We begin, not by choice, in the middle of the crisis. or anyway, squatting on the lawn that circles the middle of the crisis, peering in on the new guy who just moved in on that plot of historical real estate, a cranky old gay guy with thick accent equal parts Jersey-Boston-Yiddish lite and a younger boyfriend who reminds us a bit of Todd Palin.
The crisis is an historical property is many zeroes too vast and several speeds too vast for the present to comprehend. But when economists and politicos and anyone else with a time share on the moment gives it a try, we’ve noticed, there are two big themes to the way they explain it to us, “information asymmetry” and “moral hazard.” You cannot have a halfway serious discussion about the financial crisis, and you can tell a lot about a person by which they choose to harp on.
Information asymmetry is just that: a gap between the amount of information understood by two sides of a transaction. Asymmetry is what can make a market that is supposed to be efficient very inefficient, so you have to take care to go about bringing alignment to the asymmetries, which is a challenge, but not quite the Bubonic Plague.
Barney Frank is a full-on asymmetrist. Throughout his career he has framed most political problems as a series of misunderstandings, miscalculations and misplaced misgivings. By way of example, it is the Thursday post-election, two days after the passage of Proposition 8, a California state referendum on gay marriage that just effectively annulled 18,000 single-sex marriages, dampening an otherwise historic election for civil rights. Frank is in the conference room of his office in Newtonville, looking vaguely irritated. But he always looks vaguely irritated when he is not telling a joke, which is the other thing he always seems to be doing.
“I really wished they’d waited another year for that,” he says. “What we’ve found is that the more time voters have to actually get to know same-sex couples, the more the prejudice falls away.” Frank, himself a gay serial monogamist, does not question this assertion. He is friends with Tom DeLay, of all people, who last week in the midst of a hysterical speech on the dangerous radical Marxism of Barack Obama, took a moment to call Frank a “brilliant man” and great American. Take it from a gay serial monogamist: there are more pressing issues.
Outside the door, by way of example, a strikingly well-dressed man who happens to be in the business of manufacturing solar panels is patiently awaiting to speak to someone on his staff per the advice of the governor. Before the crisis, the man’s Worchester-based company had been working out a deal to raise $300 million by selling what is called “convertible debt” — bonds affixed to stock options — to the public. To close the transaction, the investment bank handling the offering asked company to lend Lehman some 31 million of its shares, about 15% of the company, as a condition of pricing the options. But the deal never went through, because the investment bank was Lehman Brothers, whose implosion in September touched off the worst financial crisis since the Great Depression…and, by the way, the well-dressed man never got his shares back. Barclays, the British bank that bought Lehman’s investment banking division, isn’t letting them go, and bankruptcy law isn’t forcing them to. It’s a bizarre situation, typical to the financial meltdown only in that it is just the sort of Kafkaesque outcome that follows a complete breakdown of a system.
“Moral hazard” is the darker, more enigmatic force at play in the crisis. The term refers to the simple fact that people who’ve been insulated from a risk behave differently from those who have not. Coined in the seventeenth century by life insurance underwriters concerned that the buyers of their premiums would be increasingly likely to indulge in unhealthy excess, it has in more recent decades been applied to American politics, with the idea having taken hold that the federal government is a veritable landfill of morally hazardous waste, manned by entrenched bureaucrats and machine pols unnaturally insulated from the risk of losing their jobs and wanting only to spread the wealth of the risk-free government payroll life to friends and lazy poor people.
If politics is truly, as the Frank’s predecessor in Congress, the late Father Robert Drinan, said when he stepped down in 1980, “the formation of public morality,” then there is no more ideal year to which to peg that shift. Drinan, the last Roman Catholic priest to serve in Congress, whose portrait hangs in the vestibule solemnly facing the well-dressed man, had been asked by the Pope himself to resign after a group called the Christian Voice Coalition gave him a grade of zero on its new “Moral Report Card.” Drinan, you see, had supported sex education, birth control, abortion rights and other advances of the era that had served to take the risk out of sex; he also supported welfare, which removed the risk from laziness.
