Anatomy of a Breakdown

Concerted government policy helped trigger the financial meltdown-and will almost certainly extend it.

It was not an absence of federal intervention that produced the Great Financial Panic of 2008. Contrary to the assertions of those clamoring for new regulations (see "Is Deregulation to Blame?," page 36), the liquidity shortage and credit freeze that triggered Washington's biggest intrusion into the economy since Richard Nixon's wage and price controls were caused by bad government policy and worse crisis management.

As the housing bubble inflated from 1997 to 2006, banks, fueled by the Federal Reserve, prodded by activists, and egged on by Wall Street, created ever more exotic mortgage loans that pushed up housing prices and extended mortgage debt to families vulnerable to economic downturns. Several layers of financial products were tied to these mortgages. As some of the derivative instruments and underlying mortgages collapsed, collateral damage raced through the entire system.

In 2008 the Bush administration took a series of frantic steps to stop the bleeding. It backed a hostile takeover of the investment bank Bear Stearns. It took over home lending behemoths Fannie Mae and Freddie Mac, an act that put $5 trillion worth of mortgages—more than $1 trillion of which are subprime—on the federal government's books, not to mention the $200 billion it had to commit to guarantee Fannie and Freddie's debts. It made hundreds of billions of dollars available to banks through the Fed's "discount window," its mechanism to make short-term loans to certain institutions, put up $85 billion to take over the insurance giant AIG, and offered another $250 billion to individual banks to rebuild their balance sheets.

In October the administration convinced Congress to authorize the Treasury Department to spend upward of $700 billion buying up toxic mortgage-backed securities, most of which contain sizeable numbers of subprime mortgages. Each step not only failed to calm the market but seemed to increase the sense of impending doom (also fanned by sky-is-falling pronouncements from President Bush on down). After a month of U.S. government action, the mortgage crisis had grown into a global financial panic, the repercussions of which we'll be living with for decades.

The Roots of the Crisis

Throughout the 1990s and the early years of this century, both major political parties became intoxicated with the idea of promoting "affordable" housing. By the time the crisis blew up, Congress was mandating that roughly 50 percent of the mortgages issued by Fannie and Freddie go to households making below their area's median income.

Many conservative commentators have blamed the housing mess on the 1977 Community Reinvestment Act (CRA), which essentially required banks to increase lending in low-income areas. While the CRA was a bad law, its role in recent events has been overblown. After all, it was on the books for decades before the bubble began. The law's worst legacy is the permanent network of "affordable housing" advocates that sprang up after it passed. These groups, which were intended to facilitate lending in poor areas, continually called for increased activity by banks and additional government support for affordable housing initiatives. The CRA also helped create a climate in which lending to low-income households was a key metric and condition regulators used in approving bank mergers.

Other, more recent developments played a bigger role in the financial crisis. In 1993 the Federal Reserve Bank of Boston published "Closing the Gap: A Guide to Equal Opportunity Lending." The report recommended a series of measures to better serve low-income and minority households. Most of the recommendations were routine and mundane: better staff training, improved outreach and communication, and the like. But the report also urged banks to loosen their income thresholds for receiving a mortgage. In the years after the report was published, activists and officials—especially in the Department of Housing and Urban Development, under both Bill Clinton and George W. Bush—used its findings to pressure banks to increase their lending to low-income households. By the turn of the century, other changes in federal policy made those demands more achievable.

You can't lend money if you don't have it. And beginning in 2001, the Federal Reserve made sure lots of people had it. In January 2001, when President Bush took office, the federal funds rate, the key benchmark for all interest rates in this country, was 6.5 percent. Then, in response to the meltdown in the technology sector, the Fed began cutting the rate. By August 2001, it was at 3.75 percent. And after the terrorist attacks of September 11, the Fed opened the spigot. By the summer of 2002, the federal funds rate was 1 percent.

The central bank's efforts went so far that, at one point in 2003, we had interest rates below the rate of inflation, or effectively negative. Institutional investors, looking at low yields on Treasury securities, needed a place to park money and earn some kind of return. Mortgage-backed securities became a favorite investment vehicle. Under traditional models, they were very safe and, because of Fed policy, even the most conservative fund could earn better returns than they could on Treasury notes.

Investment houses would bundle individual mortgages from several banks together into bond-like products that they would sell to individual investors. Mortgages historically have been seen as among the safest investments, and the era of rising house values transformed "safe" into "guaranteed returns."

For the first half of this decade, trading in mortgage-backed securities exploded. Their growth provided unprecedented levels of capital in the mortgage market. At the same time, investment houses were looking to replace the healthy fees earned during the dot-com bubble. Mortgage-backed securities had fat margins, so everyone jumped into the game.

The additional capital to underwrite mortgages was a good thing—up to a point. Homeownership expanded throughout most of Bush's presidency. During the last few decades, the American homeownership rate has been around 60 percent of adult households. At the height of the bubble, it reached almost 70 percent. It is clear now that many people who got mortgages at the high-water mark should not have. But Wall Street needed to feed the stream of mortgage-backed securities.

Fannie and Freddie

It's hard to overstate the role Fannie Mae and Freddie Mac played in creating this crisis. Chartered by Congress, Fannie in 1938 and Freddie in 1970, the two government-sponsored enterprises provided much of the liquidity for the nation's housing market. Because investors believed—correctly, it turns out—that Fannie Mae and Freddie Mac were backed by an implicit guarantee from the federal government, the companies were able to raise money more cheaply than their competitors. They were also exempt from federal, state, and local taxes.

The chief mission of Fannie Mae and Freddie Mac was to buy up mortgages issued by banks, freeing up bank money for additional mortgages. Fannie and Freddie would package these mortgages into mortgage-backed securities and sell those on the secondary mortgage market, providing cash to continue the cycle. Even when selling these securities, they often retained the full risk for any default, pocketing a portion of the interest payments in return.

Fannie and Freddie would also keep a portion of these mortgages in their own investment portfolios, providing a constant influx of interest payments. Starting in the 1990s, they increasingly created and traded in complex derivatives, financial instruments designed to insulate them, through hedging, from mortgage loan defaults and interest rate increases. From the mid-'90s through the early 2000s, Fannie Mae and Freddie Mac were the darlings of Wall Street, with steady earnings growth and solid credit ratings. Fannie's share priced peaked in 2001 almost 400 percent above its 1995 level; Freddie peaked in 2004, almost 500 percent higher than in 1995. This growth would not last.

In June 2003, Freddie Mac surprised Washington and Wall Street with a management shakeup. The top executives were sent packing, and a new auditor, PricewaterhouseCoopers, identified several accounting irregularities on the company's books, especially related to its portfolio of derivatives. The company would have to restate earnings for the previous several years.

Just days before, the agency responsible for regulating Freddie, the Office of Federal Housing Enterprise Oversight, had reported to Congress that the company's management "effectively conveys an appropriate message of integrity and ethical values." Just how wrong this assessment was would soon become abundantly clear.

As the extent of the accounting irregularities emerged, federal regulators descended on the company and quickly determined that the accounting troubles extended to Fannie Mae as well. With concerns about the companies growing, the Bush administration unveiled proposals to rein them in. Then-Treasury Secretary John Snow proposed putting Fannie and Freddie under his department's oversight and subjecting them to the kind of controls over risk and capital reserves that apply to commercial banks. (Fannie's debt-to-capital ratio was 30 to 1, whereas conventional banks have debt-to-capital ratios of around 11 to 1.)

But Fannie and Freddie by this point were political powerhouses. When the accounting scandal first emerged, Fannie's chairman was Franklin Raines, former director of the Office of Management and Budget under President Bill Clinton. Its vice chairman was Jamie Gorelick, a former Justice Department official who had served on the 9/11 commission. The two companies provided tens of millions of dollars in annual campaign contributions and spent more than $10 million a year combined on outside lobbyists.

Fannie and Freddie rallied their friends on Capitol Hill, who immediately pushed back against the Bush proposals. Rep. Barney Frank (D-Mass.), the ranking Democrat on the House Financial Services Committee, said, "These two entities-Fannie Mae and Freddie Mac-are not facing any kind of financial crisis. The more people exaggerate these problems, the more pressure there is on these companies, the less we will see in terms of affordable housing." The reform effort fizzled.

In 2006 the Office of Federal Housing Enterprise Oversight issued the blistering results of its investigation. The irregularities, investigators concluded, amounted to "extensive financial fraud." The purpose of the deception was clear: to "smooth" earnings from year to year in order to maintain increasing returns and maximize executive bonuses. Raines, for example, earned more than $50 million in bonuses tied to earnings growth during his six-year tenure.

Interestingly, the report noted two questionable transactions Fannie conducted with the investment bank Goldman Sachs in 2001 and 2002 that pushed more than $100 million of existing profits into the future, creating a kind of cushion for future earnings. The chairman of Goldman Sachs when the dodgy transactions took place was the man behind the 2008 bailout: Treasury Secretary Henry Paulson.

In the end, Fannie and Freddie had to restate more than $15 billion in earnings. The Office of Federal Housing Enterprise Oversight and the Securities and Exchange Commission fined Fannie $400 million and Freddie $125 million. There was a new push for tighter oversight on the Hill, but this too withered as Fannie and Freddie rallied support through increased lending to low-income borrowers.

Then Fannie and Freddie went on a subprime bender. The companies made it clear they wanted to buy up all the subprime mortgages—and Alt-A mortgages, whose risk is somewhere between prime and subprime—that they could find. They eventually acquired around $1 trillion of the paper. The market responded. In 2003 less than 8 percent of all mortgages were subprime. By 2006 the number was more than 20 percent. Banks knew they could sell subprime products to Fannie and Freddie. Investments banks realized that if they laced ever-increasing amounts of subprime mortgages into mortgage-backed securities, they could add slightly higher levels of risk and, as a result, boost the returns and earn bigger fees. The ratings agencies, thinking they were simply dealing with traditionally appreciating mortgages, didn't look under the hood.

But after several years of a housing boom, the pool of households that could responsibly use the more exotic financing products had dried up. Essentially, there were no more people who qualified for even a subprime mortgage.

Banks realized they could make ever more exotic loan products (such as interest-only loans), get the affordable housing activists off their backs, and immediately diffuse their risks by folding the mortgages into mortgage-backed securities. After all, Fannie and Freddie would buy anything.

The Crash

Everything worked as long as housing prices continued to rise. Suddenly, though, there weren't enough buyers. (See "Houses of Pain," page 40.) At the same time, the first wave of the more exotic mortgages began to falter. Interest rates on adjustable-rate mortgages moved higher; the Fed was finally constricting the money flow, with the federal funds rate peaking at 5.25 percent in July 2006. Mortgages that were initially interestonly were close to resetting, with monthly payments jumping to include principal. A significant number of these mortgages moved into default and foreclosure, which further dampened housing prices.

The overall foreclosure numbers were small; someone simply looking at housing statistics could be forgiven for wondering what all the fuss was about. Nationally, throughout 2007 and 2008, the number of mortgages moving into foreclosure was only about 1 percent to 2 percent, suggesting that 98 percent to 99 percent of mortgages are sound. But the foreclosed mortgages punched way above their weight class; they were laced throughout the mortgage-backed securities owned by most financial institutions.

The complexity of these financial products cannot be overstated. They usually had two or three "tranches," different baskets of mortgages that paid out in different ways. Worse, as different firms bought and sold them, they were sliced and diced in varying ways. A mortgage-backed security owned by one company could be very different when it was sold to another.

