September 19, 2008
Some Observations on the Ongoing Crisis: Causes and Opportunity Cost Again
There's a lot of commentary -- more comprehensive and up to date than I can provide -- on the crisis and the attempts to resolve the logjam in the financial markets.,  But I stilll have a couple of thoughts about the causes, and the implications, of the process that has resulted in so much turmoil this week.
First, what is the source of the crisis? Is it as is asserted here in this statement from John McCain today?
There are certainly plenty of places to point fingers, and it may be hard to pinpoint the original event that set it all in motion. But let me give you an educated guess. The financial crisis we're living through today started with the corruption and manipulation of our home mortgage system. At the center of the problem were the lobbyists, politicians, and bureaucrats who succeeded in persuading Congress and the administration to ignore the festering problems at Fannie Mae and Freddie Mac.
These quasi-public corporations lead our housing system down a path where quick profit was placed before sound finance. They institutionalized a system that rewarded forcing mortgages on people who couldn't afford them, while turning around and selling those bad mortgages to the banks that are now going bankrupt. Using money and influence, they prevented reforms that would have curbed their power and limited their ability to damage our economy. And now, as ever, the American taxpayers are left to pay the price for Washington's failure.
I certainly concur with the first sentence. But I do wonder about the assertion that the problem started with and is fundamentally driven by Fannie Mae and Freddie Mac. After all, neither of these two institutions were at the heart of the massive surge in subprime mortgages that are the most toxic component of these asset backed securities. Smarter people than me (Justin Fox, Tanta at CR h/t Mark Thoma, not to mention Jim Hamilton) have been similarly dubious.
Moreover, the originating entities for these subprime mortgages were not Fannie Mae and Freddie Mac, by large, but rather the banks that the Federal government refused to let state agencies regulate. Or the ones the Treasury's OTS itself failed to regulate. To refresh memories, consider this article from December 18, 2007 NYT:
WASHINGTON-- Until the boom in subprime mortgages turned into a national nightmare this summer, the few people who tried to warn federal banking officials might as well have been talking to themselves.
Edward M. Gramlich, a Federal Reserve governor who died in September, warned nearly seven years ago that a fast-growing new breed of lenders was luring many people into risky mortgages they could not afford.
But when Mr. Gramlich privately urged Fed examiners to investigate mortgage lenders affiliated with national banks, he was rebuffed by Alan Greenspan, the Fed chairman.
In 2001, a senior Treasury official, Sheila C. Bair, tried to persuade subprime lenders to adopt a code of "best practices" and to let outside monitors verify their compliance. None of the lenders would agree to the monitors, and many rejected the code itself. Even those who did adopt those practices, Ms. Bair recalled recently, soon let them slip.
And leaders of a housing advocacy group in California, meeting with Mr. Greenspan in 2004, warned that deception was increasing and unscrupulous practices were spreading.
John C. Gamboa and Robert L. Gnaizda of the Greenlining Institute implored Mr. Greenspan to use his bully pulpit and press for a voluntary code of conduct.
"He never gave us a good reason, but he didn't want to do it," Mr. Gnaizda said last week. "He just wasn't interested."
Today, as the mortgage crisis of 2007 worsens and threatens to tip the economy into a recession, many are asking: where was Washington?
An examination of regulatory decisions shows that the Federal Reserve and other agencies waited until it was too late before trying to tame the industry's excesses. Both the Fed and the Bush administration placed a higher priority on promoting "financial innovation" and what President Bush has called the "ownership society."
On Tuesday, under a new chairman, the Federal Reserve will try to make up for lost ground by proposing new restrictions on subprime mortgages, invoking its authority under the 13-year-old Home Ownership Equity and Protection Act. Fed officials are expected to demand that lenders document a personâ€™s income and ability to repay the loan, and they may well restrict practices that make it hard for borrowers to see hidden fees or refinance with cheaper mortgages.
It is an action that people like Mr. Gramlich and Ms. Bair advocated for years with little success. But it will have little impact on many existing subprime lenders, because most have either gone out of business or stopped making subprime loans months ago.
The Fed was hardly alone in not pressing to clean up the mortgage industry. When states like Georgia and North Carolina started to pass tougher laws against abusive lending practices, the Office of the Comptroller of the Currency successfully prohibited them from investigating local subsidiaries of nationally chartered banks.
Virtually every federal bank regulator was loathe to impose speed limits on a booming industry. But the regulators were also fragmented among an alphabet soup of agencies with splintered and confusing jurisdictions. Perhaps the biggest complication was that many mortgage lenders did not fall under any agency's authority at all.
