How We Got Here

A useful talk on the cause of the financial crisis:

Before talking about how we did get here, let me say a quick word about what didn’t cause this mess. Those who wish to blame greed for the crisis need to explain how and why it is that greed seems to causes crises only at specific times, despite the fact that it is omnipresent as a feature of human nature and market economies. As the economist Larry White has noted, if we saw a bunch of planes crash all on the same day, we wouldn’t blame gravity. It’s always there. Something else must be at work. I would argue that the key is the set of institutions through which greed or self-interest is channeled. That is, good institutions can cause self-interest to generate desirable unintended consequences, and bad ones can cause undesirable ones. So perhaps we should be looking at institutions and policy.

Those who wish to blame deregulation or the supposed “laissez-faire” philosophy of the Bush Administration are going to have to identify the deregulation in question, which will be a challenge given that the last deregulatory legislation in the financial industry was in 1999 under Clinton. These folks will also have to explain how the enormous growth in the Federal Register and domestic spending over Bush’s two terms reconciles with his supposed belief in laissez-faire. Answer: it doesn’t.

The two key causes of this crisis are expansionary monetary policy on the part of the Fed and a series of regulatory and institutional interventions that channeled that excess credit into the housing market, creating a bubble that eventually had to burst. In other words, the boom (and the inevitable bust) are the product of misguided government policy, not unbridled capitalism.

The Fed drove up the money supply and drove down interest rates very consistently since 9/11. When central banks do so, they make long-term investments relatively cheaper than short-term ones, thus the excess funds flow toward such goods. Historically, these were producer goods in capital industries, but in this particular case, a set of other government interventions and policies pushed those funds toward housing.

A state-sponsored push for more affordable housing has been a staple of several prior administrations. Fannie Mae and Freddie Mac are key players here. Although they did not orginate the questionable mortgages, they did develop a number of the low down-payment instruments that came into vogue during the boom. More important, they were primarily responsible for the secondary mortgage market as they promoted the mortgage-backed securities that became the investment vehicle du jour during the boom. Both Fannie and Freddie are, we must remember, not “free-market” firms. They are “government-sponsored entities,” at one time nominally privately owned, but granted a number of government privileges, in addition to carrying an implicit promise of government support should they ever get into trouble. With such a promise in place, the market for mortgage-backed securities was able to tolerate a level of risk that truly free markets would not. As we now know, that turned out to be a big problem.

Read all. It also points out the ways that this mess is the debris of the New Deal and the depression.

And yet the lies that got Obama elected — that this was caused by “greed,” “deregulation,” and “tax cuts” continue, and continue to be used to justify running up the national debt to insane levels and nationalizing vast swathes of the economy.

[Update at 9 PM Pacific]

Richard Epstein:

…we take [failing enterprises] away from bankruptcy judges, who are experts, and give them to a collection of congressional individuals who are charitably called clowns. When you bring commercial decisions to Congress they become politicized, and politicized decisions become destructive decisions.

Charitably indeed.

20 thoughts on “How We Got Here”

  1. “And yet the lies that got Obama elected… continue…”

    Well, duh! As long as the politicians who wield these lies continue to aggrandize themselves, of *course* they will continue.

    I mean, let’s face it. Dodd and Frank et al will be dead long before these bills get paid.

  2. Quite frankly, I think maybe it’s just the century for bubbles. We had a dot-com bubble, and then what that imploded everyone got hot for real-estate and mortgage securities, and now that that has gone wahooni-shaped — we’ve got an Obama Bubble!

    Everyone is investing more and more — money, faith, political and human and actual capital — in this one guy. Everyone else is wrong, backward, corrupt, ordinary. It isn’t even about the Democratic Party anymore, since the faithful aren’t all that happy with Dodd and Pelosi and assorted tax finagles in the Cabinet.

    No, it’s all about The Savior. Everyone’s put all their chips on Red 44 and his holding their breath while the croupier spins the wheel.

    Strange. Is it all that high-fructose corn syrup we’ve been drinking? Whence the madness for Operators Are Standing By Now superamazing late-night TV deals? You can have your cake and eat it too. There IS such a thing as a free lunch, and free dinner and dessert, too!

  3. Thanks. The summary of Horwitz’s talk is excellent and I will read the rest.

    The scapegoating by pols (who caused most of the problem) and their journalist allies of productive businesspeople and businesses is infuriating and terribly harmful. Our political class is literally destroying the country via outrageous spending and harebrained dirigiste schemes

  4. Howitz’s hypotheses fail to satisfy his own criteria. We’ve had low Fed rates before. We’ve had a government interest in homeownership, expressed through such vehicles as the CRA and Fannie/Freddie, for decades. So blaming these two factors alone is as inadequate as blaming ever-present greed.

    So what was new this time? Some possibilities:

    * The credit default swap market
    * David Li’s Gaussian cupola function, which let banks use data from the credit default swap market to (faultily) estimate the risks of mortgage-backed securities (Google “The Formula That Killed Wall Street” for details)
    * The willingness of the rating agencies to certify securities backed by risky mortgages as AAA investments

    These factors were all new on the scene, and all contributed to the crisis.

