A story about Maxine Waters [h/t Instapundit] and Barney Frank’s intervention on behalf of a minority owned bank on whose board Waters sat, has this little gem:
In January, Ms. Waters acknowledged she made a call to the Treasury on OneUnited’s behalf. The bank’s capital, which was heavily invested in shares of Fannie Mae and Freddie Mac, was all but wiped out with the federal takeover of the two mortgage giants, and the bank was seeking help from regulators. [emp added]
For leftists, OneUnited should represent the perfect bank. It’s small. It’s minority owned. The “socially responsible” Maxine Water’s invested in the bank and sat on its board. There’s no evidence it made predatory loans.
Yet, it failed.
It failed not due to any short-sighted greedy decisions that the bank’s management made but rather because the bank’s management, including board members like Waters, trusted that the mortgage-backed securities issued by the government sponsored enterprises (GSEs) Fanny Mae and Freddie Mac were worth the paper they were written on.
OneUnited is a microcosm of the entire financial collapse. Over the past 40 years the GSEs have piled up a vast store of toxic assets created by the attempt to get something for nothing by fooling the market about the risk of residential mortgages. Ratings firms gave the GSEs top ratings because of their implied government guarantee and oversight. Banks like OneUnited bought into the political myth and now they and everyone else are paying for it.
Leftists need to explain why we shouldn’t regard the failure of OneUnited and other institutions as the results of government action. They won’t, of course.
typo in the title…
Besides noticing, too, typo in the title (it’s easy to see the typos made by others…) I’d say – great shooting, in the post. Precise.
…and that explains the entire economic meltdown? whety, then, is Greenspan apologetic?Glad to see SEC, under Bush, and credit rating dudes all in the clear.
Fred Lapides,
Glad to see SEC, under Bush, and credit rating dudes all in the clear.
No, but the critical failure, the one that did everyone in, was with the GSEs. If everybody else had performed perfectly, the failure of the GSE would have still brought the system down. Look at Maxine Water’s bank. Are you seriously going to suggest that one of the most radical leftist in the congress was playing fast and loose? Should the SEC and other regulators have prevented the bank from purchasing the government sponsored securities?
We’re paying for 40 years of intentionally distorting the market. The crisis was caused by issuing to many risky loans. The entire point of the existence of Fannie Mae and Freddy Mac was to encourage lenders to make loans that the free-market had determined as to risky.
How exactly was the SEC supposed to offset that?
Oh, I corrected that embarrassing typo in the title.
Are you seriously going to suggest that one of the most radical leftist in the congress was playing fast and loose?
Are you seriously suggesting that being a radical leftist puts her above suspicion?
Bgates,
Are you seriously suggesting that being a radical leftist puts her above suspicion?
No, but for someone like Fred it probably does. Besides, the sad truth is that no fraud is needed to bring down an institution if they bought into the the entire GSE system. A lot of people fell for it all across the financial system.
The basic problem is that the market is like mother nature, you can’t fool it for long without paying the price. We tried to trick the market with government programs and now we have to pay the consequences.
Fannie Mae and Freddie Mac were specifically put outside the regulation of the SEC.
Congress maintained close oversight of what Fannie and Freddie (FanFred) were doing, and approved of it. Congress created OFHEO (The Office of Federal Housing Enterprise Oversight) especially to regulate FanFred. The much larger and more visible SEC (Securities and Exchange Commission) was available, but Congress wanted its own regulator.
OFHEO was captive to House congressional committees, and outside the influence and control of the Bush administration.
This seems unconstitutional to me, but I am not an expert.
The House committee regulating banking and financial services (the Financial Services Committee) did not object, and actually encouraged more lending to subprime borrowers.
Barney Frank (D. MA) has served as ranking (most senior) Democratic member on this committee at least since 1992, and has chaired the committee since 2007 in the Democratic majority.
There is a long history of Barney Frank proclaiming that all was well with FanFred, and no further oversight or inquiry was needed.
Much more at
We Guarantee It
That is,
We Guarantee It
Despite the rating agencies and the role of Fannie/Freddie, there was still considerable private sector actions needed to make this crisis endemic to the system itself.
1. Greedy (mostly middleclass) homeowners who sought homes slightly outside their means.
2. CDO’s which made the “too big to fail” a reality
“leftists” who have to explain themselves is just a hyperbolic knee-jerk simplification.
Zach,
Blaming financial problems on greed is like blaming a building collapse on gravity. Both a universals that need to be planned for. Creating a system that will fail if people are “greedy” is just stupid.
The central problem here is that government intervention blinded the market to the risk of residential mortgages. The government made securities based on bundled mortgages seem safe. That is why they’re use grew in the private sector. Indeed, most of the growth in the industry came about as private actors cannibalized the market share of the GSEs.
This isn’t a moral problem, its an issue of the government intentionally destroying information in the financial system so that the system could no longer calculate risk. Once blinded to risk, the entire system began to come off the rails.
Leftist who extoll the virtues of political system versus the private need to explain why the government issued securities proved more worthless than the private ones. If the political system makes such great decisions then the GSEs should be a financial Gibraltar in a private collapse instead of ground zero.
The issue isn’t with greed, which as Shannon remarked above, is universal. The issue is with market failure – specifically, the failure to accurately price risk. The market, like any human creation, is imperfect.
Factors such as imperfect information and bad incentives make it more likely for market failure to occur. To oversimplify a little, markets aggregate human behavior and markets are more likely to fail where humans (a) don’t, in general, know very much and (b) have structural incentives to behave badly. Both of those things were true about the US banking / securitized debt markets.
It’s unsurprising that Canada, which regulated CDO’s and securitized security trading in general has come out of this rather well. It’s unsurprising that Iceland, whose banking system was run by a ideologue whose favorite thinker was Hayek, has come out of this mess in perhaps the worst shape.
