It Took Two Ingredients to Make this Financial Crisis
After having time to think more about the current crisis, I think the reason it is confusing is that it is the result of two parallel but largely independent causes that worked together to create this mess. I told my mother-in-law in an email last week that the financial crisis would likely be a Rorschach test where everyone sees the crisis caused by all the things they opposed before the crisis. Conservatives will see government intervention, liberals will see greed and deregulation.
What makes this situation particularly confusing is that of the two causes I believe led to the crisis, each has been embraced by one of the two parties as the only cause. It's a case where everyone is half right, but the other half is important too. It's a two part recipe, with neither active ingredient causing much of an explosion until mixed with the other. (special thanks to the folks at Q&O who have had a lot of good posts on these issues).
Cause 1: Creating the Asset Bubble
The first thing that had to happen for the crisis was the creation of an asset bubble. We need some type of over-valued asset whose prices crash to earth to spark the crisis. So we begin with housing.
Home prices have gone through boom-bust cycles for years, just as have many commodities. There is a whole body of literature on such cycles, so we will leave that aside and accept their existence as a feature of markets and human behavior.
But this housing bubble had a strong accelerant, in the form of the Federal government. For years, this nation has made increasing home ownership a national goal and many laws and tax policies have been aimed at this goal. The mortgage interest deduction on personal income taxes is just one example.
Starting in 1992, Fannie Mae and Freddie Mac, which were strange quasi-public / quasi-private entities, came under pressure from the Congress (e.g. Barney Frank) and the Clinton administration to add increasing home ownership to poorer people part of their missions.
Fannie Mae, the nation's biggest underwriter of home mortgages, has been under increasing pressure from the Clinton Administration to expand mortgage loans among low and moderate income people and felt pressure from stock holders to maintain its phenomenal growth in profits.
In addition, banks, thrift institutions and mortgage companies have been pressing Fannie Mae to help them make more loans to so-called subprime borrowers. These borrowers whose incomes, credit ratings and savings are not good enough to qualify for conventional loans, can only get loans from finance companies that charge much higher interest rates -- anywhere from three to four percentage points higher than conventional loans.
''Fannie Mae has expanded home ownership for millions of families in the 1990's by reducing down payment requirements,'' said Franklin D. Raines, Fannie Mae's chairman and chief executive officer. ''Yet there remain too many borrowers whose credit is just a notch below what our underwriting has
Beginning in 1992, Congress pushed Fannie Mae and Freddie Mac to increase their purchases of mortgages going to low and moderate income borrowers. 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.
For 1996, HUD required that 12% of all mortgage purchases by Fannie and Freddie be "special affordable" loans, typically to borrowers with income less than 60% of their area’s median income. That number was increased to 20% in 2000 and 22% in 2005. The 2008 goal was to be 28%. Between 2000 and 2005, Fannie and Freddie met those goals every year, funding hundreds of billions of dollars worth of loans, many of them subprime and adjustable-rate loans, and made to borrowers who bought houses with less than 10% down.
Fannie and Freddie also purchased hundreds of billions of subprime securities for their own portfolios to make money and to help satisfy HUD affordable housing goals. Fannie and Freddie were important contributors to the demand for subprime securities.
Simultaneously, the 1977 Community Reinvestment Act was pushing private banks to make more loans to less qualified borrowers:
The Community Reinvestment Act (CRA) did the same thing with traditional banks. It encouraged banks to serve two masters — their bottom line and the so-called common good. First passed in 1977, the CRA was "strengthened" in 1995, causing an increase of 80% in the number of bank loans going to low- and moderate-income families.
These actions had a double whammy on the current crisis. First, by pushing up housing demand, they inflated the housing pricing bubble. Second, it meant that these inflated-price homes were being bought with lower and lower down payments. In effect, individuals were taking on much more leverage (leverage is a term that I will use to mean the percentage of debt used to finance a set of assets -- more leverage means more debt and less equity. The term comes from the physics of a mechanical lever, in that more debt, like a lever, can magnify force. Profits from assets are multiplied by leverage, but, alas, so are losses.)
When the economy softened and the housing bubble started to burst, these new mortgage customers the government went out of its way to bring into the system did not have any resources to handle the changes -- they did not have the down payment to cushion them (or the banks) against falls in asset value and did not have the cash flow to cushion them against falling income in the recession and/or rising interest rates.
The result: Huge portfolios of failing loans with rapidly falling collateral values.
