The role of Government in the Sub-prime Crisis

I have read with great interest the whole media campaign against the "greedy" Investors of Wall Street, and our very own PM's attack on "Gordon Gekko Wannabes." But is all this warranted?

Although Brokers had a role to play in the crisis, Greed cannot be blamed for this shambles - their role in this crisis has been grossly overstated.

Brokers and Wall street executives alike have all been targeted by media outlets eager to place the blame of these events on a group of people. Wall Street executives didn't suddenly get greedier overnight, and neither did brokers. The occupation of a mortgage broker, being largely commission based, means they will do all they can do earn a good income. Holding them accountable for selling the product is ridiculous. Do we blame shop assistants for causing cancer when they sell cigarettes? No! Its their job!

Brokers promoting a product they have an external benefit in isn't anything new, and they are not the first or the last people to promote a product they have an external benefit in. The entire brokerage business is built on this concept, in Australian finance brokerage where a broker pushes you to go with a different bank because Westpac no longer pay them commission; or in Pharmaceuticals where drug reps entice proprietors with commissions and benefits for meeting certain sales targets. Stock brokers for years have been paid nice little fees by managed funds to get clients to invest in them. No, this problem is deeper, and started with the US Government.

The "Great American Dream" has always been to own a home. Many acts lead to this snowball effect, with an act passed in 1992 getting the ball rolling. The Federal Housing Enterprises Financial Safety and Soundness Act (1992) required Fannie Mae and Freddie Mac to devote a percentage of their loan books to support affordable housing. In October 2000, the Department of Housing and Urban Development required that Fannie and Freddie were to dedicate 50% of their loan books to low income housing. This was increased to 56% by 2004.

The result of this political populism was a soaring home ownership rate, where standard lending criteria were abandoned as regulatory bodies sat idly by and didn't regulate the use of Collateralized Debt Obligations (CDO)'s to raise money for these mortgages. Standard regulatory procedures no longer applied - after all, they were secured against Real Estate, how could you POSSIBLY lose?

The problem was further compounded by the Commodity Futures Modernization Act (2000) which BANNED the regulation of Credit Default Swaps (CDS). A CDS acts as an insurance policy on risky investments, such as mortgage backed securities, where a buyer makes a series of payments to the seller and is entitled to compensation in the event of default. The downfall of giants such as AIG, Bear Stearns and Lehman Brothers was brought on by the fact that they didn't have the equity to cover their CDS obligations. In this ridiculous situation, an insurance market was left unregulated - this was always going to lead to failure.

This all fell on its face when the record capital gains experienced in the American Real Estate market ground to a halt. Suddenly, an oversupply of houses hit the market as sub prime mortgage holders, tempted into the loans by Honeymoon rates, suddenly felt the pinch and defaulted on their loans. House prices fell, and the securities became worthless. Holders of these CDS's were left with nothing and credit dried up from many sources.

Is Australia at risk of a similar scenario? No. The RBA effectively regulates financial markets and the foundations of lending are upheld and not sacrificed for political populism. Blaming the crisis on brokers who played within the legal framework around them is uncalled for, as the Government shifts the blame away from itself after failing to regulate areas of the market which required their attention.

DS