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December 2008
Vol. 22, No. 11
Finance
From Reform to Crisis
It wasn't a lack of government regulation, argues Jim Walsh, that caused the economic crisis.
Jim Walsh is an assistant editor of Liberty.
An old college friend of mine is just about the perfect rational economic actor. Backed by some family resources, he did well in business early in his adulthood. Now, in his 40s, he doesn’t have to work in a conventional sense. He isn’t married and doesn’t have children, so he’s not tied to a certain place. He owns houses in desirable locations and travels a lot. He invests, in both the stock market and directly in small businesses. The most remarkable thing about him is that he has few pretensions, personal or professional. He says that his investments, regardless of the legal forms they take, are basically loans. And here’s what he says about lending money:
I’ve followed a sort of bell curve. At first, I wasn’t comfortable about being a lender. So, I avoided lending to people for that reason. Especially to family and friends. Then, I started getting used to it. So, I loosened up a little. It went okay, mostly; I never got completely “burned,” so to speak. But, lately, I’ve moved back again from the family and friends part. Lending to people isn’t good for personal relationships. [Lending] is an inherently unequitable activity. No matter how professional you make it, the lender will always be skeptical and the borrower will always be resentful. It’s human nature.
The United States is a debtor nation. As the country’s “family and friends,” American citizens should pay attention to that rational decision-maker. As the country plunges into a recession, it is asking us to lend it money. Again. We’re making the loan; but our relationship is going to change.
My rational friend has been spending a lot of time in the last few years outside of the United States.
“Reform” and “crisis” are words that no politician can resist. They can make a dim-witted hack seem a visionary leader. But, in practical terms, they mean very little.
The details of the economic “crisis” of late September and early October aren’t exactly simple, but they follow a fairly predictable narrative. (That’s part of the reason it’s hard to use the word “crisis” seriously in regard to these downward economic turns.) And they follow from statist reforms.
In the second half of 2007, after more than a decade of coaxing and prolonging a boom in the U.S. real estate market, the statist sausage-makers at the Federal Reserve and the Treasury Department ran out of ways to keep the party going.
The Feds had been using various accountancy tricks and monetary manipulations to extend the boom. And they’d done a pretty effective job through the 2000s. The bubbling housing market had lifted many boats. Private-sector real estate lenders had followed the Feds’ tricks — and pressed them far beyond anything the Feds envisioned. The resulting loose credit drove up residential real estate prices and allowed debt-based consumer spending to create the impression of financial expansion. Americans borrowed against the rising value of their homes to buy lots of stuff.
Some statists say that the current economic problems are the result of deregulation. That’s false. They’re the result of a disorienting cycle of crisis and reform.
The recent real estate bubble began in the late 1970s, when Jimmy Carter signed the Community Redevelopment Act (CRA) into law. The CRA was designed to encourage private home ownership in poor neighborhoods — a noble goal. It did this by loosening some of the credit standards applied to applicants for mortgages that would be guaranteed or subsidized by existing government housing programs. The bankers doing business under the CRA euphemistically called the resulting loans “subprime” and tried to keep them a small part of their portfolios.
It’s an under-realized fact that Carter signed several “deregulation” bills into law. (In fact, the Carter-era measures shared a common theme of partially deregulating industries and markets. And partial deregulation is often worse than no deregulation at all.) The peanut farmer from Georgia rightly considered deregulation a reform of cronyism and other institutionally-corrupt government practices. The part he got wrong was overestimating the power of his good intentions and underestimating the unintended consequences of his partial measures.
During the Reagan and the first Bush administrations, many of the deregulation programs that had begun under Jimmy Carter were substantially expanded. New deregulation plans were enacted; and Reagan, especially, made deregulation a prime directive. All the while, the CRA languished as an obscure program in a field that Reaganauts didn’t care for much. Of course, in Washington, even obscure laws have a way of lingering.
When Bill Clinton moved into the White House in the early 1990s, he saw potential in the CRA as a tool for his brand of aggressive statism. He expanded and strengthened the law, setting it up as a tool for social engineering. The once-obscure law would channel money into inner-city and racial minority communities. Using the rhetoric of “reform,” the Clinton administration advised banks that they would either make loans through the CRA or face regulatory scrutiny and punishment.
