My mom wanted to listen to Brad’s radio show, so we played the mp3 last night. Listening to it, I was reminded both that I’m too damn polite for radio, and that I have some unfinished business with Dave Dayen. We went back and forth on the subject of the evil subprime originators vs. Fannie and Freddie and never got to finish the point.
Brad suggests that no one cares; but I do because the responses to housing mortgage policy are going to be critical in the next Administration, and I think we need to be approaching this issue with wide open eyes.
Let’s start with the issue D-Day and I were disagreeing on when Brad rescued him. Here’s the Washington Post:
In January 2007, as years of loose mortgage lending were about to send the nation’s housing market into devastating decline, Fannie Mae chief executive Daniel H. Mudd wrote a confidential memo to his board.
Discussing the company’s successes, Mudd said one of Fannie Mae’s achievements in 2006 was expanding its involvement in the market for subprime and other nontraditional mortgages. He called it a step “toward optimizing our business.”
A month later, Fannie Mae outlined plans to further expand its activities in the subprime market. The company recognized the already weak performance of subprime loans but predicted that they would get better in 2007, according to another Fannie Mae document.
Internal documents show that even late in the housing bubble, Fannie Mae was drawn to risky loans by a variety of temptations, including the desire to increase its market share and fulfill government quotas for the support of low-income borrowers.
Since then, Fannie Mae’s exposure to loosely underwritten mortgages has produced billions of dollars of losses and sent its stock price plummeting, prompting the federal government to prepare for a potential taxpayer bailout of the company. This month, Fannie Mae reported that loans from 2006 and 2007 accounted for almost 60 percent of its second-quarter credit losses.
So let me pull out the section on “what happened” from the Milken Institute slide deck I link to above and let’s dig a little further into this.
Dave and Marcy Wheeler were taking the “Fannie had nothing to do with this” position. I countered with “I’ve got this 92-page Powerpoint from the Milken Institute that says otherwise…”
Dave immediate dismissed it, saying “Did Fannie or Freddie make subprime loans?” And while I went to get the appropriate slide from the deck to show him, we moved the conversation along – because according to Brad, no one cares.
But I do, and I’ll suggest that we all should. because they did, and further because of who they were and their position in the financial ecology, what they did was dramatically more important than what any other single institution chose to do.
So let me cherrypick from the entire deck (which you can download here as a pdf) and present what I see as some key points.
First, here’s the residential mortgage market. Note that subprime and delinquent loans (set out in the next two slides) are a relatively small part of the market.
First subprime:
Note that less than 10% of loans outstanding are subprime, and that represents roughly 5% of the total housing value in the US.
Next, here’s the state of the market today:
Note that 66% of the houses in the US have mortgages. Of those, 9.2% are in arrears, and 2.8% in foreclosure – which compares with approximately 50% who were in the same state in the Great Depression. That 9.2% represents 6% of the homes in the US, and the 2.8% represents approximately 1.8% of the housing stock in foreclosure.
Here are slides from the section of their presentation on what went wrong. Let’s go through them and let me try to fit an argument:
The first slide in this section:
This shows the assets and MBS (Mortgage Backed Securities) of Fannie and Freddie, in comparison to the entire residential real estate assets of commercial banks and savings banks – the scale of Fannie & Freddie become fairly clear.
Next we have the escalating leverage within Fannie & Freddie.
Look at how the asset/MBS ratios changed from 2003 to 2006.
Now look at the impact on the solvency of the two institutions:
The righthand set of columns for each – with the assets marked to market – show how the debt/equity ratio of Freddie and Fannie deteriorated from 50 – 60X (one dollar of equity for every 50 – 60 dollars of loans held on the books) to 167X and 255X, respectively – and insolvency.
Now this insolvency has two cascading problems; the first of which is the sheer scale of the two organizations (see above). The other is that securities of Fannie and Freddie were largely held by banks and other financial institutions. Here’s an article from Bloomberg on August 22:
Fannie Mae and Freddie Mac’s $36 billion in preferred stock was downgraded to the lowest investment-grade rating by Moody’s Investors Service, which said the increased likelihood of “direct support” from the U.S. Treasury may devalue the securities.
The ratings were lowered five steps to Baa3 from A1, New York-based Moody’s said today in a statement. Moody’s kept its Aaa senior debt ratings on Fannie and Freddie stable and affirmed the subordinated debt because the Treasury will likely make sure the companies continue to make interest payments in any bailout.
…
Regional banks including Midwest Bank Holdings Inc., Sovereign Bancorp and Frontier Financial Corp., may have the most to lose. Melrose Park, Illinois-based Midwest has $67.5 million, or as much as 23 percent of its risk-weighted assets, in the preferred stock, while Philadelphia-based Sovereign owns about $623 million and Everett, Washington-based Frontier about $5 million.
The downgrade “puts a little more pressure on banks to record some sort of impairment charge on these securities,” Daniel M. Arnold, an analyst at Sandler O’Neill & Partners LP in New York, said in a telephone interview. “The more and more likely it becomes that the value of these isn’t going to return back to where it was,” the harder it is to avoid writedowns.
(emphasis added)
As I understand it, shares and securities of Fannie and Freddie were widely held in the financial sector, because they were considered such high-grade securities that banks wanted them to count as a part of their equity – the required capital they need to be able to continue to make loans or even just stay in business. Here’s a Sept. 12 press release from Central Bankcorp:
Central Bancorp, Inc. (NASDAQ: CEBK) (the “Company”), parent company of Central Co-Operative Bank (the “Bank”), announced today that the U.S. government’s actions with respect to the Federal Home Loan Mortgage Corporation (“Freddie Mac”) and Federal National Mortgage Association (“Fannie Mae”) will adversely impact the value of the Company’s perpetual preferred stock investments in Fannie Mae and Freddie Mac.
…
At June 30, 2008, the Company had five securities totaling $10.1 million of perpetual preferred stock of Fannie Mae and Freddie Mac, which had an unrealized loss of $799,000. The impact of the above actions and concerns in the marketplace about the future value of the perpetual preferred stock of Fannie Mae and Freddie Mac have caused the values of these investments to decrease materially, and it is unclear when or if the value of the investments will improve in the future. Given the above developments, on September 11, 2008, the Company concluded that it will record a non-cash other than temporary impairment on these investments for the quarter ending September 30, 2008, the amount of which is expected to equal the difference between the net book value of the securities at September 30, 2008 and the market value of the securities at September 30, 2008. As of the closing price on September 11, 2008, the market value of these securities was approximately $890,600.
If the investments were valued at zero and if the Company was not able to record a tax benefit for the loss, the resulting capital ratios would render the Bank adequately capitalized because the Bank’s total risk-based capital ratio would fall below 10%. The impact on the Company’s and Bank’s capital ratios would be as follows…
Note that the last paragraph is contradictory – the “resulting capital ratios would render the bank adequately capitalized because the Bank’s total risk-based capital ratio would fall below 10%” But it’s clear that holdings in Fannie and Freddie securities were widespread in regulated financial institutions, and that their capital ratios were at risk from the insolvency of these organizations.
Now if you’ll recall, this all started when I suggested, arguing with Marcy Wheeler, that Fannie and Freddie did have something to do with the meltdown. Dave Dayen countered with “do Fannie and Freddie make subprime loans?” And I was flipping through the deck, looking for this slide:
You’ll note that 61% of the loans Freddie had in its retained portfolio in 2006 were subprime, and a further 25% were Alt-A.
It’s the kind of thing you wish you’d had at your fingertips when you’re arguing in public…
As to Fannie, in 2006 the ratios were 46% subprime and 35% Alt-A.
I’ll send this link over to Marcy and Dave (as well as Brad) and see what they have to say.
Meanwhile, let’s continue with the Milken presentation.
Here’s another slide showing the insanely risky leverage of Freddie Mac in relation to other financial firms.
Here’s a slide showing the overall level of leverage at major investment banking firms.
Now, let’s shift focus to S & P and Moody’s. Here’s a table showing securities issued by rating – note the vast majority of all rated securities were rated AAA. Now on the right is a table of the MBS that were downgraded by rating. Over 50% of the issues MBS’ were downgraded.
I’d suggest that people have a lot of reason to be really, really unhappy with the rating agencies these days.
Here’s the way we magically created creditworthy value out of – noncreditworthy value:
Via financial engineering, we managed to create a lot of perceived value. The solidity of that value, on the other hand, proved not be so great.
Engineering took place on a lot of levels – fraud at origination existed as well. But overall, it hasn’t been that great – it looks like it was about $1 billion at peak to date.
Out of a total mortgage market of some $8 trillion, $1 billion in mortgage fraud is serious, but seems far from central.
As a final note, the question is whether the crisis is incomes-driven; i.e. that it was caused by declines in people’s incomes from job loss or wage reductions. Let’s look at their data.
Looking at this chart, it’s apparent that the biggest driver of foreclosure rate wasn’t job or income loss – it was home price collapse.
And now let me try and fit a theory to this. We had a speculative boom in housing (and commercial real estate) fed in large part by low interest rates and lax loan standards. That boom had to end sometime, and that time is now. Typically the damage would be limited to some suburban banks like Countrywide, but in this case the damage is throughout our financial institutions. Why?
The collapse of the boom is much more damaging than it needed to be, I’ll suggest, for two significant reasons:
Because the far-and-away largest institutions in the market, Fannie and Freddie, added risky loans to their portfolio while they were immensely overleveraged – putting them significantly at risk. But their securities were still treated as something other financial institutions could use as equity, meaning that they could in turn highly leverage them. So when Fannie and Freddie were shaken, the effects on the balance of the highly leveraged financial industry were vastly amplified.
This wasn’t the sole cause, and there are complex enough issues here that financial historians will be studying and debating this for generations.
But it’s vitally important to note the roles of Fannie and Freddie because the likely policy going forward will likely continue to rely on government market-makers and sources for mortgages, and if we don’t pay attention to what went wrong here, we’re likely to do it again.
–
AL,
Thanks for an interesting post. I’m going to have to go back over the source material you link to, and crunch some numbers, but what you’re saying here corroborates a story-line that’s been cohering from several other sources– in particular, that slide about the creation of CDO and CDO-exponential devices now has numbers. I can understand numbers, given enough time.
And Arnold Kling made a comment a few days ago, calling this sort of practice a form of regulatory arbitrage. Arbitrage is also something I understand– it’s the effect of creating a (usually… always? Not sure) artificial price or other economic differential for some good. If crap mortgages were being transformed into AA or AAA assets in sufficient proportions, the arbitrage comes into play by virtue of the regulations requiring far less securitization than other more solid and expensive assets. No one interested in making money, who has the funds, is going to pass that up in the early stages, and then it’s addictive, like printing money.
Until it all crashes down.
Likewise, the growing question of, “Where the hell were the independent ratings and auditing companies?” is starting to move from a persistent whisper in the background to a serious and broad-based question. Understand, I’m very much a free market kind of a guy, but the capital-L Libertarian doctrinaire crowd might end up in a very uncomfortable position after this nonsense.
(I claimed a few weeks ago I’m not any kind of financial expert. I’m still not. But I read a lot, I read fast, and I work with numbers more than enough to have a good intuition for systems of them.)
Finance again! Can’t we at least talk about Pakistan going bankrupt?
_do Fannie and Freddie make subprime loans?_
The more precise answer is that while they did not make subprime loans, the regulations allowed the GSEs to buy some loans from some of the institutions that made subprime loans. No one forced a company to make a subprime loan. Knowing that you could foist them off onto the GSEs in addition to an investment bank or holdng it yourself didn’t hurt, especially when fees were your primary concern.
However, that portfolio number also comes from buying securities backed by loans(including subprime). So, the bank(s) have already taken a significant cut, packaged them up, and decreased visibility.
And – watch out for only retained vs. total backed. Both scary numbers, but it’s “not like this wasn’t known by Federal regulators”:http://www.ofheo.gov/newsroom.aspx?ID=431&q1=0&q2=0
_But their securities were still treated as something other financial institutions could use as equity, meaning that they could in turn highly leverage them. So when Fannie and Freddie were shaken, the effects on the balance of the highly leveraged finanical industry were vastly amplified._
Sort of. There were a series of clauses based on the Government taking over the GSEs that shook up the CDS market, causing payments of about ~$500B, and for a bunch of companies to start locking things down in expectation of payments.