No one fully understood how exposed the mortgage-backed securities were to the rising foreclosures. Because of this uncertainty, it was hard to place a value on them, and the market for the instruments dried up. Accounting regulations required firms to value their assets using the "mark-to-market" rule, i.e., based on the price they could fetch that very day. Because no one was trading mortgage-backed securities anymore, most had to be "marked" at something close to zero.

This threw off banks' capital-to-loan ratios. The law requires banks to hold assets equal to a certain percentage of the loans they give out. Lots of financial institutions had mortgage-backed securities on their books. With the value of these securities moving to zero (at least in accounting terms), banks didn't have enough capital on hand for the loans that were outstanding. So banks rushed to raise money, which raised self-fulfilling fears about their solvency.

Two simple regulatory tweaks could have prevented much of the carnage. Suspending mark-to-market accounting rules (using a five-year rolling average valuation instead, for example) would have helped shore up the balance sheets of some banks. And a temporary easing of capital requirements would have given banks the breathing room to sort out the mortgage-backed security mess. Although it is hard to fix an exact price for these securities in this market, given that 98 percent of underlying mortgages are sound, they clearly aren't worth zero. (For more proposed solutions, see "Better Than a Bailout," page 30.)

Alas, the Fed and the Treasury Department, in full crisis mode, decided to provide their own capital to meet the regulatory requirements. The first misstep, in March, was to force a hostile takeover of Bear Stearns, putting up $30 billion to $40 billion to back J.P. Morgan's purchase of the distressed investment bank. In the long term, it probably would have been better to let Bear Stearns fail and go into bankruptcy. That would have set in motion legal proceedings that would have established a baseline price for mortgage-backed securities. From this established price, banks could have begun to sort out their balance sheets.

Immediately after the collapse of Bear Stearns, rumors circulated on Wall Street of trouble at another investment bank, Lehman Brothers. Lehman went on a P.R. offensive to beat back those rumors. The company was successful in the short term but then did nothing during the next several months to shore up its balance sheet. Its demise in September-the only major bankruptcy allowed during bailout season-was largely self-inflicted.

The collapse of the mortgage-backed security market now started to pollute other financial products. Collateralized debt obligations and credit default swaps are complicated financial products intended to help spread the risk of defaults. An investor holding a bond or mortgage-backed security may purchase one of these products so that, in the event the bond or mortgage-backed security defaults, they would recoup their investment. Bonds rarely default, so collateralized debt obligations and credit default swaps had traditionally been a fairly safe and conservative market.

But like the underlying bonds and mortgage-backed securities, these instruments became more exotic. Companies sold credit default swaps on an individual bond or security to multiple investors. If there was a default, each one of these investors would have to be paid up to the full amount of the bond or security. Imagine if you bought fire insurance on your house and all your neighbors did too. If your house burned, everyone would be compensated for the loss of your house.

Suddenly, stable firms such as AIG, which aggressively sold credit default swaps, were over-exposed. These developments threw off the accounting in one division of AIG, threatening the rest of the firm. Given a few days, AIG could have sold enough assets to cover the spread, but ironclad accounting regulations precluded this. So the government stepped in.

The Bailout

The one-two punch of Lehman's failure and the government's $85 billion bailout of AIG on September 16 spooked both Wall Street and the White House. With Fannie Mae and Freddie Mac already in government receivership, there were fears that the weakness stemming from mortgage-backed securities would spread through the entire financial system. Money began leaving the markets to seek the security of Treasury bonds.

Then, on September 18, it was reported that the Reserve Primary Fund and the Reserve International Liquidity Fund, two commercial paper money market funds, "broke the buck," meaning they lost money. The commercial paper market is supposed to be boring. Every day, companies around the world borrow hundreds of billions to smooth cash flows; the next day they pay it back, giving the bank that lent the money a very small return. When these money market funds lost money, it was a signal that the commercial paper market was drying up, that banks were hesitant to make even these very safe loans.

That's when the market freaked out. The Dow Jones Industrial Average fell over 600 points on September 19. When the government announced that there would be a rescue plan, the market temporarily rebounded. After some details of the plan emerged over the weekend, the Dow had another selloff. A roller-coaster of selloffs and rallies followed, as the market waited to see what the government would do. Every gyration, up or down, was used as an argument for the bailout. If the market moved lower, it was because Congress hadn't approved the bailout. If it moved higher, it was because the market was convinced the bailout would happen. On October 2, after initially defeating the package, the House of Representatives bowed to pressure and passed it.

The original plan crafted by the Treasury Department would have authorized the government to spend up to $700 billion on mortgage-backed securities and other "toxic" debt, thereby removing them from banks' balance sheets. With the "bad loans" off the books, the banks would become sound. Because it was assumed that the mortgage-backed security market was "illiquid," the government would become the buyer of last resort for these products. There was a certain simple elegance to the plan. To paraphrase H.L. Mencken, the solution was neat, plausible, and wrong.

No market is truly illiquid. Last summer, Merrill Lynch unloaded a bunch of bad debt at 22 cents on the dollar. There are likely plenty of buyers for the banks' toxic debt, just not at the price the banks would prefer. Enter the government, which clearly intended to purchase mortgage-backed securities at some premium above the market price.

We don't know yet what the premium will be nor how it will be determined. Well, in a sense we do. It will mostly be determined by politics, not economics. This is the foundational flaw in the Treasury Department plan.

The department has begun a process to determine the assets it will buy and the manner it will set a price. As with everything in government, these are lobbyable moments, a time when swarms of financial service firms, investor groups, and housing advocates try to game the system for their clients or members. The further away from economics these decisions are made, the more risk there is for taxpayers. The higher the premium over any current market price, the longer the government will have to hold the assets and the more exposure there will be for taxpayers.

The risk here is particularly high given the complicated and opaque nature of the financial instruments involved. Few on Wall Street truly understand these products. The bailout authorizes the Treasury Department to bypass normal contracting rules and hire outside private firms to handle the purchases and manage the toxic assets. The fact that these private firms have ongoing relationships with the banks selling the bad assets creates a serious conflict of interest.

Some commentators have drawn parallels to the savings and loan bailout in the 1980s, when the government established the Resolution Trust Corporation to dispose of the assets of failed thrifts. But the Resolution Trust Corporation took on those assets only as thrifts went bankrupt. Under the new plan, by contrast, federal bureaucrats and their outside contractors decide which assets to buy, including equity stakes in commercial banks that aren't particularly happy about having Uncle Sam as a major shareholder. Bureaucrats will be actively investing taxpayer funds in individual securities and then managing the portfolio until they decide to sell. You don't have to be paranoid to fear the political dynamics that will shape these decisions.

More to Come

We have crossed a financial Rubicon. The bailout is just the beginning of Washington's increased involvement in the economy. The government has now taken partial ownership of the nation's nine largest banks. There is talk of bailouts for other weak industries, including the carmakers and the airlines. There certainly will be a host of new regulations that will likely be with us long after the government has sold off the last of the bad debt. We could be entering an era where the financial services sector evolves into a kind of regulated utility.

Libertarians used to joke that we were on the verge of another rerun of That '70s Show, with a return to old regulations and high taxation. We should be so lucky. The events of the last several months presage a return to the 1930s, with a new surge of direct federal involvement in the economy. If we fail to beat back these new controls, future historians may mark this time as the beginning of a long winter of statism and stagnation.

Mike Flynn is director of government affairs at the Reason Foundation.

Comments

[Casey Serin]

Hank Paulson is an incompetent oaf.

[J sub D]

Once we get the right people writing the right regulations and implementing the right governmantal policies this economic cycle thing will be broken.*

This will occur aproximately an eternity after hell freezes over.

* All govermental interference in the economy is not equally harmful.

[Other Matt]

Didn't Paulson abandon the idea of buying the "toxic" debt?

[Billy Beck]

Paulson = Lurch.

[Warren]

doom
DoooM
DOOOOM

[joe]

Freddie and Fannie don't make loans.

Loans to low-income homebuyers are a tiny fraction of the mortgage market, while the defaults and loose lending standards have hit at all price levels. This is primarily a problem of loans given to middle- and upper-middle-class people buying and refinancing houses in the suburbs.

Most of the loans on Freddie and Fannie's books were, per Ron Paul's floor speech, refinances - in other words, loans that had nothing to do with "affordable housing."

So, in summary, this is the fault of Freddie and Fannie making loans to poor people.

[James Ard]

It isn't loans to poor people that make Fanny and Freddy guilty. It was the fact that they were a repository for the crooked bankers to unload the worst of their portfolios.

[ed]

Terrific article. It's comforting to note that none of Fannie's or Freddie's former administrative thieves is being prosecuted or even investigated, and that a major player in this disaster, Barney Frank, is now more powerful than ever.

[mr simple]

Isn't this article a month too late? Hank shirked that "buying toxic assets" plan as soon as it got passed and moved on to bigger and better government involvement.

[joe]

Agreed, James.

When I see blatantly wrong facts, like "Freddie Mac and Fannie Mae make loans" or "banks were required to make loans under the CRA, and didn't care about standards because they could sell them to Freddie and Fannie" it drives me crazy.

Neither of those things happened. Neither of those things could ever have happened, and yet you see entire theories spun purporting to explain the mortgage meltdown based on them.

[Pro Libertate]

Where did the article say that Fannie and Freddie originated loans? I thought it was clear about their role being in the secondary market.

[P Brooks]

When I see blatantly wrong facts, like "Freddie Mac and Fannie Mae make loans"

[citation needed]

[James Ard]

The bankers didn't listen to the warnings about enforcing standards because 3rd party lenders weren't going to be subject to the regulations. Paulson, Frank and their buddies should be joining Bernie Ebbers at club fed, not working on the solution.

[Bingo]

joe, I take it you didn't read the article. Mike Flynn makes it pretty clear that the CRA was not the cause of the crisis.

[joe]

Pro Libertate, P Brooks,

By the time the crisis blew up, Congress was mandating that roughly 50 percent of the mortgages issued by Fannie and Freddie go to households making below their area's median income.

Right under the heading "The Roots of the Crisis."

[Bingo]

Also, excellent article Mike! It was very educational.

[joe]

Bingo,

I guess I must not have read the article, because I described and quoted from it.

I didn't say this particular article blamed the CRA, just that I see that argument all the time.

[joe]

Bingo,

You were on old threads based on articles blaming the CRA. I guess you didn't read the article, because Mike Flynn makes it pretty clear that he sees this argument made all the time, too.

[Other Matt]

joe, I take it you didn't read the article. Mike Flynn makes it pretty clear that the CRA was not the cause of the crisis.

Referring to:

While the CRA was a bad law, its role in recent events has been overblown. After all, it was on the books for decades before the bubble began. The law's worst legacy is the permanent network of "affordable housing" advocates that sprang up after it passed.

ie-Don't confuse joe with facts when he's trying to hijack a thread.

[Other Matt]

Also, excellent article Mike! It was very educational.

Seconded.

[Hazel Meade]

joe,
Fannie and Freddie's mortage quotas are real, and unrelated to the CRA.

Also, 20% of the mortage market (what subprime had swollen to under those quotas) is not a "tiny fraction".

Also, almost everyone agrees that the crisis is rooted in subprime mortages, not the regular kind.