Clinton also built up the connections between banks making CRA loans and the so-called “government-sponsored enterprises” (GSEs), the larger Federal National Mortgage Association (known commonly as Fannie Mae) and the smaller Federal Home Mortgage Corp. (Freddie Mac).
The GSEs weren’t government agencies; they were private companies created and maintained by special laws. They were designed to buy high-quality mortgages from banks, combine the loans into geographically and demographically diverse pools and then sell interest in the pools to private investors as “mortgage-backed securities.” The process was called “securitization” or “repackaging.” It allowed banks to remove loans from their own balance sheets and reallocate the capital elsewhere — usually into making more loans.
Investors who bought Fannie Mae and Freddie Mac securities (usually bonds) received regular dividends or distributions based on the monthly mortgage payments that flowed into the mortgage pools. Fairly basic stuff.
But the combination of the lax underwriting standards of the CRA loans and the securitization of the GSEs’ mortgage pools changed the home loan industry fundamentally. Banks making subprime loans under CRA didn’t have to worry about keeping the loans on their books. The reason most banks had written only a few subprime mortgages was that the things had a higher default risk than the “conforming” mortgages that could be repackaged through Fannie Mae and Freddie Mac. No bank wanted to keep a lot of that risk; and the state regulators who examined the bank’s books didn’t like to see a lot of subprime loans there.
When banks could move subprime loans off of their books and into GSE loan pools, they didn’t have to worry about the default risk anymore. They didn’t even need to have loan portfolios in the traditional sense anymore; they could write as many subprime loans as they wanted and sell the things through the GSEs or a group of Wall Street firms that offered similar services. The higher application and processing fees that banks charged subprime borrowers stopped looking like a sign of trouble and started looking like a feature. Word spread and the business boomed. The party was in full swing.
Between 1996 and 1998, the Clinton administration relaxed the GSEs’ loan requirements for down payments on conforming loans and made other changes that allowed more creative securities based on mortgages (or based on other securities based on mortgages). Clinton said these reforms would help America’s lower classes get into home ownership.
These may have seemed like small steps to the Clinton administration. In fact, they were a major signal to the mortgage marketplace. The government was supporting looser credit standards.
Once the mortgage industry realized it could unload subprime loans on the market for mortgage-backed securities, it wanted more. The fat origination and underwriting fees that subprime loans generated were irresistible. Wall Street investment banks smelled this opportunity, too. They offered to provide the same securitization services that Fannie Mae and Freddie Mac did — but with even fewer underwriting guidelines or restrictions.
The GSEs ended up in a statist version of the innovator’s dilemma. Private investment banks were taking away market share for the securitization business that Fannie Mae and Freddie Mac had invented. The GSEs were seen as being too conservative, their loan guidelines too strict. A principled limited government would have let Wall Street have the go-go securitization market. But Bill Clinton wasn’t running a principled limited government. His Treasury Secretary, former Goldman Sachs head Robert Rubin, knew that the Wall Street firms didn’t care about social justice; they were creating capacity for subprime loans to anyone. The Clinton administration could earn political points on the Left by focusing the GSEs on the social justice elements of loosening mortgage credit.
In 1999, Clinton named his friend and long-time political operative Franklin Raines chairman of Fannie Mae. Raines quickly adapted the rhetoric of reform and social justice. In the process, he allowed the inference that the government’s legal guarantee of the GSEs was a guarantee of the whole subprime mortgage market. This was a fundamentally fraudulent proposition — and it led to various, smaller fraudulent activities that took place during Raines’ six-year tenure at Fannie Mae.
Soon after Raines’ arrival, Fannie Mae launched a “pilot program” that it promoted as something that would — in the credulous words of The New York Times — “help increase home ownership rates among minorities and low-income consumers.” The program actively encouraged banks to extend home mortgages to individuals whose credit was not good enough to qualify for conventional loans. Raines pitched the deal as follows:
Fannie Mae has expanded home ownership for millions of families in the 1990s by reducing down payment requirements. . . . Yet there remain too many borrowers whose credit is just a notch below what our underwriting has required who have been relegated to paying significantly higher mortgage rates in the so-called subprime market.
He said that Fannie Mae hoped to take the program nationwide by the spring of 2000.