Once the government did takeover the GSEs, institutions starting hoarding cash to pay out their $200m owed, and in case they did not get the $190m in the same event back.
Once the government stepped in to guarantee payment of flagging loans, their value may have even gone up from a month previous, so it’s not like people went from regarding them as AAA to junk. Not as valuable as in June 2006, but nothing like a private issue that didn’t have government backing. I don’t really know about the spreads though.
>No one forced a company to make a subprime loan.
Well, unless you were a bank and wanted to do anything requiring regulator approval, which is to say pretty much anything (open another branch, merge with someone, etc), in which case you had to show a good CRA score, which meant doing lots of business that ended up being “sub-prime loans.” Sorry, I don’t have pretty pictures to link to.
I’m going to have to do a lot of research on this to comment comprehensively. It’s not so far off from my day job that maybe I can at least make it look like work. Here are some offhand observations inspired by a lengthy article by McClatchy.
I’m discomfited by your fourth slide [importance], because it seems possible that mortgage companies like Countrywide and Ameriquest that were not commercial banks are not included anywhere on the slide at all. (Were they considered savings institutions?) They went bankrupt first and were responsible for the most egregious loans. Let me see if I can find other measures of F/F weight in the market…
See, I was always working under the assumption, until about 3 weeks ago, that “sub-prime” by definition was something that didn’t meet Freddy and Fanny’s standards. This is the first thing I’ve seen that confirms my assumptions need revising other that finger-pointing by partisans.
The ratings companies sure have some ‘splainin’ to do. Seriously. What event suddenly caused Triple-A MBS’s to all of a sudden tank? The Housing bubble bursting, right? If you’re in the MBS ratings game, or in the an industry having anything to do with housing, you saw the bubble and that it would eventually burst by 2006 — especially if you were in the business of calculating risk on mortgages for Pete’s sake.
Why should the GSE’s have seen this coming, that their MBS’s would eventually cause writedowns, any more than those who’s job it is to tag them with AAA? How was it irresponsible to rely on the rating companies? It wasn’t wrong for the GSE’s more than any other investment house with a fiduciary responsibility to their shareholders to invest in MBS’s if they were rated AAA. If there were subprime loans in there, they never should have been given AAA ratings in the first place since the loans underlying the security was, you know, not prime.
I know everyone is looking for a scapegoat, and Freddy and Fannie are convenient places to start. But I don’t see how they acted irresponsibly. To me, they were trying to fulfill both of their duties, to protect and turn a profit for shareholders and to promote a public policy through a private means for increased home ownership.
Seems to me the privatization of everything the administration pushed with religious fervor is something that lays very near the heart of the problem. We could have pumped $100 billion directly into low income housing and accomplished more of the goals of the “ownership society” without risking the whole system and costing 10 times as much in tax dollars for the bailouts and 20 times that in the value of lost pensions and vanished wealth, which might eventually result in the end of America as a superpower. But that would have been unAmerican.
I guess when there’s a systematic failure, there are points all over the system we can find blame.
One thing I can see from the chart on foreclosures rates and housing prices showing that there seems to be a direct correlation, this sinks the knife in the idea that poor folks as opposed to house flippers and speculators drove this thing — and also takes the onus off the CRA and ACORN?
You can try to fool mother nature for a short while. But she always prevails in the end.
Affirmative action was bad enough when applied to university admissions, but market forces correct for it (in the form of real college grad wages not rising this decade, to account for the dilution in quality of grads).
But now, affirmative action was applied to home ownership, and is about to be applied to the Presidency. The former is causing a predictable correction, and the latter it likely to cause various corrections throughout our society, which will be quite the opposite of what the proponents want.
Here are some links that may be of interest.
Randall Parker writes “Markets Lose Faith In Credit Ratings Agencies”:http://www.parapundit.com/archives/005615.html
10/4/08 NYT account of Charles Mudd, CEO of Fannie: “The Reckoning: Pressured to Take More Risk, Fannie Reached Tipping Point”:http://www.nytimes.com/2008/10/05/business/05fannie.html?_r=2&adxnnl=1&oref=slogin&partner=permalink&exprod=permalink&pagewanted=all&adxnnlx=1223175687-o2eJdDiA2hYen6a50H7g8w
From July 2007, a chart on delinquencies of “Fixed vs Variable Subprime Default Rates,”:http://www.portfolio.com/views/blogs/market-movers/2007/07/18/chart-of-the-day-fixed-vs-variable-subprime-default-rates showing that the weakness was focused on the ARM side.
bq. My best guess is that subprime borrowers split into two camps. On the one hand, there are the Noble Few, who took advantage of excess liquidity to get their feet onto the bottom rung of the property ladder… But the Noble Few were outnumbered by the Reckless Many, who had dollar signs dancing in front of their eyes and would read daily in the newspaper of the fortunes being made in the property market by people who followed the time-worn advice to “buy the biggest house you can afford”… [these borrowers] chose the mortgage with the lowest monthly payments – and the mortgage with the lowest monthly payments was always a variable-rate mortgage.
bq. To put it another way, what we’re seeing in this chart is the entry of a whole new borrower class into the subprime market… home-equity withdrawals and speculative purchases and dodgy mortgage originators all conspired to change the profile of the average subprime borrower – especially the sort of subprime borrower who chose a variable-rate mortgage. Which is one of the reasons why all the models which had worked in the past suddenly broke, despite no huge spike in interest rates.
bq. The financial markets knew how people behave after taking out a mortgage. They just didn’t realize that in the specific case of variable-rate subprime mortgages, they were dealing with a completely different set of people.
10/3/08 “Anatomy of a Train Wreck: Causes of the Mortgage Meltdown,”:http://www.independent.org/publications/policy_reports/detail.asp?type=full&id=30 by Stan Liebowitz.
bq. his report concludes that, in an attempt to increase home ownership, particularly by minorities and the less affluent, virtually every branch of the government undertook an attack on underwriting standards starting in the early 1990s. Regulators, academic specialists, GSEs, and housing activists universally praised the decline in mortgage-underwriting standards as an “innovation†in mortgage lending. This weakening of underwriting standards succeeded in increasing home ownership and also the price of housing, helping to lead to a housing price bubble. The price bubble, along with relaxed lending standards, allowed speculators to purchase homes without putting their own money at risk.
bq. The recent rise in foreclosures is not related empirically to the distinction between subprime and prime loans since both sustained the same percentage increase of foreclosures and at the same time. Nor is it consistent with the “nasty subprime lender†hypothesis currently considered to be the cause of the mortgage meltdown. Instead, the important factor is the distinction between adjustable-rate and fixed-rate mortgages. This evidence is consistent with speculators turning and running when housing prices stopped rising.
Steve Sailer has “a cogent analysis,”:http://isteve.blogspot.com/2008/10/my-new-vdare-column-big-enchilada.html too:
bq. The truth is, we were never as rich as we thought we were. The last decade’s growth was largely driven by huge flows of lending dollars to dubious borrowers. At the bottom of an unknown but frightening number of convoluted new-fangled debt instruments were homebuyers who had no chance in hell of paying the mortgages back when the music stopped and the price of houses in California (and a few similar states) stopped heading toward infinity.
Fannie and Freddie and their implicit (now explicit) taxpayer guarantees certainly helped inflate the bubble, making the inevitable Ponzi-like collapse worse. But they were far from the sole cause of this disaster. Like most crashes, multiple elements contributed.
A major domestic goal of the Clinton and then Bush administrations was to raise homeownership levels to about 70%, bringing minority rates about equal to white rates. This was actively supported by most players in the housing market, including Raines and then Mudd at Fannie Mae (see NYT article) and Angelo Mozillo at Countrywide. Widespread adoption of a series of financial innovations was the solution to this problem. ARMs, Option ARMs (with delayed repayment of principal), low- and no- down-payment loans, granting mortgages to riskier debtors at higher interest rates (Subprime and Alt-A loans).
As Nassim Taleb (The Black Swan) has pointed out, the overarching problem was that the market–ratings agencies, Wall Street, Fannie, Freddie, purchasers of mortgage-backed securities–had computational models with which to quantitate Risk. While precise, we know with hindsight (and some saw at the time) that the estimates were delusional, and orders of magnitude too low.
Wow. SLide 75 of the Milken presentation is astonishing, to my naive eyes: 51% of securities that were rated by S&P in 2007 were rated AAA. There’s a histogram on that slide showing all the ratings and the percentages issued. Nice gental bimodal distribution… except for that last bin for the AAA being bigger than the sum of all the bins.
I’d love to get my hands on comparison histograms for the last 20 years, but I don’t, so I have to ask: Is that at all typical?
Slide 76 is also fascinating. But I’m not sure if I understand it: Is it telling me that the top 95% of some entity gets wrapped into a high-grade CDO while the lowest 5% get wrapped into a mezzanine CDO? If so, that alone might not be insane, but the resultant breakdown of the credit ratings of those two CDOs appears to be… insane. I can’t be reading that right. But if I am, then I understand the regulatory arbitrage a lot better– if sub-prime housing loans were in there, some significant number of them were getting rated up to AA and AAA, which is considered less risky than a typical home loan with a 20% down payment! Which means that the banks need less cash on hand to provide security, which means they can go out and do stuff with it. That’s Kling’s arbitrage.
Possibly playing against type, I want to recommend “this NPR radio show”:http://podcast.thisamericanlife.org/podcast/365.mp3 about just where the regulation hole was that seems to have led to the big-dogs credit freeze that’s bugging folks so, and what the size was. Worth the time while you’re doing laundry or whatever.
One more element of the state of play.
Fair warning: the wrap-up final few minutes are a bit too dolorous, in my view. “Boy, ah’m pow’r’ful skeered. Are you skeerred too? Let’s take it out with an old spiritual / folk song from the Dust Bowl / Depression, shall we?”
A meta-observation:
The financial meltdown has all the hallmarks of what engineers call a ‘failure chain’ – a number of things going wrong one after another to create a spectacular or catastrophic failure.
Potential failure chains can be anticipated in systems that are well understood or where there’s a lot of experience. One easy example – familiar to some here – is shooting. The classic safety briefing includes something like the following:
– Don’t point the gun at anything you don’t want to destroy
– Don’t load the gun until you’re ready to shoot
– Don’t put your finger on the trigger until you’re on target
– Don’t pull the trigger until you’re certain what’s in front of and behind the target
The principle is that you have to screw up on EVERY ONE of these before someone gets hurt or something destroyed. Do even one correctly and the failure chain is prevented.
That’s a simple engineered system that we’ve been using for hundreds of years. More common is having to do failure analysis of the bridge debris in the river – or something similar – and it’s commonly found that a concatenation of errors and unknowns resulted in the mayhem. Then you write down that sequence of events and try not to allow it again.
In this case the smoking debris is a very complex, internationalized human system. It would seem almost certain that there is no dominant cause, but a sequence of events that produced the outcome. So it’s good to see some of this discussion turning from an ‘either/or’ that seems to reflect partisan desire more than reality, to a ‘yes, and…’ form that’s probably more truly the case.
One common underlying theme to the organizational component of failure analysis is to find responsibility for ultimate outcomes that has become diffused, with no one really in charge of the final sanity or go/no-go decision. Take, for instance, NASA and the Challenger explosion. This definitely seems a feature of the financial debacle. Each stage became more and more detached from the reality of whether the real estate market or the particular buyer could support the loan over its life, until finally there was a stage (CDS) that had more to do with the intervening institutions and their credibility than that of the original borrower. And no one to ask if it all made sense.
Mr Oren:
Absolutely. Check my prior link out for a piece of the puzzle there, and also Wretchard’s “Musketeers post”:http://pajamasmedia.com/richardfernandez/2008/10/11/musketeers/
In Wretchard’s leading metaphor, when everybody’s building nothing but cruise ships, survivability takes a hit. When they are effectively all connected with “skyways,”:http://www.minneapolis.org/page/1/skyways-minneapolis.jsp it’s even more fragile. You don’t have to be living in an Idaho intentional community clinging bitterly to guns and religion to figure that out. But you need to be reminded in your bones. I hope this current crisis has that effect to a salutary degree, rather than just inspiring “Heeeelp! Saaaaaave Meeeee!”
