I'm so glad that I'm voting with the reality based community this time around.
I interrupt this post to note that thanks to Bill Clinton, millions of people have died of cancer in the last ten years. It seems to me that if he cared, he could have funded research that would have cured cancer. What research? I don't know, I'm not a damn doctor. All I know is, a lot of people are dying of cancer.
Now back to our regularly scheduled programming.
One of my commenters blames Bush for gutting the predatory lending laws at the state level. A wicked pundit would note that this is a project near and dear to the heart of one Senator Joe Biden, (D-MBNA). A less divisive voice would point out that predatory lending laws are aimed mostly at payday loans and credit cards, not housing loans. The fraud problems in the housing market seem mostly to have been perpetuated by mortgage brokers, who are still regulated at the state level. The worst problems are in Democratic-dominated California.
Another comment is such a treasure that I must reproduce it in its entirety:
I disagree strongly with McCardle on this one. In the run up to being admitted as an attorney, I spent one summer at the SEC's division of Market Regulation under Donaldson. I was shocked and appalled at the excessive coddling of industry that was standard operating procedure and consequently chose not to return after law school. And as disturbing as practices were then under Chairman Donaldson, an industry insider appointed by Bush, the situation deteriorated even further after he was pushed out in favor of the ham-handed Republican ex-congressman Cox. The ideology of achieving "small government" by reducing or eliminating regulatory oversight is a pandemic throughout Washington and state government. The current meltdown is a direct consequence of the lack of oversight combined with the effect of Gramm Leach Bliley stripping all remaining profitability out of the basic business of banking, leaving only leveraged speculation as a possible source of income. Much the same can be said about lack of oversight causing the run of crude from $60 to $147 under Wendy Gramm's CFTC -- a surge inexplicable in terms of supply and demand fundamentals but entirely accounted for by the combination of 1) oil traders taking control of Cushing oil storage facilities 2) the subsequent reporting of false inventories 3) profiteering from highly leveraged positions 4) a complete lack of transparency into speculation via massive swap positions with investment banks and 5) an influx of highly leveraged momentum investors.
Of course the best part of all of this is that the cash (please recall all those budget surpluses under Clinton) that might have used to bail us out of this mess has been more than entirely squandered on or embezzled via the the occupation of Iraq. But lacking the funds to manage an orderly resolution of the mess, the entire country will suffer through a prolonged and uncertain period of reduced economic growth (or recession), currency depreciation and attendant inflation, diminished foreign investment, individual anxiety arising from lack of confidence in banks and the FDIC, and depleted international prestige. These effects aren't the consequence of "the invisible hand" they are the consequence of a philosophy of government that derives from the elegant yet fictional universes crafted by the likes of Ayn Rand, Milton Friedman, Myron Scholes, and Robert Merton rather from the reality that the rest of us live in.
I infer that you're proud of your Chicago MBA, but Megan, the paper is worth more as kindling.
This is a first class example of what I like to call "Supertwaddle": thoroughgoing nonsense wrapped up in just enough technical knowledge to be more thoroughly, amusingly wrong than the ordinary twaddle you buy at your local drugstore or neighborhood bar. Sadly, it often sounds very convincing to people who a) have no idea what any of the jargon means and b) badly wish to believe the twaddler.
We start by asking what beefier SEC enforcement was supposed to do to portfolios and banks that were in full legal compliance with the SEC rules until the subprime market collapsed. Aside from standing there with their superdetective tweezers and magnifying glass in hand, clicking their tongues and saying, "That looks like it might be infected. You should get it looked at."
As an aside, we point out that the more lightly regulated hedge fund industry is weathering this storm better than the more heavily regulated banks.
Then we move on to Gramm-Leach-Bliley, bugbear of Glass-Steagall nostalgists everywhere. We first observe that GLB passed under the Clinton Administration. We second note that it passed in 1999, too late to have had any effect on the stock market bubble.
Then we pass into la-la-land, where we try to figure out which of the provisions of Gramm-Leach-Bliley created any of the major contributing factors to the current crisis:
- Steadily rising prices in the housing market
- A flood of foreign capital flowing into US debt markets
- A conviction among ordinary Americans that housing purchases were an easy, and possibly even quick, way to get rich
- A 20 year government committment to ever-expanding homeownership
- A global shift towards increasingly exotic financial instruments for pricing and distributing risk
- Resistance in the Democratic controlled Senate to the Bush administration's 2003 attempt to put some teeth in OFHEO (which regulated Fannie and Freddie)
- Lunatic bankers who confused beta with alpha.
Even more bizarre is his contention about oil. Oil is a fungible commodity priced on world markets. Local regulations have at best extraordinarily trivial effects on its price, unless your government controls a very large source of supply; the traders simply take their business to another exchange. Even the Arab oil embargo of the United States had basically no effect on US prices.
My Chicago MBA may not have taught me everything, but somewhere along the way I did learn not to opine on legal matters based on my one summer as a paralegal.
Brooksfoe, ordinarily one of my favorite commenters, admits he doesn't know enough about finance to get specific, but he's nonetheless very sure that the Bush administration could have stopped this in his tracks. As evidence, he points out that there have been analysts urging Bush to do just that.
Okay, let's explore this. What those people were talking about, by and large, was the easy credit provided by the central bank, over which Bush has no direct control. During both speculative booms, there were people who thought that the markets were in a bubble, and that Greenspan/Bernanke should have acted to shut it down. But prior to the actual crashes, those people were in a minority. The considered opinion of Robert Shiller, probably the greatest living expert on bubbles (and a Democrat) is that any Fed or regulatory action would have had at best marginal effect on the housing bubble--or at least so he told me when I interviewed him.
The problem is that we think we know what to do to pop bubbles. What we know how to do is to make it very, very difficult to borrow money. (The reason I say we think we know is that when foreign capital is involved, it gets complicated--the Fed raised interest rates on margin loans in 1929, but that just attracted more lenders). The problem is, if you do this whenever you might be in a bubble, you will throw a lot of people out of work unnecessarily. And if you wait until it's clear you are in a bubble, you will have to raise interest rates high enough to throw really a lot of people out of work.
At that it might not have worked; there was so much long term capital flowing into the US from abroad, eager to lend to Americans, that it might have required shutting the economy down to reverse the flood. Arguably, our budget deficits actually helped the problem by soaking up some of that excess capital.
At the Federal level, we might have forbidden securitization, or more exotic instruments. But this wasn't even on peoples' radar before the subprime market went sour. The bank regulators could probably have done something to tighten lending standards, but this would have amounted to saying "Don't lend money to poor people". A Democratic congress saying "don't lend money to poor people".
Obviously, in hindsight we wish we had done this. And in hindsight, I wish I'd played the winners at the track last weekend. The things that might have worked were not among the solutions that were being proposed at the time. The only thing a Democrat could obviously have done differently, other than dial the psychic friends' network for economic advice, was appointed a more hawkish Federal Reserve Chair--one who was willing to tolerate higher unemployment in return for lower inflation. That's exactly the opposite of normal Democratic policy direction.
Democrats seem unable, or unwilling to grasp, that to the extent that this is a regulatory problem, the seeds were laid under Clinton, not Bush. There simply haven't been any significant financial regulatory changes over the last eight years that we can point to as the culprit; nor does "stronger enforcement" work as the solution to a crisis when the companies in trouble seem to have been in full compliance with the law.
And these are the good comments. The rest are ordinary twaddle--and not even good twaddle. Stale twaddle that's been sitting around on the back of the shelf for six months.
sometimes you're a mean person.
and by that I mean, I think your guilty of what I called the pundit-expert body slam. Your knowledge of the situation is so much greater than the average person's, you can completely body-slam/humiliate anything a lay person has to say, while not bothering to acknowledge what only peer-experts would notice, which are flaws in your own points.
Do I know what those flaws are? No, I'm a lay person. But I do know that, more often than not, when experts talk to lay-people, they speak as if they are speaking for all experts in their field, and aren't entirely honesty about points of contention in their own arguments.
I think you are spending a lot of time and effort talking to people who won't be able to hear what you mean, regadless of how cogent you are or how clearly you enunciate.
Still, very nice post, I always feel my IQ go up when I read you. Then I go back to work and it dips again.
Hi -
Great post.
If anything, the roots go back further to the 1970s and the creation of the regulations requiring banks to give subprimes: without these, there wouldn't have been any problems. Misguided policy at best: the idea that the rest of loan payers should subsidize loans for people who wouldn't otherwise qualify is a fundamentally bad one, since it means creating an instrument with permanent, built-in risk.
Hindsight is a lovely thing, but fundamentally completely and totally useless unless you are clever enough to understand what the mistakes were. And make sure that you make your own, instead of repeating those of others.
I shall endeavor to use the word "twaddle" in at least one conversation today.
Maybe it's beacuse everyone else is smarter than I am, but I don't understand how so many commenters seem to have a semi-expert opinion on everything, including subjects that one would have to have gone to school for to know much about. I try to avoid commenting on threads about finance and law because I know squat about either, and reading a few articles doesn't get me any closer to being an expert.
Megan,
Great article, as always.
Here's to hoping the gatekeepers at GSB let me have some of that fine Chicago "kindling".
1-2
I haven't read through the comments on the other post, but here was Obama's proposal from mid-2007.
http://andrewsullivan.theatlantic.com/the_daily_dish/2008/03/obamas-prescien.html
It's unclear that it would have solved all the problems, but it recognizes the clear extent of the problem earlier and would have at minimum helped the financial crash happen more gradually, which would have caused less market shocks.
Now I want to flip the question. As a libertarian, I assume Megan doesn't want to see more regulation and probably wants to see less. Do you consider this type of market failure a natural part of an ideal libertarian market or could you suggest things that would have prevented it while sticking to your libertarian beliefs?
The Democrat response is sort of like shouting "fire" in a crowded theatre because someone lit a cigarette. The Republican response is "we have nothing to fear but fear itself."
Panic should not substitute for rational discourse. As others have pointed out, this mess can be traced back to decisions made twenty or thirty years ago under various administrations and with various parties in control of Congress.
It is a bi-partisan screw up which neither party will acknowledge. For every finger pointed at Bush, we could point one at Chris Dodd, Joe Biden, Barney Frank and other enablers. Maybe the only one with clean hands is Ron Paul?
From my reading over the last few months, two items have cropped up time and time again as being the source of problems.
1) Excessive leverage made possible by extremely cheap credit
2) Treating novel financial instruments as low risk and allowing them to be part of the capital reserve of a bank.
Applying specific regulation to various problems does absolutely no good, as the market will come up with ways around each line item regulation faster than the regulators can make new rules. If your regulations force entities to have greater, sounder reserves then any time they do something dumb, they have the resources to bail themselves out of it. Had regulators required that all capital reserves be in cash, t-bills, or bonds issued by entities with the power of taxation, many more banks would be in a sound capital position currently. Limiting the leverage ratio (both for the banks and anyone they lend money to) by law or regulation would have handled the first issue. Neither of these dictate what sort of decisions market actors can make, only the size of the bet they can put down.
Admittedly both those changes would produce a drag on growth, but they would also limit the magnitude of busts.
Stop whining you Big City elitist
Feeling a little defensive, are we?
You completely ignore the vital role of incumbents, which is to take all the credit for what goes right and all the blame for what goes wrong. Then we throw the bastards out and put in new people who will do new things wrong and (hopefully) new things right.
The only policy that I think can even be loosely said to bear any blame is the extended loose-money policy of the Fed. When money's easy, people get it, and once they've got it, it needs somewhere to go.
This, coupled with the fact that the US was the choice destination for foreign capital meant that there were more investment dollars than good investments to put them in. So, by using complicated math, freshly-minted Masters of the Universe convinced themselves that crappy investments were actually sound ones.
Had money been tighter, it seems that the financing which drove much of the foolish lending/borrowing wouldn't have been available.
Tighter money would have had other, negative effects, but could have prevented this. Or at least it seems so to me.
Lunatic bankers who confused beta with alpha.
Ha ha, two favorite blogospheric terms, but here they are not being used in the customary men-scoring-with-women context.
But seriously, I see the housing bubble not so much as an economic phenomenon, but as an example of mass herd psychology, something very, very difficult to stop.
Shorter Sid-
"I don't know why Megan is wrong, I just know she is."
"As an aside, we point out that the more lightly regulated hedge fund industry is weathering this storm better than the more heavily regulated banks." --MM
Thin argument, really. First, hedge fund positions typically are designed to offset, to some significant extent, risk (both market and instrument specific). Hence the name 'hedge.' Second, we're still in the first half of this ballgame. If, for example, AIG goes under, hedge funds could be crushed.
That rings true. But then again, all of our elected politicians from both parties, I believe, had no incentives to do anything to stop any of the bubbles, even if they could have.
As you say, bubbles aren't correctly identified until after the fact. Yet the succession of bubbles inflating and popping in recent years should have given policy makers some cause for concern: The tech bubble was followed by the housing bubble, which was followed by the run on commodities that now seem to be deflating.
For elected officials, though, the risk of taking action to deflate any bubble is the risk of being tarred as the loser who called the police to quiet the raucous party next door. The politician or political party that kills the thrills would be blamed for causing countless individuals for losing their shirts and perhaps their jobs.
Some people feel a need to blame someone when the shit hits the fan. It's childish and medieval, but there are lots of folks who believe that when something goes wrong, it must be the fault of the man at the top.
Good harvest? Must be a good king. Lightning struck the church steeple? The king has displeased God. Credit markets crash? The President is an idiot.
It is no coincidence, of course, that those who blame Bush for the current financial mess weren't too fond of him in the first place. Where will they be if things get worse under Obama, should he win? "Oh, well, you know markets aren't really under the government's control. Let's talk about hope, shall we?"
I would make two points. One is that both McCain and Obama are claiming that they would stand up to corporate bankers etc. and prevent. Two is that it is better for McCain and Obama to claim that they will regulate better than it is for them to argue over who will give people the most tax relief or health care benefits.
That is a great post Megan. You do so much better when you write about stuff you know and stay away from things like city planning or foreign policy.
There is a real upside to all of this. How much wealth and time was spent essentially churning money over and speculating in the real estate market? A lot. That couldn't go on forever. the fallout of this is that housing prices go back to a sane level and a lot of wealth that was being wasted flipping houses and financing subprime mortgages will be redirected into something more productive.
Excellent post. It's also worth noting a major problem with the meme about Republicans and rampant deregulation: The Bush Administration actually signed into law a set of (some have called) onerous financial regulations, Sarbanes-Oxley. Recall that when we still had a functioning IPO market, many market participants and pundits feared that SarBox would drive companies to London to seek capital. The Bush Justice Department also meted out some of the harshest sentences ever for corporate crime in the wake of the Enron and other accounting scandals.
The uncomfortable truth is that there was a bipartisan drive to promote home ownership above all else, even if it meant encouraging lenders to extend to credit to marginal borrowers.
I wonder whether it might ameliorate the situation if the federal government created a $100 billion or $200 billion vulture fund to buy distressed mortgages at significant discounts. If these loans were bought at enough of a discount, and held for several years, the government could probably make a profit on the operation, while putting a floor under the value of the mortgages, as well as the mortgage-backed securities and more complex CDOs derived from them.
The feds could get multiple appraisals on properties with distressed loans against them, and then offer to buy those loans for, say, 50% of the lowest current appraisal value of the property (or 50% of the face amount of the loan, whichever is lower). Write the loan down to, say, 80% of the lower of the current appraisal or face value of note and see if the borrower can make the reduced payments. In either case, commit to holding the loans in the fund for 5 years, and then start gradually liquidating them after the market has stabilized.
