Proposals Concerning the Current Financial Crisis

A basic cause of the current financial crisis was the mandate from the U.S. Congress to the Federal National Mortgage Association (Fannie Mae) to increase its support of low-income housing. This mandate led to a lowering of lending standards, which encouraged home buyers to spend beyond their means. The problem was aggravated by novel, obscure, highly leveraged financial instruments that were not well understood by either lenders or borrowers. At least two steps are required for the solution to this crisis: (1) Congress should instruct Fannie Mae that the safety of the financial system must take priority over the objective of providing low-income housing, and (2) this article’s “modest” proposal for bringing transparency to the tangle of financial instruments should be implemented. A basic cause of the current financial crisis was the mandate from the U.S. Congress to the Federal National Mortgage Association (Fannie Mae) to increase its support of low-income housing. This mandate led to a lowering of lending standards, which encouraged home buyers to spend beyond their means. The problem was aggravated by novel, obscure, highly leveraged financial instruments that were not well understood by the companies that used them. Part of the cure for the current crisis—which would also remove one potential cause of future crises—is for Congress to stop pressuring Fannie Mae to acquire mortgages with insufficient borrowing standards. On the contrary, any mortgages that Fannie Mae purchases should meet solid, traditional down-payment and documentation requirements. Inducing families to buy houses they could not afford did not benefit them, the U.S. and international financial systems, or the world economy. Reducing the pressure on Fannie Mae to promote low-income housing, however, would not address the financial transparency crisis involving such instruments as collateralized mortgage obligations (CMOs), which pool mortgages and slice them into “tranches” that are sold to clients that, in some cases, use these tranches as inputs to other exotic instruments, such as collateralized debt obligations (CDOs). The result is that the parties do not know the risks to which they and their possible counterparties are exposed. Credit default swaps (CDSs), which are insurance against the default of various obligations, have proved especially dangerous because they are, in effect, insurance against correlated risks. The following proposal can help solve the current financial crisis and minimize future crises: First and foremost, Congress should instruct Fannie Mae that the safety of the banking system must take priority over the objective of providing housing for low-income families. Second, the government should sponsor a survey of direct exposures and an analysis of indirect exposures of obscure financial instruments. This action is necessary to help restore clarity and trust to the financial system. Third, regulators should recognize that credit default swaps are insurance against correlated risks and are thus subject to much greater portfolio risk than is a portfolio of uncorrelated risks. In general, businesses should understand that financially engineered products are based on assumptions regarding not only parameter estimates but also model specification (model risk). With a highly leveraged portfolio of marked-to-market products, such a misspecification can have disastrous consequences.