How Basel regulations fucked over both American real estate and Southern European governments

A blog dedicated to explaining the causes of the financial crisis has an excellent summary of the argument that Basel regulations doomed us all, both Americans and Europeans.

Basel regulations essentially tells large banks and institutions (and only them) precisely how much risk they can take with certain asset classes. Under Basel I, adopted in the West in 1992, banks were allowed to take huge risks in mortgage-backed securities and small risks in vanilla business loans. Basel I is in the process of being phased out in favor of Basel II, which went into effect in Europe in 2006-07. The second incarnation allows institutional investors to plow all of their clients' money in certain classes of sovereign debt (which at the time included Greek or Portuguese government bonds) without leaving a cent left over in case the bonds default. Obviously, it was precisely the asset classes that required little capital that have been taking down the global financial system, more slowly that us Americans realized.

As Jeffrey Friedman explains in the first piece, these rules only applied to large institutions such as banks and pension funds. While other investors were not as heavily invested in these risky products, they did fall victim to the mania to a lesser extent – though in the end, it's the banks who need the bailouts (and the public pension crisis in America is coming), not hedge funds and S&L's.

Those who call for more regulation of financial risk are frequently unaware of how minutely risk is regulated for large institutions. Proponents of regulation that are aware often argue that these are merely ceilings on risks and that an unregulated market would have been able to go even wilder on these risky loans, but the truth is that regulations are more than just ceilings. As they used to say in IT procurement, nobody ever got fired for buying IBM – a company whose big break was FDR's 1935 Social Security Act and the lucrative federal contracts it created. And when you lower ceilings on risk – presumably the Democrat's desired regulatory policy – you're only entrenching the idea of relying on the government to tell you what is a good investment and what is not.

€500 note taken out of circulation in the UK

The Brits have withdrawn the €500 note from circulation in the UK, on evidence that the vast majority of them are used by those conducting illegal business:

However, fed up with abuse of the currency, Britain's Serious and Organised Crime Agency (Soca) has decided with the Treasury and Home Office to remove €500 notes from circulation in Britain. Soca's ban follows an investigation which revealed that 90 per cent of the €500 notes in this country are being used for criminal purposes. It's the latest of a number of high-denomination bank notes favoured by villains that have fallen out of favour. Richard Nixon halted the circulation of $10,000 bills in 1969 because of their association with organised crime; these days the 1,000 Swiss franc note, while rare, is another popular choice for those engaging in nefarious deeds, and the 1,000 Dutch guilder note was a black-market favourite before the introduction of the euro.

It's not exactly clear to me how they're doing this, since the euro isn't a British currency to begin with – are they forbidding banks from accepting them in transactions?

Would Germany be better off now if it were on the pound rather than the euro?

I don't really feel very qualified to talk about European monetary and macroeconomics, which is why for the most part I've avoided writing about Greece and the Eurozone's crisis, but – and maybe it's just the benzos – I feel like I have something slightly relevant to say.

First of all, Tyler Cowen has a great round-up of recent events and indicators (although I hate his first point) here. Additionally, I hear that even Paul Krugman – someone who, sometime during his transition from serious economist to columnist, turned into a man who never met a bailout he didn't like – thinks Greece is going to be dropped from the euro. (Although later in the article he seems overjoyed at the fact that a Greece back on the drachma would be able to destroy the currency to its heart's content.)

As far as I can gather, the consensus among economists is that debt restructuring (in Krugman's words, "a polite term for partial default") is certain, a more serious default is likely, and Greece leaving the eurozone – an that was seen as very fringe a few weeks ago – is now a distinct possibility. In the end, I think that the quicker Greece leaves the euro, the better. Many in Europe worry about the resultant instability won't be worth the risk – after all, even Greek dogs like to riot. But in the end, Greeks have become too accustomed to capitalism and liberal democracy, and once its leftist protestors no longer have the euro and lack of monetary and fiscal sovereignty to blame, the rioting will stop and the hard reforms will begin. Greek voters are too sophisticated to give into geography and regress to the level of its Balkan neighbors, who despite Greece's problems, they still make it look like Switzerland in comparison.

The big European monetary debate has always been whether the UK and Scandinavia should give up their pounds and crowns in favor of the euro. But it now looks like it would have been better for Germany, the Benelux, and Scandinavia to give up their marks, francs, guilders, and crowns in favor of the pound sterling.