And for some more concrete examples of how deregulatory zeal had an effect, consider this account from the WSJ (March 22, 2007):
Regulators appointed by President Bush often have been more sympathetic to industry concerns about red tape than their Clinton administration predecessors. When James Gilleran, a former California banker and bank supervisor, took over the OTS in December 2001, he became known for his deregulatory zeal. At one press event in 2003, several bank regulators held gardening shears to represent their commitment to cut red tape for the industry. Mr. Gilleran brought a chain saw.
He also early on announced plans to slash expenses to resolve the agency's deficit; 20% of its work force eventually left. When he left in 2005, Mr. Gilleran declared that the OTS had "exercised increased diligence in its review of abusive consumer practices" while reducing thrifts' regulatory burden. But his successor, Mr. Reich, a former community banker, has reversed many of Mr. Gilleran's cuts. Citing "understaffing," he hired 80 examiners last year and plans to add 40 more this year. A spokeswoman for Mr. Gilleran, now chief executive of the Federal Home Loan Bank of Seattle, said he wasn't available to comment.
So, from my perspective, locating the source of the current crisis in corruption/influence peddling surrounding Fannie and Freddie exhibits a misreading of recent history. (More important might have been lax monetary policy and the saving glut, and exemptions from capital requirements for certain investment banks... [see Ritholtz])
Second, how hard will the rescue be given the reckless decisions of the past? It seems that whatever entity is established to purchase these bad assets will require some fiscal outlay. Estimates are all over the place, given that there is so much uncertainty over how much the assets will be bought for and eventually sold; here is one account:
U.S. Debt May Grow $1 Trillion on Rescue, Barclays' Pond Says
By Sandra Hernandez
Sept. 19 (Bloomberg) -- The U.S. may have to borrow an extra $700 billion to $1 trillion to fund the biggest rescue of the financial system since the Great Depression, according to Barclays Capital Inc.'s Michael Pond.
Federal takeovers of Fannie Mae, Freddie Mac, and American International Group Inc.; the central bank's expansion of lending to financial firms; and a slowing economy will add $455 billion to the Treasury's borrowing needs, the New York-based interest-rate strategist estimated. Pond said Treasury Secretary Henry Paulson's plan to rid banks of "hundreds of billions" of troubled assets would bring the amount to $700 billion assuming the plan costs $200 billion.
"We could easily add up to an additional trillion to the outstanding Treasury debt just from the initiatives announced over the past couple of weeks," said Pond, ranked the best Treasury Inflation-Protected Securities analyst in 2008 by Institutional Investor magazine.
The government's liabilities swelled in past weeks as policy makers sought to arrest a growing financial crisis by taking over financial institutions threatened by a shortage of capital.
The Treasury on Sept. 7 took over mortgage-finance companies Fannie Mae and Freddie Mac and said it would buy mortgage-backed debt in the open market. The Fed this week boosted its Treasury auctions to bond dealers by $25 billion, loaned $85 billion to the insurer AIG, and quadrupled the amount of dollars foreign central banks can auction to $247 billion. Paulson today said the government will buy illiquid assets from banks' balance sheets and insure money-market mutual fund holdings.
"The odds of the deficit becoming enormous are certainly there," said Nils Overdahl, a bond fund manager in Bethesda, Maryland, at New Century Advisors, which oversees $500 million. "I suspect you will see issuance at a variety of maturities."
The deficit will likely widen to $650 billion in fiscal 2009 because of the U.S. rescue of Fannie and Freddie, analysts at JPMorgan Chase & Co. wrote in a Sept. 12 report.
Over the next decade, the gap between spending and receipts will swell to $5.3 trillion, Goldman Sachs Group Inc. analysts wrote Sept. 10, revising a previous forecast of $3.6 trillion. The non-partisan Congressional Budget Office forecast a record $438 billion deficit for 2009 on Sept. 9.
"The deficit will soar to enormous proportions,'' said Lou Crandall, the chief economist at Wrightson ICAP LLC in Jersey City, New Jersey. ``Even before this week's events, estimates based on visible factors were pointing to a deficit above $500 billion next year, with the prospect of billions of mortgage- backed securities on top of that."
See also this Bloomberg article.