Cause 2: Over-leverage of Risky Assets and Related De-regulation of Capital Requirements
I think the word "greed" was used about a zillion times last night in the Vice-Presidential debate. But what does it mean in this context? After all, we are all greedy in one way or another, if one equates greed with looking after one's self-interest.
So I will translate "greed" for you: When you hear "greed on Wall Street", think leverage. Remember, we said above that as long as the underlying asset values are going up, leverage (ie more debt) multiplies profitability. [Quick example: Assume a stock that goes from $100 to $110 in a year. Assume you pay 5% interest on money. No leverage, you make $10 on a $100 investment. With 95% leverage -- ie buying $2000 worth of the stock with $100 equity and $1900 debt -- you would make $105 on the same $100 equity investment. Leverage multiplied your returns by more than a factor of 10]
Remember that around the year 2000 we had the Internet bubble burst in a big way. A lot of companies not only dropped, but went to $0 in value. This was painful, but we did not have a cascading problem. Why? In part because most of the folks who invested in Internet companies did not do so in a highly leveraged way. The loss was the loss, time to move on. Similarly in this case, if these mortgage packages had been held as a piece of a un-leveraged portfolio, like a pension fund our an annuity, the loss would not have been fun to write off but it would not have cascaded as it has. The government would have had to bail out Fannie and Freddie, a few banks would have failed, but the disaster would have been limited.
One reason this problem has cascaded (leaving aside blame for Henry Paulson's almost criminal chicken-little proclamations of doom to the world) is that many of these mortgage packages or securities got stuck in to highly leveraged portfolios. The insurance contracts that brought down AIG were structured differently but in the end were also highly leveraged bets on the values of mortgage securities in that small changes in values could result in huge losses or gains for the contracts. (Some folks have pointed to actual securitization of the loans as a problem. I don't see that. Securitization is a fabulous tool. Without it, we would be seeing a ton more main street bank failures, as they would have had to keep many more of these on their books.)
If this all sounds a bit like cause #1 above, ie buying inflated assets with more and more debt, then you are right. There is an interesting parallel that no one wants to delve into between the incentives of home buyers trying to jump into hot housing markets with interest-only loans and Wall Street bankers putting risky securities into highly leveraged portfolios. Leverage is really the key theme here. In a sense, houses were double-leveraged, bought the first time around with smaller and smaller down payments, and then leveraged again as these mortgages were tossed into highly-leveraged portfolios. Sometimes they were leveraged even further via oddball derivatives and insurance contracts whose exact operation are still opaque to many.
Those who have read me for a while know that I am in the "let them die" camp. These Wall Street guys have been living high on the extra profits from this leverage in the good times. They knew perfectly well that leverage is a two-edged sword, and that it would magnify their losses in a bad time. But their hubris pushed them into doing crazy things for more profit, and I am all for a Greek-tragedy-like downfall for their hubris. The sub-prime, first-time home buyer can claim ignorance or unsophistication, but not these guys.
During the Bush Administration, these bankers came to the SEC trumpeting their own brilliance, and begged to be allowed to leverage themselves even more via a relaxation of capital requirement rules. And, in 2004, without too much discussion or scrutiny, the SEC gave them what they wanted:
Many events in Washington, on Wall Street and elsewhere around the country have led to what has been called the most serious financial crisis since the 1930s. But decisions made at a brief meeting on April 28, 2004, explain why the problems could spin out of control. The agency’s failure to follow through on those decisions also explains why Washington regulators did not see what was coming.
On that bright spring afternoon, the five members of the Securities and Exchange Commission met in a basement hearing room to consider an urgent plea by the big investment banks.
They wanted an exemption for their brokerage units from an old regulation that limited the amount of debt they could take on. The exemption would unshackle billions of dollars held in reserve as a cushion against losses on their investments. Those funds could then flow up to the parent company, enabling it to invest in the fast-growing but opaque world of mortgage-backed securities; credit derivatives, a form of insurance for bond holders; and other exotic instruments.
In part they traded capital requirements for computer models, a very dubious decision in the first place, made worse by the fact that most of the banks were gaming the models to reduce the apparent risk. The crazy thing is that, in gaming the models, they really weren't trying to fool regulators, who pretty much were not watching anyway, but they were fooling themselves! Certainly I would not expect government regulators to do a better job of risk assessment in this environment, which argues for a return to the old bright-line capital requirements that are fairly simple to monitor. Investment banks played a game of Russian Roulette, and eventually blew their own brains out. Which begs the question of whether the government's job is to protect consumers at large or to protect financial institutions from themselves.
