Two Economists From The University Of Chicago Explain What The Hell Just Happened

It’s one thing to understand what just happened to the financial markets, and yet another to actually be able to explain what just happened. Thankfully, Steven Levitt from Freakonomics walked down the hall and found two economists from the University of Chicago (Doug Diamond and Anil Kashyap,) who gave him the best explanation I’ve been able to find about what the hell just happened.

From A.I.G. and credit default swaps to why Bear Stearns got a bailout but Lehman Brothers did not, this Q&A sheds some much appreciated light on the most nagging puzzles presented to us in the past week.

Here’s a taste:

The Fannie and Freddie situation was a result of their unique roles in the economy. They had been set up to support the housing market. They helped guarantee mortgages (provided they met certain standards), and were able to fund these guarantees by issuing their own debt, which was in turn tacitly backed by the government. The government guarantees allowed Fannie and Freddie to take on far more debt than a normal company. In principle, they were also supposed to use the government guarantee to reduce the mortgage cost to the homeowners, but the Fed and others have argued that this hardly occurred. Instead, they appear to have used the funding advantage to rack up huge profits and squeeze the private sector out of the “conforming” mortgage market. Regardless, many firms and foreign governments considered the debt of Fannie and Freddie as a substitute for U.S. Treasury securities and snapped it up eagerly.

Fannie and Freddie were weakly supervised and strayed from the core mission. They began using their subsidized financing to buy mortgage-backed securities which were backed by pools of mortgages that did not meet their usual standards. Over the last year, it became clear that their thin capital was not enough to cover the losses on these subprime mortgages. The massive amount of diffusely held debt would have caused collapses everywhere if it was defaulted upon; so the Treasury announced that it would explicitly guarantee the debt.

But once the debt was guaranteed to be secure (and the government would wipe out shareholders if it carried through with the guarantee), no self-interested investor was willing to supply more equity to help buffer the losses. Hence, the Treasury ended up taking them over.

Diamond and Kashyap on the Recent Financial Upheavals [Freakonomics]
(Photo: shadowmancer76 )

Comments

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  1. fonetek says:

    I can sum it up in a lot less words. “This country is going to hell in a handbasket”.

  2. In other words: lack of oversight.

  3. TommyFeds says:

    OH, well now I get it…………err….uhh

  4. courtarro says:

    Law professor Michael Greenberger was on Fresh Aire last night explaining the whole situation, and he fingered the main culprit as legislation passed in 2000 by the Republican Congress to restrict regulation of credit-default swaps, which led to this whole mess:

    [www.npr.org]

    If you’ve got 40 minutes, it’s a fascinating listen.

    • The_Gas_Man says:

      @courtarro:
      Yeah except you can find tens of other professors and economists who lay the blame at the Democrats’ feet even farther back. And let’s not forget the long list of high profile Democrat politicians who were at the top of the receiving end of these deals (#1 Chris Dodd, #2 Barack Obama, etc). I’m sure there’s plenty of blame to go around for people of all parties and motivations.

    • Erwos says:

      @courtarro: Greenberger, IMHO, is something of a conspiracy theorist. Entertaining to listen to, mind you, but I’d take what he says with a grain of salt.

      Anyways, I’m not the biggest fan of Freakonomics the book, but Levitt is clearly a smart guy, and he also works with smart people, as evinced by this excellent explanation of events.

      • Invective says:

        @Erwos: It was a conspiracy of sorts. That’s the point. Yesterday a new spin has entered the game, now the talking point is how State OVER regulation has created this mess. That point of view is exactly wrong and exactly without fact, period.

        Greenburger was exactly right. Betting outside the normal economy is why we are in this mess. The banks did not want to take further risk, so they got the insurance industry to write insurance for the ‘Structured Investment Vehicles’ and that was done with great enthusiasm because they thought there was no risk. So did the Senator(s) that inserted the lingo specifically deregulating those ‘Structured Investment Vehicles’. As I stated here before, now the insurance companies, next will be credit agencies and finally states will have to cough up their financial shortcomings.
        This all is true. So if you want to call it a conspiracy, so be it, but it is fact. People need to drop the blind allegiance to the party line, otherwise we really are a doomed nation. I really do want those responsible to be ‘outed’ and pay for what they’ve done to millions of families in America. A changing of the Guard is the best we can hope for. Otherwise it’s corruption as usual!

