For my MBA students: some scattered links on the current financial problems

I currently teach several sections per year of economics for MBA students. My MBA students are a joy to teach: they are energetic, curious, engaged, and motivated. (And even better, they laugh at my jokes. Most of the time.)

But this term, even before the first midterm exam, there has been some sotto voce grumbling.

Why is he messing around with indifference curves when financial history is being made? When the World As We Know It is Ending?

I know. I'm finally interested in economics and want to learn what's going on, but Newmark's doing . . . other stuff.

My defense, which I plan to offer my students this week, is two-fold:

1. My university has a fine finance faculty--the MBAs will take at least one course in finance--and it seems both proper and efficient to let those folks discuss the issue.

2. It's too early. A lot of what we--economists as well as everybody else--think we know about the current trouble could change depending on what happens in the months and years to come.

But perhaps those are cop-outs. And there is one economics-related aspect of the mess that I am intensely interested in, even if I'm far from the best person to address it.

There will be a huge fight, just as there was about the Great Depression, over whether the current mess was caused by "free markets". The sneering and jeering have already begun: "The Free Market: A False Idol After All?" (Peter S. Goodman, NY Times); "Americans May Be Losing Faith in Free Markets" (Peter G. Gosselin, LA Times); "Capitalism's Reality Check" (E. J. Dionne, Washington Post).

It is hard to overstate how important the outcome of this fight will be for public policy in the United States and throughout the world. And while, as noted, it's early, let me declare my bias: by instinct, training, and experience, I believe free markets work well the vast majority of the time. To coin a phrase, based on one from one of my favorite authors, Ernest Hemingway, "Markets are a fine thing, and worth fighting for."

[Digressive rant: by "free market" I mean the institution as understood by scholars from Adam Smith to Milton Friedman and beyond, not the grotesque caricature offered by some people today.

Don't free markets require at least some laws to operate?

Wouldn't markets utterly collapse without government rules and regulations?

Financial markets in particular have always required a huge amount of regulation to operate. Where's your "free market" now, Monkey Boy?!

Answer: yes, markets usually require some laws and some government. Confidence in free markets does not imply a preference for anarchy. The question, as always, is how many laws and what kinds, and how much government and what kind. Are we clear, now?]

So here are more than two dozen links that I'll use for a projected 15-minute talk to my MBA students that primarily relate to that issue. They advance what seems like sound reasons why, at the very least, government has been heavily involved in creating the problem. I've made no attempt to be complete or "fair". These are just links that I think are interesting or useful or both. They may not even be the best links I've seen recently; they're just ones I could gather quickly on a Sunday morning when I should be doing other things.

Some government-related causes

1. "Anatomy of a Train Wreck: Causes of the Mortgage Meltdown" (Stan Liebowitz). Concise summary (John R. Lott, Jr.).

The federal government has pursued the objective of "increasing homeownership" for a long time. Pursuit of that objective really picked up steam in 1992 after a study by researchers at the Boston Fed supposedly found systematic discrimination by mortgage lenders. But the study was flawed, and the pursuit of the objective was largely misguided. Poorly-chosen government, actions helped cause, therefore, the vast increase in mortgage lending to people who turned out to have trouble repaying, lending that sparked the problem.

2. "The Subprime Mortgage Market Collapse: A Primer on the Causes and Possible Solutions" (Ronald D. Utt).

There would have been less interest in making houses "affordable" if they hadn't been so freakin' expensive in places. Why were they? Amidst much other detail on the history and causes of our current problem, Utt states (pp. 14-15) that local land-use regulations helped propel house prices higher.

3. "Time to Break Up the Credit Rating Cartel" (Mike "Mish" Shedlock).

4. "The subprime turmoil: What’s old, what’s new, and what’s next" (Charles W. Calomiris).

Not only were a lot of lousy mortgages written, they were securitized and "tranches" of the securities were rated investment grade by Standard & Poor's and Moody's. Some of those ratings turned out to be grossly wrong. Why did the ratings agencies fail? Shedlock points to a 1975 SEC mandate that debt be rated by a Nationally Recognized Statistical Rating Organization. The effect, he argues, was to constrain competition in the ratings market and to distort the incentives of the ratings agencies. (Note that Arnold Kling disagrees that that was a cause.) Calomiris points to distorted incentives caused by the Basel I and II capital requirements and to 2005 and 2006 actions by the Congress and the SEC that encouraged ratings inflation.