“The wisdom of crowds”, in general, is not a broadly general thing. Even the author of the eponymous book says so. Crowds of people all doing “netting” (see the prior NPR link for a good explanation) on zillions of dollars, with a paper value far exceeding the value of the root entities (that’s what they call “leverage”) with none of the safeguards in place that are supposed to be present in securities or insurance… well, it’s… insecure.
Using insurance as a leveraged investment? On a huge scale? With no one knowing anything about the state of play? Nope. Not prudent. As we are figuring out.
Sorry, last two posts of mine were not strictly on-topic. But salient.
Re: Tim Oren in #10 —
Richard Fernandez of The Belmont Club “discusses”:http://pajamasmedia.com/richardfernandez/2008/10/10/unseen/ unseen risks, using an (anonymous) account of a risk manager at a large global bank as a jumping-off point. The referenced Economist piece is worth reading for a view of how things seemed in the inside, before the bubble burst.
bq. In January 2007 the world looked almost riskless.
I worked through some numbers that yield insights that are all-too-clear in retrospect. Suppose, in mid-2006, that a Los Angeles family was willing to put 5% down on a home selling at the median price in that county. Suppose that they got a 2/28 Option ARM (i.e. no principal repayment for two years). If this family made twice the median household income, their monthly payments to escrow would consume near 50% of their pretax income. Once the mortgage reset in mid-2008, that proportion would rise to over 70%!
In other words, by mid-2006 houses were for sale at prices that were unaffordable to the people that might live in them. For many people of modest means, the only way to move from renter to owner was to go with an Option ARM or something similar. But that pretty much guaranteed that the mortgage would be completely unaffordable at reset.
The only way this system could work was with serial refinancings, based on continually rising housing prices. But with houses already unaffordably expensive, how could this process sustain itself?
Somehow, in all the calculations on risk characteristics and arbitrage opportunities on collateralized debt obligations, this simple fact never registered. Charles Ponzi’s ghost must be chuckling: a self-assembling Ponzi scheme that required no mastermind.
AMac, there are two additional fillips to add:
1) The houses that were / are more nearly within folks’ means — if present — were to a great extent in the same areas being redlined before CRA, or too far to commute practically, or crappy shacks in BLM forests, that kind of thing.
Re the first option, the lack of affordable housing in pleasant surroundings can be related to the deterioration of culture in low-rent neighborhoods.
Any way to make the neighborhood simultaneously more resilient and intolerant of evil enough to successfully drive out the meth/crack/you name it?
The little remodeled bungalow on two Levittown-sized lots that I grew up in, in a blue-collar tiny town in fly-over land, is now two blocks away from a 7-11 where drug deals get done at the pay phones. Its value in present day dollars is about the same as it was in 1970 at 1970 prices: maybe $20k. Hmmm.
Nah, there’s no money in fixing that. /sarcasm
2) During flipmania, and probably even now, lots of house appraisers got paid the same whether they filled out forms in the car or actually went and inspected the place and told the truth about what they saw. Guess what a lot of them did? Guess what that does to the prudent expectation of the true value of those properties when the music slows down to a stop?
I hate to sound like a cranky curmudgeon, but Covey was right: character matters.
The system clearly broke down.
WHO SHOULD OVERSEE THE FIX and WHO SHOULD BE HEADING TO JAIL?
Too many have fed at the trough. What Fannie Mae and Freddie Mac executives did was illegal. Congressmen taking their cash favors was morally bankrupt.
“[link]”:http://pacificgatepost.blogspot.com/2008/09/fanny-mae-freddie-mac-congressional.html
Some executives and some in Congress should see jail time.
…. starting with all Senators who took cash from Fannie and Freddie?
It isn’t an an abundance of regulation that will prevent future bubbles, abuses and ensuing collapses.
Congress just has to do its job.
Corporations should be prevented from making ANY financial contributions to ANY politicians, before OR after they have been elected. Make it a law. Break it and you get LIFE. Otherwise it’s just talk, and just wait for the next crash.
[Bare link fixed for you. In future, please try to use he format recommended in the text presented above the comment entry fields.
You’re welcome to drop by and to contribute substance here, but I’ll point out that no matter how strongly your feel about the situation, SHOUTING PHRASES, etc., doesn’t make the best first impression. –NM]
*#3 from andrewdb*
_in which case you had to show a good CRA score, which meant doing lots of business_
Since we’re dealing with millions of loans and trillions of dollars, care to quantify lots? You would figure – given the amount the CRA is catching flak – someone would be able to quantify simple things like ‘how many mortgages are we talking about’ and ‘volume of total’. And that’s without talking about fun stuff like purchaser of a loan instead of originator.
No one seems to be able to. That alone should send up a red flag when someone says this argument about correlation instead of a general stance opposing government interference for social programs. As both Tim Oren(#10) and Nortius Maximus(#11) call out, it’s definitely one of many, if for no other reason than it distorts perfectly working credit markets.
*#5 from Mark Adams*
_Why should the GSE’s have seen this coming, that their MBS’s would eventually cause writedowns, any more than those who’s job it is to tag them with AAA? _
The GSEs carried a guarantee of backing in case of default, generally believed (and now truly) to be US Government backed even if they couldn’t on their own. Regardless of how many times it was threatened otherwise, no one really believed it, and a move would have to be made if for no other reason than to stabilize the market. Too big to fail strikes again.
In part, the GSEs have to find out if their securities are rated high because of backing (theirs and now explicit government backing) or superior work. Few people believed the latter.
_and also takes the onus off the CRA and ACORN?_
Nah, since if people want to blame that they will no matter what the data shows (or doesn’t). And others won’t blame it no matter what. And most sane people will realize it will take years to sift through data.
*#8 from Marcus Vitruvius*
_I’d love to get my hands on comparison histograms for the last 20 years, but I don’t, so I have to ask: Is that at all typical?_
No. It was done to allow these to be bought by a broader range of institutions, and make more money.
Check out “The Giant Pool of Money”:http://www.thislife.org/Radio_Episode.aspx?episode=355 , in addition to the episode #365 that Nortius calls out above.
_But I’m not sure if I understand it: Is it telling me that the top 95% of some entity gets wrapped into a high-grade CDO while the lowest 5% get wrapped into a mezzanine CDO_
More or less, and the % can change as well. You can also have senior/mezzanine/junior. As you go down the ladder, you get a better rate and a higher payout, but you also stop getting payments first and steadily move towards junk. While I haven’t seen the math on how many of these were done – really, if you have a 95/5 split you are going to hit the top level fast(and get those AAAs knocked down). If you went to 80/20 or to 60/20/20, you could protect that top for a bit longer.
And make less money.
Dave #16 & #17 —
As far as “Why should the GSEs’ management known?,” read the sympathetic (!) NYT article linked in #7 for a view of the pressures that drove decsions. Also see the back-of-the-napkin example (#13) that shows what everyone knew for years–that in many parts of the country, the stock of single-family housing that must keep rising in price, forever, was already unaffordable to the families that were to live in them. (I’ll fill in those numbers later today as they are so stark.)
Would you risk your country’s financial future on that sort of Ponzi scheme, Pres. Clinton, Pres. Bush, Congress, crony-execs? Oh, wait.
You can take comfort, however. The very people who made a bad situation much worse (e.g. Frank, Dodd, Gorelick) through the unintended conseqences of risky, doctrinaire-left social engineering policy are about to win a generational victory in the power sweepstakes. With their media pals, they’ll be the ones to set the terms of the debate. A full accounting and workable solutions are just around the corner, you betcha.
#17, Dave
More or less, and the % can change as well. You can also have senior/mezzanine/junior. As you go down the ladder, you get a better rate and a higher payout, but you also stop getting payments first and steadily move towards junk. While I haven’t seen the math on how many of these were done – really, if you have a 95/5 split you are going to hit the top level fast(and get those AAAs knocked down). If you went to 80/20 or to 60/20/20, you could protect that top for a bit longer.
And make less money.
Well, I figured the percent numbers would change, and probably every organization had their own special sauce… but are those numbers even close to being correct?
Was there any sort of process in place by which anyone with a basic notion of statistics could be convinced that the sum of securities before and after this activity could be seen to have about the same risk or value, as rated?
bq. Was there any sort of process in place by which anyone with a basic notion of statistics could be convinced that the sum of securities before and after this activity could be seen to have about the same risk or value, as rated?
I believe there was at least an appeal to portfolio theory, under the notion that bundling together loans originated in different geographic markets would reduce exposure to a downturn in any particular area.
Fine so far as that goes, but portfolio theory requires that the components of the investment be as uncorrelated as possible if it’s to average out the risk. To the extent the individual investments remain correlated, you’re left with systematic risk. E.g., in my domain of venture capital, you might build a ‘green tech’ fund, in which you try to spread the bets over various alternative energy sources as well as energy optimization and saving technologies. This will reduce your exposure to the failure of any particular approach, but leave you (deliberately) with systematic risk exposure to the viability of the green tech market itself.
So the rebundling of mortgage based securities still left systematic risk exposure to the viability of housing price levels nationwide, as well as other more-or-less-visible hazards: inflated appraisals, deliberate or negligent failure to assess creditworthiness, regulatory capture by part of the reselling chain, perverse incentives for ratings agencies. Presumably at least the pricing risk element was realized, else why the CDS market at all? One supposes that at least claiming the systematic risk had been hedged let all the people in the chain pass their ‘grin tests’ when they said that what they were doing was prudent.
Trouble is the CDS market, even before it turned into a gambling arena, seems to have been used to spread out the responsibility so that no one was in a position to stand up and say “Wait a minute, there’s no counter-party robust enough to assume this quantity of risk and stand if there’s a downward move across the entire market.” And here we are.
Tim, #20:
Ah, I see. This makes sense, of a particularly sad sort. And now I have some new search terms to further my education, like “Portfolio theory.” (You seem to be using it as a term of art, so I’m guessing it is its own subfield of study. I sense a number of computational economics PhDs over the next five years studying exactly this sort of thing….)
Tim Oren #20 —
bq. Trouble is the CDS market, even before it turned into a gambling arena, seems to have been used to spread out the responsibility so that no one was in a position to stand up and say “Wait a minute, there’s no counter-party robust enough to assume this quantity of risk and stand if there’s a downward move across the entire market.” And here we are.
I think the following calculations show why even that interpretation is too generous.
Here are some simple, non-statistical estimates of what a somewhat typical experience of a middle-class Los Angeles home-buying family might have looked like in June, 2006.
In 2006, the “median-priced L.A. County home cost $574,000.”:http://factfinder.census.gov/servlet/ACSSAFFFacts?_event=Search&_lang=en&_sse=on&geo_id=05000US06037&_county=Los+Angeles+County
Assume that John and Jane Doe’s family earned $75,000, which is almost 150% of the median income of LA County households of “$51,315.”:http://factfinder.census.gov/servlet/ACSSAFFFacts?_event=Search&_lang=en&_sse=on&geo_id=05000US06037&_county=Los+Angeles+County Thus, only 33% of Angeleno households “earned more than the Does in 2006.”:http://factfinder.census.gov/servlet/ADPTable?_bm=y&-geo_id=05000US06037&-qr_name=ACS_2006_EST_G00_DP3&-ds_name=ACS_2006_EST_G00_&-_lang=en&-redoLog=false&-_sse=on
Further, assume the Doe family is on the high end of the Subprime market, with FICO scores beteween 600 and 620. They put 5% down, and take out a loan of $545,000. Closing costs would include the down payment ($29,000), one-half point ($3,000), “private mortgage insurance of about $11,500,”:http://www.frbsf.org/publications/consumer/pmi.html and the usual other fees. Say $60,000 or so.
If the Does had gotten a prime 30-year fixed conventional mortgage, their rate in June 2006 would have been about “6.8%.”:http://www.freddiemac.com/dlink/html/PMMS/display/PMMSOutputWk.jsp?week=26&ending=20060629 Principal and interest “calculates”:http://www.dinkytown.net/java/MortgageIOAdjustable.html to about $3,100. To that must be added county and local property taxes of at least “1% a year;”:http://www.lacountypropertytax.com/portal/contactus/overview.aspx say 1.3% or $600/month, and homeowners’ insurance of about “$150/month.”:http://www.trulia.com/voices/Home_Buying/How_much_does_home_owners_insurance_cost_in_Los_An-33495– So a 30-year fixed prime mortgage’s monthly payment would be about $3,900, or 62% of the Doe’s pre-tax earnings. This is plainly an impossible burden.
