TheAgitator.com
Anatomy of a Meltdown
Wednesday, December 3rd, 2008Several of you have emailed me asking if I’ve seen a good breakdown of the government’s role in the financial meltdown that’s accessible to what you might call the educated layman.
Mike Flynn’s piece in our January issue is the best I’ve seen. It’s also now available online.
If I might self-promote, I would suggest my own “Open Letter to my Friends on the Left” which you can find here:
http://myslu.stlawu.edu/~shorwitz/open_letter.htm
Government:
1) caused it all.
2) created an intricate scheme to steal the wealth from the middle class.
3), as is typical, mucked this one up due to extreme incompetence.
4) all of the above.
It further amazes me that the public trusts the same morons that created the problem to fix it. Isn’t that akin to starting a fire then trying to put it out with gasoline?
That Reason story is one of the most fatuous pieces of crap I’ve ever read. It’s a wonder how all the facts are correct, but the analysis wildly overstates the importance of small factors like government encouragement of lending while completely ignoring much more important ones, like the tendency of capital markets to go where returns are best.
Mortgage-backed securities were touted as risk-free, high-return investments. Those words are honey to the ears of investors, and huge influxes of capital were inevitable. And when there’s a lack of traditionally viable investments to meet that demand, what happens? That’s right, you create new investments that aren’t quite as safe as the old ones. Hence all those complicated financial instruments to make them seem as risk-free as traditional mortgages.
For such believers in the wisdom of the market, libertatians seem to think it’s awfully easy to lead astray. The very idea that financial institutions of all kinds needed any prodding from “affordable housing activists” to start lending the wrong people money is preposterous.
For an explanation of the crisis that actually makes sense, check out these two NPR pieces:
http://www.thislife.org/radio_episode.aspx?episode=355
http://www.thislife.org/Radio_Episode.aspx?sched=1263
It’s worse than that, MacGregory. This is more like someone starting a fire, then trying to put it out with gasoline while people are standing right beside him with buckets of water, then taking their water and trading it for more gasoline.
It sounds to me like Flynn’s thesis is that Fannie and Freddie did it, with assist from the federal reserve, while the government sat idly by and let it happen. So, while government policy creating Fannie/Freddie and encouraging low income loans caused this crisis, so too, stricter regulation of same could have prevented it.
It’s pretty disingenuous to leave out the CDS market, wholly created out of thin air by Phil Gramm, and absolve the financial services industry of ANY sort of blame. Yes, the CRA was intervening, but funny how it was working just fine until the FS guys started trading meaningless instruments back and forth… after the Republicans gave them carte blanche.
It’s also pretty disingenuous to leave out the EXTREMELY aggressive marketing tactics of the mortgage lenders, most of whom were not obligated by CRA-related regulation at all, to borrowers, most of whom were not sub-prime or low-income. It was very, very hard for many years to get any sort of standard fixed-rate mortgage. There was a LOT of pressure on homebuyers to “just get an ARM, housing prices ALWAYS go up, you’ll make a ton of money in five years!” Most borrowers were not stupid. Most mortages were not given to people who couldn’t afford them.
The CDS market accelerated the pace of the housing bubble’s inflation, and increased the pain of its bursting, and the bailout rewards its engineers. The government’s culpability belongs to those on the Right AND the Left.
The reason article gives quite a pass to the ratings agencies, relegating their role in the problem to one sentence: they ‘didn’t look under the hood’. Isn’t that the role of ratings agencies? Trillions of dollars depend on those ratings and the assumption is implicit that they ‘look under the hood’. Fannie and Freddie didn’t buy individual subprime mortgages, they bought securities that were rated AAA, expecting that these were the least risky and would additionally satisfy the affordable housing requirements.
Sounds like the government wasn’t really all that involved. The key point seems to be this:
The overall foreclosure numbers were small; someone simply looking at housing statistics could be forgiven for wondering what all the fuss was about. Nationally, throughout 2007 and 2008, the number of mortgages moving into foreclosure was only about 1 percent to 2 percent, suggesting that 98 percent to 99 percent of mortgages are sound. But the foreclosed mortgages punched way above their weight class; they were laced throughout the mortgage-backed securities owned by most financial institutions.
The complexity of these financial products cannot be overstated. They usually had two or three “tranches,” different baskets of mortgages that paid out in different ways. Worse, as different firms bought and sold them, they were sliced and diced in varying ways. A mortgage-backed security owned by one company could be very different when it was sold to another.
No one fully understood how exposed the mortgage-backed securities were to the rising foreclosures. Because of this uncertainty, it was hard to place a value on them, and the market for the instruments dried up. Accounting regulations required firms to value their assets using the “mark-to-market” rule, i.e., based on the price they could fetch that very day. Because no one was trading mortgage-backed securities anymore, most had to be “marked” at something close to zero.