Personally, I think the current economy is a huge problem for the conservative movement in the US.
Here’s why – people are remarkably reluctant to admit mistakes. Political opinions and “truths” tend to be formed early and are very resistant to change. Cognitive dissonance (i.e. when the real world annoyingly refuses to do what we think it should) actually tends to encourage further denial.
And the conservative movement in the US is in denial right now. It experienced some success with the idea of solving economic problems through tax cuts and deregulation. It then jumped to the unwarranted conclusion that deregulation and tax cuts were the panacea to any economic issue. Predictably, that led to a giant mess.
Now, the movement is in denial – and having to come up with convoluted explanations that convince only those who are already conservatives. I think this is good news for the Democrats because the Republicans will lose independents, new voters, and the educated. The whole effort to paint the GOP as the party of Rush was a masterstroke. It’s hard to deny because it’s at least partially true. The conservative “base” has only helped the GOP electorally – so far. If Rahm’s strategy to make the GOP “base” an electoral liability pays off, we could experience a realignment along the lines of 1980.
So in short: the GOP’s attempt to blame the collapse on Clinton, Maxine Waters and big government is a good strategy. For the Democrats.
“..independents, new voters, and the educated….”
independends, new voters, and the indoctrinated….
There, fixed that for ya…
What is it, SeanF, that you think conservatives are denying? If it’s the ability of the Dems to make rhetorical hay out of the crisis, you could be right. Politics ain’t beanball, as a noted Chicagoan once said. And another notable once said that a conservative is someone who stands athwart history and yells Stop.
But if you’re really talking about the roots of the crisis, and not just indulging in schadenfreude, then I haven’t really heard you take issue with Shannon’s thesis that at the bottom of it all is a government policy which encouraged the making of loans to folks who wouldn’t have otherwise got them, with ensuing moral hazards and unnatural events cascading therefrom.
I’m a Canadian. Right now we’re sitting somewhat prettier than we customarily do when we compare ourselves with our elephantine neighbour. However, history matters. Canada didn’t have to confect a social policy to deal with a legacy of slavery and a permanent underclass. It didn’t matter so much to Canadians that it was relatively harder for our poor, unsustained by institutions like Freddie and Fanny, to get credit, because we didn’t see the necessity given that there aren’t racial and cultural divides in need of healing behind that phenomenon. In big cities like Montreal the poor and somewhat poor happily rent apartments all their lives and don’t think of buying a house. Nobody thinks they need to do this to show that that they’ve escaped the noose of poverty and racism.
Canadians are inherently less likely to take risks anyhow – for many reasons but broadly the cultural effects of a former colony in a northern climate with a great playground for adventure next door. The risk-takers in our midst usually head off south of the 49th. These are not reasons for national congratulation, particularly, put history and culture matter.
A dose of reality always gets administered by the dismal science when nature is mocked. It may be hard for a liberal to believe, but conservatives see such effects as validation. As another Chicagoan said, ideas have consequences.
seanF,
The issue isn’t with greed, which as Shannon remarked above, is universal. The issue is with market failure – specifically, the failure to accurately price risk. The market, like any human creation, is imperfect.
Factors such as imperfect information and bad incentives make it more likely for market failure to occur. To oversimplify a little, markets aggregate human behavior and markets are more likely to fail where humans (a) don’t, in general, know very much and (b) have structural incentives to behave badly. Both of those things were true about the US banking / securitized debt markets.
I agree totally with everything in these paragraphs. Where you go off the rails is you lack of examination of why the market failed to accurately price risk.
Let me give you a hint: The commercial real estate market has no government intervention at all, it has some securitization and it was fine until the entire financial system tanked. Now, if as you have previously argued, private individuals cannot price risk without the guiding hand of the State, why didn’t the commercial real estate market bubble and burst before the heavily regulated residential market?
The market couldn’t price risk properly because the government set out specifically to blind the market to the risk of residential mortgages. THE ENTIRE POINT OF THE CREATION OF FREDDIE MAC AND OTHER GSEs WAS TO HIDE THE RISK OF RESIDENTIAL MORTGAGE LENDING!
Do I need to repeat that?
You claim that free-market advocates are in denial but it is you that can’t see the problem even when you type it out yourself. Unless you can explain why the 40 years of government intervention in the market did not produce dangerous distortions, you look really foolish.
Blaming financial problems on greed is like blaming a building collapse on gravity. Both [are] universals that need to be planned for.
Shannon, at the risk of sounding like a sycophant, that’s possibly the pithiest summary of sound economics I’ve heard. You could pretty much hang all of Austrian or Chicago School economics on that peg.
That’s definitely going on my official list of Axioms That I Use Way Too Often, along with
“Any sufficiently advanced stupidity is indistinguishable from malice.”
and
“Experience is what you get when you don’t get what you wanted.”
I would also suggest a corollary:
“Blaming political problems on lying and corruption…” etc.
In the Donahue interview, Donahue accused Milton Friedman of basing everything on greed, to which M.F. pleaded guilty but asked incredulously whether Donahue really believed that politicians and leaders in the Communist world (as it then was) operated on some different principle. Donahue didn’t have much of a reply except to suggest that virtue would be a better principle. Doesn’t that say it all about the liberal worldview of wishful thinking? And the sinister implication that if you aren’t virtuous a Robespierre or Pol Pot will see that you get that way.
The “government made securities based on bundled mortgages seem safe. That is why they’re use grew in the private sector.”
Another aspect of the situation is that, when the FMs changed the rules of game by backing insecure loans, private institutions figured to stay in the game (you can call it greed if you want to, I suppose, although it also might be seen as a matter of “keeping one’s job” – a created moral hazard) and began the same loose practices in order to stay competitive and get what they saw as their share of the spoils.
