The Boom/Bust Cycle Isn’t about Emotion

My first experience with manias was in the 1950’s. As a pre-schooler, I was dragged along to the Filene’s Basement annual designer dress sale. Thousands of women of all types and sizes pressed against the glass doors opening into the subway station. Within minutes of the doors opening, these “maniacs” cleared all the racks and, holding armfuls of dresses, began stripping to their slips. That’s when I panicked.

Looking back, those women acted rationally. There was a limited supply of deeply discounted dresses available on a first come basis. They traded among themselves to get the right size and their most desired dress. Buyer’s remorse was cushioned by Filene’s liberal return policy.

The premise of U.S. financial regulation is that actors within private markets are irrational, but the evidence shows that it’s not maniacal, illogical behavior that sends markets into freefall.

Great Depression and Recession

Now in its seventh edition, Manias, Panics and Crashes: A History of Financial Crises, Charles Kindleberger’s seminal work provides the narrative that underlies virtually all public financial protection and regulation: First, the irrational exuberance of individuals transforms into “mob psychology” and fuels an asset bubble. Then, when the exuberance of a few turns to fear, the mob panics and overreacts, causing a crash that brings down both solvent and insolvent financial institutions.

In his memoir, the former Federal Reserve Bank President and Treasury Secretary Timothy Geithner, who was at the epicenter of the last crisis, concluded, “It began with a mania — the widespread belief that devastating financial crises were a thing of the past, that future recessions would be mild, that gravity-defying home prices would never crash to earth.”  

Most U.S. federal financial regulation originates from the Great Depression and the subsequent introduction of federal deposit insurance provided by the Federal Deposit Insurance Corporation (FDIC), which was established in 1933 to protect “small” savers. All prior state attempts to provide insurance failed. Because there were no effective, non-politicized regulations that could prevent the moral hazard of insured banks and savings institutions taking on excessive risks, an extensive regulatory infrastructure was put in place.

Rational Actors

Now, the U.S. has about 100 financial regulators, including those in the U.S. Treasury and the Securities and Exchange Commission (SEC), the FDIC, and the Fed. With near-universal deposit insurance, bank runs have become a rarity, but systemic crises have occurred more frequently. It is incontestable that big bubbles eventually burst, asset prices crash, and financial crises ensue. What causes the bubbles to inflate to systemic proportions, and to ultimately burst, is more contentious.

At the time of Kindleberger’s analysis, individuals were assumed to be rational. The latest edition of his book, written after the 2008 financial crisis, postulates numerous theories about mob psychology (mania) that could lead rational individuals to produce irrational markets, but these ideas are all rather lame.

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Seth Barrett Tillman: National Conference Of State Legislatures: Number Of State Legislative Seats Held By Each Party

The shift to the Rs represents just over 1/2 of 1% of all state legislative seats (i.e., (44) / (7,297)). Interesting, 12 House state legislative chambers and 2 Senate state legislative chambers are controlled by 5 or fewer seats. Small changes in seat distribution can have highly significant effects.

Read the details.

A Really Big Short Still Awaits

When testifying in 2010 before the Financial Crisis Inquiry Commission into the financial crash, then Federal Reserve Board Chairman Ben Bernanke recommended only one reference, Lords of Finance: The Bankers Who Broke the World (2009), presumably for the narrative that insufficient money printing in the aftermath of the Great War lead to the next one. Right idea, wrong narrative!

The US homeownership rate peaked at a rate well above the current level almost a half century ago mostly funded by a system of private mutual savings banks and savings and loans. The historical justification for federal “secondary market” agencies was political expediency exemption from now obsolete federal, state and local laws and regulations inhibiting a national banking and mortgage market. Now government-run enterprises account for about 90% of all mortgages, with the Fed their primary funding mechanism, what the Economist recently labeled a de facto nationalization.

