How Did We Get Here? Jan 11, 2010

This may take more than one night, because I have a lot to discuss.  I want to look back at the Great Financial Crisis of 2007 – 2009 and poke a few holes in the conventional wisdom about how it all went pear-shaped.


First of all, I believe there is plenty of blame to go around, but the core perps of this debacle will never be hauled before a Congressional committee to defend themselves, because they are Congressmen themselves.  And despite the bitterness of partisan differences, one thing both sides of the aisle agree on wholeheartedly is that they should not hold themselves accountable for the chaos they wreak on the US economy.  Presumably, that’s the voters’ job, but the bold hypocrisy of hauling all and sundry before the cameras to be grilled by these posturing fools who caused the problems in the first place is beyond galling.

How are they responsible for this mess?  It starts with the noble prospect of trying to get everybody into a home of “their own.”  This is an objective held dear by all of Washington officialdom, and it is true that people who own their homes generally make better citizens – they care more about their local circumstances because they are more committed to being there.  Renters can move (except of course in New York, where the market has been hopelessly distorted by rent control, but that’s for another time).  But trouble arises when legislators tinker with the market to achieve their chosen social objectives (listen well, Obama administration!)  Congress pushed banks into increasing their lending to poor neighborhoods – essentially making money-losing loans to people without good credit.  The first push came with the Community Reinvestment Act of 1977 – designed, so they say, to combat discrimination in mortgage lending.  But is uneven lending between communities evidence of discrimination or of uneven creditworthiness?  Didn’t matter to Washington.  And banks had to pay this tribute if they wanted regulatory approval for expansion, mergers, new branches, etc.  Soon enough “community organizers” and other local organizers realized that banks could be held to blackmail if they wanted to expand, so they ensured that their voices were heard when it came time for regulatory approvals.  And banks made more bad loans as a cost of growth.

Things really kicked into high gear with the creation of Fannie and Freddie, who between them defined creditworthiness down – especially after their patrons in Congress like Barney Frank and Chris Dodd pushed them into a huge expansion.  Essentially, F&F turned the mortgage backed securities markets from a business into a colossus, and in the process bought up loans with less and less creditworthiness, guaranteed them, and sold them on into the market.  With the quasi-government guarantee, all of a sudden these dodgy credits became good credits, and investors bought them all over.  Soon enough, and in response to more urging from Congress (Barney Frank wanted to “roll the dice a little bit” with the low-quality mortgages) F&F were lowering standards still further, and made it known that they would buy and repackage loans made under conditions that no mortgage banker would accept (no documents, no money down, no risk to the buyer…)

F&F’s patrons in Congress protected them well.  Despite repeated accounting scandals, in which billions of taxpayer money was miscounted and the apparently profitable companies actually produced huge losses while at the same time demonstrating they could not manage their hedging portfolios, Congress resisted calls for reform.  With hundreds of billions of mortgages on their books and poor risk controls, they were a Casey Jones on steroids.  The Bush administration sought to rein them in, but could get no meaningful reform done before it was too late.

Meanwhile, the Federal Reserve was quietly pouring gasoline on the building conflagration.  Throughout 2002 – 2006, the Fed kept short-term interest rates exceptionally low.  Even after the Bush tax cuts resulted in robust economic recovery from the dot-com bust, and even after commodity prices signaled inflation fears, and even in the midst of house-price increases that were completely unsustainable, the Fed kept pouring money into the system.  For two years, real interest rates were negative, meaning that after inflation your interest costs were less than zero – borrowing was better than free.

The Fed did this for one simple and devastating reason – their inflation measures were wrong.  The tools they used to track inflation, and therefore to gauge the right level of interest rates, did not properly account for the cost of housing, which is about one-third the cost of living.  They looked at the rental market, which was being distorted by the gush of new apartments that the easy money made possible, and completely missed the fact that home ownership was rapidly inflating out of the reach of the average wage earner.

Instead, the Fed looked at the odd fact that long-term rates, which should be signaling inflation, stayed perplexingly low – this was Alan Greenspan’s famous “conundrum.”  But it wasn’t such a puzzle at all.  With so much money flushing through the system, people leveraged up and spent like crazy.  Meanwhile, in China, a quarter of the world’s population was busily entering the global work force for the first time and keeping wages low throughout the world economy.  This kept retail prices low, and gave China hundreds of billions of export earnings thanks to those US spenders, more than their economy could absorb.  So what do you do when you’ve got billions to invest?  You buy US government bonds by the truckload – which keeps long-term rates down and confuses the Chairman of the Federal Reserve.

So, by ignoring the asset inflation their easy-money policy inflamed, by missing completely the true inflation picture in the US, and by failing to appreciate that the phenomenon of low long-term interest rates was a result of the US’s huge trade imbalances, the Fed poured more hooch into the punch bowl just when they should have been taking it away.

Bubbles are always and ever a result of too easy money.  When it pays to go into debt, guess what – people will leverage up.  And when the cost of leverage is so cheap, risk gets cheap, and people do foolish things.

