Kevin Villani

Why the Big Short didn’t work but the next one likely will!

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In promoting the Hollywood version of The Big Short by Michael Lewis, Paul Krugman (NYT, December 18) misrepresents the central point of this excellent book, previously made by Peter Wallison, who Krugman attacks for his Republican dissent to the 2010 Financial Crisis Inquiry Commission (FCIC) majority Report.

The Hollywood version reflects the Report’s fundamental conclusion that the root cause of the financial crisis was Wall Street greed: hardly newsworthy, disputable or dispositive. The Big Short is about the equally greedy speculators who were shorting the housing market: had they succeeded early on – as they do in less distorted markets – they would have prevented the bubble from inflating to systemic proportions.

Contrary to the “indifference” theorem (i.e., between debt and equity finance) of Nobel Laureates Franco Modigliani and Merton Miller, both household borrowers and mortgage lenders chose to finance almost entirely with debt, a strategy best described as “going for broke.” The first distortion – tax deductibility of debt – makes leverage desirable until discouraged by rising debt costs. The second distortion – federally backed mortgage funding as Depression era deposit insurance became virtually universal and the Fannie Mae “secondary market” facility morphed into a national housing bank – prevented these costs from rising. This highly leveraged strategy was guaranteed to fail systemically if bad loans entered the system.

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Economic and Political Turmoil a Century after the Great War: Is it Deja Vu All Over Again?

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This year marks a century since the outbreak of WW I and coincidently the initiation of US Federal Reserve System operations. Prior to these events, politics were democratizing, economic growth was booming, economies were liberalizing and global trade and finance were growing, all at a pace not seen again for almost another century. Recognizing that achieving these mutual benefits required an externally imposed political discipline, all of the countries participating in this happy situation voluntarily followed a set of rules governing domestic and international trade and finance for automatic and continuous adjustment to changing economic reality, then provided by the gold standard.

It was during this enlightened period that philosopher George Santayana wrote: “those who cannot remember the past are condemned to repeat it.” Hedge fund manager and Brookings Director Liaquat Ahamed set out to remind us why countries failed to recapture this economic dynamism after the Great War with the publication of the Pulitzer Prize winning Lords of Finance: The Bankers Who Broke the World in 2009. This book took on greater significance when in 2010 Federal Reserve Board Chairman Ben Bernanke recommended only this historical account in response to the Financial Crisis Inquiry Commission’s request for a book reference explaining the 2008 financial crisis. What history had this most recent financial crisis already repeated and what was Chairman Bernanke determined to avoid repeating in the aftermath?

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Income inequality: Social justice or crony capitalism?

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The political movement Occupy Wall Street has shaped the tax and spending proposals of the Obama administration’s budget and political debate on the premise that our capitalist economic system is rigged to favor the top-earning “one percenters.” But income inequality can result either from capitalism or politics, each for better or worse.

Historically, political elites focused on enriching themselves at the expense of the general public: In 1773 patriots threw the tea into Boston Harbor of the East India Tea Company, granted a “royal charter” in 1600. The U.S. system was founded not just on the principles of democracy but on limited government complementing private market capitalism that encouraged individuals to “pursue happiness” — accumulate wealth — on merit rather than political connections. Support for the less fortunate was provided by family members, religious and other charitable organizations.

Believing (wrongly) that class envy against the new economic elites — innovative entrepreneurs — would cause revolution, Karl Marx offered the socialist alternative “from each according to his ability, to each according to his need” with politics supplanting merit. Despite totalitarian methods universally employed by governments seriously pursuing the socialist model leading to the murder of tens of millions, one historian recently concluded that communism reduced workers “to shiftless, work-shy alcoholics.”

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Fixing the US Housing Finance System

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This is a summary of a working paper available at the links for which comments are welcome. (An earlier post on related topics appeared here.)

Download the paper (500KB pdf).

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The Administration will soon propose legislation to address the future of the US housing finance system, and it’s a sure bet that this will include re-incarnating Fannie and Freddie in some form. Prominent Republican politicians have also recently called for “privatizing” these entities. This is sheer folly. The problem with keeping Fannie and Freddie or an alternative government sponsored capital market hybrid that seeks to limit and/or price government backing is that policymakers have always done just that! It was investors, not policy-makers, who conferred “agency status” on Fannie and Freddie in spite of their prior ill designed privatizations.

Regardless of whether you believe they were leaders or followers in the sub-prime lending debacle—and the evidence overwhelmingly favors the former view–they have always represented a systemic risk and are inherently inconsistent with a competitive financial system. There are significant roles for government in a competitive market oriented housing finance system, but this isn’t one of them.

Public deposit protection is here to stay. Nobody is suggesting getting rid of the Federal Deposit Insurance Corporation, but public protection requires appropriate regulation.

Whether homeownership subsidies such as the mortgage interest deduction are appropriate is an ongoing debate. Nobody is suggesting getting rid of all homeownership subsidies, but credit subsidies for low-income borrowers and other politically preferred groups should be budgeted, targeted and separated from finance.

Discrimination in lending that is not based on the ability to pay is illegal. Nobody is suggesting relaxing current anti-discrimination laws and regulations, but competition often mitigates all forms of inappropriate lending discrimination better than regulation.

Capital market financing will remain necessary. Nobody is suggesting getting rid of the FHA/Ginnie Mae program or the almost equally massive Federal Home Loan Bank System, but reforms of these programs are necessary after the housing markets recover.

