Tuesday, September 16, 2008

The Bush Economy Part 3 - Housing and Credit

I'll put it up front, there is some blame reserved for the Bush administration on the Housing/Credit crisis. But the largest credit bubble in the history of the human race can hardly be put at the feet of one man, or even one administration.

The easiest policy target in the Bush administration was probably an SEC rule change in 2004 that allowed hedge funds and investment banks to leverage themselves to 30 and 40 times, when previous capital requirements limited them to something like 13x (I haven't found the exact level yet, but this is accurate enough to make the point). Over-leveraged funds have a history of catastrophic failure due to their extreme sensitivity to capital losses, and this time is no exception.

Certain Democrats want to say that the Bush administration failed to regulate mortgage originators sufficiently. This misses the point by a mile. Fundamental market checks and balances were broken, and the downright fascist oversight necessary to keep things copacetic would not have been tolerated... by the Democrats...

The Kindling:
Once upon a time, FDR brought us Fannie Mae to help more people afford to buy homes. In the 1970s, Fannie was spun off as a private company with a public mandate. Freddie Mac was created at the same time in order to instill market discipline. For decades this was a relatively benign market distortion that continued to allow access to credit for home-buyers. But the seeds of their eventual demise had been sown - Fannie and Freddie served two masters, their shareholders and the Congress.

Easy Money:

Asset bubbles become dangerous when easy credit is introduced. Though he denies it, many blame former Federal Reserve Chairman Alan Greenspan for keeping the Fed funds rate too low for too long. In the wake of the NASDAQ bubble, speculators were looking past tech stocks to real estate for their high risk/high reward investment vehicles. Unlike dot-bomb stocks, real estate is based on a tangible asset, and lenders (with the institutional support of Fan and Fred) were more willing to give credit on something they could repossess if necessary.

Government Subprime Encouragement:
Once again I am blessed by the fact that somebody else has done some of the heavy lifting for me. Ed at HotAir found two articles (NYT, IBD) showing which elected officials are at fault. IBD reports that Clinton-era policies mandated the creation of the subprime market as a means toward creating greater minority home ownership. Lenders not conforming to policy faced fines.

"Creative" Banking:
Now faced with inordinately risky subprime mortgage debt, the banking sector found a way to distribute and normalize the risk across several loans. While the risk of any single loan may have been deemed too risky, a bundle of similar loans offered a high yield while reducing the individual risk that any one loan in the bundle might fail. And even if a loan failed, the property could be repossessed and much of the principal recovered.

High Yield, Low Risk(?):
Having "solved" the risk problem of subprime debt, debt rating agencies branded these new Collateralized Debt Obligations with the highest imprimatur.

High Yield, Low Risk (!):
Seeing a financial product giving a large degree of safety with yields above Treasury, institutional investors short-sold Treasuries and bought CDOs. And they did it a lot. Seeing a demand for this product, loan originators like Countrywide Financial violated Federal law by handing out loans to every crackhead and/or house-flipper who came along.

Broken Risk-Taking Mechanism:
The Big Hairy Problem of the previous paragraph is that the people who were originating loans were not the ones taking on the risk. The market mechanisms controlling risk taking were fundamentally broken. It would have taken an army of regulators to police this problem.

Still, as Ed at HotAir pointed out, the Bush administration wanted to reform Fannie and Freddie, but Congress balked...

Lobbying and Misguided Policy Goals:
The link between lobbying and the positions of the officials being lobbied has always been a tricky one. Pro-gun legislators are naturally favored by the NRA, and pro-choice officials are naturally favored by NARAL. Causal relationships are not terribly easy to disentangle.

Nevertheless, it is important to know who was aligned with Fannie and Freddie PACs and employees (1989-2008):
1. Sen Dodd, $133,900
2. Sen Kerry,$111,000
3. Sen Obama, $105,849
4. Sen Clinton, $75,550
5. Rep. Kanjorski, $65,500

Keep in mind that while Dodd has been in the Senate since 1981, Obama has only been in the Senate since 2005, and Clinton since 2001.