Shannon, Your clear descriptions made me think of something that you noted but I hadn’t thought of before. In previoius booms and busts, weren’t commercial properties hit harder than private ones? They would seem considerably more volatile in theory, but that they haven’t been exceptionally problematic at this time may indicate how much more tinkering it takes to increase that volatility. Are my memories (vague) wrong?
KJ:
I think conservatives are denying the responsibility for the economic collapse that occurred under 8 years of a conservative presidency that prided itself on a lack of oversight and a lack of regulation of new financial products (and, actually, old financial products like stocks too – the SEC went down the tubes).
The excuses go something like – Bush wasn’t conservative (so only successful conservatives are conservative(?)), excessive regulation was really the problem (addressed below), etc. The problem is that sure, people tend to believe even imperfect explanations if the explanations reinforce their current beliefs, and yes, these explanations might convince conservatives. they’re not likely to convince non-conservatives, because they’re not very credible. When even Greenspan thinks deregulation was the problem, the old time religion just ain’t gonna fly, if you pardon the mixed metaphors.
And Shannon: you’re rational and smart, from what I’ve seen of your posts. Try a thought experiment – assume you’re not correct, and government policy with Freddie and Fannie wasn’t the problem that led to the collapse. Don’t assume they didn’t distort the market – that would be unrealistic- but set aside, for a minute, the assumption that their distortion was the trigger.
Look at all the evidence suggesting that something else was. Give it a fair hearing, no preconceptions. Do what I do, read the rational people you don’t necessarily agree with ideologically. Try Krugman. Read Marginal Revolution. Not everyone’s opinion is entitled to the same weight so discount those who, regardless of partisan affiliation, don’t have any basis for their opinions.
You may still come out the same way – regulation is somehow, as usual, the problem. But you may not. At least you may not be so sure whatever answer you have is correct.
Sean,
If deregulation is the source of the current economic problems, then what, specifically, needed to be regulated? If something like risky mortgages needed further oversight, for example, that would put banks and other lenders in a difficult position. On the one hand, they have the FMs encouraging and willing to back up such mortgages, while whatever regulatory body telling them they can’t do it. So, what would really need to be regulated are the FMs themselves. Without any backing, banks would be less willing to take on any particularly risky mortgages. However, the responsibility for that would fall on Congress, rather than the President. And now, we have the problem of Barney Frank and others trying to prevent any such further restrictions on the FMs.
Let me see if I understand you, Sean. You’re willing to half accept that the underlying cause of our current problems was government policy – Freddie and Fannie and so on. But you think that lots of regulation could have controlled the underlying pathology, permitting the benign aspects of market distortion and suppressing the malignant ones. That is, poor people would get loans backstopped by the government (a good thing), and the same government would root out all the morally hazardous activity that would otherwise naturally flow from this policy. Voila: the Just Society.
I’m not enough of an economist to know whether benevolent interventionism on such a scale could actually work effectively rather than stultifyingly. It might in a time of war or crisis. I’ll sit tight during the current crisis and what will doubtless be a decade of liberal ascendancy and see whether the future I seem to see actually works. I’m sceptical but willing to wait for the returns to come in.
Conservatives don’t deny the possibility of crisis, whoever’s at the helm, indeed they think it’s part of the structure of reality. Liberals think it’s always preventable and always someone’s fault – likely someone with evil in his heart, a greedy Republican or Yahoo Texan or both.
KJ:
First of all, I disagree that “liberals always think its preventable and always someone’s fault.” But although it does not jibe with my experience, I do get what you mean, and it is probably not an inaccurate view of how conservatives see liberals. Reverse the words and it probably equally (and, in my admittedly biased perception, more accurately) applies to how liberals see conservatives, especially social conservatives.
Any attempt to “remedy” human behavior through enforced control is bound to fail. Human behavior is, for better or for worse, human behavior. Yes, of course government regulation of private activity – economic or not – always creates its own set of problems.
But one has to maintain a sense of proportion. The solution is not always worse than the problem. Our system of criminal justice is plagued with all sorts of problems. Would you rather have no police system and no criminal courts at all?
Also, I don’t think that government policy was “half the problem”. The policy probably made it worse. Would regulation of the CDO market have helped? It may not have eliminated the problem but it may very well have. And we came to know about the problems with Feddie and Frannie first, before the full scope of the crisis emerged, only because they were regulated and subject to public disclosure requirements.
Personally I think you’re right. We probably will see some liberal ascendancy as the pendulum swings back a bit. We’re also likely to see liberal overreach; the left is just as susceptible to that as the right.
Personally I suspect the growth of the regulatory state – police, the SEC, zoning laws, whatever – is really the result of the increasing and mindboggling complexity of modern life. State action is not a great tool to order human life. I don’t know whether my view is shared by most of those on the American left, but I’m certainly not a big fan. I just don’t see a better alternative; some regulation, at least, is essential.
At a (rather pessimistic) minimum one could say that the regulation through the political process at least legitimizes outcomes and prevents social stability. One reason I don’t hate taxes as much as I could is that I do think it’s the price we pay for civilization. I can’t think of one society that has endured as a democracy for a long time without a strong middle class (and the attendant lower levels of income inequality that implies). In my view the naive ones are conservatives who buy into the “research” churned out by thinktanks like AEI – those who imagine they’re living in some heroic Randian free-market Eden with rewards for the deserving, risk-taking yet honest small business salt of the earth and justice for everyone else.
