Category Archives: Financial Crisis of 2008

I Disagree with Brad DeLong

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He writes,

Martin Wolf’s The Shifts and the Shocks; and my friend, patron, teacher, and (until the last reshuffle) office neighbor Barry Eichengreen ‘s Hall of Mirrors. Read and grasp the messages of both of these, and you are in the top 0.001% of the world in terms of understanding what has happened to us–and what the likely scenarios are for what comes next.

Pointer from Mark Thoma.

These are ultra-Keynesian treatments of the financial crisis and its aftermath. The all-purpose causal variable is a glut of savings and a dearth of government spending.

I cannot prove that this view is wrong. However, I am more convinced by Jeffrey Friedman and Wladimir Kraus, Engineering the Financial Crisis. The easiest way to summarize the book is that (with a nod to a different Kraus) risk-based capital regulations were the disease that they purported to cure.

The Friedman-Kraus story is one in which regulators suffer from the socialist calculation problem. With risk-based capital regulations, regulators determined the relative prices of various investments for banks. The prices that regulators set for risk told banks to behave as if senior tranches from mortgage-backed securities were much safer than ordinary loans, including low-risk mortgage loans held by the bank. The banks in turn used these regulated prices to guide their decisions.

In 2001, the regulators outsourced the specific risk calculations to three rating agencies–Moody’s, S&P, and Fitch. This set off a wave of securitized mortgage finance based on calculations that proved to be wrong.

Friedman and Kraus challenge the basic mindset not only of DeLong but of 99 percent of all economists. That mindset is that the socialist calculation problem, if it matters at all, only matters for full-on socialists, not for regulators in an otherwise capitalist system. In the conventional view, regulators can fail for ideological reasons, or because they are manipulated by special interests. But Friedman and Kraus offer a different thesis. When information discovery is vital, regulators, like socialist planners, are doomed to fail because they are unable to mimic the market’s groping, evolutionary approach to learning.

In Friedrich von Hayek’s Nobel Lecture, The Pretence of Knowledge, he concludes,

The recognition of the insuperable limits to his knowledge ought indeed to teach the student of society a lesson of humility which should guard him against becoming an accomplice in men’s fatal striving to control society–a striving which makes him not only a tyrant over his fellows, but which may well make him the destroyer of a civilization which no brain has designed but which has grown from the free efforts of millions of individuals.

What Friedman and Kraus claim is that well-intended but now well-informed bank regulations were the destroyer, not of an entire civilization, but of a financial system. Like Hayek, they offer a profound critique of mainstream thinking. Like Hayek, they are sadly likely to be ignored.

How to Live Beyond Your Means

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1. The WaPo reports,

Today, they struggle under nearly $1 million in debt that they will never be able to repay on the 3,292-square-foot, six-bedroom, red-brick Colonial they bought for $617,055 in 2005. The Boatengs have not made a mortgage payment in 2,322 days — more than six years — according to their most recent mortgage statement. Their plight illustrates how some of the people swallowed up by the easy credit era of the previous decade have yet to reemerge years later.

Living rent-free in a $600,000 house is a “plight” only in the sense that at some point you may have to stop.

2. John Cochrane relays,

80% of Greek debt is now in the hands of “foreign official.” Now you know why nobody is worrying about “contagion” anymore. The negotiation is entirely which government will pay.

I must be really old-fashioned or something. But paying taxes so that Greek governments can live beyond their means or that people can live in houses twice the size of mine rent-free is not really my idea of “the things we all do together.”

PG County Foreclosure Story Focuses on the N-word

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This WaPo story is long, but nonetheless incomplete.

Using court and land records, The Post analyzed 173 home purchases in Fairwood that wound up in foreclosure between 2006 and 2008.

In 43 of those home purchases, borrowers financed 100 percent of the cost of the home with loans that had high interest rates and reset periods within three years. The loans were of the type that Angelo Mozilo, the CEO of defunct subprime lending powerhouse Countrywide Financial, had called “toxic” because they offered such onerous terms. He warned his own company in internal e-mails that the loans were “the most dangerous product in existence.”