The Historical Evolution

How did the private US housing finance system repeatedly go bankrupt? To quote Hemingway: Gradually, then suddenly. The two competing political narratives of the cause of financial market crises remain at the extremes – either a private market or public political failure with diametrically opposite policy prescriptions. The politician-exonerating market failure narrative has not surprisingly dominated policy, with past compromises contributing to the systemic financial system failure, the global recession of 2008 and subsequent nationalization.

The Great Depression stressed the S&L system, but the industry’s vigorous opposition to both federal deposit insurance and the Fannie Mae secondary market proved prescient as the federally chartered savings and loan industry eventually succumbed by 1980 to the federal deposit insurer’s perverse politically imposed mandate of funding fixed rate mortgages with short term deposits and competition from the government sponsored enterprises.

The S&Ls were largely replaced by the commercial banks. To make banks competitive with Fannie and Freddie, politicians and regulators allowed virtually the same extreme leverage, in return for a comparable low-income lending mandate CRA requirements leading to a market dominating $4 trillion in commitments to community groups to whom the Clinton Administration had granted virtual veto power over new branch and merger authority.

The Financial Crisis of 2008 and the aftermath

The Big Short by Michael Lewis and more recent movie portrayed not just banker greed but the extreme frustration of those shorting the US mortgage market stymied by a housing price bubble many times greater than any in recorded US history that refused to burst. The reasons: 1. the Fed kept rates low and money plentiful, and 2. whereas banks would have run out of funding capacity, the ability of Fannie and Freddie to continuously borrow at the Treasury’s cost of funds regardless of risk and their HUD Mission Regulator requirement to maintain a 50% market share kept the bubble inflating to systemic proportions.

The Obama Administration fully embraced the alternative private market failure narrative in Fed policy, regulation and legislation:

  • To partially ameliorate the effects on the real economy of disruption to the global payments mechanism the Fed had to bail out the banking system. QE1/2/3/4 and ZIRP (zero rates), now NIRP, did this by re-inflating the house diazepamhome price bubble, postponing defaults while allowing banks risk-free profits. The Fed and taxpayers – would lose more than the entire S&L industry did should rates rise by a comparable amount if it marked its balance sheet to market.
  • Regulators had to appear to punish the banks. In response to paying hundreds of billions of dollars in what the Economist labeled “extortion” – some of which ironically went to populist political action groups – and the subsequent oppressive regulatory regime, U.S. commercial banks are exiting the US mortgage market in spite of ongoing profits enabled by extreme leverage.
  • One legislative centerpiece, the Dodd Frank Act passed in July 2010 in direct response to the financial crisis, doubled down on political control of financial markets without addressing the future of Fannie and Freddie. The other, Obamacare, enacted four months earlier, was similarly premised on regulating private health insurers to make health insurance simultaneously cheaper and more widely available.

The Long Term Consequences

Bernanke’s focus on choosing the narrative was useful, but the political choice of the market failure narrative appears to reflect convenience rather than conviction. The direct taxpayer costs of implicit or explicit public insurance and guarantees come with both a whimper – tax savings amounting to tens of billions annually due to the deductibility of interest costs and a bang – future taxpayer bailouts generally delivered off-budget.

Fannie and Freddie conservatorship deftly avoided debt consolidation while dividends reduced reported federal deficits. The student loan market has also been de facto nationalized, with potential unbudgeted losses totaling hundreds of billions. Obamacare was similarly premised on regulating private health insurers to make health insurance simultaneously cheaper and more widely available, but under-budgeted health insurance subsidies predictable caused massive losses and health insurers are now withdrawing from the market.

Monetary policies caused household savings to stagnate as returns to retirement savings evaporated. Defined obligation public pension funds were all rendered technically insolvent when funding is valued at current market returns rather than the assumed rate as much as ten times that. The failure of the economy to grow per capita was explained as the “new normal”. But politicians made no attempt to reflect the implied technically insolvency of public pensions or Social Security and Medicare.