These sorts of funds have already been started on a small scale by private sector entrepreneurs, but I'm not sure these entrepreneurs will be able to attract enough capital soon enough to materially affect the broader financial system. A $200 billion fund might be able to do that though, and it would be a better use of government funds than another writing another round of stimulus checks -- and, if done right, it would probably pay for itself within several years.
Yeah, Bush's been president for 8 years, the housing bubble and the drastic overleveraging occurred largely/completely on his watch, but he has no responsibility.
In Connecticut, the housing bubble got started in the late 90s. I know this because I bought a home in 1998, and watched the homes being built around mine (basically the same design) rising in price by over 50% during the next two years. There was brief pause in 2001-2002 (but homes did not fall in price, just stop rising so rapidly), but then the zoom upwards began again in 2003.
The problem was too low interest rates on the short end. The only way to prevent what happened was to have far more hawkish central bankers around the world, not just in the US. They were convinced inflation was low, but did not consider the fact that the inflation was showing up in the assets backing the lending. Once the credit expansion slowed, the support for the asset prices was gone, and they began the return to where they should have been in the absence of the credit boom, but the debt remained.
DD - The Obama submission is a species of "supertwaddle". You simply can not have better (i.e. more restrictive) underwriting and origination procedures without restricting credit and foreclosing on a metric crap-ton of homes.
Many, many people were saying that the existence (never mind proliferation) of NINJA loans was insane. The loan companies were rationally responding to congress' threats if they didn't lend to poor people (i.e. blacks and hispanics in bad neighborhoods). ACORN's business is to cry racism, especially when banks are trying to avoid writing bad loans. Obama is strongly affiliated with ACORN. So the mortgage industry was up a creek without a paddle.
Further, NOTHING done in 2007 could have fixed this. The market was CRASHING in 2007, it just hadn't sunk in as real estate doesn't have the same velocity of information as stocks. If the Dow is down 1000 points one day, everyone knows about it. The housing market might move a few thousand new houses a day across the entire US, so results are at best a monthly phenomenon, if not quarterly. You then need enough data points to see a trend.
The census's new home sales chart http://www.census.gov/const/newressales.pdf shows July 07 with a peak annual rate of 796k sales, with fairly steady declines to 515k in July 08. The iceberg had met the Titanic.
If you wanted to prevent foreclosures, you would have needed to ratchet down lending in the 01-06 period. Require banks to verify income, assets, and source of downpayment while limiting exotic loans to people with net worths greater than 5M (maybe more, doesn't take much for 5M in stock to disappear). If you're not rather well off (and in a few specific situations even if you are) you should be in a 30 year fixed, maybe go for a variable rate, but absolutely no mortgage with balloon payments or teaser rates.
As to what libertarian prescriptions would be? Don't let anyone with any ties to community activism or multicultural groups anywhere near financial regulation. Applying conservative loan policies to everyone, rich and poor, isn't racism. It's prudence and looks after the interests of the banks and the consumers. Anyone that did that was attacked as a racist by groups like ACORN and people like Rangel and Obama.
Responsible loan policies had a "disparate impact" and were thus racist. Fannie had policies about trying to lend to more minorities. This was finance looking solely to achieve political goals, rather than worrying about the security of the mortgage first.
As to how people can have opinions on a bunch of different subjects - have an interesting career trajectory, work in strategy consulting, work in an executive role. You quickly gain experience in many different domains and run into all sorts of problems. Entrepreneurship helps too - you run into legal problems, marketing issues, financing challenges, regulatory obstruction, collusive competitors... An existential challenge to your business gets you to quickly absorb several credits worth of information on a given subject in a few weeks. That's the difference between the 16/7 schedule of an exec and the 5/4 (maybe 3/4) schedule of a college student not in finals.
There is one other elefant in the room; the home mortgage deduction. It is the only tax break available to average people outside of having children. Most people get to a point in their lives, especially after getting married and having two incomes where they simply cannot affort to forgo buying a house. This artificially raises the price of housing and causes people to save less and accumulate their wealth in the form of home equity.
I've thought of economics and weather being similar.
In the past, before the scientific tools were available weather just appeared without warning.
Mostly nice enough but sometimes a hurricane.
Now the government can warn of impending disaster.
Economic disasters used to be the same. However this
weekends storm was no more a surprise than hurricane Ike. Yet nothing was done.
By the way, Google Theodore Roosevelt V wedding.
He got married Saturday. He works for Lehman Bros.
so does his new father-in-law.
They'll be needing a tax credit for retraining I suppose.
Honeymoons over.
I don't find anything about the practice of keeping mortgage debt off the balance sheet. If deregulation creates all these exciting new debt structures, layered and folded until no one seems very clear on who owns what, more transparency would help with letting people know what they're buying. Everyone seems to agree that the banking regulations are outdated; no one was doing anything about it.
I'm with Zbicyclist. Republican message of the week: "Help, help, we're being oppressed by the economy!"
Yancy Ward - notice how I never said she was wrong. In fact, I agree with her, as far as I can understand the situation anyway. I'm a big fan of this blog because I learn a lot in it. My objection was to the tone of the post.
Also I realize I'm floating dangerously close to 'fair and balanced' territory by claiming that there MUST be experts who have an opposing view. For that, I apologize, for it was not my intent.
My only point was that experts in the field wield a big stick, and they should use it judiciously when responding to lay people. It's better for convincing people - if you ridicule someone for being an idiot, chances are you're also going to turn off people who happen to agree with them, even if its only because they didn't know better.
Sid,
I apologize. You did not say she was wrong. I inferred when I should not have.
In Connecticut, the housing bubble got started in the late 90s. I know this because I bought a home in 1998, and watched the homes being built around mine (basically the same design) rising in price by over 50% during the next two years. There was brief pause in 2001-2002 (but homes did not fall in price, just stop rising so rapidly), but then the zoom upwards began again in 2003.
Speaking as a former Connecticut resident, the truly horrifying thing is that Connecticut had been through a housing bubble in the late 1980's, which popped with alarming quickness in 1990 and plunged the state into the Great Recession. Yet the same thing starts up less than a decade later! What is it with people?
If we're taking back to Clinton, I think it be disingenuous not to take it all the way back to Reagan
I don't think you'll find many democrats that were too pleased with the continuation of trickle down economics and deregulation under Clinton....
Megan writes: The fraud problems in the housing market seem mostly to have been perpetuated by mortgage brokers, who are still regulated at the state level.
That's true. However, the big problem was not simply bad mortgage practices, it was bundling the loans and packaging them into tradable securities. Absent the latter, the former bad (sometimes no doubt corrupt and/or illegal) practices would have had a limited, local/regional effect. Securitization enabled loan originators to take a fee for writing a mortgage but to pass on responsibility for it to someone else. Not exactly a recipe for good lending practices, and a function of the vertical de-integration of the mortgage lending business over the past 3 decades or so.
The bundlng and securitization that magnified the problem are regulated at the Federal level, and certainly there were some obvious steps that could have been taken as it became apparent that a dangerous financial bubble was emerging. For instance: better loan documentation requirements for any mortgage included in a securitized bundle, limitations or prohibitions on bundling and securitizing certain types of loans, requiring the originating bank to maintain x per cent of the mortgage on its books etc etc.
At the Federal level, we might have forbidden securitization, or more exotic instruments. But this wasn't even on peoples' radar before the subprime market went sour.
Simply untrue. People have been warning that this was a speculative bubble for several years. It may not have been on the radar for Wall Street and/or it's p.r. spokespeople in the media, but as a casual informed observer (business school professor but this is not my area) I certainly read warnings that this was a dangerous bubble.
I fail to understand how your assertion that "internet competition for trading commissions" made "ordinary banking unprofitable" has any relevance to Lehman's failure. If by "banking" you mean stock brokerage then yes there would be an application to Merrill and Bear Stearns, but Lehman? But I fail to see how internet trading affected many traditional investment banking businesses (e.g., advisory, M&A).
And obviously, the Federal Reserve under the Mr. Greenspan might have used interest rate policy to slow down the mortgage market.
It's unfair to pin all this on the door of the Bush Administration, but color me an old-fashioned cynic for believing that cutting taxes, increasing spending and running up one of history's largest deficits (financed from abroad) just might have something to do with overheating some parts of the economy and the consequent bubbles.
You know Megan you sometimes write very interesting columns, but when criticized you reflexively reach into an arch and condescending dismissal of your critics that often is warrantged neither by the facts nor your superior knowledge of them
Wow, my entire comment reproduced and refuted in its entirety as "supertwaddle" and really I only spent well under 10 minutes reading your article, skimming the other comments, and responding. But in looking at your current post, I note that you apparently do not know the difference between the business of banking and securities brokerage (little surprise as you apparently think that GLB was a good idea) are unaware that the SEC operates multiple divisions and that enforcement is only one of them, and are also apparently unaware that oil is largely traded in the US, in dollars, and under US CFTC regulations. Was it just coincidence that oil began to plummet after the bankruptcy of energy trader/storage facility operator SemGroup?
While I'd like to respond further, I'm a bit busy today as you might expect. Maybe later.
The irony is, I only read your blog because you've had some intelligent things to say about animal welfare in the past. In my google reader you are grouped under Food not Finance.
-Jed
Megan, what do you think of McCain's assertion that this was caused by "greed and corruption on Wall St."? I'm not sure where he gets "corruption" out of all this.
Ms. McArdle says,
At the Federal level, we might have forbidden securitization, or more exotic instruments....Obviously, in hindsight we wish we had done this.
I quail here, because I definitely know less about this stuff than she, but, I'm still not sure that's right. In fact I think it's just a flat unsupported thing to've said. Clearly the financial instruments were hell of complex and the risk models used for them were goofy. But it's still not clear to me that the growth of the derivatives market is such a terrible thing: it seems to me that if people are less enamoured of the thrilling glow of derivates, they do in fact serve to spread out risk and make markets more robust. If there's some reason that that's obviously wrong (as opposed to maybe-but-we're-not-sure wrong, which I concede it is), I'd welcome one of those McArdle smackdowns explaining it to me .
One small correction: Republicans controlled the Senate for the duration of the 108th Congress (2003-2005).
Sid, we're ridiculing partisans who have no clue but are very confident in their opinions. You can't be nice to liberals. This is also a technical subject that not enough people know the history of. Breaking out the clue-by-4(tm) gets some people to shut up long enough to listen.
One of the problems with the concept of "tightening" the money supply is that so much money was coming in from offshore. Usual Fed operations simply didn't work (they tried a bit, there were many odd yield curve situations due to the gusher of foreign money into US markets). The Fed funds rate only matters when there's a rough equilibrium in demand and supply of money. People just ignored what the Fed was doing and used market rates, which were being pushed lower by everyone looking for returns in a safe environment. This is also what led to excessively weak Asian currencies (especially China's) vs the US dollar.
So absent interest rate tinkering, regulators could only have changed capital requirements, LTV issues, verification... These are hard things to change (everyone lobbies like crazy and idiot Congressmen like Barney Frank get involved) and they don't change quickly. It's a process of years, if you're lucky, especially when there isn't a crisis. The process is slow for a reason - changes need to be well thought through and market participants need to get ready for them. Sarb-Ox was written and implemented in haste yet it still took many years to fully implement.
The people who are blaming the current administration simply don't know what they're talking about or are simply mindlessly partisan (usually both). It would be the equivalent of blaming Carter for a lack of innovation in telecommunication. He was president and yet nothing happened - it took 2 decades before cell phones became close to common. You'll try to excuse that by highlighting the decades it took to rewrite telecom laws, but that's just a stale talking point from a discredited administration, as is laying responsibility on Nixon, Johnson, Kennedy, and Eisenhower.
I'm a computer programmer. I don't know anything about the causes of our latest problems. What I do know is, during the many years I produced business software, I worked with managers in many industries; e.g., retail, wholesale, manufacturing, finance, banking. My consistent impression of the folks in the finance and banking industry is that they were a bunch of dim bulbs, compared to the ones in the other industries. My assumption has always been that they were rich kids who got the jobs because of daddy's connections; they certainly didn't earn them.
So, when I read that these "geniuses" had been buying pieces of packages of mortgages without any idea of what was in them, I wasn't surprised.
Hey (9:38AM),
I don't think anything done in 2007 could have prevented the crash. The question is whether anything could have been done to smooth the decline and decrease the long-term damage. Obama was primarily proposing high level meetings and publicity of the issues with some potential policy guidelines, but no specific policies.
This didn't happen. What might have happened with a bit more attention? Here's an example:
http://www.nytimes.com/2008/09/16/business/16nocera.html?hp=&pagewanted=all
Take Richard Fuld, the chief executive of Lehman Brothers. Last summer, as the credit crisis first gripped Wall Street, Mr. Fuld’s firm, which was fundamentally a bond-trading firm, concluded that the problems would be short-lived — and that those firms willing to take big risks would be the ones that would reap the big rewards once things calmed down. So Lehman doubled down on mortgage-backed derivatives.
I think that more empirical data on the scope of the problems in Summer 2007 could have prevented Lehman Brothers from making the bad investments that bankrupted them. This is all armchair quarterbacking, but the simple fact is that the current administration did virtually nothing in terms of public fact-finding, increased oversight, or increased regulations. It's very hard to argue that nothing could have prevented the events from being as bad as they are today.
Why do ordinary people believe this stuff? Just look at this morning’s top headline on the NYT:
Wall St. in Worst Loss Since ’01 Despite Reassurances by Bush
Forget that it’s misleading with regard to the story; a glimpse of that on their way through Starbucks is more than enough evidence for those who’d like to believe.
I am very discouraged after reading the comments to your excellent post. The majority of the comments appear to be driven only by one factor: what is the party affiliation of the correspondent. Have we lost our ability to collect and analyze data? Are we as a nation doomed to make all of our decisions based on preconceptions and damaged philosophies that ignore reality? I ask everyone to read Scott Adams' Dilbert Blog to see the results of his survey of economists. It does nothing more than illustrate that economists conform to their own political philosophies. There are more economists registered as democrats. The majority of economists favor the Obama platform. It provides no more information than we had before the survey was performed. So sad.
Supertwaddle olympics! Jed, again, in what way did GLB cause this drop in profits? And if GLB is at fault, how come all the problems are occurring in standalone banks? I could have cited a half-dozen other things, like decimalization. Still none of which had anything to do with GLB.
Yes, obviously the SEC operates multiple divisions. Which division was it that was going to tell banks with perfectly adequate balance sheets to stop what they were doing?
As for oil, you seem to think that this is some sort of a law of nature, rather than a historical artifact. Oil does not have to be traded in US dollars, or on US exchanges.
Ok, I know squat about economics. But I do know that Bush and Cheney have said deficits don't matter. Debt is good...That thinking filters down through society to mean buy, buy buy even though you don't have any money.
How bout Bush is physiologically responsible?
One thing?
I think you answered this yourself, yes, with this observation:
"This crisis can be seen as a failure to adequately regulate new financial products that came out of the revolution in financial theory that took place in the late 20th century."
There have been plenty of voices over the years warning about the rather "uncontrolled" (rather than "unregulated) growth in these new risk management products.
That hiatus should have been proactively stopped, even if on a phased approach.
Separately, the end of lending-at-a-spread, the traditional way to make money while lending, especially in the mortgage market, should have been aggressively questioned.
This has nothing to do with a "20 year policy supporting home ownership", but with an unregulated and foolish approach to selling loans, right (through 'mortgage brokers')?
