Says it all, part 2

"The True Origins of This Financial Crisis". (Peter J. Wallison, American Spectator, Feb. 2009.)

Two narratives seem to be forming to describe the underlying causes of the financial crisis. One, as outlined in a New York Times front-page story on Sunday, December 21, is that President Bush excessively promoted growth in home ownership without sufficiently regulating the banks and other mortgage lenders that made the bad loans. The result was a banking system suffused with junk mortgages, the continuing losses on which are dragging down the banks and the economy. The other narrative is that government policy over many years--particularly the use of the Community Reinvestment Act and Fannie Mae and Freddie Mac to distort the housing credit system-- underlies the current crisis. The stakes in the competing narratives are high. The diagnosis determines the prescription. If the Times diagnosis prevails, the prescription is more regulation of the financial system; if instead government policy is to blame, the prescription is to terminate those government policies that distort mortgage lending.

There really isn’t any question of approach is factually correct: right on the front page of the Times edition of December 21 is a chart that shows the growth of home ownership in the United States since 1990. In 1993 it was 63 percent; by the end of the Clinton administration it was 68 percent. The growth in the Bush administration was about 1 percent. The Times itself reported in 1999 that Fannie Mae and Freddie Mac were under pressure from the Clinton administration to increase lending to minorities and low-income home buyers--a policy that necessarily entailed higher risks. Can there really be a question, other than in the fevered imagination of the Times, where the push to reduce lending standards and boost home ownership came from?

For those keeping score at home, John H. Pilla provides a handy list of some of the key events in the federal government's intervention in the housing market.

Note: I don't think the Fannie Mae/Freddie Mac/CRA influence was enough, by itself, to cause the problem. (For one thing, it doesn't explain the timing.) Like most other big economic/social/political disasters, there are multiple causes. You need a "perfect storm" for things to go this wrong. I'll post a list of links tomorrow or Tuesday of the other key factors: heavy regulaton of land use in some areas, abnormally low interest rates, regulatory arbitrage, the misincentives of the ratings agencies, and mark-to-market accounting. All are connected, at least somewhat, to government.

Comments

[MattYoung]

The third narrative is that if we obviously knew what happened, we would not be in the mess.

Look for something that is right in front of our eyes, but we fail the forest and trees test.

[bjk]

I like the "it's all China's fault" explanation . . . that all the regulation in the world isn't going to stop people from using ultra-cheap money to get rich. If the Chinese had bought US tractors and software instead of recycling the trade deficit in the mortgage market, the bubble never would have happened.

[david foster]

A couple more factors:

1)Too much credibility placed in simple-minded mathematical models of collateralized debt obligations, and on mathematical modeling in general. Business schools overemphasize theory at the expense of tacit knowledge and of experience.

2)Media tends to reinforce whatever trends are going on: if there is a bubble, they are eagerly pumping in air; if there is a recession, they are putting additional nail holes in the tires.

[SSP]

Our financial crisis and our response here reminds me of the story of the little boy and the dike. You know the little boy is walking along and see a leak in the dike and sticks his finger in to block the water flowing in. Except we don't have anyone trying to block the leak or fix it. What we have here, is a bunch of guys running around with different plans on how to bail out the water that's already leaked in. Ok, the flood has hurt the banks, jobs, etc, but rather than fix the root cause, we are trying to alleviate the symptoms, already at the cost of hundreds of billions of dollars, and there is no end in sight. We need to fix the root cause and I have a plan that will do it, fairly, quickly, and one which should stop the massive layoffs and stimulate growth.

Here are the root issues as I see them:

1. Housing started this and has a number of issues
a. There are a ton of adjustable mortgages still out there that will fail, and plenty that are in the process of failing (duh)
b. Credit default swaps and the bad loans are killing the banking sector (duh)
c. Those with good credit are finding it hard to get a mortgage, those with medium credit extremely difficult, and those with damaged credit, almost impossible.
d. If we don't allow those with damaged credit, to rehabilitate themselves in a controlled manner, there will never be enough demand to rescue our housing industry.
e. The lack of liquidity in the credit marketplace has not only destroyed consumer lending, but is now destroying small business and affecting their ability to survive.
f. We need to reduce our consumption of foreign oil. (duh)

The housing issue and the demand or lack of it, has affected all of the following industries: home builders, building supply, manufacturing, the auto industry, banking, credit, etc. If we can fix the housing industry, and create renewed demand for houses, the trickle down effect of this will jump start the economy. If people were buying houses at reasonable prices, creating demand for labor and building supplies, and fiberglass, and wood, and brick, and faucets, and people could go buy cars, the ancillary affects would to stem the layoffs and create growth in our economy. So how do we do it?