But times change, and with them, hazards. In August of this year the modern Christian Right was forced to concede on an epochal scale that teenage girls deprived of all the modern enablers of premarital sex are still wont to do it—they just become teenage hockey moms. And then in September the financial system caved in on itself, the casualty of a decade-long ritual risk-burning started by hedge funds and sustained by investment banks, lax regulators, mortgage brokers, bond insurers, and two terribly conflicted corporations founded by the government to promote homeownership, Fannie Mae and Freddie Mac. It was a vast menagerie of miscalculations, misjudgments and misplaced assumptions that prompted host of questions, but the only one that mattered in the moment was “Can I borrow, like, a trillion dollars, quick?” Stunned by the magnitude of it all, most in Washington asked the question posed by John McCain to his chief economic adviser: “Who are the villains?”
Henry Waxman was on the case. Within a week the California Democrat chairing the House oversight committee had begun systematically hauling in some of the country’s most unsympathetic plutocrats: Lehman CEO Dick Fuld and two former CEOs of AIG, the insurance company that has been the single-biggest generator of moral hazard, booking billions in profits on insurance policies it couldn’t honor and golfing at the St. Regis after the government promised to make good on them, followed by the former chiefs of the credit rating agencies who underplayed the risk and finally Alan Greenspan, whose false “ideology,” was the system’s original sin. The night before the first vote on the bailout, Nancy Pelosi gave a speech laying blame squarely on the “reckless,” “irresponsible” “anything-goes” policies of Republicans, and an anonymous Democratic congressman wrote a widely-hailed email vowing not to vote for a “$700 billion dollar giveaway to the most unsympathetic human beings on the planet” unless it was “as punitive as possible” and included curbs on executive behavior “that would serve no useful purpose except to insult the industry.” It was astonishing: the Moral Hazard Majority belonged to the Democrats.
But curiously, Barney Frank wasn’t joining it. Even when he himself would be denounced as a villain for some misguided—and wildly misunderstood—statements he’d made about Fannie Mae a few years back, he would not name an enemy. Hill insiders found it noteworthy that he had ceded so much turf to Waxman when he could have excoriated some corrupt billionaires in his own committee. Instead, he invited the preeminent scholar of information asymmetry, Nobel Laureate Joseph Stiglitz, to offer the committee his prescriptions for the future.
“Barney Frank is not a hypocrite,” says Larry Lindsey, the ex-chief economic adviser to President Bush, leaving little doubt that he does not share the same view of Waxman. In June Lindsey wrote a Weekly Standard column praising Frank’s “intellectually honest” mortgage foreclosure legislation. “He’s been dealing with this crisis in a very positive way,” Lindsey says. “He understands there’s nothing criminal about being wrong.”
But there in times of short supply, there’s insatiable public demand to prosecute the wrong. That does not exempt Barney Frank, who has said a few things in his 27 years on the committee that turned out to be wrong. “There are some people who have speculated that he should be prosecuted and spend some time in jail,” said Earl Sholley, his perennial Republican opponent for Congress, who believes Frank was the “key architect of the mortgage meltdown.” This was, he assured me, a mainstream view: Frank’s independent opponent, Susan Allen, “seems to think he’s guilty of treason and should be put in jail.”
Neither candidate had much of a chance of unseating Frank. Sholley did his own time in jail in the nineties for domestic violence; Allen’s case did not even seem coherent to herself in a debate with the congressmen. But far from ignoring or dismissing the attacks, Frank seemed energized by them. As his staff in Washington worked the phones monitoring the minutiae of the bailout package with the hundreds of interlocking regulators, economists, risk managers and officials comandeering it, he returned to Newton and ran a passionate campaign for reelection that spilled far outside the borders of his district and resembled a lecture circuit on steroids. In the month before the election, he gave at least fifty — his staffers were too busy to count — lectures at community breakfasts, Chamber of Commerce luncheons, Democratic party dinners, municipal conferences, newspaper editorial board meetings and various other events—even as he was booked on at least one national news show a day to discuss the Wall Street mess.