[joe]

Oh, look, OtherMatt can't read, either.

Please, quote me the part where I said Flynn's article made that argument.

[Pro Libertate]

Well, joe, given that the rest of the article is clear about Fannie/Freddie's role, I'd say that the author didn't mean to imply that they were originating loans.

What's interesting and not talked about as much is the whole "conforming" loans issue. Fannie and Freddie defined the kind of paper and the types of features different loan products could have (to be traded in the secondary market, that is). That influenced things on the origination front quite a bit, I'm sure.

I think most people around here (including the author of this article) view CRA as symptomatic of the underlying "loans for everyone" mentality that gave a major assist to the explosion of the derivative products and to preventing any reform of the process when it might've done some good. I would take issue with anyone blaming CRA principally for the mess.

[joe]

Hazel,

Also, 20% of the mortage market (what subprime had swollen to under those quotas) is not a "tiny fraction".

Subprime does not equal loans to poor people, or loans in low-income neighborhoods.

Also, almost everyone agrees that the crisis is rooted in subprime mortages, not the regular kind. Almost everyone would be wrong, if this were actually the case.

[Naga Sadow]

Oh, oh! Joe may have come to do battle once more! Knuckle up, people!

[Bingo]

Yadda yadda yadda, joe puts up fields of strawmen in his mind so he can voraciously attack them. Chill out hombre.

[P Brooks]

Joe- I didn't pick up on that sentence first time around, but based on what was in the body of the article, I'm going to allow for the possibility of careless editing.

We now return to our regularly scheduled quibblefest.

[Other Matt]

Please, quote me the part where I said Flynn's article made that argument.

Look, up there, a commmon house finch!!

Goalpost moving already joe? Damn, you aren't even past 100 yet.

[joe]

Pro Libertate | December 3, 2008, 12:59pm | #

Well, joe, given that the rest of the article is clear about Fannie/Freddie's role, I'd say that the author didn't mean to imply that they were originating loans.

I'd say that the author set out to put all of the blame on the government and excuse the private actors, and somehow decided that the NYSE-traded GSEs were "the government," so tried to pass off the zany loans that were given out as coming from the government.

I think most people around here (including the author of this article) view CRA as symptomatic of the underlying "loans for everyone" mentality that gave a major assist to the explosion of the derivative products and to preventing any reform of the process when it might've done some good. The problem here is that the community activists and Congressmen who were pushing for anti-redlining standards were the same people pushing for stronger regulation on the loans themselves. Remember, CRA loans (which are bank loans) have a lower default rate than loans in those same neighborhoods by non-banks, because the CRA loans were made with better lending standards, even as they were helping to expand credit to poorer people.

[joe]

Goalpost moving already joe? Damn, you aren't even past 100 yet.

No, addressing exactly the point YOU raised. You said I accused Flynn of saying the CRA caused this. Back up, or shut up.

And you can't.

Do you have anything else to add?

[Hazel Meade]

Subprime does not equal loans to poor people, or loans in low-income neighborhoods.

Because everyone knows poor people are more credit worthy than the middle class, right?

Regardless of how you slice and dice it, Fannie and Freddie were told "make more loans available to low-income borrowers" - an explicit quota of >50%. And they chose to implement that policy by buying up subprime and Alt-A mortgages. Does it matter that that point whether those loans were in "low-income" neighborhoods?

I note you haven't brought up your claim that they only owned 3% of the subprime market again.

[joe]

Because everyone knows poor people are more credit worthy than the middle class, right?

No, because "subprime" has an actual meaning, and that meaning has nothing to do with income levels. Lower-income people quality for prime loans all the time - smaller ones, maybe longer mortgages, but prime loans.

You have two arguments, Hazel, and they're both false. Subprime loans are not "loans made to poor people," and subprime loans are not the only ones defaulting at much higher-than-expected rates, thus setting off the MBS collapses.

Maybe you should rely less on what "everyone knows."

BTW, that wasn't "my claim," that was the figure that came out of a Treasury study of the MBSs that Freddie and Fannie bought between, IIRC, 2004 and 2007.

[Hazel Meade]

joe, you're being really stupid. You jumped into the thread without reading the article, spouted a bunch of Democratic talking points, and then got pissed off when people said "Hey joe, have you actually read the article? Because it has nothing to do with what you just said."

Then you went back and decided to cherry pick a couple sentences out of context to cover your ass while simutaneously claiming that you never attributed anything to Michael Flynn. Which makes it all the more obvious that you didn't actually read the article.

Why don't you try addressing the actual points the article makes instead of beating that CRA strawman ?

[joe]

Subprime loans are not "loans made to poor people," and subprime loans are not the only ones defaulting at much higher-than-expected rates, thus setting off the MBS collapses.

This might need some more explaining.

Subprime and Alt A mortgages already had their additional risk priced in, and MBSs that took bundled them already had that additional risk priced in - wrongly, as it turns out.

This idea that loans were going out and being sold without regard to risk is wrong - a great deal of attention was paid to risk. The Street just got that risk wrong.

[Mike Laursen]

NYSE-traded GSEs were "the government,"

I'm afraid I can't let you get away with passing Fannie Mae and Freddie Mac off as private corporations. True, the government guarantee behind those GSEs was implicit, but the financial sector's trust in that implicit guarantee was not mistaken -- the GSEs were bailed out by the government.

[Hazel Meade]

You have two arguments, Hazel, and they're both false. Subprime loans are not "loans made to poor people," and subprime loans are not the only ones defaulting at much higher-than-expected rates, thus setting off the MBS collapses.

1) I didn't say they were loans made to poor people. However, poor people do tend to be less credit worthy, and therefore make up a larger percentage of the subprime mortgage market. Obviously, Fannie Mae and Freddie Mac agree, since they chose to fulfill their "low income" quotas by buying subprime mortgages.

2) That must be why everyone calling it the "subprime mortage crisis".
http://en.wikipedia.org/wiki/Subprime_mortgage_crisis
Read up on it.

BTW, that wasn't "my claim," that was the figure that came out of a Treasury study of the MBSs that Freddie and Fannie bought between, IIRC, 2004 and 2007.

It was a claim made by the Orange Country register, based on their own calculations from data available from the Treasury study. Which doesn't happen to be backed up by any other source, and is mathematically impossible based on information available elsewhere. Obviously, the OC register is bad at math.

[joe]

Oh, Jeebus, now you have to to start with the insults.

"Stupid, strawman, joe you're so terrible, you troll."

I know, how about trying to have a civil discourse without the personal attacks? I now OtherMatt can't hack that, but come on Hazel, give it a shot.

You jumped into the thread without reading the article I read the article. Even the people who questioned me on that have gone back and read the line they missed, that my comment was based on.

out of context? Huh? How is it out of context?

while simutaneously claiming that you never attributed anything to Michael Flynn. Where did I do this, exactly? Can you quote it? I was quite clear that I did attribute something to Mike Flynn, and then cleared up that I didn't attribute the CRA argument to him.

Why don't you try addressing the actual points the article makes instead of beating that CRA strawman ?

I did. Instead of considering them, you decided that they're "Democratic talking points," so you don't have to think about them. Which makes me a partisan or something.

[jsh]

It isn't a case of either CRA or Fannie/Freddie. One reinforced the other:

WSJ: How Government Stoked the Mania

The Community Reinvestment Act (CRA) did the same thing with traditional banks. It encouraged banks to serve two masters -- their bottom line and the so-called common good. First passed in 1977, the CRA was "strengthened" in 1995, causing an increase of 80% in the number of bank loans going to low- and moderate-income families.

Fannie and Freddie were part of the CRA story, too. In 1997, Bear Stearns did the first securitization of CRA loans, a $384 million offering guaranteed by Freddie Mac. Over the next 10 months, Bear Stearns issued $1.9 billion of CRA mortgages backed by Fannie or Freddie. Between 2000 and 2002 Fannie Mae securitized $394 billion in CRA loans with $20 billion going to securitized mortgages.

[Pro Libertate]

I must quibble. Subprime loans most assuredly did not have their risk "priced in". There are a number of state and federal laws that forced lenders to cap rates (for the riskiest of the subprime class) far below the purely risk-based rate.

Only a part of the overall issue with subprime, of course, and, as I said, only a quibble.

[Naga Sadow]

Pro Lib,

Also, the rating agencies totally fucked off on their work.

[joe]

Mike Laursen,

True, the government guarantee behind those GSEs was implicit, but the financial sector's trust in that implicit guarantee was not mistaken -- the GSEs were bailed out by the government. By this definition, Merril and Citigroup were "the government," too. They were bailed out, and they clearly understood that their "too big to fail" status meant they had an implicit guarantee.

But my point about their private status wasn't that they had no government guarantee - they clearly did - but that they were for-profit corporations traded on the NYSE, working with the same incentives as any other corporation (higher profits, higher stock values) and run by people with the same incentives as any other corporate officers and executives. So they acted like a corporation.

[Pro Libertate]

Naga,

Darned tootin'. The fact that anyone pays any attention to their opinions is beyond me. Oh, you just relied on the people making the loans for their opinions on valuation? How is that any better than appraisers relying on the seller for the valuation of the home?

joe,

They acted like corporations with a bailout implicit in their charters. Kind of like the non-GSE auto industry!

[Hazel Meade]

http://www.mbaa.org/NewsandMedia/PressCenter/58758.htm

As can be seen in the chart below, while subprime ARMs only represent 6.8 percent of the loans outstanding, they represent 43.0 percent of the foreclosures started during the third quarter.

Yeah, subprime mortages. Clearly not defaulting at unusual rates. Nothing to do with the crisis.

[ChanceH]

Buying a bond is the same thing as making a loan. So yes, Fannie and Freddie did make loans.

[Mike Laursen]

joe, you're conveniently skipping over the difference between the GSEs and corporations like Citigroup. It was widely understood that there was an implicit government guarantee behind the GSEs. You even acknowledge that in your second paragraph: "But my point about their private status wasn't that they had no government guarantee - they clearly did..." How come you can never, ever admit when you make a bad argument?

[joe]

However, poor people do tend to be less credit worthy, and therefore make up a larger percentage of the subprime mortgage market.

Bigger than what? And in what terms? It's the dollar value that matters, not the number of loans.

That must be why everyone calling it the "subprime mortage crisis". That's your argument, that "everyone" calls it something? You know who doesn't call it "the subprime mortgage crisis" anymore? People who know what they're talking about.

The higher default rates on mortgages extends well behyond the subprime level. Those empty subidivisions in California weren't cheap houses with subprime loans.

Also, you completely ignored the fact that the higher level of risk in subprime mortgages was already priced in when they were originated and sold. If this had been done right, the defaults at all levels wouldn't have caused such a huge collapse in MBS values - said collapse, and not the housing bubble itself - being the cause of the economic meltdown.

[Pro Libertate]

I wasn't aware that anyone was arguing that subprime wasn't a major component to the meltdown. It certainly was. The default rates on ARMs and some of the other more exotic prime products isn't the core problem here. MBSs and other derivatives that had major subprime elements are. Subprime lending shot through the roof once the secondary market became eager to trade in paper backed wholly or in part by subprime mortgages, making the problem even worse. The debt-multiplier effect from overvaluing subprime paper is the real kicker. Oops.

