Sunday, October 19, 2008

Finance IV

What lessons does the financial crisis teach? Drawing the wrong inference could lead to regulatory overreach while simultaneously killing the free market capitalism that made the West prosperous. So it's vital that we properly dissect the problem.

Many explanations have been proffered. France’s President, Nicolas Sarkozy, argues "Self-regulation is finished." Frequent commenter OBloodyHell blames the GSEs (Fannie/Freddie) and long-standing Federal pressure to increase loans to low-income earners, citing Professor Mark Perry's Carpe Diem blog and a 1999 New York Times article. Recent Economics Nobel winner Paul Krugman says the GSEs bear little blame. Libertarian economist Peter Schiff disagrees.

Blogger bobn at Liberative has variously blamed the SEC, Gramm-Leach-Bliley, Federal banking agency deregulation, and credit rating agencies. MaxedOutMama appears to agree with the latter point.

OBH, Investor's Business Daily and Conservative Dialysis, also accuse the Community Reinvestment Act. Professor Perry cites dramatically increased sup-prime mortgage securitization.

Barack Obama's analysis can be discerned from his unprecedented barrage of ads, including in the DC market (on ESPN, so I've been force-fed), and even within video games. In sum, Obama blames greedy, overpaid Wall Street CEOs, "fraudulent brokers and lenders," lobbyists (no surprise) and "Republican deregulation", which he would combat by increased financial regulation.1

Who's right? Listen up:
  • The chattering class is wrong: Contrary to the pundits, it isn't G-L-B or deregulation or changes in SEC oversight. Indeed, this week's Economist reminds:
    Heavy regulation would not inoculate the world against future crises. Two of the worst in recent times, in Japan and South Korea, occurred in highly rule-bound systems.
    So unspecific pledges to implement stricter Washington control is precisely the sort of populist paternalism that I fear will be overdone so as to risk killing the capitalist goose. As the Economist observes:
    In fact, far from failing, the overall lowering of "barriers to intercourse" over the past 25 years has delivered wealth and freedom on a dramatic scale. Hundreds of millions of people have been dragged out of absolute poverty. Even allowing for the credit crunch, this decade may well see the fastest growth in global income per person in history.
  • No bad guy: Fingering fraud ignores the relatively small contribution of outright criminality. Fraud has always existed, but there's scant evidence it increased recently. Nor are Republicans primarily to blame: the key actors were drawn from both parties, as National Journal legal columnist Stuart Taylor shows:
    Democrats have been a big part of the problem, in part by supporting governmental distortions of the marketplace through mortgage giants Fannie Mae and Freddie Mac, whose reckless lending practices necessitated a $200 billion government rescue last month. It is dangerous because misdiagnosing the causes of the crisis could lead both to regulatory overkill and to more reckless risk taking by Fannie, Freddie, or newly created government-sponsored enterprises.

    Fannie and Freddie aside, it's worth pointing out that many, if not most, of those greedy Wall Street barons are Democrats. And that the securities and investment industry has given more money to Democrats than to Republicans in this election cycle. And that opposing regulation of risky new financial practices by private investment banks and others has been a bipartisan enterprise, engaged in by the Clinton and Bush administrations alike.

    But the roles of Fannie and Freddie are my focus here. Powerful Democratic (and some Republican) advocates of affordable housing, including Senate Banking, Housing, and Urban Affairs Committee Chairman Christopher Dodd, D-Conn.; Sen. Charles Schumer, D-N.Y.; and House Financial Services Chairman Barney Frank, D-Mass., have been the GSEs' most potent and ardent champions in recent years. Meanwhile, the agencies and their employees have orchestrated a gigantic lobbying effort (costing more than $174 million between 1998 and 2008). They have also made campaign contributions of more than $14.6 million between the 2000 and 2008 election cycles, with some of the largest going to Dodd and Barack Obama.

    A leading illustration of this Democrat-GSE symbiosis came in summer 2005. The Senate Banking Committee adopted a bill to impose tighter regulation on Fannie and Freddie, with all Republicans voting for it. But the Democrats voted against it in committee and killed it on the floor.
  • GIGO: Still, something went south. What? Well, Washington and Wall Street were wrong--as, ironically, the Wall Street Journal concludes:
    How did the smartest people at the best banks running the most sophisticated financial models fail to forecast the collapse of mortgage-related securities? How did this unpredicted collapse devastate the system? And most of all, can we ever again trust the financial models on which value is supposed to be determined? . . .