But most subprime loans in 2006 were Option ARMs or Hybrid ARMs, and about one-third of them had initial ‘teaser’ rates of “4% or less.”:http://en.wikipedia.org/wiki/Subprime_mortgage_crisis Assume that the Does’ broker got them lined up for a fairly-common 2/28 Hybrid ARM with an introductory rate of 4% for the first two years. “(Without the teaser, the initial rate might have been about 6.5%.)”:http://www.freddiemac.com/dlink/html/PMMS/display/PMMSOutputWk.jsp?week=26&ending=20060629 Now, the Does’ interest (no principal) payments would be $1,800, for a total of about $2,550, or 41% of pretax earnings. This is a heavy but possibly manageable burden.
Fast-forward to June 2008, when the initial fixed 4% rate on the 2/28 Hybrid ARM resets, and when principal repayments must begin. If this were a prime mortgage, the interest would have risen to “about 6%.”:http://www.freddiemac.com/dlink/html/PMMS/display/PMMSOutputWk.jsp?week=26&ending=20080626 The principal and interest $3,400 would lead to monthy escrow payments of $4,150. That’s 66% of pretax earnings.
Subprime interest rates are trade secrets (29-pg PDF from 2004). Thus, it’s hard to know what the Does’ mortgage would actually have reset to. However, in 2003, IndyMac’s high-end subprime ARM rates were running about 2% higher than 30-year fixed prime mortgages—when the loan-to-value ratio was 65% or less. For LTVs of 85% (as high as IndyMac listed), another 0.9% would be added (same PDF as just linked). Assume the Does got lucky, and their 2/28 ARM reset to 8.5%, only 2% higher than the prime 30-yr fixed rate. In that case, their monthly contribution to escrow would have jumped to $5,100.
That’s 82% of pretax earnings.
To summarize:
* All of the above statistics and calculations were known or readily estimatable in early 2006, before the mortgage-backed security crash began. In particular, the biggest obvious risk–that interest rates would jump between 2006 and 2008–did not occur.
* The Does’ situation isn’t a worst-case scenario–far from it. Recall that they earned 150% of the median LA household income, more than all but one-third of Angeleno households. They bought a median-priced house. And still could not have conceivably afforded to have stayed with their mortgage once the teaser rate ran out.
* As we now know, the value of many homes near the median have dropped by 35% to 50%. The Does might thus owe $545,000 on equity that is now worth under $300,000. Might they be tempted to mail the key back to Countrywide before driving off to parts unknown?
* Among the “innovative financial products” rolled out in the go-go years are many that are yet riskier (i.e. yet worse) than the 2/28 Hybrid ARM profiled here. Many of these products have yet to mature to their reset point. This is a big reason why this meltdown will not draw to a conclusion for some time to come.
* This scenario is completely consistent with two models of the housing market. The first rests on the assumption that owner-occupants will skip from mortgage to mortgage, refinancing every time that the teaser rate runs out. This requires sustained and substantial increases in real estate prices, because no principal is paid down.
* The second model holds that housing purchasers are speculators, indifferent about the end of the two, three, or five-year initial period. They are certain to have sold by then in the constantly-rising market, with their windfall profits tucked away safely. All will be well: as long as the supply of “Greater Fools”:http://en.wikipedia.org/wiki/Greater_fool_theory isn’t exhausted before the sale.
The value of a single family dwelling ultimately gets back to the economic circumstances of the families that live in the area, and might live in that house. As “Steve Sailer has noted,”:http://vdare.com/sailer/081010_meltdown.htm Los Angeles–like most other U.S. real estate markets–never had the human capital to support the prices that underlay the real estate boom.
Like a Ponzi scheme, it could only end in collapse.
Marcus, #21: “Here you go”http://en.wikipedia.org/wiki/Modern_portfolio_theory If you just want the salient bit, skip the formulas and jump down to the heading ‘Diversification’. The most important sentence: “An investor can reduce portfolio risk simply by holding instruments which are not perfectly correlated”.
Correlation is a statistical measure of the tendency of the ‘instruments’ to move together in value over time. If the investments are highly correlated, holding a number of them doesn’t actually reduce your risk (volatility). A lot of ‘financial engineering’ is trying to assemble a collection of investments that are deliberately correlated in a way that you want, while uncorrelated (or negatively correlated, even better) in other aspects.
The problem with all of this theory is that it rests on having some valid estimate of volatility of and correlations among the various investments in the future. Sometimes that’s obviously untrue, e.g., in dealing with inherently illiquid and novel investments like startups. In which case you’re just appealing to common sense (and a hand wave), not attempting to be a ‘quant’.
But because you can analyze time series of data on publicly traded securities, it gets easier to tell yourself that you’ve got a good knowledge of these parameters going forward. What you’ve really got is a set of ‘prior’ estimates of how the system and the particular investments have behaved in the past. But it’s just history, and not really a forecast. The parameters work until they don’t, in which case you now have some more realistic ‘posterior’ estimates. And if the two differ radically, your nice little risk model is now SOL. (See Taleb and ‘black swans’, as in the thread above.)
So the way in which both I and AMac can be right (because he is), is that parties further along the investment chain took supplied parameters like that on faith and/or obeyed their incentives to not look too hard when making their investments. Each step scrubbed out some of the information about the underlying truth: Loan brokers, originators, MBS packagers, GSEs, rating agencies, CDS writers, speculators in CDS’. You get to the end, and someone that’s either too dumb or greedy could talk themselves into missing the elephant in the room: No matter how repackaged, there remained a huge amount of systematic, correlated exposure to the asset bubble and the inability of borrowers to support their loans.
For some, it became “The spread on this is good, it’s S&P AA rated, and we’ll make our incentive compensation goals”. But if you’d summed up a number of bets like that across some institutions, they added up to “If the price of California real estate drops 20%, you will lose your company”. And they did.
It’s not about Fannie and Freddie.
“Check out the McClatchy article”:http://www.mcclatchydc.com/251/story/53802.html
What is your article for, if not to further the right wing claims of “democrats FORCED banks to lend to poor people, and that’s the cause of this mess”?
hypo – there’s no word for your claim except that it’s deranged partisanship. The reality of the situation is far more complex than “greedy bankers!!” “forced loans to poor people!!” and the structural issues I raise in the post are things to which people – even people on the left – ought to pay attention.
A.L.
hr #24 —
Reporters David Goldstein and Kevin G. Hall should have been embarrassed to write the article you cite at this late date. Granted they’re only journalists, but if they had read some of the commentary here (to say nothing of clicking on some hyperlinks), they would have recalled that old saw that starts “Better to keep silent than”.
The roots of the financial crisis are complex. Simplistic McClatchy screeds make Barney Frank, Franklin Raines, Jamie Gorelick, et al. feel good. That’s about all.
bq. What is your article for, if not to further the right wing claims of
Stakhovites. Stakhovites and Wreckers, the whole lot.
This all started back in the 1930s with a man in a town called Bedford Falls. He ran a Building & Loan that insisted on lending to people not able to save $5000 to put a downpayment on a house, all against the advice of the local banking expert. There were also some allegations of scandal that were quietly hushed up, a lot of people suspect the plastics magnate Sam Wainwright had something to do with it, possibly in conspiracy with the man’s brother, a war hero who is said to have had the ear of President Roosevelt.
What does that get us? A discontented, lazy rabble instead of a thrifty working class. And all because a few starry-eyed dreamers like Peter Bailey stir them up and fill their heads with a lot of impossible ideas.
Amac,
Nice refutation by facts, hmm? Calling what they write a screed, isn’t actually facts.
So refute the facts:
More than 84 percent of the subprime mortgages in 2006 were issued by private lending institutions.
Private firms made nearly 83 percent of the subprime loans to low- and moderate-income borrowers that year.
Only one of the top 25 subprime lenders in 2006 was directly subject to the housing law that’s being lambasted by conservative critics.
So why did Freddy Mae have to be bailed out at all?
hypo, I know you can read, so I assume you understood the topic of the post, which had nothing to do with the CRA.
In fact the claim was made on the radio show that Fannie and Freddie made no subprime loans, which I think we can agree is untrue.
Now the issue I raise is that the size of Freddie and Fannie and their status as a quasi-government agency meant that the financial industries were hyper-vulnerable to what happened to them.
What, in the wide world or sports, does that have to do what you posted?
A.L.
You wrote this:
_The collapse of the boom is much more damaging than it needed to be, I’ll suggest, for two significant reasons:_
_Because the far-and-away largest institutions in the market, Fannie and Freddie, added risky loans to their portfolio while they were immensely overleveraged – putting them significantly at risk_
And that is simply FALSE – as the “significant reason”. FALSE. NOT TRUE. NOT REALITY-BASED. AN AGENDA CLAIM.
The collapse DOES have to do with the home pricing bust. It also has to do with lending.
And even more to do with the deregulation that underlies the packaging of those loans into slices, securitizing them, and then building eveer more complex financial packages – and insurance on those packages – and then everyone taking a cut on all the resulting financial activity.
But yeah, the claim above is simply wrong, and deceitfully so.
MB: Because Freddie and Fannie kept a lot of the nastier tranches of their mortgage backed securities for their own account. Made their returns look good, for awhile, until they were worth nothing. That’s why THEY needed a bailout – their capital was wiped out. If that was it alone, they’d have likely been let go.
But they also sold onward a lot of those MBS’ to both the public and to institutions. Those turned out to be a lot less ‘prime’ that the ratings given to them by S&P and the like implied. Their purchasers (probably unwisely) relied on the implied sovereign backing for securities issued by Fred and Fannie, and used them for purposes where loss of principal would cause huge financial damage. That’s why a lot of other people needed F&F bailed out in the short run. I wouldn’t give too much for them emerging intact at the end of the game.
HR, if you can’t bother to read the discussion and links, why don’t you just go back and play with the other kids in the Ayers thread?
Hey Timmy – can I call you Timmy?
Again, I’ll choose to believe the new Nobel Laureate, rather than you: Right here. (link)
To quote a bit:
_But here’s the thing: Fannie and Freddie had nothing to do with the explosion of high-risk lending a few years ago, an explosion that dwarfed the S.& L. fiasco. In fact, Fannie and Freddie, after growing rapidly in the 1990s, largely faded from the scene during the height of the housing bubble._
_Partly that’s because regulators, responding to accounting scandals at the companies, placed temporary restraints on both Fannie and Freddie that curtailed their lending just as housing prices were really taking off. Also, they didn’t do any subprime lending, because they can’t: the definition of a subprime loan is precisely a loan that doesn’t meet the requirement, imposed by law, that Fannie and Freddie buy only mortgages issued to borrowers who made substantial down payments and carefully documented their income._
_So whatever bad incentives the implicit federal guarantee creates have been offset by the fact that Fannie and Freddie were and are tightly regulated with regard to the risks they can take. You could say that the Fannie-Freddie experience shows that regulation works._
I suggest you go back to the rightwing pool, and just start shouting “Timmeh! Timmeh! Timmeh!” It would make as much sense.
[Incorrect link format fixed: David Blue]
hypo – you’re one namecalling post away from some bench time.
Want to try and explain the data in the slides above contra Krugman’s claims? because it sure doesn’t look like to two fit at all to me.
A.L.
A.L.,
This was a “response in kind” to Tim’s _why don’t you just go back and play with the other kids in the Ayers thread?_
Not much difference there – why the double standard?
You ever notice that when a discussion (here and a number of other places) starts to have substance, some flying monkey or another shows up and attempts to knock it off the rails?
Wonder why that is?
Very simple Tim.
Because you aren’t engaging in true discussion, but rather in fantasy.
Oh, A.L. – there we are again – “flying monkey”. Does Tim get a bench?
Again – back to the main discussion –
A.L., from what I can tell, there are two issues –
1. The subprime loans, or bubble created when people bought and were lended mortgages they couldn’t afford.
2. The investment into the financial products that existed ON TOP of the loans. That again, if you count the derivative market, is 62 trillion dollars. Which is again is the fault of deregulation, and the hope that because everything is “interconnected”, that inter-connectedness alone protects you from risk. But really, it is only pushing of paper, mith everyone taking a cut.
If you take a look at the Lehman sale last Friday, the value sold is only, so far, about 10-15% of the book value – the paper value.
And that’s where the issue is – you can bundle all you want, but what is happening is that, even if a small value of homes are defaulting (say 10%) if there is this massive unregulated amount of paper resting on it, it can take the whole system down.