[joe]

Pro Lib,

The laws you refer to are about interest rates paid by the borrowers, not about the value of bundled loans. In pricing MBSs that included those loans, the bundlers and buyers were, in theory, looking at the chance of default and the interest rates, so lower-than-market interest rates would have made the MBSs value lower.

But they didn't do it very well - they seem to have been overly-optimistic about defaults, based on an assumption of ever-rising home values.

[P Brooks]

the higher level of risk in subprime mortgages was already priced in when they were originated and sold.

It was? By whom?

[Rich Ard]

You know who doesn't call it "the subprime mortgage crisis" anymore? People who know what they're talking about.

This is a pretty amazing effort to deny that the first round of defaults came overwhelmingly from the subprime market; and the number of loans matters immensely. A neighborhood with ten foreclosed properties has a greater ripple effect than does a single foreclosed home with a bigger dollar sign on the front page of the mortgage.

...the higher level of risk in subprime mortgages was already priced in when they were originated and sold. If this had been done right...

Come on man, you've gotta admit that's a pretty funny sentence.

[Hazel Meade]

joe,
Read the link I posted above. Yes, defaults and foreclosures are up across the board, but they are especially higher in the subprime market. So far, you havn't provided a single link to back up your claim that subprime default rates aren't higher than those of prime loans.

Also, the whole problem with MBS's is that the higher risk was NOT priced into the securities. You obviously havn't read the article carefully enough, since that's one of the main points. The banks realized that they could sell to Fannie and Freddie and started slicing subprime loans into the securities. The ratings agencies didn't look under the hood, so people were buying up risky securities without knowing it. Hence, when the default rate went up, everyone freaked and stopped trading MBSes, and thus we get "toxic assets".

[joe]

jsh,

Just to be clear, what that article is about is the bundling of loans by non-banks who weren't subject to the CRA, to be bought by banks looking to satisfy their CRA requirements by purchasing loans (and their derivatives) in CRA-covered neighborhoods. In other words, we're still not looking at the CRA forcing banks to make irresponsible loans, but MBSs being bought by buyers at the wrong price, based on faulty assumptions about their risk and value.

[jsh]

In other words, we're still not looking at the CRA forcing banks to make irresponsible loans,

No, we evidently seem to be looking at CRA/Fannie/Freddie 'encouragement' to buy irresponsible loans.

[Pro Libertate]

The rates on the paper underlying the securities of course did play a role in the valuation of the securities themselves. As did the fee income and other features of the loan that would provide income/cash flow (not to mention the "value" of the house in the event of foreclosure). There was a half-assed attempt to consider default risk in the bundling of these loans, but I think we can all safely agree that no one knew what the real default risk was back then. The fact that so many data points were wrong--borrower's income, value of the house, etc.--made valuation difficult at best, anyway.

I don't want to go too far in making all of these pronouncements, because the whole mess had a lot of causes and a lot of aggravating factors. The looniness of mortgage brokers and lenders as well as borrowers played no small role. But we'll probably never fully understand all of what went wrong.

[joe]

Also, jsh,

First passed in 1977, the CRA was "strengthened" in 1995, causing an increase of 80% in the number of bank loans going to low- and moderate-income families.

The key word here being BANK loans. The CRA only covers banks. In fact, banks have much lower default rates on their loans in CRA-covered neighborhoods than non-banks which aren't subjec to CRA. The effect of the act was to expand the availability of responsible loans in those neighborhoods, resulting in some segment of the market borrowing on more responsible terms than they otherwise would have. The end result is that the CRA reduced default rates, not increased them.

[joe]

Hazel doesn't understand risk-pricing, and isn't interesting in finding out.

For those who are: the issue is not whether subprime mortgages default at higher rates than prime. Of course they do. That's why they're worth less on the secondary mortgage market, and why the MBSs made out of them are supposed to be worth less - because a higher % of them are expected to default.

To show that subprime mortgage defaults caused this crisis, you'd have to show that their change in default rates, the difference between their real and expected default rates, was larger than that of loans at other levels.

[joe]

ChanceH | December 3, 2008, 1:30pm | #

Buying a bond is the same thing as making a loan. Uh, yeah, and buying a car is the same thing as manufacturing one. WHAT?

Beyond the logical, definitional flaw in this statement, there's an important factual problem: the people who issued loans were in a much better position to understand their risk, as they were looking at individual loans, while the people buying and bundling them had the fog of a flawed risk model (or, a model with flawed inputs) making a portfolio of such loans seems safer than they were.

[joe]

joe, you're conveniently skipping over the difference between the GSEs and corporations like Citigroup. It was widely understood that there was an implicit government guarantee behind the GSEs. You even acknowledge that in your second paragraph: "But my point about their private status wasn't that they had no government guarantee - they clearly did..." Nice close edit. Why did you cut off the part that contains the central point I was making?

How come you can never, ever admit when you make a bad argument?

Because it's not a bad argument, but a completely accurate one, which is why you had to mutilate it to make it look like a bad argument.

I'm not skipping over the fact that the GSE's had and "implicit government gurantee," I'm pointing out that the other players in this market, like Citi, had that same implicit guarantee. You know this, because you had to append that elipsis to the chopped statement, so wtf is your problem?

I'm not going to sit here and worry about "admitting" that an argument I didn't make was bad.

[Hazel Meade]

That's why they're worth less on the secondary mortgage market, and why the MBSs made out of them are supposed to be worth less - because a higher % of them are expected to default.

The key word being "supposed". In actuality, nobody knew what they were buying because these mortgages were sliced and diced into securities and derivatives, and the ratings agencies weren't paying attention. ence the "market price" did not effectively represent the actual risk. In other words, read the article.

To show that subprime mortgage defaults caused this crisis, you'd have to show that their change in default rates, the difference between their real and expected default rates, was larger than that of loans at other levels.

Try reading the link I posed above.

http://www.mbaa.org/NewsandMedia/PressCenter/58758.htm
The seriously delinquent rate was 52 basis points higher for prime loans and 460 basis points higher for subprime loans.

[joe]

Pro Lib,

The debt-multiplier effect from overvaluing subprime paper is the real kicker. This is my point exactly - if the MBSs that included subprime loans had been priced correctly, the increase in subprime lending wouldn't have set off the crisis.

But that problem isn't limited to subprime lending. MBSs based on Alt A and prime loans were overvalued, too.

[Hazel Meade]

joe,
Another difference between the GSEs and the regular banks is that the regular banks weren't under explicit instructions from the government to make 56% of the loans (they purchased) to low-income borrowers.

[joe]

P Brooks,

It was? By whom?

Interest rates on subprime mortgages are higher than for prime. That's how the banks price in risk.

In theory, the purchase price of MBSs prices in the risk of the underlying loans. This is what didn't work out so well.

[Pro Libertate]

joe,

I'll grant that everything was overvalued, especially considering the housing price bubble that burst in most markets. However, the unanticipated defaults are the biggest problem, and those are happening far, far more in subprime than anywhere else.

As usual, all the guilty parties here--lenders, borrowers, investors, rating agencies, government actors--all got hung by the usual petard: arrogant ignorance.

[Mike Laursen]

You know this, because you had to append that elipsis to the chopped statement, so wtf is your problem?

If you don't see the difference between the widely-perceived implicit guarantee behind the GSEs and the unexpected, post facto implicit guarantee behind corporations like Citigroup, you're clearly dissembling to avoid admitting you're wrong.

[Seward]

Wow, the government promotes a loose or "cheap" money policy and it blows up in our faces. Who could have predicted that? I mean, that has never, ever happened before! 0_o

[joe]

The key word being "supposed". In actuality, nobody knew what they were buying because these mortgages were sliced and diced into securities and derivatives, and the ratings agencies weren't paying attention. ence the "market price" did not effectively represent the actual risk. In other words, read the article.

Not only did I read the article, but I've both made this point several times, and knew this before this article was written. Please, Hazel, talk down to me more.

Try reading the link I posed above. I did. Defaults on prime ARMS increased by 40% (from 0.62% to 1.02%), while defaults on subprime ARMS increased by 23%, from 3.84% to 4.72%.

Risk-pricing is based on the % of loans you expect to fail.

[joe]

Rich Ard,

This is a pretty amazing effort to deny that the first round of defaults came overwhelmingly from the subprime market; and the number of loans matters immensely. A neighborhood with ten foreclosed properties has a greater ripple effect than does a single foreclosed home with a bigger dollar sign on the front page of the mortgage.

Point taken, but I was talking about the financial sector, not neighborhood impacts.

[Seward]

Mike Laursen,

One thing to derail a progressive's thinking with is to note that MBSs were created by the government.

[ChanceH]

Scenario 1:

Party A gives 100 dollars to Party B. Party B makes 10 monthly payments of 11 dollars back to Party A.

Scenario 2:

Party A gives 100 dollars to Party B. Party B makes 10 monthly payments of 11 dollars back to Party A.

So joe, using your superior skills of logic, and your superior knowledge of financial definitions, please tell me which of the above scenarios is the loan, and which is the purchase of a bond.

[Pro Libertate]

joe,

Most lenders didn't engage in true risk-based pricing. That's a part of the overall problem. And, as I noted above, the regulatory framework prevented lenders from accurately pricing a good number of the subprime loans. When I was working for a bank, I saw charts that showed the actual risked-based pricing matrix (that we wanted to institute) and the legal cap. For the lower end of the credit spectrum, the rate that should have been charged was hundreds of basis points higher than the maximum rate that could be charged.

In a sane world, both the government and the lenders would've agreed that loans that priced over the cap shouldn't be made at all.

[Seward]

Mike Laursen,

More to the point, as many have noted, without the perceived guarantee the GSEs in question would not have likely grown to be so large because their profitability would have been more like any other company in the area of business it dealt with.

[joe]

No, we evidently seem to be looking at CRA/Fannie/Freddie 'encouragement' to buy irresponsible loans.

You've mixed a couple of things up here. Freddie and Fannie, like City and a lot of other similar organizations, irresponsibly bought loans. Even if they'd bought exactly the same loans, but had packaged and sold them at the right price (ie, had accounted for the risk correctly), there wouldn't have been a problem.

As for the CRA encouraging the purchase of MBSs, again, that wouldn't have been a problem, if the MBSs were priced correctly for the risk.

[Other Matt]

No, addressing exactly the point YOU raised. You said I accused Flynn of saying the CRA caused this. Back up, or shut up.

No, I didn't say a f-ing thing to you. I was talking to someone else, pointing out how fruitless it was to say something involving facts to you.

As I said "Look over there! Something completely different!"

[Hazel Meade]

Defaults on prime ARMS increased by 40% (from 0.62% to 1.02%), while defaults on subprime ARMS increased by 23%, from 3.84% to 4.72%.

Holy freaking cherry picking.
Not to mention avoiding the fact that the basis point increase is larger for suprime ARMs than prime ARMs (88 vs. 40).

You really can't admit when you're wrong can you? The entire thrust of that article is "Holy Shit the Subprime Market is Imploding!!!" and you manage to excise the one statistic that can be twisted to make it look like it's not.

[P Brooks]

Interest rates on subprime mortgages are higher than for prime. That's how the banks price in risk.

In theory, the purchase price of MBSs prices in the risk of the underlying loans. This is what didn't work out so well.

Nice theory. However, it is plainly obvious that the originators of the individual loans, many of whom were not banks, did not apply anything close to an appropriate risk premium, because they *knew* somebody [Fannie? Freddie? Anyone?] would buy and securitize them, and that their fees would be safely in the bank by the time the borrower went tits up.