Sean, you’re one of a vanishing breed – a liberal one could actually have a conversation with. I reckon that’s why you’re a regular on this site! Granted the wisdom of much of what you say about government as a sort of necessary evil and it being a question of where we draw the line, etc., at the very end of your post you make the natural assumption of all good liberals – that the real goal of the regulatory state is redistribution. You believe that disparities of wealth are socially destructive, perhaps evil. When you say that regulation “legitimizes outcomes”, you’re really saying, aren’t you, that it rigs the deck to get the outcomes which it wants? For only the best of reasons, of course!
That’s what makes a reasonable guy like you – one that’s half right! – a man of the Left on a continuum that leads to the Naomi Kleins of this world. Thomas Sowells has written well on the reason socialism never dies. We thought it had been finally discredited some time in the late 80’s, but he knew otherwise. The longing for utopia is perennial. So is the longing to soak the rich. I have some of those longings from time to time myself.
I see here that the Chicago Mercantile Exchange will start clearing credit derivatives. The SEC will have regulatory authority over it and will make these transactions more transparent. Instead of an investment bank determining the value of these instruments, many parties can play a role. You’ll be able to option them and use short positions which can be a hedge against inflation or irrational exuberance if you will.
seanF,
Look at all the evidence suggesting that something else was.
I would point out that your role in this conversation is to provide that evidence. Yet, although I’ve asked repeatedly for you to provide alternative evidence e.g. explain why the commercial real estate securities market did not boom and boost, you never do so.
Instead you make arguments like the following:
Try a thought experiment – assume you’re not correct, and government policy with Freddie and Fannie wasn’t the problem that led to the collapse. Don’t assume they didn’t distort the market – that would be unrealistic- but set aside, for a minute, the assumption that their distortion was the trigger.
I have had religious people make this exact argument to me in discussions on evolution/creationism. They ask me to ignore actual science and instead think about the possibilities of their particular religious explanation. They claim that my unwillingness to consider a religious explanation of matters subject to scientific study makes me closed minded, a slave to scientific authority etc.
You’ve made the same type of argument: You consider it axiomatic that without continuous political interference in the market the markets will fail. You take the recent collapse as a “proving” your axiom and don’t understand why I don’t see that. Just like the creationist, you want me to ignore data and instead just adopt your viewpoint as an act of faith.
Ain’t gonna happen.
You can’t ignore the role of the GSEs in the collapse for two reasons: (1) The GSEs were HUGE. Imagine what would happen to the economy if every bit of debt issued by the federal government prior to 2009 had been declared worthless overnight. That is pretty much what happened with the GSEs. If you want me to ignore them, you need to present a stronger, numbers based argument. You need to explain how the economy could had survived such a massive hit.
(2) You need to explain why, even though GSE insolvency preceded that of the rest of the financial system, the GSE insolvency was actually caused by the failure of the private parts of the financial system and not the other way around.
I don’t insist that the GSEs alone caused all the problems in the planetary financial system. Obviously, the GSEs did not cause the problems that German and French banks have in Eastern Europe. However, they did play an enormous role in the damage done to the American part of the system. You’ve offered me no intellectual or numbers based argument for why I should think otherwise.
Your an honest and thoughtful guy but I think you’ve got a bad case leftist insularity. You think it so obvious that political intervention in the economy is usually for the better that you don’t even understand arguments to the contrary enough to shoot them down. You fall into the religious type argument above because you don’t actually know anybody who thinks otherwise.
Your belief that we here at a libertarian blog are just gagga over Bush’s big-government conservatism shows that you really don’t understand how we think. You don’t actually address the factual argument we make, you just keep inviting us to abandon of our intellectual constructs and to instead make a leap of faith to join your “church”.
KJ & Shannon: Thanks for your gracious comments. The reason I read Chicagoboyz is because I find the posts interesting, the dialogue rational, and the posters intelligent. Quite unlike a lot of the blogosphere.
FYI, my aim is not to “convert” anyone. Joining a movement requires loyalty and faith – two things I suspect you can’t afford to have, if you want to think for yourself. I post here for selfish reasons – because debating ideas with thoughtful people helps me think through things, and because I think I can learn more by having a discussion with those who have a genuinely different perspective.
Shannon: Yes, the GSE MBS debt was huge. But why do you think that somehow proves that “big government” or “regulation” was to blame for poor decisions at the GSEs? And why do you think that the GSE debt is the most important trigger of the entire financial crisis when so many other actors were involved? The real story is more interesting..I’ll summarize, excuse the long post.
1. Mortgage brokers, all private, are an unregulated part of the financial market – no controls. In the mid-1990s, they began surging growth by targeting high-risk borrowers – to the point that 20.1% of all US mortgages were subprime. They didn’t care about the risk because they repackaged and sold the loans immediately as MBS to investment banks. The credit rating agencies (who were paid to rate, and had an incentive not to upset their customers) rated the higher tranches as considerably lower risk than they actually proved to be.
2. The investment banks made a lot of money selling these loans (now smelling like the roses) to international investors. By 2007, the international market for these loans was $1.5 trillion.
3. AIG and other international insurers sold insurance (credit default swaps) to the buyers of these loans who needed to hedge their risk. AIG may have known – probably did know – their risk estimation completely ignored systemic risk. But the money was too good to pass up. Investors thought they were golden because they had high-grade supposedly backed by insurance.
4. This whole thing worked as long as payments were being made. When the economy slowed, payments stopped being made. And the whole system came crashing down, because the risk estimation, from everyone, was completely off. Some people, certainly the mortgage brokers, knew this from the start. But they didn’t have the right incentives to care, not when so much money was to be made in the short term.