    • meechybee says:

      @courtarro: Let’s not forget what’s been keeping this economy chugging for the last eight years — housing starts. So the government underwrites cheap mortgages while at the same time dismantling the rules that govern credit swaps.

      I always understood 2% interest rates as only to be used as the shot of adrenaline to revive the dying patient. Instead, the Fed has kept these rates so artificially low for so long, that there’s no way to shock our way out of the current mess.

  5. VeeKaChu says:

    Or, as they say on the beer commercial, “BUUUUUUSSSSHHHHH!”

  6. I wish the press would call it like it is. Lehman did get a bailout. If $87 billion in guaranteed loans isn’t a bailout, I don’t know what is…

  7. chrisjames says:

    The decision by the Federal Reserve to not cut interest rates suggests the Fed also recognizes that the short-term interest rate is a very inefficient way to address this problem.

    At least they learned something.

    … finally.

  8. nicemarmot617 says:

    It really is remarkably stupid and people were pointing out many of these problems years ago, but everytime someone tried to make a change, the feds would prevent them from doing it. At any level.

  9. fonetek says:

    In the late eighties and early nineties De-regulation was the way to go. More capatalistic views and less government regulations. Look where we are today. Financial markets are falling. You can’t sell your house at all. All because people thought it was a great idea to give someone who makes $11.00 an hour at Target a $500,000.00 no doc mortgage. Wow, glad Citibank and other major banks and credit unions had the foresight to see that might actually fail. Stop bailing out firms that bet on subprime mortgages. I got my mortgage two months ago and had to practically allow the bank to do a financial colonoscopy before closing on my loan. If it doesn’t make financial sense, don’t lend. Simple as that. 20% plus solid credit and a 30 year fixed rate and this problem we have today would have never happened.

    • The_Gas_Man says:

      @fonetek:
      Blaming this on capitalism is dangerous and naive — and backwards. You need to dig a little deeper to find out what’s really going on here before making that kind of a statement. At the most basic level, this is what happens when government does meddle in the free market, not when it doesn’t. At the end of the day, this situation is only possible because the government had a hand in it.

      • ppiddyp says:

        @The_Gas_Man: And let’s not forget the long list of high profile Democrat politicians who were at the top of the receiving end of these deals (#1 Chris Dodd, #2 Barack Obama, etc).

        Interesting. What reward did Obama get from what deals?

        “Blaming this on capitalism is dangerous and naive — and backwards”

        Any time anyone says “blaming X is dangerous, naive and backwards” my bullshit/fascism detector goes off. Part of the problem with your line of ‘reasoning’ is that we don’t know what would have happened had the government completely stayed out of the markets.

        Anyone who believes in pure free markets (or pure socialism or any other philosophy) is wearing a big pair of blinders.

      • @The_Gas_Man: That makes no sense. The government relaxed the rules, the greedy banks took advantage of them to hand our bad mortgages like Halloween candy, brokerage firms bought into this through badly structured securities and the end result is that instead of helping the people who got sucked in to these bad mortgages directly, the government is bailing out the companies who screwed things up in the first place. Frankly, someone who’s about to lose their house to foreclosure could care less if Bear Stearns or Lehman Brothers lives or dies.

    • chrisjames says:

      @fonetek: More capatalistic views and less government regulations. Look where we are today.

      Implying that was the source? How so, mon frère?

    • Oranges w/ Cheese says:

      @fonetek: Seriously. I make $32,000 a year and I can’t even afford to pick up a $80,000 mortgage, within reason…

  10. rugman11 says:

    A lot of this could have been avoided had Sen. Chris Dodd (D-umb) not torpedoed the Federal Housing Enterprise Regulatory Reform Act, which Sen. McCain co-sponsored in 2005. This law would have established

    “an independent Federal Housing Enterprise Regulatory Agency which shall have authority over the Federal Home Loan Bank Finance Corporation, the Federal Home Loan Banks, the Federal National Mortgage Association (Fannie Mae), and the Federal Home Loan Mortgage Corporation (Freddie Mac); and (2) the Federal Housing Enterprise Board.

    Sets forth operating, administrative, and regulatory provisions of the Agency, including provisions respecting: (1) assessment authority; (2) authority to limit nonmission-related assets; (3) minimum and critical capital levels; (4) risk-based capital test; (5) capital classifications and undercapitalized enterprises; (6) enforcement actions and penalties; (7) golden parachutes; and (8) reporting.”

