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  • Government and Moral Hazards

    Posted by Shannon Love on March 17th, 2009 (All posts by )

    Sometimes, I hate Glenn Reynolds of Instapundit. I started writing a post on moral hazards in the financial system last night and then I pop onto Instapundit today to find a link to a Popular Mechanics article he wrote about moral hazards. He even uses the example of auto-safety improvements that I intended to use. 

    *Sigh*

    Glenn makes something like the  point I intended to make:

    This approach could be taken beyond the world of personal transportation. We’re in the current financial mess in part because things that were actually dangerous—from subprime mortgages to risky financial instruments that no one fully understood—felt safe and ordinary. Modern financial markets, with computers, regulations, deposit insurance and bond ratings, felt as routine and as smooth as that four-lane highway in Spain, causing a lot of people who should have been paying attention to doze off. Investors might have been more careful if it had felt like they were driving down a twisty mountain road with no guardrails, especially since we really were engaged in the financial equivalent of high-speed mountain driving, only without the discipline of fear.

    The current financial crisis definitely resulted from government generated moral risk. The massive federal-government-created and -managed enterprises, Freddie Mac, Fannie Mae and the Federal Home Loan Banks, aka Flubs, (henceforth, collectively the GSEs) are ground zero for the crisis. They were simply too big not to dramatically impact the market. Collectively, the GSEs purchase half of the mortgages issued in the U.S. Collectively, they issued most of the mortgage-backed securities (MBSs) currently in circulation. By design, these institutions created a vast moral hazard that built up over four decades until the system collapsed under the weight of risky behavior. 

    The GSEs created moral risk in several ways. 

    (1) By design, the GSEs separated the profit earned from a particular mortgage from the risk of issuing that mortgage. Prior to the GSEs most institutions who issued a mortgage had to hold the mortgage, because few people would trust a private institution’s judgment about the safety of the mortgages it issued but did not keep in-house. If the borrower defaulted then the mortgage issuer lost money. This created a strong feedback system that tied benefit and risk tightly together. Politicians decided that this aversion to risk caused lenders to loan too conservatively, so they created the GSEs to remove the risk from issuing mortgages.  Now the only feedback on the risk of mortgage came from the GSEs, and with their government backing they paid far less attention to risk posed by mortgages. 

    By analogy to autos, this is the same effect you would get if the government started providing free, full coverage, no-fault collision insurance.  Suddenly, the economic risk from dangerous driving would disappear. People would no longer have a financial incentive to avoid fender benders, nor would they worry that risky driving would raise their insurance rates. Everyone can see this kind of moral hazard clearly but most have a problem seeing the same moral hazard in the financial system. 

    (2) By design, the GSEs hid the hazard of buying their MBSs by using their implied government guarantee. With private MBSs, the purchaser of the MBS has to trust that the seller has correctly calculated the risk of the collection of individual mortgages that back each unit of the security. Again, prior to the GSEs, few people would take that risk. Privately issued MBSs covered only a few percent of the residential real estate market, and those few percent dealt with high-value properties that historically held their value in good times and bad. The GSEs solved this “problem” in two ways. First, they used the presumption of political oversight and regulation (which in fact turned out not to exist) to convince buyers that the GSEs would properly calculate the risk of the mortgages the GSEs bought. Second, they used the implied guarantee to assure buyers that even if the GSEs made a mistake, the government would make good the payout on the securities. 

    By analogy with autos, this is the same effect you would get if the government claimed to protect against lemons at an auto dealer. Imagine if an auto dealer could claim that (a) the government checked the dealer’s car inventory for lemons and that (b) the government implied it would make good any financial loses that a buyer might incur if he got a lemon anyway. How carefully would people check out cars before they bought them? 

    (3) By design, the GSEs had much better credit ratings than did any private actors. All credit-rating agencies, both in America and overseas, rated the GSEs as much safer than their private-sector counterparts, due solely to their presumed government oversight and backing. This in turn made insurance against their defaults, called Credit-Default Swaps (CDSs) much cheaper than it should have been. Since most CDS issuers hedged by bundling GSE-based CDSs with private ones, this artificially lowered the prices of all CDSs. 

    By analogy with autos, this is the same effect you would get if the government generated the actuarial tables for auto insurance to make accidents seem less common than they actually are. Auto insurance would be cheaper but the entire industry would be built on a flawed understanding of the risk of driving. Also, imagine that it turned out that the government wouldn’t pay for damages and lemons and that the insurance companies had to take up the entire slack. 

    So, by extended analogy, imagine an automobile-based transportation system in which people (a) paid no financial penalty for reckless driving, (b) paid little attention to the mechanical quality of the cars they purchased and (c) private insurance companies operated on faulty accident statistics. Eventually, such a system would collapse. People would recklessly drive unsafe cars and the auto insurance companies would go bankrupt trying to pay damages.  

    This vast moral hazard explains most of the financial collapse. Lenders issued increasingly risky mortgages because, like government-insured drivers, they paid no penalty for making risky loans. Buyers of MBSs ignored the dangers of MBSs because, like drivers protected against lemons, they assumed that the MBSs were safe. Insurers charged too little for MBS default insurance because, like insurance companies using government statistics to price risk, they misjudged the true risk of MBSs. 

    I can’t repeat this often enough: By design, the GSEs were intended to distort the markets in favor of more-risky lending and that is exactly what we got. The private institutions that failed did so because they (a) mimicked the business model and practices of the GSEs, (b) bought GSE-issued MBSs, and GSE stock, based on their high ratings and/or (3) issued insurance against the default of the GSEs’ MBSs based on their high ratings. 

    Without the GSEs, the circumstances of the collapse would have never developed. To use automotive metaphors, fewer of us would have cars and we would pay higher insurance, but the cars we did have would be mechanically safer, we would drive them more safely and our auto insurance could pay out any damage claims if we had an accident. Instead, our political impulse to get something for nothing has led us to the financial equivalent of a nationwide pile-up of rust heaps driven by meth-crazed teenagers. 

     

    46 Responses to “Government and Moral Hazards”

    1. renminbi Says:

      The backing of GSE was only implicit.There was no legislative guarantee of Fanny and Freddy debt.Don’t know about the flubs.

      Bush could have stopped this by making clear that this debt was not legally binding and that he would veto any attempt to make it so.That would have stopped it earlier by making their stopping them floating bonds ,but he would would have gotten much vituperation and hate from the people benefitting from this racket.It is not reasonable to have a system requiring unusual virtue from office holders. In a proper system having a non-entity like Obama would make no differanc,here

      Yes,Shannon you are spot on.

    2. Mitch Says:

      “simply to big” — that should be “too”

    3. Shannon Love Says:

      Renminbi,

      Bush could have stopped this by making clear that this debt was not legally binding and that he would veto any attempt to make it so.

      I doubt it. The ultimate surety came from congress. Most investors might assume that congress would override Bush’s veto or force him to back down just as they did with his GSE reform attempts. Also, there was no market belief that the GSEs would fail before Bush left office.

