John McCain is correct: The current financial crisis is "difficult to understand." Judging by the opening paragraphs of the speech he delivered in Cedar Rapids, Iowa, today, on financial reform, we can include his speechwriters in the category of "those who fail to comprehend it."
I know that the events unfolding can be difficult to understand for many Americans. The dominoes that we have seen fall this week began with the corruption and manipulation of our home loan system. The reason this crisis started was the abuses that took place within our home loan agencies, Fannie Mae and Freddie Mac and within our home loan system.
Ever since the government seizure of Fannie and Freddie, it has been a tenet of right-wing talking points to assert that that "the home loan agencies" are the root of the subprime mortgage crisis. Since Republicans have long wanted to privatize Fannie and Freddie, they are now eager to claim that by obstructing that privatization, the Democrats are the party responsible for the current crisis.
Except: Fannie and Freddie did not cause the subprime mortgage crisis. The private sector, acting on its own initiative, serenely confident in its own financial manipulations, spawned the greatest Wall Street conniption since the Great Depression. Fannie and Freddie got into the game late, after watching in dismay as their market share in the lucrative business of originating and selling off pools of mortgage-backed securities began to shrink.
There are many bit players in this drama who bear blame, from home-buyers to government regulators, but the two biggest culprits live on Wall Street.
First: The innovative financial products that allowed bankers to pool together risky loans into packages that could earn high enough credit ratings so as to be sold to investors who would normally deem risky loans made to people with bad credit, well, risky.
Second: The proliferation of credit derivatives that allowed financial players, banks, hedge funds, insurance companies, mortgage lenders, etc., to buy protection against the risk that those pools of mortgage-backed securities (and any other kind of bond) would default.
These two innovations dovetailed nicely, allowing Wall Street to gorge itself on risky bets, while comforting itself that all bases were covered.
There were people, like the former investment banker Frank Partnoy, who saw this as it was happening and warned of potential disaster. From my review of his 2003 book, "Infectious Greed":
What does it all add up to? In a worst-case scenario: quite a bit of trouble. In the long run, "risk" is being sold off by people who know best how to evaluate it to people who don't know what they're in for. As government for the most part looks the other way, the stability of the financial markets is increasingly an illusion. In the last decade alone, the markets have come closer than most people realize to collapsing. Unless serious steps are taken to change the status quo, disaster could be imminent. We haven't seen the last of the bubbles, by any stretch of the imagination. We seem, in fact, to be addicted to them.
Wall Street's best, brightest and filthy richest scoffed at the critics. We were shouted down by those who told us that we just didn't understand how modern finance worked -- how these new products really made the whole global financial system safer, how risk was more widely distributed than ever before, making the chances of any one disastrous economic event bringing down the system, less than ever before.
And for awhile, I will concede, it did look like Wall Street had a pretty good case. Titans like Enron and Worldcom collapsed, and the world kept on chugging along. Sept. 11 shocked the markets, but did not appear to do serious damage. Derivatives markets flourished, and a lot of people made a lot of money.
But now we know that the critics were right, that instead of distributing risk more widely, we achieved the opposite. We have indisputable evidence that the edifice constructed out of state-of-the-art financial innovation was actually weaker and more prone to collapse than we ever imagined. Sure, it's a complicated story to explain -- but it is most definitely not a case of "corruption" or "abuses" at government-sponsored enterprises such as Fannie Mae and Freddie Mac. What we have witnessed over the last 18 months is a self-inflicted wound delivered by the private sector unto itself, by people who were adamant that government should stay out of their business, because the private sector simply knew better.
Government regulators agreed. And I think we're going to wait a long time before we get a complete explanation from John McCain on how this all happened, because it would have to include the role played by his friend and economic mentor (not to mention fellow deregulator!) Phil Gramm, who did so much to make sure that the credit derivative market remained unregulated.
If you are looking for an abuse of power, that's where to start.