We need to allow credit to EVERYONE who can afford it, regardless of past credit history, in a manner that will eliminate the risk of doing so. Sounds like a pretty tough task. How do you give a guy a loan with a history of borrowing money and never paying it back? Well, there is a solution. Rather than spend 800 billion on a government bailout, this is what we should do.

1. Create a government program, that allows anyone with a job to get a new mortgage loan or refinance an existing mortgage loan at a 30 year fixed term with a 4% interest rate.
a. Rather than the normal 28% income to payment ratio, restrict this to 20%, creating affordable payments.
b. Allow for an additional 4% to be added to the principal of this loan, for borrowers to reduce current credit card debt and roll this into the long term mortgage loan.
2. To insure repayment of these new extremely desirable loans and to eliminate any possible fraud REQUIRE the following:
a. All payments will be deducted directly from the borrowers paychecks by the employers as with IRS withholding and paid directly to the US Government.
b. Create massive criminal penalties to anyone abusing this program
c. Allow the IRS to administer the collection of the payments.
3. Create a tax credit of $2000 to anyone buying a car that gets an average of 35 MPG.
4. Allow the purchase of new vehicles under similar conditions as the above mortgage terms with the stipulation that the vehicles purchased meet a minimum fuel economy of 35 MPG.
5. Limit the ability to access and utilize this program to a reasonable but not extended window of time, say 12-18 months to create demand.

Not only does this allow liquidity of credit, create demand and spending, etc, this also reduces the issue of credit swaps, toxic mortgages, etc, as most of those loans are paid off with new lower interest fixed term loans.

[Greg Ransom]

Justabout everything you need to know to explain what happened you can find here:

http://hayekcenter.org/?p=159

(I need more on the quants, anything else?)

At it's core, we have a miscoordination problem across the time structure of production and consumption (i.e. Hayek), with the Fed as the prime cause here (see Taylor).

This was all massively complicated and made far worse by the CRA/Freddie/default swaps/mortgage fraud/banking meltdown.

The housing bubble/default swap issue is PART of the miscoordination of the time structure of production -- both part of what made it bigger, and part of how it was instantiated.

This is a complicated story. But it's not particle physics.

We've got a lot o

[Dave]

Huh. Searched for "securities" (and variations), found one sparse mention.
Searched for "ratings agencies" (and variations), and found 2 sparse mentions.

I'll go with the more obvious answer of the writer having made his money in deregulation, wants to continue deregulation. Strange that he mentions economic incentives for all other groups - but not himself.

I'm shocked by this realization. Next thing you know, we'll find out that partisan comments are desperate to blame problems on everything but themselves.

"Says it all, part 2"
Does nothing of the sort - same old comment, same old bogeymen, an article barely retouched from previous work or dozens of uninformed rants on the internet.
http://www.aei.org/publications/filter.all,pubID.29015/pub_detail.asp

[JorgXMcKie]

So, Dave, regulation like CRA, had nothing at all to do with the problem? Even more regulation would have prevented human cupidity?

What's the color of the sky on your world?

[Dave]

"So, Dave, regulation like CRA, had nothing at all to do with the problem? Even more regulation would have prevented human cupidity?"

Some, yes. Preventing the bond agencies from rating as AAA when they obviously had no idea what was going on. Preventing infinite CDSs from being written without any guarantee on how much money is behind it, causing people to lock up without knowing true exposure. It doesn't at all stop someone the issuance of a NINJ - but it could make sure that it is treated poorly.

CRA caused inefficient allocation of capital, in minor amounts. Nothing approaching what we have.

Take away Fannie/Freddie/CRA - does the problem still happen? Yes, in likely greater amounts, since securitization+passing risk down the line still happens. And they cannot sell to the GSEs.
Take away securitization/bad ratings agencies - does the problem still happen? No, since the banks have to keep much more of the loans outside of the GSEs on their books, and have to face the risk of what they are doing, or at least. In addition to having less money coming in, to inflate the bubble.

"What's the color of the sky on your world?"
Ask anyone if there was efficient (or at least proper) regulation applied to the ratings agencies and securitization, if the problems would be as bad. No one would say yes - at best, you would have people decrying the regulation itself.

This alone tells me my sky is a perfect winter grey, and I am still correct in blaming poor regulation, poor acting government agents, and poor private actors.

More than one thing can be wrong.