Credit card stealing app in Apple's official store

The other day, I downloaded an update to an iPhone app that I own that streams Romanian radio stations called roRadio. They added a page of ads that are displayed each time you open the app, and they struck me as a very candid assessment of what tech-savvy Romanians are into. The first one (in no particular order – they're displayed randomly) is an ad for a DEX app. DEX is the official Romanian dictionary, and, for what's essentially a dictionary with some etymology notes, it comes up surprisingly often in everyday conversation with Romanians. The second is some utility with Romania-specific facts – not exactly sure what they are, but it seems pretty normal.

The third one, though, is the most fascinating: it's an app whose only apparent utility I can see is to credit card thieves! It's 99¢ and I didn't buy it, but according to screenshots, it tells you the card issuer and whether or not a given credit card number is valid – things that you'd only need to know if the card in question wasn't actually yours (who forgets whether their card is a Visa or Mastercard??). Romanians are prolific hackers, but given Apple's notoriously stringent App Store policies, I'm surprised this one made it through.

The WaPo burries the lede on a story about Fannie and Freddie

Talk about burying the lede – here're the last two paragraphs of a Washington Post story about the federal government doing some bureaucratic shuffling with Fannie and Freddie:

The administration's discussions on the future of the companies began in earnest earlier this year during the regulatory reform planning process and are just entering a more serious phase now. National Economic Council director Lawrence Summers has long wanted to overhaul the structure of the companies and warned as far back as the late 1990s that Fannie Mae and Freddie Mac posed a threat to the financial system.

I'm embarrassed to say this, but I didn't realize how good of an understanding Larry Summers (and Tim Geithner, for that matter) had of the causes of the financial crisis (check out this liberal Fox Business Channel commentator's critique of him). It's sad that someone with such a good understanding of economics before he was vested with so much power can so easily fall into the trap of supporting interventions that in a past life he might have known were a bad idea.

But here's the real kicker:

The government seized the firms last fall as the financial crisis worsened and has since used them to help reduce interest rates on mortgages generally and to assist borrowers who are at risk of losing their homes.

I wish the Post would make clearly that Summers' fear back in the late '90s was exactly that Fannie and Freddie's were doing too much of exactly that – reducing interest rates on mortgages.

Regulatory capture in P2P lending

Via The Browser, this article from some Slate affiliate has an excellent example of regulatory capture in action in the peer-to-peer lending industry.

For those of you unfamiliar with the concept, essentially it's a broker who facilitates loans between regular people over the internet. There's also a sort of charity version of this – Kiva – but the difference between P2P lending and Kiva is that Kiva doesn't return a profit for lenders whereas P2P lending generally does, and also P2P lending is often from people in rich countries to people in rich countries, whereas Kiva has people in rich countries lending to those in poorer ones.

But anyway, it looks like these P2P sites like Prosper and Lending Club return relatively high profits to lenders (7-9% are the quoted figures) with very low (>1%) delinquency rates. One forward-looking company, Lending Club, realized that regulation was imminent, so they did what any prudent firm does faced with the incentives of imminent-yet-malleable regulation: they tried to co-opt them for their own benefit, and it looks like they succeeded:

With venture capital money behind it and a high-powered team of former executives from American Express, Goldman Sachs, MasterCard, and E*Trade, [Lending Company] decided to be proactive and hired lawyers who reached out to the SEC in early 2008. "We wanted to help define the space, to participate in the dialogue about how our industry would work, and how it would be regulated," CEO Renaud Laplanche says. "Because we really expect this business to grow huge in coming years, and we wanted to be sure everything was done right." [...]

In April of 2008, Lending Club registered with the SEC and accepted the somewhat daunting task of filing every single loan with the SEC as a security. Starting in October—just in time for the global economic meltdown—Lending Club went online with full federal approval and all paperwork duly filed. Laplanche told TBM that the process has now been mostly automated; the same technology that enables his company to replace a traditional bank or collection agency allows it to make regular automatic filings through the SEC's EDGAR filing system. While there was some initial pain and expense, he thinks they are far outweighed by the potential of the business.

So now Lending Club is quickly gaining ground on the hogtied Prosper and Loanio. While its main competitors twiddle their thumbs waiting to get back into business, the company has facilitated more than 3,000 loans for $30 million.

So basically, because they were the first ones to ask about the rules, they were the only ones not blind sighted by them, and so they get to do $30 million in competition-free business. Now, some could say that that's their reward for being good corporate citizens and proactively seeking out regulation, but then again, I don't think it's a coincidence that they also happen to have "venture capital money behind it and a high-powered team of former executives from American Express, Goldman Sachs, MasterCard, and E*Trade." I'm not sure that stacking the game in favor of incumbents with deep pockets is really the best way to encourage innovation.

A possible explanation for the American and Spanish property bubbles

From an interesting post at The Money Illusion, we find this novel explanation for the housing bubble, which manages to answer that pesky rejoinder, "But why did Spain have a real estate bubble, too?" (Then again, I don't think immigration to Iceland has been especially strong lately...)