    4. Jeanne Says:

      Adding insult to injury:

      Fannie Mae execs collected HUGE bonuses as a result of Fannie’s lower operating costs. Oh, and even that wasn’t good enough. They cooked the books with fraudulent accounting to pump up those bonuses. Franklin Raines alone was paid NINETY ONE million dollars for about 5 years’ work. He then pleaded guilty to the accounting fraud, got a slap on the wrist, and went on to advise the Obama campaign.

      In the end, taxpayers and shareholders got screwed. But the politically connected former execs are still sitting on their enormous pile of ill-gotten gains.

    5. DaveKe Says:

      Your auto example reminds me of a real life case in China some years ago when the country insured bikes against theft for a premium of about 1% of the value per year. However, far more than 1% of new bikes are stolen each year, so the system collapsed within 2 years.

    6. Shannon Love Says:

      Jeanne,

      Fannie Mae execs collected HUGE bonuses as a result of Fannie’s lower operating costs.

      Yes, for advocates of politically managed enterprises over free-market enterprises, the GSEs are a serious conceptual challenge. These government creations represented all the worst excesses that such advocates claim plague the free-market. There were unregulated, used non-standard accounting, insanely high executive bonuses and outright illegality.

      Had the GSEs been private entities they would have replaced Enron as the poster child for evil corporation. However, since they are political creations of the left, they get treated as hapless victims.

    7. John Says:

      It is true that there was an implicit government guarantee of debt (bonds) issued by the GSEs (which is now explicit for Fannie and Freddie but not for the FHLBs). But was there really an implicit guarantee of MBSs issued by GSEs, as point 2 states? That doesn’t seem right to me. Why would anyone expect the government to guarantee my mortgage just because it was bundled and sold by Fannie?

    8. Shannon Love Says:

      John,

      Why would anyone expect the government to guarantee my mortgage just because it was bundled and sold by Fannie?

      The implied guarantee was not to the home buyer who took out the mortgage but rather to the people who bought the MSBs. The GSE did nothing to help home buyers beyond inducing lenders to make risky loans. The guarantee to purchasers of MSBs was necessary because no one would buy residential mortgage-backed securities from the free-market. People just didn’t trust private entities to bundle mortgages safely nor did private entities have the scale necessary to buy up enough mortgages to make each individual failed mortgage a mere statistical blip.

      People who purchase GSE MSBs expected that the government would make good the securities if the GSEs screwed up. That is a protection they would not have with a privately issued security.

    9. Paul A'Barge Says:

      The fact that some banks did not engage in risky lending refutes your thesis. Also, at least some politicians, economists, investors and pundits have been saying this was a nightmare waiting to happen. Others did not listen.

      Some people will travel carelessly down a twisting mountain road in complete denial no matter how risky it seems. These people are sometimes called morons. Other times they are called idiots.

    10. Fresh Air Says:

      John–

      Ask any student who has taken a Money & Banking course what they are told about the GSEs. It’s always the same: they are technically private enterprises but investors fully expect the federal government to step up and guarantee their solvency. We never got a test of this theory until recently. Now, I think we can safely say it was correct–as rotten as that fact may be.

    11. Shannon Love Says:

      Paul A’ Barge,

      The fact that some banks did not engage in risky lending refutes your thesis.

      No, it just mean some people are smarter than others. Specifically, banks that did trust the free-market more than the government came out on top while those who believe in the assurances of the GSEs got hurt badly. The moral to the story is that the government and finances do not mix

      Most financial institutions in trouble today, from arch-leftist Maxine Waters’ pet bank to AIG, got into trouble because they bought GSE MBSs, GSE stock or tried to insure GSE MBSs against default and not because they themselves made risky loans. Water’s bank went under because it held to many of its assets in the form of GSE stock and MBSs. AIG got in trouble in main because it foolishly insured GSE MBSs against default based on the assumption that such securities were extremely safe due to their government backing.

      People didn’t have to be predatory, greedy or foolish to be hurt. They just had to trust the government.

      The government didn’t force financial institutions to make bad decisions, it merely bribed them to do so with the promise of hundreds of billions of government secured profits. Since the market works based on price signaling due to profit seeking, the government is to blame for distorting the market.

      And just to repeat myself because you don’t seem to have grasped the concept: This is exactly what the GSEs were intended to do, distort the market in order to induce lenders to make risky loans.

      They succeeded, brilliantly.

    12. looking closely Says:

      >>>”Some people will travel carelessly down a twisting mountain road in complete denial no matter how risky it seems. These people are sometimes called morons. Other times they are called idiots.”

      Yet other times, they are called “victims”.

      In this case, that’s exactly the label given to many individuals who by ignorance or by design purchased homes using mortgages they couldn’t afford to repay.

    13. Claude Hopper Says:

      When it Raines it poors.

    14. bob Says:

      What isn’t mentioned often is the utter failure of the regulatory agencies, both state and federal in this disaster.

      Elliott Spitzer both as governor and NY State AG, Mario Cuomo NY State AG and the failure of the NY State Dept. of Insurance. AIG is headquartered in NY state and is regulated by the state of NY.
      There appears to be a major failure by the NY State Dept. of Insurance in the supervision of and regulation of AIG which does not absolve Congress since they to failed in their oversight capacity of the FDIC and OCC in asking the obvious question: who guarantees that the underlying credit insurance and insurers for all of the CDO’s and swaps? Why did the Feds allow a state insurance department in essence to put the entire United States on the hook as co-signer of the risk? AIG was the bookies, bookies, bookie but none of the supervisory and regulatory agencies apparently saw fit to see if the bookie could actually be able to pay off the bet. This also appears to be an unintended consequence of the mark to market rule and another failure to think through legislation and possible unintended consequences.

      The outrage isn’t the one about the bonuses, shameful and greedy as they may be, but the fact that every politician who should have done their job by actually reading bills before they vote for them, actually performing the oversight function and all of the state and federal agency employees who were charged to actually regulate and supervise these insurers and banks failed completely in their functions yet they all were paid salaries, bonuses and benefits. Perhaps they too should be forced to give back their unjust riches. Since this AIG debacle apparently took place within the last two years after Spitzer hounded former AIG Chairman Greenberg out of the company perhaps this once again a matter of name that party.

    15. Paul Says:

      Good post and comments. However, I think it would help to distinguish among the GSE’s stock, direct debt and mortgage backed securities. The stock never had an implicit guarantee. Its holders, like Maxine Water’s bank, hoped it would be covered but it wasn’t. The direct debt has always had an implicit guarantee, which is why it was priced only a few points above direct U. S. Treasuries. The market was sure that it would not default partly because its holders included many banks, including foreign central banks. The mortgage backed securities had no implied guarantee and their high yields reflected that. It is true that, prior to about 1999, the GSE’s were known as conservative lenders and this reputation probably followed them into the “go go” years that followed, thus creating a false sense of security among buyers.

    16. Shannon Love Says:

      Bob,

      Why did the Feds allow a state insurance department in essence to put the entire United States on the hook as co-signer of the risk?