Looks like building up roads and bridges can solve the financial crisis http://www.cnbc.com/id/15840232?video=857802595&play=1 ...
I do know that Bush and Cheney have said deficits don't matter. Debt is good
They did no such thing.
TheAce:
So do they? "They do," Cheney answers with his trademark terseness. "The [deficit] conversation, as I recall, was in a political context. But deficits, if you're going to look at deficits - and you should - you've got to evaluate them relative to other priorities. Another priority, for example, would be defending the nation in wartime. And you need to look at deficits relative to the total size of the economy, which oftentimes we don't do."
the second quote is from late 2007, the first one is from 2004. These are not from transcripts, so feel free to deny that he said what he's quoted as saying. But if you believe that he's being quoted accurately here, then it's hard to deny that Cheney did not take the issue of the deficit particularly seriously.
source:
http://www.cbsnews.com/stories/2004/01/09/60minutes/main592330.shtml
"Don't know much about the economy" McCain is sounding a lot more informed on this crisis than Obama:
"think you have to [let AIG fail], but I also know that there are great efforts being made to try to raise sufficient capital to keep AIG in business"
"the moral-hazard issue is something that we have to take head-on"
"There is a risk of overregulation and overreacting. Congress has a tendency to do that, but to say this is just a blip on the radar -- this is serious."
"This isn't just going to cost jobs on Wall Street, this is going to cost jobs all over America"
None of this is particularly profound, but it is far more substantive than Obama's finger-pointing and demagoguing. McCain's comments show some understanding that government didn't create this problem on its own, and it can't be expected to fix it on its own. The system will get purged, and in the meantime we'll just have to suck it up and weather the storm.
If the Dems succeed in bringing the debate back to economic issues, Obama is going to have to do a lot better than mindlessly invoking the mantra "Yes we can", which is no more effective than trying to pray the problem away.
Most people get to a point in their lives, especially after getting married and having two incomes where they simply cannot affort to forgo buying a house.
I've thoroughly debunked the myth of this deduction as well. It helps people who are wealthier, and those that buy expensive houses. However, for the median level house/income earner it does very little. It certainly isn't the big deduction everyone thinks it is, when you factor in the loss of the standard deduction (over $10,000 for married couples). I'm not trying to make a point about the "rich getting tax breaks" I'm just saying that only a minority of people get to a point in their lives where they will see a large mortgage interest deduction.
I wonder whether it might ameliorate the situation if the federal government created a $100 billion or $200 billion vulture fund to buy distressed mortgages at significant discounts.
There are plenty of people who will indirectly buy those mortgages through the foreclosure and REO process if we allow it to happen. The problem is that house prices are still too high for most people to qualify under classic underwriting standards. If the government is going to buy them at 50% value, why not just have the banks sell them to individuals at that price? Anything marked down that heavily isn't staying on the market very long.
Democrats seem unable, or unwilling to grasp, that to the extent that this is a regulatory problem, the seeds were laid under Clinton, not Bush. There simply haven't been any significant financial regulatory changes over the last eight years that we can point to as the culprit
By what stretch of logic does "the seeds to the regulatory problem were laid out under Clinton (and earlier) and untouched by Bush's appointees over 8 years" come around to "so nothing can be blamed on the Republicans, even though they were in charge of everything as this unscrolled"?
I'm not particularly defending Democrats (I'm an independent, though amongst those who can't stand Bush) but this is sounding Katrina-like: DISASTER STRIKES! And we want you to know it is not our fault, even though we've been in charge! Not our fault! Everything is Bill Clinton's fault! Nothing we could have done, in the sense that we did nothing for 8 years as this unfolded.
The approach to this has been "bail out one, hope that stops things" when we needed a deeper, smarter "Bear Stearns is a massive wakeup call, and here's how we propose to reform our banking regulations to catch up to the 21st century."
So, sure, to the extent that some people at Kos will be on about "yet another thing happened and this shows why Bush is mean and dumb," it's a silly argument. Unfortunately "Bush did nothing for 8 years and so it is NOT his fault" is equally silly.
I do know that Bush and Cheney have said deficits don't matter. Debt is good
They did no such thing.
Posted by The Ace | September 16, 2008 10:42 AM,
Unless O'Neill is a liar, Cheney said exactly that.
"Former Treasury Secretary Paul O'Neill was told "deficits don't matter" when he warned of a looming fiscal crisis.
O'Neill, fired in a shakeup of Bush's economic team in December 2002, raised objections to a new round of tax cuts and said the president balked at his more aggressive plan to combat corporate crime after a string of accounting scandals because of opposition from "the corporate crowd," a key constituency.
O'Neill said he tried to warn Vice President Dick Cheney that growing budget deficits-expected to top $500 billion this fiscal year alone-posed a threat to the economy. Cheney cut him off. "You know, Paul, Reagan proved deficits don't matter," he said, according to excerpts. Cheney continued: "We won the midterms (congressional elections). This is our due." A month later, Cheney told the Treasury secretary he was fired."
Full disclosure: I have no background in or sophisticated knowledge of financial markets. I'm sure I will get ripped a new one here, but nonetheless:
It seems almost too cynical that the "conservatives" are bleating here in the comments about how "you made us give loans to black people, and look what happened!" ('Hey' is most explicit in this regard.)
Again, I'm a layperson, but everything I've read about this situation indicates it was the bundling and repackaging of these "bad loans" as CDOs (collateralized debt obligation - I just looked that up!) that lead to the massive scope of the crisis. I find it hard from my layperson's perspective to rationalize laying this entire calamity at the feet of those original bad loans when the spirals of repackaging and profiteering that piled on top of them are really what appears to be dragging the whole damn contraption to the ground.
I think you'll also have a hard time convincing me anyone "forced" financial institutions into making these loans. Pressure from "ACORN" seems to me a laughable root cause.
I imagine there is enough blame to go around. Government (Democrats and Republicans), Corporate Interests, and of course each and every one of us.
1. Instead of less regulation or more regulation, why don't we start with effective regulation and go from there.
2. There is no sense to rush and lock the barn door after the horse has already knocked over a lamp and burned it down. Lets take our time and do some meaningful reform rather than end up with Sarbanes Oxley.
3. Is it possible to go the next 3 days without the candidates saying anything. I'm tired of it today.
My consistent impression of the folks in the finance and banking industry is that they were a bunch of dim bulbs, compared to the ones in the other industries. My assumption has always been that they were rich kids who got the jobs because of daddy's connections; they certainly didn't earn them.
Seriously. For the number of times that the phrase "the smartest guy in the room" appears in the descriptions of top financiers, they're a bit thick.
"As an aside, we point out that the more lightly regulated hedge fund industry is weathering this storm better than the more heavily regulated banks." --MM
Har-D-Har. You just haven't heard about it yet. I manage a HF -- no leverage; mostly short at the moment -- so we're doing okay, but there's blood everywhere else I look. Most of my pals/acquaintances have been leveraged to the eyeballs for the past several years, and they're toast now.
Educated guess: by year end ~20% of hedge funds will be gone, and the majority of those still standing will be WAY underwater.
ps: since the Republicans always and everywhere relentlessly push the deregulation of everything and oversight of nothing, it shouldn't surprise you that people blame them, rightly or not, when things blow up.
Unless O'Neill is a liar, Cheney said exactly that.
Nice.
No link to the one sided account of course.
since the Republicans always and everywhere relentlessly push the deregulation of everything and oversight of nothing,
Hysterical.
You can't cite a single instance of any elected Republican doing any such thing.
Or do you mean "oversight of nothing" like this?
In October 1992, a brief debate unfolded on the floor of the House of Representatives over a bill to create a new regulator for Fannie Mae and Freddie Mac. On one side stood Jim Leach, an Iowa Republican concerned that Congress was "hamstringing" this new regulator at the behest of the companies.
He warned that the two companies were changing "from being agencies of the public at large to money machines for the stockholding few."
On the other side stood Barney Frank, a Massachusetts Democrat who said the companies served a public purpose. They were in the business of lowering the price of mortgage loans.
Congress chose to create a weak regulator, the Office of Federal Housing Enterprise Oversight. The agency was required to get its budget approved by Congress, while agencies that regulated banks set their own budgets. That gave congressional allies an easy way to exert pressure.
Link
You want to take a guess as to who controlled Congress in 1992?
This is a first class example of what I like to call "Supertwaddle": thoroughgoing nonsense wrapped up in just enough technical knowledge to be more thoroughly, amusingly wrong than the ordinary twaddle you buy at your local drugstore or neighborhood bar.
This is a good description of Megan's writing.
As an aside, we point out that the more lightly regulated hedge fund industry is weathering this storm better than the more heavily regulated banks.
This is so far off it's not even wrong. The statement betrays a total ignorance of how tightly hedge funds and I-banks are interrelated, not to mention eliding the difference between the regulation of traditional banks (extensive) and I-banks (minimal). Considering the I-bank/hedge fund nexus was the key generator of the "toxic waste" that is now polluting the entire world financial system, it's pretty incredible to see a self-described "econblogger" saying something like this.
Anyway, of course the Bush administration could have stopped this. The Fed could have stopped this. It was obvious what was happening (read Dean Baker and Nouriel Roubini for the past couple of years).
But this is a failure that goes way beyond the Bush administration. It goes to the neoliberal market orthodoxy that has become an unquestioned article of faith among our privileged classes since the early 90s. (This blog is a just one minor example of what happens as that orthodoxy congeals into knee-jerk propaganda that replaces thought). We have regulators who not only didn't regulate, but don't even understand the assets on the balance sheets of some of our most important financial institutions. Why? Because if the free market generated those assets, it all must be OK.
As a sentimental Democrat, I like to think the Clinton administration would have done a better job here. At a minimum, not invading Iraq and not putting in massive tax cut cuts for the wealthy would have left the Federal government in a somewhat better fiscal position to step into the liquidity gap without completely tanking the dollar and fueling inflation.
But on the regulation end, it's really hard to argue that an administration that didn't do anything about the dot-com bubble would have done something about the credit bubble, which was more complex. I suppose there's a small chance they would have been more sympathetic to regulating hedge funds, but in general they would have deferred to Greenspan and the Fed. Both the Republicans and the Democrats have become basically market orthodox parties, except that the Democrats are more willing to redistribute the wealth generated by the market. Neither party was open to the idea that markets could fail on this scale.
I have made the following point many times here and elsewhere:
The problem was not the regulations, it was the overly cheap credit at the short end. This credit expansion was a deliberate policy of the central banks, and certainly done at the prodding and with the aquiescence of every government around the globe- no politician in any party anywhere likes recessions or economic slowdowns- they prefer booms, as do most ordinary people. To have emplaced regulations that limited this flood of cheap credit would have been at cross-purposes to the goal of the credit expansion itself. You would not have needed increased vigilance on loan standards/methods if you did not have a flood of credit looking to be lent long.
Ace (and others), Fannie and Freddie were much more victims than generators of this crisis. So whether or not they corrupted Barney Frank is not relevant to the question of how the crisis happened. (I actually agree with you on Democrats being too soft on F/F, but that was not the driver of this thing).
You can't cite a single instance of any elected Republican doing any such thing.
No one can find a single instance of a Republican weakening regulation or pushing deregulation? You know, I think you might be wrong about that.
One Chicago MBA to another: I accuse you of ultra-twaddle!
Defined as thoroughgoing nonsense wrapped up in just enough technical knowledge to be more thoroughly, amusingly wrong than the ordinary blog commenter.
I particularly enjoyed this nugget: "As an aside, we point out that the more lightly regulated hedge fund industry is weathering this storm better than the more heavily regulated banks."
Well, as an aside, the lowly I wonders how you know this. Are the hedge funds sharing their balance sheets with you? Seems like good information to have. I'd keep that under wraps.
No, dear Megan, leadership matters. Ideology matters. Even ideas matter. The combination of weak leadership, loony ideology, and poor ideas did not conceive the current crisis, but certainly nurtured it.
Megan,
There was an OCC regulation implemented in 2003 (I believe) that forbid states from regulating local subsidiaries of national banks in the mortgage market. In other words, all the state protections passed to curb predatory lending became null.
The regulation was upheld by a 5-4 vote of the Supreme Court in Watters v. Wachovia (and it produced a very strange split amongst the court). However, the OCC is an executive agency under the department of the treasury; and all the evidence surrounding its implementation points to lobbying the Bush administration.
And yes, I do have a law degree.
This credit expansion was a deliberate policy of the central banks, and certainly done at the prodding and with the aquiescence of every government around the globe- no politician in any party anywhere likes recessions or economic slowdowns- they prefer booms, as do most ordinary people. To have emplaced regulations that limited this flood of cheap credit would have been at cross-purposes to the goal of the credit expansion itself. You would not have needed increased vigilance on loan standards/methods if you did not have a flood of credit looking to be lent long.
There's also a lot of truth to this. Certainly this whole thing can't be understood without making note of the concerted effort by the Fed to juice the economy through cheap credit, and the deep desire by politicians of all stripes to keep the consumption binge that started in the late 90s going. Someone who was a real Austrian / Ron Paul type who wanted to tag central banks could probably more effectively make hay with this crisis than either a current Democrat or Republican. However, a semi-socialist could also argue that if you want/need to pump demand into the system, it's better to do it through something like democratically overseen public works than through massive infusions of cheap central bank credit to unaccountable parties motivated by private profit.
I don't fully agree with either ideology, but what we are seeing now is a big challenge to current orthodoxies.
A Democratic congress saying "don't lend money to poor people".
You keep saying this, as if "make loans that will never be repaid" were a liberal principle.
So like so many commenters, I know nothing about this and have to take what you're saying on blind faith. That said, could you do a post on what Obama's proposing to do (if he really has any particular proposals) and why you think it won't work?
Blame Clinton for current financial crisis? Of course! Because in addition to anything Bill might or might not have done, he put in extra special rules that said absolutely nothing could ever be changed. What was Bush to do? His hands were tied!!! The poor guy!!!
MQ,
I think you are going to see the semi-socialist approach- the exact one used in Japan during the 90s (Biden explicitly promised this on CNBC in the link GinNTonic posted above), but in a country without the private savings to finance any of it. The dollar is going to die. Rather than let the debt come to the government second hand through bailout after bailout, it will just accumulate it all directly.
No one can find a single instance of a Republican weakening regulation or pushing deregulation?
You can't find a single instance of any elected Republican saying they want oversight of nothing and deregulation of everything.
Prove me wrong.
I dare you.
McArdle's "smackdown" is a house of cards completely exposed by Deborah, in the thread above.
I know I've been reading folks like Bonddad predicting this mess for a long time, and explaining how and why it was developing.
Republicans have controlled everything for 6 of the past 8 years (and the house since 1994), and still control all the key regulatory functions. To the extent there's been a failure of regulatory functions, they own it - even if some democrats were part of the problem in 1999.
Why are republicans the "no responsibility" party these days?
Ace (and others), Fannie and Freddie were much more victims than generators of this crisis
The government was and is the generator of this crisis.
Example:
Once, a high-ranking Democrat telephoned executives and screamed at them to purchase more loans from low-income borrowers, according to a Congressional source.
Link
Example:
Eager to put more low-income and minority families into their own homes, the agency required that two government-chartered mortgage finance firms purchase far more "affordable" loans made to these borrowers. HUD stuck with an outdated policy that allowed Freddie Mac and Fannie Mae to count billions of dollars they invested in subprime loans as a public good that would foster affordable housing.