The housing bubble in 2004-2006 was partly driven by rapid immigration from Latin America (as was the bubble in Spain itself!), and also by a perception (which turned out false) that coastal zoning constraints were spreading into interior markets. Many Hispanic immigrants were snapping up older ranch houses, allowing native born Americans to move on to bigger McMansions. The immigration crackdown in 2007 dramatically slowed this immigration (as did the worsening economy.) Population growth estimates going several years forward fell sharply, hurting housing speculators. Ground zero of the sub-prime bust is in working class areas of the Southwest and Florida. Any guess as to who bought homes in those areas?

The folly of capital requirements

Jeffrey Hummel at the History News Network has a great post (which repeats information originally give by Less Antman) on the harm of capital and reserve requirements, and how deposit insurance encourages banking consumers to ignore the risks their banks are taking with their money:

"While foresighted bank executives might have chosen to maintain capital in excess of regulatory requirements so that a decline in value wouldn't trigger a crisis, it would have made no business sense to do so, since it would have reduced their lending income and ability to pay competitive rates on deposits or offer other benefits to attract customers. In a free market, they would have been able to do so, since they would have gained a reputation advantage from their greater safety, but with FDIC insurance protecting all deposits, customers don't shop based on safety, as they assume they are protected by the government from the loss of their deposits. Thus, only the rates and benefits offered by a bank matter to a customer, not the reliability of the bank, thanks to the FDIC."

The whole post is well worth reading, as it delves into some of the other unintended consequences of bank regulation.

Greenspan: But the way up was sooooo good!

Alan Greenspan, in an incredibly candid moment about the incentives he faced as Fed Chairman:

The Fed’s “easy money” policy created an excess of cash that inflated equity and asset prices, leading to both the technology bubble of the late 1990s and the housing bubble in this decade.

While Mr. Greenspan acknowledges that he could have done something to avert the housing crisis, he contends his hands were tied.

“If we tried to suppress the expansion of the subprime market, do you think that would have gone over very well with the Congress?” Mr. Greenspan said. “When it looked as though we were dealing with a major increase in home ownership, which is of unquestioned value to this society — would we have been able to do that? I doubt it.”

Mr. Greenspan said that if he had taken steps to prevent the crisis, the outcome would have been painful.

“We could have basically clamped down on the American economy, generated a 10 percent unemployment rate,” he said. “And I will guarantee we would not have had a housing boom, a stock market boom or indeed a particularly good economy either.”

But Greenspan also almost stumbles onto the explanation to why the rating agencies' ratings failed so poorly, attributing it to "the Good Housekeeping seal of approval" as opposed to what it really was – Basel I and II requirements:

Mr. Greenspan also lays the blame on the ratings agencies and the people that trusted their judgment for the proliferation of the mortgage derivatives that were a major part of the current financial crisis.

“What we have created in this world is an aura around the credit rating agencies about certification from them is the Good Housekeeping seal of approval,” Mr. Greenspan said. “I will tell you the record of a lot of the forecasters of ratings have not been distinguished. They never were.”

Calomiris explains how the government essentially gave up regulatory power to the ratings agencies:

Unlike typical market actors, rating agencies are more likely to be insulated from the standard market penalty for being wrong, namely the loss of business. Issuers must have ratings, even if investors don’t find them accurate. That fact reflects the unique power that the government confers on rating agencies to act as regulators, not just opinion providers. Portfolio regulations for banks, insurers, and pension funds set minimum ratings on debts these intermediaries are permitted to purchase. Thus, government has transferred substantial regulatory power to ratings agencies, since they now effectively decide which securities are safe enough for regulated intermediaries to hold.


Ironically, giving rating agencies regulatory power reduces the value of ratings by creating an incentive for grade inflation, and makes the meaning of ratings harder to discern. Regulated investors encourage grade inflation to make the menu of high-yielding securities available to them to purchase larger. The regulatory use of ratings changed the constituency demanding a rating from free-market investors interested in a conservative opinion to regulated investors looking for an inflated one.

The problem here is that the government realizes that it cannot itself tell investors which financial products are good investments, so rather than realize that that's something that has to be left up to the market, they close their eyes, hand power off to the ratings agencies, and hope it all turns out okay. Surprise, it didn't!

Worst since the Great Depression?

From the Minneapolis Fed via MR, these charts should thoroughly debunk all those ridiculous claims that the current crisis is the worst since the Great Depression.

