Regulation

The Loan-Filled Lending Crisis

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In the Wall Street Journal, Cato's Alan Reynolds makes the oft-neglected point that, until the last week or so, the presumed national "credit crunch" over the past year has yet to actually reduce the amount of credit:

Bank loans to commercial and industrial business, real estate and consumers continued to expand nearly every month. Commercial and industrial loans exceeded $1.5 trillion this August, up from less than $1.2 trillion a year earlier. Real-estate loans exceeded $3.6 trillion, up from less than $3.4 trillion a year ago. Consumer loans were $845 billion, up from $737 billion. Credit standards are tougher, which is surely a good thing, but interest rates for creditworthy borrowers remain low.

Reynolds also makes a point for those who are suddenly pining for the re-imposition of the Glass-Steagall Act, specifically its ban on commercial banks owning investment banks.

that would mean J.P. Morgan could not have bought Bear Stearns, Bank of America could not have bought Merrill Lynch, Barclays could not buy most of Lehman, and Goldman Sachs and Morgan Stanley could not become bank holding companies. It is hard to imagine how things would have worked out in that situation, but it surely would not have been an improvement.

Whole thing here. Then, to be transported to a faraway time and place, go read Reynolds' June 1995 reason piece arguing against a federal balanced budget amendment!

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  1. that would mean J.P. Morgan could not have bought Bear Stearns, Bank of America could not have bought Merrill Lynch, Barclays could not buy most of Lehman, and Goldman Sachs and Morgan Stanley could not become bank holding companies. It is hard to imagine how things would have worked out in that situation, but it surely would not have been an improvement.

    Well, JP Morgan and Barclay’s would exist in their current forms if you reenacted Glass-Steagal. JP Morgan-Chase would be JP Morgan and Chase (as two companies). JP Morgan would be allowed to buy Bear. Barclays would have to have an i-bank portion and a commercial bank portion. When you consider the fact that Barclay’s bought Leahman for its i-bank portion, the new company would probably do the same.

    As for Goldman and Morgan Stanley converting themselves to bank holding companies, it’s a net negative. They did it so they wouldn’t have to mark to market, instead they can identify assets as held for investment. This is essentially accounting fiction and could (and should*) have been done away with by Cox. In exchange, they have to hold higher reserves (a good thing) and they are under significantly greater banking regulations. To use the Goldman/Morgan Stanley conversion as a point for Glass-Steagel is pretty dumb.

    * Ending/suspending mark to market is a possible way to not need the bailout.

  2. that would mean J.P. Morgan could not have bought Bear Stearns, Bank of America could not have bought Merrill Lynch, Barclays could not buy most of Lehman, and Goldman Sachs and Morgan Stanley could not become bank holding companies. It is hard to imagine how things would have worked out in that situation, but it surely would not have been an improvement.

    And if we hadn’t invaded Iraq, we wouldn’t have been able to fight al Qaeda in Iraq.

    See the problem here?

  3. “To use the Goldman/Morgan Stanley conversion as a point for Glass-Steagel is pretty dumb.”

    How is it dumb when it is factually correct?

  4. Accurate facts:

    Mo’s comment = 9.

    Don’s comment = 0.

  5. How is it dumb when it is factually correct?

    Because the same outcome could have been reached merely by ending the mark-to-market rule. That’s the only functional difference between Goldman and Morgan today and the same two banks a week ago*. Unless they’ve started opening bank branches and people have rushed to deposit money in them (which hasn’t happened). All the conversion has demonstrated is that the banks are financially stable (they can pay their liabilities), but they’re screwed because of accounting rules. So instead of doing the rational thing and ending mark-to-market, we’re going to buy the shitty assets.

    * Another big difference is they have higher deposit limits and are exposed to more government regulations. However, that won’t kick in yet.

  6. Joe, the repeal of Glass-Steagall didn’t cause this problem, so your point doesn’t apply in this case.

    You can make a good case for more regulation, or that deregulation is bad, but in this case blaming GLB for this banking crisis is not correct.

  7. DDP,

    I think it would be better to say that Glass-Steagel repeal was only a part of what brought this about, and not the most important part, but that it played a role.

    It had the effect of increasing the number of mortgages made by non-banks (institutions that weren’t federally insured and didn’t have to abide by such regulations as capitalization standards), and of increasing the amount of those mortgages that got converted into mortgage-backed derivatives that were over-rated.

    Not a dominant role, but some.

