Saturday, September 20, 2008

Thoughts on the Mortgage Crisis

On my trip to Hawaii, I had the opportunity of having a barley based beverage with the CEO of a major financial institution, the institution I work with. As we discussed the financial crisis, we felt a certain pride that our institution, though facing challenges, wasn't losing asset values and is still profitable. Over the years, we've lost alot of business to the various purveyors of creative financing that qualified people who should have qualified for a modest $130,000 home, but got into a $300,000 home instead. The whole basis for these loans was a paradigm that was sustainable under one set of assumptions. The assumptions were that the income of the individual getting the mortgage would increase, and that the value of the house would increase, creating instant equity that would give the borrower flexibility to refinance, or even perhaps, move to an even more impressive home.

Well, the assumptions behind this paradigm, just like the assumptions regarding the continual rise of stock prices in the 1920's that drove people to borrow money to put into the stock market, proved to be wrong. And these people made the wrong decisions and those companies which bought these mortgages as investments made bad decisions. And the instability created by these decisions is creating waves in our financial markets and panic among investors. And unfortunately, it is creating an environment where the government somehow feels the need to bail people out of their bad decisions.

People, and institutions overbuilt in the residential market, driven by tax incentives, and by a drive for easy profits and quick equity. Risks were assumed, but they were assumed ignorantly, on the basis of the future looking exactly like the past. This is symptom of a people who have no knowledge of history or basic finance. And our government bailing out those who hadn't learned the lessons of history only reinforces the idea, that you can essentially speculate with other's money. And the other's our us, the U.S. taxpayers.


kneedeepinutah said...


Yes, you are right about how we got ourselves into this mortgage mess. We economists call that "moral hazard" when you get to profit using other people's money (depositors/taxpayers) and you don't lose when you are wrong.

What you didn't touch on was the role of the Federal Reserve in creating the asset bubble in the first place. As you recall, there was the stock market crash of 2000, followed closely by 9/11 which was in 2001. The Fed responded by flooding the financial system with so much liquidity that real interest rates were negative. The last time real interest rates were negative was in the late 1970's which led to runaway inflation. Anyway, this time the excess liquidity created an asset bubble in the housing market. The lending practices you outlined are a direct result of the banking system having too much liquidity and they were just bending over backwards trying to figure out who they could lend all this money too. If credit was normal, meaning interest rates reflected inflation plus risk plus a real return, then banks would ration capital and only lend to higher quality borrowers. The stupid lending practices were a direct result of the excess liquidity created by the Fed. So, when this asset bubble burst then everyone realized that a lot of these loans aren't going to be paid back and a lot of the homes underlying those mortgages aren't worth that much, and should never have been worth that much.

So, what are the conclusions?

1. Using insured depositors/taxpayer money to lend you have created an opportuity for moral hazard and the insurer/taxpayer has an interest in seeing that you don't do stupid things with it. So yes, one set of goverment regulations necessitates another set of regulations.

2. Government action (the Fed) was the root cause of all this. Before we start seeing government as the answer to all of Wall Street's probelms, we need to remind ourselves that the Goverment made this problem.

Obi wan liberali said...

Certainly, government played a role in this fiasco, but they were but a minor driver. Most of the bad mortgages that are now coming to roost were written within the last seven years. The drive of insurance companies to acquire mortgage backed securities to some extent sounds rational. The payout timeframes align beautifully with the payouts on insurance claims. But the decline in underwriting standards and the qualifying people for mortgages based upon projected collateral values and future pay increases was irrational and had nothing to do with governmental action.

The reality is, risks were taken where only under a certain set of outcomes, could the whole loan lending structure work. When the variables didn't pan out, and no hedging took place to counteract the change in these variables, it is not reasonable to blame the government for this. This was mainly a private sector failing. And the government should not be bailing out these institutions that made such fatally flawed decisions.

kneedeepinutah said...

Your comment about the last seven years is correct. It was about 2001-2002 when the Fed lowered the Fed Funds Rate to 1% and flooded the banking system with excess liquidity. I would not call this a "minor role". None of the lending excesses would have existed if it were not for the excess liquidity in the first place.

David said...

Obi wan,

Thank you for summarizing our financial position and the causes that got us here so succinctly. My wife was asking me to explain it, but you framed it much more clearly than I was able to. I think kneedeep is right about how much blame the government holds for creating the problem, but you are right that the government should not be bailing our the institutions that made their poor decisions. After all ,they are supposed to be the experts who know better.

kneedeepinutah said...

A nice recap for David's wife from the WSJ:

Yes, greed is ever with us, at least until Washington transforms human nature. The wizards of Wall Street and London became ever more inventive in finding ways to sell mortgages and finance housing. Some of those peddling subprime loans were crooks, as were some of the borrowers who lied about their incomes. This is what happens in a credit bubble that becomes a societal mania.