The Irish real estate bubble

One thing that I've wondered about the global credit meltdown is why did the crisis affect so many countries outside of the US? Obviously there would be some spillover effects considering the increasingly globalized nature of the world's economy, but I don't think globalization by itself hasn't been extensive enough to cause what we're seeing today. One possible explanation is that other countries were doing the same things that America was doing, by pumping up their own housing bubble. The NYT today gives a hint that this happened to some extent in Ireland, Europe's biggest success story and a country where real estate tycoons acquired the wealth and cachet that hedge fund managers had in the US:

Irish banks, unlike those in the United States, didn’t dole out that many subprime loans. Rather, they lent furiously to big property developers who themselves were liberated to build pell-mell by government-imposed tax breaks.

The Times takes a stab at free market economics by saying that such tax breaks "liberated" developers, but a consistent free marketeer believes in a broad tax base and low rates – that is, no preferential treatment to particular industry.

I've been trying to find information on the web that corroborates the NYT's story about the real estate industry paying lower taxes than other Irish industries, but I'm coming up short. Anybody know anything about this?

The NYT wrongly puts more blame on Bush than Clinton for the housing bubble

In the latest installment of the NYT's ongoing series about the financial collapse, The Reckoning, three reporters trace the history of Bush's housing policy, from its initially bullishness on housing and desire to increase homeownership rates, to the latter half of his presidency when he was forced to come to terms with the GSEs' imminent collapse, but wasn't up the task of convincing Congress that reigning in the quasi-public mortgage giants was necessary.

It could be that the Times has another article up their sleeve, in which they investigate the Clinton-era roots of the housing bubble, but the tone of the article places the lion's share of the blame on Bush, mentioning his predecessor only once: "Advocating homeownership is hardly novel; the Clinton administration did it, too."

The truth is that there's a lot more to say about Clinton and the housing bubble than just that. BusinessWeek took a stab as far back as February, unearthing some Clinton administration documents that clearly signal that the White House considers mortgage lending terms too strict. Clinton also tried (but luckily failed) to allow mortgage down payments to be drawn, without penalty, from retirement accounts. While Bush's successful attempts to ease the burden (obviously necessary in retrospect) of the down payment is met with scorn from the NYT, Clinton's failed attempt (along with other attempts that succeeded) doesn't even seem to have caught the eye of the Times, from what I've read of their financial reporting.

The NYT just a few days ago did manage to publish an article about a Clinton-era special tax break, though the focus of the article was the tax break, not Clinton's role in it. So Clinton passes a law seriously exacerbating the crisis, whereas Bush merely fails to curb a phenomenon that was already underway – and yet Bush's article is decidedly more critical of him as an individual than Clinton's.

Now, I'm not saying that I think Bush is blameless. Obviously he toed the same line as Clinton – homeownership is an unalloyed good, no matter how much you have to intervene in the article to achieve it. And in some ways it's even worse, since Bush is at least supposed to care about libertarian issues like, "Is the government unnaturally pumping up the housing market?" But to paint Bush as individually more responsible for the crisis than Clinton is just intellectually dishonest.

NYT: Preferential tax cuts contributed to financial meltdown, or: What I said in September

The NYT published an article Thursday on something that readers of this blog would have known about back in September: special tax breaks on capital gains from real estate passed in 1997 encouraged the housing bubble, worsening the crash. The article includes a summary of some empirical research:

Perhaps the most detailed analysis of the provision has been the study by a Federal Reserve economist, Hui Shan, who did the analysis while at M.I.T. Ms. Shan looked at homeowners with significant equity gains, before and after 1997, and compared the likelihood of their selling their house. Her study covered 16 towns around Boston and took into account a host of other factors, like the general rise in home prices at the time.

Among homes that had appreciated less than $500,000, she concluded that the change caused a 17 percent increase in sales in the decade after 1997. Before the law changed, many people apparently avoided paying the tax by simply staying in their homes.

Ms. Shan also found that sales actually declined among homes with more than $500,000 of gains after the law passed. (Under the new law, couples have to pay taxes on gains above $500,000, even if they roll all those gains into a new house.) Nationwide, however, less than 5 percent of home sales over the last decade had gains of more than $500,000, according to Moody’s Economy.com.

It also notes that Grover Norquist, America's most prominent opponent of taxes, actually opposed this specific tax cut, on the basis that a broad base and low rates are better than cuts given to special interests:

At the time, Realtors and home builders lobbied for the provision and there was only scant opposition. Grover Norquist — a conservative activist and adviser to Newt Gingrich — said home sales did not deserve special treatment. But Republicans ended up voting for the bill by even wider margins than Democrats.