Link
Republicans have controlled everything for 6 of the past 8 years (and the house since 1994), and still control all the key regulatory functions
Except you can't explain how "regulations" could have prevented it.
You say that as if "make loans that will never be repaid" were a business principle. If people had known the loans weren't going to be repaid, they wouldn't have made them. If the Democrats had known the loans were going to get poor people into trouble, they wouldn't have pushed for them. The ignorance was widespread.
Nick: again, there is no evidence that this actually had much effect. The problems were at the state regulatory level with the mortgage brokers, not the national level, and moreover it's not clear how many, if any, of these loans would have violated predatory lending laws, which tend to focus on things like interest rates, no? Furthermore, my understanding from talking to people from various regulatory bodies is that the states that were most affected by the nationalization of loan regulation are not the same as the states that had the worst problems; New York is a notorious loan regulator, yet has had relatively few problems.
WE: Obviously, we have had big hedge fund failures, and may well have more--you don't know and neither do I. What we do know is that the hedge fund industry is not lined up at the discount window asking for a bailout, and the banking industry is.
As for the idea that Bush caused this crisis by somehow manipulating the zeitgeist, this is a cheap way of trying to pin blame where you lack evidence.
Many commenters bizarrely seem to believe that the commercial banks haven't been touched by this. Plenty of commercial banks *are* failing as a result of this mess. The difference is, we have an orderly procedure for winding them down, so the contagion isn't systemic. Regulation is not a panacea.
I enjoyed reading this post, and there should be a lot more debate about the repeal of the Glass-Steagall Act by the Clinton Administration.
Ms. McArdle writes: "Democrats seem unable, or unwilling to grasp, that to the extent that this is a regulatory problem, the seeds were laid under Clinton, not Bush."
If Democrats don't grasp the regulatory issues, then how have Republicans responded in a more responsible way?
Megan McArdle: " The bank regulators could probably have done something to tighten lending standards, but this would have amounted to saying 'Don't lend money to poor people.'"
I disagree-- it is tantamount to saying: "Don't lend money to people who aren't able to repay it." Imagine that idea! Since the regulatory framework wasn't fit to discipline lenders, it was left to the forces of the market. I think we can agree everyone has been suitably disciplined. And, guess what-- banks aren't lending to poor people, and we are all worse off than we would be if proper lending standards had been applied in the first place.
The implication here is that all of this regulation is really hard. How many times have we heard this bit from the Bush administration? All of these things-- fighting a war, terrorism, the economy-- it's really hard.
Megan McArdle: "The problem is that we think we know what to do to pop bubbles. What we know how to do is to make it very, very difficult to borrow money."
Manipulating the interest rate is not the only way to affect the economy. The housing bubble was influenced by a wide variety of institutions: banks, mortgage brokers, real-estate agencies, property appraisers, etc. All of the involved institutions function within a regulatory framework, that, needless to say, could have been tightened. Lawmakers have direct control over many of these areas. Lawmakers know how to pop bubbles-- they simply have ZERO political incentives to do so, a point that has been sorely missed. Of course, there are long-term interests, etc., but we all know that politics is traditionally a short-term game. Unfortunately, it's easier (and more heroic) to clean up broken dishes than to keep the party from getting out of hand.
Blame is not really the main issue, but will become the main issue if the economic problems that are now very apparent are not handled appropriately. Debate about which course to choose is important. But, the "it's really hard stuff" line of reasoning is getting old, and it accomplishes nothing.
So whether or not they corrupted Barney Frank is not relevant to the question of how the crisis happened.
Are you somehow suggesting what has happened at Fannie is not related to what happened with Lehman?
That the subprime mortgage mess did not hurt Lehman?
So banks that survived the Great Depression (like Lehman and Bear) have disappeared. The worlds' biggest insurer is about to. The subprime mess has already made the S&L crisis look like a joke. There is rampant fear that the mortgage crisis is going to start hitting the A grade mortgages (for those with great credit scores that weren't required to verify income), which are supposed to be the safe MBSs and CDOs (or at least the safe bucket). This whole thing is coming unhinged. And we're supposed to believe that none of this is the result of "conservative" fiscal and monetary policy? Really? This has nothing to do with staffing every government agency with individuals whose views are directly contrary to the goals of the agency? Not to go all "wrecking crew" on you, but c'mon. Things are broken. The tech bubble didn't wipe out the entire iBanking industry. Does anyone really think more than a handful of the iBanks are going to make it through this? What's really great is that some of these iBanks are getting plugged back into the commercial banks. Hey what a great source of liquidity . . . all of our savings. What could go wrong there? To say that when the Market fails the Republicans cannot be blamed is ridiculous. They are the party of unfettered markets. They don't deny this. Generally I think this is the right philosophy, but it only works if you let the market operate honestly, not tip the scales and turn a blind eye toward corruption. It's like the Republicans mantra of privitization. Good in theory, terrible in practice. It'd be fine if opened up to the competitive market, but instead it become simply a wealth distribution engine, due to no-bid contracts and no oversight. A f*cking free for all. But nobody gives a shit. At least if everything just comes apart at the seams not even the greedy masters of the universe will make it through.
Who is to blame? Us economists, of course. We knew for years there was a problem, but were too slow in analysing it to offer useful policy options convincingly in time to do any good. No use blaming bankers and politicans - as always, their ideas were formed by economists; and so they did not have a clue about how do manage the economy better than they did.
Things are improving. It is no longer true to say that "Men of affairs are slaves to dead economists". Maybe next time round economists with the benefit of electronic publishing will actually get the analysis done in time to say accurately what has just gone monumentally wrong.
As for what we do now, I suggest looking first at the places where things have not gone as bad as might have been expected. Hedge funds are one case. Living in Spain, which was widely expected to be very vulnerable to a financial crisis, I suggest also looking at what the Bank of Spain did different: insisting on capital to match off-balance-sheet activities, and insisting on provisioning of loans in expectation of a cyclical rise in bad debts. I hope others will be able to suggest other useful case studies in disasters that did not happen (or at least did not fully develop).
And, it seems to me that the other point that's missing here is that the mortgage backed securities and CDOs were designed to hedge much of the risk internally. By having dozens of different buckets, they were designed to incorporate the risk profile of the loans that made them up. Those of you saying the problem is that the poors couldn't pay their mortgages have missed the scope of this problem. That would have only wiped out the more risky series of these derivatives. But that's not what happened. Nobody was getting paid, the entire thing failed. Now, part of the blame lies with the ratings agencies, who were in bed with the iBanks, but even that doesn't fully explain what went wrong.
You know, the funny thing is that when these MBSs and CDOs were new, the reason they were thought to be risky was that people would pay off their mortgages ahead of schedule. Haha. Priceless. F*ck.
I never thought any group of people could be more condescending than lawyers, and then I had some exposure to economists and I changed my mind.
I don't have Ph. D. in economics but I do know that people have been complaining about the housing bubble/credit market for years. Those complaints went unheeded by the person who had the greatest ability to address those concerns, the President.
If, as you suggest, Clinton had the ability to create this regulatory problem then Bush had the ability to fix it.
Shorter Megan: She voted for Bush, and she's wicked smart, so there's no way he could have done anything at any point that could have ameliorated the current situation. Anyone that thinks otherwise is an idiot. The buck stopped stopping in the Oval Office once Clinton left.
Got it.
Okay, let's explore this. What those people were talking about, by and large, was the easy credit provided by the central bank, over which Bush has no direct control.
Let's return to what Obama said. We are talking about a philosophy. Alan Greenspan is a more central figure in the market purist philosophy that animates the Republican party than George Bush is. The key moments here were in 1996, when Greenspan apparently recognized that a bubble was forming but decided that he should neither do anything about it nor should he even speak in a rhetorical framework that admitted the possibility of bubbles; and in...what, 2003? when he encouraged the American people to take advantage of ARMs to refinance their houses and go further into consumer debt.
During both speculative booms, there were people who thought that the markets were in a bubble, and that Greenspan/Bernanke should have acted to shut it down. But prior to the actual crashes, those people were in a minority....The problem is that we think we know what to do to pop bubbles. What we know how to do is to make it very, very difficult to borrow money. (The reason I say we think we know is that when foreign capital is involved, it gets complicated--the Fed raised interest rates on margin loans in 1929, but that just attracted more lenders). The problem is, if you do this whenever you might be in a bubble, you will throw a lot of people out of work unnecessarily. And if you wait until it's clear you are in a bubble, you will have to raise interest rates high enough to throw really a lot of people out of work.
I am going to have to organize my thoughts more clearly on this, but I think you are thinking about this wrongly because you are thinking about it too narrowly. You don't seem to recognize the intellectual or behavioral connection between the Efficient Markets Hypothesis and the formation of bubbles. You don't seem to recognize the fairly simple way in which ideas Greenspan embraces and propounds have also formed the governing philosophy of the Bush administration and have also been the vulgar-economic intellectual furniture that drove all those Americans who were buying houses as investments and driving up prices. The belief that markets are always right, or always righter than you are, is naturally going to lead to the formation of bubbles. Markets in which people do not believe there is any such thing as an underlying value of the equities traded, or where the underlying value is unknowable, tend to be volatile, as any Shanghai trader in shares of companies with utterly opaque bookkeeping practices will tell you.
I admit it: I report on the market here every other day, but I never report anything but a sampling of what authoritative sources tell me, because I don't have the background to assess these things on my own. Fortunately I'm in a country where these things aren't very complicated yet, or where the ways in which they are complicated are so opaque that in fact no one knows what's going on. But here's the thing: I always agreed with the economists who worried about the bubbles and said we shouldn't be encouraging them. Perhaps this is simply a statement about my pessimistic worry-wart apocalyptic character. But you can hardly be surprised that, now that the bubbles are proving to be really, really dangerous, I would have a general sense that the economists I had a hunch were right 5 and 10 years ago must in fact have been right, and that I should now be listening to what they're saying, and not what you're saying.
You wrote, "thanks to Bill Clinton, millions of people have died of cancer in the last ten years. It seems to me that if he cared, he could have funded research that would have cured cancer. What research? I don't know, I'm not a damn doctor. All I know is, a lot of people are dying of cancer."
But remember, thanks to Bush more than 4000 soldiers are dead for lying us into a war that was based on deception.
You sound cynical at best, if you want to be taken seriously breath before you steam out.
A few thoughts and questions re: "should-a would-a" regulatory steps.
(1) The continued cutting of interest rates: Greenspan's legacy is his belief that an economy can be freed up, and fired up, by making money more accessible to consumers. He lowered interest rates, promulgated (directly or indirectly) the function of Fannie and Freddie, and created an environment where banks could create loan instruments that appeal to consumers at first glance. Yes, we got the 30-yr fixed out of it, but we did also get ARM's. So here're the questions - could a regulatory body (oh, let's say the Fed, for kicks) not have understood that this strategy may very well create a bubble, driving up housing demand, as well as creating an untenable lending situation where banks are incentivized to create ever more exotic loan products? Didn't Greenspan's deregulatory philosophy have a significant contribution to what we're dealing with today?
(2) The securitization of mortgages: The ongoing philosophy was that by securitizing these banks' mortgage assets, splicing them up and selling them off into the capital markets, you could diversify enough to even out the risk. What happened, of course, was the creation of untraceable assets that eventually turned bad, and a fundamental inability to accurately track and report on risk. The result? A monkey on the backs of the financial services industry in the hundreds of billions, financial reportings that investors don't even trust, and a real problem on some of the biggest balance sheets on Earth. Questions: Could the SEC not have taken a closer look at the securitization of the more exotic mortgage instruments? Mortgage-backed securities may not all be bad, but ARM's with a high default-risk may not be the best thing to flush into the capital markets. Also, has either the SEC or the AICPA come out with any guidances on how to properly account for these assets?
Ok, I'm done. Feedback, please!
Here's what Obama would have done, a year and a half ago:
http://andrewsullivan.theatlantic.com/the_daily_dish/2008/03/obamas-prescien.html
Would it have worked? I don't know, probably not. But it couldn't have hurt, and it's more than Bush did.
What do you think of that?
I find amusing that Megan talks about how Bush's predecessors did not prevent a housing bubble. Duh. They were not confronting one.
The problem is not who passed what that provoked the bubble; the problem is when many analyst realized (and that was in 2004-2005) that the whole stimulus package/tax cut had been a lousy job creator and the Fed had to push the economy forward by crashing the interest rates, no one in this administration moved a finger. They had a role creating the circunstances (fiscal policy does affect what the Fed can do), and they totally ignored what was going on when it was unfolding.
The problem is not what Bush did. It is what he did ignore.
The following are responses to your query about GLB's provisions. The are amended in several ways. They are numbered, for convenience. They are edited down, to provide some focus (Fannie and Freddie are a red-herring since they didn't themselves engage in the risky practices that caused this, they simply remained true to their task, which is to facilitate liquidity in the market. Yes, they might have been able to act as a throttle, but that would be a regulatory function, which is not their job.). More importantly, the scope of potential causes is expanded, to address the question of assigning responsibility for the current mess.
Note: since you seem to feel that credentials are necessary information in this blog, let me preface this by saying the answers are the product of a collaboration between a political scientist (myself) and a Chicago MBA (my father, who used his degree to build a successful accounting practice over the last 40 years that specializes in forensic auditing, as opposed to a career in journalism, like yourself).
1. Steadily rising prices in the housing market
See #5 below.
2. A flood of foreign capital flowing into US debt markets
See #5 below.
3. A conviction among ordinary Americans that housing purchases were an easy, and possibly even quick, way to get rich
See #1 above
4. A 20 year government committment to ever-expanding homeownership
Twenty years ago, Ronald Reagan was president, followed by George Bush (the other one). Yes, Clinton was president, too. But why single him out? Oh, and I seem to remember something about the "ownership society." Thanks, Bush Administration!
5. A global shift towards increasingly exotic financial instruments for pricing and distributing risk
Ah. Finally, something for my dad to contribute. The most significant act of Congress is not the GLB, but the Commodity Futures Modernization Act of 2000. That let's Gramm off the hook, doesn't it? Oh, wait. He authored that one as well. That is the legislation that opened the door to these fancy slice-and-dice-and-repackage mortgage-based securities. It attracted a flood of capital into the mortgage market, boosting demand, inflating real estate prices to point of creating a massive bubble. Slicing up the mortgages prohibited borrowers from exiting the market, preventing the bubble from deflating on its own. Re-enter the GLB: breaking down the regulatory barriers between i-banking, mortgage lending, and insurance virtually guarantees that a failure in one industry will spread to the others. Thus, instead of a sector crash, we risk a system crash. Thanks, Phil Gramm!
(I posted this to yesterday's article, but my point/question remains, that a more robust SEC enforcement might have caused the external auditors to work a bit harder on making the banks accurately value the mortgage-backed securities. Is that not a possible argument that more regulation might have helped here?)
I'm surprised that amongst all of the parties who are (rightly) catching the blame for this problem, the accounting firms who were auditing the financial companies seem to be overlooked.
Their job was to make sure that these mortgage-backed securities were valued reasonably on the balance sheets, and apparently they weren't.
Arthur Andersen went down, and Sarbanes-Oxley (sp?) was passed, but the auditors were still allowed to do high-level analysis on the valuation of these securities (which were often based on prior-years' data, an approach that always works right up until things change).
And that was enough to pass muster, but not enough to cause the banks to write down the value of the assets in time to head off the meltdown.
That's why stronger SEC oversight might have helped. Maybe.