5. "The Mark to Market Fiasco" (Terence Corcoran, Financial Post).

Attempting to fix a previous alleged debacle of the market , the collapse of Enron, and strongly encouraged by Congress, the FASB adopted "mark to market" rules. Which are probably fine, ordinarily. But what about during extraordinary times, when there is little or no trading, and "market price" is difficult to determine? Might not the rules add gasoline to the fire? Corcoran relates that a number of central bankers warned of potentially serious problems. (Art DeVany agrees the rules contributed to the problem; Daniel Gross sharply disagrees.)

6. "Derivatives and regulation" ("Mindles H. Dreck"). (Via Marginal Revolution.)

No surprise: people respond to incentives.

". . . regulation and/or accounting rules are the most fertile breeding ground for derivatives and synthetic or packaged securities. Regulations and accounting rule-inspired transactions describe the bulk of the well known derivative-related blow-ups of the last two decades. Proscriptive regulation and the derivative trade have a symbiotic relationship. . . .

"Complicated rules encourage complex transactions that seek to conceal or re-shape their true nature. Regulated entities create demand for complex derivatives that substitute proscribed risks for admitted risks. If a new risk is identified and prohibited, the market starts inventing instruments that get around it. There is no end to this process. Regulators have always had this perversely symbiotic relationship with Wall Street. . . .

"Regulations that focus on complete disclosure are much more effective than those that attempt to dictate behavior, and they impose less of a burden on the regulated entity."

7. "Too Few Regulations? No, Just Ineffective Ones" (Tyler Cowen).

Like the piece above, Cowen argues that regulations, themselves, induce a lot of problems. He also notes that "it's not obvious that the less regulated financial sector performed any worse than the highly regulated housing and bank mortgage lending sectors, including, of course, the government-sponsored mortgage agencies."

Not a cause: repeal of Glass-Steagall

8. "Glass Steagall: The Real History" (Alex Tabarrok).

9. "Clear as Glass-Steagall" (Megan McArdle).

The repeal of Glass-Steagall, which separated investment banking and commercial banking, did not play a role. McArdle concludes:

"If Glass-Steagall's repeal had meaningfully contributed to this crisis, we should see the failures concentrated among megabanks where speculation put deposits at risk.  Instead we see the exact opposite:  the failures are among either commercial banks with no significant investment arm (Washington Mutual, Countrywide), or standalone investment banks.  It is the diversified financial institutions that are riding to the rescue."

A warning to fans of excessively big government: what became of Fannie Mae and Freddie Mac

10. "Andrew Cuomo and Fannie and Freddie" (Wayne Barrett, Village Voice[!])

11. "Fannie Mae and the Vast Bipartisan Conspiracy" (Jack Shafer).

12. "How Washington Failed to Rein in Fannie, Freddie" (Binyamin Applebaum and others, Washington Post).

13. "Where Was Senator Dodd?" (Al Hubbard and Noam Neusner).

14. "Freddie Mac and Fannie Mae: An Exit Strategy for the Taxpayer" (Arnold Kling).

Even if--and it seems like a big "if" now--the federal government should have encouraged home ownership, and even if--ditto--Fannie Mae and Freddie Mac were the appropriate means to do so, the two agencies were deeply corrupted by politics. There are many more articles I could have linked to that make the same point. The problems were well-known, but Congress and the agencies simply wouldn't correct them. A fine example of "public choice".

15. Anatole Kaletsky, London Times.

And the government may have converted a problem into the imminent threat of a meltdown by fixing, way overdue, Fannie Mae and Freddie Mac.

“What triggered this change was the US Government's ‘rescue’ of the Fannie Mae and Freddie Mac mortgage companies. This rescue was actually more of an expropriation.”

What is to be done?

16. "Welcome to History" (Jim Manzi).

I like Manzi's conclusion: there are terrible potential problems with past and current government bailouts, as well as with the likely future ones. But sometimes ideology has to be set aside, and we must pick, reluctantly, a bad action over an even worse result.