“We foolishly believed that the firms had a strong culture of self-preservation and responsibility and would have the discipline not to be excessively borrowing,” said Professor James D. Cox, an expert on securities law and accounting at Duke School of Law (and no relationship to Christopher Cox).
The Dog that Didn't Bark: Ratings Agencies
Clearly, ratings agencies have really failed in their mission during this fiasco. Right up to the last minute, they were giving top ratings to highly risky securities. But I think folks who want to lay primary blame on the rating agencies go to far. Ratings agencies are for individuals and state pension funds and the like -- I have a hard time imagining Goldman or Lehman depending on them for risk assessment. Its a nice excuse, and we may well have very different companies rating securities five years form now, but its just a small contributor.
So you see what is going on. Republicans are running around saying "the government caused it with the CRA" and Democrats are saying "it was greed and deregulation." Incredibly, both parties seem to come to the conclusion that sickly mortgage securities need to be pulled out of the hands of the folks who created and bought them and put in ... my hands. I had smugly thought that I had avoided buying a home with zero-down at the peak of the market, but I was wrong. Via the federal government, I have bought a lot of them!
I personally would let the whole thing sort itself out, and live with the consequences. My hypothesis is that much of the current credit squeeze in the money markets is due to Henry Paulson's clumsy public statements and the Fed's busting open the door to overnight borrowing. Everyone is frozen not by the crisis, but by the prospect of some sort of government action. Short term borrowers and lenders are doing their business with the Fed, as the government crowds out the private short term markets and causes the very problem it is trying to prevent.
Without the government bending over backwards to take in short term money from lenders, private firms would be forced to find private options. Lenders have to lend to stay alive financially, just as much as borrowers have to borrow. Money may go into the mattresses for a week or two or three, but it can't stay there forever.
I do know that the fix is NOT.
Fixing these financial problems listed above does not include:
Sec. 101. Renewable energy credit.
Sec. 102. Production credit for electricity produced from marine renewables.
Sec. 103. Energy credit.
Sec. 104. Energy credit for small wind property.
Sec. 105. Energy credit for geothermal heat pump systems.
Sec. 106. Credit for residential energy efficient property.
Sec. 107. New clean renewable energy bonds.
Sec. 108. Credit for steel industry fuel.
Sec. 109. Special rule to implement FERC and State electric restructuring policy.
Sec. 111. Expansion and modification of advanced coal project investment credit.
Sec. 112. Expansion and modification of coal gasification investment credit.
Sec. 113. Temporary increase in coal excise tax; funding of Black Lung Disability
Sec. 114. Special rules for refund of the coal excise tax to certain coal producers
Sec. 115. Tax credit for carbon dioxide sequestration.
Sec. 116. Certain income and gains relating to industrial source carbon dioxide treated as qualifying income for publicly traded partnerships.
Sec. 117. Carbon audit of the tax code.
Sec. 111. Expansion and modification of advanced coal project investment credit.
Sec. 113. Temporary increase in coal excise tax; funding of Black Lung Disability Trust Fund.
Sec. 115. Tax credit for carbon dioxide sequestration.
Sec. 205. Credit for new qualified plug-in electric drive motor vehicles.
Sec. 405. Increase and extension of Oil Spill Liability Trust Fund tax.Sec. 306. Accelerated recovery period for depreciation of smart meters and smart grid systems.
Sec. 309. Extension of economic development credit for American Samoa.
Sec. 317. Seven-year cost recovery period for motorsports racing track facility.
Sec. 501. $8,500 income threshold used to calculate refundable portion of child tax credit.
And, of course, the big one:
Sec. 503 Exemption from excise tax for certain wooden arrows designed for use by children.
Posted on October 3, 2008 at 11:20 AM | Permalink
You have to remember as well that the ratings agencies were granted a special permit by the Federal government to that no other firms enjoy. Their special status let them and only them peek inside the structures that they were rating.
Posted by: Josh | Oct 3, 2008 12:12:03 PM
So maybe that is what this bailout is designed to do ... not to protect those who are holding mortgages that they can't pay for, but to protect those who are highly leveraged ...
Posted by: Some Dude ... | Oct 3, 2008 12:54:28 PM
I think your missing something with your dismissal of the Ratings Agencies. W/O their special imprimatur Global investors would not have been buying up the Super Senior Tranches of the CDO's containing the toxic brew. The ratings agencies in essence granted AAA status to Joe & Sue Sixpack's ability to pay their mortgage.