  8. From the balanced-budget article:

    “It is unfashionable to say so, but it makes sense for governments to finance capital investments with debt, because infrastructure yields benefits over decades. It also makes sense to borrow during recessions . . .”

    Fair enough – so why not require a supermajority of voters to approve any additional federal indebtedness? Require the support of a majority of those voting, plus approval in a number of states containing a majority of the population and electoral votes.

    Experience taught the states to let the voters rule up or down on the wisdom of most kinds of new indebtedness. At best it would make the voters themselves accountable, not blaming “those SOBs in Congress.”

  9. The number one underlying cause of the financial mess was the federal reserve creating a real estate asset bubble by pumping up the money supply, driving down interest rates and devaluing the dollar.

    Other culprits include Fannie Mae and Freddie Mac and the “Community Reinvestment Act”

    And the Sarbanes Oxley “mark to market” rules did indeed greatly contribute.

  10. joe,
    I disagree. If Glass-Steagall’s repeal caused this problem we probably would have seen a joint i-bank/commercial bank fail. In fact, G-S has made things better because the joint banks are more stable than a standalone i-bank*. The thing is, those banks have survived because:

    a) They have significant reserve assets to rely on in tough times
    b) They are less leveraged than a standalone i-bank
    c) They are more heavily regulated, so are less likely to engage in as much risky behavior (related to point b)
    d) They don’t have to mark assets to market price

    * This only really applies to the bulge bracket banks. The smaller, boutique banks have been stale because they avoided hedge fund activities, prop trading and other risky transactions. They’ve pretty much stuck to underwriting and mergers.

  11. Barclays would have to have an i-bank portion and a commercial bank portion.

    Barclays is based in the UK and had retail and i-banking before Gramm-Leach-Bliley passed, so unless my understanding’s wrong they would actually have to split up to acquire Lehman. Granted, I think the government would have at least allowed JPMorgan-Bear and BofA-Merrill, especially since they allowed Citi’s buying sprees before GLB.

  12. The number one underlying cause of the financial mess was the federal reserve creating a real estate asset bubble by pumping up the money supply, driving down interest rates and devaluing the dollar.

    I hear this argument a lot, but we’ve seen real estate bubbles pop before without the losses causing a cascade like this. Absent the silly games people were playing with other people’s debt, a popping real estate bubble would have been just that, a downturn in a specific market. Maybe it would have caused a wider recession, but then again, the “real” economy (manufacturing, exports, ideas, culture, etc.) was finally on the upswing in 2006-2007, which would have dampened or maybe completely swamped the sluggishness in the real estate market.

    The CRA argument is also B.S. The CRA only applies to federally-insured deposit institutions, not non-banks. The banks covered by CRA have much lower default rates, and issued far fewer risky loans. In fact, because the CRA made vanilla mortgages from banks available in places where they otherwise would not have been, it served to reduce the number of risky, dumb loans people took out in CRA-covered neighborhoods.

    Mo,

    Maybe. You raise some good points.

  13. The number one underlying cause of the financial mess was the federal reserve creating a real estate asset bubble by pumping up the money supply, driving down interest rates and devaluing the dollar.

    Other culprits include Fannie Mae and Freddie Mac

    So in other words, when non-banks made all sorts of risky loans, and then packaged them as foolish securities, monetary policy made them do it.

    When Freddie and Fannie engaged in comparable behavior, it was all their own responsibility.

    Sure, that makes sense, Gil.

  14. joe,

    When private banks make risky loans, they are only risking themselves and their shareholders money. When Fannie/Freddie do it, with their guarantee, they are risking everyone’s money.

    At least that was the theory. But Im okay with letting them all fail.

  15. The underlying cause of the current problems is greed.

    If you’re a progressive, you believe government should impose rules to prevent greed from leading to crises.

    If you’re a libertarian, you believe greed should be punished by the market.

    The details are mostly irrelevant.

  16. Everyone in the industry acted in the belief that the GSEs would be bailed out by the government. How much that contributed to the bubble is an open question, but zero would be the wrong answer.

  17. kinnath,

    Dead on. Great post.

  18. that would mean J.P. Morgan could not have bought Bear Stearns, Bank of America could not have bought Merrill Lynch, Barclays could not buy most of Lehman, and Goldman Sachs and Morgan Stanley could not become bank holding companies. It is hard to imagine how things would have worked out in that situation, but it surely would not have been an improvement.

    Sigh. Yes, obviously in the short run, for this relatively small problem, it helps.