Here, I want to return the issue I've brought up countless times before. We cut taxes, and we embarked upon a war of choice, and in addition to the opportunity and fiscal costs, this constrained our range of actions for the future. Even if you thought the Bush tax cuts of 2001 and 2003 "benefitted" the US economy on net, we know that the war in Iraq has cost on the order of $653 billion nominal dollars from FY03-FY0-09  -- in current dollars that's even more given inflation. Those dollars could have been spent fixing the financial system. Now, we'll have to either borrow or tax to to finance the operation.
So, if you wanted the McCain extension of the Bush tax cuts, and the additional $1.3 trillion tax cuts, then you might wonder about the impact on US borrowing rates. If you were hoping for more domestic initiatives, perhaps to give tax relief to the lower and middle income households, or to invest in infrastructure, the borrowing constraints will be more binding than they otherwise would have been.
Perhaps that's obvious, but sometimes in the midst of crisis, the obvious bears repeating. Here's a picture to illustrate the budget balance outlook pre-intervention....
Figure 1: US budget surplus to GDP ratio actual (blue), baseline under current law (dark blue), balance if EGTRRA and JGTRRA made permanent (green), balance if EGTRRA and JGTRRA made permanent and nominal discretionary spending except Iraq/Afghanistan grows with nominal GDP (red). Adding in $350[$700] billion borrowing (orange square [purple square]). Source: Author's calculations based upon CBO, The Budget and Economic Outlook: An Update (September 2008)Table C-2 and Table 1-8 [xls], and author's calculations.
The purple square is just for illustrative purposes. If you think the Treasury will only have to borrow $350 billion in FY2009, then the orange square is relevant. Further, if we're lucky (and Brad Delong is right), in future years we will recoup all and more of these outlays, so the deficit will be smaller than otherwise. But, in the short run, we'll have to take a hit (of unknown magnitude) now and hope for the best.
Update, Saturday, 9/27 6:36am: See this post from WSJ RealTime Economics about the budgetary implications of the rescue plan.
Posted by Menzie Chinn at September 19, 2008 07:15 PMdigg this | reddit
I'm not smarter than you, Menzie.
Posted by: Justin Fox at September 19, 2008 07:33 PM
JPM sez: "Initiative relieves stress but US net debt issuance may reach 10% of GDP," or around $1.5tn, largely depending on home prices (inventory/affordability/sales), negative equity, unemployment, and default/recovery...
Posted by: glory at September 19, 2008 07:35 PM
Here is Nassim Taleb's view on the current crisis:
Posted by: Black Swan Baby at September 19, 2008 09:29 PM
As an economist I would think that you would know the the very strong connection between Fannie Mae and Freddie Mac and the subprime mortgate crisis.
Is your political bias showing again ?
"Fannie Mae, the nation's biggest underwriter of home mortgages, does not lend money directly to consumers. Instead, it purchases loans that banks make on what is called the secondary market. By expanding the type of loans that it will buy, Fannie Mae is hoping to spur banks to make more loans to people with less-than-stellar credit ratings."
The above is from a 1999 NY Times article: "link
Posted by: Jason at September 19, 2008 11:10 PM
You really believe McCain's first sentence about what caused the current financial crisis's is even somewhat accurate???
C'mon; Like his blaming of Christopher Cox pointing the finger at... subprime mortgages (???) as being the cause of the problems besieging the global financial system is not only frighteningly simplistic for someone running for President (especially anyone with McCain's checkered history), it's completely incorrect.
The subprime mortgage crisis, as with the credit crisis, as with the entire derivatives market (a $60 trillion dollar market?), are the BYPRODUCTS of the REAL PROBLEMS in the financial system that made those crisis's possible.
We have to focus on what CAUSED those consequences, not mistake those crisis's for the CAUSE. Especially if you want to be President...
Heck- You're far smarter than me... Don't enable McCain one iota. You think we have problems now... elect that crooked super-hawk and his nutty VP pick into office...
The Societal Retard
Posted by: The Societal Retard at September 20, 2008 01:44 AM
Why should the tax payer have to borrow this money at all.
The Treasury could just print the money and use it to settle the system by nationalizing the banks and selling the securities. Tax payer money would be paid back first, shareholders would receive the remainder.
We are heading into a great deflation anyway so just printing the money would help to counteract this deflationary process leaving the tax payer to deal with any inflation but not on the hook for principle and interest.
This process is far from over. Here is a chart from Calculated Risk that shows starting next year a second tsunami of bad mortgage debt hitting and lasting another 2 years or more !
Posted by: Michael McKinlay at September 20, 2008 02:42 AM
Right now I only understand the basic theme of this bailout plan. I get the impression that this time we'll be buying a huge amount of CDS paper rather than actual mortgages. I'm also wondering if we'll ever get a detailed accounting (or even a data release) of exactly what we bought and how that investment is doing.