This threw off banks’ capital-to-loan ratios. The law requires banks to hold assets equal to a certain percentage of the loans they give out. Lots of financial institutions had mortgage-backed securities on their books. With the value of these securities moving to zero (at least in accounting terms), banks didn’t have enough capital on hand for the loans that were outstanding. So banks rushed to raise money, which raised self-fulfilling fears about their solvency.
So while the government may have made some missteps in encouraging looser lending standards, also perhaps in requiring mark-to-market (though as I understand it, it’s actually not a bad idea) accounting, and later on with the bailout, the fundamental fact is that our financial institutions were buying and selling things they didn’t understand.
The other thing I’d add is that it’s not at all clear that a totally unregulated market wouldn’t have come up with the same sort of scheme.
I mean, you can argue that the government mucked things up by pushing for lower lending standards, but even if that’s true, you have to assume that since the banks in question found ways to make a slew of money packaging and reselling those riskier mortgages, they would have eventually done so anyway absent any government pressure at all.
There is enough blame to go around between both the government and the private sector and to pin the blame on one or the other is disingenuous. I do find it hard to believe that private firms held on to that garbage although I guess they thought swapped out their risk through CDS contracts. What I would love to see is for someone to prosecute the folks at the National Association of Realtors who clearly and repeatedly made misleading statements about the state of the housing market.
Buck B. – You are incorrect in assuming that we don’t take into account that people are greedy, that is one of the basic pillars of capitalism. That people will act in their self-interest is probably a natural law in addition to an economic one.
The thing you seem to ignore is that while self-interest will drive people to go after the highest returns it is risk that will turn them away. Risk (in this case higher interest rates) is what the Government intentionally suppressed in order to meet their goals of higher rates of home ownership. Without risk there is no feedback mechanism that tells investors/banks/gamblers to stop what they are doing. Freddie/Fannie gobbled up all the risk leaving capitalists free to re-use the capital in similar or even riskier ventures.
If the Fed wasn’t printing money 24-7 the capital behind these ventures would have run out long before 110%/no collateral loans were even dreamed of driving interested rates up. Had Freddie and Fannie stopped buying up the mortgages, banks would have had to take in a few payments on the ones they held prior to makine new loans, again, driving interest rates up.
So yah, evil capitalists did what you’d expect, they tried to make money, go figure.
And yah, evil government entities did what we’d expect, threw the market out of whack by persuing unrealistic political goals aimed at coddling the masses.
Fay:
No, not really… I took out a mortgage for a home in 2005 (sold in 2007, luckily in Atlanta where I didn’t lose my shirt on it), and all I had to do to get a 30-year-fixed mortgage was ask for one. I told the mortgage broker right up front, “I want a 30-year fixed loan, not an ARM.”
Poof! Easy.
Matt D – Without the flood of funny Fed money these kinds of loans would be impossible not to mention far too risky to bet the farm on.
…..and Buck, the last place any of us would (or should) look for truth is within the government sponsored NPR propoganda-sphere…
@ Reasoned
Bingo. The Fed’s cheapening of the money is the meat and potatoes of the current crisis. You can’t blame everyone who lined up to eat.
The CRA and and lax regulations on mortgage securities were just the side salad and garnish. They in and of themselves could have caused no serious damage to the economy. They also make for easy scapegoats for those who seek to politicize this downturn.
All the other actors were just devouring the meal the Fed provided. Everyone. The lenders, the institutional bankers, the realtors, the ratings agencies, governments, right down to the a-holes buying the McMansions three counties away from their job.
If money wasn’t so cheap everyone in the system would have guarded it more carefully.
Dakota –
“If money wasn’t so cheap everyone in the system would have guarded it more carefully.”
Worth repeating.
Oh yah, Ron Paul was right, that needs repeating over and over again as well.
At the beginning of this decade there was a use surplus of foreign investment money that was going to find a home regardless of anything the Fed did. It’s possible they made the problem slightly worse, but it’s a matter of degree, not magnitude.
The reason people so seriously misjudged the risk of mortgage-backed securities was because they bullshitted themselves into thinking that even in the likely even the housing market tanked (that never happens!) credit default swaps would protect them from liability. Needless to say, this was a slight misjudgment on their part.
Also, when you trash NPR you sound like an idiot. Don’t do that.
An idiot because trashing NPR is idiotic or because they aren’t actually government sponsored/subsidised?
Neil Boortz has a good breakdown too.
http://rightklik.blogspot.com/
Imagine the following two scenarios:
-1- Joe’s Casino offers the following game: A player puts up $100 and pick a card from a shuffled deck. If it’s nine or lower, the player loses $100. If it’s a ten or higher, he receives his $100 plus $100 more.