    The danger is this: what if in a few years, there’s a problem so big it drags down the banks too? If the government has to bail out all the FDIC-insured accounts, it’s going to be very very ugly. Think Zimbabwe ugly.

    FDIC insurance means that the investment banks are now playing with taxpayer-guaranteed funds.

  19. “So in other words, when non-banks made all sorts of risky loans, and then packaged them as foolish securities, monetary policy made them do it.

    When Freddie and Fannie engaged in comparable behavior, it was all their own responsibility.”

    Next time, try arguing against something I actually said – which was that federal reserve generated real estate bubble was the main cause of this mess – and that is true. If there had been no run up in real estate there would have been no rush to make loans to begin with.

    Nor did I say that there was no responsibilty for it from financial institutions such as Countrywide. There are multiple factors that play into it.

    As for Fannie and Freddie, they were enablers of the explosion in subprime loans because not only did they buy loans directly and securitize those loans themselves, they also bought a bunch of the loan backed securities that had been created by other financial institutions. That allowed the other institutions to free up capital to generate even more loans. And Fannie and Freddie were operating with an implicit (now explicit) guarantee of government backing. Those entities were creations of government in the first place and could never has existed in the market without the advantage of implicit government backing.

  20. I see nothing but support for a bailout–even from The Heritage Foundation (WTF?). Can someone explain WHY a bailout is necessary?

  21. The number one underlying cause of the financial mess was the federal reserve creating a real estate asset bubble by pumping up the money supply, driving down interest rates and devaluing the dollar.

    Don’t worry though, cuz a “new establishment” of financial leaders that includes people like Paulson, Bernanke, Tim Geithner, Robert Rubin and Paul Volker are gonna step up and lead us out of this mess.

    David Brooks told me so, and with those outsiders taking the reigns we are gonna be all right.

  22. Other culprits include Fannie Mae and Freddie Mac and the “Community Reinvestment Act”

    Yet another person spouting nonsense about the Community Reinvestment Act.

    The CRA didn’t require that lenders lend money to people who don’t have the ability to repay. It didn’t require anyone to lend money to anyone. It just forbid redlining neighborhoods.

  23. I don’t understand why progressives aren’t mad as hell with Fannie ‘n’ Freddie. Not only did they fail to prevent greed from leading to a really big fucking crisis — they were complicit in fanning that greed.

  24. ChicagoTom,

    Maybe some neighborhoods needed to be redlined.

  25. And if we hadn’t invaded Iraq, we wouldn’t have been able to fight al Qaeda in Iraq.

    Bad analogy. We removed Saddam, and AQ and Shia militias (both of whom already had some presence there) filled the gap. Then we and the new Iraqi security forces defeated those, and now Iraq is better off than it has been in decades, probably since their last parliamentary democracy was ended.

  26. Next time, try arguing against something I actually said – which was that federal reserve generated real estate bubble was the main cause of this mess – and that is true. If there had been no run up in real estate there would have been no rush to make loans to begin with.

    Answered at 2:04. You must have scrolled past it. To sum up, we’ve had bubbles pop before, no big deal, and in this case, the drop in the real estate market would have been largely attenuated by the growth in the rest of the economy, if the capital markets that invest in the rest of the economy hadn’t been dragged in by MBSs.

    Nor did I say that there was no responsibilty for it from financial institutions such as Countrywide. There are multiple factors that play into it. OK. You omitted them from your previous list.

    As for Fannie and Freddie, they were enablers of the explosion in subprime loans because not only did they buy loans directly and securitize those loans themselves, they also bought a bunch of the loan backed securities that had been created by other financial institutions. That allowed the other institutions to free up capital to generate even more loans. Agreed. They should not have been buying crappy loans or crappy derivatives, and their doing so helped make this problem bigger.

  27. On the Community Reinvestment Act:

    The CRA only covers federally-insured deposit institutions, ie, banks. The bank loans that were given in redlined neighborhoods have lower default rates than the non-bank loans. Which makes sense, because the banks provided a far smaller % of risky loans than the non-banks.

    If the CRA was causing dumb loans to be made, we’d expect to see institutions covered by the CRA to be more deeply involved in this crisis than CRA-exempt institutions. What we’re actually seeing is just the opposite.

    In fact, by making boring loans with such arcane conditions as “down payments” and “fixed rates” and “affordability standards” more available in poor neighborhoods, the CRA had the effect of squeezing risky, non-bank loans out of the market.