Of course, getting into the subprime market exposed Fannie Mae to default risks that it had traditionally worked hard to avoid. Amidst its breathless words of support, the Times noted, presciently:
In moving, even tentatively, into this new area of lending, Fannie Mae is taking on significantly more risk which may not pose any difficulties during flush economic times. But the government subsidized corporation may run into trouble in an economic downturn, prompting a government rescue similar to that of the savings and loan industry in the 1980s.
So, the crisis was predictable — and predicted — a decade before it took place.
In the meantime, Raines made a lot of money; he paid himself nearly $100 million during his reign.
In 2000, Sen. Phil Gramm coauthored the Commodity Futures Modernization Act. The CFMA expanded the scope of futures trading and removed several types of investment from direct federal regulation. Gramm called the CFMA a necessary reform of patchwork futures trading rules.
Among the investments that the CFMA sheltered from regulatory scrutiny was something called the “credit default swap” (CDS). This was a kind of insurance one bank could exchange with another, making it safer for banks to make riskier loans. By removing government regulatory control of CDSs, the CFMA gave the sharp guys from Harvard and Wharton a tool for obscuring credit risks. They picked up this tool quickly.
There were a number of errors and bad assumptions that affected how the Wall Street whizzes priced CDSs and related derivatives. The biggest was their focus on cash flow rather than underlying asset value.
Also, most of the investment banks that created and traded CDSs seemed not to understand fully the concept of “duration” as it applies to mortgages. Duration is a calculation that takes into account the prepayment rates for pools of mortgages. These rates include voluntary prepayments (usually the result of a house being sold) and involuntary prepayments (usually foreclosures — but also things like insurance payoffs after natural disasters). The investment banks focused their analysis on voluntary prepayments and ignored involuntary ones. This, on a very mechanical level, reflected the assumption that the bubble would last forever.
W. Bush’s administration saw problems looming for the GSEs. In 2003, it proposed some reforms that would have pulled Fannie Mae and Freddie Mac out of the subprime securitization market. But congressional leaders (most vocally, Massachusetts Rep. Barney Frank), still clinging to the social justice justification, resisted. In 2003, Frank said:
These two entities — Fannie Mae and Freddie Mac — are not facing any kind of financial crisis. The more people exaggerate these problems, the more pressure there is on these companies, the less we will see in terms of affordable housing.
The younger Bush decided that the GSE reform wasn’t a hill worth dying for. Loose credit was as important to the continuing real estate boom as the low interest rates maintained by the Federal Reserve under chairman Alan Greenspan and his successor Ben Bernanke.
So, W.’s administration backed away from the reform proposals that might have dampened the effects of Clinton’s earlier reforms.
The U.S. real estate market was still booming. And it would keep booming through 2004 and 2005. Pushing through the pinhole created by the CRA, subprime mortgages quickly flooded the home loan industry. Their easy credit terms created a debt version of Gresham’s law: subprime loans chased out conforming loans. A creditworthy homebuyer who wanted to keep a standard, fixed-rate loan had to bid against breathless competitors pre-approved for no-documentation, 100% loan-to-value adjustable rate mortgages (ARMs). The creditworthy bidder couldn’t keep up. If he really wanted a particular house, he’d have to offer a price that only a shady loan could cover.
In some areas, houses would be listed for sale and have dozens of offers within hours. Speculators and “house flippers” talked about making money on properties that they sold the day after they’d received title. Realtors, mortgage brokers, and bank lending officers had so much business they could afford to turn new clients away.
On Wall Street, the market for mortgage-backed securities was also booming. The smart guys who worked for investment banks and stock brokerages were creating, in addition to CDSs, all kinds of new investments based on mortgages and other loans. And they had lots of willing buyers.
The Sarbanes-Oxley Act of 2002, a financial reporting reform passed into law after the Enron and Tyco accounting crises became big news, substantially raised compliance costs for publicly-traded companies. Unintended consequences followed. The higher compliance costs chased money — and people — into the privately-held investment vehicles known as hedge funds. Free from the most stringent reporting requirements, hedge funds could act decisively, compete ruthlessly, and didn’t care so much about transparency in their dealings.