His speeches, which he continues to give, are varied and extemporaneous and tailored to each audience, but rarely does he pass up the chance to talk about his new favorite topic,”credit default swaps.” Credit default swaps (CDS in Wall Street parlance, but Frank audibly relishes the words “defawwlt SWAAAHPS”) are a $66 trillion business no one really knew about a few months ago. They play a central role in the magnitude of the crisis, in large part because no one really knew about them. They were never regulated by the government. And while most people in the government who knew about credit default swaps were concerned about this, they were constrained by a party that did not trust regulation.This was a huge asymmetry, as Frank enjoys pointing out. “People should not be surprised that people who do not believe in government are incompetent at running it. It’s like making me chief judge of the Miss America contest,” he tells an audience at a party fundraiser in New Hampshire.
“I am reminded of a great quote by Marx,” he pauses. “Chico.” The crowd goes nuts. “Who you gonna believe, me or your own eyes?”
It is a technically partisan speech to a thoroughly partisan audience. But it is nothing Rush Limbaugh himself wouldn’t laugh at. In a philosophical debate, there is nothing criminal, or nefarious, or even immoral, about being wrong. The hazard, Frank knows all too well, is that the winners pass up the chance to open their opponents’ eyes.
In interviews Barney Frank has generally traced the realization he was gay to age thirteen. He knew about gays because three years earlier, in 1950, the State Department had fired 91 of them in an episode that touched off a mass government purge of men the newspapers dubbed “perverts.” The information chasm between gays and the straight majority seemed almost unbridgeable: even empathetic quarters thought to be a mental illness. Constitutionally, the purge was justified because gays were considered a “security risk” susceptible to blackmail.
The rationale was irrational. In communities in which homosexuality is considered taboo, a gay person, by the laws of moral hazard, should actually be far less likely than a heterosexual to engage in blackmailable activity. In fact, the discretion required to have any sort of gay affair in that era meant gays were almost ideally suited to hold sensitive positions in government (which may help to explain why McCarthy employed a closeted gay man, Roy Cohn, as his chief counsel).
But never mind: Barney Frank, a garrulous slob who loses his cell phone every few weeks (first campaign slogan: “Neatness Isn’t Everything”) has never been a naturally discreet guy. He dealt with his sexuality for the first 40 years of his life mostly by not dealing with it. His political career was inspired and emotionally sustained by the civil rights movement, yet Frank was keenly aware of the cultural sensitivities and unarticulated fears that could turn decent people away from just causes. During his college days at Harvard, when Frank spent a summer in Mississippi as part of the Freedom Riders movement to enforce desegregation, a reporter asked him whether he thought blacks were the vanguard of a new American Revolution. “No!” he said. “They just want to sit back and relax and have a house in the suburbs like everyone else.” (The quote is vintage Frank, whose two guiding principles could be articulated as “1. Everyone is pretty much like ‘everyone else’ 2. So let’s keep perspective and not pretend the Apocalypse is at hand.”)
But since Frank had no desire to sit back and relax, his pragmatic side could not see much benefit to being an “open homosexual.” The workload kept his mind off his emotional needs. He had plenty of company when he graduated to Congress from the Massachusetts state house: Straight-laced Washington had a deep closet for practical-minded politicos with a network of interlocking secrets that sustained a mass discretion. During his first year in Congress, about the only thing Frank had a reputation for was promise. Frank’s colleagues voted him “Best New Member,” and he was tapped as a shoe-in for first Jewish Speaker of the House by the legendary Tip O’Neill, who held that job at the time.
Then came AIDS.
The disease first emerged as a public health epidemic in 1981. The prevailing conservative wisdom considered it the Almighty’s private purge of homosexuals and heroin addicts; a more apocalyptic wing of the Right saw the disease as a pox sent to punish all of America for decades of Godless rock ‘n’ roll-enabled permissiveness. Orange County congressman Bill Dannemeyer was one of the latter. Elected the term before Frank, he introduced numerous measures to quarantine AIDS patients. To highlight the unhealthiness of the “gay lifestyle,” he read aloud on the House Floor graphic descriptions of gay sex. (Frank’s line at the time: “He’s so concerned with how the penis is inserted into the anus, but how did California insert an anus into Congress?”) In 1985 Dannemeyer ran for Senate on a platform including the assertion that “a person with AIDS emits a spore that has been known to cause birth defects.” The next year the Justice Department wrote an opinion arguing that employers should be allowed to fire people with AIDS if they feared the disease to be “contagious in the workplace.”
