Anatomy of culpability

Government policies and 'loophole mining' contributed to the US subprime crisis and policymakers should heed the lessons

If the global financial crisis has caused a decline in the popularity of the free market system, then "Reforming America's Housing Financial Market", a report to Congress submitted by the US Treasury and the Department of Housing and Urban Development implies an end to the government's flawed home policy.

The US real estate market had more government involvement than nearly any other sector. Congress passed many laws that encouraged people to own a home. For example, in addition to setting up government-sponsored enterprises (GSEs) such as The Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac), income tax deductions for mortgage interest were permitted and exemptions from capital gains tax were allowed. The purpose of these measures was to make mortgages more easily available to people eager to buy a home.

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Fannie Mae and Freddie Mac issued trillion of dollars in bonds to purchase or guarantee and securitize home loans made by commercial banks and other creditors. By the end of 2009, Fannie Mae and Freddie Mac owned or guaranteed about $5.5 trillion worth of home mortgages.

But as a result, many US families, especially middle- and low-income families, became heavily indebted and when the housing price bubble burst, many people defaulted on their loans and the financial system crashed.

Since being taken over by the US government in September 2008, the GSEs have received nearly $150 billion of taxpayers' money, forming the most costly part of the government's bailout scheme. Moreover, we have probably not seen the end of the affair, and the cost is likely to increase.

Politicians, of course, are keen to take popular positions to gain votes and people's support. The GSEs, making "affordable housing goals" their mission, aggressively grew their businesses at a rapid pace in the past few decades.

Recently, the US Senate Permanent Subcommittee on Investigations issued a 635-page report, "Anatomy of a Financial Collapse". The report provides enough evidence to lay the blame on financial institutions, regulators and ratings agencies. But it would have been more complete if it directly pointed at flawed government policies that distorted the housing market. There is no doubt that government policy was one of the main causes of the crisis, and that policymakers should shoulder their responsibilities.

Historically, financial innovation arose from the desire to avoid existing regulations to make greater profits. This process of avoiding regulations can be viewed as "loophole mining". In other words, it is a cat-and-mouse game between financial institutions and regulators. US regulators have proposed to pursue civil claims against the former chief executive of Freddie Mac over failures to appropriately disclose the company's exposure to high-risk mortgage loans.

A similar case was registered against Citigroup and its two executives. The regulators are expected to file up to 100 lawsuits against executives of bailed-out banks in the next two years. But it will be very difficult to determine whether the bankers actually broke the laws or just exploited regulatory loopholes to develop innovative financial products. On the contrary, it is clear that government policies increased home loans and pumped up home prices, leading to massive mortgage defaults in the end.

In the 1980s, the loss of billions of dollars of farmer and student loans required a bailout by the US government. At that time, there was growing concern over the health of the federal credit agencies. So the government set new rules that required such agencies to increase their capital to offset any potential losses. Too bad, that history has repeated itself, and this time the government's bailout has been even more costly.

The newly proposed reform of the housing financial market in the US redefines the relationship between the government and the market, shifting the government's role from that of an active player to that of a "janitor". Therefore, the US government wants to gradually exit the housing financial market. Since this April, the US Treasury has begun to sell its $142 billion holding in GSEs' bonds, which it bought during the worst period of the crisis, at the rate of $10 billion each month.

To invest in GSEs' bonds is profitable. Bank of China used to be the biggest bondholder among domestic peers, and has still been getting a normal payment of principal and interest in the three years since the US housing bubble burst.

Currently, Standard & Poor's has reduced its outlook on US debt from "stable" to "negative", the first time in 70 years. The stock markets reacted with shock, but investors still played down concerns over the US' creditworthiness, regarding investing in US sovereign debt as "risk-free". Recognizing that the US deficit is a political problem, financial institutions across the world continue to operate on the assumption that the US will continue to protect investors' interests in its debt.

The biggest lesson for government policy stems from the pursuit of excessive homeownership. Japan was a similar case in the 1970s and 1980s. In the US, chasing this "American dream" encouraged financial institutions to misallocate too much capital and credit to the home markets.

Failure is the mother of success. As long as governments can learn better lessons from their experiences and make appropriate policy changes, a more balanced, job-creating economy can definitely be attained.

The author is chairman of the Board of Directors of Bank of China.

(China Daily 05/13/2011 page8)