The FHA picks up where Fannie Mae and Freddie Mac left off

As if New York City's rent control (which regulates rents in about half of all units in the five boroughs) hadn't done enough damage to the city's housing stock and renters' wallets, the Federal Housing Administration is currently doing its part to ensure that no luxury Manhattan condo goes unsold:

At least nine Manhattan condo developments south of 96th Street have sought approval for FHA backing since the agency loosened its financing rules in December, according to a database of applications maintained by the U.S. Department of Housing and Urban Development. The change allows the FHA to insure loans in new projects where only 30 percent of units are in contract, down from at least 50 percent. About 1,900 apartments in New York’s most expensive neighborhoods would be covered by the applications.

This is precisely the sort of mission creep that led Fannie Mae and Freddie Mac to move outside their core mission of offering home loans to the needy, and which eventually brought down the two companies, and likely played a key role in bringing down the world's economy. One economist's assessment of the risk the FHA is taking on sounds pretty familiar:

Caplin testified before Congress in March, arguing that FHA may need a taxpayer bailout because the agency relies on overly optimistic assumptions on unemployment, home prices and loan performance to predict losses.

This trend is not necessarily new – I noticed it first two years ago – but the fact that the FHA is still growing its housing portfolio suggests that whatever meager recovery the US housing sector has managed may not be sustainable. History is full of people repeating mistakes, but America's housing czars seem downright amnesiac.

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.

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.

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?

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!

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.

Andrew Cuomo pissed that Caroline Kennedy stole his Senate seat

New York Attorney General Andrew Cuomo is apparently pretty pissed that Caroline Kennedy has emerged as a frontrunner to fill Hillary Clinton's Senate seat, since he's evidently been eyeing a Senate seat for a while. While he obviously has more experience than Caroline Kennedy, Andrew Cuomo's pedigree is nothing to laugh at: he's the son of a former New York governor, and up until his 2003 divorce from one of RFK's eleven children, he was Caroline Kennedy's nephew-in-law.

And as much as I hate aristocracy, I can't say that I feel bad for Cuomo – he had perhaps the single largest individual role in the subprime collapse in his capacity as Clinton's HUD secretary from 1997 till 2001, leaving aside maybe Alan Greenspan.

Something interesting also to note is that the three biggest winning personalities this electoral season (all senators, I might add) – Obama, Biden, and Clinton – have all had their former senate states shrouded in mystery and intrigue. Obama's seat led to the undoing of Illinois Governor Blagojevich, and Clinton's new job as Secretary of State led to Caroline Kennedy's interest in the newly-vacated seat and the ensuing uproar. Joe Biden's son Beau (current Attorney General of Delaware), who has been rumored as a possible replacement for Joe Biden's senate seat, has taken the (sort of) high road and stayed out of the running for the unelected seat, and instead might run in an actual election in 2010 – made easier by the fact that the person appointed to Joe Biden's old seat, Ted Kaufman, was Joe Biden's former chief-of-staff and has stated that he doesn't intend to run to keep the seat in 2010.

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 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!

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.

Credit default swaps and you

Don't know what credit default swaps are and why they matter? Neither did I. Till now. From Arnold Kling, via Reason:

A credit default swap is like insurance against default. If you want to buy a municipal bond or a corporate bond but not take default risk, you try to buy a credit default swap. You pay a fee, and in exchange for that fee the seller of the swap will make you whole if the city or corporation defaults.

The seller of swaps collects nice fees, and most of the time the borrowers don't default. But if borrowers do default, then the seller is like an insurance company in a town that was hit by a hurricane. [...]

Suppose I have sold a credit default swap on Sallie Mae. That means that if Sallie Mae defaults on its bonds, I will have to pay some of the bondholders a big chunk of money. One way I can hedge that risk is to sell short Sallie Mae securities..... However, the more short-selling takes place, the closer they get to default. It is a vicious cycle. Ordinarily, I do not believe that short-selling affects the price, but when there is massive short-selling that is driven by dynamic hedging, I can see where the short selling would drive down prices.

Tax policy and the subprime crisis

Here's a cause for the real estate bubble that I'd never heard before, via Russ Roberts at Cafe Hayek: bad tax policy. In 1997, Clinton signed into law a tax act which gave taxpayers a substantial exemption from the capital gains tax when they sell their home. Married homeowners filing jointly could pay 0% capital gains tax on up to $500,000 of the difference between the selling price and the buying price. This gave real estate investment an edge over salaried/wage labor – you could never get away with earning half a million dollars through a job and not paying any tax on it. It diverted resources in the economy towards real estate and away from other sorts of work and entrepreneurship. Chris Farrell at Business Week summed it up well in 2005:

The issue goes way beyond tax fairness. A growing number of economists are deeply concerned that residential real estate is absorbing far too many economic resources. Money is pouring into concrete foundations rather than high-tech innovation. "Residential investment accounted for 35% of private investment in the past year, a level not seen since the early 1970s," notes Martin Barnes, the perceptive financial-market observer at Bank Credit Analyst.