In 1987, Connecticut congressman Stewart McKinney died of AIDS his staffers said he’d gotten from a blood transfusion. The next day the Washington Post produced a litany of accounts that the legislator, a liberal Republican, had slept with men. Frank decided at the funeral that he had no choice. It was already well-known among Frank’s friends that he had been dating his “house boy,” a sometime escort he paid to drive him around and run errands. Now that deception was beginning to unnerve Frank. And for good reason: Weeks after he came out (“of the room,” as Tip O’Neill memorably mis-announced to his staff) to the Boston Globe with a gruff “Yeah I’m gay, so what?” Frank’s landlady called to tell him the “house boy” had been hosting a suspicious number of visitors while he’d been away.
Steve Gobie was house boy’s name, and it was not until after Frank had broken things off with him that he fully appreciated the perils lurking in the secrecy and discretion of the closet. The danger in perpetuating the informational asymmetry was on both sides of the door: not only was the secrecy an emotional and ethical burden to him, it fundamentally underestimated the capacity of the public to cope with the truth. Worse, it cultivated the paranoia that comes when truth is substituted with hearsay and imagined plots.
Frank had made other faulty assumptions in the closet. When Gobie sold his story two years later to Penthouse for $50,000, the rattled congressman would tell the Washington Times that he had perceived the relationship as something akin to My Fair Lady’s Henry Higgins and Eliza Dolittle. But it is more than apparent that Gobie was, as today’s reality show contestants so often say, “not here to make friends.” Gobie told Penthouse he had hosted legions of high-profile prostitution clients at Frank’s house, and moreover, that Frank had known about it. While Gobie lacked the evidence to prove those or any of his myriad other claims, only Frank was willing to endure the endless series of sessions of public introspection in the media required to parse fact from fiction. Another client, an elementary school principal who told the Washington Times Gobie reminded him of the son he’d just lost to a drug overdose, moved away. A Republican lobbyist Gobie had serviced committed suicide.
The ensuing ethics investigation concluded just under a year later in July 1990. Most of Gobie’s stories seemed fabricated, and whatever prostitution did take place at Frank’s house, it seemed highly doubtful he’d known about it. But Bill Dannemeyer sponsored a bill to expel Frank anyway, reading aloud a portion of the Penthouse article on the House Floor wherein Frank and Gobie have sex in the House gymnasiuma story Frank had strenuously deniedand intoning ominously that “the House is on trial today.” But by that point, the sympathies of Congress, and his constituents, were with Frank. Dannemeyer’s bill got only 38 votes, and Frank, after being reprimanded, was reelected by a 66-point margin.
The scandal had redefined Frank’s career. While it would limit his ambitions for higher office, the episode humanized Frank to colleagues and constituents. From practically his first day in office, he had been widely considered its smartest member, and possibly its funniest. (He regularly tops both rankings in Washingtonian magazine.) But the scandal forced him to articulate the private loneliness and emotional underdevelopment that had led him into such a colossally dysfunctional romance, something wholly relatable to “everybody else.” The truth had set him free.
Today Bill Dannemeyer is 79 and retired, in good health he credits to a vegan diet and rejection of Western medicine. Still a resident of Orange County, he voted for Proposition 8 and maintains the homosexual “lifestyle” is unhealthy. But he has lost all faith in the Republican Party over its handling of the economy, and now reserves the preponderance of his conspiracy theorizing and moral outrage for the elites to whom he claims they “sold their souls,” the Federal Reserve and its New York branch. When asked about Barney Frank, his first challenge to his old foe is that he conduct a thorough audit of the New York Fed.
An information vacuum, as we have learned, is a dangerous thing. In times of confidence the public will abide, mythologize even, secrecy in their public servants, but that only nurtures the paranoid zealots and conspiracy theorists who come out of the woodwork when those same figures, again and again, turn out to be fallible. There is no more salient apotheosis of this phenomenon than the Federal Reserve under Alan Greenspan, whose cult of personality during his 19-year tenure drove skeptics nuts on both sides of the aisle. Few in Congress dared question his judgment or his certainty, for fear of looking like fools. But Barney Frank had already proven himself fallible.