Many hedge funds bought MBSs and CDSs based on subprime loans; many of these also bought even more complex derivative securities that focused investment on certain levels of risk within subprime risks. One east coast hedge fund trader says that between 2004 and 2006 he
must have listened to a hundred pitches that all said the same thing. “Americans are borrowing more and their credit is getting worse. But they’re hooked and are going to keep on borrowing. Here’s a derivative security we’ve cooked up that gives you the prime cut of these fat interest spreads.” At first, it was just one or two investment banks pitching this shit. But, pretty soon, it was all of them. Sharp guys from Harvard and Wharton selling glorified payday loans. They knew [this] was really bad.
The derivative securities that worked like bets on the various outcomes of the subprime mortgage market went by various names: credit default swaps, structured investment vehicles (SIVs), collateralized mortgage obligations (CMOs), and collateralized debt obligations (CDOs) — to name some of the most popular. Basically, these derivatives divided and reassembled pools of mortgaged-backed securities in various ways. SIVs and CMOs were pools of standard MBSs sliced up (often into 64 equal parts) and reassembled according to their riskiness, geographic concentration or other standards. In some cases, Wall Street whiz kids would break a 30 year mortgage into individual securities based on each of 360 monthly payments; then they would bundle thousands of the one-month payments into larger securities offerings.
Finally, CDOs were pools of CDSs sliced up and reassembled to reflect default risks more precisely. The important thing to keep in mind about these insurance-like investments was that the Wall Street whizzes needed rich and patient clients to buy them. Entities (called “counterparties”) that bought CDOs and CDSs received regular income and saw their investments appreciate as long as the party kept going but, when and if it ever stopped, the investments would lose value. Perhaps completely.
The sharp guys from Harvard and Wharton needed to sell the CDOs and CDSs, so that they could convince investors — and bank regulators and credit rating agencies — that mortgage-backed securities were “hedged” or “insured” or “guaranteed.” Most were ready and willing to be convinced.
So, CDSs and CDOs were a kind of investment insurance. But, despite their claims, Wall Street firms have never been good at risk assessment. They are dominated by the trader’s mentality, which values the adrenaline rush of doing deals over the cautious work of actuarial analysis.
When you write insurance, you get a lot of people to pay you a little more than their share of what it could cost if a bad thing happened to one of them. Then, if the bad thing happens, you pay the injured person back. You need to have money available to pay people who have been injured. Or there will be trouble.
What happened with the CDSs is that traders and investors made bad (that is, favorable to them) assumptions. They jumped at the cash flow that the investments offered and ignored the potential losses that would result if the mortgages underlying the derivatives actually defaulted.
An insurance company succeeds if its premiums are lower than its competitors’ but still higher than its actual cost of claims. When it comes to structuring health, home, and car coverages, actuaries calculate the relevant risks and make sure that insurers keep enough money on hand to pay expected losses. In the Wall Street version of insurance, no one was making such informed analysis. Why not? Because the “insurance” wasn’t covering actual mortgages or even simple mortgage-based securities; an actuary could analyze the default risks of those, based on relevant local market data, loan-to-value ratios, etc. Instead, the “insurance” was covering the default risk of derivatives like SIVs and CMOs — that had been designed to obscure risk factors.
How did the Wall Street whizzes calculate the value and dividend payments on derivatives that were insuring other derivatives? They based everything on cash flow, not actual risk. This is like pricing a person’s car insurance premium based on his income, not on the value of his car or his driving record.
Through the go-go years of the early- and mid-2000s, CDSs and CDOs were traded like stocks or other simple investments. They changed hands dozens or scores of times, growing in value with each trade. Some of the firms that traded swaps — effectively insuring billions (or tens of billions) of dollars in subprime loans — only kept a few million dollars (or less) in cash on hand to cover any losses.
Similar things had happened in insurance circles before. In the 1990s, Lloyd’s of London suffered what its executives would come to call a “risk spiral.” The combination of insured losses related to storm damage to some offshore oil rigs in the North Sea and asbestos liability lawsuits in the United States had much-worse-than-expected effects on Lloyd’s investors. These investors — called “names” in Lloyd’s jargon — functioned just like the counterparties to CDO and CDS contracts. They bought into “syndicates” which essentially paid them to be standing by with checkbooks ready in case of major losses.
