Some very dangerous myths have been generated in the wake of the subprime crisis. It is hard to think of a more charitable word for them than "nonsense".

The first is that the crisis is attributable to ‘free market capitalism’ and this is justification for compromising or abandoning the system. This myth overlooks two basic facts, that markets have and should have fluctuations, panics, crises and the failure of big corporations. These are natural and desirable manifestations of the dynamic nature of markets and essential parts of what make markets superior to government alternatives where countless follies are perpetuated at the expense of taxpayers and national prosperity.

Destitution is normal

Even if the market is responsible, which it is not, for the crisis, there would be no justification for tampering with the system that has made countries with it the wealthiest countries on earth. Countries with the systems now being proposed as supposed solutions are the hellholes on earth where destitution is so normal that it is not regarded as a ‘crisis’. Brief setbacks in the world’s most successful system are no reason to switch to the world’s least successful systems.

Secondly, as far as the South African economy is concerned, exchange control can, at best, now be credited with brief and slight benefits, which do not justify its continuance in the long term. The NCA, which is also credited with protecting the economy, has plunged South Africa into an opposite ‘supraprime’ crisis. The American government forced the market to provide credit to credit unworthy (subprime) people whereas the South African government forces our market to deny credit to creditworthy people. This has caused or contributed to a collapse in our credit intense sectors (vehicles, housing, furniture, clothing, etc) by as much or more than the collapse in America’s subprime housing sector. Thousands of creditworthy South Africans, especially blacks, have been denied credit and hundreds of marginal businesses have collapsed due to the NCA making credit excessively costly and risky.

Wall Street greed

The third and most fundamental myth is that the crisis is a manifestation of ‘the market’. The nonsense surrounding this idea goes so far as to attribute the problem to ‘Wall Street greed’ as if it is some new phenomenon, unique to the past few months and Wall Street financiers. An idea so obviously absurd as to justify no further comment. ‘The market’ has indeed been responsible for dubious practices such as underrating the risk of securitised and highly geared and leveraged derivatives, but this, on its own, is neither a sufficient or necessary condition for the crisis. At most, it would have caused spontaneous market corrections and insolvencies for the guiltiest parties.

The sufficient and necessary condition for the crisis is the fact that the US government created such GSEs as Fannie Mae and Freddie Mac. Their sole purpose was to promote subprime housing mortgages because the market refused to do so. GSEs purchased mortgages the market would otherwise never have made at full nominal value thereby reducing high risk credit to zero risk. Needless to say, increasing the supply of credit drove prices up into a classic ‘bubble’. In order to prevent the bubble from bursting and perpetuate the folly, GSEs securitised and sold subprime mortgages on an unimaginable scale to international institutions. It got them to purchase obviously ‘toxic’ mortgages by providing government backing, thereby reducing risk once again supposedly to zero. In due course, Freddie and Fannie were nominally privatised and formal government backing discontinued in 1996, after which official government documents and the international financial press described the mortgages as ‘implicitly’ government backed. Whilst nobody was quite sure what was meant, it induced rating agencies to assure the market that subprime mortgages were sound.

South Africans can easily understand government provision of subprime credit and implicit backing by reference to our Land Bank, the sole purpose of which is subprime credit to farmers, and South African parastatals such as SA Airways, which are implicitly government backed and therefore able to purchase planes and equipment on credit.

Carrot and the stick

The fourth myth is the thought that the crisis was caused by ‘deregulation’ or would not have happened but for it. The truth is that there were various laws which obliged banks to provide subprime credit such as the Community Reinvestment Act and the prohibition of ‘red lining’. What little deregulation there was, was firstly trivial and secondly of no direct relevance to subprime mortgages. Apart from direct intervention by way of GSEs (the carrot), and laws (the stick), it was firm policy of successive US governments that banks should provide subprime credit to which end they were under constant political pressure.

The fifth myth is that securitised subprime derivatives are worth close to zero. The fact is that compulsory accounting and banking practices force companies to ‘mark down’ assets when they cannot ‘mark to market’. Traditional accounting permitted companies to value assets and explain their logic which the market could accept or reject. In the wake of Enron and other scandals, the law was changed to GAAP and BASEL II which had the effect when markets are illiquid of forcing accountants to lie about the value of assets. Everyone knows that subprime mortgages have not yet incurred significant losses, that real losses will occur only over many years as and when mortgages are foreclosed and the value of the house concerned is less than the outstanding balance. Whilst no accurate estimates have been made – indeed it is technically illegal for mortgage holders to do so – discounted losses are unlikely to exceed 10 percent or 20 percent. One of the reasons for markets leaping up and down with unprecedented volatility and uncertainty is that valuable assets have had to be written down to nominal values with no way for investors to know what the real value of underlying assets is.

Bail out bonanza

The sixth myth is that ‘bail out’ could be a solution. There are various bail out scenarios ranging from nationalisation of banks to government purchase and resecuritisation of subprime mortgages. The former simply entails transferring the largely government created problem from private investors to taxpayers, and the latter entails a repetition of what caused the problem in the first place. Curiously, critics on the far left and the far right have one thing in common, the view that governments should not intervene, allow the companies concerned to fail, and allow market correction to occur spontaneously and expeditiously – those on the left wanting it to happen with a massively increased role for government. If it is accepted that the main cause of the problem has been a succession of reckless government interventions, the case can be made for the government to ‘do something’. Since the ’fundamental’ problem has been misclassified as the collapse of share prices and nominal assets, the solution is presumed to be to prop them up. Proper analysis suggests a different approach, which is gaining support, namely, that attention be directed at the true underlying problem, namely, the compromised value of subprime mortgages. This can be done by the US government insuring mortgage holders around the world against a proportion, say 50 percent, of actualised losses on mortgage foreclosures over the next thirty years. This will immediately reinstate the value of underlying security which will in turn restore the solvency of mortgage holders. The biggest benefit will be that the cost will be spread over many years, probably reducing to zero within a few years as outstanding balances diminish and property values recover.

The final myth is that the phenomenon has manifested itself in many countries. In truth, dubious market practices have been exposed, but they themselves would not have caused a crisis beyond the USA in which GSEs are a unique socialist underbelly of American capitalism. The impact on other countries is primarily due to the extent of international trade in US subprime derivatives.

This analysis does not deny genuine market aberrations and a need for them to be exposed and corrected in ways that are natural and desirable characteristics of free markets. My purpose has been to correct extreme and dangerous misconceptions, especially the notion that more rather than less government intervention is the solution.

Leon Louw is an executive director of the Free Market Foundation.


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