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What Just Happened – Non-Partisan Edition

October 7, 2008

Megan McArdle has the best take on this mess so far:

Another way to think about it is as a series of cognitive errors that afflicted everyone:  investors, home buyers, lenders, regulators.  They’re standard cognitive errors that so far, no one has a very good way of eradicating:

We are all to blame for our shortsightedness, our greed, our willful ignorance, our wishful thinking- ultimately our failure as a society to act responsibly. That no doubt goes for a lot of issues, not just this burst housing bubble. The worst p

Over the past few weeks, much has been made of the various regulatory actions that enabled this mess.  Though some are wrong, two are not:  the Democrats protected OFHEO’s shockingly loose regulation of Fannie and Freddie against the White House’s attempt to toughen it; and the Republican-appointed SEC loosened the capital requirements for the five largest banks.

I think this fits with Timmy’s recent comments.

But why did they do this?  Democrats seem to believe that the Republicans and the SEC simply did this out of wanton greed and a blind faith in markets; Republicans seem to believe that OFHEO, the Democrats, and Fannie/Freddie did this because of political corruption and a blind belief in homeownership for poor people.  But neither side was simply accepting the risk that the whole thing might come crashing down leaving the economy in tatters and the taxpayers on the hook.  The regulators, too, were misled by recent history.  In recent history, lending had been safer, and risk models did seem to be performing better.  Both groups genuinely believed that improvements in both computer models, and in economic theory of regulation, would allow them to identify and halt any crisis before it occurred.  And just like everyone else, when no disaster occurred, they became ever more confident in their own genius.

What we need, fundamentally, is not simply stricter regulation or less greedy bankers.  What we need is better economic theory of how these things play out, so that the regulators have better tools to assess and prevent systemic risk.  But that’s not how we’re thinking right now.  What we’re looking for is not better tools, but someone to blame.

There’s no question that the Democrats have sought to blame the entirety of this mess on Republicans which are by definition greedy bankers that care nothing about the poor. I object strenously to that assertion as well as to Barney Franks’ outragous comment today that criticism is racially motivated. These kinds of assertions are routine poison, yet somehow it’s always the Republicans who are accused of being divisive. Enough already.

My concertn going forward is that the right lessons will not be learned and that higher taxes and excessive regulation will be levied making things even worse. As in this form Biden in the debate:

we should be allowing bankruptcy courts to be able to re-adjust not just the interest rate you’re paying on your mortgage to be able to stay in your home, but be able to adjust the principal that you owe, the principal that you owe.

(Bonus Palin gaffe: she said McCain was not against this idea- major oops!).

That to me sounds a lot like price controls on housing. You know, socialism. Has it really come to that? Donald Sensing explains why this would destroy the housing market.

At the bottom of all this is the demand from the Ameican people for a risk-free world. We ask it, and politicians try to guarantee it, but it is impossible, or at least not at a price anyone wants to pay.

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2 Comments leave one →
  1. Timmy C. permalink
    October 7, 2008 10:56 am

    And I did also like the link you did to the Atlantic piece: VERY glad to see that she didn’t simply blame the CRA. And I agree that Barney Frank’s comments were over the line. Correct that the CRA is not to blame, bad form in demonizing those who think it was.

    And also glad (for once!) a link of mine made sense to you…. (I’ll take what I can get!)

    I really have grown to like Ritholtz’s blogging on the crisis overall, and it continues real time with the events each day.

    http://bigpicture.typepad.com/

    I pointed before to his Barron’s article. Just for grins, figured I’d take a stab at “who is to blame” for each of the items his the Barron’s piece:

    He opened the piece this way:

    Dear D.C.,

    WOW, WE’VE MADE QUITE A MESS OF THINGS here on Wall Street: Fannie and Freddie in conservatorship, investment banks in the tank, AIG nationalized. Thanks for sending us your new trillion-dollar bailout.

    We on Wall Street feel somewhat compelled to take at least some responsibility. We used excessive leverage, failed to maintain adequate capital, engaged in reckless speculation, created new complex derivatives. We focused on short-term profits at the expense of sustainability. We not only undermined our own firms, we destabilized the financial sector and roiled the global economy, to boot. And we got huge bonuses.

    But here’s a news flash for you, D.C.: We could not have done it without you. We may be drunks, but you were our enablers: Your legislative, executive, and administrative decisions made possible all that we did. Our recklessness would not have reached its soaring heights but for your governmental incompetence.

    THE WHO IS TO BLAME sections IN CAPS below are MY AMATURE ATTEMPTS to fix blame, not his.

    Here is his list with my guesses at where the “Wag O the Finger” should go:

    1997: Federal Reserve Chairman Alan Greenspan’s famous “irrational exuberance” speech in 1996 was somehow ignored by, um, Fed Chairman Greenspan. The Fed missed the opportunity to change margin requirements. Had the Fed acted, the bubble would not have inflated as much, and the subsequent crash would not have been as severe.

    WHO IS TO BLAME FOR THIS: REPUBLICAN FED CHAIR ALAN GREENSPAN, UNDER A CLINTON PRESIDENCY

    1998: Long Term Capital Management was undercapitalized, used enormous amounts of leverage to purchase all manner of thinly traded, hard-to-value paper. It failed, and under the authority of the Federal Reserve a “private-sector” rescue plan was cobbled together. Had these bankers suffered big losses from LTCM, they might have thought twice before jumping into the exact same business model of undercapitalized, overleveraged, thinly traded, hard-to-value paper. Instead, they reaffirmed Benjamin Disraeli’s famous aphorism: “What we learn from history is that we do not learn from history.”