    I am not saying that Republicans share no blame in this debacle. Both sides were turning a blind eye to the problem. But there was at least one man who realized that the FM’s were trouble and that the taxpayers were going to be stuck with the bill.

  11. lannister80 says:

    In other words: too little oversight, too little regulation. Free market FTL!

  12. rugman11 says:

    Forgot my source:

    [www.govtrack.us]

  13. fonetek says:

    @The_Gas_man:
    @chrisjames: By not regulating the financial markets, people who were not qualified, were getting loans and that paper was being in turn sold off to government backed subsidies. When the loans became toxic and were defaulting at an alarming rate who got stuck holding the bag? Fannie and Freddie. By allowing these “exotic” loans to be packaged as securities not only did the loans hurt the banks holding them, but pension funds, and 401k’s. Most of these loans were fraudulantly obtained either by overstating income and debt or simply no docs.

    Now I know that if you can’t afford to buy a house you don’t. However a lot of the people were either plain stupid for accepting the terms or were coerced into signing an agreement they really didn’t understand. Where were the regulations and oversight to prevent these loans from closing. Yes a foll and his money are soon separated, but at the cost of our economy?

    • chrisjames says:

      @fonetek: The only thing that didn’t fit in that mostly correct explanation is the phrase “By not regulating the financial markets…”

      What’s the connection? Is that connection in favor of government intervention? The government was all over those securities, pretty much egging them all on, because it was a boon for the housing market. Or rather, it seemed so at the time. What standards and punitive policies could they have enacted to combat the situation? You can’t misrepresent a loan… or else what? It auto-defaults? It’s appropriated by the government? You’re fined and lose capital? They didn’t want that because it might actually stifle the market. Or rather, so they thought at the time.

      These places were guaranteed by the government from the beginning of this mayhem, though maybe only implicitly. That put the lending industry in college-student-with-parent’s-credit-card mode. The government gambled on rapid growth, forgot they couldn’t afford it, and it’s all popping like a huge funny-shaped balloon animal: each arm and leg in succession.

      Maybe if they had let things be–you know, actually stayed out of the financial market like they were supposed to–this wouldn’t have happened. Maybe not. It’s not like anyone could know which was, or is, the better road. Hindsight only tells us that we screwed up, and the problem was either too much or too little government hand-in-pocket.

      • kingmanic says:

        @chrisjames: For the past 12 years or so the government has been pretty hands off on mortgage industry and a lot of new forms of banks skirted around a lot of the existing regulation. You are saying that intervention would have done nothing to stop this but simply enforcing the existing rules would have blunted how much damage this has done. Remember the repackaged debt was a way for banks to skirt existing banking regulation and the government was hands off with correcting this partly because they were being lobbied to do nothing and partly because people with your mind set have grown as a voting block. There was no incentive to intervene even though to everyone looking it looked like a disaster waiting to happen. There are many what ifs. Enforcing existing regulations and closing loopholes would have likely both blunted growth and blunted the extent of this fiasco. Both were tied together, the US growth int he last while was artificially driven by inflated real estate prices. Slowing of the economy may have been a lot milder in consequences then this style of mortgage industry collapse. Hard to say. But we do need to close that loop hole and enforce whats on the books now. To bring some measure of confidence back to the markets if for nothing else.

        • chrisjames says:

          @kingmanic: I had a really long reply written up about regulation, government backing, and delusions of invincibility. I was pointing out that the industries would have self-regulated if they didn’t believe they had the financial support of the government. If the government had just stayed away from the financial market, then the companies (a) would have been more careful about the risk they were buying into (as the government is trying hard to imply now*), and (b) couldn’t have bloated to their monstrous size, dominating the economy like they did. Really, regulation couldn’t have stopped it, because the government was in on it already…

          But, it hit me. They already had their hands so far up the asses of FMs and others, that they were practically using the market as a puppet long before the takeovers. That’s not to say it was a bad thing, but that would have been the perfect time for setting some ground rules. I don’t mind regulation, but fence-sitting or, worse, compromise is what tears down systems. One or the other. Control or freedom. They both have costs, but you can’t compromise like they did or you get irreversible exploitation like this.

          Oh, that and zero tolerance works.

          * Something tangential that bothers me is the claim that everyone runs wild when the government steps out of the picture. That’s just healthy fear talking. Entities will minimize risks to stay afloat first and make profits second. The government took away quite a bit of risk, causing them to run wild. That’s not pro-involvement.