A Look Back at the Crisis Unfolding
Stopping the Panic 09/20/08 – Now the task is to protect taxpayers and restore markets.Be It Resolved 09/19/08 – Paulson and Bernanke ask Congress for a resolution agency.The Fed and AIG 09/18/08 – Nationalizations aren't stopping the financial panic.McCain and the Markets 09/17/08 –

Denouncing 'greed' and Wall Street isn't a growth agenda.The Fed's Epic Day 09/17/08 – It's only fair to praise the central bank when it does the right thing.Surviving the Panic 09/16/08 – A resolution agency, steady monetary policy, and a big tax cut.Wall Street Reckoning 09/15/08 – Treasury Secretary Hank Paulson's refusal to blink won't get any second guessing from us.But Washington is as deeply implicated in this meltdown as anyone on Wall Street or at Countrywide Financial. Going back decades, but especially in the past 15 or so years, our politicians have promoted housing and easy credit with a variety of subsidies and policies that helped to create and feed the mania. Let us take the roll of political cause and financial effect:

- The Federal Reserve. The original sin of this crisis was easy money. For too long this decade, especially from 2003 to 2005, the Fed held interest rates below the level of expected inflation, thus creating a vast subsidy for debt that both households and financial firms exploited. The housing bubble was a result, along with its financial counterparts, the subprime loan and the mortgage SIV.

Fed Chairmen Alan Greenspan and Ben Bernanke prefer to blame "a global savings glut" that began when the Cold War ended. But Communism was dead for more than a decade before the housing mania took off. The savings glut was in large part a creation of the Fed, which flooded the world with too many dollars that often found their way back into housing markets in the U.S., the U.K. and elsewhere.

- Fannie Mae and Freddie Mac. Created by government, and able to borrow at rates lower than fully private corporations because of the implied backing from taxpayers, these firms turbocharged the credit mania. They channeled far more liquidity into the market than would have been the case otherwise, especially from the Chinese, who thought (rightly) that they were investing in mortgage securities that were as safe as Treasurys but with a higher yield.

These are the firms that bought the increasingly questionable mortgages originated by Angelo Mozilo's Countrywide and others. Even as the bubble was popping, they dived into pools of subprime and Alt-A ("liar") loans to meet Congressional demand to finance "affordable" housing. And they were both the cause and beneficiary of the great interest-group army that lobbied for ever more housing subsidies.

Fan and Fred's patrons on Capitol Hill didn't care about the risks inherent in their combined trillion-dollar-plus mortgage portfolios, so long as they helped meet political goals on housing. Even after taxpayers have had to pick up a bailout tab that may grow as large as $200 billion, House Financial Services Chairman Barney Frank still won't back a reduction in their mortgage portfolios.

- A credit-rating oligopoly. Thanks to federal and state regulation, a small handful of credit rating agencies pass judgment on the risk for all debt securities in our markets. Many of these judgments turned out to be wrong, and this goes to the root of the credit crisis: Assets officially deemed rock-solid by the government's favored risk experts have lately been recognized as nothing of the kind.
When debt instruments are downgraded, banks must then recognize a paper loss on these assets. In a bitter irony, the losses cause the same credit raters whose judgments allowed the banks to hold these dodgy assets to then lower their ratings on the banks, requiring the banks to raise more money, and pay more to raise it. The major government-anointed credit raters -- S&P, Moody's and Fitch -- were as asleep on mortgages as they were on Enron. Senator Richard Shelby (R., Ala.) tried to weaken this government-created oligopoly, but his reforms didn't begin to take effect until 2007, too late to stop the mania.

- Banking regulators. In the Beltway fable, bank supervision all but vanished in recent years. But the great irony is that the banks that made some of the worst mortgage investments are the most highly regulated. The Fed's regulators blessed, or overlooked, Citigroup's off-balance-sheet SIVs, while the SEC tolerated leverage of 30 or 40 to 1 by Lehman and Bear Stearns.

The New York Sun reports that an SEC rule change that allowed more leverage was made in 2004 under then Chairman William Donaldson, one of the most aggressive regulators in SEC history. Of course the SEC's task was only to protect the investor assets at the broker-dealers, not the holding companies themselves, which everyone thought were not too big to fail. Now we know differently (see Bear Stearns below).

Meanwhile, the least regulated firms -- hedge funds and private-equity companies -- have had the fewest problems, or have folded up their mistakes with the least amount of trauma. All of this reaffirms the historical truth that regulators almost always discover financial excesses only after the fact.

- The Bear Stearns rescue. In retrospect, the Fed-Treasury intervention only delayed a necessary day of reckoning for Wall Street. While Bear was punished for its sins, the Fed opened its discount window to the other big investment banks and thus sent a signal that they would provide a creditor safety net for bad debt.