Some of the “names” had been making money this way for so long that they’d forgotten about the potential liability. They expected to keep getting distribution payments . . . forever. When the losses mounted and they had to pay money into the syndicates, many weren’t prepared. The resulting shortfalls almost wiped out Lloyd’s of London.
Lloyd’s survived. But it had to turn to the British government for financial aid. And it had to restructure its syndicates, demanding more formal capital investment and clearly-written liability agreements with its “names.”
Who was buying CDOs and CDSs? Some domestic hedge funds — but, more often, quasi-governmental banks in Asia. The Asian banks saw buying complex derivatives as a way to keep the U.S. debt party going, keep their goods flowing into American markets, and make some investment profit along the way.
You shouldn’t be embarrassed to admit that you don’t understand these derivatives. The people who traded them didn’t understand what they were. But there was so much excitement in the trades that they didn’t hesitate to join the party.
Roger Altman, a former executive at the Wall Street investment bank Lehman Brothers and a deputy Treasury Secretary under Bill Clinton, has written:
The lack of transparency was stunning. Many big lenders did not disclose off-balance-sheet risks. In some cases, they did not understand these risks themselves. More fundamentally, we allowed a second, huge financial system to develop outside the normal banking network. It consisted of investment banks, mortgage finance companies and the like. It was unregulated, not transparent and way too leveraged. But with nine separate and mostly ineffective financial regulators, these risks were ignored. That is, until this second system crashed.
Why did the second system crash? Because all markets have cycles of boom and bust. By 2006, at least some of the sharp guys from Harvard and Wharton had realized the party couldn’t go on forever. They started trying to get the potential liabilities off of their banks’ books. But risk transfer is a zero-sum game. In order to get the toxic waste off of their books, the smart guys had to find someone willing to take it on.
The fact that no one seemed to know what any of the derivatives were really worth made deals difficult. In economics jargon, the complexity of the derivatives meant that price discovery was nearly impossible.
Price is the mechanism that balances differences in supply and demand. Price discovery is the process by which markets clear — that is, assign efficient values to goods or services. For mortgage-based securities, the price should be the net present value of expected future cash flows. But the real market prices bid for the securities didn’t always match that formula. Why? Again, unintended consequences.
Throughout the 1990s and early 2000s, federal banking rules required financial institutions to follow so-called “mark-to-market” pricing models when reporting the value of their investments. These models — justified as reforms that would prevent Enron-like accounting abuses — required banks and other financial institutions to report the current market value of any securities they owned at the end of every trading day. And adjust their balance sheets accordingly.
Transparent, no?
Yes. But this transparency made MBSs and more complex derivatives attractive to financial firms (including Fannie Mae and Freddie Mac) precisely because they defied clear reporting and simple analysis. The MBSs were backed by blocks of thousands of mortgages. Even as the mortgage market turned bad, most of the loans underlying any particular MBS were still good, a smaller segment might be good with some minor adjustments, and only a small segment — perhaps 10% or 15% — were foreclosures. The challenge was that identifying specific loans in each category was designed to be difficult. The slicing and dicing that Wall Street firms had done meant that payments from a single 30-year mortgage might go into one MBS pool for the first five years, another for the second five years, a third for the third five years . . . and so on.
Even more complex: some of the derivative securities sliced and diced risk “tranches” within various pools or mortgages so that — effectively — part (say, $1,000 of $1,500) of a specific mortgage’s monthly payment went in to one investment’s cash flow and the rest (say, the remaining $500) went into another’s cash flow.
So, these SIVs and CMOs were designed to defy transparency requirements. On this count, they were extremely successful. Very few people understood how they worked. As long as real estate prices continued to rise, no one cared to know.
In May 2006, the Office of Federal Housing Enterprise Oversight (OFHEO), released an investigation report that described a culture of corruption at Fannie Mae that rivaled the worst of Enron or Tyco.
The OFHEO investigation covered the years 1998 to 2004, which included most of Franklin Raines’ tenure as chairman. According to the report, during that period, Raines and his senior management team grossly overstated Fannie Mae’s earnings — by approximately $10.6 billion — for the purpose of paying themselves big bonuses.