The FHA tries to reinflate the housing bubble

Throughout this whole real estate bubble-induced economic disaster, the most shocking thing to hear has got to be the idea that we need to stop housing prices from falling. Fortunately, you aren't likely to hear it from any economist or anyone with passing knowledge of the matter. But unfortunately, the people who run the American government (both elected and unelected, it seems) don't seem to have caught on to the fact that the answer to the real estate bubble popping is not to pump air (money) back into the balloon (hole).

BusinessWeek reports on a downright stupid new trend in mortgage lending: subprime lenders metamorphizing into Federal Housing Administration loan purveyors. These lenders are substituting the implicit guarantee of the Fannie, Freddie, and the mortgage market in general and low interest rates of a bubble at its height with the artificially low interest rates that come with the explicit government guarantee of the FHA.

The scale of lending backed by the FHA has grown rapidly in the wake of the meltdown. BusinessWeek reports that "[b]y fall 2008, FHA loans accounted for 26% of all new mortgages being issued nationwide, up from only 4% a year earlier." Part of that is due to the fact that lending is down generally, but that's not the whole story: the FHA approved 140,000 new loans in September of this year, compared to 60,000 just eight months prior. The number of lenders "approved to market federally insured home loans" is up 140% since December 2006, as subprime lenders are driven by market incentives out o the subprime market, and by government incentives into the government housing sector. Financial heavyweights like Goldman Sachs have been cashing in on the government guarantees by buying subprimes and refinancing them as FHA-backed loans, reaping the rewards of arbitraging between the market rate and the subsidized rate.

The scope of the problem is much narrower than the interventions in the housing market that created the bubble in the first place, as the FHA only guarantees about half a billion dollars in single-family home loans. But it is nevertheless disturbing that lawmakers are still so eager to promote and subsidize personal home ownership after the most recent meltdown.

Why did the ratings agencies fail so badly?

Credit ratings agencies have taken a lot of heat for the subprime meltdown, with the apparently true accusation leveled against them that their ratings were optimistically and unrealistically high for traded derivatives based on subprime mortgage loans. But according to economist Charles Calomiris, the regulatory framework unintentionally rewarded what were essentially fake ratings. The excerpt of the article where he discusses the four regulatory signals to the agencies to lie is very long, so I've stitched together the four main points. Since it's highly redacted, I'm not going to indicate where the cuts are, but you can find the text on pages 31–36:

1. Insurance companies, pension funds, mutual funds, and banks all face regulations that limit their ability to hold low-rated debts, and the Basel I and II capital requirements for banks also place a great deal of weight on rating agency ratings. By granting enormous regulatory power to rating agencies, the government encouraged rating agencies to compete in relaxing the cost of regulation (through lax standards). Rating agencies that (in absence of regulatory reliance on ratings) saw their job as providing conservative and consistent opinions for investors changed their behavior as the result of the regulatory use of ratings, and realized huge profits from the fees that they could earn from underestimating risk (and in the process provided institutional investors with plausible deniability).

2. Unbelievably, Congress and the SEC were sending strong signals to the rating agencies in 2005 and 2006 to encourage greater ratings inflation in subprime-related CDOs! In a little known subplot to the ratings-inflation story, the SEC proposed “anti-notching” regulations to implement Congress’s mandate to avoid anti-competitive behavior in the ratings industry (Calomiris 2007a). The proposed prohibitions of notching were directed primarily at the rating of CDOs, and reflected lobbying pressure from ratings agencies that catered most to ratings shoppers.
   
   This effectively would have further emboldened the most lenient rating agencies to be even more lenient to ratings shoppers, since it effectively would have required the relatively conservative agencies (e.g., Moody’s) to accept the ratings of other agencies in repackaging securities rated by others. Unbelievably, the SEC agreed that notching was anti-competitive and proposed to prohibit notching. In light of the CDO debacle, and a flood of criticism from academics (including myself), the SEC quietly withdrew this proposed anti-notching regulation (at least for the time being). But it still contributed to the subprime rating problem. In the face of the threatened anti-notching rule, the likely response by the relatively conservative rating agencies was to loosen their ratings standards on subprime MBS and CDOs.

3. Changes in prudential bank capital regulation introduced several years ago relating to securitization discouraged banks from retaining junior tranches in securitizations that they originated, and gave them an excuse for doing so. This exacerbated agency problems by reducing sponsors’ loss exposures. The regulatory changes relating to securitization raised minimum capital requirements for originators retaining junior stakes in securitizations. Sponsors that used to retain large junior positions (which in theory should have helped to align origination incentives) no longer had to worry about losses from following the earlier practice of retaining junior stakes. Indeed, one can imagine sponsors explaining to potential buyers of those junior claims that the desire to sell them was driven not by any change in credit standards or higher prospective losses, but rather by a change in regulatory practice – a change that offered sponsors a plausible explanation for reducing their pool exposures.
   
