Collapse, in Review
But Democrats ignored the warning signs .


Stephen Spruiell

Sarah Palin missed a big opportunity Thursday night to lay the blame for the mortgage meltdown squarely where it belongs: Fannie Mae, Freddie Mac, and their enablers in the Democratic party. With a massive bailout for Wall Street set to pass as early as today, it is vital that conservatives win the debate over what led to the financial collapse. Otherwise, Democrats will succeed in branding it as a failure of deregulation and free markets.

Conservatives should take these words and turn them around. A lack of regulation did indeed cause this crisis: In 2005, the Democrats refused to regulate government-sponsored enterprises Fannie Mae and Freddie Mac. The GSEs subsequently bought up a trillion dollars worth of subprime mortgage debt and went bust, leaving taxpayers holding the bag.

The details are spelled out in a crucially important report written by American Enterprise Institute scholars Peter Wallison and Charles Calomiris. In “The Last Trillion-Dollar Commitment,” Wallison and Calomiris describe how Fannie and Freddie nearly succumbed to accounting scandals in 2003-04. They report that in 2005, free-market conservatives sounded the alarm about the risk the GSEs posed to the financial system. But Democrats ignored the warning signs and used the crisis to turn Fannie and Freddie into political tools to pursue affordable-housing goals.

This latter step in the chain precipitated the GSEs’ disastrous, trillion-dollar push into the subprime-mortgage market. Wallison and Calomiris report that “Between 2005 and 2007, Fannie and Freddie acquired so many junk mortgages that, as of August 2008, they held or had guaranteed more than $1.011 trillion in unpaid principal balance exposures on these loans.”

Why did Fannie and Freddie buy up so many problem loans? According to Wallison and Calomiris, it was to advance the affordable-housing goals of people like Barney Frank, the Massachusetts Democrat who now chairs the House Financial Services Committee. At a hearing in 2003, Frank explicitly stated that Fannie and Freddie’s government privileges were conditional on their willingness “to make housing more affordable.”

Fannie and Freddie’s privileges stemmed from their government charters. Because lenders knew the government would never let them fail, Fannie and Freddie could borrow money at rock-bottom interest rates. This allowed them to grow large and profitable by borrowing and expanding. As a bonus, they were exempt from Securities and Exchange Commission oversight. Their regulator, the Office of Federal Housing Enterprise Oversight, was toothless.

But those privileges came at the price of subservience to two masters. Like private companies, the GSEs had shareholders who wanted to make money. But like government agencies, they were also accountable to politicians who wanted to use them for their own ends. After the accounting scandals, Alan Greenspan and other free-market types argued that Fannie and Freddie had grown too large and had taken on too much risk. Republicans in Congress, including John McCain, pushed for a stronger regulator for the GSEs.

But Democrats blocked a GSE-reform bill in the Senate, arguing that restrictions on the GSEs’ portfolio size would limit their ability to promote affordable housing. At this point, Wallison and Calomiris write, “The only element of their activities that had not come under criticism was their affordable housing mission, and it appears that the GSEs determined at this point to play that card as a way of shoring up their political support in Congress.”

Wallison and Calomiris relate a telling anecdote that illustrates the symbiotic relationship between members of Congress and the GSEs. In 2006, Sen. Charles Schumer pressured Freddie Mac to launch an affordable-housing initiative in his home state of New York. Then, when Freddie Mac came through with a $100 million commitment to fund a low down payment home-loan program in a small town upstate, Schumer issued a press release taking credit for the program.

Wallison and Calomiris report that in pursuit of affordable-housing goals, the GSEs took on an increasing number of subprime mortgages between 2005 and 2007. According to the GSEs’ investor summaries, up to 40 percent of the mortgages the GSEs added to their books during this period were subprime, Alt-A and other “junk loans.” As mentioned above, this added up to over $1 trillion.

The GSEs defenders argue that many market players contributed to the subprime debacle, which is true. Subprime lending grew from 8 percent of all mortgages in 2003 to 22 percent in late 2006, and that increase involved irresponsible behavior on the part of borrowers, lenders, ratings agencies, and Wall Street investors.

But Fannie and Freddie made the crisis possible by assuming a large share of the risks associated with subprime lending. Wallison and Calomiris argue that “It is likely that this huge increase in commitments to junk lending was largely the result of signals from Fannie and Freddie that they were ready to buy these loans in bulk.” If a lender could sell a bundle of subprime mortgages to Fannie and Freddie, he no longer had to worry about whether the borrowers could pay.

As home prices went south and foreclosures started to rise, the GSEs suffered massive losses related to their trillion-dollar commitment to a misguided vision of affordable housing. Now taxpayers will pay an estimated $200 billion to clean up Fannie and Freddie’s collapse, and possibly billions more to clean up the mess they helped create on Wall Street. Wallison and Calomiris’s account of how it came to this should be the next item on Sarah Palin’s cram list. This is a debate conservatives can’t afford to lose.

 – Stephen Spruiell is an NRO staff reporter.


Sign up for free NRO e-mails today:

NRO Polls on LockerDome

Subscribe to National Review