7 thoughts on “The mess, and how we got into it

  1. Interesting that this post purports to discuss the current economic crisis, and dredges back into the prehistory of completely separate crises, and yet never mentions two institutions directly at the core of what’s going on right now: Fannie Mae and Freddie Mac, who, until they collapsed, held at least half of the subprime housing debt in the country, pioneered mortgage securitization, and were the largest conduit between subprime lenders like Countrywide and investors in the rest of the economy for the subprime debt that everybody’s drowning in.

    Of course, this is the Daily Kos, so if they did mention Fannie and Freddie, people might start asking questions, like “Hey, weren’t Fannie and Freddie set up under the New Deal as government-sponsored enterprises?” “Weren’t they supposed to be highly regulated?” “Weren’t the implied federal guarantees and assumed regulation as GSEs how they were able to get so big, push so much subprime paper into the rest of the market, and avoid accounting best practices?” “Aren’t they staffed primarily with a lot of veterans of previous Democratic administrations?” “Didn’t the Democrats in Congress shoot down a bill to regulate them more tightly three years ago, a bill that John McCain cosponsored, after they had a big accounting scandal?”

    Oh, and “Hasn’t Barack Obama, in his less-than-one Senate term, been the second-largest recipient of campaign contributions from Fannie and Freddie over the past decade?” (Right behind the guy the Dems currently have up there to “fix” things, Senate Banking Chairman Christopher Dodd).

  2. I found Bill Moyers interview of Kevin Phillips (former Nixon White House strategist and political and economic critic) far more detailed. He was interviewed on the last segment of Bill Moyers Journal (PBS). Phillips latest book BAD MONEY: RECKLESS FINANCE, FAILED POLITICS, AND THE GLOBAL CRISIS OF AMERICAN CAPITALISM explores the role that the crumbling financial sector played in the American economy.

  3. Tom brings up good points. I find it rather dubious that Fannie and Freddie’s mandate was to help the typical American secure an affordable mortgage for low-income Americans yet was given the authority to deal leans up to 700,000 dollars in initial value. I don’t know about you, but I don’t think many “low-income” Americans can typically afford mortgages that are worth that much. This is precisely where the concept of government induced (and now government subsidized) moral hazard comes into play

    In addition to what Tom has said, I’d like to add that the regulation versus deregulation debate is far from being settled. I do not support either of the two presidential candidates, especially with respect to their proposed economic plans. However, John McCain has taken some flak for even bringing up the possibility that deregulation has helped the economy in some sectors. Whether or not he actually believes it is another story–and considering his lack of knowledge in basic economics, I’m willing to bet he’s only spouting what his advisers tell him to.

    Despite what the Daily Kos article states, there is some evidence that the repeal of certain regulatory legislation has prevented the economy from suffering even more than it already has.

    The repeal of the Glass-Steagall Act in 1999 is a good example. Glass-Steagall was Depression era economic legislation that forced the separation of investment and commercial banks. The legislation was largely supported by banks whose competitors offered a broader range of investment service at a lower price. Of course, it was officially passed under the guise of economic regulation necessary in order to “reign in the destructive free market.” However, without its repeal, Merill Lynch and other investment banks would have no place to turn to during this crisis, forcing a direct taxpayer bailout of these firms instead of their purchase by commercial banks. That in mind, this outcome is not the ideal one by any means but is most certainly step closer to a market equilibrium state.

    For more information on Glass-Steagall, see “The Separation of Commercial and Investment Banking: The Morgans vs. The Rockefellers,” by Alex Tabarrok (1993)
    http://www.qjae.org/journals/qjae/pdf/qjae1_1_1.pdf

    I fear many analysts/economists are looking at the symptoms rather than disease. More need to consider the idea that it was precisely government intervention, not the free market, that set up the conditions and the moral hazard that lead to this severe malinvestment. The Federal Reserve brought interest rates down to almost zero during the earlier part of this decade, flooding the market with liquidity and leading to distortions in prices that allowed lenders to become irresponsible with their practices. Now, instead of letting these entities that have no reason to exist anymore quickly die, the government is rewarding risky behavior and yet again setting us up for complications down the road.