Who came out of this ahead? According to the Prospect article, the executives and officers of some mortgage finance companies cashed out before the market crashed. The poster boy is Angelo Mozilo, the CEO of Countrywide Financial, the largest sub-prime lender. He made more than $270 million in profits selling stocks and options from 2004 to the beginning of 2007. And the three founders of New Century Financial, the second largest sub-prime lender, together realized $40 million in stock-sale profits between 2004 and 2006. Paul Krugman reported in The New York Times that last year the chief executives of Merrill-Lynch and Citigroup were paid $48 million and $25.6 million, respectively.
But they’re just poster boys – really, the financial services industry made a killing by packaging sows ears as silk purses.
And where do the GSE’s come into this? A part, but not the central part by a long shot. In 2000, Fannie, a mortgage *insurance* company made a fateful decision to expand into sub-prime, relying on computer models to manage risk. Why? Politics – the Bush Administration wanted to expand home ownership, the Democrats were not going to complain. If you want to be a cynic, the real explanation: supercharged stock prices, Raines, the Fannie CEO for a while made $90 million between 1998 and 2004.
In 2004, Countrywide (Angelo Mozilo) threatened to end it’s partnership with Fannie unless Fannie bought Countrywide loans. In 2003, Fannie had lost 56% of its business to competition from Wall Street Banks. Also, Mozilo was a major political (GOP, actually) donor and player. The new CEO, Mudd, caved and agreed. Between 2005 and 2007, the company’s acquisitions of mortgages with down payments of less than 10 percent almost tripled. By 2007, the whole thing came crashing down.
Fannie wasn’t the cause of the crisis. It made the crisis worse because it was “captured”, in a sense, by an unregulated industry, mortgage brokers like Countrywide, who used it for their own short term profit.
See: http://www.nytimes.com/2008/10/05/business/05fannie.html?em
More generally, http://topics.nytimes.com/top/news/business/series/the_reckoning/index.html is an excellent series.
Who is really responsible? Very poor structural incentives, a belief in deregulation for the sake of deregulation, a complete failure by the Bush Administration, unwarranted faith in the ability of free markets to fix their own failures despite all the causes for market failure being present.
An early analysis, from 2007 is eerily prescient (if you can get past the partisan language, the authors really do think conservative dogma had a major part to play in this crisis – and they make good factual points). Looking back from 2009, they were dead on.
http://www.prospect.org/cs/articles?article=the_conservative_origins_of_the_subprime_mortgage_crisis
seanF,
Yes, the GSE MBS debt was huge. But why do you think that somehow proves that “big government” or “regulation” was to blame for poor decisions at the GSEs?
Because they were government creations. They operated under an implied government guarantee that allowed them to borrow money at around half the cost of private actors. They operated under a custom set of laws and accounting regulations established by congress purely for the GSEs. They were created solely for the purpose for distorting the market to encourage the making of loans that the free-market judge to risky. There is simply no way that their distortions of the market and their eventual catastrophic failure cannot be laid at the feet of the political system.
I don’t think you understand just how huge the GSEs were in terms of market share of the MBS market. Since the late 80’s, the GSE’s have bought at least 40% of every residential mortgage issued in the U.S. by 2003, when they got busted for corruption that had grown to 54%. Unlike in the private sector, most of those mortgages were bundled into MBS. The accumulation of these long term MBS, means that the majority, something like 60%-70% of all MSBs in the market today were issued by the GSEs. Almost every company that went broke due to MSBs, such Water’s pet bank, did so because they bought the government sponsored MBS. Had the GSEs remained solvent and their MSB retained their value, we would not have a major crises even if every private issuers failed.
That is one reason why the GSEs and the political complexes that created them bear the lion’s share of the blame in the crisis.
I would point out that when it came to the regulation of the GSEs. The Democratic and Republican roles reversed. Bush tried on 18 separate occasions to bring the GSE practices in line with those of private issuers. The Democrats shot him down each time. This is especially important because the GSEs because they did not have the external discipline of the market as private actors did. They really needed political oversight.
Mortgage brokers, all private, are an unregulated part of the financial market – no controls.
This is not true. All private mortgage issuers operate under the same set of federal and state laws. Countrywide and a small town bank all operated under the same laws. What mortgage brokers didn’t have were the same free-market controls as did small banks that kept their own mortgages in house.
In the mid-1990s, they began surging growth by targeting high-risk borrowers – to the point that 20.1% of all US mortgages were subprime.
Well, here the government played a role. It doesn’t take a genius to know that high risk borrowers are more likely to be people in the bottom half of the income distribution, exactly the people that the Clinton administration sought to help by leaning on banks and leftist organizations by suing banks for discrimination. This lead to changes in long standing free-market evolved lending standards. Since banks can’t legally discriminate between borrowers, changes in lending standards, for some borrowers became changes in standards for all borrowers. Again. a government intervention drove a change that the free-market would not have made because subprime loans are to risky.
They didn’t care about the risk because they repackaged and sold the loans immediately as MBS to investment banks.
Yeah, you left out a part. It should read, “They didn’t care about the risk because they sold the loans to the GSEs which repackaged and sold the loans immediately as MBS to investment banks.” The GSE were created specifically to sever the issuing of a mortgage from the risk of holding it. The mortgage brokers, both pure brokers and banks who acted like brokers, were not bugs in the GSE system, they were its intended consequence!
The entire point in creating the GSE was to induce banks to make loans that the free-market judged as to risky. To this end they induced everyone issuing mortgages to only pay attention to whether they could sell the mortgage to the GSE. The GSE, with their government backing and political mandate, grew less and less concerned about the risk of the mortgages they bought. The entire systemic risk assessment system of the residential mortgage market broke down. Which, again, was the point of creating the GSEs in the first place.
The credit rating agencies (who were paid to rate, and had an incentive not to upset their customers) rated the higher tranches as considerably lower risk than they actually proved to be.