          • rugman11 says:

            @chrisjames: This is the most well-written summation I’ve seen. What nobody seems to be asking is why there was not risk assessment. And the reason there was no risk assessment is because the lenders had very little risk. They knew they could take on any risk because if any of their debt started to go bad they could funnel it off to Fannie and Freddie. Then, once the FMs stopped buying everything in sight, these guys were left holding their rotting mortgage “securities”. Deregulation played a big part, but without Fannie and Freddie (and especially the lack of oversight for them, for which you can thank Barney Frank) the lenders wouldn’t have found any buyers for their crappy mortgage products.

          • kingmanic says:

            @chrisjames: I’d agree that a large part of it is the governments reaction. The mixed bag of hands off and “ass puppetry” as you put it. They wanted both an unfettered market and the illusion of security. Had it been truly unfettered it would have collapsed more completely and asshats like the AIG and Lehmans would be cautionary tales earlier and the scope would be smaller. Enforcing the regulations and not allowing this type of debt swapping we’d also not be here.

            There were a lot of ways out but each one had some economic pains which no administration wanted. Instead they waited and now there is a massive economic anal gang rape instead of a little economic finger bang, to adopt your euphemisms.

      • fonetek says:

        @chrisjames:

        I agree with that statement. Hindsight is always 20/20 I guess.

  14. fonetek says:

    Sorry mispelled fool. Also didn’t know how to reply to your posts either. I suck.

  15. YamiNoSenshi says:

    A far as I can tell, the market is collapsing because there is no money. There never was actually any money. But the banks and the mortgages and the financing companies acted in a way that has now brought to the surface the fact there is no money. And (here’s the fun part), nobody is buying the lack of money with their own lack of money anymore. Unless I’m completely and utterly wrong.

    And they say engineering is hard.

    • kingmanic says:

      @YamiNoSenshi: That’s pretty much sums it up. We took property worth X pretended it was worth 1000X and grew our economy on the difference. The set up came to it’s inevitable conclusion when the banks forclosed on the suckers who bought it at 1000X and tried to redeem that property for 1000X and found the only ones who’d pay 1000X for it were the suckers they foreclosed on.

      Those complex investment vehicles were just a creative way to repackage the inability for the average American to do math.

  16. opedog says:

    For those of you who might yourself or know people who point fingers you should probably read up on the Community Reinvestment Act (CRA).

    [en.wikipedia.org]

  17. Tiber says:

    It seems to me deregulation and government meddling were to blame. Deregulation was responsible because no one was taking a look at how much money was being loaned out, or making sure the FM’s were making good on their part of the bargain. Government meddling was responsible because the government’s backing of the FM’s led people to believe that the two were more stable than they were.

    Personally, I think it’ll be interesting to see the aftermath of this. People are sharpening their pitchforks and ready to use them on whoever gets a finger pointed at them. Politician’s are going to be going into CYA mode, and putting blame on the other party wherever possible. I’m doing alright financially, so I’m going to grab some popcorn and wait for circus to start the show.

    Either way, I predict a turn away from deregulation, and expect to hear the word “oversight” uttered from a lot of politician’s mouths.

  18. este says:

    Entitlement. The problem here is just as much culture rooted as it is poor decisions and greed.

    Some dumbass sees that some rapper on cribs with a pool, cars, man-cave (gay btw), basketball court, lcd tvs in the jacuzzi etc or even a neighbor with just one of those things (and a better paying job) then decides that if someone else has that stuff that he deserves it too!

    So now we have tons of wasteful spenders buying the latest phones, going to Starbucks everyday, living in the big house – keeping up with the Jones’ and a financial institution that is more then willing to lend these idiots money with no regard for the problem they may cause.

    I believe its going to get worse but when we come out of it I think there will be less cribz, less Paris, less starbucks, less bling and we’ll be right back to where we should be.

    Its not all their fault for shotty lending. Its everyone’s.

    • Coelacanth says:

      @este: I love how everyone keeps picking on Starbucks. Yes, it’s overpriced, but not any more than other botique coffee chains.

      All told, it’s a fairly inexpensive vice. Not going to Starbucks can save a few bucks, but it fails to compare damage that people bring on themselves by buying luxury cars and McMansions.

      I live well within my means, but I do frequent Starbucks almost daily. If it’s my indulgence, so be it. I can also afford it, too.