    WHO IS TO BLAME: HARD TO SAY A MIX: THE FED?, DEM LEAD CONGRESS?
    http://www.riskinstitute.ch/146500.htm
    http://en.wikipedia.org/wiki/Long-Term_Capital_Management#1998_bailout

    1999: The Financial Services Modernization Act repealed Glass-Steagall, a law that had separated the commercial-banking industry from Wall Street, and the two industries, plus insurance, came together again. Banks became bigger, clumsier, and hard to manage. Apparently, risk-management became all but impossible, even as banks had greater access to larger pools of capital.

    WHOSE TO BLAME: REPUBLICANS IN CONGRESS (INCLUDING KEY MCCAIN ADVISOR PHIL GRAMM, WHO SPONSORED) AND CLINTON WHO SIGNED IT, AND MCCAIN VOTED FOR IT. GREENSPAN ALSO DID PUSH FOR THIS BIL. AND BILL CLINTON SIGNED IT.

    2000: The Commodities Futures Modernization Act defined financial commodities such as “interest rates, currency prices, and stock indexes” as “excluded commodities.” They could trade off the futures exchanges, with minimal oversight by the Commodity Futures Trading Commission. Neither the Securities and Exchange Commission, nor the Federal Reserve, nor any state insurance regulators had the ability to supervise or regulate the writing of credit-default swaps by hedge funds, investment banks or insurance companies.

    WHO IS TO BLAME: ALL SPONSORS AND COSPONSORS WERE REPUBLICANS, BUT PRESIDENT CLINTON SIGNED

    http://en.wikipedia.org/wiki/Commodity_Futures_Modernization_Act_of_2000

    2001-’03: Alan Greenspan’s Fed dropped federal-fund rates to 1%. Lulled into a false belief that inflation was not a problem, the Fed then kept rates at 1% for more than a year. This set off an inflationary spiral in housing, and a desperate hunt for yield by fixed-income managers.

    WHO IS TO BLAME: ALAN GREENSPAN, UNDER A BUSH PRESIDENCY

    2003-’07: The Federal Reserve failed to use its supervisory and regulatory authority over banks, mortgage underwriters and other lenders, who abandoned such standards as employment history, income, down payments, credit rating, assets, property loan-to-value ratio and debt-servicing ability. The borrower’s ability to repay these mortgages was replaced with the lender’s ability to securitize and repackage them.

    WHO IS TO BLAME: ULTIMATELY FEDERAL RESERVE CHAIRMAN GREENSPAN AND THEN BEN BERNENKE, UNDER A BUSH PRESIDENCY

    2004: The SEC waived its leverage rules. Previously, broker/dealer net-capital rules limited firms to a maximum debt-to-net-capital ratio of 12 to 1. This 2004 exemption allowed them to exceed this leverage rule. Only five firms — Goldman Sachs, Merrill Lynch, Lehman Brothers, Bear Stearns and Morgan Stanley — were granted this exemption; they promptly levered up 20, 30 and even 40 to 1.

    WHO IS TO BLAME: ULTIMATELY BUSH’S SEC CHAIRMAN SEC CHRISTOPHER COX

    2005-’07: Unscrupulous home appraisers found that they could attract more business by inflating appraisals. Intrinsic value was ignored, so referrals kept coming in. This helped borrowers obtain financing at prices that were increasingly unsupportable. When honest appraisers petitioned both Congress and the bureaucracy to intervene in the widespread fraud, neither branch of government acted.

    WHO IS TO BLAME: A REPUBLICAN (2005-2006) AND A DEMOCRATIC (2006-2007) LEAD CONGRESS

    Plenty of perps.

  2. Timmy C permalink
    October 25, 2008 9:50 am

    So In this earlier discussion I brought up the view that Greenspan held a lot of blame, that Fannie and Freddie were cogs in a larger system, etc…. well, don’t want to dig up a dead thread needlessly, but this week Greenspan did something very rare in DC, admitted his fault…

    That his ideology was flawed:

    “Those of us who have looked to the self-interest of lending institutions to protect shareholders’ equity, myself included, are in a state of shocked disbelief… I made a mistake in presuming that the self- interest of organizations, specifically banks and others… were best capable of protecting their own shareholders and their equity in the firms….

    Q: Do you feel that your ideology pushed you to make decisions that you wish you had not made?

    MR. GREENSPAN: Well, remember that what an ideology is, is a conceptual framework with the way people deal with reality. Everyone has one. You have to — to exist, you need an ideology.
    The question is whether it is accurate or not.

    And what I’m saying to you is, yes, I’ve found a flaw. I don’t know how significant or permanent it is. But I’ve been very distressed by that fact…

    …and fannie and freddie were only a symptom of larger broken system:

    The breakdown has been most apparent in the securitization of home mortgages. The evidence strongly suggests that without the excess demand from securitizers, subprime mortgage originations (undeniably the original source of crisis) would have been far smaller and defaults accordingly far fewer.

    Was the core cause of the meltdown? The CRA? Even Fannie and Freddie? Nope, he never mentioned the CRA once. But he did say:

    The consequent surge in global demand for U.S. subprime securities by banks, hedge, and pension funds supported by unrealistically positive rating designations by credit agencies was, in my judgment, the core of the problem.

    Demand became so aggressive that too many securitizers and lenders believed they were able to create and sell mortgage backed securities so quickly that they never put their shareholders’ capital at risk and hence did not have the incentive to evaluate the credit quality of what they were selling. Pressures on lenders to supply more “paper” collapsed subprime underwriting standards from 2005 forward. Uncritical acceptance of credit ratings by purchasers of these toxic assets has led to huge losses.

    All in all a rare honest moment in DC, worth noting.

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