      I think the fundamental problem in this entire mess is that neither AIG nor the regulators could properly assess the risk of GSE securities due to their implied government backing. By design, the GSEs were supposed to get money on the cheap just hooking their thumb over their shoulder at the Federal government standing behind them whenever people ask them how they would secure their debts. All the ratings institutions both public and private as well as international gave the GSEs AAA ratings.

      What kind of crap-storm would an insurance regulator had gotten from the Democrats if he suggested that the GSEs were much risker than commonly assumed? The Democrats would have accused the regulator of undermining people’s hopes to own a home instead of praising him for making the financial system more stable. Moreover, what objective evidence could the regulator provide that the GSEs presented a high risk. People who argued the opposite could always point to the consensus of the rating institutions.

      I do agree that the AIG debacle highlights the failure of government regulation. In this case, I think the regulators simply did not have the necessary information to work from even if the political will had existed. It also shows that the failure is much more broad than just the Bush administration as many would like to portray it.

    17. Shannon Love Says:

      Paul,

      However, I think it would help to distinguish among the GSE’s stock, direct debt and mortgage backed securities. The stock never had an implicit guarantee

      That’s all true. I had to simplify things due to length. I think, however, that the implied government backing leaked over into everything these institutions did, including their stock price. After all, the stock price was linked to their core business of buying up individual mortgages and bundling them into securities. If the government guaranteed the securities it guaranteed the stock by extension.

      Anyway you put it, we have a case of the government intervening in the market in a huge way which sent out distorting ripples across the entire financial industry. It was like a hippo jumping into a kiddie pool. A kid doesn’t have to be right under the hippo to get swamped.

    18. Roger Sweeny Says:

      Shannon,

      Don’t you mean MBS (mortgage-backed security), not MSB?

      [From Shannon — Yes dammit, I put MSB in my spellchecker by mistake and then it gleefully “corrected” my “mistake” when writing MBS and I’m to word blind to catch it. Now corrected.]

    19. Mule Says:

      I’ve always envisioned a huge “Blame Chart” assembled in the form of a pie. There are plenty of culprits in this game, each requiring their own slice: Fed, SEC, commercial banks, investment banks, rating agencies, Fannie/Freddie, regulatory bodies, etc. I don’t think anyone will try to state this “crime” carries only one smoking gun. However, I have always maintained that Fannie and Freddie deserve the largest piece of the pie due to all the variables you, Shannon, expand upon.

      How would AIG have grown to their statistically significant role in this debacle in the absence of Fannie and Freddie? I have no doubt the CDS market amplified the issue, but that is cause and effect, not chicken or egg. Why would the rating agencies throw away decades of analysis in the absence government’s implicit (now explicit) blank check? Try to control for all these variables and it just seems Fannie/Freddie serves as the main denominator for subsequent second tier effects.

      If a careless driver slams into the back of another car and causes a five care pileup, I don’t blame the third car for the collision. I guess the old saying “In complexity lies deceit.” comes to mind. Unfortunately, our dear public servants are utilizing this fact as the veil by which they disguise their own guilt.

    20. Shannon Love Says:

      Mule,

      How would AIG have grown to their statistically significant role in this debacle in the absence of Fannie and Freddie?

      I don’t think it would have happened. At most you would have a CDS system like that which grew up around the free-market commercial real estate mortgage-backed securities. With no government backing, people viewed those securities as much more risky and as a result the cost of CDSs for them was significantly higher.

      The free-market operates by positive and negative feedback loops. Profit motive forms the positive feedback and fear-of-loss/actual-loss forms the negative feedback. The government created the GSEs to sever the negative feedback. This created a runaway signal that spread across the entire financial system.

      We probably would have had some kind of reversal without the GSEs and other government interference. Such setbacks are a normal and healthy part of the economic system. Usually, the free-market negative feedback of risk of loss keeps these setbacks relatively small scale. We lost that protection when we destroyed that feedback.

    21. Mule Says:

      I fully agree Shannon. Those trying to massage this into a chicken vs. egg issue are missing the cause and effect. Apparently, our current administration is taking the stance that it wasn’t the fact we (government) sent mixed imperatives to the market, it’s that we didn’t send enough of them. Great post and we all know that Reynolds character is a blatant psychic plagiarist.

    22. John Says:

      Thanks for addressing my question, Shannon. I may have been unclear by using my own mortgage as an example but Paul articulated my point nicely in his comment distinguishing among stock, direct debt, and MBSs. Perhaps you are right that the implicit government guarantee ‘leaked over into everything these institutions did’. But as an investor purchasing an MBS or shares of an MBS, I wouldn’t expect a government guarantee regardless of whether that MBS originated at Fannie, Freddie, or Citi. Did others really expect such a guarantee? This may be splitting hairs at this point and I don’t mean to diminish the role of the federal government acting through GSEs in bringing about this mess. I just wonder about the true scope of the implicit guarantee.

    23. Shannon Love Says:

      John,

      But as an investor purchasing an MBS or shares of an MBS, I wouldn’t expect a government guarantee regardless of whether that MBS originated at Fannie, Freddie, or Citi. Did others really expect such a guarantee?

      I think so. From what I’ve read many people did rely on the idea that the MBSs of the GSEs had some degree of government backing. Certainly, the ratings industry took it like that. There really isn’t any other reason, especially 20+ years ago when residential MBSs were novel and seldom used, for investors to view them as solid investments. If they had, then the free-market would have created the market without the government having to get involved.

    24. kjackman Says:

      This article, and the comments that follow, are a fantastic example of how clear thinking and writing can take what is to most people (like me) a hideously complex situation, distill the simple essence from it, and present something totally understandable.

      I understand basic economics, and I can follow most of the acronyms, but I have no clue what it’s like buying and selling these instruments. I didn’t know that *nobody* was assessing the true risks of these instruments, for example.

      I’ve seen a well-produced animated YouTube video that supposedly explains how this whole mess happened, the one with the three “risk” inboxes (sadly can’t find it now). Hopefully someone will remember here and provide a link. It contains a lot of detail, so I assume it was made by people who understand finance. Coming away from that, I felt armed with all the info I needed to understand the collapse. Only now do I remember that it contained not a word about how government was screwing around with the risk assessments. It tried to be neutral on blame by not mentioning it at all, but in doing so, it left out critical information, without which it is impossible to form a complete and accurate mental model of the collapse.

      The government created the GSEs to sever the negative feedback. This created a runaway signal that spread across the entire financial system.

      Nothing sums it up quite so succinctly while remaining accurate. Blaming this on “greed” doesn’t work. Wall Street has always been greedy; that’s a constant. Something changed to bring this about. What was the variable? This time, government not only changed the rules, they rewired the entire frickin’ system.

      Imagine the financial system as a hideously complex, but mostly self-regulated, power plant. When maintained properly, it keeps the power (i.e. money) flowing to everyone to keep commerce moving. Government officials, not understanding the dangers, walked up to the patch panel on the control board, said “I think we need more power here, here, and here,” rewired the board without thinking about the consequences, and walked away, leaving the plant workers to take the blame and clean up the mess after the inevitable explosion.