Prior to the creation there was no significant residential MBS market. No private MBS issuer could assure buyers that the securities would retain their value. The government stepped in to address the “lack” in the market. You will not that only after the GSEs had been issuing such securities for nearly 30 years did private institution find they could also issue them. The GSEs conditioned the market to treat MBS as safe and sound investments. Again an intentional distortion. The private issuers used the same risk assessment methods of the GSEs. Since the rating agencies gave good rating to the GSEs, based initially on their government backing, they had no reason to downgrade the private issuers.
Again, no GSEs, no high rating for MBS. The industry would not have developed on its own to the scale it did.
2. The investment banks made a lot of money selling these loans (now smelling like the roses) to international investors. By 2007, the international market for these loans was $1.5 trillion.
Again, so did the GSEs but they did it first. You seem to keep implying that the private MBS issuers where doing something different and irresponsible when in fact they were merely mimicking the GSEs. And again, the accumulation of GSE MBS was so large that even if the private issuers remained solvent, the failure of the GSE would have destroyed the system.
3. AIG and other international insurers sold insurance (credit default swaps) to the buyers of these loans who needed to hedge their risk.
Which would have worked if the GSE had not collapsed. Again, we see private actors using the statistical models of the GSE to assess risk. Had the GSE not existed, this market would not have existed or it would not have grown so large.
4. This whole thing worked as long as payments were being made. When the economy slowed, payments stopped being made
Actually, this is wrong. The whole system worked as long as the market value of the properties backing the MBS stayed up. When those values tanked, the MBS became worthless. It had little to do with the money coming in the door. Instead, the accountants downgraded the value of the GSE issued MBS to near zero. Anyone who held those MBS as assets, including Water’s bank, found themselves technically insolvent.
In 2000, Fannie, a mortgage *insurance* company made a fateful decision to expand into sub-prime, relying on computer models to manage risk. Why? Politics – the Bush Administration wanted to expand home ownership, the Democrats were not going to complain.
You need to check your dates. Bush assumed office in 2001 and Fannie and Freddie had both been increasing their subprime lending since 1995. Bush certainly wanted to increase home lending, all politicians do, but when it comes to oversight on the GSEs Bush is clearly on the side of the angles. He tried 18 times to reform their practices but got shot down by the democrats every time. The record on this is very, very clear.
I would point out that by the time Bush came into office, the damage to the market was already done. All of the trends that would lead to disaster were already running by the time he came into office. Had Bush gone to the mat to try and restrict lending to home buyers, who would have supported him? Certainly, not the Democrats.
Fannie wasn’t the cause of the crisis. It made the crisis worse because it was “captured”, in a sense, by an unregulated industry, mortgage brokers like Countrywide, who used it for their own short term profit.
Fannie and Freddie did cause the crisis because they created the entire residential MBS market along with the intentional destruction of the markets perception of risk. Had they never existed, the residential MBS market would be small and stable like the commercial MBS market. Had they never existed, there would have been no mortgage brokers or banks acting like mortgage brokers.
Your American Prospect article simply ignores the creation of the GSE as instruments of market distortion. It ignores the role of the GSEs in the rise of the mortgage broker. It ignores the fact that the mortgage industry is the most heavily regulated part of the financial sector. It ignores that the volatility of the mortgage industry has increased has regulation has increased. It ignores the fact that the least regulated sectors, such a commercial mortgages, work just fine.
I’ve read dozens of articles, blog post and comments from the leftist perspective and none of them address any of the complaints of the free-market perspective. Indeed, just like the articles you link to, they don’t even give a clue they understand the crucial free-market concept of prices as a means of communication of information such as the risk of mortgages. Instead, they see this a moral drama, as narrative, in which the noble and altruistic leftist trying to restrain the greedy and stupid business people. The entire story is not a technical examination of a system, but a morality tale with the moral that one political group should be dominant over the other.
If you want to criticize free-market types, conservative or not, criticize us for not recognizing the market distortions and responding accordingly. We should have pushed harder and sooner for more oversight over the GSEs. We should have forced rating agencies to asses risk of private MBS without regard to the GSE experience. We should have destroyed the GSEs.
In the end, we collectively got into this problem by wanting something for nothing. We wanted house but we couldn’t accept the verdict of the market that we couldn’t afford them. Our short sighted politicians gave us an easy answer of tricking the market and we took it. Once we built our housing policy around using the guarantee of the Federal government to hide the risk of mortgages back in the 70’s, we were going to have a major problem. The market cannot be fooled forever.
Shannon:
Just one point.
You’re saying that the GSE’s distorted the market perception of risk and created the problem. That view allows you to sidestep any responsibility for the crisis for private actors, and retain your trust that unregulated free markets don’t fail.
But consider – if the GSE’s were mostly responsible for the bulk of the crisis, then the commercial MBS market should be fine. After all you claim it is the GSE’s that are the major source of the distortion. So a market subject to the same forces but without the GSE’s should be fine – or at least much less affected.
And therein lies a problem. The facts. The commercial MBS market is as dead as a dodo. See, e.g. http://www.cmalert.com/headlines_list.php for a rather depressing roundup of the current news.
Perhaps one could jump through a few more hoops and come up with yet another explanation that somehow implicates the GSE’s. I’m sure it might be fun to try. But at some point, you run into Occam’s razor.
For most of those without the faith that markets can effectively self-regulate – i.e. anyone not part of the conservative movement – the simpler explanation is probably correct.
The conditions for market failure were ripe. The market failed. That doesn’t mean markets are bad – they’re great, better than most other forms of economic ordering.
But they’re not perfect. Lowering taxes and trusting in the market doesn’t always work. Deregulation or non-regulation can sometimes lead to an incredible amount of value destruction and market failure. It isn’t always good.