If the risks associated with these loans had been priced appropriately, we wouldn't be in this mess. But Barney Frank couldn't shake down Franklin Raines, Toll Brothers, et al, if that were the case.

There is PLENTY of blame to go around.

[Mike Laursen]

One thing to derail a progressive's thinking with is to note that MBSs were created by the government.

Interesting. I'd never heard about that before.

[joe]

Well, Mike Lauren, given the $700 billion and growing bailout we just saw, I have to say that my "failing to see" the difference in the implicit guarantees given to the GSEs vs. those given to Citi and the other investment banks isn't so much a "failure" as "completely effing right."

They both knew there was implicit backing, so they were both likely to take risks.

[Seward]

Anyway, the deepest roots of this crisis clearly lays in government action, primarily in the effort to make every person in the U.S. a homeowner. I've heard this policy analogized to that of the industrial policies undertaken by other countries, and that analogy fits fairly well.

[Seward]

Mike Laursen,

Yeah, I don't think they existed prior to the creation of Fannie Mae and its efforts to create a secondary market in mortgages.

[joe]

Hazel Meade | December 3, 2008, 1:57pm | #

joe,
Another difference between the GSEs and the regular banks is that the regular banks weren't under explicit instructions from the government to make 56% of the loans (they purchased) to low-income borrowers.

And another difference is that they are headquartered in the DC metro area instead of New York. So?

What does changing the subprime/non-sub-prime split of the overall market between the GSEs and the "private" investment banks have to do with the crisis? If some % of the hit that Freddie and Fannie took had been taken instead by Citi - that is, if the GSEs' portfolio has a slightly lower % of low-income loand and the "private" investment banks had owned slightly more, what different would that have made in how the meltdown played out?

[Hazel Meade]

Even if they'd bought exactly the same loans, but had packaged and sold them at the right price (ie, had accounted for the risk correctly), there wouldn't have been a problem.

Well, not exactly. Even if the securities were priced lower, you'd still have the hosuing bubble and the collapse to deal with.

Arguably, without the steady stream of cash available from purchased securities the housing bubble might not have inflated as much (we can't be sure).

I think the key point of the article you are missing is that Fannie and Freddie created a perverse incentive to entangle subprime loans with the higher "tranches", since banks knew they would buy these products to fulfill their quotas. That helped to obscure the true risk as well as pumping money into the subprime bubble that otherwise wouldn't have been available.

[P Brooks]

Would this be a good time to bring up the concept of regulatory arbitrage?

[joe]

Chance H,

The difference between a loan and the purchase of a bond doesn't lie in anything you provided in your simplistic description.

[Seward]

P Brooks,

How about a regulatory lottery? 🙂

[joe]

Pro Lib,

I understand what you're saying. My point is that the additional, uncompensated risk resulting from the loans should have been priced into the MBSs, and wasn't.

In a sane world, both the government and the lenders would've agreed that loans that priced over the cap shouldn't be made at all. I wouldn't make such a sweeping statement, but there certainly should have been less of it. Getting banks to extend a little more risk to lower-income borrowers can be defended on policy grounds (and would have been a much smaller chunk of change), but letting that lowered risk aversion to extend to multiple refinances on homes worth $600,000 to upper income familes - what was that supposed to accomplish?

[joe]

One thing to derail a progressive's thinking with is to note that MBSs were created by the government.

MBSs themselves aren't a bad thing. They're a very valuable tool - if they're handled right. They were dependable, stable instruments for years, before the ratings and risk-pricing went all pear-shaped, and higher-risk loans were getting rolled in without their ratings, and thus their price, changing.

[joe]

Holy freaking cherry picking.

OK, look at the other numbers. Across the board, default rates increased by a larger % in prime than subprime.

If I'm counting on an X% default rate on prime loans and Y% default rate on subprime, and I've built in a margin that allows them each to be 10% higher than either of those figures, it's going to hurt me more if prime loans default 20% more often then I thought than if subprime defaults 10% more than I thought. This is true even if the prime default rate is lower than the subprime default rate, and even if the subprime default rate rises by more basis points.

[jsh]

Across the board, default rates increased by a larger % in prime than subprime.

The higher % increase is a result of the lower starting point. 1 + 1 is a 100% increase. 10 + 5 is a 50% increase. Which is worse?

[joe]

P Brooks,

Your statement doesn't contradict mine at all.

However, it is plainly obvious that the originators of the individual loans, many of whom were not banks, did not apply anything close to an appropriate risk premium, because they *knew* somebody [Fannie? Freddie? Anyone?] would buy and securitize them, and that their fees would be safely in the bank by the time the borrower went tits up.

And the GSEs initially, and other investment bbanks later, were willing to buy them, and buy them at the wrong price, for exactly the reason I described. If they were paying lower prices for riskier loans, the lenders wouldn't have as much incentive to make those risky loans. They would have made better loans, or fewer, if the buyers - and both the GSEs and the investment banks fall into this category - were pricing the risk correctly.

[Seward]

I'm not exactly sure why a higher default rate in the sub-prime market should be all that surprising. After all, there is a reason why they call it a sub-prime market.

[joe]

Hazel,

Even if the securities were priced lower, you'd still have the hosuing bubble and the collapse to deal with. Arguably, without the steady stream of cash available from purchased securities the housing bubble might not have inflated as much (we can't be sure). Right, right. I meant just the financial meltdown. We still would have had a popping real estate bubble, and the subsequent recession.

I think the key point of the article you are missing is that Fannie and Freddie created a perverse incentive to entangle subprime loans with the higher "tranches", since banks knew they would buy these products to fulfill their quotas.

But, once again, that wouldn't have been a problem, if the GSEs and other loan buyers/bundlers were buying them for the right prices, and if the buyers of those bonds were buying then at the right prices. But I absolutely agree, the ability to make good money selling risky loans created a moral hazard for lenders, resulting in more ill-advised loans.

[bob]

At this point I wouldn't be surprised if Santa Claus begged congress to bailout Christmas.

They'd probably go for it.

[joe]

Seward,

It's not a surprise. That's also why subprime loans have higher interest rates, and why securities that include subprime loans should have lower prices.

[Hazel Meade]

They would have made better loans, or fewer, if the buyers - and both the GSEs and the investment banks fall into this category - were pricing the risk correctly.

Or, maybe, if they weren't being ordered by Barney Frank to buy more low income loans in exchange for covering up their bad accounting.

[joe]

So the question I have is, why did the value of MBSs inflate so much?

Was there an honest screw-up in the understanding of mortgage risk?

Was there bubble behavior not just in the real estate market, but in the mortgage-paper market as well? That is, were people overpaying for MBSs because they thought they could sell them at an an even higher price to yet another speculator?

Was is those derivatives-of-derivatives that the "Liar's Poker" author described?

[joe]

Or, maybe, if they weren't being ordered by Barney Frank to buy more low income loans in exchange for covering up their bad accounting.

Congress could have ordered the GSEs to buy a zillion loans, if they had been priced correctly for the risk, it still wouldn't have produced the moral hazard for the lenders.

Not to mention, the decline in real estate values wouldn't have caused a cascade of financial failures, because investment banks wouldn't have leveraged themselves so much to buy those go-go MBSs.

[Seward]

Hazel Meade,

Well, I think it is pretty clear by this point that the entire mess is an example of government failure (something which libertarians (liberals) constantly warn about). It is where we go from here with that knowledge which is most important.

[ChanceH]

The difference between a loan and the purchase of a bond doesn't lie in anything you provided in your simplistic description.

So "Fannie and Freddie didn't make loans", but they did hand out money, with a contractual agreement that they'd get a future cash flow which repayed all the principal plus some interest?

Why is this not a loan? To my simplistic mind it looks like a loan. What are the important nuances I have missed here?

Does everybody else here agree with joe? that "Fannie and Freddie didn't make loans"?

[Seward]

ChanceH,

While not authoritative, this is what wikipedia states:

A bond is simply a loan in the form of a security with different terminology: The issuer is equivalent to the borrower, the bond holder to the lender, and the coupon to the interest. Bonds enable the issuer to finance long-term investments with external funds. Note that certificates of deposit (CDs) or commercial paper are considered to be money market instruments and not bonds.

[jsh]

Does everybody else here agree with joe? that "Fannie and Freddie didn't make loans"?

Does it matter, only an idiot would claim Fannie/Freddie don't represent govt involvement in the housing loan market. Did the govt make bad loans, mandate bad loans, encourage bad loans? Does selecting one of those over the other two absolve the govt of responsibility?

[Pro Libertate]

They didn't make loans directly to borrowers. I believe that's accurate. They funded all sorts of other nonsense, though.

joe,

The misvaluation of MBSs was only part of the problem. The real kicker was acquiring many multiples of debt (in some cases up to 30-1) based on assets of questionable value. Once those assets exploded, that debt bubble collapsed. That was the day the music died.

[joe]

I don't know why you're making this so complicated, Chance. Freddie and Fannie didn't make loans. They bought loans. You can use all sorts of clever descriptions to blur the difference between making a loan and buying one, but they're not the same thing.

When Freddie Mac bought a mortgage from MomNPop Bank, they weren't lending them the money; they were buying an asset.

The reason this matters is because Freddie and Fannie weren't the ones establishing the terms of the loan, or approving the applicants.

[Seward]

Pro Libertate,

They did ease credit requirements though, right? Which is presumably integral to the loan making process.

[joe]

Does it matter, only an idiot would claim Fannie/Freddie don't represent govt involvement in the housing loan market.

Good thing no one's said that, then.

[Seward]

Apropos my last remarks it should be noted that Fannie Mae was not simply in the loan buying business, it was as best as I can tell in the loan encouraging business. So it is and presumably still is intiminately involved in who and who does not get a loan.

[joe]

Pro Lib,

The misvaluation of MBSs was only part of the problem. The real kicker was acquiring many multiples of debt (in some cases up to 30-1) based on assets of questionable value. Once those assets exploded, that debt bubble collapsed. That was the day the music died.

Maybe this is an ideological question, but would those levels of leveraging have been a problem if the asset was accurately priced for the risk?

[jsh]

How about this part, Joe?

"Does selecting one of those over the other two absolve the govt of responsibility?"

[Mike Laursen]

...if the GSEs' portfolio has a slightly lower % of low-income loand and the "private" investment banks had owned slightly more, what different would that have made in how the meltdown played out?

Hard to say. There's no way of knowing how many additional low-income loans the private investment banks would have been willing to buy.

[Seward]

Pro Libertate,

So, absent the sort of significant government intervention we've seen in an effort to put a home in every pot, it seems unlikely we would have had this bubble. Would you agree with this?

[Mike Laursen]

The reason this matters is because Freddie and Fannie weren't the ones establishing the terms of the loan, or approving the applicants.

No, it's actually an unimportant distinction. If Freddie and Fannie were willing to buy up loans that weren't sufficiently scrutinized at the time they were made, then they were encouraging the bad practices.

[joe]

jsh,

"Does selecting one of those over the other two absolve the govt of responsibility?"

It may. If the involvement the government has with the GSEs isn't what caused them to behave badly - if they went hog wild in buying loans and leveraging themselves based on the ephemeral value of MBSs in order to raise their stock value, turn profits, and give big bonuses to their officers - then the government involvement isn't responsible.