      And even today, they have the gall to tell us to leave that control board alone. The legal changes that severed the negative feedback loop have not changed, have they? To use another analogy: the boat still has a huge hole in it, and they’re just switching to bailing out with bigger buckets.

      I guess everyone’s smart enough not to touch MBS’s with a 10-foot pole now, but what happens when real estate picks up again and B. Frank et al start harassing banks for “redlining” again?

      Thanks for clarifying this to the awesome degree that you have, but it just makes me even angrier at the govt officials than I already was. Wall Street types share the blame, but only inasmuch as they *played along*.

    25. Shannon Love Says:

      Kjackman,

      Imagine the financial system as a hideously complex, but mostly self-regulated, power plant.

      A better example would be computer network sense the financial system actually moves information around in the form of money. But yes, in this case the government interfered in the natural negative feedback mechanism that prevented the issuing of to many risky loans.

      Human action creates markets but no human understands them enough to control them or predict their behavior. In the end, they’re natural systems. Any you can’t fool mother nature.

    26. seanf Says:

      No further comment on the GSE’s other than this:

      (1) The only people who genuinely (i.e. no bad faith – they really believe this) appear to see the GSE’s as the major cause of the crisis are economic libertarians.

      (2) Regardless of its accuracy, blaming the GSE’s is an explanation which allows libertarians not to question any beliefs they currently have, unlike virtually all other explanations.

      My personal view is that those two facts are related. YMMV.

      For those who’re not convinced that government regulation was the problem (and aren’t scared by an equation or two), here is the clearest explanation why the insurance industry’s underestimated systemic risk I’ve yet read.

      http://www.acredittrader.com/?p=65

    27. Roderick Reilly Says:

      So, the mortgage market was severely distorted by inflated, illusory credit ratings for GSEs, creating a ccading effect of lenders being duped into buying MBSs (although “duped” may be too generous towards the lenders).

      In essence, it means that our own government is guilty of monumental fraud on a scale 100 times greater than Bernie Madoff.

    28. Shannon Love Says:

      Seanf,

      (1) The only people who genuinely (i.e. no bad faith – they really believe this) appear to see the GSE’s as the major cause of the crisis are economic libertarians.

      Well, that proves it. Obviously, the majority is always right. After all, isn’t that what got us to this present point. Actually, quite a lot of the detailed business press points to the GSEs as key players in this problem. The mainstream press and politicians obviously won’t because they would then face questions. Evoking the regulation fairies is much easier.

      (2) Regardless of its accuracy, blaming the GSE’s is an explanation which allows libertarians not to question any beliefs they currently have, unlike virtually all other explanations.

      Regardless of its accuracy, blaming a lack of government power allows leftist not to question any beliefs they currently have, unlike virtually all other explanations. If also gives them a model which justifies them subordinating all the rest of us under the guise of “protecting” us from the evils of the free-market. I think the conflict of interest is obvious.

      The article you link to is very informative but only goes to prove my point here. The supersenior (above AAA) ABS CDO the article mentions are heavily weighted with MBSs from the GSEs. AIG used the GSE MBS in order to balance the possibility that one of the private issuers would default. If the GSE had not defaulted then AIG could have survived.

      You simply state it as matter of faith that more government intervention is better yet you don’t explain why the government created GSE failed at all. If government is so great and good, why aren’t they stable rock in the financial storm instead of the a big part of the problem? If government intervention solves more problems than it causes, why is there an inverse relationship between the stability of a financial market and the degree of government intervention e.g. the commercial real estate market vs the residential real estate market.

      Honestly, seanF, you’re a nice guy but you have to understand, I’m not in your church. I don’t have the same faith based axioms you do. If you want to argue, you’ve got to bring facts and figures and plausible models. You never do that. You just keep insisting that I “see the light.” It ain’t going to happen.

    29. seanf Says:

      >>You simply state it as matter of faith that more government intervention is better yet you don’t explain why the government created GSE failed at all. If government is so great and good, why aren’t they stable rock in the financial storm instead of the a big part of the problem?

      Actually, I never said this. In fact I find it hard to believe that anyone – really, I mean anyone – believes that more government intervention is always better. Putin, maybe. You can set up a straw man who might believe that but really, no point in arguing with a (wrong) straw man.

      What I do believe is that markets are subject to imperfection and rigging. By both private participants and through government intervention. Experience teaches us that too much regulation makes a market inefficient, unfair or both. Too little allows for unchecked manipulation. The administration over the last 8 years (and the GOP over the last 28) took a simplistic “government = bad” strategy. It paid off in the polls – for a while – but had predictable results.

      >>I don’t have the same faith based axioms you do. If you want to argue, you’ve got to bring facts and figures and plausible models. You never do that.

      I make my assumptions, and where I stand, as clear as I can. I also try and provide links where possible. I’m a commenter, not a poster and don’t have the same incentives to respond to comments by others.

      In this particular case, I don’t think I’m the one with the factual or ideological problem. The market failed. The most likely explanation involves a lot of factors – mostly related to bad structural incentives and a lack of regulation in the eyes of most observers, including a number of Chicago-school economists and virtually every economist of every other stripe. That isn’t to say the GSE’s didn’t contribute in some way but making them the centerpiece – hard to do.

      Unfortunately, that’s very hard for libertarians to swallow. You’re having to expend an awful lot of intellectual energy to fit the facts into your worldview. You have an explanation that’s a minority position and hard to defend against those who don’t share your ideological views – but you have to defend it aggressively. That’s difficult. Even Reagan-era deregulators and Alan Greenspan are blaming this on a lack of regulation, not on big bad government.

      Personally I have no great love for Greenspan. But I think he’s doing this to maintain credibility. If you’re not going to concede a point that appears reasonably clear to most other observers, they will eventually discount your opinion accordingly, reasoning that you have an especially sharp ideological axe to grind.

      >You just keep insisting that I “see the light.” It ain’t going to happen.

      Hey, I’m not running a church and have no claim to any greater capacity in general to see truth than you or anyone else. You may continue to expend that energy. You may not. You may alter your position to make it easier to defend, without sacrificing your essential suspicion of regulation. I suspect you’re rather unlikely to develop a crush on the lovely Naomi Klein and start boring people by spouting Chomsky at parties.

      You know Shannon, I said I wasn’t going to argue with you any more more and now look at me … here I go again. I’m
      going to have to be more disciplined.

    30. Shannon Love Says:

      What I do believe is that markets are subject to imperfection and rigging. By both private participants and through government intervention.

      Yes, but free-markets are less susceptible to imperfections and rigging than are mixed-markets in which government plays a major role. It takes a lot more money to rig an international market of any kind than it does to bribe a few legislators by legal or illegal means.

      Too little allows for unchecked manipulation.