   More fundamentally, the prudential regulatory regime lacked any device for ensuring that bank risk would be adequately measured or that capital would be commensurate with risk. As Adrian and Shin (2008) show, both risk and leverage increased during the subprime boom, which provides prima facie evidence of the regulatory failure to measure risk and budget capital accordingly. Interestingly, Calomiris and Wilson (2004) show that in the 1920s this was not the case. During that lending boom, as banks’ risks increased, market discipline forced banks to reduce their leverage in order to limit the riskiness of their deposits. In the presence of deposit insurance and anticipated too-big-to-fail protection, however, debt market discipline is now lacking. If prudential regulation fails to limit risks, banks may fail to maintain adequate capital cushions. The recent failure of banks to maintain adequate capital in the face of rising risk suggests a need for fundamental reform of prudential regulation, which is explored in detail in Section III.

4. The regulation of compensation practices in asset management likely played an important role in the willingness of institutional investors to invest their clients’ money so imprudently in subprime mortgage-related securities. Casual empiricism suggests that hedge funds (where bonus compensation helps to align incentives and mitigate agency) have fared relatively well during the turmoil, compared to other institutional investors, and this likely reflects differences in incentives of hedge fund managers, whose incentives are much more closely aligned with their clients.
   
   The typical hedge fund compensation structure is not permissible for some other, regulated, asset managers. Mutual fund managers must share symmetrically in portfolio gains and losses; if they were to keep 20% of the upside, they would have to also absorb 20% of the downside. Since risk-averse fund managers would not be willing to expose themselves to such loss, mutual fund managers typically charge fees as a proportion of assets managed and do not share in profits. This is a direct consequence of the regulation of compensation, and arguably has been a source of great harm to investors, since it encourages asset managers to maximize the size of the funds that they manage, rather than the value of those funds. Managers who gain from the size of their portfolios rather than the profitability of their investments will face strong incentives not to inform investors of deteriorating opportunities in the marketplace, and not to return funds to investors when the return relative to risk of their asset class deteriorates.

Did you catch that part in the third point about federal deposit insurance creating a moral hazard that exacerbated the crisis in a way that didn't happen in the run-up to the Great Depression? Also, though I didn't excerpt it, in the section right before this one, the author argues pretty convincingly that the big institutional investors using the ratings agencies were aware of the unrealistic assumptions that the ratings were based on (i.e., an eternally appreciating housing market). This has all convinced me that the ratings agencies' optimistic ratings were a symptom of the problem, and not a cause of the crisis brought on by lack of regulation of the agencies.

(HT: Institutional Economics)

The NYT rehabilitates the payday lender

The New York Times Magazine has a fascinating and uncharacteristically libertarian feature called "Check Cashing, Redeemed" – pretty self-explanatory. In it, Douglas McGray traces the history of Nix Check Cashing – a "ghettoized" bank that's become the biggest in Southern California. "Ghettoized financial services," as one expert calls it, is an $11 billion industry in America. Through the story of Nix, the author discovers that the appeal of check cashing is the simplicity of the transactions. Traditional banks are seen as tricky and unreliable:

But he pays a fee to cash his paychecks. Then he pays even more to send a Moneygram to his wife. There’s a bank, just down the street, that could do those things free. I asked him why he didn’t take his business there.

“Oh, man, I won’t work with them no more,” Enriquez explained. “They’re not truthful.”

Two years ago, Enriquez opened his first bank account. “I said I wanted to start a savings account,” he said. He thought the account was free, until he got his first statement. “They were charging me for checks!” he said, still upset about it. “I didn’t want checks. They’re always charging you fees. For a while, I didn’t use the bank at all, they charged like $100 in fees.” Even studying his monthly statements, he couldn’t always figure out why they charged what they charged. Nix is almost certainly more expensive, but it’s also more predictable and transparent, and that was a big deal to Enriquez.

Marlo Lopez had no broad gripe with banks, but his experience was similar. He moved to the United States from Peru a couple of years ago (with a visa) and got a job as a mechanic at a food-processing plant. Lopez opened his first bank account last summer. A couple of months later, out for dinner, he overdrew his account by 18 cents and got hit with a $35 penalty. It was his fault, he said; he thought he had more in the account than he did. Still, losing that money all at once unsettled him. He kept the account but returned to cashing his checks at Nix.