Posted by: cold white guy at September 20, 2008 03:14 AM
The connection between deregulation philosphy and the lack of regulation and the financial mess is clear and should be repeated over and over again. The first step, to clear our head, is to all agree that deregulation is useful sometimes and it is horrible sometimes. It is horrible when applied to financial systems and it is horrible when applied to the provision of electricity to homes.
The feasting of "those engaged in the financing of mortages" made possible by the craze to deregulate everything was well underway in the decade of the 90's, long before Freddie and Fannie joined the fun. When they had no stockholders, they were staid institutions that did a good job providing insurance and upholding standards. When they were allowed to sell stock, they bacame interested in increasing their profits and began to do crazy things just like the other profit oriented business firms.
McCain is working hard to deflect blame from the deregualtion philosophy he has supported all his political life. We will see how many of the media point to his past behavior.
Posted by: ReformerRay at September 20, 2008 06:54 AM
The following comment goes beyond he job of assigning blame but it is an extension of the topic of the day.
Abraham Lincoln said, "We are engaged in a great experiment, testing whether any nation so conceived and so dedicated can long endure". Today, we are engaged in another great experiment, testing whether aggressive governmental response can prevent a collapse on Wall Street from creating a world wide depression. The refusal of Herbert Hoover and his Sec. of the Treasury to intervene in the economy in the period between 1929 and 1932 led to the Great Depression. We are not going to repeat that mistake.
However, the decision to intervene does not provide guidance as to what kind of intervention is desirable. Hank Paulson seems to be aiming to use some modified version of the Resolution Trust Fund set up to handle the Savings and Loan crisis 3 decades ago.
The Resolution Trust Fund may not be the best model because of the many differences between the current problems and the S & L crisis. Better to start from scratch and develop a solution tailor made to the current realities.
Another lesson from history is that "haste makes waste". Too quick a decision as to what kind of intervention to make is both unnecessary and undesirable. Congressional leaders were told they must act quickly to stave off a world-wide economic collapse. Well, they acted. They agreed with the Administration that the federal government will intervene in this situation. That agreement was enough for the stock market on Friday, Sept. 18th. That agreement was widely supported throughout the nation. That agreement is solid, will not change, no matter how much sound and fury develop as the details are thrashed out.
Paulson and Congressional leaders should announce that the details of the intervention will take at least 2 weeks to develop, perhaps more. We need to get it right the first time this time.
Posted by: ReformerRay at September 20, 2008 07:02 AM
News headline (from CNN)-
Bush seeks to spend $700 billion.
Last two paragraphs of that report.
"Without these bad loans weighing on their books, banks may be more willing to lend. Or at least that's the goal.
The problem is that the bailout will not automatically make banks profitable, nor will it stop the slide in home values that is wreaking havoc on the economy".
Let's make sure there are no cheaper options for getting the bad loans off the books.
Posted by: ReformerRay at September 20, 2008 07:34 AM
Menzie - Am I wrong in taking the view that the fundamental underlying problem is the late, lamented, real estate bubble whose bursting makes mortgages and derivatives hard to value? If that is fair then you seem to be saying that if subprime borrowing had not taken off in late 2003-early 2004 the market would have levelled off and we would all be sitting pretty? (At an equilibrium much higher than the postwar average.) If I look at the Case-Shiller index it looks like we are getting close to its value in late 2003 so except for some undershooting maybe we are about done? Alternatively, we aren't done - there was already a bubble by late 2003 - and then at least some of the blame attaches to the systemic factors that allowed the bubble to get that far and plausibly enabled the further froth that followed? (Jim's earlier post that you liked to seemed to allow for this.)
Posted by: Shivaji Sondhi at September 20, 2008 07:42 AM
The Rush to Bail Out?
The same psyche that led to the ?Rush to War? is now leading us to history?s biggest taxpayer funded bailout of Wall Street. Reckless bets placed by investment banks have gone irretrievably sour and rather than face the music any individual investor would face, Wall Street, now taking on newfound socialist religion, pleas to preserve the common good. This plea is utter nonsense and here?s why. Bank ?A? carries a mortgage backed instrument on its books, marking its value at say 85 cents on the dollar. Its true value is unknown but probably less than 50 cents. The Treasury steps in and buys it at 75 cents, the bank takes a small hit, leaving the taxpayer to stomach the difference and hope that maybe someday the money comes back, so far so good but now the really wicked part. Bank ?A?, now knowing that it can unload all its toxic waste is now free to aggressively foreclose on homeowners as its balance sheet has been cleared. By selling the MBS to the taxpayer at prices that are orders of magnitude above the real market, the bank has a huge cushion to take on real assets as part of its balance sheet.