Upon reading this, my first inclination is to say that this might have been a more important impetus for the bubble than state intervention in housing through government-backed mortgage agencies.

This reminds me of an article that I read yesterday by Kevin Carson, founder of the vulgar libertarian watch. In it he argues that you cannot evaluate a policy in an "atomistic" way, but rather how it relates to other laws in a "dialectical" way. As it applies to this tax policy change, though the action – lowering real estate capital gains taxes – was a very libertarian thing to do if you look at it in isolation, the fact that the law left all other tax levels unchanged makes it an illiberal policy. When people decide how they're going to earn money, real estate speculation will receive more consideration in relation to working than it otherwise would it a totally free market.

Cause of the mortgage crisis

So, the bubble has burst, the banks have been bailed out, but there still remains the question: what caused the subprime mortgage collapse? There are, generally, three competing hypotheses: the stereotypical left-wing explanation that it was underregulation; the wishy-washy sudden-outbreak-of-greed theory; and the stereotypical right-right explanation that it was government meddling. In this post, I want to try to list all the pros and cons of each theory, and hopefully elucidate the causes of the collapse.

Left-wing explanation: not enough regulation!

This hypothesis most often blames the Gramm-Leach-Bliley Act of 1999, which repealed parts of the Glass-Steagall Act of 1933. Passed in the wake of the Great Depression, the Glass-Steagall Act – among other things – drew a thick line between "investment" and "commercial" banks. Investment banks made wild bets, and commercial lending banks kept your money safe. This distinction formally melted away in 1999 with the Gramm-Leach-Bliley Act, when banks were able to be both commercial lending banks and investment banks. The argument goes that this encouraged what were otherwise commercial banks to get into the risky subprime business – to play roulette with your bank deposits. Though figures as public as Paul Krugman have all-but-endorsed the theory, Alex Tabarrok at Marginal Revolution demolishes this myth. In studies done with the benefit of hindsight, "unified" banks (i.e., those that took advantage of the diversification that the repeal of Glass-Steagall allowed) actually did better through the subprime crash than solely investment banks.

Wishy-washy explanation: too much greed!

Unfortunately, this is probably the most popular explanation. It's popular among politicians, because it allows for a lot of grand-standing without any real solutions. Like I wrote yesterday, you cannot use basic human proclivities to explain one-off crises.

Right-wing explanation: too much regulation/intervention!

Readers of this blog will know that this is where I stand: the government, from back to the Clinton years, has been using homeownership rates as a proxy for general welfare, and both Clinton and Bush II have tried their damnedest to ride roughshod over free market financing and cram as many mortgages down as many throats as they could. Russ Roberts at Cafe Hayek has done an excellent job in documenting all of the ways in which government has intervened in the housing market, by way of the GSEs, the FHA, HUD, and the CRA. There are various retorts to this, depending on which government agency you think caused the crisis. When presented with evidence that Fannie and Freddie were big players in the subprime game, opponents of this theory will point out that they were forced to get out of the subprime business before the bubble burst. When questioned about the Community Reinvestment Act, opponents will point out that though the reinterpretation of the CRA did lead to a "flurry of CRA activity," it was over by 2001. Still, though, given that Fannie/Freddie/FHA/HUD/CRA combined for sure accounted for the majority of the mortgage market, it's not difficult to imagine a situation in which government mortgage agencies kicked off the bubble, and then the increasing housing prices gave the situation a momentum of its own (subprimes aren't risky when home prices are constantly climbing), so that even if by the end there were no government players, they were still ultimately responsible.

Edit: Another explanation is a change of tax policy in 2007, which I discuss in a post on September 23.

The greed levels here are through the roof!

This quote about the current financial crisis has been flying around the econblogosphere, but it's so good that I feel the need to repeat it:

On greed, let me repeat: If unusually many airplanes crash during a given week, do you blame gravity? No. Greed, like gravity, is a constant. It can’t explain why the number of crashes is higher than usual. And let me add: This isn’t a morality play. What we’re seeing are the consequences of monetary-policy distortions of interest rates and regulatory distortions of incentives, amplified in some degree by private imprudence, not the consequences of blackheartedness.

Something very good to keep in mind when you hear John McCain blather about how greedy suits made bad investment decisions. Funny how that happens – everyone all of the sudden just gets greedier than they were before! Maybe if those whippersnappers had gone through McCain's national service plan they wouldn't be so goldern greedy!

(Lest you think McCain is the only mindless jabberer, keep in mind that Obama is also a proponent of the sudden-outbreak-of-greed theory of finance, and maybe he thinks his national service program would keep the third deadly sin in check.)

Andrew Cuomo and the subprime meltdown

I just read an article by the Village Voice in which I learned about a central character in the subprime meltdown that I didn't even realize was relevant: Andrew Cuomo. The author Wayne Barrett sure has a negative opinion of Cuomo, Clinton's Secretary of Housing and Urban Development from 1997 till 2001 (he's also been New York State Attorney General since 2007). He blames him for the mortgage meltdown, both for fundamental failures in policy and unethical ties to housing industry interests.

