Assessing the financial market damage.

• Author: Melloan, George

If there is a role for the government to play in restoring financial harmony it would have to be quite the opposite from the role Washington has played over the last decade, which has produced financial chaos. But the chances at this point that Washington will reverse its past practices and quietly withdraw to the sidelines so that the markets can make necessary corrections are quite slim, or, more precisely, non-existent. It is the nature of governments to first interfere with market forces and then make the problem worse by addressing the resulting confusions and dislocations by interfering still more.

Government Intervention and Financial Chaos

The relevant interference began over a decade ago when Congress and the Clinton administration began forcing banks to make highly risky loans to advance home ownership for Americans whose ability to afford homes and pay off mortgages was marginal, Two government sponsored lending and loan guarantee enterprises, Fannie Mae and Freddie Mac, became a receptacle for most of these dubious loans and folded them into mortgage-backed securities of equally dubious quality.

The credit bubble created by the Federal Reserve Board in 2003-04 provided an environment for further irresponsible lending on a massive scale. Eventually it all came crashing down with a freeze-up in the $7.6 trillion mortgage-backed securities market that left several large players like Lehman Brothers mad Bear Steams insolvent.

The government's response was to double down with a massive bailout of the banking industry and a conversion of the Federal Reserve System from a mere central bank into a putative economic life support apparatus. The federal government took effective control of the vast Citicorp and acquired varying levels of influence over most other large financial institutions by virtue of the $700 billion Troubled Assets Relief Program (TARP). Fannie and Freddie were put into conservatorship in August 2008, which means that they are now effectively nationalized and their losses have been transferred to the taxpayers. There will be more losses to come and don't expect these institutions to be liquidated under the present regime in Washington.

By some estimates, these actions put about 90 percent of home mortgages outstanding either directly or indirectly into the hands of the government, a circumstance altered only somewhat when some banks in 2009 paid off their TARP loans and gained at least a measure of freedom from government control. The Federal Reserve acquired over a trillion dollars worth of tainted mortgage-backed securities. Billions of dollars of other types of assets new to its books were added by its bailouts of the MG insurance colossus, issuers of commercial paper, and other distressed entities. After all this, it was no longer even a quasi-independent body as was envisioned when it was founded in 1913. It was now simply another arm of the state. The Fed and the Treasury, acting together, now exercise control...