As a lot of these comments show, this is a complicated problem, with blame to be shared, but it just seems like the big accounting firms have managed to fly under the radar, despite the fact that THEY are the ones who purport to ensure that financial statements are reliable.
brooksfoe,
I no longer know what philosophy Greenspan has in his mind and heart, but his actions were not those of a person that respects free markets. His actions were always attempts to forestall the correction of excesses, and excesses must be corrected at some point- this is what the free market tries to do (and is trying to do now, in the face of the efforts of all the king's men and all the king's horses). The only question for us is whether or not to let the excesses be corrected now or later in a more catastrophic fashion. We see the answer to this question already, and the answer is bipartisan in nature- don't let the excesses be cleared- it is too painful.
C'mon Megan. I expect more of you on this. To say that no one saw this coming is either evidence that you haven't been paying attention, or that you've had your fingers in your ears, singing "la-la-la." Ray Charles could have seen this coming.
I know you have an MBA from U of Chicago and have studied under economic titans, so are you telling us that U of Chicago never offered an Austrian class? Or did you just not take it? Did you study Austrian and disregard it? I realize lots of people think the Austrians are batshit crazy, but you gotta admit they called this YEARS ago.
Regardless of whether Ron Paul is a loon and Lew Rockwell is a racist bastard, at this point can you really argue with them?
The sad result of all this is just as Yancey said. Enough people are just clueless enough to believe that more onerous government intervention is what is necessary.
Megan,
What an interesting post. Obviously, you're a smart, highly educated commentator and not some fool reciting from one and a half poorly understood articles you read. It should be noted, however, that for your educational pedigree, you still thought invading Iraq was a good idea and voted for Bush.
Further, your blog seems most concerned lately with calling out folks who blame President Bush and the Congress for their part in this crisis - and calling their comments "twaddle". There's not a whole lot of substance as to 'What's going on, exactly?'; 'How did we get here?'; 'Where is this all going?'; and 'What should we be doing?' The most likely reason for that is that you, like all of the other "experts" don't know the answers to those questions any more than some jackass who's read one and a half articles on the subject.
So, as we ride out a crisis created by individuals., many of whom had MBA's from Chicago, maybe some humility is in order, and appreciation that good ideas sometimes come from unlikely sources, that highly educated people can be idiots and that blind devotion to ideology (regulation anyone?) can be just as bad as complete ignorance itself.
To paraphrase Forest Gump, 'twaddle is as twaddle does.'
Sid, I've got news: Megan is a lay person too. If she weren't she wouldn't just be a full-time blogger. The true experts know that they don't know shit. Megan thinks she knows better than all of them put together. She still hasn't offered a single example of someone, especially Obama, blaming Bush. It's the extreme anti-regulatory ideology that both Obama and her commenters are saying was part of the problem. Megan is engaging in blatant strawmanism and projecting her own tactics ("wrapp[ing her arguments] up in just enough technical knowledge to be thoroughly, amusingly wrong") on to her commenters, from whom she feels under siege. Her behavior is laughably transparent.
No one has denied that Clinton policies were part of the problem, but the greater part was the driving economic philosphy of the party in power as the crisis mounted. It's a simple idea, and it really doesn't matter how the economics work -- it's a legitimate political argument.
reader1,
I missed your point about the AIPCPA perhaps playing a role. Yes, there are guidelines about valuing these things (although it has been a prior life ago since I read them, so I can't cite the standard off hand). But I think the problem is that the actual auditing standards on the ground are too lax.
I thought that after ENRON and the collapse of Andersen,the passage of Sarbanes-Oxley, and the creation of a that new promulgating body (the FSB?) they might have gotten a better handle on this. I guess not.
AICPA was the quintessential example of industry self-regulating. Its shortcomings only became apparent when Enron et. al. failed so publicly.
Maybe there will be a further tightening of the ropes after all of this shakes out.
But it seems to be a decent argument that it was a lack of regulation that made this problem possible.
Otherwise we are left with the explanation that millions of individual rational private actors (lenders, investors, and borrowers) ALL, simultaneously somehow moved in the wrong direction together.
I know you have an MBA from U of Chicago and have studied under economic titans, so are you telling us that U of Chicago never offered an Austrian class? Or did you just not take it? Did you study Austrian and disregard it?
I just looked and Chicago does NOT, in fact, offer a class in Austrian theory. Color me surprized that the most famous Economics department doesn't even want to talk about it. I guess going to GMU really skews my perception, considering even my Intro to Micro class had us reading Menger. I thought it was only podunk schools that ignored Austrian. Now I know that it really is the black sheep of the academic Econ world.
It's too bad, especially since, as I said, the Austrians had this pegged. I guess the fact that they eschew fancy modeling must rub the Chicago school the wrong way.
You say that as if "make loans that will never be repaid" were a business principle. If people had known the loans weren't going to be repaid, they wouldn't have made them.
If the loans were going to be sold before repayment became an issue, why not? Create a market for low-quality loans, and you'll get more of them.
You understand that the problem comes from these big, fancy experts *buying* the loans, not selling them, right?
I second Nathan's point.
Perhaps Megan is an expert in identifying "Supertwaddle" because she does it herself so often.
"Then we move on to Gramm-Leach-Bliley, bugbear of Glass-Steagall nostalgists everywhere. We first observe that GLB passed under the Clinton Administration. We second note that it passed in 1999, too late to have had any effect on the stock market bubble."
Let us third note that, while it was signed into law by Clinton. GLB was very much an initiative championed by the Republican-controlled Congress.
"The bills comprising the act were introduced in the Senate by Phil Gramm (R-TX) and in the House of Representatives by James Leach (R-IA). The bills were passed along party lines with Republican support in the Senate and with bipartisan support in the House of Representatives[2]. It was signed into law by President Bill Clinton."--Wikipedia
In the Senate, the bill passed on a 54-44 vote.
53 Republicans (including John McCain) voted for the bill. Except for Sen. Ernest Hollings (D-SC), every Democrat (including Joe Biden and Joe Lieberman) voted against it.
http://www.senate.gov/legislative/LIS/ro...
In the House, the vote was more bipartisan, passing by a 362-57 margin:
Republicans: 207 for, 5 against
Democrats: 155 for, 51 against
http://clerk.house.gov/evs/1999/roll570....
Clinton may have ultimately signed the damn thing, but this was nevertheless very much a Republican monstrosity. And it's now biting us in the butt. Thank you, GOP.
Spambalaya, how is the repeal of Glass-Steagel biting us?
The only banks that are surviving are the universal banks (commercial bank + investment bank). If it wasn't repealed, all of the US investment banks might be bankrupt.
"You understand that the problem comes from these big, fancy experts *buying* the loans, not selling them, right?"
And they bought them believing that they could rely on the financial disclosures. But the assets were over-valued.
Isn't THAT where the case for more regulation comes in?
After all, the regulators oversee the financial reporting of public companies. And that reporting is deemed to be reliable by the requirement of external auditors who serve as the stop-gap, the assurance that the free market can rely on disclosed financial information.
In order to keep every single investment from devolving into a full-blown "due diligence" exercise, we implement accounting and auditing standards. Is that over regulation? Would you argue that to the national partners of the big-4 (or however many are left)?
If not, then once those standards are in place, isn't it reasonable for users of financial information to rely on them?
And if so, isn't the failure of those standards a result of too little continued regulation?
Enron's failure led to lots of blame (and some reform)on the self-regulated accounting profession, and yet all of this crisis is to be explained by politics alone?
jus' asking
Isn't "Supertwaddle" by definition exactly what a full time economics blog does? I mean, not to sound aggressive or condescending, but given the reward structure for economic knowledge, a full time blog is not the best place to find in depth economic analysis. It might be a great way of discussing economic phenomena with the general public in brief comments, but that, in itself, is as much "Supertwaddle" as anything comments or candidates say.
Now, we might discuss the origins of this bubble until we turn blue in the face, and, let's face it, we won't solve this in a blog, Chicago MBA or not.
However, we do know quite a lot about the basic economic prescriptions for when bubbles burst, and the recent administration has made it significantly more difficult to apply those prescriptions, given the existing twin deficits, the ensuing devaluation of the dollar and inflation. Now, none of this is novel under Bush, but what IS novel is the speed in which these deficits increased in the last 8 years.
McArdle's article is absolute nonsense. It is the kind of twaddle that impresses other Beltway types, but is entirely disconnected from reason and common sense.
The issue is not simply whether lenders violated the law or even whether or not they were properly regulated. Lenders violated every generally accepted accounting principle by disregarding their own standards in making loans to people whose income and credit were insufficient. Auditors violated their own standards by not accurately describing the riskiness of the lending practices of the bankers and mortgage companies. The business media failed the public by not honestly reporting on the degree to which subprime lending practices were based on faulty assumptions. And most of all, the government failed not only in not providing meaningful regulation, but also in failing to provide useful and unbiased information to the public.
But the problem with the securities is that everyone underestimated the default risk. It's possible that forcing originators to hold onto some portion of the loans might have helped, but often originators did hold onto their loans. The issue wasn't that the packagers were selling subprimes as AAAs. It was that the rising house prices had basically disguised default risk, because people could always sell or refinance. This fooled people into believing that they had become better at assessing credit risk than they really were, because their loans weren't going sour. After a decade of this, everyone was under the impression that we were in a brave new world where portfolio theory would allow us to lend more money to more people at lower risk. When the housing market crashed, the underlying fallacy became all too readily apparent.
Keep in mind that for all the allegations of fraud in the market, these remain largely anecdotal. Undoubtedly they did play a role, but it's far from clear that that role was substantial, much less dominant. As far as I can tell, most of it was buyers and sellers being equally fooled.
A good article, but it has one glaring flaw: there's really no need to wait to decide that you're in/not in a bubble.
Many of the steps to reduce easy credit could have been taken when it was clear the housing market (2005 certainly, but 2004 is a good candidate) was simply overheating. Its not as if we didn't have data to back the assertion of a propped up housing market; simple analysis of income to mortgage payments in most areas of the United States should have been enough to at *least* start a more in-depth investigation into lending practices, and bring some light on some of the more toxic loans and their legalities/obligations.
The Republicans controlled the Senate in 2003 after the 2002 elections.
My long-standing crush just deepened.
Love her or hate her, Wound Up Economics Megan is a very fun date!
I had consigned myself to the idea that posts and comment sections like this lived on only the archives. Great stuff.
"But the problem with the securities is that everyone underestimated the default risk."
If "everyone" makes the same mistake, even while they all have have different roles as information gatherers, double-checkers, triple-checkers, and invested, self-interested rational players, doesn't that point to something other than an act of God?
Doesn't that seem like a systemic problem? Not just "asymmetrical information?"
Of course, rising r/e prices drove this all, but wouldn't an auditor, properly regulated to do more than a this-year-versus-last-year analysis have been able to flesh this out earlier? How did the ENTIRE market of investors get fooled? Did they rely on the SEC requirements that auditors would, at least, ensure a semblance of reasonableness on the balance sheet?
(your charge of "supertwaddling," while perhaps applicable to the post you quoted, is starting to seem like a (psychological) projection)
How do you suggest the President should have prevented the housing bubble when people were complaining about it? What set of regulations would have helped?
A major issue is that Fannie and Freddie kept housing at artificial highs (even though the vast majority of their securitizations were not for subprime mortgages). The high price of homes made people think that they had lots of equity when they took out boneheaded mortgages. And it made it more likely that they'd default on their debt since they were buying at or near peaks. When housing crashed, they ended up upside down on their mortgage and had to walk away. The silly stupid thing about Barney Frank's support for Fannie is that it made housing _less_ affordable, not more, by encouraging more and more people to buy homes easily (since they could now easily obtain a mortgage due to securitization).
Whoever the commenter who mentioned that the ABS CDO's used to be risky because of prepayment is absolutely correct. The biggest modeling issue in ABS CDO has always been modelling prepayment speed. It was not modelling default speed. That was known how to figure out from ABS CDS spreads.
Banks certainly loved having the GSE's around since it guaranteed large fees for creating CDO and CDO^2-like structures built around the ABS bonds issued by the two GSE's. Sure, we can move to the Mexican model of derivatives, which essentially bans or severely hamstrings the creation of derivatives that are too complicated. But derivatives are also extremely useful in other situations. I bet the airlines wished that they had bought options on oil futures.
As for the commenter who bashed people in finance as having gotten their jobs because mommy or daddy were well-connected is way off-base. First, different firms' cultures are different. But even leaving that aside, different areas of finance have different types of people who enter them. Go visit a structured credit or mortgage trading group at most banks. You'll find lots of people with Ph.D.'s, foreigners, and immigrants sitting on those desks. The people involved in this mess aren't cash equity traders (the employees at banks who are more likely to be the frat-boy types).
The issue here is actually quite complicated. We have what, six different federal banking regulators? Why? The problem was that there was no one specific entity responsible for it all. It's not an issue of more regulation, necessarily, but of smarter regulation. And it didn't help that when Paul Ryan (R-WI) and Jim Leech (R-IA) tried to increase oversight of Fannie and Freddie they were strong-armed into relenting.
Let us also not forget that many of Lehman's problems were not related to subprime mortgages. The issue is that other asset-backed securities soured as well out of a general panic. Lehman was involved in a large part with commercial real-estate assets which ended up tanking simply because credit has dried up.
Finally, (really, I promise), the way that CDO structures work is that a bank pools all of the underlying bonds (or often the case, CDS) into one giant pool and then defines tranches in that pool that denote the order of responsibility for losses. What happened was that the banks bought protection on equity, junior mezzanine, and mezzanine (the three riskiest) tranches and were left holding senior and super-senior, which were considered safe. Furthermore, the subprime market led to the deterioration not just of subprime and alt-a backed mortgage bonds, but also those backed by sound traditional mortgages simply because there was a failure of trust in the overall securitization system. Banks have to mark to market and the collapse of the ABX index market forced banks to write down their holdings substantially.
ZBycyclist wrote:
"Yeah, Bush's been president for 8 years, the housing bubble and the drastic overleveraging occurred largely/completely on his watch, but he has no responsibility."
Zing! (Oh, wait...)
Oh, also, a distinction must be made between banks who give out mortgages (and mortgage brokers) and investment banks who sell structured products based on them. Those are often very different entities with the latter, large corporations and the former, smaller regional players. Part of the issue is that the larger entities were taken for a ride by the smaller regional banks and mortgage brokers and didn't do their due dilligence evaluating the actual pool of mortgages that went into the abs's.
Ben Stein is a Republican and economist: Here's what he says:
Stein: And it's a terrible problem that we don't have enough government supervision. I'm going to shock you and say there's a gigantic flaw in Republican policy, which is not believing in regulation. A few hundred million dollars worth of regulation would have avoided this entire problem of the credit meltdown. Maybe $20 million, $30 million of decent regulation would have avoided this entire problem in the credit meltdown.
So Ben's a stupid Republican? Maybe. But since most or your post seems to fingerpoint and cherry pick Democrats rather than describe terms and analyze problems, its hard to believe that this blog will be a good source of intelligent insight.
The truth is that most of us are smart, but few are really subject matter experts. You are not either.
From some of the less rabid things you say on this blog, you and I might even agree on certain key points, but the partisan animosity makes it hard to determine the extent of agreement or disagreement, or even what the problem is.
Sub-prime mortgages and predatory lending practices which contributed to the "housing-bubble" are separate but related problem from mis-rating the risk of CDO's and the CDO-bubble.
Finally, I think you are being knowingly disingenuous with weasel-wording that tries to implicate Clinton.