Barney Frank joined the Financial Services Committee his first year in Congress for the reason most Democrats still do: it is big, not exclusive, and oversees housing policy, one of his passions. The sense that he’s a “liberal housing activist” still in the financial world. When he became chairman 26 years later, the trade publication HedgeWorld wrote that Frank was “lacking any deep personal interest in corporate financial issues.” And when he opined recently that Wall Street should impose a “moratorium on bonuses” an investment banker friend told me to tell the “financial antichrist” to “stop hypocritically murdering America” — and this is a guy who voted for Barack Obama.
But during his fourteen years under Republican leadership of the committee, he made a reputation as its most thoughtful, pragmatic Democrat. While the committee, much to his chagrin, did not pass a single housing bill of any significance, this freed up Frank to channel his intellect into issues in which he had little emotional or ideological stake. And one thing his intellect had trouble abiding was the secrecy and insularity of the Fed.
As a free-market Republican who oversaw a thriving economy during a Democratic Administration, Alan Greenspan had a bipartisan appeal few politicians felt like going up against. And through its official role of buying and selling Treasury bonds, the Fed funds itself, granting the agency a much-vaunted “independence” from political concerns. But under Greenspan, Frank felt the Fed had so bought into the notion of its own independence it was in its own sort of closet, a point he drove home with eerie prescience on what was probably his busiest day in Congress as a minority member: October 1, 1998.
On that day, Frank’s other committee, the Judiciary, was preparing a series of cases for and against impeaching President Bill Clinton. Like most Congressmen, Barney Frank felt the process was an absurd joke that cheapened the whole institution — but Frank, his own sex scandal having removed the pieties that bound most Democrats, was the only one willing to say it, and he had been making a national name for himself by granting anyone who asked an interview lambasting the process.
The process, of course, continued despite him, and on October 1 the committee was in the final stages of entering into the public record a 4,610-page supplement to the 461-page Starr Report„ in order to provide the public with all due transparency on the details of Bill Clinton’s affair with Monica Lewinsky. News cameras clogged the halls of the Rayburn building as reporters camped out waiting for the documents. As usual, reporters clamored Frank for good soundbites.
But Frank had to tear himself away for a few hours that day because a far more important hearing was in session down the hall in Financial Services. The week earlier, the Fed had intervened to organize a bailout of a huge hedge fund, and Greenspan and New York Fed President William McDonough were there to explain what had happened.
Long Term Capital Management was legendary for a trading strategy that relied on complex algorithms which, among other things, used historical data to arbitrage the relationships between the price swings of stocks, bonds, currency, and commodities. It had worked splendidly until earlier that year, when a series of emerging markets crashed, the Russian government defaulted, and the predictable market logic went haywire. This mistake alone would hardly have sent shock waves through the financial system but for two things: To increase its profits, Long Term traded not the actual stocks/bonds/etc. but derivative contracts that bet on the movements of their prices, with each of those contracts having a “counterparty” bank on the other side of its bet. And to further amplify returns, Long Term Capital had loaded up each bet with massive amounts of short-term debt, which meant dozens more creditors. No one knew for sure how much money was on the line if the fund blew up; neither hedge funds nor derivatives are regulated by the government. But the Fed estimated it could be as high as a trillion dollars, which was why it had been moved to intervene.
At the same time, McDonough and Greenspan maintained coolly, the intervention was really not that big a deal. “Not a penny” of federal funds had been put on the line, because it was the affected banks that had chipped in on the bailout. Sure, McDonough and his deputies had provided the conference rooms and “observed” the negotiations; but he hadn’t, he claimed, actually participated. “This was a private sector solution,” he repeated, “to a private sector problem.” If there were lessons, he warned, it was “far too early” to say what they were.
Frank laid into McDonough with a perceptiveness that can only be appreciated in hindsight. First he corrected his fellow congressmen for mistakenly addressing him as “governor,” which is a political appointment, when in fact McDonough the New York Fed president, and, while the second most important person at the central bank, neither a public official nor appointed by one. (Frank left out the fact of who appoints the New York Fed president, which is to say, “the banks,” for all intents and purposes.) Then Frank suggested that for all McDonough’s supposed “passivity” in the intervention, he was most likely in his “heart of hearts, proud” of his hard work averting financial collapse, and that McDonough, while “a very persuasive man” could not have done what he did without the “implicit power” bestowed upon him by the New York Fed — which is to say, a branch of government. And, from one government employee to another, surely he had to understand how bad it looked when the “mistake-makers” were shielded from huge personal losses by the Fed’s actions.