  28. How would eliminating the mark-to-market rules stave off the collapse?

  29. There’s blame galore in this mess, but one thing I think is worth noting is that the desire to ensure that everyone had access to (relatively) cheap credit, combined with the use of the regulatory hammer to ensure that credit was made available to most at a capped rate, had a lot to do with creating the disaster. Of course, even people who could afford credit went crazy, buying more house that they could afford, which made the problem worse.

    I think we always take a big gamble when we move from using regulation to limit bad action and to promote disclosure to using it to create some preferred social end result. Incidentally, though this sounds like I’m blaming the left, I’m not. Both parties have encouraged this sort of ill-conceived meddling.

  30. kevin,

    How would eliminating the mark-to-market rules stave off the collapse?

    As I understand it, the “market” value of a lot of these subprime derivates and etc are at about 22% of full value. Obviously, they arent worth full value. Also, obviously, the value if you just foreclosed and sold all the property is worth more than 22%. However, there isnt really a market for these things and what market there was has dried up as no one really knows how to value them and doesnt want them on their books with the mark-to-market rules.

    If these things were valued at say 60% instead of 20%, the owners would have much higher assets on their books and wouldnt be facing the liquidity crisis that is driving them under. It would still suck, but they would be able to ride out the next few years and hope the housing market finally bottomed out, settled down and a better market value would exist for these assets.

    That is my understanding. It could all be bullshit, I claim to be no expert on mark-to-market rules.

  31. Of course, the cynic says that any system put in place to regulate greed, will itself be corrupted by greed.

  32. Joe, Mo addressed a lot of my thoughts previously, but there are a few points that I would like to add that others have also touched upon.

    The issuance of mortgage backed securities correlates very well with lower interest rates, the former having peaked in 2003 as the latter was reduced to record lows by the Fed. Interest rate influences are by far a more powerful driver than the removal of regulations which were never meant to prevent such a crisis, and the data suggests just that. The now failed investment banks still would have taken advantage of the record number of home loans made possible by lower rates, by buying and selling in a record number of MBSs.

    And if there was any policy or agency that acted as a driving force, it was Fannie and Freddie. Implicit guarantees has already been mentioned a multitude of times, and should not be ignored. But, more importantly in my mind, these were agencies whose chartered purpose was to make home ownership more available. Why would we be so surprised that they were successful in their efforts? Their purpose was not the prevention of housing bubbles. They were monstrosities and perversions of the market meant to achieve a supposedly desirable social end. This is not a child of the free market. There is a very good reason why the bubble was not in widgets.

    If GS had a marginal effect, it was just that, marginal. Heck, even as a libertarian, I can say that deregulating irresponsibly is not advisable. And deregulating is not necessarily a preferable end in itself. But GLB did not cause this crisis, and GLB was not irresponsible deregulation. Progressives that keep pointing this out need to offer more corroborative data than the fact that a banking deregulation act having passed at some point before this crisis.

    But I am surely bewildered at how any progressive can look at this data and honestly shout “OMG Free Markets!” (not suggesting that you are doing this at this moment). Craning your neck around the elephants in the room (Fed policy and government policy regarding home ownership) to assign blame to the free market sitting in the corner is not an appropriately honest analysis. While a good case can be made for regulation in the home lending industry and of F&F, the cows have already escaped the barn, closing the doors will solve nothing regarding the current problem.

    And that’s the fundamental problem with regulation, it tries to solve problems after the damage has been done. That is because the finance industry, like technology, worked much more quickly than the government could/would/should legislate or regulate.

    No administration would have stopped this bubble. Not Bush. Not Clinton. Not Bush the Wiser. Not Reagan. Not Carter. Not Ford. Not Nixon. Not LBJ. It is politically untenable to try and do so, and I would guess that you know that. But maybe I’m wrong about that.

    We, progressive and libertarians alike can find common ground here. That there is a fundamentally disturbing problem with our system, that neither regulation nor deregulation will solve. Regulation will put bandaids on the patient, but it may hemmorage again elsewhere. Deregulation may only reopen the wound. At some point, we have to administer the medicine.

    /end rant

  33. I also agree that the CRA had no effect, or at worst a marginal effect, in this crisis. This is the analagously ridiculous meme from the right and libertarian circles that is simply supported by little evidence.

  34. DDP speaks wisely.

  35. “If you’re a progressive, you believe government should impose rules to prevent greed from leading to crises.”

    Actually, all progessives I know believe government should impose rules to mitigate the effects of negative externalities. As with many things, the devil is in the details.