It's probably best to say that the government was responsible for some of Fannie and Freddie's bad behavior, while the same forces that drove other investment banks to bad behavior was responsible as well.

You sometimes see this argument, I call it the "libertarian one drop rule," made - if there is any government involvement in a problem, the entirety of the blame shall be put on the government, there are no reforms necessary other than ending the government involvement, and no other causes shall be considered.

[Pro Libertate]

joe and Seward,

Yes, I blame the government's meddling primarily for this getting as out of hand as it did, and yes, if the MBSs (and other derivatives) had been properly valued, the scope of the damage would've been much less.

[Mike Laursen]

Yup, some libertarians do engage in the one-drop rule. You acknowledge that not all libertarians think that way, yes?

[jsh]

You sometimes see this argument, I call it the "libertarian one drop rule," made - if there is any government involvement in a problem, the entirety of the blame shall be put on the government, there are no reforms necessary other than ending the government involvement, and no other causes shall be considered.

And the Joe one drop rule is that if anyone outside govt is involved, the govt is totally blameless and must have more power.

How responsible was the govt for this mess? What were the total dollar amounts of bad Freddie, Fannie, CRA, etc loans?

[joe]

There's no way of knowing how many additional low-income loans the private investment banks would have been willing to buy.

No, not in any absolute sense, but if you look at the last five or so years, the private investment banks were doing some pretty crazy things. Did you see that story by the author of Liar's Poker a couple days ago? Yikes!

No, it's actually an unimportant distinction. If Freddie and Fannie were willing to buy up loans that weren't sufficiently scrutinized at the time they were made, then they were encouraging the bad practices. As were everybody else who bought mortgages, then, but the point is, with the lenders merely being "encouraged," they too bear responsibility, and this isn't just a problem with the government.

Not to mention, even with all of the loan-buying in the world, the lack of standards for loans was the government's fault in the sense of being too uninvolved, not overly involved. If liar loans had been banned, the banks wouldn't have issued liar loans, no matter what Freddie and Fannie were told to buy.

[jsh]

Ah, so the govt is only responsible if it puts a gun to your head, not if it bribes you.

Hmmmm..... The people torturing WoT suspects weren't threatened with jail if they refused, they just might have lost their paychecks. I guess the govt, and thus the Bush admin, isn't responsible for torture.

[joe]

Mike,

Yes.

jsh,

And the Joe one drop rule is that if anyone outside govt is involved, the govt is totally blameless and must have more power. Uh, yeah, Lord knows I never blame the government for anything. WTF?

What were the total dollar amounts of bad Freddie, Fannie, CRA, etc loans? I don't know the answer to those. I do know that the CRA reduced irresponsible lending and reduced default rates, so the size of the dollar value for CRA loans is a measure of how much government involvment, in that particular area, reduced the mortgage meltdown - which is, not much, since the CRA is such a small part of the overall lending market.

Did you know that Cato came out with a paper a few years ago arguing for the abolition of the CRA on the grounds that the rise of mortgage lenders willing to provide all sorts of screwy loans in low-mod neighborhoods rendered efforts to make bank loans available unnecessary? Sheesh, think of how much worse this would be if 100,000 plain vanilla bank and credit union mortgages, which the borrowers could afford, had been replaced by exploding option ARMs and the like, as Cato would have had it.

[Seward]

Mike Laursen,

Yup, some libertarians do engage in the one-drop rule.

And of course no one has engaged in such here today.

[jsh]

"I do know that the CRA reduced irresponsible lending"

Site?

"Did you know that Cato came out with a paper a few years ago"

Saying that the market would make the bad loans, or that the loans that were worth making would be made by the market. Two different things.

[The Angry Optimist]

If Freddie and Fannie were willing to buy up loans that weren't sufficiently scrutinized at the time they were made, then they were encouraging the bad practices.

Even worse would be if they were actively incentivizing poor lending practices by making it a point not to know or understand what they were buying.

[joe]

Ah, so the govt is only responsible if it puts a gun to your head, not if it bribes you.

This bears no resemblance to anything I've written. I'M not the one arguing that responsibility must only be assigned to one or the other, so your snark here is misguided.

Seriously, what's so difficult about this passage: It's probably best to say that the government was responsible for some of Fannie and Freddie's bad behavior, while the same forces that drove other investment banks to bad behavior was responsible as well.

How do you get from that to "the government has no responsibility?"

[Seward]

joe,

Not to mention, even with all of the loan-buying in the world, the lack of standards for loans was the government's fault in the sense of being too uninvolved, not overly involved.

The lack of standards was actually encouraged by the government. That is well known by this point and completely uncontroversial.

[The Angry Optimist]

Not to mention, even with all of the loan-buying in the world, the lack of standards for loans was the government's fault in the sense of being too uninvolved, not overly involved.

Are you for reals with this, joe? Relaxed lending standards were pushed by the government. Both parties, I might add, encouraged the easement of lending standards.

[J sub D]

joe | December 3, 2008, 12:58pm | #

Oh, look, OtherMatt can't read, either.

joe | December 3, 2008, 1:22pm | #

Oh, Jeebus, now you have to to start with the insults.

Kinda like Billy Martin calling others drunkards.

[joe]

The lack of standards was actually encouraged by the government.

Only in the sense of their not passing regulations forbidding it. Not a common libertarian argument.

You'll have to forgive me, but what is "widely known and uncontroversial" on libertarian comment threads doesn't necessarily hold true in the larger world.

[Seward]

Indeed, more to the point, in order for the U.S. government (meaning here, people in the government) to pursue its industrial policy of putting a home in every pot, it had to encourage lax standards. Indeed, even if it did so initially to encourage just one small segment of the potential home buying market the way mission creep works in government it was always going to necessarily bleed over into other areas of the potential home buying market.

It is a perfect example of a one-size fits all approach falling flat on its face. Instead of the diversity of an open market the government opted for something that far more resembles a planned economy.

[joe]

Oh, thank God J sub D chimed in! Such a significant contribution to the thread!

Hey, J sub, I'm n yr hed, obsessin yr thawts agin!

BTW, why didn't you copy the comment from OtherMatt I was responding to:

Don't confuse joe with facts when he's trying to hijack a thread.

BAD JOE! Insulting people like that!

[The Angry Optimist]

Only in the sense of their not passing regulations forbidding it. Not a common libertarian argument.

Who do you think directed FNM/FRM not to pay attention to the content of the securities they were buying?

[joe]

Indeed, more to the point, in order for the U.S. government (meaning here, people in the government) to pursue its industrial policy of putting a home in every pot, it had to encourage lax standards.

This is a bit misleading. The loosening of standards for purchases of, and refinancing on, high-prices homes in the suburbs was completely unnecessary for the goal of promoting homeownership.

[Seward]

joe,

No, in the sense that pressure was brought to bear on Fannie Mae, etc. to loosen standards. From 1999. Check out paragraph three in particular.

[joe]

Who do you think directed FNM/FRM not to pay attention to the content of the securities they were buying?

Nobody. Nobody directed them to, nobody directed CitiGroup to, nobody directe Merril to, nobody directed the county governments that put MBSs in their short-term accounts not to pat attention to the content of the securities. They actually did pay attention - but they were highly rated, owing to systemic problem with pricing risk.

[The Angry Optimist]

Seward, from your link:

In moving, even tentatively, into this new area of lending, Fannie Mae is taking on significantly more risk, which may not pose any difficulties during flush economic times. But the government-subsidized corporation may run into trouble in an economic downturn, prompting a government rescue similar to that of the savings and loan industry in the 1980's.

Whew...the NYT wasn't just whistling Dixie.

[Seward]

joe,

It doesn't matter if it was unnecessary; it was what was going to happen. This is public choice economics 101. If you have a benefit to one party then other politically connected groups will also want that benefit and there will be no stopping them from getting it. This has been happening with all manner of government benefits since governments started handing out benefits. So it is not misleading; it is completely predictable.

[joe]

TAO,

See above, differentiating between lending standards for the purpose of encouraging homeownership - the pilot program you mention - and the across-the-board lowering of standards for things like refinances and jumbo loans.

[Mike Laursen]

As were everybody else who bought mortgages...

I guess we libertarians scrutinize the government's actions more because we voters/taxpayers/citizens, at least in theory, are supposed to have control over what the government does. We tend to not scrutinize the actions of private parties as carefully because we are philosophically/viscerally opposed to telling other people what to do.

[Seward]

TAO,

The best thing we could have done at the time was to downsize Fannie Mae, etc. by loosening the policies that led them to garnering such a large portion of the MBS market.

[Seward]

Mike Laursen,

I think libertarians (liberals) criticize both on average equally. However, one cannot simply ignore the 900 lb. gorilla standing in front of you either.

[Seward]

One thing I have as yet to see progressives talk about much is the monopoly power of the GSEs in this area. Which is rather odd given how progressives go on and on about the virtues of breaking up monoplies.

[joe]

Mike L,

I guess we libertarians scrutinize the government's actions more because we voters/taxpayers/citizens, at least in theory, are supposed to have control over what the government does.

But Freddie and Fannie aren't the government, and when their behavior is just like private entities, they're probably responding to the same things. By all means, it makes sense to look at what the government did; what doesn't make sense is to assume that the government did everything, and stop looking.

[argumentum ad hominem]

just going to throw it out there that I stopped believing that anything joe says is actually true when he asserted that a loan and a bond were not the same thing, then proceeded to defend his statement once more with some sort of appeal to his own authority, and then got utterly owned by the very definition, and then proceeded to pretend like he doesn't look like a dumbass asserting things that he can't guarantee to be true.

[joe]

Seward,

What monopoly power?

What business were the GSEs in that others were not? Certainly not the secondary mortgage market.

[J sub D]

joe,

What's the matter? The cramping, the bloating? Out of Midol again?

[Hazel Meade]

Joe: They would have made better loans, or fewer, if the buyers - and both the GSEs and the investment banks fall into this category - were pricing the risk correctly.
...

Congress could have ordered the GSEs to buy a zillion loans, if they had been priced correctly for the risk, it still wouldn't have produced the moral hazard for the lenders.

You are sort of contradicting yourself.
On the one hand, you're arguing that if risk were priced correctly, banks would have bought fewer MBSes. On the other hand, you're saying if they were priced correctly, they could buy an infinite amount of it without any consequences.

The latter position seems obviously wrong to me.

Clearly, the GSEs would have bought less of this stuff if they hadn't been under government pressure to buy it. And the banks would have bought less if it had been priced correctly. The issue is the interplay between A and B. Did the GSE's quota-induced irrational behavior distort valuations for MBSes and lead to perverse incentives for banks to engage in risky lending?

[Mike Laursen]

But Freddie and Fannie aren't the government...

I don't accept that premise, for reasons we've already argued about. Nothing more to say in that direction unless one of us changes his mind.

[joe]

I just reread the "buy a bond" exhange and figured out the problem: I read that "buy a loan and issue a loan," not "buy a bond."

Probably because Fannie Mae issues bonds, but buys loans.

I was going to comment, when the wikipedia definition was pasted, that that actually set up Fannie Mae as the borrower when it issued its MBSs, exactly the opposite of "issuing a loan," so its issuance of MBS isn't the same thing as issuing a loan, either.

[Paul]

There was a new push for tighter oversight on the Hill, but this too withered as Fannie and Freddie rallied support through increased lending to low-income borrowers.

AKA "community investment".