*#18 from AMac *
I’m not saying that the GSEs choices were limited and they were hamstrung by some of the evolving standards that put more pressure on them. Including, as they were coming out of their penalty phase, to increase their leverage in 2007.
And hamstrung again to be used as a tool to stabilize the markets while they were slipping in late 2006 through mid 2008.
What I am saying is that there is a difference from being rated as AAA and knowing why you are rated that way. Which few people did, really.
*#19 from Marcus Vitruvius*
_but are those numbers even close to being correct?_
Yes, since companies wanted to maximize the high end to maximize their own profit. In addition they has other bits of arcane finance – corporate debt, other CDOs, CDS, eye of newt – in order to boost up their rating.
_Was there any sort of process in place by which anyone with a basic notion of statistics could be convinced that the sum of securities before and after this activity could be seen to have about the same risk or value, as rated?_
In addition to what Tim Oren said – nothing simple. Once the CDO becomes more complex – adding in payments of B- corporate debt, $1m payout in case of default of Citibank and the cash holding of $1m of Euros, you lose visibility.
Unless you are a bond rating agency, then you call it excellent.
#33, other than the childishness, is a classic appeal to authority, Krugman in this case. He may have done good work back in the day, but as long as I’ve paid any attention to him he’s been a partisan hack of the worst sort, and that’s the level of authority I assign to him.
The particular article is a prime example. It’s attempting to evade the issue by the argument ‘they couldn’t be dealing in subprime, because by definition F&F can’t buy anything that’s subprime.’ But it’s precisely the (um) flexibility of definition of what was prime and not that got us here. The argument is simply disingenuous, and an attempt to obfuscate rather than inquire.
There’s no getting around F&F’s faults in the matter, and how they acted to amplify the crisis by making bad paper liquid. But they were not alone, sharing blame with those who wrote inherently unsound loans (per AMac) whether they be CRA, Alt-A, and other crummy paper. Also with those who took on CDS obligations that could not meet, and those who speculated in that paper. And perhaps most of all the rating agencies who sold their credibility for a pittance.
Just yelling ‘more regulation’ is no solution. There’s a little thing called regulatory capture, one of the nastier outcomes of public choice theory, and we’re staring at some prime examples here. Give profit maximizers a way to fiddle the market by first subverting and them employing government power, and it will happen in the long run. Give the regulators more power, and those incentives just grow.
If I were to draw one conclusion at this point, it would be that F&F as either implicitly or explicitly government backed institutions need to go. We’re likely to get the former, as that’s part of what allowed regulatory arbitrage in the first place and it’s now blatantly visible. I fear they may be too politically useful, in that kind of nob-and-wink favor buying sense, to be allowed to go entirely.
There’s nothing inherently wrong with securitizing mortgages, and if we want to keep some liquidity in housing post-F&F we’re going to need to do so. They became toxic when their risks were obscured. That would lead me to look hard at the ratings agencies, as in auditor and FBI level, to find out how much was incompetence and how much malfeasance. That might be a place to look at regulation to some extent, since they have a market definitional role.
I’ve read some good arguments that going long on CDS’ ought to be banned unless the buyer holds the underlying security. I don’t understand enough about the structure of the speculation that happened there to opine whether that’s necessary or sufficient, but I can see the logic.
bq. Unless you are a bond rating agency, then you call it excellent.
* Applause *
_”Again, I’ll choose to believe the new Nobel Laureate, rather than you”_
The nobel prize for political spinning by a economist. From the same people that brought you a nobel prize for environmental science by a politician and a nobel prize for peace by a terrorist.
_There’s no getting around F&F’s faults in the matter, and how they acted to amplify the crisis by making bad paper liquid. But they were not alone, sharing blame with those who wrote inherently unsound loans (per AMac) whether they be CRA, Alt-A, and other crummy paper. Also with those who took on CDS obligations that could not meet, and those who speculated in that paper. And perhaps most of all the rating agencies who sold their credibility for a pittance._
So the causes –
a. F&F
b. Mortgage lenders who wrote CRA & Alt-A
c. Investment firms who bundled and sold the paper, playing a PAPER 62 trillion dollar game.
d. Rating Agencies.
Here’s the difference – I agree there are a lot of people at fault. But what percentage goes where?
That’s the disagreement, here. The fixation with the PRIMARY – or in A.L.’s term, “significant” cause being Fannie and Freddie. Most mainstream economists disagree.
After all, rating agencies don’t ‘rate’ individual mortgages. They rate the book, the paper the mortgage is written on.
And it’s that stage from the ACTUAL MORTGAGE, to wrapping the mortgage into various collateralized debt – where the process became opaque, and unable to be judged. Again, LACK OF REGULATION DUE TO LACK OF SCRUTINY.
– and, funny, enough, the IMMEDIATE REASON for the cardiac arrest of the system was “when Paulson refused to bail out Lehman Brothers”:http://www.koreatimes.co.kr/www/news/opinon/2008/10/160_32518.html
Now, I actually have sympathy for that decision – these Masters of the Univere – of which Dick Fuld seems to be a particularly nasty breed – think they can take as many risks as they want, and Uncle Sam will take the heat.
Moral hazard cubed, I’d say.
But no one with SENSE can believe that F&F were main culprits here.
A.L., I don’t think Krugman and your slides are using ‘subprime’ in the same way, although it is hard to be sure. Subprime in one sense is a loan given to people with poor credit scores that will not be as advantageous, say, in terms of interest rate, as a prime loan. AFAIK, the GSEs could (contra Krugman) participate in those mortgages as long as they were ‘conforming’ in terms of LTV and down payment. I think there’s another related but not identical use of subprime for the weird ARMs, balloon mortgages, etc. held by many subprime borrowers, and those loans were not (as I understand it) eligible for the GSEs.
While we are on the subject of inconsistencies, you have one slide that gives a total of over $10T in US mortgage debt but the amount shown on the subsequent “importance” slide is much less. This reinforces my worry that non-bank mortgage brokers (e.g. Ameriquest) were left off to make the GSEs’ share look bigger.
I wish I had time to research this properly, but right now, no.
As evidence why listening to the Nobel Laureate might be a good idea, though, I offer the following priceless quote from Powerline 8/8/2005 (h/t Kos personally)
hr #24 —
Sorry for my sharp response. Please look at the links that have been posted in this thread (e.g. comment #7) and in earlier ones.
The “more regulation” argument is that the current financial crisis is largely due to lax regulation. (I’ll save my agreements and disagreements for another day.) How strange to hear the partisan-left version of “more regulation,” which goes “more regulation on unscrupulous, greedy, risky, incompetent Wall Street entities, except for the special cases of the GSEs.” Which failed for exactly the reasons the WSJ editorial board has been predicting for over a decade. And which were demonstrably run by unscrupulous, greedy, risky, incompetent crony-capitalist executives who ignored the warnings of Congressional Cassandras and their own staffs. And which played central roles in securitization of morgages–the nexus of the real estate financial meltdown. No, the partisan-left argument goes, the GSEs had little to do with all these problems, and the Barney Franks and Chris Dodds who protected them from regulation shouldn’t hang their heads in shame.
Here is Prof. Stan Leibowitz, writing in “Anatomy of a Train Wreck: Causes of the Mortgage Meltdown”:http://www.independent.org/publications/policy_reports/detail.asp?type=full&id=30 (10/3/08):
— begin Liebowitz quote —
Nevertheless, our work largely evaporated down the memory hole as government regulators got busy putting the results of the Boston Fed study to use in creating policy. That policy, simply put, was to weaken underwriting standards. What happened next is nicely summed up in an enthusiastic Fannie Mae report authored by some leading academics (Listokin et al., 2002):
bq. Attempts to eliminate discrimination involve strengthened enforcement of existing laws… There have also been efforts to expand the availability of more affordable and flexible mortgages. The Community Reinvestment Act (CRA) provides a major incentive… Fannie Mae and Freddie Mac… have also been called upon to broaden access to mortgage credit and home ownership. The 1992 Federal Housing Enterprises Financial Safety and Soundness Act (FHEFSSA) mandated that the GSEs increase their acquisition of primary-market loans made to lower income borrowers… Spurred in part by the FHEFSSA mandate, Fannie Mae announced a trillion-dollar commitment.
bq. The result has been a wider variety of innovative mortgage products. The GSEs have introduced a new generation of affordable, flexible, and targeted mortgages, thereby fundamentally altering the terms upon which mortgage credit was offered in the United States from the 1960s through the 1980s. Moreover, these secondary market innovations have proceeded in tandem with shifts in the primary markets: depository institutions, spurred by the threat of CRA challenges and the lure of significant profit potential in underserved markets, have pioneered flexible mortgage products. For years, depositories held these products in portfolios when their underwriting guidelines exceeded benchmarks set by the GSEs. Current shifts in government policy, GSE acquisition criteria, and the primary market have fostered greater integration of capital and lending markets. These changes in lending herald what we refer to as mortgage innovation.
One man’s innovation can be another man’s poison, in this case a poison that infected the entire industry. What you will not find, if you read the housing literature from 1990 until 2006, is any fear that perhaps these weaker lending standards that every government agency involved with housing tried to advance, that congress tried to advance, that the presidency tried to advance, that the GSEs tried to advance—and with which the penitent banks initially went along and eventually enthusiastically supported—might lead to high defaults, particularly if housing prices should stop rising.
— end Liebowitz quote —
From the NYT piece in #7 above:
bq. Between 2005 and 2008, Fannie purchased or guaranteed at least $270 billion in loans to risky borrowers — more than three times as much as in all its earlier years combined, according to company filings and industry data.
bq. “We didn’t really know what we were buying,†said Marc Gott, a former director in Fannie’s loan servicing department. “This system was designed for plain vanilla loans, and we were trying to push chocolate sundaes through the gears.â€
etc.
In the Milken slide deck, check out slides 31-31, and 69-73. Especially 72, “Freddie Mac’s and Fannie Mae’s retained private-label portfolios,” noting the huge exposures of the GSEs to subprime andAlt-A mortgages.
More unwelcome links documenting the GSEs’ central role in the Clinton-Bush-Congressional-Democrat housing debacle at “Parapundit.”:http://www.parapundit.com/archives/005602.html
To repeat, no serious commenter believes that the GSEs are entirely or even mostly responsible for the setting off the real estate meltdown. But merely being a big contributor to a multitrillion-dollar implosion is still something to be proud of.
hypo, let me try again and see if I can make my core points clearer…
…we were absolutely in a housing bubble, and due for a crash. The effects of this crash, however, are likely to be much more severe than they have historically been, and the question is – why?
I suggest two things; the ballooning size of the GSE’s and equally importantly, the way their securities – which were actually quite risky – were treated as cash equivalents by a lot of other highly leveraged entities.
So the system was uniquely vulnerable to a collapse in GSE creditworthiness, as not only they – but all the other institutions who relied on them for the equity they needed to maintain solvency – imploded.
So the GSE’s didn’t ’cause’ the housing bubble or collapse (although their rapid expansion, triggered by delusional levels of liquidity), but they may have caused the wider financial crisis because of the way the GSE securities were releveraged (among about a million other reasons).
A.L.
Amac writes, correctly, [t]o repeat, no serious commenter believes that the GSEs are entirely or even mostly responsible for the setting off the real estate meltdown. However, this appears to be pretty much the position of Steve Sailer, whom AMac himself cited upthread. That’s the same link that AMac had, and the title is “America’s Minority Mortgage Meltdown/ Diversity Recession: The Smoking Gun?”. VDare, where the article is hosted, is a white supremacist site, and Sailer is personally a eugenicist. There’s actually some valuable data in his essay, but, then, the best early data on smoking and cancer was developed in Nazi Germany and had to be rediscovered by American scientists who ignored it…
Let me be blunt: the cartoon version where 100 percent of the blame goes to the GSEs (somewhat culpable) and the CRA (almost irrelevant) is going to be pushed heavily by the yahoo right wing. It’s easy to understand, fosters resentment, and implicates liberals, Democrats, and non-whites. What more could you ask for from a theory?
And Andrew, what do I have to do to get credit for opposing that simplistic view?
A.L.
Tim Oren wrote
bq. Portfolio theory requires that the components of the investment be as uncorrelated as possible if it’s to average out the risk. To the extent the individual investments remain correlated, you’re left with systematic risk.