Check cashers benefit from their smaller scale and lack of bureaucracy that keeps banks from adapting to the needs of the poor:

Nix’s cashiers also try to never say no. Take photo identification. A lot of customers don’t have a driver’s license. Nix stores have accepted high-school yearbooks. They’ve been known to cash a McDonald’s paycheck if someone comes in wearing a McDonald’s uniform. They even have a phone in the lobby, so a cashier can call a customer’s job site and then patch the customer in, listen to him talk to his supervisor and decide if they sound like a legitimate boss and employee. Nix says he loses as much as 5 percent of his check-cashing revenue on bad checks, but it’s worth it, he says, to be known as a place that says yes.

And at least some of the customers use the high-interest loans in financially sound ways, in order to avoid even higher fees for nonpayment of debts. Nix explains why he went from check cashing to the more villified payday lending:

In the late 1980s, when a few check cashers started to accept postdated personal checks and advance cash for a fee, Nix thought it was a sleazy scheme. He thought so even after California legalized the practice in 1997. “I didn’t want to be a loan shark,” he told me. “But the reality is, customers wanted it.”

He told Lagomarsino why. A bounced check, a fee to reconnect a utility, a late-payment fee on your credit card, or an underground loan, any of those things can cost more than a payday loan. And then there are overdraft charges. “Banks, credit unions, we’ve been doing payday loans, we just call it something different,” Lagomarsino says. “When it starts to get used like a payday loan, it’s worse.”

The spread of Nix has challenged payday lenders, check cashers, credit unions, and other "ghettoized finance" outlets to lower their rates, and seems to have energized the industry:

Kinecta’s executives decided to keep the payday loan and change the terms. Starting with three stores in the spring, and eventually across the entire chain, Nix is increasing the maximum loan from $255 to $400. They are dropping the fee from 18 percent ($45 for a two-week $255 loan) to 15 percent ($60 for a two-week $400 loan). And they will rebate a third more ($20, in the case of a $400 loan) into a savings account, after six months, if you pay your loans back and don’t bounce any checks. People get payday loans because they have no savings, Lagomarsino explained. After six months, heavy payday borrowers will accumulate a small balance. Enough, she and Nix say they hope, to convince them they can afford to save more. Later, they say, they intend to drop fees further for borrowers who always pay back on time.

Once Kinecta finishes rolling out its new payday loans, Lagomarsino has promised to open Nix’s books to outside researchers and publish data on its profits and losses. In the meantime, Kinecta will be under enormous scrutiny. “Some people said, ‘Why does it have to be so visible?’ ” Lagomarsino told me, and laughed. “One or two branches wouldn’t make a difference. This is the beauty of buying Nix. They were the largest alternative financial-services company in Southern California. If they change their fee structure, everyone has to change.”

The Wikipedia article has an interesting comparison of payday loans to different forms of late payment fees.

The infinite monkey theorem in action, or: Naomi Klein almost gets it

Naomi Klein has got to be my favorite liberal commentator to read. Not because she's got any clue about what she's saying, but because she has an amazing ability to gather tons of fascinating and relevant facts and come to all the wrong conclusions, and every once in a while she'll say something brilliant that effectively debunks all the wrong things she'd said up until then. Radley Balko notes this same tendency, with her book The Shock Doctrine coming "dangerously close to making a Higgs-ian point about the growth of government at the expense of civil liberties in times of crisis."

Up until now (from what I can tell), Klein's interpretation of the recent financial meltdown has been the standard progressive party line – a mixture of sudden-outbreak-of-greed and deregulation. But about two weeks ago in the Nation, she published an article where she basically tows the libertarian line. The idea of the piece is that the Bush administration is being "like the Portuguese in Mozambique in the mid-1970s, [pouring] concrete down the elevator shafts" and running off with as much money as possible. Well, not him specifically – I guess we're meant to assume that he derives his pleasure from the well-being of the general "big business" community.

So, in the midst of this condemnation, she explains why the bailout is so insidious: it's not necessarily the money itself, but rather the signal that it's sending to the market – that "big business" has the backing of the US federal government. Very astute point, Naomi! But then she stumbles upon an even more fundamental point about the root of the crisis:

Interestingly, Fannie Mae and Freddie Mac both enjoyed this kind of unspoken guarantee. For decades the market understood that, since these private players were enmeshed with the government, Uncle Sam would always save the day. It was the worst of all worlds. Not only were profits privatized while risks were socialized but the implicit government backing created powerful incentives for reckless investments.

Now, with the new equity purchase program, Paulson has taken the discredited Fannie and Freddie model and applied it to a huge swath of the private banking industry. And once again, there is no reason to shy away from risky bets--especially since Treasury has not required the banks to give up high-risk financial instruments in exchange for taxpayer dollars.

