Most everyone has seen the dizzying fall of the Dow Jones Industrial Average over the last few days. After falling 812 points to its lowest level in three years, many are beginning to panic at the state of the economy.
The subprime mortgage crisis is breaking the back of American stock markets. Investment banks, which were largely deregulated in the late 1990s, engaged in irrefutably dubious lending practices that became problematic with the downturn of the housing market.
To say that irresponsible decisions were made by financial institutions is an oversimplification. These financial institutions – such as American International Group, Fannie Mae and Freddie Mac, Bear Sterns and Lehman Brothers – enabled risky transactions that would not have been possible before the period of deregulation that preceded the Savings and Loan Crisis.
For example, deregulation allowed banks to make loans and finance mortgages with extremely confusing and complicated terms for individuals who didn’t qualify.
Subprime mortgages and mortgages with rates that periodically changed were being offered to individuals who couldn’t afford any kind of loan or mortgage, risking the debilitating debt for a pipe dream of home ownership.
For the most part, banks that made these loans are being allowed to fail in record numbers. It’s the institutions that guarantee these deals that are being bailed out. Freddie Mac and Fannie Mae, for example, owned about half of the mortgages in America. A bank would sell a person’s debt to Fannie or Freddie for a lump sum they could immediately use, while the actual payments go to Fannie and Freddie.
Fannie and Freddie are quasi-government sponsored institutions. We say “quasi” because Fannie and Freddie make a profit that goes to shareholders and executives while the government assume the risk at a loss. No one makes a profit off of the Federal Deposit Insurance Corporation, another vital backer that helped the economy stabilize after a better-known financial crisis, the 1929 Stock Market Crash.
Profit is a reward for risk and, until now, Freddie and Fannie have been allowed to risk it all on dubious loans at our expense. Other financial institutions that have been bailed out recently failed for different reasons and should be examined separately.
They are being bailed out because each is vital to the health of the world economy. Many banks and institutions aren’t being bailed out because those institutions won’t cause systemic failure when they collapse.
Each bailout is different, but the real root of the problem was deregulation across all financial markets. Though we’re not placing blame on a particular person or party, as it was ultimately a bipartisan effort (as tempting as it is to lay the blame entirely at the feet of former Sen. Phil Gramm), it’s clear deregulating this sector of the economy has had some rather catastrophic effects.
We have to reinstate at least some regulation. Removing it was clearly a mistake, but it is one we can fix. Hopefully, we won’t fall into the abyss of economic collapse before we can.