Morgan Stanley, Lehman and Goldman Sachs all concluded that they could ride out the panic without changing their business models or reducing their leverage. John Thain at Merrill Lynch was the only CEO willing to sell his bad mortgage paper -- at 22 cents on the dollar. Treasury and the Fed should have followed the Bear trauma with more than additional liquidity. Once they were on the taxpayer dime, the banks needed a thorough scrubbing that might have avoided last week's stampede.

- The Community Reinvestment Act. This 1977 law compels banks to make loans to poor borrowers who often cannot repay them. Banks that failed to make enough of these loans were often held hostage by activists when they next sought some regulatory approval.

Robert Litan, an economist at the Brookings Institution, told the Washington Post this year that banks "had to show they were making a conscious effort to make loans to subprime borrowers." The much-maligned Phil Gramm fought to limit these CRA requirements in the 1990s, albeit to little effect and much political jeering.

We could cite other Washington policies, including the political agitation for "mark-to-market" accounting that has forced firms to record losses after ratings downgrades even if the assets haven't been sold. But these are some of the main lowlights.

Our point here isn't to absolve Wall Street or pretend there weren't private excesses. But the investment mistakes would surely have been less extreme, and ultimately their damage more containable, if not for the enormous political support and subsidy for mortgage credit. Beware politicians who peddle fables that cast themselves as the heroes.

Obi wan liberali said...

I also am amazed at the lack of insight federal regulators had at the FDIC. However, having talked to some FDIC regulators, they admit they were brow-beaten by those in the industry and recognized that the administration in power favored deregulation, not more regulation. Safety and soundness was trumped by a perceived "opportunity cost" of not taking advantage of the rising property values and higher interest rates an institution could earn on mortgages relative to the paltry interest rates they could gain on federal funds or other safe instruments.

The question that will come out of this fiasco, is whether this resulted from too much federal involvement or too little federal oversight? People with their own ideological agenda may be quick to judge the circumstances in their favor.

As I talked with the CEO of a 2.5 billion asset financial institution, I said this situation resembled less the fiasco of the 1970's, where inflation and interest rates coupled with federal regulations doomed the savings and loans. This more resembles the build up to 1929, where people borrowed money on the basis of increased projected stock values to invest in stock. The mortgage industry lent money on the basis of increased property values believing that the equity in their collateral would shield them from damage. It was a fatally flawed paradigm and those who took these risks did so foolishly.

Are we as a society to reward foolishness? Are we to let executives off the hook for rash and narrow-sighted behavior? A buyout of these poor yet overpaid executives shows us to not be a republic, but an oligarchic process where executives take risk with no risk to themselves, but to the body public.

kneedeepinutah said...

I would say yes to both Obi. Too much goverment intervention by the Fed, Fannie, Freddie led banks to do silly things which was not being watched by the FDIC, SEC, etc. So yes, too much and too little.

kneedeepinutah said...

My imperfect analogy for the day:

Let's say the US governemt drops 100 kilos of cocaine on downtown SLC and thousands of otherwise ordinary people have one huge coke party and get stoned out of their minds to the point where some OD.

So, who is to blame?
1. The people who succumed to temptation and snorted lots of coke?
2. The police for not enforcing drug laws?
3. The US government for dropping the coke on downtown SLC in the first place?

Obi wan liberali said...

You are quite the apologist for the private sector. I don't think your analogy works because an addictive drug is different from available capital. The capital could be used many different ways, not just shooting it up your nose. Blaming this on the government is nothing more than a smokescreen for the failures of the market to make sound business decisions based upon risk and possible gains. It all resembles the hubris of the Iraqi invasion, where Iraqis would treat us as liberators. No provision was given for the possibility of other likely scenarios.

This wasn't prudent financial decisions based upon uncertainty, but pie in the sky speculation and blind faith, that things would turn out as one hoped. We should not reward reckless behavior as a nation. Your pinning this on the government is nothing more than shifting blame, rather than accepting responsibilty.

kneedeepinutah said...

Yes, I grant you that the banks acted recklessely and foolishly in making the loans that they did. And that all those loan officers should be lined up and shot. In fact I am personally aware of many cases of mortgage fraud and collusion among bankers, appraisers and developers. I happen to know they are under investigation by a mortgage fraud task force of the FBI.

However, markets react to market conditions. Maybe my analogy with cocaine wasn't so good. But the point is that the government did indeed intervene in the markets in several ways as noted before. These goverment intervenions set up the conditions for the private banks to do dumb things. Yes yes yes the banks did dumb things. But the conditions which made that possible was directly caused by the Fed, Fannie, Freddie, etc.

I think we can agree that we agree.