They are a HUGE reason for the catastrophe.
Posted by: JoeSixPack | Oct 3, 2008 1:02:04 PM
As a quasi-libertarian, I'm sympathetic to the idea that government intervention started/strengthened the housing bubble. And there may be something to the "government caused it" story, at least in some versions. But blaming the CRA doesn't ring true to me. If the government were to decide, for example, that to encourage farmers to sell wheat more cheaply, this would presumably not lead to a wheat bubble. Farmers would either ignore the government or, if this was impossible, would cut back on wheat production in favor of something else. In other words, the general effect of government action to keep the price of something artificially low is not a bubble but a shortage.
I don't see why the same wouldn't be true of loans. If a bank ordinarily wouldn't make certain loans, encouragement from the government is unlikely to make them do so, and even if government encouragement did effect banks behavior, the overall effect should be to make them less likely to extend credit to people, not to loosen standards across the board.
Posted by: Blackadder | Oct 3, 2008 1:17:58 PM
Racial & class bias pokes out as % of failing CRA induced is not
given relative to some total of mortgages or total of failing. Behind the asumption of less able to weather is the assumption of more likely to misrepresent by lower income or minority. That's sweet.
Which welfare class or shade does this specimen mostlikely exhibit?
Written by Guest on 2007-12-06 15:08:07
I bought a home seeing this frothy market coming, did a no doc, no income verification, no paper mortgage with a great low teaser rate. My MO did Ok, the RE agent did Ok. 12 months later I paid an appraiser to give me an objective appraisal (WINK) that increased the home value over $75,000. I got a prime -.50% Equiline and pulled $68,000 out. I bought a new car, went on several vacations, purchase a very fine wardrobe, my wife and I ate out all the time. Well that money is gone. My house costs less than I owe, big time. I stopped paying my mortgage two months ago, but grabbed out the remainder of my equiline. I'm leaving this house to the lender, WALKING. All my debts are secured with that house. Now I'm debt free and conscience is clear. I get to keep my other stuff unless you can prove fraud. GOOD LUCK SUCKER. 7 years of bumming around and I'll be ready for another booze up. YaHOO, I love America!
Posted by: Dennis Szilak | Oct 3, 2008 2:23:29 PM
I like the comments on the ratings agency's role in this. However, if the ratings agencies are at fault for mistakenly or purposely giving much higher ratings than deserved, then aren't investors just as responsible for rating (trusting) the ratings agencies much higher than they deserved?
Posted by: wade condict | Oct 3, 2008 2:34:29 PM
President Bush should commission a special investigative body headed by a special prosecutor to look into negligent and possibly criminal behavior on the part of Fannie/Freddie, HUD and Congressional members charged with oversight of these agencies...This should be handled as a financial Watergate...I mean the loss of hundreds of billions of dollars and the collapse of the two largest mortgage companies in the world should at least receive the same treatment as the bungled break-in of Democratic campaign headquarters at the Watergate hotel. Get it??? The public has a right to know since we are now on the hook for guarantees of hundreds of billions of dollars of bad loans. We need to know who are the responsible parties and what are the failed policies and flawed legislation that need to be overhauled or scrapped. If we do nothing in this regard, then we will have failed to learn from this experience and will be destined to repeat these failures in the future.
Posted by: Scott Wiggins | Oct 3, 2008 4:27:35 PM
Don't forget the capital gains exemption on personal residence sales up to $500,000. I think it went into effect in 1997. That helped fuel the asset bubble too.
Posted by: Mike | Oct 3, 2008 4:59:44 PM
I just read a post by Armed Liberal entitled Looks Like CRA Didn’t Cause It After All…
I'm not sure I believe that, but it includes a great power-point presentation (full of graphs) that are well worth looking at.
Links to the video, the power point presentation, and the post itself here
Posted by: John Moore | Oct 3, 2008 5:36:40 PM
Yesterday I had a lengthy discussion with a Vice President of the Memphis division of Banc of America (the investment arm of Bank of America). Bank of America completely avoided the risky (subprime) mortgage market, the mortgage derivatives, the buying of other banks' mortgages, etc. This conservative strategy cost B of A profits and customers (who jumped to competitors that were making bigger profits). Now, Bank of America is sitting on a gold mine. B of A bought Merrill Lynch and two other failed financial institutions for an average of twenty cents on the dollar. The VP estimates that within five years, B of A stock will be worth multiples of today's value. It's nice to know that a few institutions did not jump on the bandwagon, and that they'll survive long after the greedy risk-takers bite the dust. This story also shows that other financial institution CEOs who claim that this catastrophe could not be foreseen are dead wrong.