Additionally, the bank?s bondholders benefit immensely. Main Street is not being helped by this. Secretary Paulson has gone to extraordinary lengths to paint himself as the man on horseback coming to save the system. He is playing on the average congressman?s and average citizen?s ignorance of corporate finance. A corporation?s debtholders are highest in the pecking order, the common shareholders are lowest. The rich and the well connected own the debt, Main Street largely owns the common stock. By intervening, the government usually wipes out the common stock and saves the debtholders. Wealth is simply transferred from Main Street to Wall Street in this processs. Somber looks are given at press conferences as any great showman would but rest assured beneath the surface the reality is even more depressing as the country has now been rushed into an even more unwinnable war against an unsound financial system. At the end of the day excessive credit cannot be cured by extending even more credit but it sure can ensure that the rich and well-connected come out of the inevitable hardship in far better shape than the rest of us.
Where will the money come from? The US will be forced to sell bonds, the size required will drive interest rates higher as foreign governments are already choking on US debt they own. This inevitable process will defeat the key public objective of helping prospective homeowners obtain affordable mortgages. I?ll dodge discussing the implications for the US dollar. On Friday we saw the market?s reaction with crude oil soaring nearly 7 dollars a barrel. The market fears a dollar collapse and is rushing to buy real assets, this will also force interest rates higher.
Finally, let?s keep in mind that there is far more to come, the commercial real estate debacle is beginning to unfold, several months from now countless hundreds of additional billions will be needed to rescue the collapsing commercial real estate market and oh, by the way, just wait until the Chinese real estate market begins to fold.
Posted by: MEDLO at September 20, 2008 08:32 AM
Jason: It's exactly because I'm an empirical economist that I'm skeptical of the reasoning that the GSE's were the primary and substantial cause of the crisis that started in entities besides those GSEs. Until you can provide a model and estimates that substantiate your claim, I remain skeptical. I understand the reasoning why the GSEs were a distortion in the system, and a large contingent liability to the Federal government, but I don't understand your reasoning. You should also get some more substantive background based on the academic literature regarding the GSEs, e.g., this Journal of Economic Perspectives article I cited in this post.
The Societal Retard: I was taking his statement, extracting it out of the context of his other mischaracterizations [Factcheck via CNN]. In that light, I am willing to allow that there is a legitimate debate in the academic and policy community about the proportion of blame to ascribe to monetary policy, deregulation or dereliction in regulatory enforcement (the two are different), financial innnovation, regulatory arbitrage, saving glut, etc.
Michael McKinlay: I'm aware of the challenges; I posted that graphic on Econonbrowser on Oct 21, 2007. That being said, the subprime mortgage problem started even before the resets, as housing prices slowed their rise.
Reformer Ray: I might be making an unpopular remark, but I don't think all deregulation is bad (for instance, it's probably a good thing that we allow investment banks and commercial banks hook up). But I do think that we can point pretty specifically at some that was, and that is what I tried to focus on in the post.
On your other two posts, I would say we do need to pay attention to the development of the rescue plan parameters. That's why the Elmendorf piece is quite useful for framing questions.
Shivaji Sondhi: My view is that had we regulated subprime mortgages more carefully, then the boom in housing and the associated accumulation of hard-to-value derivatives would have been smaller. But there were a lot of other things that were securitized and some of those asset backed securities might yet become a problem. In addition, the development of an opaque OTC CDS market was an accident waiting to happen. So I'm not saying we'd be sitting pretty -- just that the size and breadth of this crisis would likely have been substantially smaller.
Posted by: Menzie Chinn at September 20, 2008 08:40 AM
I am not sure that drawing conclusions between deregulation and the current crisis tell the whole story. You are missing an important element where government has failed us: monetary policy. It is clear that Greenspan kept monetary policy way too loose (even by his own admission) and inflated housing prices. Add to that a clear government intent to increase the level of home ownership beyond what is economically viable. Fannie and Freddie were subsidized in that the implicit backing of their debt eliminated competition in the conforming mortgage market. As a consequence, banks (flush with Greenspan liquidity) were forced to turn to other sources of profit: Alt-A and subprime mortgages. The track record of government enterprise is poor at best. Now we, as taxpayers are proposing to give the Fed even more authority to "fix" this mess that they created???
