"It is better to light a candle than to curse the darkness."
Eleanor Roosevelt
There is a new word for 'politics of envy' and it's called 'social justice'. In economics it's known as taking other peoples' money to distribute to the under class. The Democrats in the US have honed this skill to perfection. The mendacity of Democrats is so prevalent but they have the unassailable ability to fool a generation of Americans churned out by liberal institutions of learning, and a black community kept in the DNC plantation for a hundred years. Take for example the fact the Democrat Party is the party of Ku Klux Klan, but they have been able to capture majority of black votes for a hundred years and call the other party racists. What could be so wrong to push 'social justice' agendas, of economic policies that will level the playing field, for equality of opportunities. So the case for free healthcare, forgive student loans, reparation for slaves, the list goes on.
As a young student of accountancy, I learnt of an incentive scheme in a factory in the old Soviet Union.The factory produced chandeliers and reported production numbers in terms of tonne weightage to communist bosses. Communist Party members in charge implemented a bonus scheme based on weightage output. Made sense, right? The result was chandeliers got heavier and heavier until they started dropping from ceilings. Just like incentive schemes, economic policies can and often do, result in outcomes never anticipated due to dynamics in complex interconnectedness of things and the psychology of human motivation.
In the previous blog "Trump-Harris : Which side Singapore wants and why?" I shared why I feel the Singapore government prefers a Harris presidency. Harris is of course also the preferred choice of the educated liberal Singaporeans sitting on the high horses of virtue signalling who have bought into a Trump persona sold by leftist media of a thuggish, mysogist, fascist, racist, tyrannical candidate.
Because of its role in world economy, miss-steps in US policies impact all countries. In this blog I want to discuss one specific illustration. This is a re-visit to the 2008 global financial meltdown known as the subprime mortgage crisis. You most likely have read bits and pieces here and there, but I am certain no one locally has explained it the way it's done here. I explain how it happened, the tecnical aspects, the human motivational aspects that Ludwig von Mises and his Austrian School of Economics would have explained, the policy mis-steps. Then I bring this home to show why Singaporeans should be concerned about what happens thousands of miles away because it impacts our nation, and to several hundred Singaporeans, personally, in a very painful way. The purpose is to show the danger of Democrats in general and Harris in current play. In the process, I lay a condemning finger on Obama, the first black president enamoured by most people including Singaporeans, all unable to see he is the one who bears most responsibility for the cultural chaos in US for bringing identity politics to the fore, and where we are concerned here, his role in the 2008 financial mess which has gone mostly un-noticed.
A very simple explanation of what the mess was all about:
The crisis was triggered by a combination of lending to high-risk borrowers, financial innovations like securitization and derivatives, and deregulation that allowed financial institutions to take on excessive risks. When interest rates rise and housing prices began to fall, the entire system collapsed, leading to widespread defaults, contagion financial institution failures, and a global recession.
To understand how this happened, one must understand the human motivation dynamics at play. In the aftermath of the Dot.com bubble, interest rates were pressed low to stimulate the economy, With low interest rates, people invest in houses. As demand side builds up, housing prices went up. More people began taking advantage of low interest rates to buy houses to flip and make a profit. So a speculative market built up that fueled prices to greater heights.
Lenders extended credit which soon covered borrowers they normally would not lend to. These were called subprime mortgages which are pecked at higher interest rates for the higher risks. Deregulation allowed commercial banks to securitise their subprime mortgages into derivatives to sell to investors generating for them a great stream of income. Proceeds from sales of derivatives created a cashflow back into their operations that beefed up liquidity, which allowed banks to onlend into the subprime mortgage again. The repeat loop of cash backflow from sale of securities created extremely leveraged housing loan portfolios in banks that grew way beyond their capital reserves.
In case you still don't get it, it works this way. Banks lend to house buyers at high margins. Banks package their assets (mortgage loans) as backing for financial derivatives. Banks sold derivatives to investors whose earnings come from a share of the margins banks earn from housing loans. By giving away some of their earnings, banks receive cash from investors who purchased the derivatives. With the cash, banks can lend again to more house buyers. Rinse and repeat. The profitable game continued so long as the higher margin on the subprime mortgages is sufficient enough to be shared with investors of the derivatives. It's the familiar frenzy that creates bubbles.