"Against all of this we have one huge consideration. If investors lose confidence in the safety of money market funds, mutual funds, demand deposit accounts and the other storehouses of value in the modern economy, we would have a problem that would make somewhat higher taxes and moral hazard seem like child’s play. Trust me — you do not want to experience a full-scale bank run in contemporary America."

17. "Why Paulson is Wrong" (Luigi Zingales).

18. "Hindsight regulation" (Megan McArdle).

19. "Modern Financial Systemic Risk: A Primer" (Arnold Kling).

20. "The Real Impact of the Plan" (Michael Mandel).

21. "Why You Should Hate the Treasury Bailout Proposal" (Yves Smith). (Via Marginal Revolution.)

That said, Zingales--Robert C. McCormack Professor of Entrepreneurship and Finance at the U. of Chicago Business School--sharply criticizes what's brewing. The other pieces also look at potential problems. Smith points to a really scary-sounding part of the current proposal.

22. The Subprime Solution (Robert J. Shiller).

I've only read the summary. But it's probably worth reading because it seems as though Shiller has been right about a lot recently.

Finally, we should laugh, at least a little

23. "Top 11 Things That Will Change in the Post 2008 Economy"

Number 1.  Lender of Last Resort: Oprah.

UPDATE: ten additional links are in a later post.

Comments

[Richard]

Craig - a fantastic post. Excellent stuff here.

Richard

[Ryan]

Hey Professor Newmark. I'm in your MBA class, the one who usually sits in the back with the fat Obama sticker plastered on my laptop :-).

I'm glad to hear will be spending some time in class tomorrow talking about this stuff. I worked in the subprime mtg industry for 2 years in San Francisco. This was back in the hey day: 2004-2006, when obscene amounts of money were being made off godawful loans. It was something to be in the middle of that, and it's also a strong reason for why I took an even harder left hand turn in my politics after I graduated.

Having said that, it's a lot of fun to hear an intelligent, conservative, economic perspective. I also want to ask you what your individual take on the bailout plan is. I see that it's been pretty much roundly panned in both the conservative and liberal blogospheres, and I'm pretty certain you have an opinion on it. Hopefully, I'll get to ask you in class.

Cheers,

Ryan

[Ernie]

We should vote this guy into office:

John McCain, campaigning in Scranton this morning, said:

"We cannot have taxpayers footing the bill for bloated golden parachutes like we see in the Lehman Bros. bankruptcy, where the top executives are asking for $2.5 billion in bonuses after they ran the company into the ground."

Earlier in the day McCain was asked if Carly Fiorina, one of McCain's top economic advisors, is an example of the problem. Fiorina was fired as CEO of Hewlett-Packard in 2005 but left with an estimated $45-million severance package while some 20,000 employees were laid off.

"I don't think so," McCain said on NBC's Today. "I think she did a good job as CEO in many respects."

Close enough, pay the lady!

He'll protect future MBA's even when they screw up!

[John Henry]

As an MBA student I took and later taught (once or twice) a course called "Managerial Economics" This covered things such as indifference curves, price optimization and lots more.

Is this the kind of thing you are teaching or is it more straight economics?

[Robert Bell]

Dear Sir,

I would recommend you add Jim Hamilton's post to your reading list:

http://www.econbrowser.com/archives/2008/07/did_fannie_and.html

[kim]

Hello Dr. Newmark,

I am in your 305 class. (I am the woman who constantly asks questions about the latest financial crisis.) I enjoy reading your perspective on this issue. This is the article by Pat Buchanan I mentioned in class today:

http://buchanan.org/blog/2008/09/pjb-the-partys-over/

Kim

[Levi]

Dr. Newmark. Unlike previous commentary I am NOT in your class. In fact I only somehow stumbled onto your page from your wife's article and Lord knows how I got to hers! Between the two of you I've actually begun to understand what happened here, thank you for that. What I still don't understand is why are we even considering bailing out these companies??? Why in the world are we not using this 700 billion to subsidize the mortgage payments of all the low income individuals who not only have subprime interest rates but in many cases are upside down on their houses? This might sound like a stupid question, but I'll tell you I'm only a highschool dropout who happens to own his own company. I succeed in business because I'm ambitous and optimistic, not because I"m super smart. (That's where you come in). Why aren't we letting these companies drop unceremoniously on their ASSES, go under, and let the free market bring in new entities to fill their shoes where the vacuum is created?