Yes, and that’s assuming that you live in what Taleb calls “Mediocristan” — that the streetlamp of statistics tools commonly in use in the field actually predicts where the keys are going to fall practically all of the time, as it were.
AJL #47 —
bq. Amac writes, correctly, [t]o repeat, no serious commenter believes that the GSEs are entirely or even mostly responsible for the setting off the real estate meltdown. However, this appears to be pretty much the position of “Steve Sailer,”:http://vdare.com/sailer/081010_meltdown.htm whom AMac himself cited upthread.
AJL, “this” would refer to “the GSEs being entirely or even mostly responsible for setting off the real estate meltdown.”
I searched the essay you linked for:
* GSE or GSEs – Phrase not found
* Fannie Mae – Phrase not found
* Freddie Mac – Phrase not found
Sailer has previously discussed the GSEs, and one or more of the links in his essay may lead to a piece that focuses on that subject. But the thrust of your statement is opaque.
This may be an instance of the signal-to-noise problem with your links that I alluded to earlier.
bq. VDare, where the article is hosted, is a white supremacist site, and Sailer is personally a eugenicist. There’s actually some valuable data in his essay, but, then, the best early data on smoking and cancer was developed in Nazi Germany and had to be rediscovered by American scientists who ignored it…
I’m not sure of the point of your ad hominems. Perhaps one or more of them relates to one of the claims in the essay, or earlier in this thread. If so, which one?
#27 Mark Buehner:
bq. This all started back in the 1930s with a man in a town called Bedford Falls. He ran a Building & Loan that insisted on lending to people not able to save $5000 to put a downpayment on a house, all against the advice of the local banking expert…
Hey. I think I’ve seen this movie. Every time a bell rings, a family gets a house they won’t be able to afford. Am I close? :)P
“[last lines]”:http://www.imdb.com/title/tt0038650/quotes
Zuzu Bailey: Look, Daddy. Teacher says, every time a bell rings an angel gets his wings.
George Bailey: That’s right, that’s right.
George Bailey: Attaboy, Clarence.
Andrew, as far as I know, “conforming” and “subprime” are terms of art in the industry, and mean different things – “conforming” being a lone that ‘conforms’ to one of the GSE programs and this can be resold to them, “subprime” meaning a certain level of creditworthiness hasn’t been reached by the borrower.
On top of that, we have ‘structured’ loans, like ARM’s, interest-only, neg-am, teaser rate, etc. etc…
I think that people have taken to mix up ‘subprime’ and ‘structured’ since a lot of the loans that were structured were made that way b/c the borrower wouldn’t have qualified under a non-structured program.
A.L.
Apropos of nothing, “the lost ending to It’s a Wonderful Life.”:http://www.nbc.com/Saturday_Night_Live/video/clips/its-a-wonderful-life-lost-ending/2731/
bq. Yes, and that’s assuming that you live in what Taleb calls “Mediocristan” — that the streetlamp of statistics tools commonly in use in the field actually predicts where the keys are going to fall practically all of the time, as it were.
Yup. There are two ways to get scr**ed by the notional portfolio theory formulas. The first error is to inaccurately estimate the volatility and correlation parameters of the securities in question. That’s what I alluded to with ‘prior’ and ‘posterior’ in #23. It’s inherent in the situation that this will happen periodically – the market is not a ‘stationary’ system where yesterday’s parameters (or even structure) necessarily predict tomorrow. Hopefully any risk analyst worthy of the name is going to do some sensitivity studies around the possibility of being incorrect with the initial parameters…
The formulas themselves bake in statistical assumptions about the patterns of distribution of values, and even the patterns of distribution of the modeling parameters. Those assumptions of Gaussian or other simplistic distribution, are what Taleb’s calling Mediocristan. If it turns out the true distribution is something else, that can produce periodic extreme outliers, then you’re in Taleb’s Extremistan. Out there, your nice risk analysis can be waste paper because it incorporated statistical models that said extreme outcomes are rare. And to be even more nasty, the same lack of sufficient data that plagues estimates of parameters also means you may not observe, in advance, the type of behavior that would suggest you’re not really in a Mediocristan model at all.
And all this fun is before we construct a multiple stage market with perverse incentives and information loss.
Whee! Time for another spin on that ride. Be sure to stoke up on soft drinks and hotdogs before strapping in.
AMac, it takes a few clicks, but soon we get to Sailer’s article (also on VDare)
I don’t blame you for not having the heart to wade through all of his blaming Hispanics and (to a lesser degree) blacks for the housing bubble. I worked backwards; I figured anyone who drew those final conclusions must have been blaming the GSEs and CRA on his scratch paper. As far as the ad hominems, they are intended to bolster my claim that the thoughtless subset of the right wing, including its racist component, will be signing on to what you correctly caused the “cartoon” version, for its simplicity and the identity of its villains.
A.L., I think we are in sync here, and it’s the new Nobel Laureate who is a little vague. The number of non-conforming loans the GSEs could take was, as I understand it, often zero, and when not, only as an exception because they were losing share to reckless private lenders. (This would suggest that while Fannie Mae was important because of its size, its common sense, while deficient, was in no way the industry reverse-leader.)
bq. Hopefully any risk analyst worthy of the name is going to do some sensitivity studies around the possibility of being incorrect with the initial parameters…
But will he be listened to?
Experience suggests the answer is “Only for a while, only a little; and then the wheeler dealers will whine about how all the other kids have banana seat bikes and cute girlfriends — see? — so it must not be that bad, and they’ll get the OK, and yell lustily as they go and do likewise.”
These elements in human cognition have been studied somewhat of late, comprising in part the tendency to extinguish chastening institutional memory, to be overconfident rather than humble (confidence gets the Benjamins, the babes and the Bentleys), and to extrapolate giving too much weight to present conditions.
Only a little better than “not being able to learn from what they had for lunch”, pace Chad Mulligan.
And to be even more nasty, the same lack of sufficient data that plagues estimates of parameters also means you may not observe, in advance, the type of behavior that would suggest you’re not really in a Mediocristan model at all.
Akin to Edward de Bono’s “Village Venus” effect [my wording follows]:
* Everyone in the village knows that Marie is the most beautiful girl in all the world.
* But they’ve never been out of the village.
Tim Oren, multiple messages:
Oh! Now that I look at the Wikipedia Page, I see that it looks familiar! I’ve had a rather long and varied educational career, and now I recall attending a few seminars and study groups on these topics. (I’ve attended a few seminars and study groups on lots of topics– the trick is remembering that breadth is not the same as depth.)
I remember being more than a little skeptical about some of these models for many reasons. At the time, the correlation issue and other problems you’re describing weren’t among them– would that I were that perceptive. But now that I think about it, in terms of something where I do have some depth of knowledge, it looks like something I’d start to attack with estimation theory. For me, that conjures up RADAR applications, but you’re certainly speaking the right language: a priori, a posteriori, questioning the normal-distribution assumptions, etc. (My personal rule– no one gets a free pass on the normal distribution thing unless I know they can prove the Central Limit Theorem and apply it correctly to the situation at hand.)
And sensitivity analyses…. well. This is not an observation based on finance geeks, this is an observation about any field which geeks started and someone else figured out could make money: Sensitivity analyses are often discouraged in exactly the situations where they can do the most good, namely, where there is any suspicion that they will reveal too much sensitivity. There’s always the underlying assumption that the sensitivities will reveal themselves eventually, and that it’s better to fix them later, rather than sooner.
It’s a battle I fight on a regular basis.
AJL #56 —
You are perhaps a bit confused. Please don’t worry about me “not having the heart to wade through all of [Sailer’s] blaming Hispanics and (to a lesser degree) blacks for the housing bubble.”
The signal-to-noise problem is much simpler than that: the links you offer often don’t say what you purport them to say. As I explained in comment #50, I don’t have the desire to wade through links in these circumstances. The essay you claimed was Sailer blaming GSEs (#47) “didn’t mention them.”:http://vdare.com/sailer/081010_meltdown.htm
Now your Exhibit 2 is “Freddie Mac’s Richard Syron—Architect Of The Diversity Recession’,”:http://www.vdare.com/sailer/080810_loans.htm and your indictment has broadened to “[Sailer’s] blaming Hispanics and (to a lesser degree) blacks for the housing bubble.” My word processor says “Freddie Mac’s Richard Syron” is a lengthy 1,670 words, while “Diversity Recession”:http://vdare.com/sailer/081010_meltdown.htm is 1,240. Sailer indeed finds fault for the housing bubble. What is your count for how many of those 2,910 words he devotes to “blaming Hispanics and (to a lesser degree) blacks”?
bq. As far as the ad hominems, they are intended to bolster my claim that the thoughtless subset of the right wing, including its racist component, will be signing on to what you correctly caused the “cartoon” version, for its simplicity and the identity of its villains.
Ah, thanks for the explanation. You offer ad hominems on Sailer being a eugenist comparable to a Nazi (#47) and a thoughtless racist (#56) because… it helps you show that these two essays present a simplistic, cartoonish view of the identity of their villians.
Actually, Sailer’s view seems rather sophisticated to me, and not only to me. He was recently singled out for the quality of his insights by Bruce Charlton, editor of the peer reviewed journal Medical Hypotheses “(vol. 71, pgs. 475-480).”:http://medicalhypotheses.blogspot.com/2008/08/figureheads-ghost-writers-and-quant.html
True to its title, Sailer spends the final 1,200 words of “Freddie Mac’s Richard Syron” discussing the CEO of a GSE–your jumping-off point back in #47. I suppose it would therefore be safe to say that you find Sailer’s characterization of Syron’s role in the meltdown to be simplistic and cartoonish.
I’d be obliged if you’d point out where Sailer misquoted the NYT or the Globe, or took Syron’s words out of context, or falsified numbers he offers the reader, or fooled readers by mischaracterizing the other four or so primary sources he links. Not where you think his conclusions are incorrect–that’s pretty much a given. Looking for simplistically, cartoonishly wrong.
Signal to noise.
bq. Sensitivity analyses are often discouraged in exactly the situations where they can do the most good, namely, where there is any suspicion that they will reveal too much sensitivity. There’s always the underlying assumption that the sensitivities will reveal themselves eventually, and that it’s better to fix them later, rather than sooner.
bq. It’s a battle I fight on a regular basis.
Yes, in my figure of speech, the Rat Pack, the “swingin’ d***s” (the commissioned salespeople and so on), want the Benjamins, babes and Bentleys too much. Make hay while the sun shines. Go go go go GO!
Human, all too human.
AMac, according to Wikipedia, Medical Hypotheses is not peer-reviewed. (It is, however, from a major publisher.) The current front page of the journal web site features two articles, one a review by the editor-in-chief concluding that IQ is largely inherited and the second a defense of James Watson’s recent remarks that were generally taken as racist.
Would you be happier if I described Sailer as a polite eugenicist?
Now, as for Sailer blaming non-whites for the economic situation, in what sense do you believe he is using the word “diversity” in his label “Diversity Recession”? I believe you will find your answer right there.
The numbers #45 and #46 above, are worth responding to – but like AJL suggests, they make assertions, that rely on questionable facts, pushed by questionable agencies.
Still, I will take those comments at their face, and respond, as if they are made in good fath.
Thing is, I don’t have time to research this right now.
But a few links, in the meantime.
First, to show I’m considering both sides here, a much more coherent essay for the AL/AMac point of view – “Government Ownership of Banks”:http://www.outsidethebeltway.com/archives/government_ownership_of_banks/
And now, a couple of other articles rejecting this point of view with disbelief –
“Subprime Suspects”:http://www.slate.com/id/2201641
“Misunderstanding Credit and Housing Crises: Blaming the CRA, GSEs”:http://bigpicture.typepad.com/comments/2008/10/misunderstandin.html
Both these, again, look at the fact that the bubble got out of hand because of _lack of regulation,_ and nothing up above so far, regarding the culpability of the GSE’s, looks at that point.
Even AL’s point admits this – “I suggest two things; the ballooning size of the GSE’s and equally importantly, the way their securities – which were actually quite risky – were treated as cash equivalents by a lot of other highly leveraged entities.”
That actually speaks about a lack of regulation, and a lack of transparency. Although it makes an assumption about the path of a majority of the non-performing loans, that I believe is incorrect.