-2- Joe’s Casino offers the same game, but with a twist: if the card is nine or lower, the player loses $50 and taxpayers supply another $50 via the “Joe’s Victims’ Protection Fund” (so Joe gets $100).
In the former scenario, for every $1300 wagered, Joe will collect $800 and pay out $500, for a net gain of $300; the customer will pay out $800 and collect $500, for a net loss of $300. In the latter scenario, Joe will still gain $300; the customer will collect $500 and pay out $400 for a net gain of $100, and taxpayers will shell out $400 and collect nothing.
By offering to ‘help’ the ‘victims’ of Joe’s lop-sided game, the government has totally and disastrously changed the dynamics. The game which had been a losing proposition for the players becomes a winning proposition; there’s no reason for people not to play if they can keep all their upside while half their losses are covered. Even if people would have only lost a total of $10,000/year in the absence of the JVPF, taxpayers will get soaked for a lot more than $10,000/year once the fund is put in place. Further, even though the fund supposedly exists to protect Joe’s “victims”, it’s Joe himself who will be the primary beneficiary.
What’s needed to restore market sanity is the re-imposition of a simple rule: if you lose money, you lose money. If you think you were defrauded, you can try to collect it from the people you claim defrauded you. If you can manage to collect from them, great. If it’s only possible to collect pennies on the dollar, too bad. The fact that you were ripped off does not give you the right to demand the money of other people who did nothing to harm you.
Brad: Isn’t that interesting, we are in the same city; I think my mortgage salespeople experience was a lot different from yours. And several of my friends, which admittedly makes this still anecdotal: I was pretty much told that I’d be a fool to take a fixed-rate mortgage, and I didn’t force the issue until a later re-finance. Also, for what it’s worth, my purchase was a few years earlier than yours.
I shouldn’t have said it was “very hard,” huh. The marketing was very aggressive and… snooty, for lack of a better word. From everywhere; I shopped around, and it was pretty universal. And I was very conservative, price-range-wise.
Thanks for the website, Radley. I am not very economic-savvy and I appreciate a well-articulated article about this whole mess. Now that I understand more about what’s going on, I’m just scared. :(
Oh, well. At least I’m not paying any kind of mortgage. . .hooray for renting an apartment!
I guess my problem with the cheap money argument is that I don’t see why the market couldn’t have adapted in a manner that didn’t invite catastrophic failure later on. It seems like there’s a whole, whole lot that happened between “the government held down interest rates” and “our entire financial sector dissolved over a few foreclosures.”
I was watching something at some point back during the bailout hearings that really stuck with me. It’s not so much that they pushed to lower lending standards, or that banks made a bunch of money on it. The problem lies with the government taking fear out of the equation (although, if I understand it correctly CDSs did the same thing). Fear is the offset for greed. If you remove that offset, greed runs rampant. I mean why not? You have no risk, so why not make these crazy deals.
If the market was allowed to figure itself out, there might be problems like this, but somebody’s always afraid of losing their shirt and finally says “no more.” This didn’t happen due to propping up banks.
Matt D – If you replace money with any other comodity it becomes a lot more clear. Lets use carrots.
There are only a certain number of carrots available, with a small growth rate year to year (let’s assume that carrots don’t go bad). When the carrots begin to become scarce their value will go up relative to other things, like houses. Say a house costs 100,000,000 carrots. When I go into the bank to get a loan for a house I’m asking the bank to lend me 100,000,000 carrots under the condition that I pay them back 200,000,000 carrots over 30 years. If they approve the loan the 100,000,000 carrots are immediately moved from their inventory and are put into the home sellers inventory and ARE NOT REPLACED until I make a bunch of payments on my loan.
The bank stands to double it’s investment over the next 30 years and I’ve got myself a house, we both gain.
As soon as I take out that loan carrots have become more scarce and the price of the next loan becomes higher in reaction. This process continues until the price of carrots becomes too high for the buyer to bear or the bank runs out of carrots. Either way loans stop and the market cools.
The bank needs to save for a bit before it can loan at a reasonable rate or buyers need to save a bit (via production) in order to take less of an interest hit by putting more carrots down to start with.
Step back into our reality… carrots are replaced by infinite pieces of paper produced by some quasi-governmental enterprise for who-knows-what-reasons for who-knows-who’s benefit. The money supply is constantly expanded fueling continued growth based on nothing, no saving, no comodoties, production etc. The cost of money is constantly going down due to the expanding supply so interest rates never rise in response to spending.
I take out the loan but the bank makes the next customer a cheaper deal because there is more money available after my deal is done. Now the bank is in a position to quadruple it’s investment over 30 years while maintaining the same level of risk (even lower if you add in freddie and fanny), who would say no to that? Interest rates get so low that buyers don’t have to produce to save to buy, they only need to show up and sign.