  19. MrDo says:

    Subprime mortgages were a very small percentage of paper issued over the term of the bubble. What was most distressing was the complete abandonment of anything close to underwriting standards, the issuance of 125% loans, stated income, and lots of fly by night mortgage companies (you know the ones advertising on the radio) who basically cashed out as fast as they could on teaser rates to morons who had no idea what they were getting into. The multiple payment option loans, where you could pay interest only, or any variation of plus tacking on principle to the end of the loan, the list of shady and unethical practices goes on and on.

    There was almost zero oversight. Keep in mind, both parties are responsible for this. Democrats controlled congress for almost 4 of the 8 Bush years. Barney Frank never held Fannie/Freddys feet to the fire, time and time again he let their total lack of oversight slide. And it doesn’t help that these institutions took on a highly unique role of quasi-governmental organization.

    But as with all major fiasco’s involving the government, regardless of who is in power, there will be absolutely ZERO accountability. Where they went after Ken Lay at ENRON, there will probably be nothing done to the Fan/Fred executives who helped egg on this fiscal disaster. The fact that the CEO of Fannie works with the Obama campaign, and the massive amount of cash both organizations threw at politicians on both sides of the isle, will almost ensure no prosecution for their deceit.

    The TLDR version: people who should know better took crazy pills fueled by an insane mortgage bubble and lined their pockets with money they had not earned. Oh and they are getting away with it.

  20. MrDo says:

    Also, I can’t stress enough how involved Barney Frank is with the Fannie/Freddie mess. Calls had been made years ago to address the exact issues they got involved in, but their lobbying efforts paid off.

    2003

    The new agency would have the authority, which now rests with Congress, to set one of the two capital-reserve requirements for the companies. It would exercise authority over any new lines of business. And it would determine whether the two are adequately managing the risks of their ballooning portfolios.

    The plan is an acknowledgment by the administration that oversight of Fannie Mae and Freddie Mac — which together have issued more than $1.5 trillion in outstanding debt — is broken. A report by outside investigators in July concluded that Freddie Mac manipulated its accounting to mislead investors, and critics have said Fannie Mae does not adequately hedge against rising interest rates….

    Significant details must still be worked out before Congress can approve a bill. Among the groups denouncing the proposal today were the National Association of Home Builders and Congressional Democrats who fear that tighter regulation of the companies could sharply reduce their commitment to financing low-income and affordable housing.

    ”These two entities — Fannie Mae and Freddie Mac — are not facing any kind of financial crisis,” said Representative Barney Frank of Massachusetts, the ranking Democrat on the Financial Services Committee. ”The more people exaggerate these problems, the more pressure there is on these companies, the less we will see in terms of affordable housing.”

  21. MrDo says:

    And something a little more current:

    In fact, Mr. Frank was publicly arguing for an increase in the size of their combined $1.4 trillion portfolios right up to the day they were bailed out. Even now, after he’s been proven wrong about a taxpayer guarantee, he opposes Treasury’s planned reduction in the size of the portfolios starting in 2010, according to a quote attributed to him in this newspaper last week. “Good luck on that,” he reportedly said. Mr. Frank’s spokeswoman hung up the phone when we sought confirmation Tuesday.

    The MBS portfolios have long been both the chief source of the systemic risk posed by the two mortgage giants and of the profits that so handsomely enriched shareholders and officers alike for decades. Without the extreme leverage inherent in those portfolios — which the companies borrowed heavily, at taxpayer-subsidized rates, to accumulate — their federal takeover might never have become necessary.

  22. chauncy that billups says:

    Fannie and Freddie were weakly supervised and strayed from the core mission.

    Um. Jim Johnson. Franklin Raines – Obama’s top advisors. Chris Dodd. Obama. Fannie and Freddie funneling money to these two guys. But yeah, its Bush’s fault.

  23. MrDo says:

    The thing that really chaps my hyde, is that accelerated their risky loans in 2007 even when they knew the house of cards was going to collapse.

    “We expect the delinquencies to rise considerably further, given the deterioration of the GSE book of business in 2007. As the non-Agency markets shut down in 2007, conforming product that had risk layering came into Agency space.

    No matter what box one looks at, the results are the same – in the first 8 months of 2007, the % of Freddie and Fannie issuance with risky characteristics rose considerably. … It is well documented that increased risk layering causes losses to multiply.”

  24. MrDo says:

    I’m no fan of Obama, so I admit my bias, but keep this in mind when he talks about how the evil republican’s are the cause of all our worries:

    Penny Pritzker, “the Michael Milken of subprime mortgages,” is Obama’s Finance Chair.