    Financial models take logic and historical data into account, but it's now clear that these elegant models have a serious weakness: They can't cope with illogical and uneconomic factors. . .

    Until recently, bank CEOs and regulators slept well at night thanks to a financial model developed in the 1990s called "value at risk" or VaR. It assesses historical variances and covariances among different securities, informing financial institutions of the risks they're taking. By assessing risk factors across all securities, VaR can compare historical levels of risk for given portfolios, usually up to a 99% probability that banks would not lose more than a certain amount of money. In normal times, banks compare the VaR worst case with their capital to make sure their reserves can cover losses.

    But VaR can't account for extreme unprecedented events -- the collapse of Barings in 1995 due to a rogue trader in Singapore, or today's government-mandated bad mortgages bundled into securities that are hard to value and unwind. The "1% likely" happened.
    And because the models were wrong, lenders--including banks--failed to cover a proper share of the amount at risk.

  • CRAcked: It wasn't CRA. Period.

  • Fan & Fred: Still, what about the GSEs? Was Krugman right in saying that Fannie and Freddie were legally barred from sub-prime lending, were tightly regulated, and "largely faded from the scene during the height of the housing bubble"? No, no and no, as AEI's Peter Wallison and Charles Calomiris show in a September 30th analysis. Bad loans by Fan & Fred were at the heart of the crisis.

  • The visible hand: So where did Fannie and Freddie go wrong? The government forced their hand, as Russell Roberts showed:
    For 1996, the Department of Housing and Urban Development (HUD) gave Fannie and Freddie an explicit target -- 42% of their mortgage financing had to go to borrowers with income below the median in their area. The target increased to 50% in 2000 and 52% in 2005.
    In other words, the problem was more overregulation than deregulation, as Stuart Taylor demonstrates:
    [I]n 2005, Fannie and Freddie began buying vast amounts of subprime and "alt-A" mortgages with, in many cases, virtually no down payments, that had been taken out by people with low credit scores and low incomes relative to their monthly payments. To finance more and more affordable housing, as leading Democrats, and some Republicans, had urged, the GSEs dramatically lowered their traditional underwriting standards. . .

    Fannie and Freddie appear to have played a major role in causing the current crisis, in part because their quasi-governmental status violated basic principles of a healthy free enterprise system by allowing them to privatize profit while socializing risk. That is, their special privileges as GSEs -- created decades ago to promote homeownership by buying mortgages from banks, which could then use the cash to make more loans -- enabled them to lend at high rates to reap enormous profits for their private stockholders and executives and to borrow at low rates based on the government's implicit promise to rescue them from any failure, as it has now done. . .

    Why did Fannie and Freddie dive into the subprime mortgage market? And were their practices just one facet -- or the most important cause -- of the crisis? The questions are related and the answers debatable.

    Freddie and then Fannie had been ravaged in 2003 and 2004 by accounting scandals that led to the departures of top executives, including Fannie Mae CEO Franklin Raines, a former Clinton administration official who had collected $90 million in compensation from 1998 through 2004. The scandals brought warnings from Alan Greenspan, then the powerful chairman of the Federal Reserve Board, that the government should restrain the mortgage giants' growth. Meanwhile, three Fed economists published a study casting doubt on whether Fannie and Freddie had much effect on mortgage interest rates. All of this put the two agencies on the defensive in Congress.

    By the time Daniel Mudd succeeded Raines in 2004, according to an in-depth New York Times article on October 5 by Charles Duhigg, "his company was under siege. Competitors were snatching lucrative parts of its business. Congress was demanding that Mr. Mudd help steer more loans to low-income borrowers. Lenders were threatening to sell directly to Wall Street unless Fannie bought a bigger chunk of their riskiest loans.

    "So Mr. Mudd made a fateful choice," Duhigg wrote. "Disregarding warnings from his managers that lenders were making too many loans that would never be repaid, he steered Fannie into more-treacherous corners of the mortgage market, according to executives.
  • Downside department: Banks and lenders are leveraged and try to count and cover some of the risks of deleveraging. But they understated the risk they needed to cover, and over-leveraged. And I understand that over-leveraged institutions, desperate for high yield protective investments, turned to securitized or derivative products based on high yield home loans. Fannie and Freddie, and some other lenders, then took these items "off book"--without recognizing that this covered risk within the same industry, and possibly identical counterparties. In any event, once housing prices fell, there was insufficient cover.
Conclusion: Contrary to Sarkozy, banking and finance have never been solely self-regulated. The OCC, for example, properly oversaw Federally charted banks; most commercial banks are fine. Deregulation wasn't the problem. Politics pushed federally guaranteed lenders into products deemed safe only by flawed financial models. The increased demand for housing finance funneled "hundreds of billions of dollars . . . into the housing market instead of more productive assets," drove up house prices, creating a speculative asset bubble, which then burst.