"Community Investment" is one of those things that sells itself on the Hill.

[Paul]

We're all government sponsored enterprises, now.

[joe]

joe,

What's the matter? The cramping, the bloating? Out of Midol again?

No, it's just fun to whack away at you when you do your usual thing of writing pointless personal attacks without the slightest connection to the discussion. When you set yourself up for it with a really easy-to-prove bit of disingenuity, that's just gravy.

[Pro Libertate]

Anyone catch the stomach "flu" going around? My whole family has it, and I feel it starting with me. This variety involves lots of vomiting.

[Huh?]

Huh? joe is hacking away at himself?

[moody\'s]

in light of joe's surprising admittance to a mistake, his credibility rating has been adjusted upward.

no, but seriously, it's pretty rare that people 'round these parts admit a mistake. good for you.

[joe]

Hazel,

On the one hand, you're arguing that if risk were priced correctly, banks would have bought fewer MBSes. On the other hand, you're saying if they were priced correctly, they could buy an infinite amount of it without any consequences.

There's no contradiction. Since Diet Coke has a sugar substitute instead of sugar, I can drink as much as I want without getting fat. I won't, however, since I don't like sugar substitutes. Taking out the sugar means I could drink all I wanted, AND it means that I wouldn't drink very much.

Also, I didn't write "without any consequences." I was saying that the demand wouldn't have caused the banks to provide supply of things that they weren't allowed to supply.

[Hazel Meade]

"Community Investment" is one of those things that sells itself on the Hill.

It has the word "community" in it, which is almost as effective as "children", when it comes to emotive arguments.

[ChanceH]

I don't know why you're making this so complicated, Chance.

I'm not making it copmlicated. I in fact made it as simple as I could, and you informed me that I was being too simple. You told me I was wrong, by definition, and then refused to provide your definitions.

I'm now guessing that you don't know the difference between "making" a loan and "originating" a loan, and that really is most of where our dispute lies. If this was merely a case of ignorance of a particular jargon, and you could admit such a thing, it really wouldn't have taken so long. But you had to be a pompous windbag about it, and prolong the agony.

Of course, as other people have pointed out, once everybody knows that Fannie and Freddie are going to buy up all the crap, the originator of the loan really isn't that important. But I wasn't even going to get into that until the absurd statement "Fannie and Freddie didn't make any loans" had been completely crushed.

[Seward]

joe,

The vast majority of MBSs were bought by them (as was part of the original design of Fannie Mae I believe). Its funny, 19th century monopolies created by market actors pushed down prices across the board, whereas in 20th and 21st centuries government created monopolies push up prices (until they collapse).

[Hazel Meade]

I was saying that the demand wouldn't have caused the banks to provide supply of things that they weren't allowed to supply.

But you said that the government could order the GSEs to buy a zillion subprime loans without causing "moral hazard". (Whatever that means in this context).

So now are you saying that the GSEs buying a zillion subprime loans wouldn't have increased demand for subprime loans?

You are growing incoherent.

[joe]

Hazel,

Clearly, the GSEs would have bought less of this stuff if they hadn't been under government pressure to buy it. This stuff here means loans, right?

And the banks would have bought less if it had been priced correctly. "It" here means MBSs, right?

The issue is the interplay between A and B. Did the GSE's quota-induced irrational behavior distort valuations for MBSes and lead to perverse incentives for banks to engage in risky lending?

I don't think that's quite it. The values of MBSs didn't increase because Fannie and Freddie sold more of them. MBS prices weren't set by Freddie and Fannie - they were traded on the open market, with prices set by speculators.

What would be the mechanism by which more loans purchased by the GSEs would cause the risk of MBSs to be underestimated and their value to rise?

[joe]

Sure, Moody's, like anyone's going to belive YOU at this point!

I'm at a, what? Quadruple A?

😉

[jsh]

What would be the mechanism by which more loans purchased by the GSEs would cause the risk of MBSs to be underestimated and their value to rise?

A govt guarantee?

[joe]

ChanceH,

So, all this strutting is about the fact that I wrote "loan" instead of "mortgage," in a thead about mortgage lending, and you used language sufficiently imprecise so as to blur the difference between a mortgage and a bond?

Wow. Congratulations. You...uh...you didn't really accomplish anything there except demonstrate that you're pednantic. Impressive.

[Pro Libertate]

I think jsh is right. Why worry too much about proper valuation when someone's got your back? Keep riding on the gravy train!

[Seward]

Hazel Meade,

So now are you saying that the GSEs buying a zillion subprime loans wouldn't have increased demand for subprime loans?

Well, at some point you'd have market saturation I guess, but by that time you'd have had massive overbuilding and thus significant waste. Just like you see in countries that try to centrally plan their housing sectors (other centrally planned economies underbuild or misbuild). So on the level of economic effeciency it is not a smart idea. Note all the over building we had as a result of this government created housing bubble in the U.S.

Anyway, I don't know if this directly addresses your conversation, but if the GSEs were ordered to buy them no matter what the internals of those MBSs then moral hazard would be thrown out the window.

[joe]

Seward,

Seward | December 3, 2008, 4:22pm | #

joe,

The vast majority of MBSs were bought by them

I think you mean "owned by them," rather than "bought." I think it's in the 50-70% range, isn't it? That's not much of a monopoly.

Man, if Freddie and Fannie had a monopoly on owning Mortgage Backed Securities, and none of the banks and investment houses owned any (or only owned a little), we wouldn't be in this mess!

[Seward]

Hazel Meade,

Except in this case we have the government trying to centrally direct the housing sector.

[joe]

I'm not incoherent, Hazel. As usual, I just have to explain everything to you twice. Seriously, lose the attitude, because it just motivates me to bitch slap you instead of explaining things, two or three times, in a polite manner.

So now are you saying that the GSEs buying a zillion subprime loans wouldn't have increased demand for subprime loans?

Once again, Hazel, I'm saying that the GSEs buying up a zillion subprime loans wouldn't have resulted in banks issuing and selling subprimte THAT DIDN'T MEET LEGAL STANDARDS. If it was illegal to issue subprime loans when the documents were written in blue ink, they banks wouldn't have issues, and sold, subprime loans written in blue ink. If it was illegal to issue and/or sell liar loans, then the banks wouldn't have issues and sold any liar loans.

Did you get it this time? Shall I use smaller words?

[Paul]

I'd say that the author set out to put all of the blame on the government and excuse the private actors,

Not quite, joe. The article does point to government meddling and politicking as the core to the issue, but I don't see the excuse of the private sector. In fact, if you'd pay attention more closely to libertarian thought on just these very matters, you'd know that libertarians trust corporations about as far as we can throw them-- especially when the government makes large amounts of free or easy money available.

From the article:

The department has begun a process to determine the assets it will buy and the manner it will set a price. As with everything in government, these are lobbyable moments, a time when swarms of financial service firms, investor groups, and housing advocates try to game the system for their clients or members.
[...]
The chairman of Goldman Sachs when the dodgy transactions took place was the man behind the 2008 bailout: Treasury Secretary Henry Paulson.

This doesn't translate to a love of the private financial firms, it's merely a recognition that they're going to act as expected, within the rules that government has explicitly set up.

And to be cynical, government is the natural landing place for a dodgy character like Paulson.

[jsh]

Once again, Hazel, I'm saying that the GSEs buying up a zillion subprime loans wouldn't have resulted in banks issuing and selling subprimte THAT DIDN'T MEET LEGAL STANDARDS

GSEs buying up a zillion loans would increase the demand for loans, increasing the supply, causing standards to drop.

If it was illegal to issue subprime loans when the documents were written in blue ink, they banks wouldn't have issues

And all criminals obey gun control laws. "It can't happen, it's illegal".

[Seward]

joe,

Yes, owned. My use of the word bought doesn't take away from my point.

And 3/4s would be about right actually.

That's not much of a monopoly.

In the context of a private market actor with that sort of ownership we'd see many progressives bemoaning the market power of X company over Y product.

Anyway, why would we want government policies in place that would lead to such a concentration?

[joe]

jsh,

A govt guarantee? You'll have to explain. The question was, how would the purchase of more mortgages by the GSEs cause their values to rise.

"A govt guarantee"...what? The government won't let Freddie and Fannie go out of business, so therefore the prices of MBSs go up.

Is there a bit in the middle there?

[joe]

jsh,

GSEs buying up a zillion loans would increase the demand for loans, increasing the supply, causing standards to drop. Hence, the need for regulations rather than relying on the market to set standards. Regulation replacing market discipline.

And all criminals obey gun control laws. "It can't happen, it's illegal". Banks aren't criminals. Their livelihoods and profits rely on remaining the government's good graces, and the higher levels of overshight mean that they are much less likely to be able to slip anything through, and they know it.

[joe]

Seward,

On the monopoly, keep in mind that that 75% is divided between two distinct entities, which compete.

[jsh]

Hence, the need for regulations rather than relying on the market to set standards. Regulation replacing market discipline.

Ah, govt action encourages bad behavior, thus proving the need for more govt action. Gotcha.

[joe]

Whoope, "The question was, how would the purchase of more mortgages by the GSEs cause their values to rise."

Should be

"...cause the value of MBSs to rise."

[jsh]

and the higher levels of overshight mean that they are much less likely to be able to slip anything through, and they know it.

But I thought "deregulation" meant no oversight.

[Seward]

joe,

Before, I leave, I'd like to address this point you made in a different way:

Only in the sense of their not passing regulations forbidding it. Not a common libertarian argument.

In a way, it is the most common libertarian (liberal) argument (unless we're talking about that anarchist wing of libertarian thought). Liberals have no problem certain sets of rules created by governments to govern markets neutrally. What they have a problem with is goal setting rules (e.g., what the price of a product should be, the level of home ownership, etc.). It is the goal setting rules that get us into trouble time and time again, partly because they lead to economic ineffeciency and partly because they lead to more and more onerous involvement of the government in the lives of the individual. When a government can mandate wage and price controls (and thus wreck producers who don't want to go along and harm consumers with higher prices) it can also send undesirables to work camps or detention centers. That is liberalism in a nutshell.

[joe]

Ah, govt action encourages bad behavior...

I guess this depends on whether you consider the issuence of loans to be "bad behavior."

When you paint a house, you have to put down a drop cloth. You wouldn't need a drop cloth if you weren't paining the house. You also wouldn't get your house painted.

An objective analysis would look at whether encouraging homeownership in this manner accomplishes a good that outweighs the need to keep the banks honest.

A snarky commenter trying to score points, on the other hand, would look only at the costs, and bemoan them, without paying any attention to what the purchase.

[joe]

But I thought "deregulation" meant no oversight.

It does. Hence, the problem with not providing enough oversight of lending practices.

Although the problem was more one of never-regulation than of de-regulation.

[Seward]

joe,

On the monopoly, keep in mind that that 75% is divided between two distinct entities, which compete.

And both of those entities acted roughly equivalently due to the regulatory and political framework they worked under. One could have had twelve GSE's under those circumstances and the outcome would have been similar.

[joe]

Seward,

Once I got to the part where you were misusing the word liberal, I stopped reading.

[joe]

And both of those entities acted roughly equivalently due to the regulatory and political framework they worked under. One could have had twelve GSE's under those circumstances and the outcome would have been similar.

...which has nothing to do with the issue of monopoly power.