I think this is very hard for the GOP to accept. Goes against the dogma. I think the party needs some more electoral drubbing before that happens. Sort of like the Democrats and welfare reform.
seanF,
if the GSE’s were mostly responsible for the bulk of the crisis, then the commercial MBS market should be fine.
I would turn the question around in two ways. First, if the free-market is to blame why didn’t the commercial real estate market exhibit the same rabid boom and why didn’t the commercial MSBs fail? If your model is true we should expect to see a correlation between the degree of government intervention and oversight and the stability and reliability of the market. Instead, we see the opposite, in many different financial sectors.
Second, if the free-market is to blame, why did the GSEs, as government creations operating under special laws and with government backing, fail? If any government agency should have been able to judge the systemic risk of the residential mortgage market, it was the GSEs. Why didn’t they see the problem years in advance and limit their purchases to safe mortgages?
Why did they fail before the private entities? Why did their failure bring down so many otherwise solvent private entities? If government regulation is so good and great why are not the GSEs safe harbors in a financial storm instead of the eye wall of the hurricane? At best, you are caught in the position of arguing that the politicians you so place so much faith in are no better at managing risk than the free market. At worst the political intervention created the problem.
To answer your question directly: As a leftist, you have a very, very hard time grasping the concept of economic behavior. You have a hard time understanding that different conditions, especially government force, alter people’s economic behavior. The GSEs distorted the entire residential mortgage market and altered the behavior of all actors in the market whether they dealt directly with the GSEs or not. (As a matter of fact, almost all players did so, either in selling mortgages to the GSEs 50% market share or in buying their MBSs or stock.) The existence of the GSEs altered the standards and practices of the entire industry over the course of 4 decades. Again, this is what they were designed to do.
Even if private companies did everything right (which they never do) the failure of the GSEs would have still brought the system down. Worse, they were always going to fail eventually. The cost of distorting the market had to paid eventually.
No GSEs, no failure. Without the example of the GSE MBSs, no private company would have gone into the business because no private buyers would invest in such risky securities based on nothing but the assurances of a private issuer. For one thing, no private issuer could purchase the large numbers of mortgages needed to get statistical protection against mortgage defaults. It took the enormous deep pockets of the federal government to get the ball rolling. Only after a solid 2 decades of large scale government backed MBSs flooding the market could private issures get a foothold by using the same standards as the GSEs.
The GSEs are the elephant in leftist’s parlor. You’re all sitting around sipping tea and leaning around the elephant to see your fellow leftist talking about the failure of the free-market. You can’t even acknowledge that its your elephant that you brought to the parlor. You can’t even it died. Its kinda comical.
The market failed. That doesn’t mean markets are bad – they’re great, better than most other forms of economic ordering. But they’re not perfect.
Perfection is for leftist and their utopias. The only thing that free-marketers assert is that the free-market is more robust than political meddling. The failure of the GSEs and the politically regulated markets and the stability of the unregulated markets bears this out.
Markets fail but they fail small time. It takes the power and enormous scope of government to wreck and entire economy.
Marvelous discussion. Thank you.
Dear seanf sorry to jump into the coversation like this. To answer one of your questions the reason the brivate banks followed the lead of the GSE’s is that they were making money of the GSE system. This what the GSEs were ment to do, get banks to do what they otherwise would not do. Then once the private banks had drunk the MBS cool aid they got in on the act themselves. But that was inevitable if MBSs were a good idea then of course the banks would try and make as much money as possible on them. In fact it was hard not to get involved with MBSs because your bank would be relatively less profitable. Since profitability is the way the free market determines the right course of action, once the government and the GSEs make bad lending a highly profitable activity (in the short term) then they could not expect any other outcome than the one that transpired.
BTW you keep saying that we are following an ideology, but so are you, so is everyone. The question is does your theory lead to good results. Lets look at the history of the financial system. First kings and governemnts gave banks special privilages to lend money that they owed to third parties. That is banks are allowed to lend a depositer’s money to others while still having a legal obligatiomn to pay the depositer’s money on demand. Thus in essence two people have exclusive title to the same thing. This is the fundimental cause of instability in the financial system, it is a clasic example of having your cake and eating it too.
This caused problems, but in general the system was fairly stable because with no government backing for the depositors, the customers were causious. A bank NEEDED a reputation for probity and conservative banking practice or people would not give them money. The period from the abolition of the second bank of the united states until the indroduction of the federal licencing of banks was the only period in US history when bank capitalization actually increased. This is the so call “wildcat banking” era that we are all taught to quake in fear of during american history, but the lack of intervention caused sounder banks. Never the less this system was unstable because it was based on the contratiction of two people having the same right over the same thing. So what was the proposed solution? Did they end the government intervention that made fractional reserve banking legal? Not at all they proposed more regulations. First small banks were required to lend money to large banks causing the peramiding of reserves. When this led to more violent contractions was the government intervention ended? By no means! The federal reserve bank, a cartel of banks with government backing, was formed. When Federal Reserve policy created the great depression was the intervention undone? No, the gold standard was abandoned and the federal reserve was given even more power.
The same thing has happened here. The pols wanted to help voters to buy house they could not afford. When this had the effects that free marketer’s including among others the editorial board of the WSJ had predicted who is to be blaimed. Those who warned of the danger of government intervetion or those who promoted it? If history is any guide then the free market will take the blaime and more power will given to the state, but that dose not mean that this is a smart course of action.
I know of very few free market advocates who do not belive that their is some natural instability in the market that we just have to live with, but we all realize that the interventionists preposed cure is worse than the desease.