But it wasn't just that Democratic officials in particular had been lobbied, they believed the Fan/Fred story and honestly sought the goal of increased minority home ownership. (I'm sure it didn't hurt either that Sen Dodd got the special "friends of Angelo [Mozilo]" VIP home loan from Countrywide.)

Who said this?: "These two entities — Fannie Mae and Freddie Mac — are not facing any kind of financial crisis."

That would be Rep. Barney Frank (D) in 2006, when he was the Ranking Member on the House Financial Services Committee and presented with a Bush administration plan to reform Fannie and Freddie. "The more people exaggerate these problems, the more pressure there is on these companies, the less we will see in terms of affordable housing."

But Wait, There's More!:
Several institutions sold Credit Default Swaps in relation to the mortgage credit market. Risk was once again shifted and multiplied in what Warren Buffett once called "financial weapons of mass destruction".

Did I Mention There's More Still?:
If you'll recall from the beginning of the story, the rating agencies thought all this mortgage debt was just fine and dandy. And over-leveraged companies like Bear Sterns, Lehman Brothers, AIG, Citigroup, and many, many others owned this stuff to the gills. The mortgages, if held to maturity, would probably pay out much better than what you could sell them for on the open market, which was rapidly seizing up. As values of mortgages and CDOs began to decline, mark-to-market rules meant that owners of this debt had to show a loss on their balance sheets whether they sold those instruments or not. Without a liquid market in which to sell, firms took write-down after write-down, some eventually selling the CDOs for pennies on the dollar.

Those rating agencies? They're just now, after many billions in write-downs, deciding that many of the firms owning these debt instruments face credit downgrades themselves unless they raise some billions in new capital. When word of these shakedowns threats warnings gets out, the share prices sink, and the firms find themselves in a death spiral of having to raise increasing amounts of capital to counteract their loss of market capitalization.

So how much of all that do you want to put on Bush? Maybe some. Not nearly all of it.

Obama's central contention is that "greed" and lax regulation (aka "the free market") are to blame. Capitalism embraces greed, not because -in the words of the fictional Gordon Gekko- "greed is good", but because greed is a part of human nature, and you'd be better off harnessing it than fighting it.

Asset bubbles are an inescapable part of any mostly free society. Only a person who thinks that greed can be legislated out of humanity would think that the situation described above was not terribly exacerbated by government policy. Why does Obama think he is any less shortsighted than those central planners who came before him?


Anonymous said...

Refresh my memory Joe - I remember there was this company called Enron - they donated something like a gazillion dollars for one of the parties and this guy named "W" in particular - I can't remember which one though.

The question I would ask is - outside of regulation - what keeps corporations and the market honest? Why won't they screw us and take our money? With the short term view - why wouldn't a rational executive make a bunch of money short term, and screw'em long term? The market doesn't seem to be that smart lately - why give it a free hand?

Sockless Joe said...

I'm not saying no regulation. For one, I think the capital requirements change was a mistake.

With repackaged loans, the market mechanism was explicitly broken in that the people writing the loans were not the ones taking on the risk. That's something that needs to be changed. Maybe they should be forced to keep part of the loan, or otherwise ensure the debt package they sell.

But that sort of regulation is different from the intense personal supervision that it sounds like the Democrats are faulting Bush for not doing. Nobody should have to look over Angelo Mozilo's shoulder for every loan he writes, he should have an incentive to write good loans.

I can't find the appropriate Adam Smith quote right now, but the basic idea is that many diffuse evils are better than the evil of a central concentrated power. Again, this is the central philosophical difference between our parties. Most Republicans accept that people are greedy bastards, and our economic system is designed around that fact. Greed and Fear.

Sockless Joe said...

Also, re: Enron. It is very likely that nobody at AIG or Bear did anything illegal.

Enron was another one of those hybrid public-purpose private-profits model companies. And it was, in fact, regulated. They just violated the regulations.