Posted by: TheCaptain at September 20, 2008 09:28 AM
One more mildly subversive thought: it seems pretty plausible by now that the "zoned zone" (Glaeser, Krugman) account of the origins of the bubble captures much truth. These are, I think, mostly "blue" areas with activist local governments. So perhaps we may credit both "red" macroeconomics and "blue" microeconomics for our current joys?
Posted by: Shivaji Sondhi at September 20, 2008 10:14 AM
The advent of gain-on-sale accounting - adopted in the early 90's - and mark-to-market accounting last year are major causes of this crisis. Gain on sale essentially allowed for massive expansion of the mortgage banking and securitization business model.
Posted by: scott at September 20, 2008 10:18 AM
TheCaptain: You will note that I identified several potential culprits in both the text and my rejoinder (8:40am). Monetary policy is in my list; what's the share, is a relevant question. Indeed, I might ask if there is a synergistic element (tax cuts, exemption for 2nd houses, regulatory disarmament, lax monetary policy) such that the total is not a linear combination of the components. So, I think academic research will spend the next decade investigating these questions.
Shivaji Sondhi: Might be -- I'm not an expert in housing. But his mapshowing mortgage attributes suggests something not quite so straightforward. I guess part of this depends upon whether you classify Florida as a blue state or a red state. Personally, nationwide, I view the Akerlof-Romer effect as a more important factor.
Posted by: Menzie Chinn at September 20, 2008 10:29 AM
I don't think you characterize what Jim Hamilton said in his July 15, 2008, post quite accurately. Here is the final paragraph from that entry: "In the mean time, I very much agree with Krugman that the most egregious problems were not caused by anything Fannie or Freddie themselves did. But I disagree that their actions played no role in causing the underlying problem we face today."
Posted by: Phil Rothman at September 20, 2008 10:52 AM
Phil Rothman: Well, maybe I'm not making myself clear, but I'm pretty sure I read and re-read Jim's post and understood the last paragraph. I didn't say that Fannie and Freddie aren't responsible. In particular, as indicated in the Frame and White paper, it appeared that the two GSEs distorted the markets, and further they might have induced some risk-taking on the part of other firms. The question is the share of blame to apportion to each suspect, and as I tried to stress by use of italics (next time I'll use bold italics), I doubt it was the prime driver. Just ask yourself -- what mortgages went bad first?
Posted by: Menzie Chinn at September 20, 2008 11:01 AM
"Indeed, I might ask if there is a synergistic element (tax cuts, exemption for 2nd houses, regulatory disarmament, lax monetary policy) such that the total is not a linear combination of the components".
This gets closer to a complete picture. As you note, perhaps more to be said by later analysis.
In my opinion, the four things cited above spring from the same impulse - to help owners of businesses increase profits and retain earnings. I am not opposed to profits. I am opposed to national policy which changes the rules of the game so that profits and wealth are increased today at the cost of less profits tomorrow.
Posted by: W. Raymond Mills at September 20, 2008 11:10 AM
You know very well that sorting out the true cause and effects in such matters is quite difficult, both theoretically and empirically. It seems to me that you appear to be more comfortable than some other analysts are at this stage in making certain identifying restrictions, assumptions which allow you to reach the conclusions you do r.e. apportioning blame, e.g., you're certain that risk-taking induced by GSE distortions was not a prime driver. I respectfully differ with you on the extent to which what some others (e.g., Jim Hamilton) have written supports your take, i.e., my understanding (which may very well be off-base) is that, at this stage, they're a bit more agnostic than you are.
Posted by: Phil Rothman at September 20, 2008 11:56 AM
As to the ultimate causes I have a hunch... Which is correct matters a lot.
The thing that I noticed over the past several years was that jut about any "financial" quantity changed trend in 1995. From a gently sloping trend of growth matching or being slightly higher than GDP, the trend changed to growth much faster than GDP; a set of "hockey sticks".
Some long term graphs, first the most striking:
Then growth of M3 over decades:
Then growth of foreign USA debt:
Then some "relevant" (blue chip) stock prices:
Even IBM's stock price took off in 1995 after a near bankruptcy and losing its domination of IT:
and curiously GE started to do really well only in 1995:
So something important happened in 1995. From the graphs it looks like that it was a gigantic expansion in the availability of "money", and in particular of short term credit.