“A consequence of preventing damage to the system was to leave some of the richest people in this country better off than they would have been if the federal government hadn’t intervened,” he told McDonough. “And that rankles a lot of us, as you’ve heard, when we’re told we can’t do anything similar for people much needier.”
The debate over whether the bailout of Long Term Capital Management created moral hazard (it most certainly had) would occupy economists for years to come, but Frank had laid out the real hazard right there: McDonough had forgotten that they were all on the same team. He was appointed by investment banks, feared by investment banks, spent his day talking to investment bankers, and in a disaster averted or a job well-done, it was the bankers singing his praises.
What he had forgotten about, ironically, was the long term. Long Term’s lenders and counterparties had approached the Fed to moderate the bailout because they were too competitive to trust one another. They looked to the McDonough because he had no horse in the race aside from an interest in the health of the broader economy, and nothing to gain from the inside information and trusted the Fed to ensure the process was fair. But “fairness” among a select group of investment bank counterparties is not fairness, and over the long term even the investment banks would understand that.
Because the chain of events threatened by the explosion of Long Term Capital Management is almost exactly the scenario that has played out, albeit on a massively bigger scale, 10 years later: A single event unpredicted by the models—then the Russian default; today the foreclosure crisis—gets magnified over and over and over again by a financial system loaded up with massive debts and complex unregulated derivative securities.
Earlier in 1998, the Commodity Futures and Exchanges chairman Brooksley Born, a respected but far more obscure and politically popular regulator than Greenspan, had argued strenuously in favor of regulating derivatives and offered up her own agency for the job, but Greenspan and then-Treasury Secretary Robert Rubin had shut her down. Born had been briefing the committee for much of the year on her concerns about the growth of the derivatives market, and she too was at the hearing, calling the intervention a “wake-up call.” Then chairman Jim Leach agreed. “You’re welcome to claim some vindication,” he told her.
Ten years later, she would. (And Leach, for his part, would be endorsing Barack Obama for president and singing Frank’s praises in the financial press.)
But for the time being, Greenspan and Rubin had won. The near-collapse of Long Term Capital Management would not be a “wake-up call,” and the derivatives market would continue to balloon unmonitored and unchecked for the next ten years.
The irony is that even under Republican leadership, the committee wanted to reform financial regulation. His successor as chairman, Mike Oxley, would preside during a tidal wave of financial scandals, beginning with Enron, that would upend the accounting industry and pave the way for tough new curbs on some of the more “creative” practices that had resulted in hundreds of billions of dollars in earnings restatement. The chairman of its subcomittee on capital markets, Richard Baker, would be labeled the “scourge of Wall Street” over his probes into the conflicts-of-interest that run rampant among the various players in investment banking. But they would be handcuffed by the reflexive deregulation stances of the House Leadership, the Bush Administration and the Fed. Tom DeLay quashed Baker’s bills because he wasn’t a “team player.”
In October asked Frank about Baker, who is now a lobbyist. “He’s smart, but he had some problems with style,” Frank said, and then added, looking vaguely puzzled, that Baker had just donated money to his campaign.
As for Oxley, he would pass the only meaningful financial regulatory reform to emerge from the decade, and the lobbyists would immediately begin pressuring the committee to relax the law, warning that business would move overseas if they declined. Now a lobbyist, Oxley told the Financial Times in September that the Bush Administration had met all his calls for regulation with a “one finger salute.”
It was a legislative landscape rife with asymmetries. Republicans with the deepest intellectual interest in finance — and the most information about its excesses — generally favored more regulation, but they were hamstrung by the larger body’s generalized suspicion of regulation, coupled with the reflexive bias against it of the Bush Administration and the Fed, which also happened to harbor a reflexive disdain for Congress.