One seldom-appreciated aspect of this is that lots of legitimate investors, pension funds and the like, have legal obligations to generate a yield on their investments that is enough to pay their commitments to retirees.  When long-term rates are as low as they were in the mid 2000’s, they can’t generate enough return with safe investments.  They are forced to go riskier because they have to meet their return objectives to pay their members.

Enter the mortgage security market.  By taking F&F’s mortgage packages and mixing them up with other mortgages, banks created securities that yielded much more than government paper to sell to these folks who were calling every day looking for something with a good yield.  And the ratings agencies, Standard & Poors and Moody’s, rated these securities AAA, the highest rating available to non-government investments.

Why did they do that?  Partly because, like so many bankers, investors, regulators, and others, they looked at the past 50+ years of history and concluded that housing prices only went up.  If they went down at all, the declines tended to be temporary and localized.  So a diversified package of mortgages from around the country looked like a pretty safe bet.

So here’s the state of play: would-be homeowners who do not have the wherewithal to be in the game get in the game anyway because borrowing is so easy and because Fannie and Freddie will buy the worst loans.  Banks and other mortgage originators will lend them the money on the easiest terms because that has become the standard in the market, and because they do not have to hold onto the mortgages they make and pay the consequences if they go bad: they can sell them to F&F or to other aggregators to be repackaged and sold on to other investors who are howling for more of this mortgage paper.  The whole merry-go-round spins quite happily with everyone making money until all of a sudden it’s going too fast and people start falling off.

Note that I haven’t said much yet about the banks.  There’s no question, banks made some foolish moves, and accepted some mortgages they had no business making.  But I don’t buy the populist contention that this whole problem is a result of banker cupidity.  Think of it this way – Ken Lewis, who ran Bank of America through all of this and ended up being scapegoated for a lot of it, probably lost hundreds of millions, the vast majority of a fortune built up over decades of hard business decision making, in the tsunami that hit B of A stock.  Does anyone rationally think he would jeopardize that much money just to get a little richer by boosting these dodgy loans?   Or does it not make more sense that he was as dumbfounded as everyone else at how rapidly it all collapsed?

Should the bankers have had risk systems better able to contemplate the unthinkable?  Of course.  For that matter, so should the Fed, the ratings agencies, and everyone else who spun this top.  Bankers personally lost more than they stood to gain, and they are not stupid.  The conclusion must be that they were tragically wrong.  Hubris, no doubt.  Over-leveraged, absolutely.  But if a tiger wanders out of his cage and mauls an onlooker, you don’t blame the tiger for doing what comes naturally, you blame the guy who left the door open.  Banks make decisions every day on the balance between the cost of funds and profitable use those funds can be put to, mindful of the balance between risk and reward.  In this world, where the cost of funds was zero, and triple-A paper (will not default) was yielding substantial premiums, who wouldn’t leverage up to buy more?

One favorite liberal trope as they write their own version of this history is that it was Bush Administration lax regulation that was responsible for the mess.  You know, take care of your rich buddies, keep the government off their backs, let them get even richer, and too bad if the little guy gets a little squashed.  But that doesn’t quite hold water.  What de-regulation in fact was culpable here?  People point to the Gramm-Leach Act, which repealed the last of the Glass-Steagall separation of banks and investment banks.  Well, first, Bill Clinton is the one who signed that into law.  Second, it was not banks doing i-bank risky business who were the initial problems here; remember that it was first Bear Stearns and then Lehmann Brothers (both i-banks) who caused the great freeze-up.  Indeed, without the lifting of Glass-Steagall, Bear would not have been merged into JP Morgan, nor Merrill Lynch into Bank of America, nor Morgan Stanley into Citigroup – all moves which prevented a worse credit freeze than the one we had.

Should someone have stepped in and said “no” to liar loans and the other low-quality mortgages that were floated?  Should someone have outlawed variable rate mortgages with teaser rates that enabled someone to get into a home with exceptionally low initial costs?  Perhaps – but at the time those things were applauded as innovations that enabled the lower-paid to be able to afford a home.  Should bankers be responsible for making sure their customers can pay the loans they sell them?  Yes, there is without doubt a moral obligation to do so; by the same token there is a moral obligation – one could well argue, a stronger obligation – for borrowers to know what they are getting into, and to borrow no more than they could repay.  I’m sure at the margins there were unscrupulous mortgage lenders who were enticing the ignorant and the unsuspecting into catastrophe for the sake of a sales commission.  But I do not believe that characterized the mortgage business at the height of the boom.  There were just as many borrowers who were happy to game the system to their own advantage – taking out several liar loans at once, flipping properties before they even began to pay for them, and so forth.  When the mania is in full swing you get foolishness from all quarters.

The one regulation that should have been stronger and wasn’t was tightening the control on Fannie and Freddie – but again, it was the Bush Administration who was trying to pull in their horns and their pals in Congress who were defending them.  Hardly an indictment of the Bush folks, except insofar as in retrospect they should have made it a higher priority and spent more political capital in the process.

Oh, there’s more, much more.  I still haven’t got to the government’s reactions to the crisis when it hit, and then of course the bailouts, the gusher of taxpayer money, the bonus scandals, etc.  Hopefully I’ll get to it soon.
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