  4. Hugo,
    With all due respect to your colleague, I would be careful of calling most articles “intelligent primers” that come from a partisan organization in the homestretch of an election year.

    Interesting the author doesn’t mention the GLB Act of 1999 passed the senate by a vote of 90-8-1-1 (and John McCain did not vote for it), the house by a vote of 362-57-15, and signed by President Bill Clinton..

    Unless you want to delve into subjects like mark to market rules, FASB 157, Federal Reserve monetary policy, SEC decisions and supervision, and the ratings agencies’ models (among just a few things), it’s hard to get a thorough understanding of these economic issues.

    For example, up to 2003, investment banks had a 12 to 1 leverage rule. Then in 2004, the SEC basically gave five banks (and only five banks) the ability to lever up 30 or even 40 to 1. You can guess the five banks — Bear, Lehman, Merrill, Morgan and Goldman — and then it’s not hard to understand why 3 are down and the other 2 are looking for buyers or investors. In the press release surrounding the rule change, SEC Commissioner Paul Atkins said monitoring the sophisticated models used by the brokerages under the CSE rules — and stepping in where net capital falls too low — “is going to present a real management challenge” for the SEC. Since the new CSE rules will apply to the largest brokerages without bank affiliates, SEC Commissioner Harvey Goldschmid said, “If anything goes wrong, it’s going to be an awfully big mess.” ..that was 3 years ago.

    Or another example — the ratings agencies use data supplied by the investment banks on what the likely default rates would be. To quote from an expert in this area — “It was something like taking an open book test where you get to write the questions. And since home values had only gone up, default rates were low.” So you can guess what happens when home values fall and you have to mark the securities to market — imagine if you had to revalue and adjust your personal mortgage loan weekly.

    While regulation is necessary, the balance between how much is a debate question I would like to see asked. On one hand, the market is often self-correcting (look at underwriting rules now), but not always. On the other hand, regulations should prevent moral hazard and principal-agent market failures, but regulators are human and subject to incompetence and corruption…and do you hear any of the members of the banking committees talking about the large donations they receive from the banking, mortgage, and credit card communities as they like to point fingers at “corporate big-wigs?”

    As I said before, it’s less about these promises the candidates make and more about the people the candidates have as advisors and confidantes..

  5. Lots of good responses here.

    Hey, economics is not my strong suit, and I happily defer to others here. As the candidate for whom I am voting in November said about a different issue, “it’s above my pay grade.”

  6. Or another example — the ratings agencies use data supplied by the investment banks on what the likely default rates would be. To quote from an expert in this area — “It was something like taking an open book test where you get to write the questions. And since home values had only gone up, default rates were low.” So you can guess what happens when home values fall and you have to mark the securities to market — imagine if you had to revalue and adjust your personal mortgage loan weekly.

    Is that really what was going on? Jumpin’ Jesus! Was that including the MBS market too? I was going back and forth with my uncle a few months ago about how the agencies could have marked all this crud “investment grade” assuming that they were doing any due diligence on the underlying assets. We came to the conclusion that they either weren’t fulfilling due diligence at all, or else there was very serious misconduct going on. I figured that it would take a decade of litigation to sort out exactly who did what there.

    As to your regulation question, I have a related one: would any of this have happened had the government not “played favorites” and handed out prerogatives, either explicitly (like with bending the leverage rules) or implicitly (letting Fannie and Freddie walk around with implied guarantees of a bailout) to big institutions to play fast and loose? Some regulation is necessary, but it seems, from where I’m sitting, that when we have a correction, they’re usually going to be small enough and timely enough so as not to blow the whole market to pieces, unless the government has been letting favored institutions get bigger than they should and get away with more than they should.

Comments are closed.