Posted by: Dr. T | Oct 3, 2008 9:23:16 PM
And don't forget all of the people who worked so hard to inflate the bubble because they thought of houses as primarily an investment, instead of a place to live. Bidding up the prices because they could not afford to be left behind in the bull market of housing when there were few houses available to buy.
I think there is a LOT of blame to spread around, from the Congress-persons who encouraged lending large amounts of money to people who could not afford to pay their cell-phone bills, to the bankers who figured out a way to package these loans and sell them to the "investers" who wanted high returns with no risk ("safe as houses"), to the aforementioned speculators, to the chattering classes that stoked all of the buying frenzy, and then announced the end of the world because(surprise!) more people could not really aford those loans, to (again)the Congress-persons/accounting genuises who insisted on valuing by mark-to-market even when the market stops working, to (again) the bankers driven by greed to set up leverage schemes that would normally make them a ton of money but which collapsed when the leverage flipped.
As someone who is not/was not a member of any of the above categories, I can say this smugly, but with some concern that the same people who caused this are still in positions of power/influence or still spending more than they can afford, so that they can cause more mischief in the future.
Posted by: rxc | Oct 4, 2008 3:46:35 AM
The investment banks who created these fancy derivatives knew that when they found someone at the rating agency who really understands what was going on, they needed to hire them away from the rating agency. (That's one of those things I "heard"; it may or may not be true story.)
I can't imagine anyone would deem some of these products (particularly those formed out of many risky mortgage components) as AAA safe, no matter how they were established, after doing some basic stochastic analysis. Any scenario with falling real estate prices should at least have shown massive defaults. I won't blame them for not modeling the financial panic, but they should have seen the obvious risk.
Posted by: Greg | Oct 5, 2008 10:00:37 PM
Does the overnight window really accept loans from lenders? I've been following this reasonably closely, and I've never heard this before. It charges an above market interest rate, so, if there were lenders with money to lend, there certainly would be borrowers willing to borrow from them. The problem is that in the two or three weeks banks with money want to keep their money in a mattress, as you put it, other banks will go bankrupt.
I'm confused that you can see deregulation was one of the major causes of this problem and remain a Libertarian. I'd have thought that if you accepted that with the natural business cycle, banks without legal reserve-requirements will lend more than they can afford in the up-cycle and then go bankrupt in the down-cycle, causing enormous problems for the overall economy and for the rest of us, you'd accept that the state has a vital regulatory role to play in the financial market. I don't have a clear idea of Libertarianism, but I thought such regulation was its antithesis.
Posted by: Pieter | Oct 6, 2008 2:27:35 AM
I think this post and the Climate Skeptic blog should be required reading for everyone on the McCain campaign - including McCain and Palin both. I wanted to reach through the TV and slap Palin when she went along with Joe Biden's "greed greed greed" meme.
Oh heck, let's just make it required reading for everybody in America, including the stupid people who fell for Henry Paulson's crap (from Joe Sixpack all the way to my 2 US Senators). I'm blaming today's malaise on Henry and Henry alone.
Posted by: The other coyote | Oct 6, 2008 8:58:17 AM
"...we would be seeing a ton more main street bank failures..."
No, we wouldn't, because those main street bank would have never made those highly-risky loans on those ridiculously risky terms. Main street banks have to be profitable, like any other main street business.
Posted by: Correction | Oct 13, 2008 9:47:45 PM
I would like to see you make some comments about Barack's proposed tax increases for the "wealthy". I remember during the Regan years that it became apparent that the high tax rates was what prevented people from becoming wealthy. Its much easier to save income if the Federal Government only takes 35%, but when its starts approaching 50% or even 70%,its nearly impossible for middle class to get to the level of "upper class". The high tax rates that Obama is suggesting will kill upward mobility. If he really wanted to tax the rich, he would tax capital, but he knows he can't pick on the group - because they would not let him get away with it. I wonder how Warren would react to a 5% tax on accumulated capital. Reducing the cost of government and keeping tax rates low is the only way to attain upward mobility in the long run.
Posted by: Doc | Oct 22, 2008 5:35:02 PM
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