More later…
LACK of, LACK of regulation, jeez…
[ #63 edited to read “like AJL suggests“. “excessive regulation” changed to “lack of regulation”, is that correct? — M.F. ]
Certain members of our Congress should be in Guantanamo for mocking the regulators and blocking legislation aimed at tightening the rules. One, Sen. Dodd from CT, received a sweetheart loan deal from Countrywide to boot, then tried to claim that he didn’t know average Joe couldn’t get that loan and that there was no expectation of quid pro quo from Countrywide.
My understanding is that any average Joe with Sen. Dodd’s high income and considerable wealth did indeed get that loan. Evidence otherwise?
hypocrisyrules #63 —
bq. I will [respond to comments #45 and #46] as if they are made in good faith.
Having spent some time putting #45 together as a response to your #24 and #28, I’m puzzled. As if signifies that you think that I am offering opinions and linked quotations in bad faith. What leads you to believe this?
It the OTB piece you link (thanks), there is this paragraph:
bq. over the years there was a concentrated push to expand the number of low income/riskier types of borrowers who were covered under CRA. To claim that the timing is all wrong is just not true. CRA was the umbrella under which all of these changes took place.
I think that’s about right. One pitfall seems to be that lefties use “the CRA” to mean “the Community Reinvestment Act of 1977,” while many to your right take it to mean “the CRA of 1977, the statutory amendments of 1989, 1992, 1994, 1995, 1999 and 2005, and the administrative rulemaking and policies that implemented the act and its amendments.” While awkward, maybe “CRA and similarly-intended initiatives” would bring a bit more clarity to the discussion.
In “comment #23 to Grim’s ‘Tell Me Why This Is Wrong,”:http://www.windsofchange.net/archives/tell_me_why_this_is_wrong.php#c23 I set out my opinion as to the string of events that led to the current pass. (I think the notion that “more stringent regulation would have prevented this mess” is a strong but not conclusive argument: stringent regulation has its own well-known problems, e.g. ‘regulatory capture’ and other unintended consequences. I won’t offer my opinion until I’ve thought about it more.) The sixth point was —
bq. Wall Street and Washington (Congress, D & R, and Executive Branch officials and regulators, D & R) ended up creating a system where all the players were rewarded by focusing on their small piece of a segmented transaction. Nobody made money by looking at the big picture and exclaiming, “this can’t continue.” (Except those Soros-style short-sellers who made billions by timing their bets correctly.)
bq. This house of cards is the lens through which to view the video. Since Fannie and Freddie were golden egg-layers for investors, and since their politician/executives had already subverted them, why not engage in a little Social Engineering to promote the Undisputably Excellent Policy of Greater Home Ownership By Minorities? The CRA was born and repeatedly redefined in this spirit. “Sailer”:http://www.vdare.com/sailer/080928_rove.htm again–plenty of blame to go around.
In the piece in Slate.com that you link, author Daniel Gross misrepresents the arguments against the GSEs and offers a series of distortions in their defense. Critiqued at Comment #40 “here.”:http://www.windsofchange.net/archives/tonights_debate.php#c40 I’m not sure why these under-regulated Fortune 500 corporations that gave out millions in bonuses to their undeserving crony-executives prior to failing evoke such protective instincts among those who are otherwise rightly critical of the tunnel-vision greed of Wall Street. Or why the agents (er, certain of the agents) who successfully thwarted more capable regulation are commended for their deeds. There are plenty of formerly-lordly financial-industry types who doubtlessly believe that they also deserve a share of that affection.
Thought question: if the GSEs had been disbanded in, say, the 1980s, would the mortgage meltdown have been affected?
My answer is that they made matters worse with (1) their securitization activities, especially the promotion and packaging of loans that failed to meet old-fashioned standards (high-down-payment fixed-term mortgages to good credit risks) and (2) the reckless overleveraging that was the proximate cause of their collapses. But given the way that private securitizers stepped up to compete with Fannie and Freddie, big problems would have arrived even in the absence of the GSEs. Just not as big.
Amac,
Again, no one forced lenders to make bad loans? Who dropped the ‘standard’ of selling loans?
That’s where this starts.
“From Big Picture again”:http://bigpicture.typepad.com/comments/2008/10/goal-increase-m.html
_Understand this simple fact: In an ultra-low rate environment, where prices are appreciating rapidily, and mortgaes are being securitized, ALL THAT MATTERS IS THAT THE BORROWER NOT DEFAULT IN 90 days (or 6 Months). The goal was to make a loan that did not default in that period of time, it cannot be put back to the originator._
_As a mortgage salesman, you only lose your a fee if a borrower defaults within 3 or 6 months. What do you do to maximize your returns? The best way to do that — to put people in houses that would not default in 90 days — was the 2/28 ARM mortgages. Cheap teaser rates for 24 months, then the big reset. By then, it was no longer your problem._
The issue you are detailing out, doesn’t account for this shift in lending standards, at least how I’m reading it.
AJL #62 —
Thank you for your correction on Medical Hypotheses; it is not peer-reviewed. A family member recently discussed the review his article got there, and I drew the wrong inference.
bq. The current front page of the journal web site features two articles, one a review by the editor-in-chief concluding that IQ is largely inherited
Yes. Link. But, given that this thread follows a “Long Post on Fannie and Freddie (With Graphs!!),” can you say what the relevant point is?
bq. and the second a defense of James Watson’s recent remarks that were generally taken as racist.
Signal to noise again, AJL. That article was not authored by Charlton. Link. Again, would you make the relevant point explicit?
By the way, your mimicry of “LBJ’s noted tactic”:http://www.washingtonmonthly.com/archives/individual/2006_09/009566.php of spreading rumors that your opponents are pig-fskers “to make them deny it” begins to lose its charm on the fourth or fifth appearance in a thread. “Racist” in particular is one of the ugliest insults in the English language; I can think of only “child molester” and “animal torturer” that have an equivalently foul resonance.
Do you think that all policy debates are elevated by all uses of this tactic, or is this a case of “for me, not for thee”?
If you are interested in learning about the topic of Charlton’s article, I suggest the biology-focused blog “GNXP.com.”:http://www.gnxp.com/ Be forewarned that those authors are less tolerant of off-topic and snide comments than is the case at Winds.
bq. Would you be happier if I described Sailer as a polite eugenicist?
I would be happier if you would resolve to attend to the signal to noise problem. In some circles, it’s taken as a good sign when participants in a discussion address issues that they have raised (#50, #60), rather than drifting to a different topic. I’d be happier if you’d do that more often, too.
bq. as for Sailer blaming non-whites for the economic situation, in what sense do you believe he is using the word “diversity” in his label “Diversity Recession”? I believe you will find your answer right there.
Attentive readers have already discovered this answer, as Sailer provides it as “paragraph 5.”:http://vdare.com/sailer/081010_meltdown.htm —
bq. As I’ve argued, the Bush Administration wanted to turn Hispanics into Republican voters by making them homeowners through easy credit. George W. Bush and Karl Rove don’t deserve all the blame, however. Their lax mortgage policies were largely a continuation of trends to boost minority and low income mortgage access that were well under way in the Clinton Administration—as I pointed out in my June Takimag.com article on “The Diversity Recession.” These lax mortgage policies also had the secondary effect of encouraging residential real estate speculation—“flippingâ€â€”by minorities and non-minorities alike.
Sailer blames lax mortgage policies targeted at minority groups. The main reasons he ascribes are political gamesmanship (Bush, Rove), greed and stupidity (Wall Street, the GSEs, the real estate industry, Congress, and others) and political correctness (Bush, Clinton, Congressional Democrats, the GSEs, the press, and others).
You may find to your surprise that your imputed answer–“Sailer blames minorities!”–is far from the mark.
hr #68 —
Thanks for that link, I’ve bookmarked it for the damning Bush quote. By the way, I’ve read it before… in a Sailer essay. Not surprising, since that point is central to his thesis.
Also see the example I worked through in Comment #22, which is an illustration of author Barry Ritholz’s point about the Hybrid 2/28 mortgage in action.
Ritholtz ends with this stemwinder:
bq. Those who continue to blame the CRA, Fannie Mae, etc. reveal their fundamental misunderstanding of how credit operates in general, what the financing process was like from 2002-07, and how this situation came to pass. Or worse, they understand it, and choose to lie about it anyway for partisan political purposes.
bq. You either understand these simple facts, or you don’t. If you cannot comprehend this, well, then, I am at a loss as to what that says about your cognitive functioning. But if you understand this, but spit out the nonsense anyway, then you are merely a partisan with no respect for the truth.
bq. And that seems to be the main people blaming the CRA and Fannie/Freddie for the credit/housing crisis — those folks who either can’t think — or wont.
Clever-sounding, but his shaddup if ya disagree schtick is wrong. He’s got the What, which is important. But has little insight into the Why. Yes, as Tim Oren has discussed on this thread, there are macroeconomic and gravy-train reasons why the Pass-The-Hot-Potato approach to residential mortgages was attractive and then addictive. Dislike it though you and Ritholtz do, the already-discussed political factors add plausible Motive and Opportunity explanations to the picture.
AMac:
bq. I’m not sure why these under-regulated Fortune 500 corporations that gave out millions in bonuses to their undeserving crony-executives prior to failing evoke such protective instincts among those who are otherwise rightly critical of the tunnel-vision greed of Wall Street. Or why the agents (er, certain of the agents) who successfully thwarted more capable regulation are commended for their deeds.
Let me advance a hypothesis for this asymmetry of treatment:
CRA and Fannie and Freddie are examples of the government deliberately distorting the market in order to fulfill a political goal, without the nasty necessity of putting the cost onto the formal budget.
Fannie and Freddie have of course been around for many years across multiple administrations and Congresses. Along with favored tax treatment for mortgage payments, they’ve been part of a long-term program to increase home ownership and (deliberately or not) divert more of the nation’s capital resources into housing than would otherwise occur.
For most of that time, the ‘conforming’ loans that F&F would purchase were very traditional and conservative, the typical 30-year fixed, 20% down kind of thing. And their loan size was limited, as those of us living in expensive states knew due to the increased costs of getting a larger ‘jumbo’.
CRA (in its various versions) is also a deliberate market distortion, using coercive powers over certain financial institutions to oblige them to make loans on terms, and to borrowers, that they would not have otherwise done. Forcing this onto private institutions let the politicians achieve the ends of their client groups without having to own up to the eventual costs.
F&Fs definition of ‘conforming’ were then greatly loosened so that they could also purchase many of these loans and keep the issuing financial institutions liquid. Having loosened that definition for loans originating in one program, they were in no position to deny purchases from other institutions and other borrowers. More dodgy loans then began to be made, many as it turns out from house flippers, speculators, and those who were ‘surfing’ through teaser rate ARMs to stay in houses they couldn’t really afford.
Of all the bad decisions that led to the mess, the transformation of ‘conforming’ from being financially conservative to risky likely deserves the most scrutiny, for evidence of political influence, corruption and malfeasance. It put implied sovereign backing behind loans that were politically useful in some cases, but risky in all.
Right behind it stands the role of the rating agencies in essentially allowing this passing-off of bad securities as the conservative debt that they once were. Getting larger tranches of mortgage-backed securities rated ‘AAA’, so they could be bought by classic ‘widows and orphans’ institutions turned out to be a disastrous sham. Again, some deep digging into the political pressures, monetary incentives, and potential malfeasance there would be warranted.
So why should the left be trying to give CRA and F&F a pass? To be sure, there’s political correctness involved, in the case of the CRA, and a decidedly D flavor to the cast of characters who enabled Fannie and Freddie. But I think it’s more than that:
The current mess is clear testimony, for those who will see, that government created distortions in the market are always subject to arbitrage and perverse outcomes. The larger and more staunchly defended for political ends, the worse the result.
If you’ve bigger plans to use private resources for political ends, though overt or implied government coercion, in order to keep the true costs of programs out of public view, then having that public realize that such a program lies at the root of the current disaster is not in your interests.
But that’s just a guess.
Of all the bad decisions that led to the mess, the transformation of ‘conforming’ from being financially conservative to risky likely deserves the most scrutiny, for evidence of political influence, corruption and malfeasance.
Regulatory capture, at a minimum. Ain’t it a bitch? As Dennis Moore (played by John Cleese) said in the eponymous Python sketch: “Blimey, this ‘redistribution of wealth’ is trickier than I thought!”