    “How would eliminating the mark-to-market rules stave off the collapse?”

    mark-to-market is assigning a value to a financial instrument based on its current market value. Many of these financial instruments which are causing the problems never were marked to market, i.e., the buyers and sellers had no idea what their value was were the transaction to be held on the open market. So, they had to mark-to-model which means they had fancy computers with all kinds of pricing models based on different variables, assumptions and imputations. When one of these mark-to-model financial instruments finally does hit the marketplace, then all holders of identical or similar instruments must reprice these assets to the market price. I see nothing wrong with this practice as it is based purely on the most recent market-based information. I’m no expert on this as well, but I believe this is an accurate description.

  36. Another culprit in this mess that I forgot to mention earlier were the credit rating agengies like Moody’s and Standard & Poors who assinged AAA ratings to securites backed by pools of risky loans.

  37. Damn, DDP. Way to totally own this topic. After that, I got nothin’.

  38. with those outsiders taking the reigns we are gonna be all right

    Typo of the fucking year.

  39. Gilbert Martin is correct as well. AAA, junk bond, what’s the difference? Apparently, not much. If something is difficult to value or has a massive downside, how about rating it lower?

  40. DDP,

    The Mo abides.

    lupan,

    The problem is a lot of these instruments are like snowflakes. No two has the exact same set of mortgages, so they’re being compared to similar (though not sure how similar) instruments. Also, they can hold them as they pay off and they’re worth more. It would be as if the bank required you to give them your house if your net worth went below $XXX thousand dollars. Then your neighbor’s house gets forecloses, the bank sells if for nickels on the dollar and says that because you have a similar house, your house is also worth nickels on the dollar and you need to hand over your house. Now, you know and the ank knows that the value will bounce back, which is why you’re holding on to it. Same here.

  41. Mo,

    I’m no expert on MBS’s, but I agree that no two has the exact same set of mortgages, but they were supposed to have been pooled according to similarity in risk profiles, like individual credit risk scoring like FICO. Now, we can all argue about it’s individual accuracy, but the market has determined that this is the most accurate measure in the aggregate. So, I have to respectfully disagree with your analogy. If my neighbor forecloses, the value of my house will drop, but it has no effect on the risk profile of the pool of MBS’s which my mortgage is already in. That individual foreclosure would only have an effect in the pool of similarly risk profiled MBS’s it is in, but the effect is only felt as numbers of foreclosures (or delinquencies IIRC) rise to certain levels. But MBS’s are only a part of the current problem…from what I understand CDO’s are the immediate crisis. CDO’s are unregulated asset backed securities. They aren’t only backed by mortgage assets.

  42. Of course, the cynic says that any system put in place to regulate greed, will itself be corrupted by greed.

    That’s not cynical, that’s just true. The moment you give someone authority to regulate who makes a profit you’ve made it profitable (and in our country’s messy history often necessary) to bribe the regulators. Since the position of regulator is political, you’ve made it profitible for large groups of the financial elite to grab as much power as possible through political means because holding those positions means 1) getting rich via others’ bribes and 2) getting rich by favoring your social circle. Voila, market regulation leads to the vast and irreversible corruption of our political system by both major political parties, who do their damnedest to keep anyone else from getting their fingers near the pie.

    There’s absolutely no way to correct the problem without taking away the government’s ability to determine who makes a profit, which probably means a complete Constitutional rewrite.

  43. DDP,

    “And that’s the fundamental problem with regulation, …”

    Interesting posts, and I can go along with mark-to-market rules being part of the problem here.
    But I would argue that GLB, as well as the CFMA were irresponsible. They contributed to the current mess by reducing transparency in securities, allowing savings, investment, and insurance banks to merge into giants, and even enabling CDS trading to exist. Hell, the CFMA engendered the Enron debacle.

    Throwing out (or not enacting) sensible regulation because it solves yesterdays problem is a silly argument. Yesterdays problem has a way of becoming tomorrows.

    I’m all for free markets, but proper securities regulations are a backstop against fraud. Clever criminals are always inventing new ways to defraud people, but that doesn’t mean we should give up. As long as corporate directors are not personally liable for corporate fraud, one can’t assume that corporations are always rational actors in the marketplace.

  44. Speaking of rational actors and fraud:

    Ponzi

  45. Ha ! the greatest Ponzi scheme on earth is the social security program.

    All this bailout stuff is a street corner shell game compared to that.

  46. What I love about this crisis is that the left, amid record Bush spending on regulation (just like everything else) can call it a result of “deregulation.” In my world, at least, the “de” kinda implies LESS spending instead of more…

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