It was, it so happens, precisely the sort of needlessly contentiouslandscape about which Barney Frank had written his 1962 senior thesis at Harvard, “Financing Foreign Aid.” At the time, White House foreign aid bills had to pass through the powerful Appropriations Committee every year, a process they wanted to streamline by allowing aid to be approved by the Foreign Relations committee and funded directly by the Treasury Department. But the Appropriations Committee was loathe to relinquish its authority, although the committee generally wound up appropriating all the (relatively insignificant) funds at stake. Certainly, Frank wrote, the fact that foreign aid, like financial services regulation and accounting reform, was not an issue that won elections did not smooth the process. “The fact that the ‘State Department funds foreigners’ has long been one of the most salient facts of our political life.” But the “inextricability of substance from procedure” — the distrust that forms when different parts of the same whole are asked to cooperate or diverge from form in order to achieve a common goal — can undermine the common goal.
Unfortunately, no one at the Fed had read Barney Frank’s senior thesis.
“I understand there are those who believe that while democracy is capable of dealing with many, many issues,” Frank half-joked to him and Greenspan, “it really cannot be trusted with matters of high financial policy. There is an overwhelming tendency when you come here to speak to us as if we were adolescents who need to be told some things, but who are not ready for the entire truth.”
Of course, with the rest of the House consumed fashioning thousands of pages of documents into a case to impeach the president over not being told the whole truth about a blow job, it was not the most auspicious day to ask to be treated like adults, as veteran congressman Paul Kanjorski would wryly observe.
“Just a little while ago, I walked down the hall. I noticed the absence of television and other media parties here,” he told Greenspan. “I was just wondering, is there any way you could inject sex into this so we could get more national media attention?”
Barney Frank now says his biggest blind spot was his limited understanding of derivatives, and the extent to which they intensified the risk of the subprime housing bubble and spread it out through the international financial system. And while technically true, his true blind spot was the reason he joined the committee in the first place, housing, specifically the much-maligned federally-sponsored mortgage giants Fannie Mae and Freddie Mac.
Fannie Mae was founded by the government in the 1930s to encourage homeownership by lending money from the Treasury to banks to extend mortgages to middle-class and working-class borrowers. In 1968 it was “privatized” in a ploy to balance the federal budget that “saved” the government $1.8 billion by getting the mortgages off the government’s books. The New York Times referred repeatedly to the privatization as a “gimmick” of accounting; it was one of many more to come. No one at the time believed the government would not guarantee the mortgages it bought and no one ever would. If Fannie Mae ran into cash flow problems, it would not exactly require a lot of political capital to win a federal bailout, as Michael Lewis wrote in his definitive book on the advent of mortgage bonds, Liar’s Poker. “To stand up in Congress and speak against homeownership would have been about as politically astute as speaking out against motherhood.” Or economic growth. Which brings us back to Alan Greenspan.
Like Alan Greenspan, homeownership had bipartisan support, and for a long time they thrived under it. Where previous Fed chairmen had tried to rein in inflation, Greenspan gave himself a “dual mandate,” to grow the economy while keeping inflation in check, which he did by keeping interest rates low and limiting his definition of inflation to exempt the prices of anything (real estate, for instance) not made in China. Fannie Mae also had a dual mandate, to help middle- and working-class families buy homes, and make fat profits for shareholders — a toxic combination.
As with Greenspan, Frank was an early skeptic of the rapid ascent of the homeownership rate, especially amidst the backdrop of a rapidly widening income gap. But he abided it, and supported Fannie Mae and Freddie Mac over the years, because they were the only vehicles he had for affecting housing policy under Republicans, who had begun a deliberate effort in the 1980s to “de-fund the Left” of its social programs appropriations by preaching fiscal responsibility, then driving up deficits in their favored departments. At the same time, Fannie Mae and Freddie Mac were cozy with Republicans, whose districts had higher rates of homeownership than Democrats’. (When Richard Baker solicited information on Fannie Mae’s executive compensation practices in 2003, the request was met with threatening letters from none other than Ken Starr, who the firm retained as counsel.)
The Bush Administration began mobilizing to toughen regulations on Fannie Mae and Freddie Mac in 2003, in response to a host of accounting shenanigans that had been revealed the year later. But Fannie’s abuses were garden-variety in a year dozens of companies had been implicated in multibillion dollar accounting scams in a massive indictment of a corrupt industry that brought down one of its most storied firms, and the administration’s proposal was essentially a power grab that would have robbed the committee of what Democrats saw as their last shred of authority over housing policy. They were livid. “We [are] frankly trying to fix something that isn’t broke,” Maxine Waters said at one hearing, while another black congressman on the committee, Missouri’s Lacy Clay, called it the “political lynching of Howell Raines,” the African American then-CEO of Fannie Mae.