_Clever-sounding, but his shaddup if ya disagree schtick is wrong. He’s got the What, which is important. But has little insight into the Why. Yes, as Tim Oren has discussed on this thread, there are macroeconomic and gravy-train reasons why the Pass-The-Hot-Potato approach to residential mortgages was attractive and then addictive. Dislike it though you and Ritholtz do, the already-discussed political factors add plausible Motive and Opportunity explanations to the picture._
Actually, just from the low rates, and the belief in deregulation, you already have the What AND the why. Greed is a powerful think, is it not?
In any case, you should go argue this over at Barry Ritholz’s place. Not simply nod in tune with your fellow traveler’s here.
I have the bravery to come over here – you should do the same.
The one piece of evidence you have, for placing the centrality of the GSE’s, is the over-leverage rate. The rest of the presentation goes into the abandonment of ratings, the abandonment of good sense, because it MADE PEOPLE MONEY, if they acted irresponsibly. There was NO REGULATION.
So far, nowhere have you shot down Ritzholz’s, or Krugman’s, or my agreements with them, regarding the blame here.
hr #73 —
Thanks for the response, though I’ll pass on the advice. Pre-labeling dissenters as unthinking partisans with no respect for the truth is overrated as a way to build comment traffic. And think about teaching and learning as motives for coming here. Cf. bravery.
Concerning regulation, here’s a quote from Nassim Taleb’s “The Black Swan” (2006), cadged from “Fabius Maximus’ most recent post”:http://fabiusmaximus.wordpress.com/2008/10/14/results-2/#more-2923 (recommended) —
bq. Globalization creates interlocking fragility, while reducing volatility and giving the appearance of stability. In other words it creates devastating Black Swans. We have never lived before under the threat of a global collapse. Financial Institutions have been merging into a smaller number of very large banks. Almost all banks are interrelated. So the financial ecology is swelling into gigantic, 1ncestuous, bureaucratic banks – when one fails, they all fall. The increased concentration among banks seems to have the effect of making financial crisis less likely, but when they happen they are more global in scale and hit us very hard. We have moved from a diversified ecology of small banks, with varied lending policies, to a more homogeneous framework of firms that all resemble one another. True, we now have fewer failures, but when they occur… I shiver at the thought.
How are we to build a regulatory structure that is so close to the institutions it scrutinizes to be aware of the tricks of its trade, but distant enough to identify the unseen Black Swans and avoid the perils of groupthink? The next crisis won’t start with mortgages or their securities, but with… the implementation of some other Good Idea. How do we recruit regulators with the training and imagination to visualize the intersection of opportunity and threat? How to administer a rule-of-law-based level playing field, while at the same time granting the regulators the discretion to act proactively to nip growing problems in the bud?
Perhaps we should identify the West’s most successful agency with a complex, contentious mission (the FDA?) and seek to create a system in its image? Or is this enterprise necessarily of such scope that it’s preordained to fall short?
I don’t know, though we’re already embarked on that journey.
hypocrisy, what would you say to a “WoC Preferred Issue” site, where only non-hyperbolic comments pass muster, and where all partisan generalizations are either muted or censored, leaving only logic?
In my fantasy, WoC Classic would remain but the higher tone posts would float over to the Preferred site.
Think you could handle that? Think it wouldn’t bore you to tears?
This is not a rhetorical question, and it’s not some sort of hint. I’d ask every contributor and poster here that question if I could figure out how to make such a site work. It’s on my mind because the “fellow traveler” effect you mention means mojo / reputation systems here would not have satisfactory outcomes.
On another slant, Kos for instance seems to require registration. If we did that here certain recent contributors would probably vanish from our vista, leading further to the kind of fellow-traveler thing you point to.
Nort
PS: Your bravery is not in question by anyone here but you as far as I can see. Why else would you feel the need to announce it?
bq. Perhaps we should identify the West’s most successful agency with a complex, contentious mission (the FDA?) and seek to create a system in its image? Or is this enterprise necessarily of such scope that it’s preordained to fall short?
One big stumbling block for that is that individuals can’t hoard health.
Maybe make CEOs take “pauper’s oaths?” Certainly coupling golden parachutes to long term gains is an intersting idea.
I’d much rather that sort of thing be done by shareholders. But as I expect hypoc would agree, shareholders are not the only stakeholders.
It’s a wicked problem.
hypo, there are three key elements that I base my theory on: The over-leverage of the GSE’s; their size; and the fact that other regulated institutions could use GSE securities as cash.
#’s 1 and 3 are a product of regulation – bad regulation. It’s also certainly possible (maybe even likely) that we’ve had had the same effect in a completely deregulated or more laxly regulated environment.
But the regulatory decision – which told the accountants that GSE securities were as good as cash – is the issue that I’d point to as a problem.
I no more think that the regulatory issues around GSE’s were the ‘sole cause’ than I think that fraud by Angelo Mozilo was the sole cause.
But like all accidents, there’s a chain of causes, each of which was a link, and the GSE’s and the opportunities for regulatory arbitrage they presented were clearly among the links.
A.L.
Guys, guys, GUYS!
Okay, okay, “bravery” is clearly a stupid word. Shit, I go by a fake name, after all, I’m just a thinking monkey with a keyboard.
Still, I have a willingness to engage with those who think differently than I do – I like learning stuff, and hate echo chambers.
But yeah, actually, Mr. “Hypocrisyrules” is being brave? I’ve already generate 5 classic putdowns to my that particular idiocy, generated by me.
A.L.,
Well, we are narrowing the disagreement, at least, somewhat.
I still say the abandonment of standards – or the “go wild” attitude is clearly what is at fault.
Abandonment of standards in:
a. Buying
b. Lending
c. Leverage
d. Bundling
e. Derivatives
You really need all of the above, and the contamination and interconnected financial market to cause the cardiac arrest that was seen when Lehman Brothers went under.
Highlighting the GSE’s role, is really, looking again at what many others who have a lot more insight than I do, think is a false “main” factor.
I suppose I need more information about your #3.
I’d love for you to explain that more.
…and hypo, if there weren’t people who strongly disagreed with me here, I’d stop posting and do something else. I do – really, deeply – want good discussions, and I’m trying hard to learn how to seed them and participate effectively.
So – shocking as it may seem – thanks for being here.
A.L.
hypo – #79 – I agree, but suggest that the GSE’s changed this from a Bad Thing to a Terrible Thing for the reasons I mentioned. We would have had a housing bubble and crash if the GSE’s has been well-run. But the damage would have been more contained.
That’s my only claim.
A.L.
One more post on this, and I’ll leave this alone.
I want to strongly urge you A.L., to LISTEN TO PEOPLE WHO KNOW WHAT THEY ARE TALKING ABOUT – which isn’t you, and isn’t me.
At any rate, Byron York also arguing that Fannie and Freddie were “major causes, with Matt Tabibi:
“here is the link”:http://nymag.com/daily/intel/2008/10/matt_taibbi_and_byron_york_but.html
One taste –
_B.Y. I think that Fannie Mae and Freddie Mac were also major factors. And I believe that many of the problems in the mortgage area can be attributed to the confluence of Democratic and Republican priorities: the Democrats’ desire to give mortgages to people, particularly minorities, who could not afford them, and the Republicans’ desire to achieve an “ownership society,” in part by giving mortgages to people who could not afford them. Again, I believe that if you are suggesting that the financial crisis is a Republican creation, or even more specifically a McCain creation, I think you’re on pretty shaky ground._
Later –
_M.T. No. That is what you call a figure of speech. I’m saying that you’re talking about individual homeowners defaulting. But these massive companies aren’t going under because of individual homeowner defaults. They’re going under because of the myriad derivatives trades that go on in connection with each piece of debt, whether it be a homeowner loan or a corporate bond. I’m still waiting to hear what your idea is of how these trades work. I’m guessing you’ve never even heard of them._
And that’s the thing, really.
When you look for the SIGNIFCANT cause, you can’t GET there, unless you talk about the unregulated swap market. That interconnected fantasy paper market, that everyone bought into, is the SIGNIFICANT cause.
Sure, it rests on bad mortgages. But to think that the massive overhang can TAKE OUT countries financials? – that is the fault of fake financial products, that everyone kept building up, taking a slice of – until the house of cards all falls down.
hr #82 —
That’s a good link. Matt Tabibi is correct to highlight the role of CDSs (and Byran York is portrayed as out of his depth, rightly or wrongly). But there’s this:
bq. Tabibi: Oh, come on. Tell me you’re not ashamed to put this gigantic international financial Krakatoa at the feet of a bunch of poor black people who missed their mortgage payments… The effort of people like you to pin this whole thing on minorities, when in fact this whole thing has been caused by greedy traders dealing in unregulated markets, is despicable.
There’s a range of non-Leftist perspectives on this and other recent WoC threads. Which commenters or linked essays have offered a point of view akin to that which Tabibi condems? None or nearly none: it’s a straw man argument.
“Prof. Amy Edmondson”:http://hbswk.hbs.edu/item/4959.html observes, “…conducting an analysis of a failure requires a spirit of inquiry and openness, patience, and a tolerance for ambiguity… People tend to be more comfortable attending to evidence that enables them to believe what they want to believe…” Later, she notes that Harvard Business School’s approach to medical errors “[emphasizes] that, rather than being the fault of a single individual, medical errors tend to have multiple, systemic causes.”
Tabibi would benefit from considering her points.
The inconvenient truth of GSEs-Not-Blameworthy dogma is that they failed. Their September 7th “tumble into conservatorship”:http://www.bloomberg.com/apps/news?pid=20601087&refer=home&sid=aY5djDWqugYk was a precipitating cause and not an effect of the CDS-driven phase of the debacle.
“The NYT’s ‘Reckoning’ series”:http://www.nytimes.com/2008/10/05/business/05fannie.html?_r=2&adxnnl=1&oref=slogin&partner=permalink&exprod=permalink&pagewanted=all&adxnnlx=1223175687-o2eJdDiA2hYen6a50H7g8w explains:
bq. So [Fannie CEO] Mudd made a fateful choice. Disregarding warnings from his managers that lenders were making too many loans that would never be repaid, he steered Fannie into more treacherous corners of the mortgage market… Between 2005 and 2008, Fannie purchased or guaranteed at least $270 billion in loans to risky borrowers — more than three times as much as in all its earlier years combined… “We didn’t really know what we were buying,†said Marc Gott, a former director in Fannie’s loan servicing department.
On 9/30/08, the “Understanding Tax” blog had a “useful post”:http://understandingtax.typepad.com/understanding_tax/2008/09/7-the-financial-crisis-what-went-wrong.html fingering the special place that Teaser-Rate ARMs have earned in Mortgage Hell. See comment #22 for an example.
Comment #7 had an excerpt from economist Stan Liebowitz’s “Anatomy of a Train Wreck.”:http://www.independent.org/publications/policy_reports/detail.asp?type=full&id=30 From the summary:
bq. This report concludes that, in an attempt to increase home ownership, particularly by minorities and the less affluent, virtually every branch of the government undertook an attack on underwriting standards starting in the early 1990s. Regulators, academic specialists, GSEs, and housing activists universally praised the decline in mortgage-underwriting standards as an “innovation†in mortgage lending. This weakening of underwriting standards succeeded in increasing home ownership and also the price of housing, helping to lead to a housing price bubble. The price bubble, along with relaxed lending standards, allowed speculators to purchase homes without putting their own money at risk.
To understand whether the GSEs contributed “a lot,” “a whole lot,” or “even more” to triggering the crisis, we’d need to analyze better information:
* What percentage of failed loans–mainly subprime and Alt-A ARMs–were securitized by Fannie and Freddie?
* How were the origination and securitization practices of other players affected by GSE policies and policy changes?
* Most importantly, how and when did the GSEs’ definition of “conforming mortgage” change over the past decade? I find it likely that Tim Oren is correct to suggest (#71) that this was a crucial factor (a point contested in #44 and #56 by AJL).
My guess is that the interest of certain Members of Congress to get to the bottom of these issues will remain right where it is, for some time to come. Since a decline is not possible.
Um, hypo – I didn’t make the Powerpoint slides that are in the post, and I wasn’t presenting at the seminar where they were shown and discussed. The guys who did – they are paid a decent chunk of change by some very smart people to know something about these markets, and yes, I will suggest that listening to them is a good idea.
And with that, we’ll move on to voting fraud…
A.L.