The only plausible explanation that I found is amazingly from a gold bug (who was inspired by Luskin...):
«The key event that happened around 1995 is that the fractional reserve ratio was not only lowered, it was effectively eliminated entirely. You read that right. The net result of changes during that period is that banks are not required to back assets which largely correspond to M3 or "broad money'' with cash reserves. As a consequence, banks can effectively create money without limitation. I know that sounds hard to believe, but let's look at the facts.»
Once the rules were changed to allow for ever increasing leverage, the system was on a hockey-stick trajectory, and one that got helped, for example with other relaxations:
especially as the financial sector became an ever larger percentage of GDP, stock market valuation and corporate profits, fueled by the seemingly endless availability of credit at a very low cost.
If there is another explanation for the sudden boom in credit availability and thus zooming leverage that started in 1995 I'd like to know.
But if the above hunch is right, it was a series of bubbles engineered to maximize financial executive bonuses and options, and indeed it has made several of them billionaires in 15 years.
Consider this article by Taleb and in particular the two graphs in section "The Dangers Of Bogus Math":
However is comment is
«The banking system (betting AGAINST rare events) just lost > 1 Trillion dollars (so far) on a single error, more than was ever earned in the history of banking. Yet bankers kept their previous bonuses and it looks like citizens have to foot the bills.»
Note that the profile in those graphs is the one that maximizes bonuses and capital gains for executives.
Posted by: Blissex at September 20, 2008 12:13 PM
What explains your tenacity in trying to prevent anyone from saying that GSE had a limited role in this whole mess? Why single GSE's out for blame? Chinn's broad perspective, expressed on the post of 10:20AM, is definitive, I believe.
Lots of mistakes made by a lot of people - almost all of them due to the assumption that house prices never go down and the only problem to to get our share while the getting is good.
Posted by: W. Raymond Mills at September 20, 2008 12:16 PM
«changes the rules of the game so that profits and wealth are increased today at the cost of less profits tomorrow.»
But that maximizes the pay of Republican (and Democrat) campaign donors from Wall Street and elsewhere. And Usian democracy is pay-per-play, so the people who pay get to play with the rules they choose.
It is much better for executive bonuses to have a profit of 100 one year and a loss of 110 next year than a profit of 20 both years. Financial company executive know very well that the value of the implied options they have in their profit-related bonuses is proportional to their volatility. Wall Street makes money on beta, stupid investors on alpha.
Posted by: Blissex at September 20, 2008 12:20 PM
Dear Mr. Mills:
I'm not trying (tenaciously or not) to prevent anyone from saying anything. I was simply making a point reflecting my (no doubt terribly limited) understanding of what some other highly respected analysts have been saying.
Posted by: Phil Rothman at September 20, 2008 12:29 PM
Today I am reminded me of a case study I had years ago in ECON 101: Introduction to Microeconomics.
I hope this helps you rationalize your outrage this weekend...
Ben B. and Henry P. are deciding what to do with their money this afternoon.
Ben and Henry fund only toxic debt from their Wall Street cronies and military action in the Middle East, and are currently on their highest possible indifference curve.
Two bundles on this indifference curve are bundle A ($700BN debt and $600BN war) and bundle B ($300BN debt and $300BN war). Between points A and B, what is Ben and Henry's marginal rate of substitution of toxic debt for military action?
Professor's note: due to the incalculable, impossible to audit costs of military action this case study is purely hypothetical.
Posted by: SRL at September 20, 2008 12:39 PM
Phil Rothman: You are right that a lot hinges on the null hypothesis. I think I can understand the logic of why one might think F&F were the prime cause of the crisis unfolding (despite the fact that Fannie has been around since the Great Depression, and restrictions on its portfolio were loosened over a decade ago). Since you are familiar with the tools of Granger causality, then I ask you what seems more likely to be a cause of the sudden and fairly discrete take off in subprime lending -- a regulatory perspective that says "hands off", or the presence of two institutions that had been around for a long time? Reasonable people can disagree, and I could see why one would start with a null hypothesis of equal blame (of course, you'd still need to narrow down your set of suspects). But for me, given the sequence of timing, I know what my null hypothesis is.
On a more anecdotal level, I remember having a conversation with an economist at a major multilateral institution during the summer of 2005, and as we discussed what would likely cause the next crisis, he disagreed with my view that it would be the Twin Deficits; rather he pointed to the rapid expansion of subprime mortgages and the failure of US regulatory authorities to take any action. In retrospect, he was more right than I was.
Posted by: Menzie Chinn at September 20, 2008 01:06 PM
To : Menzie Chinn
You made no mention of having the treasury just printing the money to solve the crisis.