      No private actor has manipulated an entire market for at least a century. The markets are simply to big. This is especially true of the financial markets in the largest of the private entities have only a few percent of the total market. The current crises was caused by a near industry wide underestimation of the risk poised by residential mortgages. No private actor had the power to bring that about.

      The administration over the last 8 years (and the GOP over the last 28) took a simplistic “government = bad” strategy. It paid off in the polls – for a while – but had predictable results.

      That is of course a strawman and completely ignores the attempts by the GOP to regulate the single greatest players in the residential real estate market, the GSEs. Conversely, the Democrats could be accused by your standards of of a simplistic “government=good” to the point that they let GSE operate fast and loose with half the residential real estate market. In short, when the government manipulates the market, leftist and Democrats never see any problems.

      The market failed.

      Yes but why? I think we can agree that the market failed because it could not process the risk associated with residential mortgages to a huge degree. You haven’t proposed a mechanism by which the free-market would could blind itself to such risk given that under free-market conditions those who do correctly judge risk suffer for it immediately. Conversely, I have proposed a mechanism by which government action, consciously designed to disguise risk, blinded the market to risk. I’ve demonstrated that the GSE had both the market share, the fake ratings and the accumulation of debt to alter the entire market.

      Even Reagan-era deregulators and Alan Greenspan are blaming this on a lack of regulation, not on big bad government.

      I pretty much don’t care. I was trained as a scientist. Arguments form authority, especially arguments from authorities in an discipline with no objective empirical standards for predictive failure, are worthless.

      If you’re not going to concede a point that appears reasonably clear to most other observers, they will eventually discount your opinion accordingly, reasoning that you have an especially sharp ideological axe to grind.

      What point? Beyond your vague assertions that we needed more “regulations” you haven’t given any detail whatsoever. I don’t understand why I should accept on faith the assertions of a political class that will blame anyone but themselves for the problem.

      That isn’t to say the GSE’s didn’t contribute in some way but making them the centerpiece – hard to do.

      Well, again you don’t say why. I’ve presented a lot of detailed explanations of my model but all I ever get from you is airy hand waving. Its very frustrating. You don’t actually give me anything to argue against beyond your repeated insulting accusations that I’m am simply a brainless ideologue. I feel like I’m arguing with a parrot.

      Hey, I’m not running a church and have no claim to any greater capacity in general to see truth than you or anyone else.

      Yes you do. You just said that the answer was obvious and that if I was not so blinded by ideological attachments I would see everything just like the majority of people of do. That is in fact, the same argument that religious people often make.

      I propose a compromise. I will ignore all your comments that don’t deal with actual numerical information of posit specific cause and effect relationships. That will cut out 90% your discourse saving you a great deal of time.

    31. Bernstein Says:

      Paul’s right, Shannon, the mortgage-backed securities had no implied guarantee and their high yields reflected that.

      A few simple facts show clearly that the government guarantee had little or nothing to do with the meltdown.

      1. The government has been guaranteeing Frannie mortgages for decades. If that was a significant moral hazard, it would have blown up in the early 1980s recession when interest rates were at double digits, or, certainly, during the early 1990s Savings and Loan debacle.

      2. Mortgage-backed securities have been around since the mid-1980s. If there was some problem specific to that type of structured credit, it would have emerged long before the summer of 2007.

      3. Fund managers know all about moral hazard and, certainly, know exactly what portion of any security they buy has a government guarantee. If there is any ambiguity on that point, they are well aware of the implied risks and how to hedge them. Any professional investor who was “duped” by an implied government guarantee of Frannie securities is exceptionally unqualified to be overseeing other people’s money.

      4. Bear Stearns and Lehman Brothers did not collapse because they held too many subprime CDOs. They collapsed because they had borrowed too heavily to buy subprime CDOs. They did so because massive leverage of as much as 30 to 1 was yielding massive returns and their risk models verified for them what the ratings agencies were also saying, which was the the notes had investment grade ratings.

      5. The amound of subprime CDO issuance more than quadrupled between 2004 and 2008. Why 2004? Frannie mortgages had the govt guarantee for decades. It happened in 2004 because that’s when, at the Bush administration’s behest, the SEC agreed to lift limits on leverage investment banks could use. The burst in CDO issuance came because the big-bonus fund managers at Bear, Lehman and so on were gobbling them up using massive leverage that lead to massive gains, until it all collapsed.

    32. Marty Says:

      Good stuff, here. A little more perspective–Fannie was originally a New Deal govt agency, LBJ and Congress spun it off ca. 1968 so it wouldn’t be on the Federal budget and balance sheet (to the extent the concept of ‘balance sheet’ means anything to the govt), part of the budget games to hide the deficit growing out of the Great Society and Vietnam War. Had it remained a real govt agency it might have been more regulated and controlled, and certainly the incentives toward corrupt behavior (private-sector level salaries and bonuses, stock appreciation, and so on) would have been much less. In that sense, a lot of what is being discussed here grows out of the deception of 1968, and over time the financial community lost its institutional memory of what these entities were supposed to be all about, where lay the risks and so on.

      Lots of the current financial mess comes from people not knowing the lessons of history, there is a sort of theory that we have huge financial crises more or less when the generation that lived through teh last one is dying off and people have no memory of how these things happen and what to do about them. I can’t prove it, but it sure fits the facts.

    33. peter jackson Says:

      Saying that the market “failed” is like saying the weather “fails” whenever a weather event is powerful enough to be destructive or deadly. The laws of supply and demand being as they are produce a tendency toward equilibrium in supply, demand, and prices. This is a widely accepted, uncontroversial economic principle. When the supply, demand, or price for anything strays too far from equilibrium, countervailing economic forces are spontaneously created which bring the market back to equilibrium. The farther supply, demand, or prices swing out, the more powerful and thus disruptive the countervailing correction. The bigger they are, the harder they fall. We’re not seeing the market fail, we’re seeing it work, responding in-kind to the distortion produced by the distortions Shannon describes here. No institution is too big to fail, ever, including government sponsored enterprises, government issued mortgage-backed securities, government minted currency, or the government itself.

      And you guys maintaining that there was no implied government guarantee of the GSE owned mortgages in these securities can’t be serious. Find me one buyer of these securities or the CDSs covering them who believed that. Seriously.

    34. peter jackson Says:

      Jeebus.

      How about “We’re not seeing the market fail, we’re seeing it work, responding in-kind to the distortion produced by the moral hazard Shannon describes here.”

    35. Shannon Love Says:

      Bernstein,

      1. The government has been guaranteeing Frannie mortgages for decades. If that was a significant moral hazard, it would have blown up in the early 1980s recession when interest rates were at double digits, or, certainly, during the early 1990s Savings and Loan debacle.

      Not if the problem requires decades to build up. What I’m talking about here is a systematic warping of the perception of risk of issuing residential mortgages. Since mortgages are long term contracts, it takes decades for people to assess their risk. It took three decades to alter the markets perception of risk. Once the market decided that the MSBs were high grade instruments, they lost the market feedback that communicated the risk of residential mortgages.