As for his fundamental failings, the author believes that Cuomo's "quantum leap" in mandates for affordable housing drove the subprime and de facto subprime markets upwards, and put pressure on lenders to find ever more subprime mortgages to bundle and sell to Fannie Mae and Freddie Mac.

Cuomo's predecessor, Henry Cisneros, did that for the first time in December 1995, taking a cautious approach and moving the GSEs toward a requirement that 42 percent of their mortgages serve low- and moderate-income families. Cuomo raised that number to 50 percent and dramatically hiked GSE mandates to buy mortgages in underserved neighborhoods and for the "very-low-income." Part of the pitch was racial, with Cuomo contending that Fannie and Freddie weren't granting mortgages to minorities at the same rate as the private market. William Apgar, Cuomo's top aide, told The Washington Post: "We believe that there are a lot of loans to black Americans that could be safely purchased by Fannie Mae and Freddie Mac if these companies were more flexible."

Though this section raises the issue of racial justice in upping the number of low-income loans, and later in the article the author talks about pressure from interest groups like ACORN, ultimately it seems that Cuomo's ties with the mortgage banking industry is what really sealed the deal. The mortgage industry wanted Fannie and Freddie to stop encroaching on their higher-end mortgage territory, so they thought that pushing it further into the toxic nether regions of the mortgage industry would achieve that goal. That's why Cuomo had "closer" ties with private real estate groups like the Mortgage Banker Association and even an anti-GSE group called FM Watch. The author says that these interests were "actually driving [Cuomo's] agenda" as opposed to the affordable housing interests.

Later, however, during Bush's terms, the pressure seems to have shifted from private real estate interests to pressure from the presidency. Bush continued Clinton's legacy of supporting high homeownership rates, and his "ownership society" also put an emphasis on high rates of homeownership. During Bush's 2004 reelection campaign, he pushed the GSEs' affordable housing quota up to 56% from the 50% that Cuomo had managed during the Clinton years.

The article includes a lot more about what appear to be serious ethical failings on Cuomo's part with regards to his relations with private sector executives, and it's an interesting personal take on the subprime meltdown. I don't doubt that Cuomo orchestrated HUD's manipulation of the GSEs and the FHA to effectuate social policy, which then led to the crisis, but I do think the author is a little tough on Cuomo. The incentives were built into the institutional fabric of our government, and conflicts of interest and less than logical government are inevitable. But nevertheless an excellent account.

Finance across the pond(s)

The British government "shocked" the finance industry over there tonight when they announced a three month moratorium on short selling. Short sells are financial instruments that allow someone to bet against a stock by borrowing the stock (for a fee) for a price ostensibly based on its current price, selling the stock, and buying it back after it falls (hopefully), returning the stock to the lender and pocketing the difference. It's risky, but it allows stock prices to fall faster, and for a correction to happen, the market has to bottom out. It's just speeding up the inevitable, minimizing the amount of time that the markets fall before they start to rise again. Temporarily banning short selling has been discussed in America, too, though it hasn't happened yet.

The Guardian article also includes these disturbing bits, about the British government's plans to lean on lenders to give more mortgages to first-time buyers (i.e., less credit-worthy people):

Short-selling has inspired government action because ministers are relying on Lloyds TSB's purchase of HBOS to revive the housing market and has agreed to override competition laws in return for a pledge by the newly created megabank to offer more home loans to first-time buyers. [...]

When asked how the bank would counter abuse of its market dominance, particularly in mortgages, he said "new lending" by the combined bank for households and small businesses would "continue at least at current levels" and the bank would increase the range of products aimed at first-time buyers.

So basically, the government is going to ensure that risky loans continue to be made by state-controlled lenders (the same thing exacerbated/caused the subprime collapse over here, meanwhile ensuring that banks cannot contract their lending practices as is normal during a recession. Do they never learn?

Edit: On the other side of the Anglosphere, Australian politicians are also looking to further control their mortgage market, with the creation of an "Aussie Mac." Stephen Kirchner has an analysis of the plan, and finds that it has many of the problems that American mortgage GSEs have had. He admits it's an appealing idea, since the corporation (whether public or private) requires no federal expenditure, as it derives its superior market position from the government's credit rating, which allows it to borrow at lower rates than private banks could. But the savings are not reliably passed on to consumers – the corporation already has an inherently superior market position, so there's a lot of room to make profit without any competition). And even when the savings are passed on to consumers in the form of lower interest rates on home loans, the American real estate bubble that preceded and enabled the subprime meltdown shows that easier lending – and thereby higher housing prices – is not always such a good thing. And then there's the fact that in the end, if the government has to bail out the corporation (as the Feds just did), the costless way to raise homeownership rates ends up not being so costless.