The housing boom of 2000s increased only housing prices, it did not cause increase in the general price levels. By 2004, the economy had come out of the recession of 2001 Dot.com bubble. The Fed started a series of interest rate increases to pre-empt inflation. This caused low income mortgagees to no longer able to service their loans, especially those with floating rate mortgages. Demand decreased and housing prices fell. Speculators who can, sold their properties and suffer losses, while some speculators are caught holding properties they cannot sell. Large scale default took place. All banks with highly leveraged portfolios rushed for the exit which put further downward pressure on housing prices. Banks without credit default swap (insurance guarantees) suffered massive losses and were unable to service their derivatives books. The impact on portfolio valuation devastated bank capital and bankrupted insurance companies.
The securities worked like this:
Mortgage-backed securities (MBS).
Banks packaged their subprime mortgages and securitised them. Means they issued securities (bonds etc) backed by these package of subprime mortgages. Because the subprime mortgages were priced high, banks can share some of the interest earnings with investors of MBS. The money received from MBS is ploughed back into the housing market. So they increased their exposure to the market, but generate more profits. When interest rates rose and housing market collapsed, buyers defaulted. As cashflow from the subprime mortgages that are used to pay MBS investors vapourised, the securities valuation plummeted and caused massive losses.
Collaterised Debt Obligations (CDO).
These are backed by pools of MBS and other loans, all bundled together. Based on specified bundles of loans, banks created securities called CDO and sold to investors. In other words, derivatives of derivatives. When the underlying subprime mortgages defaulted, CDO valuation crashed.
Credit Default Swaps (CDS).
These are financial derivatives that allow investors to sell the risks of default on their investment to someone else. Insurance companies like AIG issued CDS to cover MBS and CDO of these subprime mortgages. The buyers of CDS paid annual or quarterly premiums to the insurance companies, in return they are reimbursed for losses on liquidation of their CDO and MBS when subprime mortgagees default. This allowed insurance companies to take on massive unfunded liability far in access of capital requirements and under regulatory radar due to its off-balance sheet nature. Of course, for years before the crash, they reported huge gains in premium income. When the underlying subprime mortgages defaulted, insurance companies suffered massive losses.
How did government policies play into this?
Gramm-Leach-Bliley Act (1999):
Prior to 1999, the Glass-Steagall Act of 1933 separated commercial banking from investment banking. Commercial banks were not allowed to involve in more risky financial activities of securities trading. The Gramm-Leach-Bliley Act (1999) repealed provisions of the Glass-Steagall Act of 1933 which then allowed commercial banks, investment banks, and insurance companies to consolidate and engage in a wider range of activities, including high-risk trading and investment.
Commodity Futures Modernization Act (2000):
This Act exempted derivatives, including credit default swaps (CDS), from regulatory oversight, allowing institutions to trade these financial products without adequate transparency or capital reserves.
Acts of Securities Exchange Commission (SEC).
In 2004, the SEC allowed large investment banks (like Lehman Brothers, Bear Stearns, Goldman Sachs, and Merrill Lynch) to voluntarily opt out of the traditional leverage limits. This allowed them to trade more aggressively with higher levearage.
In 2007 SEC eliminated the Uptick Rule of 1938. This rule limited short selling by requiring that a stock could only be sold short if its last trade was at a higher price than the previous trade (an "uptick"). This allowed more aggresive short selling of stocks which during the crisis, caused panic selling of bank stocks.
Basel II Capital Accords (2004-2007 Implementation)
The rules allowed banks to use their own internal risk models to calculate the required capital for different asset classes. US banks used overly optimistic risk models that underestimated the risk of default on mortgage-backed securities and collateralized debt obligations. This allowed them to hold more risky assets than their capital reserves permit.
Community Reinvestment Act (1977).
The CRA is an anti-redlining law designed to encourage banks to provide loans in low- and moderate-income neighborhoods in a manner that satisfies the safety and soundness of banks. The mission statement is an oxymoron that request an uptake of sub-quality loans which satisfies bank credit standards.
So who were responsible for these policies?
Republicans believe in government should move out of the way and allow free market to work itself out. Thus they tend to reduce tax and to de-regulate. Gramm-Leach-Bliley Act and Commodity Futures Modernization Act were bipartisan bills. They were Republican initiatives, but had Democrat support and were signed by Bill Clinton, a Democrat. The 2 acts of SEC were signed off by Republican commissioners.