The report stated:
By deliberately and intentionally manipulating accounting to hit earnings targets, senior management maximized the bonuses and other executive compensation they received, at the expense of shareholders. . . . Fannie Mae reported extremely smooth profit growth and hit announced targets for earnings per share precisely each quarter. Those achievements were illusions deliberately and systematically created by senior management with the aid of inappropriate accounting and improper earnings management.
In other words, Raines cooked the books.
This had sent another signal to the mortgage marketplace: that even congressionally-chartered companies, designed to serve the public good and achieve utopian “social justice” ends, were gaming the system.
As billionaire investor Warren Buffet said, the 2000s were like a beach where lots of people had waded into the water at high tide. As long as the tide stayed high, everything was fine. But, when the tide went out, everyone would find out who was wearing a bathing suit and who wasn’t.
By early 2007, the tide was going out. The loose lending standards and low interest rates were starting to lose their effect. Home prices in some regions (like San Diego, which many real estate experts consider a leading indicator of national trends — either up or down) were plateauing and even dipping.
In February 2007, California-based New Century Financial — a major player in subprime mortgage origination — announced that it was having trouble selling its loans and was going to have restate several years of financial reports. The sharp guys from Harvard and Wharton were starting to realize that the party was over. They started backing away from MBSs, CDSs and the various other derivatives. Loose credit started to tighten up.
About that time, the Bush administration made a 180-degree turn from its earlier position and encouraged Fannie Mae and Freddie Mac to buy up some of the most troubled mortgage-backed securities in an effort to prop up the market that was just beginning to crash. The GSEs did — and hastened their own insolvency. Just like the “no money down” home buyers whose mortgages they were supporting and the lazy Lloyd’s of London “names” who thought losses would never come, the GSEs didn’t have enough cash to withstand the collapse in the mortgage derivatives market when housing started to slump.
On Sept. 7, 2008, U.S. Treasury Secretary Henry Paulson (another ex-Goldman Sachs head) announced that Fannie Mae and Freddie Mac were both being taken over by the government and placed in a specially-designed receivership.
The GSEs had always been in an impossibly conflicted position. They competed against aggressive capitalists — the investment banks — for securitization services; but they were quasi-state agencies that were supposed to support altruistic ends. It was an impossible mix.
The fact that Chinese state-owned banks owned billions of dollars of Fannie Mae and Freddie Mac bonds made it impossible to let the GSEs fail without incurring disastrous international repercussions. It would be a crisis.
Soon after its takeover, Paulson’s Treasury Department authorized Fannie Mae and Freddie Mac to increase the size of their loan portfolios, allowing them to buy more mortgages. The plan was that, as the GSEs bought more mortgages, new cash would be freed up to lend to new home buyers. But shifting more troubled loans to the GSEs would also increase the strain on their finances, increasing the risk that taxpayers would lose more money when loans went bad.
About ten days later, the Federal Reserve bought nearly 80% of the American International Group (AIG), in exchange for an $85 billion loan. A giant company in the insurance field, AIG had operations all over the world. Most of its business was sound, conventional insurance underwriting and finance. But a small part of the company had been a big market-maker in and trader of CDSs and other mortgage-related derivatives. (Paulson would later describe AIG as a group of insurance companies with a hedge fund on top.) That one division exposed the entire company to tens of billions of dollars in financial liabilities, which made other companies and traders hesitant to do business with AIG.
That hesitation took concrete form when several major credit rating agencies — Standard & Poor’s, Fitch, and Moody’s Investors Service — had cut AIG’s rating a few days before the government takeover. The lower rating triggered larger capital requirements under some of AIG’s operating capital agreements; immediately, the insurer had to raise over $14 billion in cash to honor its contracts. And more demands were coming.
In Washington, D.C., the conventional wisdom among statist experts was that the blooming “crisis” was going to require broader reform. The ad hoc bailouts from Treasury and the Federal Reserve wouldn’t do.
In one day (September 16), the London interbank offered rate (LIBOR) — which financial institutions charge each other to borrow — more than doubled, to 6.44%. The rate had been as low as 2.07% one day earlier. This was a troubling sign, because many subprime ARMs used LIBOR as the basis for their adjustable rates. So, the interest rates on many loans were set to jump dramatically.