Private firms fail, but private markets rarely do. Public protection and regulation makes firms “too big to fail” until markets fail systemically. The current and projected future public debt bubble is unsustainable, and financial markets will eventually ignore the accounting deceptions and pop it. The relative weakness of other sovereign debt is delaying the inevitably, making The Really Big Short a good title for a Michael Lewis’s sequel. Politicians and central bankers will again say “nobody saw this coming”. What then?

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Kevin Villani, chief economist at Freddie Mac from 1982 to 1985, is a principal of University Financial Associates. He has held senior government positions, been affiliated with nine universities, and served as CFO and director of several companies. He recently published Occupy Pennsylvania Avenue on the political origins of the sub-prime lending bubble and aftermath. This article was originally published at FFE.org

Despite Drop in Home Ownership, an Increase in Renters*

Millennials cause homeownership rate to drop to lowest level since 1965:

The drop in homeownership is largely due to a delay in homebuying by the millennials, who have the lowest ownership rate of their age group in history. Millennials are not only burdened by student loan debt, but they have also delayed life choices like marriage and parenthood, which are the primary drivers of homeownership.

Why have today’s young people, as compared to young people in the recent past, delayed buying property, marrying and having children?

“While the millennial homeownership rate continues to decline, it’s important to note that the decrease could be just as likely due to new renter household formation as it is their ability to buy homes,” wrote Ralph McLaughlin, chief economist at Trulia. “Certainly low inventory and affordability isn’t helping their efforts to own, but moving out of their parents’ basement and into a rental unit is also a good sign for the housing market.”

Why are many of today’s young families choosing to rent rather than buy their homes?

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Lest We Forget: “Reasons Why Dodd-Frank Was a Horrible Law”

Jeff Carter:

One thing I have noticed over the years is when there is a crisis, it’s a really bad time to pass sweeping legislation. The momentum and justification for legislation comes from fear. “We don’t want that to happen again”, supporters say. For example, 9/11 happens and we get the Department of Homeland Security which is mostly a waste of money and allows the government to pry into all kinds of places it shouldn’t.
 
Dodd-Frank is a result of the financial crisis. There are so many bad actors in this crisis that it’s hard to list them all, but the root cause was the implicit backing government gave Fannie Mae and Freddie Mac-along with legislation and regulation that encouraged bad behavior. Sure, the ratings agencies were paid by the big banks and slanted the playing field. The big banks knew exactly what they were doing with the mortgages. But, without the implicit backing of government, the game never gets played.

and

Here are some data points:
 

  • Before Dodd-Frank 75% of banks offered free checking
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  • After Dodd-Frank 25% of banks offered free checking
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  • Small business costs are up 15% to comply with new regulation
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  • 15% less credit card accounts, and a 200 basis points more in cost
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    Remember, many small businesses get started by using credit cards. You might think they are stupid. But why should you import your financial/moral compass on them. Maybe they see the annual percentage rate credit card companies charge as cheap compared to the opportunity that lies ahead of them.
     
    In the state of Missouri, there were 44 banks with less than $50M in assets. Prior to Dodd-Frank they were profitable. Post Dodd-Frank, 26/44 are losing money and will either go out of business or be consolidated. Your local community bank which is often the lifeblood of local capital is dead. How many other states are like Missouri? It’s no wonder small town rural America is having a tough go in the Obama epoch.
     
    Dodd-Frank tried to make central party clearing mandatory for all transactions in the OTC market. Professor Craig Pirrong has blogged brilliantly about this and other aspects of Dodd-Frank. It works for a few, but not for all. This makes it more expensive to hedge risks. Businesses pass along the cost to consumers. In many cases, clearinghouses have to become the actual counterparty to the hedge. This stops commerce and more importantly has created more too big to fail institutions. Those too big to fail clearinghouses are now backed by the full faith and credit of the American taxpayer, you.

    These are great points and Jeff’s post is worth reading in full.