Soccer Dad

Long comment because this subject matter is complex.

I don't think Krauthammer knows his subject matter well. The massive crisis was started not by the horrible Negroes who bought houses, nor by Fannie Mae and Freddie Mac for buying such loans in the secondary market, but by lenders financing debt pools irrationally using bogus ratings from rating agencies.

Fannie and Freddie's own problems came not from buying notes (some of which did indeed default and cause problems) but from deviating FROM buying notes and going into much more speculative investments for their stockholders, into inter alia the infamous derivatives including credit default swaps. Had they chosen to make money the old fashioned way for their stockholders, their role in this crisis would have been minimized. OFHEO initiated a severe public investigation of both entities that continues to this day. The foregoing is all from the public record only.

Because Fannie and Freddie were federally chartered and enjoyed the appearance (and now the reality!) of an omnibus federal guarantee of solvency and were also each enormous, they could compete against other market players with an unfair advantage, spurred by the moral hazard of that guarantee.

Fannie and Freddie had other problems; both were infamous as sinecures for Democratic operatives in terms of employment, and the very structural model of a fake-real guarantee of solvency promoted moral hazard by both their executives and their deal counterparties, since they bore essentially no counterparty risk in their deals. But blaming the fair housing laws is a counterfactual farce, comparable to saying that Montgomery Ward's department chain went out of business because of the public accommodation laws requiring it to allow African-American customers to try on slacks in the fitting room.

The keys to understanding this mess at the bigger level are the aleatory risk in the literally trillion dollars in the credit default swaps and the poor and often corrupt methods of rating these swaps. Often the rating agencies had a stake in up-rating the paper that they "priced" and never down-rating it again. You may recall earlier this year (maybe late 2008, I forget) when a large pile of I think Merrill Lynch paper got re-rated from AAA to "junk" (i.e. equity tranche or "Charmin" tranche") in a single day. That's not at all a functioning market, by any definition.

Credit default swaps are designed to evade balance sheet scrutiny; they are not listed on the balance sheet in the traditional way as liabilities and ARE DESIGNED not to show up there under certain conditions.

Example: if you "buy" a swap of value X and "sell" one for value Y, under GAAP you need only report the net if they swaps match pretty tightly in terms of payment timing. Well, if the swap you are buying is from a weak institution that is relying on a rating from an agency scared to down-rate its rated paper out of losing its own credibility (a major factor and its only asset), in reality you have billions of dollars of uncovered liabilities. And no stockholder or SEC regulator (since these are essentially unregulated due to "safe" harbor rules about sophisticated investors) will ever know until bailout time. The moral hazard likelihood of an industry-wide bailout probably also created this problem. Not black mortgagees or the laws barring discrimination against them on the basis of race.

I worked briefly in a capital markets practice. Without identifying my employer, clients or counterparties or the precise nature of my work under ethical confidentiality requirements, I can state firmly that I never got comfortable with the "balance sheet" aspect of the work, and I felt like going to Confession the day that I resigned.