From Bloomberg: "Sales of CDOs worldwide have soared since 2004, reaching $503 billion last year, a fivefold increase in three years, according to data compiled by Morgan Stanley."
Gene2,
Great post. It is all true. Complicated as all get out, just as you describe. But the external auditors are supposed to be the ones who mediate between THAT complexity and the information given to the investor.
And I'm not even trying to say that the crisis should be put at the feet of the auditors. I'm just wondering why no one is talking about them in all of this.
I'm asking why it is not reasonable to argue that more regulation of the external auditors, to force them to actually fulfill that intermediary role between the complexity of the market and the needs of the investor, is proper.
(sorry for that long crappy sentence but my crappy old MBA from a crappy school, from days long gone, left me with a certain impatience;))
RE: But the problem with the securities is that everyone underestimated the default risk.
This is absolutely untrue. The models that lenders used made no sense. There were ecnonomists who noted this, but they were ignored by all the smart people who somehow became convinced that home prices would rise forever.
The lending industry had long experience in developing credit scores to identify the best customers. They then deliberately discarded the rules of their own system. The models used to justify these lending practices assumed that the value of homes would rise, and presumed that people would be able to re-finance. But these models did not ask two simple questions: what if incomes fail to rise so that people can make payments without refinancing, and what it the number of people with poor credit increases faster than the number of people with poor credit. And of course, the lenders themselves were busy making loans to people who did not qualify for them under the lenders own rules.
To put it more simply: lenders lied to people when they told them that they were creditworthy. In California, where I live, lenders told people in Spanish that they were "good to go" for home loans, but the paperwork was in English. The lenders created their own problems, and regulators turned a blind eye to potential problems.
We have already seen Moody's admit that some of the assumptions used to highly rate mortgage instruments were based on false (and easily correctible) assumptions.
The notion that people could always sell or re-finance is just absurd, and almost appears to treat people as though they are corporations, with family CFOs standing by ready to wheel and deal. Most people were buying homes to live in, not playing junior speculators. And the bottom line that economists and business writers ignore is that if people do not have rising or at least stable incomes (as opposed to access to credit), then they cannot easily refinance (paying additional fees and mortgages at higher interest rates) or sell and buy new homes (which requires a steady source of income once the down payment has been made).
The Enron example is only useful to this extent. Many business reporters have an unacknowledged bias in that they love to write about booms. It's sexy. It's exciting. Enron attracted the attention of a few good reporters who wrote about potential problems. But I recall one business writer noting that Enron's setup was so "sophisticated" that few could understand it. This kind of thing is total nonsense. Whenever an investment opportunity is sold as "sophisticated" this is usually a signal that it is either severely flawed or an outright scam. And of course, the whole point of an audited financial statement of a public company is to make the "sophisticated" intelligible to the public and to potential investors.
In short, anyone who writes that "everyone underestimated the default risk" simply wasn't paying attention.
Oh jeez, there are now 107 comments and I have about 5 minutes to post.
What I think you (Megan) really need is a primer on the American banking in the 20th century, so here it is in 30 seconds:
The business of banking is the business of taking deposits and making loans. The business of brokerage is the purchase and sale as principal of agent of securities. Historically these two businesses were carved apart by Glass-Stegal, yet one more triumph of the New Deal. Under Glass-Stegal banks were highly regulated by both their chartering regulator (state or federal) as well as their insurance agency, the FDIC. Securities firms were also regulated, but somewhat less so. As a consequence of excessive inflation in the 1960s the barriers between the securities business and banking began to break down and we experienced "disintermediation" which basically meant that customers figured out how to get higher asset returns or lower loan rates by accessing securities markets and not using banks. Securities firms became, in essence, under-regulated banks. The consequence was a decline in profitability for the basic business of banking. Banks managed this decline in profitability either through consolidation or through the generation of fee based income. By the early 90s, things were looking pretty poor for banks, particularly the thousands of small banks that had resisted consolidation. The genesis of the GLB act came in a paper written by a then obscure NY fed economics researcher named Mishkin in which he called for a "transition period" in which remaining banks would be able to engage in more non-banking activities. The rub is that Mishkin's paper very very explicitly cautioned that they would have to do so in a highly regulated and highly supervised manner. You can understand quickly why GLB did so much better in the House than in the Senate when you understand that it was being sold as a lifeline for small banks and congressman everywhere, R or D, are always highly answerable to the local bank and its board. Without GLB, the thinking then went, local banks would likely be swallowed up into a handful of surviving national and regional mega-banks. As a practical matter, GLB has mattered very little to those community banks which have survived only by dint of dumb elderly consumers who think that lower deposit rates from an tooth-bleaching local banker really means better service. GLB has been enormously useful though to the securities business. Banker types love, love, love being able to bring clients to the table for expensive securities origination or M&A activities by using the added sweetner of low-cost commercial loans.
Of course, under the GOP, which have held executive power for eight of the nine years since the enactment off GLB, we have had anything but the vigorous oversight and regulation that Mishkin advocated in his original plan. If anything, the OCC, Fed, and state banking regulators have become even more accommodating in their efforts to essentially seek clients to regulate. And as for the securities business: exhibit 1 is Harvey Pitt. Exhibit 2 is William Webster. The GOP has shown nothing but contempt for maintaining any sort of meaningful oversight.
Also, just FYI, Reg FD had almost no impact on the profitability of the securities brokerage research business. That business has pretty much been unprofitable and operated only as a "loss-leader" since the deregulation of brokerage commissions in the 1970s. If anything it has marginally improved the quality of research because it diminished the ability of "analysts" to play the earnings numbers game.
This is it for me on this subject. You can continue to mock me as a "twaddler" or supertwaddler or olympic twaddler all you want. I look forward to more good posts from you on animal welfare.
PaulC:
Ben Stein is not an economist. He has a law degree from Yale Law School and he worked as a speechwriter for Nixon and Ford, and taught constitutional law at Pepperdine. People love having him as a talking head on TV because he's a Republican and sounds funny and people remember him from The Wonder Years. I actually like Ben Stein, but just because you found one celebrity Republican saying something doesn't mean it's correct or based in reality.
Yes, Republicans have a general distaste of regulations. But it's not like Republicans went in and loosened capital requirements on banks. I think the kinds of regulations Republicans rail about are OSHA, not those of the financial industry. But I could be wrong.
flipshod--
Thanks. I don't know enough about external auditors and their role in all this. But, as Megan has mentioned in many earlier posts on the subject from months back, it's not clear that auditors/regulators would be well-equipped to deal with the problems. If someone is intelligent enough to understand how to structure CDO's, what risks these structures expose banks to, etc. why would they go work for FINRA or some other agency? They could make millions at Goldman. The regulations necessary aren't at that level, I think. Perhaps tougher capital requirements or different accounting standards. But aside from that, I can't think of any. I think there needs to be more oversight of the industries that feed the structures to the banks (i.e. mortgage brokers, etc).
One thing that Tyler Cowen mentioned on his blog was that in the bankrupcy restructuring law (granted, pushed by the Republicans, though not sure I know who specifically pushed for this specific piece), bankrupcies by derivatives counterparties were treated differently than regular bankrupcies. It created a false sense of hope that an OTC derivative counterparty, even in the case of default, would not pose much risk. But it had the nasty negative side-effect of decreasing transparency since if counterparties worry about eachother's default risk, they would want to trade an instrument in an exchange which takes on all counterparty risk for them. And greater transparency would have helped here. I am not sure if there was anyone in Congress who was opposed to this provision in the law, but while I understand the desire to eliminate counterparty risk (under the belief, well the banks would oppose exchanges for credit instruments anyway since it would cut down on their fees and ability to game the bid-ask spread), it perhaps created more serious problems. On the other hand, the law only took effect in 2006, and the OTC CDS and CDO markets were quite big by then already.
One thing that isn't mentioned is that perhaps it's mark-to-market accounting rules for broker dealers that are to blame. I'm not saying that this is necessarily the case, but my understanding is that many of the mark-to-market losses were not losses that were actually realized, but the result of a collapse in various index/benchmark markets, or even the cessation of trading in these markets. Say Lehman marks down a Super-Senior 30-100 tranche on an ABS CDO to 40 cents on the dollar, it doesn't mean that that tranche has actually seen 60% of its notional wiped out. It's just where some underlying market is trading and Lehman is using some model to map the particular SS tranche to the underlying market instruments. These markdowns require different levels of reserves to be set against those trades and severely depletes the capital position of the bank. Not saying we should change these rules, but lets not forget that many of the so-called losses were not actually ever realized.
I should have written:
The models used to justify these lending practices assumed that the value of homes would rise, and presumed that people would be able to re-finance. But these models did not ask two simple questions: what if incomes fail to rise so that people can make payments without refinancing, and what it the number of homeowners with poor credit increases faster than the number of homeowners with good credit?
And of course, the lenders themselves were busy making loans to people who did not qualify for them under the lenders own rules, thus increasing the number of bad risks in the mortgage pool.
My apologies, since I have found this article and the various comments to be very interesting, even when I disagree with many of the other views expressed.
RE: I don't know enough about external auditors and their role in all this. But, as Megan has mentioned in many earlier posts on the subject from months back, it's not clear that auditors/regulators would be well-equipped to deal with the problems.
Again, the Enron case is instructive. If an auditor is not savvy enough to understand what a company is doing, then that auditor cannot -- by generally accepted accounting principles -- fully endorse a company's financial statement. And a company could not then rationally tout its stock to potential investors. And, equally important, a business writer could not write intelligently about a company of an industry with such a cloud hanging over its head.
Here, the issue of transparency is possibly more important than the issue of regulation. Markets stand or fall not only on the degree to which people are willing to take risks, but also by the degree to which risks are presented and understood.
To be sure, investment banks are very much at fault here themselves. Part of the issue is the compensation structure which rewards traders and salespeople based on the current year's PnL. But since many of these trades are 3, 5, 10 year contracts, the losses might not be realized for years to come. Two years ago, an MBS trader was making a fortune. This kind of pay scale encourages excessive risk-taking on the short term. Sure, risk managers should be making sure that this doesn't happen. But, risk managers are a cost center and no one wants to rain on the traders' parade since everyone wants to get paid. There is a collective action problem here since no one bank would be willing to change this pay structure, lest they lose all of their top traders to their competitors. I'm not sure what financial industry regulations could do to fix that. I hope no one actually suggest that the government start regulating trader compensation. I think this would cause more problems than it would solve.
I think going forward, however, the industry will self-regulate on this. I think the days of excessive bonus payouts are over. Not to say that traders will make nothing. They'll still live comfortably, but I think IBs will think twice before basing comp on PnL without also looking at the risk exposure that trader has generated.
On the capital requirements issue, that _is_ something that can be done. But even the very conservative Swiss only recently came upon this when they decided to require UBS and Credit Suisse to hold more capital in reserve than before. And American banks generally had stiffer requirements than their Swiss counterparts. It's not that NOTHING could have been done, but the things that could have been done were, as Megan said, on no one's radar at the time. Not on the Republicans' not on the Democrats'. And a lot of the things that could be done to prevent this would cause host of other problems with the markets that could bring who knows what consequences. I think this is a perfect illustration of Hayek's Law of Unintended Consequences. It is a very complicated issue and I hope people didn't play politics with it.
"The Republicans controlled the Senate in 2003 after the 2002 elections."
Right. And they tried to pass legislation tightening regulation and oversight of the GSEs but were thwarted by Democrats who were lobbied by their friends at Fannie and Freddie.
"blah, blah, blah Glass-Steagall, blah, blah, blah securitization"
Securitization didn't start with Glass-Steagall, and no one here seems to be able to explain why Glass-Steagall was such a problem. After all, the combined commercial bank/investment banks that resulted from the repeal of Glass-Steagall have held up better than the stand-alone investment banks like Lehman and Bear.
Ben Stein is not an economist. He has a law degree from Yale Law School and he worked as a speechwriter for Nixon and Ford, and taught constitutional law at Pepperdine
From his web site: http://www.benstein.com/bio.html
He graduated from Columbia University in 1966 with honors in economics. He graduated from Yale Law School in 1970 as valedictorian of his class by election of his classmates. He also studied in the graduate school of economics at Yale. He has worked as an economist at The Department of Commerce
But it's not his main occupation and not the point, I understand.
"But, as Megan has mentioned in many earlier posts on the subject from months back, it's not clear that auditors/regulators would be well-equipped to deal with the problems."
I'll grant the argument that you may need some private accounting firms to follow, and keep up with, the latest developments in finance (although this is probably a slander of the public servants in the financial field).
But it doesn't take the smartest guy in the room to see where more work can be done to beef up confidence on the valuation of esoteric assets.
(and it is funny that one of the biggest variables used to be prepayment rate!--managers fighting over THAT)
The securities may be complicated, but it's not that hard to make the folks who created them to answer basic questions about the underlying risks, and those steps can happen at every level.
At the risk of getting political, we place civilian control over the military because it doesn't require battle experience to know what we should generally do with our military.
Likewise, it doesn't take a derivatives "genius" to dig deeper into those risk pools and ask questions at each level. And they SHOULD be asked at each level. For investors' sake.
1. Effective loan standard practices did change during the 00's:
Credit Crisis Interview: Susan Wachter on Securitizations and Deregulation
http://knowledge.wharton.upenn.edu/article.cfm?articleid=1993
Knowledge@Wharton: Now why was that? ... that the lenders were simply willing to lend to people that they had less likelihood of getting paid from than they were before. What led them to do that?
Wachter: ... There are two ways that standards erode over time. One, the underwriting standards literally started to come into play in 2006, where people could basically say what their income was on many of these loans. And that's underwriting eroding over time.
But also the standards [themselves] -- the LTVs (consolidated loan to values) -- went up with piggyback loans. So the lending standards that existed became more liberally offered. So as a consequence, supply function shifted. There was more supply. ...
Wachter: ... There is a critical factor that all of this misses, and it is not interest rates either. ... It is that the standards [are] eroding, especially in 2006 when there [was] a dramatic decline in standards, [which] was unsustainable and that retrenched.
We had a sharp reversal, starting in 2006, of these unsustainable standards which were artificially inflating housing prices. So over this period standards eroded, artificially inflating house prices. Housing price increases and even levels could only be sustained with this unsustainable, overly liberalized credit being manufactured, which directly caused the price rise of 2006.
Knowledge@Wharton: And basically, that boils down to making money so easily available that people have more to spend, and they bid up prices. Is that the mechanism?
Wachter: Absolutely. It's a credit induced bubble. People are able and willing to pay more when you have zero down payment, negatively amortized. They can get into the home and the bet is not on them. The bet is on someone else [as to] what's going to happen in the future.
...
First, is it correct that the use of adjustable rate mortgages increased? And what caused that?
Wachter: Not just adjustable rate mortgages. More to the point: teaser rate adjustable rate mortgages and option ARMs. All of these latter are negatively amortizing instruments. That is, you get into the loan and then you borrow more money over time.
That drives the loan-to-value ratio up, which again is going to be the key to the next part of the story which is: Now what do we do? Our loan is worth more than the home. Maybe we walk.
Knowledge@Wharton: And there's lots of research that people who don't have "skin in the game," as they say -- that is, equity in the house -- are more likely to walk away from it than people who do.
Wachter: Absolutely. That is a key constant in all of our research. Foreclosure loan is driven by high loan to value, upside-down LTVs greater than 1.