    Jim Johnson, disgraced former CEO of Fannie, was Obama’s vice presidential search chairman, at least until he resigned under fire due to his role in providing subsidized sweetheart loans to Democratic Senators during his stint at CountryWide.

    Franklin Raines, who participated in the accounting scandals to fix Fannie’s books and deliver unwarranted bonuses to its top executives, is a top Obama adviser.

    Obama Economics Adviser Austan Goolsbee continued defending and lobbying on behalf of the mortgage industry’s no-money-down-no-credit-check policies at least until September of 2007

    A lot of this goes to Obama’s ability to judge character. Be it Wright, Ayers, Pfleger, Harry Bridges, or any of the players mentioned above.

  25. Samuelm456 says:

    “In principle, they were also supposed to use the government guarantee to reduce the mortgage cost to the homeowners…but Instead, they appear to have used the funding advantage to rack up huge profits and squeeze the private sector…”

    So, the ONE TIME the government actually tried to help its citizens, through making housing more affordable, it’s subsidized mortgage company said “the heck with THAT!” and took that potential consumer savings and put it in their pocket.

    What could be more capitalist than that? And what could be sadder?

    The largest issue this points to…is the hazards of deregulation. No oversight = absolute power. absolute power = shoddy finance. shoddy finance = eating cardboard and living under a bridge.

  26. MrDo says:

    Something that depresses me about this whole affair is that we are probably having a far more substantive debate about this than anyone in Congress.

  27. ranchgal says:

    Has the fool Fuld decided to bother himself and communicate with the scores of Lehman Bros that are now out in the cold due to his “oversight”?

  28. MrDo says:

    For those of you who forgot:The Subprime Primer

  29. JZDK8B says:

    The general co-chairman of John McCain’s presidential campaign, former Sen. Phil Gramm (R-Texas), led the charge in 1999 to repeal a Depression-era banking regulation law that…contributed significantly to today’s economic turmoil.

    A regulatory structure set up for banks in the 1930s needed to change because the nature of business had changed…But by the time [it] was repealed in 1999, the $300 million lobbying effort that drove deregulation was more about facilitating mergers than creating an efficient regulatory framework.

    Gramm’s role in the swift and dramatic recent restructuring of the nation’s investment houses and practices didn’t stop there.

    A year after the Gramm-Leach-Bliley Act repealed the old regulations, Swiss Bank UBS gobbled up brokerage house Paine Weber. Two years later, Gramm settled in as a vice chairman of UBS’s new investment banking arm.

    Later, he became a major player in its government affairs operation. According to federal lobbying disclosure records, Gramm lobbied Congress, the Federal Reserve and the Treasury Department about banking and mortgage issues in 2005 and 2006.

    During those years, the mortgage industry pressed Congress to roll back strong state rules that sought to stem the rise of predatory tactics used by lenders and brokers to place homeowners in high-cost mortgages.

    For his work, Gramm and two other lobbyists collected $750,000 in fees from UBS’s American subsidiary. In the past year, UBS has written down more than $18 billion in exposure to subprime loans and other risky securities and is considering cutting as many as 8,000 jobs. The general co-chairman of John McCain’s presidential campaign, former Sen. Phil Gramm (R-Texas), led the charge in 1999 to repeal a Depression-era banking regulation law that…contributed significantly to today’s economic turmoil.

    A regulatory structure set up for banks in the 1930s needed to change because the nature of business had changed…But by the time [it] was repealed in 1999, the $300 million lobbying effort that drove deregulation was more about facilitating mergers than creating an efficient regulatory framework.

    Gramm’s role in the swift and dramatic recent restructuring of the nation’s investment houses and practices didn’t stop there.

    A year after the Gramm-Leach-Bliley Act repealed the old regulations, Swiss Bank UBS gobbled up brokerage house Paine Weber. Two years later, Gramm settled in as a vice chairman of UBS’s new investment banking arm.

    Later, he became a major player in its government affairs operation. According to federal lobbying disclosure records, Gramm lobbied Congress, the Federal Reserve and the Treasury Department about banking and mortgage issues in 2005 and 2006.

    During those years, the mortgage industry pressed Congress to roll back strong state rules that sought to stem the rise of predatory tactics used by lenders and brokers to place homeowners in high-cost mortgages.

    For his work, Gramm and two other lobbyists collected $750,000 in fees from UBS’s American subsidiary. In the past year, UBS has written down more than $18 billion in exposure to subprime loans and other risky securities and is considering cutting as many as 8,000 jobs.