Democrats are socialist and believe government should interfere in the market place to ensure equality of opportunities. They tend to go for more public spending. tax the rich for more funds, and more regulation. They passed the Community Reinvestment Act to force banks to lend to the poorer segment of people whom they feel have been redlined and discriminated.
Basel II was implemented during Republican George Bush's admin but this was an international regulatory framework.
How did the regulations and ideologies play out?
While the CRA had been there since 1977, it hadn't been a problem all the way through the 1980s. While Gramm-Leach-Bliley Act, Commodity Futures Modernization Act, Basel II and SEC deregulated the financial industry, banks have internal risk controls to behave themselves.
In the 1990s something happened. Social liberalism reared it's ugly head as US turned more progressive. Political pressure started mounting to do more for the housing needs of the poor. The social justice agenda of the Democrats became a good platform against a Republican administration. The DNC began shifting from centre to the left. Today, many Democrats are on the extreme left. The CRA became the socialist tool.
Banks were given a coposite rating on their commitment to CRA. At first this rating was confidential, but public pressure forced Congress in 1989 to amend the act which then required the public release of CRA ratings of banks. Continued political pressure forced tightened regulation in 1995 for CRA ratings to be examined. Big banks were examined once every 5 years, smaller banks once in 2 years. Banks generally care a great deal about CRA compliance since federal regulators consider CRA ratings when approving applications for new bank branches or for mergers and acquisitions. This forced banks to increasingly lower credit standards and grant housing loans to those who do not have the 'credit scores' to qualify.
As banks' subprime mortgage inventory built up, they securitised these into MBS and CDO and sold to investors. Liquidity flows back to the backs and another cycle of subprime housing loan is built.
How Fannie Mae and Freddie Mac got caught in the crisis
Fannie Mae and Freddie Mac are Government-Sponsored Enterprises (GSEs) which are privately-owned. GSEs are financial institutions created by the government to enhance the flow of credit to certain sectors of the economy. In the case of Fannie Mae and Freddie Mac, they cover the housing market.
They raise their own equity and working capital in the capital markets. Although not owend nor funded by the government, they operate under rules and mandates designed to promote public policy objectives, in their case, affordable housing. They are regulated by certain agencies and deemed to carry an 'explicit' government guarantee which allows them to raise capital at a cheaper cost.
Mae and Mac buy up loans from banks. By buying certain qualifying loans they set the criteria that encourages banks to lend into particular market segments that the government promotes. So if the government pushes the social mission of more credit facilities to the poor, banks will lend to those of lower credit standing since these mortgages can be sold to Mae and Mac. Look at it as if Mae and Mac are wholesalers and banks the retailers. Mae and Mac then repackage these loans into MBS, remember the mortgage-backed securities, and resell to investors. This way, Mae and Mac source the liquidity to fund their operations. Investors buy MBS of Mae and Mac because of the very low risks as they have government backing. This operation has been going on for decades.
Then in the 1990s, Mae and Mac faced two problems - political pressure to do more for the housing needs of the social underclass and competition from banks. With deregulation, banks were then securitising their subprime mortgages and selling MBS, the stuff that Mae and Mac used to do. So the two GSEs started buying more subprime mortgages as well as MBS from banks and repacking their own MBS. So some kind of derivatives on derivatives was going on. Mae and Mac got into the same rinse and repeat mode of banks and build a massive inventory of assets backed by subprime mortgages that went way beyond their capital reserves.
When the housing bubble burst, the government had to pump in US$100b into Mae and Mac to prevent them from collapsing.
Blame on Democrats in general and Obama in particular?
There is no doubt the social justice agenda of the Democrats manifested in the political pressure on the Republican George Bush admin to push housing programmes for the poor over the cliff.
Republicans sounded the alarm on the housing bubble. In 2003/2004. Representative Mike Oxley and Senator Chuck Hagel wanted more oversight on Fannie Mae and Freddie Mac. 2005 Republican Senator John McCain co-sponsored the Federal Housing Enterprise Regulatory Reform Act which aimed to reform Fannie Mae and Freddie Mac and address risks in the housing finance system. Fed Chairman Alen Greenspan warned about 'froth' in the housing market. These were rejected by Democrats (and some Republicans).
Querries with leftist media and AI bots mostly say can't blame any side, CRA is not the cause, and Obama did not cause but inherited the problem. Indeed many economists have written about the crisis and put no blames on CRA.
