All Commentary
Monday, March 2, 2009

Bootleggers, Baptists, and Bailed-Out Bankers

Who created the subprime mortgage crisis?

For more than a year now, people worldwide have experienced an extraordinary chain of economic events. Led by crushing increases in U.S. mortgage-related bankruptcies, the world financial collapse that followed has been termed the subprime crisis, the financial meltdown, the Wall Street bailout, the beginning of another Great Depression, and even the end of capitalism as we have known it.

How did it happen? How could so many smart people be struck dumb simultaneously? And what does any of this have to do with Bootleggers and Baptists?

My Bootlegger/Baptist theory was born in 1983 when I was working at the Federal Trade Commission and doing my best to understand the political forces that bring us so much federal regulation. I recalled how my kinfolk explained why Georgia and other states closed down the liquor stores on Sunday: The states that went dry on Sunday—meaning they did not allow the legal sale of alcoholic beverages—were those where the local Baptists and bootleggers lobbied for the same end. The good Baptists just wanted the Lord’s Day to be relatively alcohol-free. And the bootleggers just loved the idea of having one day without competition from the legitimate sellers.

The Baptists did the highly visible lobbying and preaching, while the bootleggers paid the politicians, or so the story goes.

“Bootleggers and Baptists” is now part of the body of theory used by economists and political scientists to explain political behavior. Let’s see if the B&B theory can help explain the subprime crisis.

Anatomy of the Subprime Crisis

The subprime crisis became part of national consciousness in the early fall of 2007. First described as a real-estate bubble that somehow got pricked, the crisis got its name from a category of mortgages that had been made to unqualified borrowers. Lending activity by banks, savings and loans, and mortgage lenders had been expanded to reach families without the means to scrape together a down payment or even make the monthly payments normally required for fixed-rate mortgages. To accommodate the less-qualified borrowers, lenders creatively offered mortgages with adjustable rates and balloon payments at the end. With billions of dollars of subprime loans being generated, U.S. mortgage lenders packaged the loans and sold them to America’s backstop mortgage lenders, Fannie Mae and Freddie Mac, two massive quasi-private firms formed by Congress to help make real the American dream that every family would own a home on its own precious plot of land. From there, the mortgage paper went to the four corners of the earth.

We have just identified the Baptist theme and some of the Baptists. The theme is achieving the American dream of home ownership. What could be more noble than this? And the Baptists? The politicians who pride themselves on helping ordinary people and even the helpless to achieve the dream. But it is also possible that these Baptists are really bootleggers in Baptist clothing. Think about it.

This highly condensed story has more than a grain of truth in it. Indeed, the broad outline is gospel truth. But there is something strange about the story so far. Where did the money come from? Why would smart bankers make loans to unqualified borrowers? And how could the lenders find a market for bonds backed by subprime mortgages?

Mr. Bush Enters the Story

There is obviously more to the story. Government was committed to making homes affordable to all Americans. That commitment took the form of banking regulations that required financial institutions to make loans in high-risk regions of cities. Added to this were special HUD (Housing and Urban Development) programs that favored lower-income families as well as long-standing programs like the FHA-insured mortgages that assisted families in purchasing homes.

The affordable-housing program took a serious turn in December 2003, when a smiling President Bush put his name on the American Dream Downpayment Act. The accompanying HUD press release described the legislation this way:

“There is a reason why many American families can’t buy their first home—they can’t afford the downpayment and other upfront closing costs required to qualify for a mortgage. For as many as 40,000 low-income families, that will change as President Bush today signed The American Dream Downpayment Act into law.”

Congress authorized $200 million to bring assistance to some 5.5 million families by the end of the decade. On signing the law, President Bush said:

“Today we are taking action to bring many thousands of Americans closer to the great goal of owning a home. These funds will help American families achieve their goals, strengthen our communities, and our entire nation.”

HUD Ups the Ante

While $200 million is a lot of money, it didn’t go far enough to satisft the baptist urge. To extend the reach of the taxpayer money, Congress instructed HUD to expand the affordable-home program. HUD put pressure on Fannie Mae and Freddie Mac to open the money valves.

Reporting on the subprime crisis in 2008, Washington Post writer Caroline Leonnig explained the process this way:

“In 2004, as regulators warned that subprime lenders were saddling borrowers with mortgages they could not afford, the U.S. Department of Housing and Urban Development helped fuel more of that risky lending. Eager to put more low-income and minority families into their own homes, the agency required that two government-chartered mortgage finance firms purchase far more ‘affordable’ loans made to these borrowers. HUD stuck with an outdated policy that allowed Freddie Mac and Fannie Mae to count billions of dollars they invested in subprime loans as a public good that would foster affordable housing.”

Leonnig goes on to describe HUD’s reaction to those accusations:

“HUD officials dispute allegations that the agency encouraged abusive lending and sloppy underwriting standards that became the hallmark of the subprime industry. Spokesman Brian Sullivan said the agency and Congress wanted to increase homeownership among underserved families and could not have predicted that subprime lending would dominate the market so quickly.

“Congress and HUD policy folks were trying to do a good thing,” he said, “and it worked.”