  30. theodicey says:

    The excerpt sounds like the stereotypical Chicago School explanation to me. Oh, if we had just let the free market act instead of letting quasi-governmental agencies interfere int the market, everything would have been just peachy!

    What a load of BS.

    No one was forcing the investment banks to use 40 to 1 leverage to buy mortgage backed securities.

    The article’s actually a little better than the excerpt. The real bottom line: “There are many indicators that the largest financial institutions are collectively short of capital.” Oops.

    If they had been normally leveraged and/or competently regulated over the last decade, they would have lost money when the housing bubble burst. But they would have had enough capital to back it up, and it wouldn’t have threatened to melt down the entire financial system.

    It’s OK to buy into a poker hand with the cash in your wallet. Or even to ask a friend to spot you. But when you raise and bet your wife or house, someone needs to step in and pull you away from the table. That’s why every stable economy needs financial regulators.

    (But you can’t be any geek off the street, gotta be handy with the steel if you know what I mean, earn your keep.)

    p.s. Not saying Fannie and Freddie weren’t in a position of moral hazard because of their government “insurance”; they clearly were. But they were just responding to the demand for real estate securities driven by out of control banks and the giant pool of money.

  31. theodicey says:

    McCain and Obama both have major ties to Fannie and Freddie:

    [www.politico.com]

    Sure, Obama’s chief economic adviser Austan Goolsbee should’ve known that the subprime loans bubble wasn’t going to end well. But a few thousand more highly paid people on Wall Street should’ve known better too.

    However he wasn’t responsible for creating the lax regulatory regime that let investment banks go crazy with housing speculation. That was largely McCain chief advisor Phil Gramm’s mistake when he wrote the bill that repealed Glass-Steagall.

    p.s. I don’t really care who McCain and Obama took money from, I care what they’re going to do about the crisis. Still waiting to find out.

  32. xkevin108x says:

    The whole problem started with the government getting involved and subsidizing.

  33. FrankReality says:

    Interesting links -

    Freddie and Fannie Mess
    [minx.cc]

    Investment Bank Mess
    [www.nysun.com]

  34. P_Smith says:

    Einstein said we can’t solve problems using the same thinking that got us into them. Well, it was the University of Shitcago that stillbirthed the neo-convicts and their economic and political idiot-ologies. Nobody from that dump is fit to talk about solutions to the mess we’re in.

    Here are three easy steps to permanently fixing the mess:

    1) A flat tax of 15% on every dollar regardless of how it’s earned, whether wages or stock dividends.

    2) Remove the ability of corporations to falsely claim themselves as “foreign based” by opening up a mailbox in Caribbean countries.

    3) Stop the illegal wars that war profiteers are getting exorbitant amounts from (and make them pay back their illgotten gains as well, with interest).

    But I have no doubt that Obama has the political will to do it, never mind the McCainchurian Candidate.

  35. ageshin says:

    The University of Chicago is a poor place to go for advice on what has happened as they are some of the prime movers in the events that have lead us to this current mess. There were lessons learned in the 30′s that set up a system of regulations to prevent a repeat of the 29 melt down. We also had usury laws that prevented predatory lending. This stood us in good stead until the great leader Reagan in the 80′s began to dismantle our regulations. This was done using the reasoning that the situation had changed since the 30′s and the modern markets were being held back by the old out of date rules. Unleash the power of the free market! For those of you who don’t remember the first result of this new thinking was the S&L debocle. This small event cost the taxpayers of the good old USA around 500Bil. The astounding thing is we did not learn anything from that and every Republican administration after has tried to out do the Reagan legasy. They have managed not to have wiped out most of our economy, and McCain is now saying that he and his fellow Republicans have the way out, by saving the rich, and more of the same old thing. Of course the Dems share a part in this debocle, by going along with the Republican drivel, but they have, when given the chance at least done less harm. Remember also that those who do not learn from the past are fated to relive it.

    • lars2112 says:

      @ageshin: You mention that UofC is a poor place to go for advice as they helped lead us to this mess but you don’t point out any economist from there that had did any policy work. The Econ dept at Chicago is if not the best one of the best, and they have both liberal and conservative PhD’s.

      One can’t blame regulation for all this mess, common sense was missing at a lot of the Ibanks. Lets us this logic.

      Bear Stearns want to put together a MBS deal, lets call it BSALTA 2008-10.