Nearly all the remaining loans The Post examined contained features associated with high default rates, such as low or no down payments, interest-only payment periods and higher rates than prime loans.

Only seven out of the 173 defaulters received the most favorable lending terms, known as conventional 30-year fixed interest rate loans. These “prime” loans are the least likely to fail, experts agree.

The neighborhood is described as primarily African-American, with a median income over $170,000.

Some questions that I have:

1. Why were so many loans made with zero down payment? If the median family income is that high, should there not have been higher down payments?

2. If the borrowers put nothing down to begin with, then foreclosure cost them nothing in terms of lost equity. Presumably, if they were affluent before, they are still affluent now. If not, why not?

3. Did anyone benefit from making these loans? The companies that ended up owning the mortgages took huge losses (taxpayers also may have been involved in some way, through bailouts). Companies that originated subprime loans but did not hold them (the “originate to distribute model”) picked up some small fees, but my guess is that they competed away a lot of profits by incurring marketing costs, and in any case enough of them went out of business that you can hardly envy their franchises.

4. When did borrowers start to fall behind on their payments? If it was within a year of buying the home, then you can be sure that even if the borrowers had gotten prime, thirty-year fixed rate loans they still would have defaulted.

Remember, it was the WaPo that said on January 1st that “narrative” is “out” and “facts” are “in.” Their story is instead all about narrative (the N-word, as I call it), and I think it could use more facts.

What I am Reading

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1. Michael Shermer, The Moral Arc. I am only a few pages in, and he already has cited Bill Dickens and Bryan Caplan, among others.

2. Jeffrey Friedman and Wladimir Kraus, Engineering the Financial Crisis. This is a re-read for me. They share with me the view that risk-based capital rules contributed heavily to the crisis. They make a very subtle point, though. They do not believe that bankers went all-out to maximize the effective leverage of their banks. Thus, the authors reject the moral hazard arguments of deposit insurance and too-big-to-fail.

The way I would put their argument is this. Suppose that bank managers were, for whatever reason, actually quite concerned about risk exposure. They thought, even if incorrectly, that the value of keeping their franchises intact and avoiding trouble was very important. Even so, with the risk weights that regulators placed on different assets, the effective rate of return on mortgage securities was much higher than that on other asset classes, including low-risk mortgage loans. Thus, the risk-based capital rules, along with the lenient ratings by rating agencies of mortgage securities, served to steer capital into high-risk mortgage loans and thereby into feeding the housing bubble.

In making their argument that the crisis was in my terminology a cognitive failure rather than a moral failure, the authors point out that if bankers had merely wanted to maximize their exploitation of implicit and explicit guarantees, they could have acted differently. They could have held higher-risk, higher-return tranches of mortgage securities. They could have held less capital (before the crisis, major banks tended to have leverage ratios well below regulatory limits).

Peter Wallison and the N-word

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He says,

By 2008, before the financial crisis, there were 55 million mortgages in the US. Of these, 31 million were subprime or otherwise risky. And of this 31 million, 76 % were on the books of government agencies, primarily Fannie and Freddie. This shows where the demand for these mortgages actually came from, and it wasn’t the private sector. When the great housing bubble (also created by the government policies) began to deflate in 2007 and 2008, these weak mortgages defaulted in unprecedented numbers, causing the insolvency of Fannie and Freddie, the weakening of banks and other financial institutions, and ultimately the financial crisis.

Remember what the Washington Post Style section proclaimed on January 1st. Narrative is out. Facts are in.

Of course, in addition to the Freddie and Fannie securities, there were lots of private-sector securities backed by risky mortgages. My contention is that this boom was fueled by risk-based capital rules, which stated that once these loans were packaged into securities, divided into tranches, and blessed by rating agencies as AAA, banks could earn three times the return on such mortgages as could be earned by originating and holding an old-fashioned, low-risk mortgage.