Of course, those who have followed the subprime epoch know how this part of the story ended. On September 7, 2008, CBS News described the demise of two secondary mortgage lenders this way:

“For decades, Fannie and Freddie fulfilled the American dream, reports CBS News correspondent Tony Guida. Consumers took out loans from banks, which in turn sell those loans to Fannie or Freddie. Then the mortgage giants repackaged those loans and sold them to investors, guaranteeing the mortgages would be repaid.

“As home ownership grew universal, Fannie and Freddie prospered. Their CEOs, Daniel Mudd and Roger Syron, together earned around $30 million in 2007, reports Guida.

“But as they fattened, critics say they got greedy, underwriting too many home loans that never should have been made.

“Fannie Mae and Freddie Mac lost a combined $3.1 billion between April and June. Half of their credit losses came from these types of risky loans with ballooning monthly payments.”

Now we have found two more bootleggers: Mr. Mudd and Mr. Syron, along with countless unnamed Wall Street executives who prospered mightily while designing, packaging, and handling the new mortgage-backed instruments that the world seemed eager to purchase. To these we might add some realtors and developers who supported affordable-housing programs.

How Do You Fool That Many People?

There is yet another important piece to the story. We still need to understand how major financial institutions worldwide simultaneously could be fooled into buying paper that turned out to be trash. What does due diligence mean?

It turns out that by U.S. law, all credit instruments associated with mortgage-backed paper must be rated by one of three rating agencies. These are Moody’s, Standard and Poor’s, and Fitch. No competing rating agencies are allowed to enter the market. These three widely-respected rating agencies often assigned their highest rating to mortgage-backed products that contained subprime loans. By mixing pieces of subprime with high-quality mortgages, the mortgage packers were able to obtain the highest possible credit rating for instruments that were not 100 percent high-quality paper. When the default avalanche started, international buyers and sellers could no longer rely on the credit rating that had been given to the mixed-bag products. Credit markets fell into a deep sleep.

Of course, there is far more to the story than just this part about subprime mortgages and the American dream. The money for making it all happen had to come from somewhere, and from where else but the Fed along with an inflow of funds from international lenders? A long period of Fed credit easing during 2000-2004 laid a foundation for interest rates so low that people were practically paid to borrow money. That’s right: At times, interest rates were lower than the inflation rate. At other times, the cost of borrowing—especially with federal assistance—was less than the expected price appreciation of the property, or so it appeared. It seemed too good to be true. And sadly, it turned out that way.

With easy money and subsidized lending, the great mortgage-making machine had nowhere to go but up—that is, until inflation reared its ugly head and the Fed reversed course.

When the Fed hit the money brakes in 2006, interest rates rose, adjustable-rate mortgages reset monthly payments, and people at the family-budget margin found they couldn’t make the payments. The American dream turned into a nightmare. Mortgage defaults followed. Glutted housing markets followed that. Falling prices followed that. And Fannie Mae and Freddie Mac found themselves in a heap of trouble—along with everyone else who had purchased mortgage-backed securities, including Lehman Brothers, Morgan Stanley, UBS, and a host of other international lenders. Obviously, not all banks and lending institutions were caught in the American-dream squeeze play, but enough large ones were caught for “too big to fail” to become the lobbying cry in national capitals.

Bailouts and Lobbying

Fallout from the Bootlegger/Baptist story brought massive cash flow to major banks and delivered mergers that would not likely pass antitrust muster under other circumstances. The acquisition of Countrywide by the nation’s largest bank, Bank of America (BOA), is a case in point. This was followed by BOA’s acquisition of Merrill Lynch, the nation’s largest brokerage firm. Countrywide’s merger was arranged by the Federal Home Loan Bank (FHLB) with funds provided by FHLB member banks. The stronger banks that did it right were taxed to assist a competitor who didn’t. Ayn Rand must be turning over in her grave.

Along the way, BOA and eight other major banks were tapped by the secretary of treasury to become part of the nationalized U.S. banking system. They were hardly in a position to turn down the invitation. With Washington now the center of the financial universe and the home of the agents of taxpayer equity owners, bankers who previously were not so engaged decided to invest more in lobbying the politicians.

This is hardly the end of capitalism, but it is another case of “Crisis and Leviathan,” the model of political behavior told so well by economic historian Robert Higgs. Once again a crisis has emerged, driven partly by Bootlegger and Baptist interest groups. And once again, a crisis has fed the leviathan, and the leviathan has taken a larger bite from the market economy.

Will Robert Higgs’s forecast come to pass?

Higgs predicts that once a crisis has passed, the fattened leviathan continues to hold sway. The agencies that emerge to manage the nationalized banks will become a permanent part of the government landscape, and those quasi-private businesses supported by government will continue to be important players in a Bootlegger-and-Baptist saga.

Betting on Higgs would be a safe bet for sure.

  • Bruce Yandle is dean emeritus of Clemson University's College of Business & Behavioral Science and alumni distinguished professor of economics emeritus at Clemson. He is a distinguished adjunct professor of economics at the Mercatus Center, a faculty member with George Mason University's Capitol Hill Campus, and a senior fellow emeritus with the Property and Environment Research Center (PERC).