That alone wasn't catastrophic. The disaster came because:
  1. politics trumped economics, leading Fannie, Freddie and followers to loans that were

  2. deemed safe only by flawed financial models,

  3. so lenders' risk-management departments under-estimated the value of the risk to be covered and, as home-loan lending grew,

  4. shunted risk-management funds into the most profitable vehicles available: derivatives and securities related to the very sub-prime mortgages undertaken by their investment sides, and possibly

  5. moving those obligations off-book and/or

  6. resulting in a similarly-secured financial sector with similar counterparties.
Re-thinking regulation is essential--but it's not clear that mere re-regulation could have caught these causes.

1 Obama also claims he would cut taxes for 95 percent of "workers and their families," paid for via tax hikes on households earning over $250,000. MaxedOutMama, the Tax Policy Center and the Wall Street Journal rubbish Obama's math.


Anonymous said...

Carl, this may be your best post ever. These are very tough questions, and you synthesize the best articles I have seen so far attempting to explain why. As you know, Stuart Taylor is the gold standard for down-the-middle legal analysis, and so he brings credibility to the Fannie-and-Freddie focus. Your solutions are necessarily fuzzy; don't know that anyone has come up yet with the 100% correct model.

Great stuff, Doug

Stan said...

Skimmed, and bookmarked for later (I have developed an "internet attention span" and am plagued with a very limited understanding of economics).

There's so much info out on this, and for people like me, it's hard to distinguish what to believe, what to take with a grain of salt, and what is complete BS. Though generally speaking, those crying about unrestrained capitalism I tend to avoid.

@nooil4pacifists said...




I'm unlikely ever to cry about unrestrained capitalism.

OBloodyHell said...

> I'm unlikely ever to cry about unrestrained capitalism.

Capitalism, like ANY other human idea, is fully capable of being taken by damnfools and run straight off the end of the Earth.

That's not the idea which is currently being taken full tilt to the edge of the planet, but it's possible to do it, nonetheless.


bobn said...

In general a good post.

A couple of things to add:

The crisis is being amplified and spread by Credit Default Swaps. Both parties missed the boat on these (Worth noting: Treasury Secretary then and now came from Goldman Sachs. Just a coincidence, I'm sure!) Phil Gramm was out front, as usual.

For growth of CDS, see the graphic here. Sure looks like the growth was on Bush's watch to me.

Also, the SEC did not help things when it let the 5 former large investment Banks increase their leverage from 12-1 to 30-1 or 40-1 in 2004. This would also be on Bush's watch.

And Bush was all over the "ownership society", "requesting" Fannie and Freddie to do low income lending.

bobn said...

From Bloomberg (hat tip comments of Calculated Risk):

Oct. 11 (Bloomberg) -- Federal regulators directed Fannie Mae and Freddie Mac to start purchasing $40 billion a month of underperforming mortgage bonds as the Bush administration expands its options to buy troubled financial assets and resuscitate the U.S. economy, according to three people briefed about the plan.

Fannie and Freddie began notifying bond traders last week that each company needs to buy $20 billion a month in mostly subprime, Alt-A and non-performing prime mortgage securities, according to the people, who asked not to be identified because the plans are confidential. The purchases would be separate from the U.S. Treasury's $700 billion Troubled Asset Relief Program.

[Emphasis added]

This must be some of that world-class regulation the Republicans kept talking about.

I have no doubt that Fannie and Freddie paid Dems a bunch to stop something from happening. But given this administration's record on regulation, including Bushite regulation of the GSEs, would it really have made a difference? I say the evidence is overwhelming that it would not.

@nooil4pacifists said...

I agree that both parties tinkered--but Dems more. At this point, I'm less interested in party blame-game, and more anxious for a smart technocrat.

Anonymous said...

Maybe it's time the USA returns to producing VALUABLE goods and services instead of mere paper products, e.g., derivatives, credit default swaps, insurance.