      2. Mortgage-backed securities have been around since the mid-1980s. If there was some problem specific to that type of structured credit, it would have emerged long before the summer of 2007.

      See above.

      I would turn the question back around. If GSE MBS model was obviously sound from the get-go back in the 70’s why did private entities largely stay out of the market until the mid-90’s? If people did not worry about the risk of MBSs why didn’t private entities start issuing their own in significant numbers. Indeed, why were the GSEs even necessary?

      Clearly, the GSE were designed to assume risk that the free-market would not. Their long term success altered the perception of risk for everyone leading the entire industry to behave differently. You can see this effect quite clearly in the differences in the commercial and residential real estate markets.

      3. Fund managers know all about moral hazard and, certainly, know exactly what portion of any security they buy has a government guarantee.

      Not if the entire market comes to a consensus about the risk. All drivers know about the risk of collisions but improved safety still creates a moral hazard. Once the ratings entities gave the MSB superior ratings and they had decades of low risk returns, no one had a firm reason for not buying them or using them.

      4. Bear Stearns and Lehman Brothers did not collapse because they held too many subprime CDOs. They collapsed because they had borrowed too heavily to buy subprime CDOs.

      Okay, so your saying that fund managers know all about the risk of MSBs but that they didn’t understand that it is a bad idea to borrow to buy high risk securities? Wow, Ivy league business schools are really falling down on the job.

      You’re only looking at one side of the problem. They borrowed heavily because they thought the risk of buying residential MSBs was very low. They thought the risk was low due to the MSBs. After all, they could get a cheap credit default swap based on the GSE MBSs superior rating. Again, here we see the difference between the residential and commercial markets. Did people go berserk buying commercial real estate backed CDOs? If not, why? They should have because historically commercial real estate is a safer bet than residential.

      What’s that? Oh, right, we didn’t have two vast government sponsored entities buying up up half the commercial mortgages and then reselling them as top grade securities.

      It happened in 2004 because that’s when, at the Bush administration’s behest, the SEC agreed to lift limits on leverage investment banks could use. The burst in CDO issuance came because the big-bonus fund managers at Bear, Lehman and so on were gobbling them up using massive leverage that lead to massive gains, until it all collapsed.

      Even if true, this does not address my fundamental argument. Why did they borrow they borrow to gobble up residential MBSs but not commercial? For that matter, why didn’t they borrow to buy up all kinds of different securities? Why is everything tied to residential mortgages? Why didn’t they see the danger in this one segment of the financial industry?

      The only reasonable explanation is a system distortion of the perception risk generated by the institutions that controlled half the residential market for nearly 20 years. Once the market grew blind to the risk, then yes, the natural negative feedback no longer existed and any loosing of regulation might have set off a frenzy. On the other hand, the boom was well underway before 2004 for the changes in regulation most likely merely accelerated the fundamental problem.

      The basic problem is that the government tired to hide the risk of residential mortgages and thus severed the natural feedback mechanism that kept lenders from lending to much money. That was going to cost us one way or the other.

    36. seanf Says:

      peter: you’re correct, but only when looking at a single market in isolation from every other. that’s very unrealistic in the real world; there are many exogenous factors that impact any given market. that’s why macroeconomics is different from, and much less well understood than microeconomics.

      again, there seems to be a (non-partisan) tendency to want to find a simple answer to explain the crisis. there isn’t. like the real world and the economy, it’s complex, involving multiple actors (the mortgage sellers, the banks, the insurance companies, the wider credit problems that resulted in the general economy), the regulatory landscape, poorly understood financial products, and a lot of bad information.

      shannon is a smart guy and his explanation of the definition of moral hazard itself is accurate. also, moral hazard was certainly involved. but trying to explain the crisis in terms of moral hazard alone is like trying to explain the wind currents in a storm using bernoulli’s principle.

    37. Shannon Love Says:

      SeanF,

      Okay, I’ll break my own rule, just to reinforce my point.

      but trying to explain the crisis in terms of moral hazard alone is like trying to explain the wind currents in a storm using bernoulli’s principle.

      Would you consider it “simplistic” to say that profit seeking behavior explains the crisis? Certainly, all the links you have provided in the past blame simple greed i.e. a desire for profit, for the financial communities collective collapse. Clearly, profit seeking is the one behavior that unites everyone in the market from the lowest paid laborer to the highest paid executive. It is a core, universal behavior shared by all actors in the system.

      Likewise, risk assessment is a universal shared behavior. When people contemplate any action for gain of any kind, they also make an assessment of the risk and tradeoffs of that action. You cannot understand anything about people’s economic behavior at any scale without understand their apprehension of risk. Every assessment of any decision has two linked components: profit and risk.

      Therefore, moral hazard, by altering perceptions of risk, has as powerful an effect on economic behavior as does the lure of profits. You and your links are very quick to subscribe blame to profit seeking behavior but you ignore completely the question of risk. Without explaining why people did not perceive the risk you can’t explain why they acted like they did.

      It is leftists who have also presented the cartoonishly simple model. In your model (judging by the links you previously provided) the business graduates of the world’s top universities are at heart brainless greedy morons who will inevitably run lemming like over a cliff unless herded by enlightened leftist using government coercion. You simply ignore the factors that alter their perception of risk and instead prefer to turn the discussion into a morality play.

      What you fail to grasp is that I really don’t disagree that various private actors bought to much on margin or that they issued credit-default swaps on unsound securities. I want to understand why they did it without having to adopt the simplistic morality tale version that you advance.

      I’ll state my model again: (1) The failure occurred because the market could no longer judge the risk of residential mortgages. (2) The GSEs were designed to hide the risk of lending for residential mortgages. (3) The GSE were so enormous compares to the residential market that their distortion had a major effect on the market. (4) Virtually all the “market failures” that you blame are actually caused at their root by the GSE risk distortion.

      I would appreciated it if you could address these concepts instead of adopting you usual vague and insulting tone. Otherwise, don’t bother.

    38. AL Says:

      Crystal clear presentation, Shannon, but I am afraid a bit simplistic.

      There were no GSE around Western Europe to pump 1.7 trillion Euro into shaky investments of Eastern Europe and former USSR republics. There were no GSE to channel equivalent of 850% of GDP loans into Iceland banking pyramid, or defaulted Honduras, or near-defaulted Ukraine, Hungary, Estonia, etc. EU finance system is in worse condition than US, and not because of US MBS.

      What is common between US and EU financial shamble, and why it happened at this particular time?

      Couple of things: oversupply of capital (too much money creation), too long uninterrupted growth of third world economies, crazy leverage, to name a few.

      But the real killer, I believe, explaining timing and wide geography of risky investment bubble is invention in 1997 by wizards of JP Morgan Chase of what I call “gambling insurance”, other vice known as “credit default swaps”.

      Once lunatics populating our financial institutions insured each other against risky investments, they felt safe to do any neck-braking and stupid investment one could imagine.

    39. Shannon Love Says:

      Al,

      Crystal clear presentation, Shannon, but I am afraid a bit simplistic.