In isolation, that's got to be one of the best analyses of the subprime crisis that I've ever seen. She says outright that the government's backing of the GSEs played at least some part in the meltdown. About a month and a half ago, Klein was of the opinion that "deregulation and privatization" were the culprits.

Unfortunately, in typical Naomi Klein fashion, the moment of clarity is brief, and her ultimate conclusion misses the point. She calls on the next president to stop the bailout, but instead of just leaving it at that, she says that: "All deals should be renegotiated immediately, this time with the public getting the guarantees." So, basically, while she concludes that private rewards/public losses was a bad model, rather than returning to private rewards/private loses, we ought to go to move to public rewards/public losses (i.e., nationalization). Damnit – she was so close to sounding like a libertarian!

The relative sizes of Apple, GM, and Alcoa

Wired's Epicenter blog has an interesting post about Apple's financial situation: thanks to their blockbuster iPod and solid laptop division, they've got $25 billion in the bank, and no debts. A normal company would buy some of its suppliers or competitors, but Apple doesn't have any competitors worth buying, and it's never been much for absorbing other companies. It's made some relatively small acquisitions in the past (that's gotta be the most convenient and unexpected article I've ever seen on Wikipedia), but nothing really looks appetizing in the current market. But anyway, the most interesting part is the "Wild Blue Yonder" section, where they list interesting but totally implausible companies for Apple to buy:

Here are some wacky ideas for companies that Apple could buy with a little more than the spare change it finds in the couch cushions: Cray ($115M), in case Apple wants to corner the market for creative supercomputer users; Alcoa ($3B), for all that shiny aluminum showing up in the new MacBooks; Seagate ($3B), in case the company feels like reinventing the hard drive; or General Motors ($3B), in case Jobs wants to reinvent the car.

First of all, it's amazing to me that Cray's total market cap (i.e., value) is less than 1% of Apple's cash on hand. And Alcoa, the aluminum multinational giant, and GM (that GM), are barely worth 10% of Apple's on hand cash. My, how the economy has changed...

Greenspan accepts responsibility for all the wrong reasons

Alan Greenspan has come under scrutiny in the House today, being compelled to declare his culpability in the ongoing subprime mess. But what's so backwards about the whole thing is that he's being lambasted for his anti-regulatory stances, but not his years of keeping the interest rate below inflation, effectively meaning a negative real interest rate. Low interest rates supposedly buoy an economy in bad times, but can result in asset bubbles – and especially in the most valuable and long-lasting assets: houses. But no one seems very interested in taking the Fed to task on its interest rate policy – just raking it over the coals for not trying to reserve consequences of bad monetary policy, rather than attacking it for creating the bad monetary policy in the first place. And the saddest part is that Greenspan is all too willing to take responsibility for not regulating the market enough, but has shown no contrition for (and isn't being asked to by Democratic Rep. Henry Waxman, who's leading the lynching) his monetary policy, and appears to genuinely believe that lack of regulation, rather than monetary policies (among other things), were what threw the market so far off balance.

Why are the libertarian standard bearers so bad?

The Economist has an omnibus article up, mainly about the causes of the subprime crisis and its global ramifications. The article, in my opinion, spends an inordinate amount of space rehashing tired talking points about deregulation and liberalization. Disappointingly, they mention Glass-Steagall, without mentioning the drastic empirical evidence pointing in the opposite direction. They also make this doozy of an error:

The share of Americans who owned their homes rose steadily. But more buyers meant higher prices, making loans even less affordable to the poor and requiring even slacker lending standards.

They have it right that rising housing prices encourage looser mortgage lending, but they don't have the reason right. The real reason is that in a rising market, a bank can be reasonably sure that even if the mortgage goes into default, the collateral (the house) will be worth more than when the mortgage was taken out, and thus will cover the principal of the mortgage. But more importantly, they know that it likely won't come to this, because rather than default and lose the extra value of the home, home"owners" are far more likely to just sell the house, pay back whatever they need to, and pocket the difference. Banks don't just loosen their standards simply because people can't afford to pay higher standards – a freshman business student who made that decision would fail.

I haven't had much respect for the Economist once I started to actually understand the issues it talked about – I agree with Andrew Sullivan that it's "a kind of Reader's Digest for the upper classes." It's disappointing that, on this crucial issue whose narrative is going to shape policy for years, the global elite's preferred "newspaper" of classical liberalism is so lacking when it comes to understanding the roots of the crisis.

But then again, even Bob Barr, in an interview on NPR (MP3 here), lays the blame of the crisis largely on the back of bad regulation – when the Economist and the Libertarian Party's presidential candidate can't even explain the statist roots of the crisis, you know that libertarianism is in trouble.