      Bear would have their sub prime lender EMC pool together and purchase a bunch of other crappy mortgages from other sub prime players and sprinkle a few prime loans in there. Lets say the average risk rating for each borrower would get a bb. But now you have pooled them together so they would now get a bbb.

      Next you find a master servicer like Wells Fargo (who did about 50% of the master servicing deals). All Wells Fargo would do is “shadow” service the majority of the loans for the BSALTA 2008-10 deal. Bear would hire wells because they had the highest master servicer rating and because they touched the loans the rating would now be A.

      Wells would pool all the loans together form the servicers and do all the bond admin work, and then send it to a trustee, who well it turns out a lot of time was also Wells Fargo, now you have a trustee on the deal, and you know the trustee is always looking out for the investor, so your rating will now be AA.

      So at the end of the day, you still have the same crappy mortgage but you have multiple firm touching that mortgage and while none of them back the mortgage, the fact that they are involved some how makes the deal less risky. Anyone with common sense can see, at the end of the day you still have the same mortgage.

      This scenario is just for the MBS market, others had their own issues.

  36. xamarshahx says:

    and McCain still thinks these fools can regulate themselves

  37. newfenoix says:

    There is enough blame to go around on both sides. The market situation can be summed in one word GREED! It’s that plain and simple. And just plain stupidity. Joe X has a house worth 80,000. The property values get artificially inflated and his house is now worth 200,000. So he takes out a home equity loan based on the new value. The market turns belly up and now Joe can’t pay back the loan.

    There isn’t that much difference between the political parties now. Politicians are out for one thing and one thing only POWER! They don’t give a shit about you or me. And to believe anything else is naive.

  38. Oh the irony: the U of Chicago econ department has been trumpeting deregulation as a cure-all for a few decades now, starting with Milton Friedman, who died before he could enjoy the sadistic fruits of his labor…

  39. kathyl says:

    I’m sure someone will be kind enough to tell me how wrong I am, but I think that the way real estate sales work (in America, anyway) contributed to the problem. Giving the realtor and the buyer’s agent a percentage of the sales price of the house is silly, and obviously contributed to the inflation of housing prices and the proliferation of iffy and just plain stupid mortgages.

    It’s the realtor who gets comps and suggests (read: sets) the price of a house when it goes on the market. They know that their take when the deal closes is higher for every dollar they can inflate the price of the house they’re selling, so why WOULDN’T they keep pushing housing prices up as long as everyone else in the chain kept playing along. The banks did it because they saw the short term money and the promise of leeching every last cent out of their borrowers before they went bankrupt and into foreclosure, and they also figured they’d get bailed out on the balance of the loans when they got into trouble with too many foreclosures.

    And guess what? That’s exactly what’s happening.

    People saw low interest rates and decided they wanted in on home ownership, and when the market was flooded with buyers, realtors inflated house prices because they could, and they’d be long gone with their cut before the next owner couldn’t make their mortgage payments anymore.

    If realtors weren’t commission-based and instead were paid reasonable salaries for completing their job and assisting people with home sales and purchases, I don’t think the sales prices on real estate purchases would have ballooned so far out of proportion. Behind every ridiculous sales price over the last few years was a realtor whispering to the owner that they could ask for $x and “make a killing”. And it did turn into a killing, but it killed the whole real estate market and now it’s the home owners who are left holding the bag.

  40. frodo_35 says:

    Lets not forget goverment sub housing driving up rental prices and inflating the value of rental properties

  41. Jordan Lund says:

    You can over-think it all you want, but it all boils down to one thing… Greed.

    The system of stocks that publicly traded companies wrap up in has one severe fatal flaw: Your stock price doesn’t depend on just being profitable… it depends on being MORE profitable. More profitable than your competitors and more profitable than you, yourself, were this time last week, last month, last quarter, last year.

    The problem is that this isn’t sustainable and when companies are up against the gun to turn bigger profit they will engage in questionable practices (Enron) or market manipulation (Exxon).

    That Bear Sterns, Freddie, Fannie and all the rest were victims of this mind-set shouldn’t surprise anyone.

  42. TMurphy says:

    If one of these highly educated economists runs for president, even this late in the game he’d have chance. To be honest I think if a candidate can show willingness to play hardball with the financial industry and intelligence in their gameplan, that alone will win the election no matter what their other policies are.

    Of course what we will actually see is each candidate trying to blame the other for this mess, and very little detailed talk about action.

  43. SamVed says:

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