      It’s a blog post that I try to keep under a 1,000 words. Yeah, it’s simplistic but it does cover an important part of the problem.

      Couple of things: oversupply of capital (too much money creation), too long uninterrupted growth of third world economies, crazy leverage, to name a few.

      All true but those don’t have a major impact on the American problem. The housing boom is the heart of our problem.

      Once lunatics populating our financial institutions insured each other against risky investments, they felt safe to do any neck-braking and stupid investment one could imagine.

      In the case of AIG, the Icelandic banks and a few other institutions, the credit-default swaps where anchored on securities and bonds issued by the GSEs. The GSE securities were rated as equal to U.S. treasury bonds and there more of them in circulation than treasury bonds. It made sense to use them as safe default protection. Had the MSBs retained their value as promised, the credit-default swaps wouldn’t have fell so hard or far.

      But I think you’re basically correct. Every major financial crises is associated with newly developed financial instruments. We have to experiment with them to find out what works. The question is why they felt so safe in issuing CDSs that included residential MSBs. The answer is that they thought they were safe.

    40. AL Says:

      Shannon:

      “It made sense to use them (CDS) as safe default protection.”

      No, it did not. I believe that broad misconception of what insurance is, who need it, and when insurance stops working is in the hart of the problem.

      Financial institution with trillions in assets need not insure their investments. If one particular investment fails, financial behemoths like UBS, Citi, RBS, etc., could easily adsorb the loss. Massive insurance of every loan they make also makes no sense: in essence it is insurance against system failure. In such case there is no insurance issuer afloat who will be able to pay counterparts for the losses. Especially when same investment banks were up the ears in same credit derivatives business.

      It is like neighbors sharing same duplex insure each other against flood or earthquake, and live happily ever after.

    41. Johanne Says:

      “The current financial crisis definitely resulted from government generated moral risk.”

      I couldn’t agree more.

    42. peter jackson Says:

      Sean,

      Sure economies are complex, so complex that you could spend the rest of your life documenting all of the knowledge required to produce and make available any of the items in your refrigerator.

      The weather is a large complex phenomenon too, so much so that predicting it with any degree of accuracy beyond 72 hours or so for most places on the globe is much more of an art than a science; this spontaneous, organic complexity is exactly why I like to use weather analogies in discussions of economics. But even though the weather is large and complex to the point of being impossible to predict or control its outcomes, it is not mysterious. It is easily understood using simple concepts of chemistry and physics such as pressure, temperature, evaporation, and so on.

      The same is true of economics. It’s large and complex, and thus not amenable to the prediction or control of its particular outcomes, but it can be competently discussed, understood, and explained in hindsight using microeconomic concepts such as the laws of supply, demand, and comparative advantage. Milton Friedman’s monetarism, for example, is nothing but a theoretical framework based on the application of the laws of supply and demand to money.

      That being said, it is agreed that our current economic crisis is not the result of a single, overarching cause. It’s description by some observers as “a perfect storm” is the closest to my personal view. But that doesn’t mean that the absence of this or that input wouldn’t have totally avoided the crisis. Shannon makes a pretty compelling case for the critical role of moral hazard created by the GSEs, but I’m sure he doesn’t mean to imply that there aren’t other, similarly critical inputs, such as the new CRA rules implemented in 1996, or the now obvious mis-rating of these mortgage-backed securities.

      yours/
      peter.

    43. seanf Says:

      Peter,

      I’m glad we agree that moral hazard created by the GSE’s was the sole cause of the crisis. Note my post above about why any explanation involving the GSE’s is rather convenient for libertarians. Note also that few non-Austrian school economists buy this explanation. In fact, if you can find even an Austrian-school economist who supports this view, let me know.

      Here’s some other things to think about.

      We had the GSEs for a long time. Then we had:

      — the 1999 Gramm-Leach-Billey Act which overturned a Depression-era law preventing commercial banks from behaving like investment banks, passed by the GOP.

      — In 2000 they passed another bill loosening regulation of derivative markets.

      — Then we had 8 years of Bush, with many federal agencies being urged to avoid regulatory action; the SEC decided to allow the nation’s financial institutions to “self-regulate”. The Greenspan Federal Reserve actually *declined* to use its power to regulate sub-prime mortgages.

      — Also during the Bush administration the Comptroller of Currency declined to preempt state consumer laws on subprime mortgages

      — Bush himself damanded that Fannie and Freddie increase their percentage of subprime mortgages, supposedly because he believed in an “ownership society.” GOP donor and Countrywide CEO Angelo Mozilo was a happy man. To their eternal shame, the Democrats went along with this belief in financial alchemy.

      We then had a financial crisis stemming from bad subprime loans. I’m not buying the GSE explanation. It doesn’t make sense to me – although I appreciate the effort Shannon has put into explaining it – because other reasons appear a lot more credible. I can understand that libertarians find this hard to swallow. But I’m not libertarian. Neither, actually, is a majority of the public.

      David Brooks once wrote that the nation turned right in 1980 because liberals had lost touch with reality and the GOP was seen as the party of order – the liberals were the crazy people. That may have been true then – I wouldn’t know – but for my generation, the GOP is seen as the party of disorder. Its recent leader was an unmitigated disaster who conservatives are still trying to forget. The economy and foreign policy are a mess. The party is out of ideas.

      And the conservative base has lost touch. Yeah, maybe gov’t really is the problem. And we should all be grateful to AIG executives who did nothing wrong and deserve their bonuses. Perhaps. But if that’s all the GOP has to offer – along with Rush for intellectual leadership and dogma conformance – the party is going to be out of power for a while. And I think America will be stronger as a result.

    44. Shannon Love Says:

      seanF,

      Note my post above about why any explanation involving the GSE’s is rather convenient for libertarians.

      And the argument that they are not is rather convenient for leftist. Again, whether or not a particular model of a phenomena provides a social or political benefit for this or that group has absolutely no bearing on models predictive power. All correct explanations benefit somebody at the expense of others.

      We had the GSEs for a long time.

      Try this analogy : We’ve had snow falling on the mountain for years. Obviously, the falling snow did not cause the avalanche. It must have Carl’s yodeling. The same issue dogs the GSE. Obvisouly, they started out having a small impact on the market. They certainly did not start out of the gate with a combined debt larger than that of the federal government. While they were small, they had little impact on the market. For example, in the 1990 S&L crises, they played little role because their size had not grown so large. By 2004 they were had been buying up 40%-54% of every residential mortgage issued in the U.S every year. They had built up an enormous debt obligation. They’re securities and stock were used as legal collateral by a wide range of institutions.

      I keep trying to emphasize the tremendous size of the organizations. They dwarfed not only any particular individual private entity but for several years were bigger than the entire private sector combined. You’ve never explained how institutions of such massive size could not have had a major impact.

