Personal Anecdote: In 1991, the Treasury Department was pushing legislation to move the regulator for Freddie Mac and Fannie Mae out of HUD and into an independent agency. I was a young analyst loaned from Economic Policy to Domestic Finance to study HUD’s models
HUD had written a report claiming that Fannie Mae could survive an interest rate shock up to 24 percent or so. I went through the model line by line and found a problem with the assumption about Fannie Mae’s portfolio. HUD assumed that the adjustable rate mortgages in Fannie Mae’s portfolio were pure ARMS with no annual or lifetime caps. Most ARMS limit annual changes in interest rates to 2 to 3 points and lifetime changes in interest rate to 6 percentage points.
The HUD model substantially overstated the ability of Fannie Mae to survive a large increase in interest rates. I was allowed to present this result to a Deputy Assistant Secretary in Domestic Finance. This DAS was a smart man who left his Wall Street firm to spend a couple of years serving in Washington. The DAS praised me for my findings and said that he was not concerned because he believed the long-term trend for interest rates was down.
An independent regulator was created. The DAS was correct. The failure of Fannie Mae and the subsequent bailout was the result of credit risk not high interest rates.
The Current Situation: Our government is a joke. After the bailout the Chairman of the Federal Reserve Board went before Congress and said he did not understand how derivatives and mortgage backed securities worked.
The issue today appears to be oil and whether bank supervisors are going to understand and evaluate and if necessary limit the way banks hedge risks against oil price changes. The issue today also remains too big to fail. Banks are bigger now than in 2008. Banks have made scant progress describing how they would unravel their business in the next crisis.
One of the major achievements of the Obama Administration was the passage of legislation mandating tighter supervision in order to restore confidence to the financial system. The Obama Treasury populated by Clinton-era officials has not aggressively implemented the new law.
President Obama is pressuring Democrats in Congress to vote for the spending bill that removes restrictions the Dodd-Frank restrictions that he fought so hard for. He should have issued a veto threat.
The sad truth is that the Administration of George H. W. Bush was more concerned about financial regulation than the current Administration. In 2010, the Tea Party not the Democratic Party, was the major force opposing the excesses of Wall Street.
The issue of the next Wall Street bailout is becoming a question of “when” not “if.”
Concluding Thoughts and Anecdotes: Elizabeth Warren appears to be one of the few Senators aware of the magnitude of this problem. The Clinton-era officials who dominate the Treasury are blithely unconcerned.
I am concluding this post with a child’s math problem. If Elizabeth Warren gave one of her balls to President Obama and another of her balls to Hillary Clinton, how many balls would President Obama have and how many balls would Hillary Clinton have? Please show your work!