6

community groups to monitor compliance and al-lowed them to receive fees for marketing loans totarget groups.

But the aggressive pursuit of an end to redlining

also required the active participation of FannieMae, and thereby hangs a tale. Back in 1968, theJohnson administration had decided to adjust thefederal books by taking Fannie Mae off the budgetand establishing it as a Government SponsoredEnterprise (GSE). But while it was theoreticallynow an independent corporation, Fannie Mae didnot have to adhere to the same rules regarding cap-italization and oversight that bound most financialinstitutions. And in 1970 still another GSE wascreated, the Federal Home Loan Mortgage Cor-poration, or Freddie Mac, to expand further thesecondary market in mortgage-backed securities.

This represented a huge moral hazard. The twoinstitutions were supposedly independent of thegovernment and owned by their stockholders. Butit was widely assumed that there was an implicitgovernment guarantee of both Fannie and Fred-dies solvency and of the vast amounts of mortgage-based securities they issued. This assumption wasby no means unreasonable. Fannie and Freddiewere known to enjoy lower capitalization require-ments than other financial institutions and to beheld to a much less demanding regulatory regime.If the United States government had no worriesabout potential failure, why should the market?

Forward again to the Clinton changes in 1995.As part of them, Fannie and Freddie were now per-mitted to invest up to 40 times their capital inmortgages; banks, by contrast, were limited to onlyten times their capital. Put briefly, in order to in-crease the number of mortgages Fannie and Fred-die could underwrite, the federal government al-lowed them to become grossly undercapitalizedthat is, grossly to reduce their one source of insur-ance against failure. The risk of a mammoth failurewas then greatly augmented by the sheer numberof mortgages given out in the country.

That was bad enough; then came politics tomake it much worse. Fannie and Freddie quickly

evolved into two of the largest financial institutionson the planet, with assets and liabilities in the tril-lions. But unlike other large, profit-seeking finan-cial institutions, they were headquartered in Wash-ington, D.C., and were political to their fingertips.Their management and boards tended to comefrom the political world, not the business world.And some were corrupt: the management of Fan-nie Mae manipulated the books in order to triggerexecutive bonuses worth tens of millions of dollars,

and Freddie Mac was found in 2003 to have under-stated earnings by almost $5 billion.

Both companies, moreover, made generous polit-ical contributions, especially to those members of

Congress who sat on oversight committees. Theircharitable foundations could be counted on to kickin to causes that Congressmen and Senators deemedworthy. Many of the political contributions wereillegal: in 2006, Freddie was fined $3.8 millionarecord amountfor improper election activity.

By 2007, Fannie and Freddie owned about halfof the $12 trillion in outstanding mortgages,an unprecedented concentration of debtand ofrisk. Much of the debt was concentrated in theclass of sub-prime mortgages that had proliferatedafter the 1995 regulations. These were mortgagesgiven to people of questionable credit standing, inone of the attempts by the federal government toincrease home ownership among the less well-to-do.

Since banks knew they could offload these sub-prime mortgages to Fannie and Freddie, they hadno reason to be careful about issuing them. As forthe firms that bought the mortgage-based securi-ties issued by Fannie and Freddie, they thoughtthey could rely on the governments implicit guar-antee. AIG, the worlds largest insurance f irm, washappy to insure vast quantities of these securitiesagainst default; it must have seemed like insuringagainst the sun rising in the West.

Wall Street, politicians, and the press all acted asthough one of the iron laws of economics, as unre-pealable as Newtons law of universal gravity, hadbeen set aside. That law, simply put, is that poten-tial reward always equals potential risk. In the realworld, unfortunately, a high-yield, no-risk invest-ment cannot exist.

In 2006, after an astonishing and unsustainableclimb in home values, the inevitable correction setin. By mid-2007, many sub-prime mortgages werebacked by real estate that was now of lesser valuethan the amount of debt. As the market started todoubt the soundness of these mortgages, their value

and even their salability began to deteriorate. So didthe securities backed by them. Companies that hadheavily invested in sub-prime mortgages saw theirstock prices and their net worth erode sharply. Thiscaused other companies to avoid lending themmoney. Credit markets began to tighten sharply asgreed in the marketplace was replaced by fear.

A vicious downward spiral ensued. Bear Stearns,the smallest investment bank on Wall Street, wasforced into a merger in March with JPMorgan

[17]

Speculators, Politicians, and Financial Disasters


6/6

Chase, with guarantees from the Federal Reserve.Fannie and Freddie were taken over by the gov-ernment in early September; Merrill Lynch sold it-self to Bank of America; AIG had to be bailed out

by the government to the tune of $85 billion;Lehman Brothers filed for bankruptcy; Washing-ton Mutual became the biggest bank failure inAmerican history and was taken over by JPMorganChase; to avoid failure, Wachovia, the sixth largestbank in the country, was taken over by WellsFargo. The most creditworthy institutions saw in-terest rates climb to unprecedented levelsevenfor overnight loans of bank reserves, which are thefoundation of the high-functioning capitalist sys-tem of the West. Finally it became clear that onlya systemic intervention by the government wouldstem the growing panic and allow credit markets tobegin to function normally again.

Many people, especially liberal politicians,have blamed the disaster on the deregula-tion of the last 30 years. But they do so in order toavoid the blames falling where it shouldsquarelyon their own shoulders. For the same politiciansnow loudly proclaiming that deregulation causedthe problem are the ones who fought tooth andnail to prevent increased regulation of Fannie andFreddiethe source of so much political money,their mothers milk.

To be sure, there is more than enough blame togo around. Forgetting the lessons of the past, WallStreet acted as though the only direction that mar-kets and prices could move was up. Credit agencies

like Moodys, Standard & Poors, and Fitch gavehigh ratings to securities that, in retrospect, theyclearly did not understand. The news media didnot even try to investigate the often complex eco-nomics behind the housing market.

But remaining at the heart of the financial beastnow abroad in the world are Fannie Mae and Fred-die Mac and the mortgages they bought and turnedinto securities. Protected by their political patrons,they were allowed to pile up colossal debt on an in-adequate capital base and to escape much of theregulatory oversight and rules to which other fi-nancial institutions are subject. Had they beentreated as the potential risks to financial stabilitythey were from the beginning, the housing bubblecould not have grown so large and the pain that isnow accompanying its end would not have hurt somuch.

Herbert Hoover famously remarked that thetrouble with capitalism is capitalists. Theyre toogreedy. That is true. But another and equal trou-ble with capitalism is politicians. Like the rest of us,they are made of all-too-human clay and can beeasily blinded to reality by naked self-interest, at acost we are only now beginning to fathom.

[18]


speculators, politicians, and financial disasters

Documents