      – the 1999 Gramm-Leach-Billey Act which overturned a Depression-era law preventing commercial banks from behaving like investment banks, passed by the GOP

      The final bill was passed in the Senate 90-8 and the House House 362-57. Democrat objections to the bill had more to do with redlining than concern over financial stability. A lot of democrats liked the bill because it opened up more lending to homebuyers. Democrats made not effort to reform the bill when they gained control of both houses in 2006. There is also the problem that there is no correlation between institutions that made use of the bill failing and those that did not. It had more to do with their specific investments. Europe has never had such restrictions and they managed not to implode for many decades.

      Then we had 8 years of Bush, with many federal agencies being urged to avoid regulatory action;

      Except of course his 18 separate attempts to bring the GSE regulation in line with that of private actors. I do find it extremely revealing that you argue that purely private entities require careful oversight but that custom private entities created by the government and using government backing for some reason required much less oversight! If you condemn Republicans for failing to regulate purely private entities how can you not condemn the Democrats for failing to regulate the much larger GSE who played under much losers than any private and who operated without any free-market feedback.

      If Republican’s lack of oversight caused the private half of the residential mortgage market to collapse then logically the Democrats failure to regulate the government sponsored half of the mortgage market.

      Also during the Bush administration the Comptroller of Currency declined to preempt state consumer laws on subprime mortgages

      Right, I can just imagine how the California federal delegation and the state government would have acted if Bush had derailed the state’s gravy train. For that matter, why didn’t the wise and wonderful Democrats that controlled the California state government step in to cool off their overheated real estate market? California was the epicenter of the real estate boom and bust. If State regulators had the power to shutdown the boom then California democrats bear the responsibility for not doing so.

      Bush himself damanded that Fannie and Freddie increase their percentage of subprime mortgages, supposedly because he believed in an “ownership society.” GOP donor and Countrywide CEO Angelo Mozilo was a happy man. To their eternal shame, the Democrats went along with this belief in financial alchemy.

      And there you have the failure of the regulatory model in a nutshell. At times, no one in the political system has an incentive to cause economic loss today in the name of future long term growth or stability. Once Democrats have a vested interest in an industry e.g. the industry employees a lot of union workers. The Democrats climb right into bed with the industry. The idea that Democrats are the guardians of the common people against the depredations of business class is simply a self-serving mythology. Democratic politicians simply want to control the benefits that flow from corporations. Once they do that, the corporations can do not wrong. This is why they allowed obscene private profits from government money in the case of the GSEs.

      Incidentally, 80% of GSE political donations went to Democrats and former Democrat political office holders on the boards and in the executives outnumbered Republicans by something like 4 to 1. These institutions where where the Democrat’s pet corporations if the Republicans own the private entities failure then the Democrats own the GSEs’.

      But I’m not libertarian. Neither, actually, is a majority of the public.

      Really, gosh! I wonder if that has anything to do with both politicians and people in general all having a motive to use state power at different time to their own benefit? Perhaps Democrats and Republicans is what you get when people can’t put down their own self-interest long enough to actually look at cause and effect.

      Freedom, egalitarianism and meritocracy are politically unstable. The human instinct is to dominate and control other people. That is why the majority of the polity in anytime or place usually support more government power of one kind or the other. Historically, all limited and divided governments have evolved towards autocracy. Americas unique conditions allowed us to remain decentralized for 120 years but we to have slowly succumbed. In another 50 years, possibly less, we to will have a functionally autocratic state wherein less than 600 federal officials elected in mostly sham elections (gerrymanding anyone?) will dictate every major economic decision.

      The only thing libertarians can do is fight a delaying action and then plan long term to find some pocket of freedom elsewhere.

      In summation, I think we can agree that the disaster represented a perfect storm. I think you are correct in that deregulation of the financial sectors contributed to the problem significantly. However, I disagree in that I believe that such regulation might have been needed because the government severed the negative feedback signal in the free-market. The government needed to regulate risk taking because the government had destroy the natural risk signal. You’ve never refuted this idea.

      A perfect storm requires an combination of events. In this case, it took a lax regulation combined with massive intentional market distortion by the government to produced a massive widespread failure. Take either out the equation and you get a much smaller problem.

      My complaint is the simplistic model you advance in which if only democrats had run everything the last 20 years we wouldn’t everything would be peachy. It wouldn’t. Eventually we would have to pay for the GSEs distortions. In additions, the realities of real world politics means that we would have had a regulatory failure at some point. Therefore, this perfect storm was going to happen.

    45. seanf Says:

      I made a mistake: I wrote “also during the Bush administration the Comptroller of Currency declined to preempt state consumer laws on subprime mortgages”

      Should have been “Comptroller of the Currency *decided* to preempt state consumer laws on subprime mortgages”

      This is an example of Bush using the power of the federal government to force the states to deregulate. No respect at all for state’s rights.

      In this case some states e.g. CA had very good consumer protection and predatory lending laws that might have prevented or at least perhaps lessened the severity of the crisis. CA also got smacked down by the EPA for its strict emission control regulations. So Shannon, to your point above, I would not call my CA state reps “wise” or “wonderful”. Having said that, they could not control the problem despite having the regulatory tools because the federal government stripped them of legal authority to exercise CA law.

      The use of federal power over the states is always fraught with consequences. Personally, I think its exercise in the ’60s to promote civil rights, was fine because a national consensus had built up that African-Americans were entitled to equal treatment, and their treatment really was unconstitutional.

      No such consensus, constitutional or otherwise, exists on economic regulation or the environment. I think any administration, conservative or liberal, should stop trying to force its policy choices on the states in the absence of one.

      Finally Shannon, I share your concerns about government power, and I’m not arguing things would have been fine had the Democrats been in charge. I’m arguing they wouldn’t have been as bad.

      Also, I’m more outraged by use of government power to abolish due process in some instances, authorize the use of torture, and go to war on bad information than I am by transfer or entitlement programs. That’s not to say I like those programs. They just don’t annoy me as much.

    46. Shannon Love Says:

      Seanf,

      …I’m not arguing things would have been fine had the Democrats been in charge. I’m arguing they wouldn’t have been as bad.

      That follows from the perfect storm analogy. I am arguing that if we had never created the GSE in the first place and never distorted the market, then we wouldn’t have needed the regulation in the first place. The Democrats basically found themselves trying to patch a hole they themselves created. Even if they had gotten all the regulation claimed, we would have eventually had a crisis associated with the GSEs.

      I’m more outraged by use of government power to abolish due process in some instances, authorize the use of torture, and go to war on bad information than I am by transfer or entitlement programs.

      You shouldn’t. Excesses of military or police power have never caused the collapse of liberal-orders. Ineffective responses to violence and disorder has.

      All modern tyrannies have started with economic control and then used that leverage that power to create a policy state. Once politicians control your food, clothing, shelter, medical care, transportation, education, job etc you are not longer a free person even if the government doesn’t actually have cops. This was the main means of political control in the Soviet Union.

      The democrats are trying to drive us further down the track to an total state in economic matters. Once they have done that it will be easy for someone on either the left or right to sieze such a concentration of power for their own ends. You really need to read Hayek’s road to serfdom. We’re at about stage 8 right now.