Why wouldn't money without debt help resolve both the banking problem and the deflation problem ?
Posted by: Michael McKinlay at September 20, 2008 01:13 PM
Is it OK to move the discussion all the way over to the solution issue?
Congressional leaders were said to be dismayed when confronted with the depth of the problem. They were also said to be dismayed that no one other than Paulson had a solution. Shouldn't more than one solution be considered?
For example, try viewing the problem as an accounting problem. These toxic contracts are not hurting anybody directly. If they were removed from the market by some other means other than Federal purchase, would that not be a solution?
I propose quarentine. Remove these toxic contracts from the market temporarily and then restore them later, after the current owners have positioned their firms that they are able to take them back on their books without problems.
Establish a Federal agency to receive, store and manage these toxic contracts temporarily, with the original owners able to repossess their contract any time they choose.
The proposed legislation would specify that the agency would only accept contracts voluntarily stored with them. While these contracts are stored off the market, they cannot be bought or sold and any hypothetical change in their value would not be refected in the books of the owners. The value of these toxic contracts would be held constant, by law, at the level they were estimated to have at the time they were stored. When recovered, their value would be reassessed at the market level at that time.
I encourage Economist to come up with other alternatives. This one is radically different from the massive bailout. Will it do the job?
What do you think? A major advantage of this proposal is that it can be tried first and if the problem persists, the bailout can be considered.
Posted by: W. Raymond Mills at September 20, 2008 03:11 PM
There were certainly many things that made the problem larger and worse, but fundamentally it is lending money that could not be repaid. That is due to not verifying incomes and failing to qualify them at fully adjusted market rates. This breaks the income price connection and allows bubbles to develop. Not all bubbles can be determined in advance but this one was obvious to anyone looking at incomes and prices for a long time.
Posted by: Lord at September 20, 2008 05:17 PM
This rush to judgment on the bailout idea is frightening.
The next few days should be focused on seeking another solution which is less costly. As of right now, we do not know whether some other better idea can be developed.
Why no comment on my proposal above? No readers left?
Posted by: W. Raymond Mills at September 20, 2008 06:06 PM
Didn't subprime eventually capture 40% of the mortgage lending market? Could they have reached this market share without Fannie/Freddie purchasing of subprime MBSs? And, from my perspective, Fannie's ALT-A, 100% financing, automated underwriting, credit score driven u/w, expanded ratios contributed to the problem. Would the financial sector losses have been as catastrophic had Fannie/Freddie sat it out?
The inability of State regulators, albeit woefully understaffed, to reign in national lenders was a problem. Unfortunately, Congress didn't have the political will to do the right thing. As I understood it, the Courts were deferring to the statutes as they were written. It was up to Congress to effect the required changes.
Posted by: simone at September 20, 2008 06:55 PM
simone: See Figure 3 in this BIS working paper.
Posted by: Menzie Chinn at September 21, 2008 07:43 AM
One of the problems here is that "subprime" has become a uselessly broad catchall term. Right now that encompasses the 30k predatory "hard money" loan to the minority homeowner in Cleveland as well as a $900k Alt-A Pay-Option ARM purchase loan in CA.
Posted by: Don at September 21, 2008 08:51 AM
Conditional on the argument you make, I'd be quite interested in your response to what Charles Calomiris and Peter Wallison write in their Sep. 23, 2008, WSJ piece titled "Blame Fannie Mae and Congress For the Credit Mess":
Some data they present appear to be inconsistent with what you and others have written. In your view, are they fudging it?
I'm not trying to "beat a dead horse." Rather, I'm just trying to learn. Thanks in advance for sharing your thoughts.
Posted by: Phil Rothman at September 22, 2008 10:52 PM
Phil Rothman: I'm not surprised that Calomiris would take this view; while a reasonable academic, I think he focuses on government induced distortion as opposed to the information asymmetries endemic to financial markets as sources of problems (and now I have a feeling for Wallison's views -- see my post of 23 Sep).
I don't disagree that F&F stimulated to some extent the problem. But the surge in purchases would not have happened in the absence of regulation, and it's not clear to me that w/o the imposition of adequate capital requirements, that a takeover would have been necessary. I still go back to the basic questions -- when and where did the subprime problem start? It was in the unregulated sectors, and the lightly regulated sectors (when the OCC stopped state regulators from enforcing regulations more restrictive than the Federal ones).
Mark Thoma aggregates the (persuasive, to me) arguments.
Posted by: Menzie Chinn at September 23, 2008 07:31 PM