In a manner reminiscent of W. Bush’s urgent advocacy of the USA PATRIOT Act after the 9/11 terrorist attacks, Paulson made public pronouncements demanding quick congressional approval of a $700 billion bailout of the financial services industry at large.
The “crisis” was a hangover. And the statists’ first impulse was to take some of the hair o’ the dog.
According to Paulson’s plan, after the government jump-started the real estate market with massive purchases of the riskiest mortgage-related derivatives, private investors (read: the Asian banks) would follow back in.
On Sept. 21, 2008, Paulson appeared on the TV news show Meet the Press to scare up support for his plan:
This is an urgent matter, and we need to move quickly. [The estimate of $700 billion] is not an expenditure . . . The cost won’t be anything like the cost of buying up these assets [because] these costs will come back. . . . Here, we’re preventing failure. Once we get this stabilized, there’s a lot we can talk about in reform. There have been excesses for a long time . . . irresponsible practices. It’s terrible, inexcusable, and we need to deal with it.
There was an element of self-fulfilling prophecy in the plan. By buying up distressed MBSs and derivatives, the Feds would establish a market value for them. Even if this value was low (say, 20 cents on the dollar of face value), it would give investors and, ultimately, lenders the clarity they needed to get back to business.
But some legislators rightly questioned the kingly powers that Paulson’s plan gave the Treasury Secretary. His actions in allocating the billions from the Big Bailout were essentially unsupervised. They weren’t even reviewable. He could not be questioned, stopped, or sued by any party — private or governmental.
Some of these kingly prerogatives were reined in by congressional modifications to the original plan’s language.
Another problem with the plan: Paulson had to keep a careful balance in how much he paid for the distressed derivatives. If he paid too little, the buyout wouldn’t help financial institutions much (they’d still have to account for the losses somehow); if he paid too much, the government would subsidize the selling banks and probably lose money when, sometime later, it sold the derivatives back into a recovered marketplace.
One proposal for keeping the balance was to use a “reverse auction” whereby banks that wanted to get rid of distressed derivatives would secretly offer the lowest price they’d accept for the things. The government would then rank the bids and buy the securities, starting with the cheapest offers and working up the list.
Reverse auctions had been used with some success by alternative investment banks, usually far from Wall Street, for initial public offerings of corporate stock. But some sharp guys from Harvard and Wharton argued that there were issues with reverse auctions. They might solve one problem — setting a market value for the derivatives — but they would not recapitalize specific distressed banks. Exchanging one asset (a bunch of shady derivatives) for another (cash from the government) does nothing to improve a bank’s asset-to-capital ratio, unless the derivatives are sold for more than they are worth.
But these criticisms were warped by a statist bias toward using blunt tools to achieve specific ends. A nearly trillion-dollar government bailout shouldn’t occur at all. But, if it must, it should be directed at preserving the system — in this case, keeping the credit markets from collapse — and not at helping any one institution.
And, again, a recurring flaw in the proposed state action is that the assets being priced and purchased aren’t analyzed on their fundamentals; they are valued on the basis of how much the sellers are willing to accept.
Nevertheless, Paulson (with some mealy-mouthed assistance from Fed chairman Bernanke) convinced Congress that “something” needed to be done.
Paulson reserved the right to bail out individual homeowners by buying up their loans. This proposal created some political problems, though. There was widespread opposition to bailing out homeowners who’d borrowed more than they could afford to buy big, fancy houses. Free-market advocates argued that people who’d made bad choices should suffer the consequences — and, more importantly, people who were prudent shouldn’t have to pick up the tab. Otherwise, the Feds would be creating moral hazard — the encouragement of destructive behavior.
An alternative proposal to buying mortgages was to use bankruptcy courts to implement forced renegotiations of the terms of specific subprime loans. The Bush White House and some Republican legislators argued (rightly, in this narrow context) that forcing lenders and investors to accept these “cramdowns” would only make matters worse. Lenders would be wary of extending any new credit if borrowers could go to court to have terms changed.
The beauty (from the statist’s perspective) of the real estate bubble plan was that the blow-up would be so widely distributed among common folk that no plan to work out individual cases could possibly be devised.