Private label mortgage securitization contributed to the sub-prime lending debacle. Nobody condones the abuses, but private label securitization worked well until regulatory distortions encouraged securitizers to bypass the private mortgage insurance industry, the traditional gatekeepers responsible for preventing excessively risky lending.

A competitive market oriented system serves qualified home borrowers and lenders best but has few political constituents. Politicians much prefer the deferred off budget costs of Fannie and Freddie but the long run costs of delivering subsidies that way far exceed the benefits.

The four steps necessary to restore a stable competitive market oriented housing finance system are:

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How Politicians and Regulators Caused the Sub-Prime Financial Crisis of 2007 and the Subsequent Crash of the Global Financial System in 2008, and Likely Will Again

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This is a summary of a working paper available at the links for which comments are welcome. (A later post on related topics appears here.)

Download the paper (1 MB pdf).

That the US financial system crashed and almost collapsed in 2008, causing a globally systemic financial crisis and precipitating a global recession is accepted fact. That US sub-prime lending funded the excess housing demand leading to a bubble in housing prices is also generally accepted. That extremely imprudent risks funded with unprecedented levels of financial leverage caused the failures that precipitated the global systemic crash is a central theme in most explanations. All of the various economic theories of why this happened, from the technicalities of security design (Gorton, 2009) to the failure of capitalism (Stiglitz, 2010) can be reduced to two competing hypotheses: a failure of market discipline or a failure of regulation and politics.

While still sifting through the wreckage and rebuilding the economy in mid July, 2010, the Congress passed the 2,315 page Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 to prevent a reoccurrence of this disaster. The disagreement in the debates regarding the appropriate policy prescription reflected the lack of a consensus on which of these two competing hypotheses to accept. The risk was that, following the precedent established in the Great Depression, politicians will blame markets and use the crisis to implement pre-collapse financial reform agendas and settle other old political scores. By having done just that, this Act   worsens future systemic risk.

That there was little or no market discipline is obvious. Contrary to the deregulation myths, regulation and politics had long since replaced market discipline in US home mortgage markets. Regulators didn’t just fail systemically to mitigate excessive risk and leverage, they induced it. This didn’t reflect a lack of regulatory authority or zeal, as politicians openly encouraged it.

The politically populist credit allocation goals that promoted risky mortgage lending, whether or not morally justifiable, are fundamentally in conflict with prudential regulation. The system of “pay-to-play” politically powerful government sponsored enterprises (GSEs) was a systemic disaster waiting to happen. The recent advent of the private securitization system built upon a foundation of risk-based capital rules and delegation of risk evaluation to private credit rating agencies and run by politically powerful too-big-to-fail (TBTF) government insured commercial banks and implicitly backed TBTF investment banks was a new disaster ripe to happen. Easy money and liquidity policies by the central bank in the wake of a global savings glut fueled a competition for borrowers between these two systems that populist credit policies steered to increasingly less-qualified home buyers. This combination created a perfect storm that produced a tsunami wave of sub-prime lending, transforming the housing boom of the first half decade to a highly speculative bubble. The bubble burst in mid-2007 and the wave crashed on US shores in the fall of 2008, reverberating throughout global financial markets and leaving economic wreckage in its wake.  

By the time the financial system finally collapsed bailouts and fiscal stimulus were likely necessary even as they risked permanently convincing markets that future policy will provide a safety net for even more risk and more leverage. Given this diagnosis, how to impose market and regulatory discipline before moral hazard behavior develops is the most important and problematic challenge of systemic financial reform.

The public policy prescription is simple and straightforward. Prudential regulation remains necessary so long as government sponsored deposit insurance is maintained, which seems inevitable. Prospectively the traditional regulatory challenge of promoting market competition and discipline while safeguarding safety and soundness remains paramount. But the prudential regulation of commercial banks needs to be de-politicized and re-invigorated, with greater reliance on market discipline where public regulation is most likely to fail due to inherent incentive conflicts. This means sound credit underwriting and more capital, including closing the off balance sheet loopholes typically employed by big banks and eliminating the incentives for regulatory arbitrage. Universal banking should remain, but divested of hedge fund and proprietary trading activity. In addition, firms that are “too big to fail” (TBTF) are probably too big to be effectively controlled by regulators and should either be broken up or otherwise prevented from engaging in risky financial activities by reducing or eliminating their political activities.

Most importantly, the two main sources of TBTF systemic risk and subsequent direct government bailout cost, Fannie Mae and Freddie Mac, no longer serve any essential market purpose. The excess investor demand for fixed income securities backed by fixed rate mortgages that fueled their early growth is long gone and now easily met by Ginnie Mae and Federal Home Loan Bank securities alone, as fixed nominal life and pension contracts have largely been replaced by performance and indexed plans. Fannie Mae and Freddie Mac should be unambiguously and expeditiously liquidated subsequent to implementing an adequate transition plan for mortgage markets.

Download the paper (1 MB pdf).

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Kevin Villani is former SVP/acting CFO and Chief Economist at Freddie Mac and Deputy Assistant Secretary and Chief Economist at HUD, as well as a former economist with the Federal Reserve Bank of Cleveland. He was the first Wells Fargo Chaired Professor of Finance and Real Estate at USC. He has spent the past 25 years in the private sector, mostly at financial service firms involved in securitization. He is currently a consultant residing in La Jolla, Ca. He may be reached at kvillani at san dot rr dot com.