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]
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In other words: lack of oversight.
OH, well now I get it............err....uhh
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:
If you've got 40 minutes, it's a fascinating listen.
Or, as they say on the beer commercial, "BUUUUUUSSSSHHHHH!"
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...
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.
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.
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.
@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.
@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.
@fonetek: More capatalistic views and less government regulations. Look where we are today.
Implying that was the source? How so, mon frère?
@The_Gas_Man: Do you have any facts to back up those accusations? Not being a dick, I just want to learn about both sides before I start pointing fingers in any direction.
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.
In other words: too little oversight, too little regulation. Free market FTL!
@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:
@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?
Sorry mispelled fool. Also didn't know how to reply to your posts either. I suck.
@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.
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.
@fonetek: Seriously. I make $32,000 a year and I can't even afford to pick up a $80,000 mortgage, within reason...
@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.
@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.
For those of you who might yourself or know people who point fingers you should probably read up on the Community Reinvestment Act (CRA).
@segfault: Lehman didn't get any loan guarantees, they simply went bankrupt. I think you're confusing AIG and Lehman.
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.
@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.
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.
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.
@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.
@MrDo: It was basically the Tech Bubble all over again. Fool me once, shame on you. Fool me twice...
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.
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.''
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.
@MrDo: God damn that's some serious stupid. Is he even thinking when he says stupid stuff like that?
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.
@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.
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."
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.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.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
@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.
@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.
"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.
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.
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"?
@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!
I can sum it up in a lot less words. "This country is going to hell in a handbasket".