Who was responsible for the subprime bubble? As with any bubble, there is no satisfying answer to this question. Bubbles aren’t the result of one party’s bad actions; they result from various parties manipulating and/or misunderstanding pricing signals. In the U.S. real estate boom of the 2000s, these parties included:
- government agencies that loosened regulatory standards to achieve social policy ends;
- borrowers who bought houses they couldn’t afford or refinanced houses so they could afford to buy cars, electronics, jewelry, or vacations they couldn’t afford;
- mortgage brokers who pressed appraisers for high valuations and pocketed big commissions on loans or refi’s they knew were unsustainable;
- Wall Street banks that obscured critical information about unsustainable loans with intentionally confounding derivative securities and ersatz “insurance”;
- investors who didn’t bother to check carefully what they were buying;
- rating agencies that tacitly (and, sometimes, actively) approved of the confounding derivatives and the balance sheets that included opaque assets.
This last member of the rogue’s gallery — the rating agencies — was a critical enabler of the bubble. The swaps and other derivatives were important (and profitable for Wall Street firms) because investors looked to the rating agencies for coverage in what they bought. The Wall Street firms convinced the rating agencies that CDSs and other mortgage-related derivatives were a viable form of insurance. So, until the last stages of the bubble, banks and hedge funds that owned a lot of derivatives were rewarded with higher credit ratings, despite their significant exposures to loss.
Watch the credit rating agencies. Influenced by the sharp guys from Harvard and Wharton, they have enabled some very bad choices by banks and insurance companies. To their credit, the rating agencies . . . eventually . . . caught on to the problems of the worthless credit derivatives and “insurance.” The question is: will the rating agencies be more cautious going foror will they be seduced by the next fashion trend in financial jimcrackery?
That next trend may be hamfisted regulation of the banking, financial services, and insurance industries. Self-regulation or “counterparty supervision” might have been effective in these markets, if not for the warping effect of an implied taxpayer guarantee of home loans (even subprime loans). Once the Feds got involved in the mortgage market with implied guarantees of subprime mortgages and social justice policies, the Big Bailout was inevitable.
Given enough time, any system of government regulation will become obsolete. It’s best for an economy to accept this fact and remove sources of moral hazard wherever they occur.
The state’s proper role in relation to capital markets is not pushing social justice policies or trying to engineer particular outcomes for specific parties. It’s not a utopian quest for zero risk. Some businesses, and some investments, will always fail. Instead, a principled limited government should encourage multiple sources of information and analysis; it should discourage vehicles or practices designed to obscure information. It should develop and maintain robust programs to wind down the inevitable failures.
Campbell Harvey, a professor of finance at Duke University, told BusinessWeek magazine:
In years to come, the real story will not be the subprime crisis or some housing bubble. It will be the spectacular failure of risk-management systems in our so-called leading financial institutions.
There’s another way to phrase this. The Federal Reserve, the Treasury Department, and the federal government in general have engaged in reckless monetary policy. They’ve been doing this for more than 60 years — but the pace and degree of the recklessness have sped up in the last 10 or 15. Multibillion dollar government bailouts aren’t good government; they are a sign of statism in excess.
Politicians and central bankers can create money out of thin air . . . but this creation rarely ends well.
There’s plenty of real money in the world. If it seems as if money’s tight here in the States, that’s because America has transferred much of its wealth to Asia through years of steady trade deficits. The Asians are buying up some marquee banks and financial services firms at the end of this housing bubble. But they’re in no rush to get (any more deeply) involved in shady mortgage-related derivatives. They’ll let American taxpayers take on the risk of dealing with those — and buy the relatively safe bonds that the U.S. Treasury will issue to finance the bailout.
What else is coming? Very likely, more bad government policies — focusing on statist shibboleths like “CEO pay” and “predatory lenders.”
According to the always useful Atlantic Monthly online columnist Megan McArdle:
This was not some criminal activity that the Bush administration should have been investigating more thoroughly; it was a thorough, massive, systemic mispricing of the risk attendant on lending to people with bad credit.
And there’s a reason the banks got it so wrong — the federal government had used regulatory incentives to blur lenders’ judgment about borrowers with poor FICO scores.
Once judgment has been blurred, it’s hard to regain. America is a debtor nation. Everyone’s credit will keep getting worse until the nation changes its profligate ways. Or until the Asians stop buying Treasury bonds.
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