The simple version of the “crisis” is this: The bankers went wild lending money because they came up with a way to sell the actual risk. These “derivatives” were developed because they sold well. The colloquial term for “derivative” is “fraud.” The crisis started because eventually there were no more buyers and the bankers were reduced to trading these “derivatives” amongst themselves. Since everyone knew they were worthless, nobody wanted to be left holding anyone else’s trash. They knew plan “B” was to go to their old friends Paulson and Berneke for a “bailout.” Unfortunately, they fritzed the election for the republicans because they had to act before a probable change in administrations because the new one may not have been as generous. Try checking out what oversight is going on with the bankers and you will see they are actually pulling this mother of all heists off.
Nope, the “better” guide for the un-sophisticated is -
http://www.youtube.com/watch?v=NU6fuFrdCJY
Another desperate attempt to deflect blame from the private sector. Fannie and Freddie were only marginally involved. If they were as important in this crisis as libertarians/right-wingers seem to believe, the whole crisis would have gone away with the conservatorship of those two agencies.
The GSEs had much, much stricter lending standards than private sector lenders and investors. Every dollar lost by AIG, Bear, Lehman, the guarantors, etc. resided on their balance sheet and was not sold to the GSEs.
While the formation of the GSEs may have been folly, placing any more than marginal blame on Fan and Fred for this crisis is just a desperate act to try to deflect blame from the primary culprits in the private sector. Sorry, but its a demonstrable fact that more regulation would have been preferable and probably would have mitigated the crisis.
Not sure but I think I found this link right here in another thread. But it’s for sure a very good look see into what happened.
http://www.portfolio.com/news-markets/national-news/portfolio/2008/11/11/The-End-of-Wall-Streets-Boom?page=0
There is plenty of blame and parts to all of this. What we should be considering is housing those responsible in concentrated and secure housing?
wallster – You’re kidding right? Is that sarcasm? Trying to say that the largest mortgage sellers/holders/dealers on the planet had little to do with a mortgage crisis, any mortgage crisis (no matter who thay are) seems more than a little silly.
And then to say that once Government took control of them the problem would have evaporated is maybe a little more silly, just a little though. Gavernment taking control of something has never solved anything and I would argue that it has never even improved anything.
F+F were/are the mortgage market. These behemoths control the market simply competition. If a bank wishes to compete with F+F they have to have the same or better deals.
I guess you can ignore F+F but you’ll still have to ask… “Where did all the money for these loans come from?” There’s only one answer to that question and it has absolutely nothing to do with the legitimate private sector.
MattD and others seeking to understand, try Mises.org, “Bailout Reader” recommended readings. http://mises.org/story/3128
Many of von Mises’ classics (which are still profoundly true today, nearly a century later) and other great writers of the Austrian School, such as Hazlitt, Rothbard, and Hayek, are available online for download: http://mises.org/literature.aspx
Or start with Henry Hazlitt’s elegant and timeless classic, Economics In One Lesson. Available online at http://jim.com/econ/contents.html
Do not let govt-apologist economists baffle and befuddle you with their pseudoscientific and pseudomathematical BS. You can understand basic economics by understanding Human Action, as described by the Austrian School.
Reasoned-
Are you joking? “Where did all the money for these loans come from?”
Well, you’ve heard of Lehman, right? I think they might have lost some money in mortgage loans. Also, AIG took a bit of a hit. And Bear Stearns. And the guarantor industry. One or two others
Each of these are private sector companies who placed their own capital at risk to write, buy, or insure mortgage loans that were of much lower quality than anything Fannie/Freddie would touch. They made the conscious decision that the risk inherent in these products were worth the expected investment return.
If Fannie and Freddie ‘were the mortgage industry’, and the private sector only got in on it to sell every piece of crap they wrote to the GSEs, then the private sector would have been unscathed by the crisis, and no bailouts beyond the conservatorship of F+F would have been necessary. But those private companies decided to keep risk on their balance sheets that was far more toxic than the stuff the the GSEs would buy!
It is the height of silliness and irresponsibility to blame the horrible business decisions of private industry on the government’s involvement in the GSEs. “Waaaah, we HAD to write subprime zero-down stated income loans because Fannie and Freddie were taking all the 20% down payment business!” But that is what free-market apologists seem to be doing in trying to avoid the realization that the free-market messed up.
wallstr,
You’re completely missing the point. These toxic assets never would have existed if not for the Fed’s artificial depression of rates for so long.
You can bitch all you want about Eve ruining things but you really need to blame the guy who grew the apple.
Dakota, I’m disputing the notion that Fannie and Freddie caused the crisis, somehow forcing private banks and investors to buy/insure/write crap mortgages.
I’m not commenting on the Fed’s actions. I’ll not dispute that they screwed up big time too.