[Seward]

joe,

The house lenging sector has plenty of regulation (as anyone who has ever bought a house knows). Consider all that stuff one has to sign, all the things the negotiating parties have to agree to, etc. That is a result of regulation. The idea that there is a "never regulation" in the housing market is just, well, odd.

[jsh]

Hence, the problem with not providing enough oversight of lending practices.

Yes, but you both claim that the current regulations are sufficient to give you what you need for any given argument, but also insufficient enough to give you what you need for any given argument.

[Seward]

joe,

Libertarians are liberals. So I wasn't misusing the term in any way.

[Seward]

joe,

It has everything to do with monopoly power, from my POV.

[joe]

Seward,

Regulation is not a commodity to be measured by the pound, yard, gallon, or page. Writing that there is "plenty" of it is irrelevant.

A hundred pages on the carpeting in bank branches means nothing whatsoever about how loand go out.

And regulations that only apply to FDIC-insured lending institutions mean nothing whatsoever about how mortgage companies operate.

And now, libertarians are not liberals. Language changes. Deal with it.

[joe]

It has everything to do with monopoly power, from my POV.

Other insitutions were driven out of the MBS market by predatory GSEs, preventing them from dealing in them?

Would that this were so! We'd be a lot better off.

[Seward]

joe,

Regulation is not a commodity to be measured by the pound, yard, gallon, or page.

Au contraire. It is a commodity actually. Like any other government action it is subject to the vagaries of our public lottery system. Again, public choice economics 101. The government is like any other market actor; except it has some enhanced powers that other market actors do not.

And regulations that only apply to FDIC-insured lending institutions mean nothing whatsoever about how mortgage companies operate.

And no amount of regulation would have stopped the bi-partisan pressure from government to expand housing oppurtunities (be it in the type of house they could afford or in whether they could afford the home at all), thus leading to increased lending, that to inflation, that to incentives to enter an increasigly murky MBS market, etc.

[Seward]

joe,

No, other institutions felt no need in general to enter the market because of all the advantages (and they were significant) which those entities had. That ought to be obvious from their history. The government created MBSs and it had favored entities which they were largely funneled through. It had those favored entities because of certain foolish public policy choices the government wanted to undertake.

The way it was set up is rather indefenisble at this point. Now, if the government had been far more market oriented and created some general rules for what a MBS is and isn't that would have made a lot more sense. But governments aren't generally inclined to decentralization as best as I can tell.

And now, libertarians are not liberals.

Actually they are. The term is used to apply to libertarians in all manner of current scholarly texts.

[Seward]

joe,

Anyway, I'll just have to humbly agree to disagree with you on these matters.

Have an enjoyable evening.

[Hazel Meade]

An objective analysis would look at whether encouraging homeownership in this manner accomplishes a good that outweighs the need to keep the banks honest.

Exactly. We're witnessing the results of several decades of government policy of encouraging homeownership, particularly the last 10-15 years. Over that time period homeownership went from a historical average of 62% to about 69% at the bubble peak. Is that enough to make it "worth it"?

[jsh]

Is that enough to make it "worth it"?

The people who vote for liberals got houses, and the crash will be used as an excuse to force liberalism down our throats. How could it not be worth it, just because some mere individuals might get hurt?

[ChanceH]

So, all this strutting is about the fact that I wrote "loan" instead of "mortgage," in a thead about mortgage lending, and you used language sufficiently imprecise so as to blur the difference between a mortgage and a bond?

no joe, all this is about the fact that starting a conversation about the housing bubble with the statement that "Fannie and Freddie didn't make loans" is absurd and incorrect.

Fannie and Freddie did make loans. Because they bought bonds. And that is the same as making a loan. You were wrong, and I was right.

I don't recall any confusion over the term "mortgage", but a mortgage is a kind of a bond, since it is a loan. Judging by your "question", you still haven't figured that out.

Also, virtually all the imprecision in our sub thread is your fault, and all my attempts to increase the level of precision have been ignored or disparaged. You are the one not being precise enough in your language. Not me.

[jhn]

Any private companies that failed have only themselves to blame. All the information about the distortions the government put into the market was out there and could have been accounted for.

Any of the big companies that failed could have instead chosen to forgo short-term profits in exchange for long-term stability. But they did not.

What, exactly, about government policy FORCED any private actor to take counterproductive options?

The government frequently puts into place incentives which tempt companies to do stupid things. If they had balls and valued stability over bigness they'd ignore them.

[ChanceH]

but I'll agree with joe on one thing.

Fannie and Freddie could have used a lot more regulation. We should have regulated the living crap out of em. Like enough so that they couldn't do anything. Can we regulate the Federal Reserve too? So ya, it was all due to a lack of regulation if you want to look at it that way.

[jhn]

And who the hell cares whether the "goal of increasing home ownership" was carried out well or poorly? It's a stupid goal. Too many people own their own homes. Real estate is the stupidest investment, especially if all your worth is tied to it. We should decrease that shit.

So whether that goal is carried well, or poorly, the public loses.

[Alan]

As an "objective observer" I'd have to say that joe has a lot of credibility all the way around. He seems to be making valid distinctions and has a good command of facts. Given the ideological nature of this web site and of the frequent commenters, the over all impression is that he represents a disinterested and empirical, as opposed to a tendentious and ideological, point of view.

Keep up the good work joe!

[Mike Laursen]

joe, I think you're not considering the comparative feasibility of two ways of preventing "liar loans":
1. Regulation combined with government risk assumption: Requires honest intent to regulate, budget for enforcement, still has small chance of catching liar loans before it is too late. Private corporation that originates the loan has reduced motivation to self-regulate.
2. No regulation combined with no government risk assumption: Private corporation that originates the loan assumes the risk, and therefore has motivation to self-regulate.

[jg]

As an even more "objective observer," I'd have to say that joe has lost much credibility all the way around. He seems unable to make valid distinctions and has a questionable grasp of the facts. Given the inquisitive nature of this web site and of the frequent commenters, the overall impression is that he represents a contrived and anecdotal, as opposed to an analytical and logical, point of view.

Nevertheless, keep trying, joe!

: )

[Alan]

I don't know, he always impresses me. He patiently explains distinctions that seem to be ignored or misunderstood by others, e.g. that subprime lending is not coextensive with loans to poor people, or loans in low-income neighborhoods. He obviously has a command of the subject's technicalities and projects a sense of competence in applying them.

And claims to be "analytical and logical" are often the conceit of those who take an excessively ideological and non-emperical approach. I find his point of view realistic, reasonable, and factual.

[Alan]

Mark, you left out "Regulation with imposition of huge fines and jail time for repeat offenders". Works much better than the other two.

[Kolohe]

I'm not skipping over the fact that the GSE's had and "implicit government gurantee," I'm pointing out that the other players in this market, like Citi, had that same implicit guarantee.

Like Mike Lauren and others have said, this is a completely ridiculous argument. This is like saying AIG had an implicit guarantee but Lehman didn't. For everyone but Freddie and Fannie it was a complete luck of the draw (more precisely, the circumstances at the time). How Bear Sterns, Lehman, Freddie/Fannie, AIG, WaMu, Wachovia, Citi, GM/Ford/Chrysler were/are being treated are all different (some dramatically, some subtlely) but only Freddie/Fannie had the market expectation of a govt backing a priori as was evidenced by the pricing of their debt.

[Kolohe]

What Flynn left out of his analysis was any mention of the 'synthetic' instuments. Felix salmon has had some good explanations here and here. Not mentioning these is like leaving oxygen out of the fire triangle

[ChanceH]

Alan,

As an objective observer, answer this question for me: Is the following statement true or false?

"Fannie and Freddie made no loans"

[Nemo31]

Just two words... SOX!

[Alan]

Chance, These guys, Fannie and Freddie, who are they anyway? How would I know what they are up to?

Seriously, When I read Joe's objection to the notion that F&F make loans, I took it as a cry of pain from someone who is knowledgeable of the technicalities of the situation and is frustrated by the superficial level of understand that exists in the general public conversation. After reading what both you and he has to say about it, I would agree that maintaining that "Fannie and Freddie make loans" is not altogether incorrect, but certainly does not capture the complexity of the situation. It may indicate a level of ignorance that disqualifies someone who uses the phrase from serious consideration in a technical discussion. Since both you and Joe seem to understand the complexities of the arrangements, I don't think arguing about it has much value.

When I called myself an "objective observer" I used scare quotes because it isn't, of course, actually true. However, I am what you might call an "intelligent layman" and, while I am open minded, I do not have the ideological commitment to an idealized conception of the "free market" displayed by some of the commenters. From this point of view, and in light of recent events, Joe is much more convincing than his antagonists.

[Cyril]

Your article makes it sound like the problem is 100% to the loss from mortage failures. Is it not true that there is a lot more toxic assest in dollars than there is default mortgages. Is is not ture that many institutions held some kind of investment vehicles while not owning the underlying paper. Its like the Giants playing the cowboys and each owner puting a million dollars on the game, while the spectators are putting billions of dollars of side bets on one team.

I believe derivatives is a zero sum game which means that someone made money on this. Those that bet against the paper.

Why did you not mention the investment modernization act (not sure exact wording) which was passed on XMAS day as a midnight rule which authorized this gambling.

[Mark Luedtke]

This is fine analysis, but like many fine analyses on the subject, it fails to address the income tax as one of the causes. The income tax rewards companies for assuming debt and punishes them for saving. This incentivizes companies to overleverage.

I hate to see good articles miss a chance to blast the income tax.

[Cycledoc]

Reason's alternate reality appears to state that somehow the government forced the banking industry loan money unwisely.

In reality, money makes people do funny things. And one of the funny things was the securitization of loans. This passed the risk from loans on to someone else.

What a foolproof system for fools. They simply couldn't pass up the opportunity to make these loans and then sell them (and the risk of default) off at a profit. Then adding insult to injury they insured them many times over. These shenanigans were not a result of government policy, but rather the failure of the free market.

In this case more regulation was and is necessary to keep these people from doing harm to themselves (and us).

[Alan]

Given the (necessary) interrelationships between government and the economy, it isn't surprising that some policies and regulations can be found that may have contributed to the financial crisis. It would be odd were it not so. We should also expect that an alternative approach to financial policy and regulation, perhaps requiring a more adversarial policy and more substantial regulation, may have served us better.

The idea that the government wears a "black hat" and that the our financial institutions wear a "white hat" and that the only alternative is to kill the guy wearing the black hat is a bit ludicrous. And, of course, no one is taking it seriously.

[John Brown]

Swing and a big miss!

I kept waiting for Flynn to address how banks leveraged their mortgage portfolios of unqualified home buyers, but he never really addressed the issue. It is hard to understand how Flynn could ignore the house of cards built from derivatives such as CDO's and CDS's.

These exotic, highly - leveraged, securities created by investment banks have compounded the credit crisis to the point of economic collapse. Is Flynn of the opinion that government regulators ought not to be concerned?

[Alan]

Here is a little background information on the attmepts by the head of the Commodity Futures Trading Commission, Brooksley E. Born, to initiate regulation of the CDO's and CDS's.

http://www.washingtonpost.com/wp-dyn/content/article/2008/10/14/AR2008101403343_pf.html

[Nicolas Adjduer]

I firmly believe that big government problems are combination of many different issues put together.

All of the points the arthor made in the article were accurate, yet he should not discount the role of the CRA.

http://www.PleaseBreakTheLaw.com

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