From financial collapse to ‘dumbing of America’

The recent financial collapse actually started back in the mid-1970s, when “redlining,” banks denying loans for homes in poorer neighborhoods, was identified as a problem. It took another two decades for Congress to devise a way to increase lending in depressed areas.

If Wall Street investment monies could be made available to Main Street banks, so the theory went, banks could make more mortgage loans. So, Congress effectively removed the separation between investment and depository banks when it repealed the Glass-Steagall Act of 1932 by passing the Gramm-Leach-Bliley Act of 1999.

Simultaneously, Fannie Mae came under pressure from Congress to expand mortgage lending in distressed areas designated in the Community Reinvestment Act of 1977. The intent was that Fannie’s enforcement of the mortgage underwriting standards maintained for more than 60 years would also provide safe and stable lending to homebuyers who did not have prime credit.

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So, in 2000, Wall Street could help Main Street banks make loans in redlined districts, with the assistance of the quasi-governmental Fannie Mae and Freddie Mac. Investment banks packaged home loans into classes, each with a different credit rating, called tranches. These different mortgage security classes, each with a different risk rating, were marketed to investors as Collateralized Debt Obligations, or CDOs. The tranches were insured by the likes of AIG, just in case the riskier ones defaulted.

Then, the tech bubble burst and 9/11 happened, throwing the U.S. economy into recession. The Federal Reserve lowered interest rates and expanded the money supply. It worked. The mortgage industry expanded sharply, new homes were in short supply and home prices started escalating rapidly. The boom was on.

But instead of providing stability, Fannie and Freddie’s stricter mortgage underwriting requirements drove business to the private investment mortgage industry, which aggressively marketed aggressive products without regard to future consequences.

Then the wars in Afghanistan and Iraq started. Government employment expanded rapidly and war expenditures ballooned, all without a tax increase to handle the growing deficit. In fact, taxes were cut.

The U.S. construction industry and war-related firms expanded rapidly. The service sector, especially the financial industry, also expanded because of lower taxes and low-interest refinancing of increasingly more valuable homes. Manufacturing, however, continued to contract as operations were moved abroad, especially into a rapidly expanding China, resulting in a loss of stable jobs.

Bubbles deflate

The bubble expanded until late 2005. Home construction peaked in Northern Colorado at that time but expanded in other areas until well into 2007. Then the money supply dried up as interest rates increased and variable rate mortgages reset, and the air came out of the housing bubble. Home prices peaked and residential construction came to a screeching halt.

Some of the riskier CDO tranches did indeed default. But they were insured – until the volume became too great and AIG and other insurers ran out of money. So they defaulted on their commitments and investors started dumping CDOs, driving prices way down.

Then the air came out of all of the bubbles worldwide. Big U.S. financial institutions said they were going to go bankrupt, potentially throwing the world’s financial system into chaos. So, a bailout was fashioned by the Bush administration and the Federal Reserve that undoubtedly saved a global financial crash. However, financial problems continued to spread.

At the end of 2008, TARP bailed out most banks and some private companies. The Fed loosened the credit spigot so cheap money continued to flow. The financial and big industry sectors were saved, preventing a big stock market crash and the loss of tens of thousands of jobs. TARP will probably turn a profit as GM and AIG pay it back; at most it won’t cost taxpayers more than $25 billion to $50 billion.

But the recession, which officially started in December 2007, was moving toward a depression like that in the 1930s. Back then, the Hoover administration and Congress grossly mismanaged the 1929 Wall Street crash caused by 10 percent margin requirements and massive financial leveraging.

Unlike the Great Depression, however, this was a demand recession. Consumers weren’t buying. Why should they? Their homes were decreasing in value, many were losing their jobs, their savings were inadequate.

It was up to the government to step in and make investments, since the private sector wasn’t. It’s called Keynesian economics and, despite falling out of favor, it’s still an effective way of creating jobs in the absence of private stimulus. Thus, the American Recovery and Reinvestment Act of 2009’s emphasis on “shovel-ready” projects to provide immediate job creation.

It worked. The slide toward depression was halted at the Great Recession, and state and local governments received a two-year reprieve to balance their budgets.

With that background, I’ll discuss the implications of the “dumbing of America” next month.

John W. Green is a regional economist who compiles the Northern Colorado Business Report’s Index of Leading Economic Indicators. He can be reached at jwgreen@frii.com.