A YouTube video with highlights from the hearing began making the rounds on the right wing blogosphere on September 29, the day the House voted down the bailout package after a minor Republican defection killed the vote. Clips of Baker and other Republicans expressing concern over the company’s governance standards are interspersed with clips of four black members of the committee and Barney Frank defending the company. Barney Frank is fairly even-keeled by contrast, but his message is the same: the Bush Administration was ginning up “accounting irregularities” as an excuse to undermine the (African) American Dream. “The more people exaggerate the problems at these companies, the more pressure there is on these companies,” he said in one of the hearings, “the less we will see in terms of affordable housing.”
And alas, thus began the political lynching of Barney Frank.
The clip reel is misleading for a few reasons, not least because it fails to mention that once passions cooled Oxley and Frank marshaled support for a bipartisan bill regulating the mortgage giants that passed 331 to 90, but the Bush Administration ignored it. Further, the real abuses at Fannie and Freddie, and in the larger mortgage business, did not begin until 2004, the year the Securities and Exchange Commission relaxed capital requirements on investment banks, allowing them to take on twenty and thirty times their cash in debt, much as Long Term Capital Management did, which just accelerated the chase around the financial world for new bets to make.
The thing is, there were only so many bets to make. And the smartest bet, that it would all go bust, was a difficult one to make. It’s relatively easy to short-sell a stock whose price you think is going to fall, and when you buy a stock you can see how much “short interest” it has. But betting against the housing market requires a kind of derivative security called a credit default swap, an area of finance Barney Frank had been putting off figuring out. (“Derivatives is also something we have to look into,” he said during a 2003 hearing. “I say that with all the enthusiasm of being told that we have to go back to trigonometry and take a test in it.”)
Perhaps as penance, he now explains credit default swaps everywhere he goes. One Saturday morning a few weeks before the election he arrived early to the otherwise deserted Sturbridge hotel hosting an annual gathering of state selectmen and launched into his lesson just before nine a.m., beginning with a topic arcane to most but familiar to anyone involved in local government: “monolines.” When a city or town decides to float a bond offering to pay for a stadium or an airport renovation or some such, it can usually borrow at lower rates if it buys default insurance from a bank—the “monoline”—which insures the principal in case of default.
Well, credit default swaps are just like bond insurance, except you don’t need to be an insurance company to sell them, and you don’t need to own any actual bonds to buy them. If you sold swaps, you could issue infinite insurance policieson the same bond; if you bought them, you could buy limitless insurance policies on the same bond you didn’t even own. The price of credit default swaps was generally a function of historical data on the rate of default for a particular kind of bond. But for most of history, mortgage bonds rarely defaulted. “They thought they were selling life insurance to vampires!” Frank says. (Indeed, AIG booked an unbelievable 83% operating profit margin on its credit default swap business in 2005.) By the time it became clear housing prices would not hold, the dollar amount pegged to or hedged by credit default swaps had reached the aforementioned (though still stunning, every time you see the number) $66 trillion.
In other words, per Frank: “These people insured so much money… that they owe more money…than there is money!”
It’s a line he’ll repeat again tonight, and over and over, always to roars of laughter, because if you can’t laugh at financial armageddon, what can you laugh at? To guys like Bill O’Reilly who blame him for the crisis, he says, “I checked, and the trade of credit default swaps in Fall River is very low.” Which highlights the biggest asymmetry of the whole mess: what if someone had told every man, woman and undocumented worker who signed up for a mortgage after 2005 that the smart money on Wall Street was betting trillions of dollars that they’d wind up in foreclosure?
Who knows, maybe the market would have worked. And maybe Barney Frank wouldn’t be diving headfirst into the moral hazard morass that is appropriating a couple trillion dollars of federal aid to a bunch of guys who are pretty sure he’s a Marxist. As it is, as he tells the crowd in New Hampshire: “I’m from the government, and I’m here to help. That used to be a right wing joke!”