Two somewhat deep technical articles that might be helpful:
1. Credit Crisis Interview: Susan Wachter on Securitizations and Deregulation http://knowledge.wharton.upenn.edu/article.cfm?articleid=1993
2.) Fraud and the sub-prime bubble
http://www.atimes.com/atimes/Global_Economy/JG24Dj03.html
Jed: Presumably, the detailed length of your post is supposed to obscure the fact that you have still failed to point out any way in which Glass-Steagall contributed to the actual current crisis. That it allowed further consolidation is factual but irrelevant when it is the unconsolidated banks that have the problem.
We can argue about whether Regulation FD, brokerage commissions, or whatever was the problem with Market Research, but it seems we can both agree that the problem was not caused by some Republican-sponsored attempt to benefit the company at the expense of the consumer. Both moves were intended to help consumers at the expense of companies.
Re: If anything, the roots go back further to the 1970s and the creation of the regulations requiring banks to give subprimes: without these, there wouldn't have been any problems.
What are you talking about? Banks created subprime loans because they were profitable! They could charge higher interest rates on them (and charge various fees too). Same reason banks handed out credit cards to people with poor credit and even people, like college students, with no income source.
Re: There is rampant fear that the mortgage crisis is going to start hitting the A grade mortgages
I assume you mean Alt A's. That prediction has been on the table for over a year. Default rates have increased of course, but so far there has been no great bonfire.
Re: Has everyone forgotten James Jeffords's party switch?)
Which left Dick Cheney (A Republican last I checked) as the tie-breaker.
Re: selling them off into the capital markets, you could diversify enough to even out the risk. What happened, of course, was the creation of untraceable assets that eventually turned bad, and a fundamental inability to accurately track and report on risk.
Nonsense. there is no reason in principle you cannot trace risk, and no reason you cannot report on which mortgages in which trusts have gone belly up. Yes, a lot of data to sift through, but the effort is hardly impossible given modern database and computing power.
Re: Keep in mind that for all the allegations of fraud in the market, these remain largely anecdotal.
It's more than allegations. Practically ever no-doc loan involved fraud (a borrower, often with lender collusion overstating his income and/or assets). They only reason we do not prosecute is because so many ordinary Americans would end up snared by that net that the backlash would be ruinous.
JonF-
You are mostly right. First, let us separate banks from investment banks. These were two different groups.
PaulC-
It seems so obvious to you that prepayment rate is an irrelevant variable. But when prepayments get written down from the top of the capital structure and prepayment rates can be very high and the IBs are usually the ones left holding the super senior tranches, this was a very important variable to take into account. It's not that no one took default risk into account. It's that we knew how to model it and the big open modeling question was prepayment.
Now, any model requires calibration of parameters and how do you calibrate those? Well, you look at present market instruments and perhaps compare to historical data (and market instruments trade based on how risky/profitable the market perceives these to be relative to things it has seen in the past). At the time, the mortgage backed bonds were not trading at very high spreads. The reason for this is that at no time in American history since the Great Depression, have housing prices in the US declined. And at no time have default rates been as high as they are now. What ended up happening is that the 2005 and 2006 vintages of abs bonds turned out to be full of junky mortgages; as JonF says, many of them (or perhaps most of them) fraudulent.
Yes, this is an issue of regulatory oversight. But some of the critics of the administration speak as if all of these things we now know to be true were so obvious back then. It's like saying Copernicus is useless because it's obvious the earth is round. Like duh, haven't you seen satellite photos of earth?!
You mentioned that Congress has failed to properly regulate Fannie and Freddie through OFHEO.
For those of us who are trying to get a grasp on a complex topic completely outside of our area of expertise, could you please elaborate on this a bit?
Thanks.
This is a really good article.
I always understood the housing bubble to be an after-effect of the Internet bubble: When stocks and bonds looked like bad investments, people starting putting money into their houses.
I remember economists saying in 2002 that the bad news was not over yet. Stocks collapsed. Bonds collapsed. The next would be real estated. But that last domino never fell. Quite to the contrary.
I pity the politician who might have attempted to stop peoples's home values from rising.
Here is another really good breakdown(via Instapundit)that shows why going to Obama to fix
this problem makes about as much sense as going
to Charles Manson for family counseling:
The Best Congress Fannie Could Buy
http://www.classicalvalues.com/archives/2008/09/the_best_congre.html
This is a long and complicated story about how Obama backers were behind the mortgage industry meltdown. It hast to start some where, so lets start with a well known Chicago name Penny Pritzker. It starts with a bank failure.
I know...I know..but,but,but it's all Bush's fault!!
Lehman Brothers' collapse is traced back to Fannie Mae and Freddie Mac, the two big mortgage banks that got a federal bailout a few weeks ago. Freddie and Fannie used huge lobbying budgets and political contributions to keep regulators off their backs....
The top three U.S. Senators getting big Fannie and Freddie political bucks were Democrats, and number two is Senator Barack Obama. Now, remember, he has only been in the Senate four years but still managed to grab the number two spot ahead of John Kerry...
Fannie and Freddie have been creations of the Congressional Democrats and the Clinton White House,...
The Clinton administration's White House budget director Franklin Raines ran Fannie and collected $50 million. Jamie Gorelick, Clinton Justice Department official, worked for Fannie and took home $26 million. Big Democrat Jim Johnson, recently on Obama's VP search committee, has hauled in millions from his Fannie Mae C.E.O. job.
...
it appears the man attacking McCain, Senator Obama, was at the head of the line when the piggies lined up at the Fannie and Freddie trough for campaign bucks.
McCain - Federal Housing Enterprise Regulatory Reform Act of 2005 (Democrats blocked reform)
govtrack.us ^ | 1/26/2005 | Congressional Research Service
Federal Housing Enterprise Regulatory Reform Act of 2005
Bill Summary
1/26/2005--Introduced. Federal Housing Enterprise Regulatory Reform Act of 2005 - Amends the Federal Housing Enterprises Financial Safety and Soundness Act of 1992 to establish: (1) in lieu of the Office of Federal Housing Enterprise Oversight of the Department of Housing and Urban Development (HUD), an independent Federal Housing Enterprise Regulatory Agency which shall have authority over the Federal Home Loan Bank Finance Corporation, the Federal Home Loan Banks, the Federal National Mortgage Association (Fannie Mae), and the Federal Home Loan Mortgage Corporation (Freddie Mac); and (2) the Federal Housing Enterprise Board. Sets forth operating, administrative, and regulatory provisions of the Agency, including provisions respecting: (1) assessment authority; (2) authority to limit nonmission-related assets; (3) minimum and critical capital levels; (4) risk-based capital test; (5) capital classifications and undercapitalized enterprises; (6) enforcement actions and penalties; (7) golden parachutes; and (8) reporting. Amends the Federal Home Loan Bank Act to establish the Federal Home Loan Bank Finance Corporation. Transfers the functions of the Office of Finance of the Federal Home Loan Banks to such Corporation. Excludes the Federal Home Loan Banks from certain securities reporting requirements. Abolishes the Federal Housing Finance Board.
What effect did the Basel Accords have on the underlying fundamentals that have come into play in this market? I was doing IT for a bank converting to these standards, and it was obvious that they had a poor grasp of the definition of how to go about the reclassification of their existing tranches to the Basel initiatives. They had begun reporting on the first Basel Accord standards and were still deciphering how to implement the second. Interestingly, the IBM SMEs they brought in to assist in the deciphering produced an incoherent and ungainly mess. I understood from reading the Accords in comparison to the Federal standards that they were more "nuanced" and seemed to generally require the banks to actually revalue their holdings to a less stringent reserve/risk requirement. But I could be wrong.
I AM just a lowly IT professional attempting to decipher the complexities of banking and finance regulations to produce data sets that have meaning - with conflicting meanings of what the proper tranch level and value of IS is.
Seems to me over-complication and silly word games killed the goose, but that's just me.
Step 1. Assume you can't lose money in real estate, ever.
Step 2. Use leverage to amplify your inevitable gains (see step 1.)
Step 3. Hedge your bets by buying credit default swaps underwritten by schmucks just like you who also subscribe to Step's 1. and 2.
When the wheels come off, make sure you have trillions of dollars on the line backing interlocking hedge contracts. Mere billions will not protect you, you need trillions of exposure.(see Lehman Bros.)
Step 4. Sell your equity to the Fed, and call your buddies who are holding the paper that you just salvaged by selling out to the Fed, and tell them they owe you a big favor. Find a nice new job. Go to Step 1.
Supertwaddle? Color me super pissed.
I have not read any of the comments (and don't intend to) and read, but probably did not fully understand, Megan's post. But I live in California and it was obvious to me and *everyone* I know - of all classes and walks of life - that the real estate bubble was a bubble even way back in '07, if not '06. This entire thing happened in super slo mo right in front of our eyes; half car wreck half beautiful fantasy. From the people lying on their 'stated income' applications (lying most of all to themselves), to the mortgage brokers (usually eager but undereducated young people with hearts full of a lethal combination of hope and financial ambition), to the Wall Street execs who took home ten figure bonuses and actually convinced themselves that they were worth all of it for their creative risk-taking acumen. Everybody involved (and you know who you are!) basically figured in the highly unlikely event anything went wrong, some super-adult, perhaps Uncle San and Aunt Samantha would come in and fix everything, and everything would be alright.
Responsibility without liberty is slavery, but liberty without responsibility is destruction. As a person who pays his (many) debts and (too high) taxes, the only question I am left with now is, what do we do as a nation. If the answer is 'bailout' then we're in an even sorrier state than I thought.
"...it appears the man attacking McCain, Senator Obama, was at the head of the line when the piggies lined up at the Fannie and Freddie trough for campaign bucks."
Turns out that we have real facts and Nancy,Harry and Barack, Barney...you have some explaining to do and NOW.
And Nancy "let 'em cake" Pelosi, the Democrat holds both houses hostage and are in charge of oversight last time I checked. Perhaps our pals in congress should have spent less time conspiring to destroy the economy.
The approach here is one of my favorites from Republicans.
For a party that used to be so dedicated to creating a culture centered around values, including personal responsibility, Republicans have shown incredible talent at refusing to take responsiblity for anything that has happened in the the last eight years.
So, a few points:
1) Let's move away from technocratic bickering. The reasons for the current economic fiasco will be resolved by economic historians (as opposed to the political chattering classes), who, after gaining historical perspective, will begin to analyze the data and documents necessary to provide a thorough analysis as to how we have come so close to global financial meltdown.
2) In my opinion, blame begins with Americans of all stripes, politics and persuasions, with the ordinary Americans, Republicans and Democrats, who got caught up in a property asset bubble that is the foundation for this mess, with all of the Americans who leveraged themselves to buy overvalued houses, who encouraged fraud to earn outrageous fees, who packaged complex securities to sell to unsuspecting investors.
3) Bush is the current sitting president of the United States, and that should mean something. It should mean that Bush administration takes responsibility for what happens to our country, whether it is Katrina, 9/11, Iraq, massive deficits or bank failures. The president should take responsibility for success and failure, because the office should stand for something more than making the supporters of the party that currently holds office feel better about themselves.
4) Question for all of us is not whether this is the fault of Republican ideology, but rather, whether that ideology can lead us forward, to take us out of this quagmire and set our country back on a path to the exceptional position that we have enjoyed for the last century.
Don't pay too much mind to Captain Law Clerk. Speaking as someone who's been in DC and dealt with the SEC for more than "a summer," I can safely say that the kids who go to SEC for the summer are truly the dumbest of the dumb.
Also, note that the guy relies on his one summer at the SEC fetching coffee, not years of actual securities practice afterwards. Even money says that clown is now doing commercial litigation and real-estate in Timbuktu because it's the only work he can get. And yet, he's a securities legend in his own mind...
what the hell is she smoking??
I don't know how old the various commenters and the author are. I don't know the average age of journalists writing about this latest financial saga. I suspect they are on the young side becasue they act as if this latest fiasco is something new, It's not.
I'm pushing 60 and have seen umpteen other crises over the years, caused by one thing or another. In each one of these various major players in the financial sector disappeared and were eventually replaced by new players or players that were created by the merger of healthy players with the collapsed ones.
I don't know how many remember the useless loans that so many banks made to foreign governments in the 70s and early 80s. Those were being run akin to the current Option ARMS. A few major banks disappeared on that one.
How about the S&L crisis of the 80s? That was a doozy. It was also the result of another real estate bubble. Just before that we had the Continental Illinois disaster with the Fed riding to the rescue.
The early "derivatives" fiascos put a few banks out of business and almost cost the survival of some of their client companies.
How about the bailout of the banks on Mexican loans under Rubin?
The Long Term Capital Management collapse in '98 was another example of the wunderkinds in banking screwing up royally.
Over the years Citibank (formerly First National City Bank and my former employer) has danced from one crisis to the next. The write downs of bad mortgage paper is only the latest in this outfit's saga. Walter Wriston conceived the concept of being "too big to fail".
I could go on and on but I'm sure you get the idea here. Unfortunately, the public has a short memory and does not put things in perspective.
If there's one difference today, it's that there a fewer giant Wall Street players. That's a result of consolidations, usually caused by various failures over the years. That concentrates the negative effects of one failure.
Not true. Treasury was well aware of the increase in fraud via the 1000% increase in suspicious activity reports (SARs) from 2000 - 2006.
You would think that SEC would have began their investigation in 2005 into mortgage fraud. They could have then began making the connection between the level of fraud at the originators to the growth in CDOs and looking at account treatment.
However, its understandable why SEC cannot be proactive. The Bush Administration has starved the agency.
So there. That's what Bush could have done: increased the SEC budget so they have the resources to pursue fraud BEFORE it becomes a problem.
So, your claim that nothing more could have been done because everyone was compliant with existing regulation is wrong. If that were the case, the SEC and the FBI would not be pursuing criminal charges of mortgage brokers without any new laws on the books.
Gene2: You're way over my head, but thanks for thinking I really understand this stuff. What I hear you saying is that there were red flags that subject matter experts might have seen at the time, but the meaning of those red flags only became much clearer with the wonder of 20-20 hindsight.
I can agree with this. I'm not a subject matter expert on financial oversight, but having been a subject matter expert with oversight responsibility for complex systems, I can say it's pretty clear to expert insiders whose job it is to monitor that certain system variables reach levels never previously seen before. Vigilant oversight will notice, even if it doesn't understand the full meaning.
Megan's criticism against regulation and oversight are much broader and more cynical, and they are just dripping with partisan attitude that confuses the entire discussion.
I probably agree with Megan on issues of "lightly" regulating, or better, expanding transparency, particularly assessing risk exposure both to investors and firms, but I don't agree that nothing could have been done, and I certainly don't agree that the Clinton administration had responsibility to oversee implementation of financial products most of which were invented after 2000, were not heavily implemented until the mid 2000's and which did not crest until 2006.
Thank you for this post! I really enjoy your blog, because you are very knowledgeable and have enough respect for your audience not to oversimplify your opinions. Bravo! Keep up the good work!
What should Bush have done? The real question is what should the Democrats have done?
1. They should have allowed oil drilling and exploration instead of restricting the production of domestic energy, causing high oil prices and causing a domino effect in reduced purchasing and job losses in the economy. The Democrats did this not Bush.
2. They should not have created Fannie and Freddie during the Clinton administration which created the housing bubble - these are Democratic programs run by Democrats and feeding large amounts of campaign contributions to Democrats.
3. They should not be talking down the economy every chance they get so that things get worse and they can win the election.
Now you tell me, if the Democrats had done these things, where would we be? Democrats can parse it all they want and they can slice it up all they want and pretend they are really analzying something real but all they are doing is pretending to actually know what caused this situation - so that no one notices that it is their policies that are at fault.