The “other” seanf – thanks for your comment. I disagree so fundamentally that we’d have to open a separate discussion thread to discuss what you’ve said but I can’t resist making one point: the reason we have government “backing” of banks, i.e. FDIC insurance for depositors, is to prevent bank runs. Back in the day, the mere suspicion that a bank was unstable was enough to cause depositors to rush to pull out their money – making the bank collapse, often for no good reason other than rumor.
FDIC has worked very well. Banks collapse for all sorts of reasons but at least not because of unfounded rumors.
This is only one example of regulation improving a market, but it is exceptionally clear cut, so I thought I’d point it out.
FYI to clear up any confusion: the immediately preceding comment was posted by another “seanf”, not by the person making most of the posts in this thread above.
Seanf sorry to take your name by mistake. I did not mean to.
Actually the FDIC is good example of bad government intervention. Though roumors could cause a run on a bank, any well run bank can withstand such a roumor. You just pay out the money to your depositors. Yes the bank will have to sell some of its assets at a discount, but if the bank is well run and there is no general financial crises, then runs will not send the bank into chapter 7. If on the other hand the bank is ill run then it ought to be sent into liquidation. I and many other free banking avocates belive runs are an important source of market diciplen and that the FDIC is a cause of aditional instability. I would advise that you look at the history of the panic of 1907 and how JP Morgan saved the banking system and was vilified for it.
SeanF,
FDIC has worked very well. Banks collapse for all sorts of reasons but at least not because of unfounded rumors.
Depends on what you mean by unfounded rumors. The bank run is an interesting phenomenon and it has not disappeared. Its just that the government steps in to satisfy creditors. The first intervention by the Treasury this time was trigger by a 500 billion dollar run on the system in September.
I think that FDIC and similar programs simply trades small problems for large ones. By analogy, I would use the example of forest fire management in the first part of the 20th century. They decided to prevent all fires but over a period of decades this allowed a large amount of brush to build up in forest so that when there was a fire it was catastrophic.
We see the same thing in the banking system. The S&L crisis would be the best previous example. Here you have specialized government created institutions that could not survive in the free-market. When inflation made their model no longer tenable, the government tried to make them into hybrid institutions that worked more like regular banks. That failed and the FDIC had to bailout a large number of depositors.
With the free-market, you tend to get a lot of little brush fires. With government intervention, you get no little fires for decades at a time and then whoosh, the whole forest burns down.
The FDIC could be accomplished just as easily by requiring all depositors to purchase insurance from a 3rd party for the accounts up to 100,000 dollars. The insurances companies would then have the responsibility of judging the soundness of a bank. Depositors could get a numeric value for the banks soundness by looking at the insurance rates for deposits there. This would encourage banks to play more conservatively. The FDIC by contrast, answering as it does to political masters and not its own self-interest cares comparatively little for the risk a bank takes.
I would note that you have still not answered any of my empirical challenges on the main thread.
steph,
what you propose is, in a word, radical. and not in a good way. you’d like to believe deposit insurance doesn’t work. it does. the US has not experienced a bank run since FDIC was instituted. you’d like to tear it down. and hope that the free market will resolve things….somehow. despite the fact that 400 years of no FDIC-equivalent did nothing but create banks runs. over and over again.
see post from wikipedia below, summarizing information that isn’t based on ideology, but on experience.
in a microcosm, this is why the conservative movement is ripe for a fall. I think the movement has parted company with reality. it has gotten radical – unconservative, in every sense of the word. what you’re proposing is destroying a time-tested institution, that works well, and has solved a problem dating back to the 1600’s.
the movement may have repudiated bush, but with proposals like these – abolishing FDIC – it’s very similar to what Bush did in foreign policy. just because you think something is true, and you’d like it to be true, doesn’t make it true. and imposing your point of view on the country, should you get the chance, will cause all of us, unfortunately, a great deal of pain.
all in the name of what you’d like to be true. without a compelling need, argument or empirical data.
you guys may disagree but my honest belief is the conservative movement has jumped the shark. rejecting time-tested institutions in favor of an untested ideological “alternative” isn’t conservatism. it’s know-nothingism.
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Bank runs first appeared as part of cycles of credit expansion and its subsequent contraction. In the 16th century onwards, English goldsmiths issuing promissory notes suffered severe failures due to bad harvests plummeting parts of the country into famine and unrest. Other examples are the Dutch Tulip manias (1634-1637), the British South Sea Bubble (1717-1719), the French Mississippi Company (1717-1720), the “Post Napoleonic Depression” (1815-1830) and the Great Depression (1929-1939).
Bank runs have also been used to blackmail individuals or governments; for example in 1830 when the British Government under the Duke of Wellington overturned a majority government under the orders of the king, George IV, to prevent reform (the later 1832 Reform Act), he angered reformers and so a run on the banks was threatened under the rallying cry “To stop the Duke go for gold!”.
Many of the recessions in the United States were caused by banking panics. The Great Depression contained several banking crises consisting of runs on multiple banks from 1929 to 1933; some of these were specific to regions of the U.S.[3] Banking panics began in October 1930, one year after the stock market crash, triggered by the collapse of correspondent networks; the bank runs became worse after financial conglomerates in New York and Los Angeles failed in prominently-covered scandals.[13] Much of the Depression’s economic damage was caused directly by bank runs,[4] and institutions put into place after the Depression have prevented runs on U.S. commercial banks since the 1930s,[7] even under conditions such as the U.S. savings and loan crisis of the 1980s and 1990s.[
Seanf Read what I wrote bank runs are a good thing! The FDIC does end bank runs that is the problem this causes further instability. Please for god sake pay atention to what I am saying.
Bank runs are a syptom of a deeper problem in the financial system, they are not the cause of the problem. You are in essince argueing that a drunk should keep drinking because if he stops drinking he will have withdrawl symptoms. It is the expansion of bank credit that causes financial crises.