In a 2012 National Bureau of Economic Research paper "Did the CRA lead to risky lending?" by researchers Sumit Agarwal, Effi Benmelech, Nittai Bergman, and Amit Seru, they gave a resounding YES. Very basically, they used banks that were not having CRA examination as the control group, and compared to banks that were being examined for CRA compliance by regulators. "The main econometric challenge in evaluating the CRA’s impact on lending is obtaining the counterfactual lending behavior in the absence of the CRA. Our empirical design addresses this issue by exploiting variation in banks’ incentive to conform to CRA standards around scheduled regulatory examinations." It was very clear that banks under examination beefed up their lendings to less credit-worthy borrowers more than the control group. The reason being these banks want a favourable CRA rating. In today's language, they needed to be seen to be "woke". (For the records, Sumit Agarwal at the time was Associate Professor of Finance and Real Estate, National University of Singapore Business School).
Before entering politics in 2005, Barrack Obama was a civil-rights attorney and community organiser. He focused on "housing rights" After he graduated, he worked for a Chicago civil-rights law firm that worked closely with radical activitist organisations Gamaliel Foundation, National People's Action, and Accorn (Association of Community Organization for Reform Now), ambulance chasing lending-cases. As a civil-rights attorney, he sued banks to rubberstamp mortgages for urban poor residents. His work basically pushed thousands of credit-poor blacks into homes they couldn't afford, and putting anti-redlining pressure on banks to take on more low quality housing loans. His work with Accorn, a very big liberal and powerful activist organisation, has been downplayed since the association had to close down in 2010 under a cloud of cheating, voter fraud, corruption and child prostitution. And whilst he can boast his work helped many poor blacks to own homes, those subprime loans came with very high interest rates that made banks rich, and after the market crashed, left those black borrowers homeless and crippled with debt.
Senator Charles Grassley Report calls ACORN a “big shell game” in which charities “are being used to raise monies which are then funneled to other charities or to other organizations for purposes other than what the donor may have intended … Dollars raised for charitable [purposes] appear to be used for impermissible lobbing and political activity.” Money from the front group that ‘ostensibly helps the poor’, is swapped to the political support of Democrats. The poor get played.
The graph below reflects the pressure Obama and Accorn put on banks.
(The feature image is ChatGPT created. I photoshopped Obama right into the centre. Can you see him?)
Kamala Harris is made in the same Democrat DNA for socialist, populist moves to win votes. It's never the economy, stupid. Harris is coy of detailing her economic plans but we know she wants to remove medical debt from credit scores, claiming it will help poor working families to borrow more money, never mind if they are already in debt. Removing medical debts undermines lenders' assessment of borrwers' ability to pay, creating low quality loan inventories. It's the same subprime loan story.
What has all these got to do with Singapore and Singaporeans?
There are many areas where the Democrat's socialist agenda can harm the US, but that is none of our concern. We should however be very concerned when their policies trigger financial meltdowns that impact beyond American shores, such as the 2008 global financial meltdown. Liberal Singaporeans who root for Harris either never experienced the pain of 2008, or never fully understood the subprime crisis had Democrat fingerprints all over, need a rethink. When pain is more direct, then people understand. So feel for the hundreds of Singaporeans who bought the 'minibonds' from DBS. These were not securities issued by Lehman Bros. They were structured products which were credit-linked notes tied to a basket of companies, including Lehman Brothers as one of the reference entities. Singaporeans bought into a fixed-rate security backed by the credit worthiness of Lehmam and other financial institutions who were all deep into the subprime mortgage market. When US housing market collapsed, Lehman et al had assets whose valuation had been wiped out. The notes that DBS sold became worthless.
So Singaporeans, be careful who you wish for.
For those who enjoy the financial thriller genre, here's "Margin Call". Great action by Kevin Spacey and Jeremy Irons. Here is a clip of the risk management committee meeting part. Watch the explanation by the analyst Peter Sullivan. If you have seen the movie before, you may not have understood what he was saying. My explanation of the 'rinse and repeat' and how selling the derivatives gave the banks the cashflow to onlend back into the subprime market, thus creating the huge leverage on their loans portfolio, is exactly the leverage that Sullivan was referring to and how an increase in their risk metrics, which would include a fall in housing prices, can wipe out their capital and market capitalisation, ie a share price plunge. And he mentioned MBS.
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