"The real question is what should the Democrats have done? ... They should not have created Fannie and Freddie during the Clinton administration which created the housing bubble"
Truly, this is a moment of commentary so thoroughly clueless that we should all stop and marvel at the form and shape of perfectly-crystallized ignorance.
Fannie was created under FDR and privatized under LBJ. Freddie was chartered under Nixon. Neither one of them "created" the housing bubble in any meaningful sense. At most they were a contributing factor.
The financial deregulation during the Clinton years was primarily pushed by a Republican Congress with most of the dissenting votes coming from Democrats, and it represented the formalization of a policy that began under Reagan. Clinton does deserve a small share of the blame.
Thanks for playing.
The bank regulators could probably have done something to tighten lending standards, but this would have amounted to saying "Don't lend money to poor people". A Democratic congress saying "don't lend money to poor people".
Just to unwind another cheap shot.
There were clearly recognizable changes in lending standards by banks culminating with a boom around 2006, and as noted earlier, the number of reports of fraud was steadily on the rise at that time. This was obvious.
Megan notes the bad lending practices were severe in "Democratic" California, but fails to note that "Democratic" California counties are the richest and have the most expensive housing prices in the US.
In my county, San Mateo (number 10 on the national list) the median price for a 2200sf home is $1.3M dollars and the median income is about $70k, both well above the national average. Single or dual income earners with few assets, but whose salary is well in excess of $200k are not qualified for bank loans on the typical 2200sf home.
Many of the exotic loan products, particularly those in California, were not designed for "poor people" but rather for affluent young families with good salaries, possessed of the American Dream,but no down payment to qualify to live in a place where the typical 2200sf cost $1.3M.
One real structural economic reason for the lowering of mortgage standards derives from the fact that those writing mortgages can offload the risk by reselling them, but Megan resorts to coded language to suggest that industry-wide bad lending practices were a product of Democratic weakness for giving welfare to minorities.
"Responsibility without liberty is slavery, but liberty without responsibility is destruction."
This is the only truly insightful post on this whole subject.
Partisan bickering aside, I see this mess is an inevitable conclusion to decades of the nanny state absolving individuals of their personal responsibilities. A herd mentality of collective invincibility begins to rule the day. Throw in the hubris of the "intelligent" class, and the only remedy is a major market correction.
Fortunately, we'll get through this very painful exercise and learn our lessons which, unfortunately, will only be forgotten a few generations hence and then the whole cycle will repeat itself.
I've been finding these posts on what could have been done extremely educational. I am curious if this bill, if passed, could have made any difference in dampening the current crisis. Would this have slowed down Fannie Mae and Freddie Mac? Would other banks simply have jumped in to fill their void?
Thanks
"The only banks that are surviving are the universal banks (commercial bank + investment bank). If it wasn't repealed, all of the US investment banks might be bankrupt."
I agree. There is a lot of blame to go around, but this one is lame in the extreme.
And I dont get this sorry excuse-making for Fannie Mae. They are putting taxpayers on the hook for $250 billion or so. To say they didnt do anything wrong is beyond feeble. $250 billion is just an 'ooops' when its a GSE?
ohn McCain attempted to control Fannie Mae and warned about the potential costs to taxpayers. He said in 2006: "I join as a cosponsor of the Federal Housing Enterprise Regulatory Reform Act of 2005, S. 190, to underscore my support for quick passage of GSE regulatory reform legislation. If Congress does not act, American taxpayers will continue to be exposed to the enormous risk that Fannie Mae and Freddie Mac pose to the housing market, the overall financial system, and the economy as a whole." - John McCain, May 25 2006
Thought you supertwaddlers might enjoy this highly relevant factoid reported by the NY Sun (and blogged by Ritholtz, an actual econoblogger).
http://bigpicture.typepad.com/comments/2008/09/regulatory-exem.html
Oh, "DC Law Talking Guy" -- I graduated from a "top 10" law school and went on to practice at one of the top Plaintiff's securities firms in NYC. (A job I mercifully quit a year ago to go back into finance -- being a litigator sucks ass, all you ever do is obsess about the ancient past -- a very unhealthy way to be.)
(Really, really this is it for me, I'm taking McArdle out of my RSS feed).
Such condescending "twaddle" (to use your own term) from a woman who less than a week ago told us:
In a world of perfect information, stock prices would never change
At the time, I said that may have been the dumbest thing ever written. However, it now has a contender in:
Democrats seem unable, or unwilling to grasp, that to the extent that this is a regulatory problem, the seeds were laid under Clinton, not Bush.
Gee... ever hear of the president who said "Government is not the solution to our problems, government IS the problem"? (Hint: He wasn't a Democrat.) Maybe THAT philosohpy is the source of the problems?
A disappointing item that should have been given more time in your article. The Bush Admin. under the direction of former Senator Jim Talent put a 36% rate cap in place some two years ago for most lending products offered to members of the military. In it's final stages it was gutted by bankers of most of its protective provisions and became a scapegoat bill on payday lenders.
Great blog! One of the few that I have found that is not all name calling and shouting matches.The securities industry in the US is one of the most regulated industries on the planet.The problem is not with the laws on the books,but proper enforcement.The current problem is leverage,not just on "wall street" but throughout the economy.There is no good way to unwind leverage, and it is almost impossible in capital markets that are not operating properly.Public companies, pension funds,state and local govts,etc. around the globe are exposed to this.We saw the capital markets frozen this week,no ability to raise capital for corporations or municipal govts.If we want to continue to have a functioning economy we have to work this out quickly. Otherwise there will be no place to hide.It's not political, it's finance.
The facts are:
Bill Clinton repealed the majority of the bank act of 1933.
For many years, the President and his Administration have not only warned of the systemic consequences of financial turmoil at a housing government-sponsored enterprise (GSE) but also put forward thoughtful plans to reduce the risk that either Fannie Mae or Freddie Mac would encounter such difficulties. President Bush publicly called for GSE reform 17 times in 2008 alone before Congress acted. Unfortunately, these warnings went unheeded, as the President's repeated attempts to reform the supervision of these entities were thwarted by the legislative maneuvering of those who emphatically denied there were problems. Many prominent Democrats, including House Finance Chairman Barney Frank, opposed any legislation correcting the risks posed by GSEs.
2001
April: The Administration's FY02 budget declares that the size of Fannie Mae and Freddie Mac is "a potential problem," because "financial trouble of a large GSE could cause strong repercussions in financial markets, affecting Federally insured entities and economic activity."
2002
May: The President calls for the disclosure and corporate governance principles contained in his 10-point plan for corporate responsibility to apply to Fannie Mae and Freddie Mac. (OMB Prompt Letter to OFHEO, 5/29/02)
2003
January: Freddie Mac announces it has to restate financial results for the previous three years.
February: The Office of Federal Housing Enterprise Oversight (OFHEO) releases a report explaining that "although investors perceive an implicit Federal guarantee of [GSE] obligations," "the government has provided no explicit legal backing for them." As a consequence, unexpected problems at a GSE could immediately spread into financial sectors beyond the housing market. ("Systemic Risk: Fannie Mae, Freddie Mac and the Role of OFHEO," OFHEO Report, 2/4/03)
September: Fannie Mae discloses SEC investigation and acknowledges OFHEO's review found earnings manipulations.
September: Treasury Secretary John Snow testifies before the House Financial Services Committee to recommend that Congress enact "legislation to create a new Federal agency to regulate and supervise the financial activities of our housing-related government sponsored enterprises" and set prudent and appropriate minimum capital adequacy requirements.
September: House Financial Services Committee Chairman Barney Frank (D-MA) strongly disagrees with the Administration's assessment, saying "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." (Stephen Labaton, "New Agency Proposed To Oversee Freddie Mac And Fannie Mae," The New York Times, 9/11/03)
October: Fannie Mae discloses $1.2 billion accounting error.
October: Senator Thomas Carper (D-DE) refuses to acknowledge any necessity for GSE reforms, saying "if it ain't broke, don't fix it." (Sen. Carper, Hearing of Senate Committee on Banking, Housing, and Urban Affairs, 10/16/03)
November: Council of the Economic Advisers (CEA) Chairman Greg Mankiw explains that any "legislation to reform GSE regulation should empower the new regulator with sufficient strength and credibility to reduce systemic risk." To reduce the potential for systemic instability, the regulator would have "broad authority to set both risk-based and minimum capital standards" and "receivership powers necessary to wind down the affairs of a troubled GSE." (N. Gregory Mankiw, Remarks At The Conference Of State Bank Supervisors State Banking Summit And Leadership, 11/6/03)
2004
February: The President's FY05 Budget again highlights the risk posed by the explosive growth of the GSEs and their low levels of required capital, and called for creation of a new, world-class regulator: "The Administration has determined that the safety and soundness regulators of the housing GSEs lack sufficient power and stature to meet their responsibilities, and therefore…should be replaced with a new strengthened regulator." (2005 Budget Analytic Perspectives, pg. 83)
February: CEA Chairman Mankiw cautions Congress to "not take [the financial market's] strength for granted." Again, the call from the Administration was to reduce this risk by "ensuring that the housing GSEs are overseen by an effective regulator." (N. Gregory Mankiw, Op-Ed, "Keeping Fannie And Freddie's House In Order," Financial Times, 2/24/04)
April: Rep. Frank ignores the warnings, accusing the Administration of creating an "artificial issue." At a speech to the Mortgage Bankers Association conference, Rep. Frank said "people tend to pay their mortgages. I don't think we are in any remote danger here. This focus on receivership, I think, is intended to create fears that aren't there." ("Frank: GSE Failure A Phony Issue," American Banker, 4/21/04)
June: Treasury Deputy Secretary Samuel Bodman spotlights the risk posed by the GSEs and called for reform, saying "We do not have a world-class system of supervision of the housing government sponsored enterprises (GSEs), even though the importance of the housing financial system that the GSEs serve demands the best in supervision to ensure the long-term vitality of that system. Therefore, the Administration has called for a new, first class, regulatory supervisor for the three housing GSEs: Fannie Mae, Freddie Mac, and the Federal Home Loan Banking System." (Samuel Bodman, House Financial Services Subcommittee on Oversight and Investigations Testimony, 6/16/04)
2005
April: Treasury Secretary John Snow repeats his call for GSE reform, saying "Events that have transpired since I testified before this Committee in 2003 reinforce concerns over the systemic risks posed by the GSEs and further highlight the need for real GSE reform to ensure that our housing finance system remains a strong and vibrant source of funding for expanding homeownership opportunities in America… Half-measures will only exacerbate the risks to our financial system." (Secretary John W. Snow, "Testimony Before The U.S. House Financial Services Committee," 4/13/05)
July: Senate Majority Leader Harry Reid rejects legislation reforming GSEs, "while I favor improving oversight by our federal housing regulators to ensure safety and soundness, we cannot pass legislation that could limit Americans from owning homes and potentially harm our economy in the process." ("Dems Rip New Fannie Mae Regulatory Measure," United Press International, 7/28/05)
2007
July: Two Bear Stearns hedge funds invest in mortgage securities collapse.
August: President Bush emphatically calls on Congress to pass a reform package for Fannie Mae and Freddie Mac, saying "first things first when it comes to those two institutions. Congress needs to get them reformed, get them streamlined, get them focused, and then I will consider other options." (President George W. Bush, Press Conference, the White House, 8/9/07)
August: Senate Committee on Banking, Housing and Urban Affairs Chairman Christopher Dodd ignores the President's warnings and calls on him to "immediately reconsider his ill-advised" position. (Eric Dash, "Fannie Mae's Offer To Help Ease Credit Squeeze Is Rejected, As Critics Complain Of Opportunism," The New York Times, 8/11/07)
September: RealtyTrac announces foreclosure filings up 243,000 in August – up 115 percent from the year before.
September: Single-family existing home sales decreases 7.5 percent from the previous month – the lowest level in nine years. Median sale price of existing homes fell six percent from the year before.
December: President Bush again warns Congress of the need to pass legislation reforming GSEs, saying "These institutions provide liquidity in the mortgage market that benefits millions of homeowners, and it is vital they operate safely and operate soundly. So I've called on Congress to pass legislation that strengthens independent regulation of the GSEs – and ensures they focus on their important housing mission. The GSE reform bill passed by the House earlier this year is a good start. But the Senate has not acted. And the United States Senate needs to pass this legislation soon." (President George W. Bush, Discusses Housing, the White House, 12/6/07)
2008
January: Bank of America announces it will buy Countrywide.
January: Citigroup announces mortgage portfolio lost $18.1 billion in value.
February: Assistant Treasury Secretary David Nason reiterates the urgency of reforms, says "A new regulatory structure for the housing GSEs is essential if these entities are to continue to perform their public mission successfully." (David Nason, Testimony On Reforming GSE Regulation, Senate Committee On Banking, Housing And Urban Affairs, 2/7/08)
March: Bear Stearns announces it will sell itself to JPMorgan Chase.
March: President Bush calls on Congress to take action and "move forward with reforms on Fannie Mae and Freddie Mac. They need to continue to modernize the FHA, as well as allow State housing agencies to issue tax-free bonds to homeowners to refinance their mortgages." (President George W. Bush, Remarks To The Economic Club Of New York, New York, NY, 3/14/08)
April: President Bush urges Congress to pass the much needed legislation and "modernize Fannie Mae and Freddie Mac. [There are] constructive things Congress can do that will encourage the housing market to correct quickly by … helping people stay in their homes." (President George W. Bush, Meeting With Cabinet, the White House, 4/14/08)
May: President Bush issues several pleas to Congress to pass legislation reforming Fannie Mae and Freddie Mac before the situation deteriorates further.
• "Americans are concerned about making their mortgage payments and keeping their homes. Yet Congress has failed to pass legislation I have repeatedly requested to modernize the Federal Housing Administration that will help more families stay in their homes, reform Fannie Mae and Freddie Mac to ensure they focus on their housing mission, and allow state housing agencies to issue tax-free bonds to refinance sub-prime loans." (President George W. Bush, Radio Address, 5/3/08)
• "[T]he government ought to be helping creditworthy people stay in their homes. And one way we can do that – and Congress is making progress on this – is the reform of Fannie Mae and Freddie Mac. That reform will come with a strong, independent regulator." (President George W. Bush, Meeting With The Secretary Of The Treasury, the White House, 5/19/08)
• "Congress needs to pass legislation to modernize the Federal Housing Administration, reform Fannie Mae and Freddie Mac to ensure they focus on their housing mission, and allow State housing agencies to issue tax-free bonds to refinance subprime loans." (President George W. Bush, Radio Address, 5/31/08)
June: As foreclosure rates continued to rise in the first quarter, the President once again asks Congress to take the necessary measures to address this challenge, saying "we need to pass legislation to reform Fannie Mae and Freddie Mac." (President George W. Bush, Remarks At Swearing In Ceremony For Secretary Of Housing And Urban Development, Washington, D.C., 6/6/08)
July: Congress heeds the President's call for action and passes reform legislation for Fannie Mae and Freddie Mac as it becomes clear that the institutions are failing.
September: Democrats in Congress forget their previous objections to GSE reforms, as Senator Dodd questions "why weren't we doing more, why did we wait almost a year before there were any significant steps taken to try to deal with this problem? … I have a lot of questions about where was the administration over the last eight years." (Dawn Kopecki, "Fannie Mae, Freddie 'House Of Cards' Prompts Takeover," Bloomberg, 9/9/08)