Narrative is the New Baloney Sandwich

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Brad DeLong writes,

When it became clear in late 2008 that the orgy of deregulation coupled with global imbalances was confronting the global economy with a shock at least as dangerous as the Great Crash that had initiated the Great Depression. . .

Pointer from Mark Thoma.

Noting that on this year’s Washington Post list, “narrative” is in the “out” column, to be replaced this year by “facts,” I resolve in 2015 to use the phrase “I call Narrative” where I would have said “I call Baloney Sandwich.”

The phrase “orgy of deregulation” is a much-used narrative/baloney sandwich. Others have used it. Interestingly, in the version of the essay that appears on Project Syndicate, DeLong does not use it.

1. The facts are that one can just as easily blame the financial crash on an attempted tightening of regulation. That is, in the process of trying to rein in bank risk-taking by adopting risk-based capital regulations, regulators gave preference to highly-rated mortgage-backed securities, which in turn led to the manufacturing of such securities out of sub-prime loans.

2. The global imbalances that many of us thought were a bigger risk factor than the housing bubble did not in fact blow up the way that we thought that they would. The housing bubble blew up instead.

3. I call narrative whenever someone talks about the causes of the financial crisis without making any reference to looser mortgage lendings standards and/or without mentioning that government policies were hostile not to those institutions who dropped rigorous lending standards but to those who attempted to maintain them.

A “Tough” Capital Rule for Big Banks?

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So the headline says. But from the actual article,

The extra core-capital requirement could be as high as 4.5 percent of risk-weighted assets on top of the baseline 7 percent defined under rules known as Basel III, according to analysts including Citigroup’s Keith Horowitz.

The term “risk-weighted” gives the banks a loophole you can drive a truck through. My guess is that if you had this rule in place in 2005, its main impact would have been to steer banks into holding more AAA-rated mortgage securities.

My Review of Peter Wallison’s Forthcoming Book

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is here.

Wallison’s thesis is that policymakers in Washington underestimated the significance of the surge in nontraditional mortgages. What is perhaps even more deplorable is the way that these mortgages continue to be downplayed in the mainstream narratives of the crisis and in the policy responses that followed.

Meanwhile, CNN Money reports on programs that offer 3 percent down payments.

The new loans will only be doled out to those who buy private mortgage insurance, have a credit score of at least 620 and offer complete documentation of their income, assets and job status. And, to further mitigate risk, the agencies will require borrowers to receive home ownership counseling.

Once again, the government is pushing home borrowership, setting households up to fail and making the housing market more speculative. Of course, when the stuff hits the fan, the government officials involved will blame lenders, not themselves.

Central Planning, Capital Regulations, and the Risk Premium

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Per Kurowski writes,

current credit-risk-weighted capital (equity) requirements for banks, allow banks to hold government debt and loans to the AAAristocracy against much less equity than when financing “risky” small businesses and entrepreneurs, and so that is de facto what you get.

Risk-based capital regulations may or may not help regulators manage bank risk. (I argued here that the results were quite the opposite.) But they certainly affect the allocation of capital.

Many economists say that there is a huge demand for risk-free assets, as if this were a puzzle. Why is the “free market” so risk averse? Well, the government tells banks that they can earn a higher return on equity holding what the government defines as risk-free assets. AAA mortgage securities, Greek sovereign debt, whatever.

Kurowski’s post reminds me that financial regulation serves to allocate capital, and capital allocation by government can be thought of as central planning. There is a major socialist calculation problem involved. Moreover, there is a tarbaby problem. As the capital regulations produce perverse outcomes, policy makers look for policies to correct the outcomes, and these policies lead to other perverse outcomes, etc.

How the Fed Became a Giant Hedge Fund

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Jeffrey Rogers Hummel tells the story.

Phase Two of Bernanke’s policies transformed the Federal Reserve from a central bank confined primarily to managing the money supply into an institution that is now a giant government intermediary borrowing massive sums in order to allocate credit. In that respect, the Fed has become similar to Fannie or Freddie, with the important distinction that the Fed has greater discretion in subsidizing a wider variety of assets.