    I agree with Horwitz that the Fed contributed to the bubble by keeping interest rates too low, and by Greenspan denying there was a bubble, and encouraging consumers to get adjustable rate mortgages. But what motivated Greenspan to make these mistakes? He has said since the crisis that his Rand-inspired free-market ideology convinced him that banks would self-regulate and not take on self-destructive levels of risk; and that the crisis has forced him to reconsider lifetime-held views about the need for government regulation.

    The only way to look at these facts and conclude that we need less financial regulation is to have started with that belief to begin with.

  5. “…lies that got Obama elected — that this was caused by “greed,” “deregulation,” and “tax cuts” continue…”

    “…scapegoating by pols (who caused most of the problem) and their journalist allies…”

    And the theme of lying for power continues. A lie can ONLY exist if no one challenges it. A lie can ONLY continue to be told if the liars are not called out to prove the lie. And when they can’t prove it, that needs to be said too. The truth should NEVER be held back.

    Just once I’d like to look at C-Span and see the non-liberal Democrat talking heads call the liars a bunch of liars!! The non-liberal Democrat talking heads sit day after day and allow the liberal Democrat talking heads to speak and compound the lies without calling them in those lies. It’s disgusting! The lied about party sits there mute, as if being quiet and conciliatory gets them something. And if your entire rhetorical act is to tell lies about our adversaries, you don’t deserve any conciliatory talk from those adversaries. You deserve to be laid bare to the voting people as a liar.

    Liars should be openly called liars and to their faces!!!

    The party line from the liberal Democrat talking heads is, get along, keep quiet, or get NOTHING. Well, how’s THAT working out? All the non-liberal Democrat talking heads have gotten is further in the hole by being friendly.

    I don’t want friendly representation, I want strong, truthful representation. And anyone, regardless of political adherence or belief who DOESN’T want the truth told, needs two things.

    Tar.

    Feathers.

    This kind of behavior is WHY the left wants the 10 Commandments removed from public places. That pesky no lying thing gets in the way of breaking all the other Commandments and any man made laws.

  6. Howitz’s hypotheses fail to satisfy his own criteria. We’ve had low Fed rates before. We’ve had…[blah blah]

    And — amazingly enough! — we’ve had bubbles before, too. Like the dot-com implosion. We’ve even had real estate bubbles before, like the time Orange County went bankrupt in the late 80s.

    Born yesterday, huh Jim? I guess when your perspective is that Time Itself begins with the 2000 election, then, yeah, you’re a little bewildered by how we got here, because you’ve never seen anything like it before. However, those of us with slightly longer memories have.

    And from that perspective your list proves the opposite of what you think. The fact that this real-estate bubble implosion looks like all the others since tulips went kablooie in the 17th century means that credit default swaps and all kinds of other modern decorative paraphernalia have zip to do with it. The mechanism is not the cause, any more than handguns cause murder.

    But what motivated Greenspan to make these mistakes?

    Who cares, Jim? This is a standard Left canard — that motivations matter more than actions. What matters is what Greenspan did — and the fact that he directed a massive government interference in the economy. His motivations for anti-free-market intervention are of no serious interest.

    I mean, seriously, you’re saying that if Greenspan were “motivated” by faith in the free market to massively interfere with the free market, and it turns out badly — well! we should disbelieve what Greenspan believes, including his faith in free markets. Not, you know, instead think that what he did (government manipulation of credit and money supply) is a bad idea?

    Gee, Jim, suppose Greenspan also believes in daily exercise and eating right. Should we abandon those principles, too, since the guy who held them screwed up the economy?

    The only way to look at these facts and conclude that we need less financial regulation is to have started with that belief to begin with.

    Pure garbage. Remember the problem began with Fannie Mae and Freddie Mac? Who runs those institutions, hmm? Who set them up? That would be government. The “regulation” we need the most is regulation against interference by lawyer sods who went to Washington because they couldn’t make a living otherwise, and who are too stupid to realize they don’t know WTF they’re doing.

    Besides, you have no idea what kind of “regulation” would do the job. You’re just defining it by its result, kind of like saying we need a cure for mortality and bad luck, damn it, so let’s get a law passed about that. Disagree? Give us a proposal then. What “regulation” would you propose that will detect and ward off every imaginable future financial invention (like credit default swaps or subprime mortgages) that will seem like a brilliant idea to the majority of people at the time. What supergenius is going to be put in charge of this “regulation?” Some guy who is always right, even when everyone else around him is on the bandwagon of wrong? Who is going to put the brakes on the next stupid bubble idea, while, of course, not putting the brakes on the next breakthrough technology that will Change Our Lives?

  7. Market Bubbles are essentially wildfires in the system.
    The key is wether the fire burns out or if it jumps the
    firebreaks.

    Now what were the firebreaks. Glass-Steagal kept
    the Commercial banks out of investment banking.
    Gramm-Leach-Bliley which Senator Phil Gramm
    championed, tore down the Glass-steagal walls.

    the Commodity Futures Modernization Act
    created Credit Default Swaps as unregulated
    insurance. Insurance contracts are regulated
    by the states, CDS nobody knew.

    then the 2003 Basel II accords which eliminated
    equity reserve ratios, banks went from 10:1 reserves
    to 50:1.

    it’s probably too complicated for people who want to
    blame the whole failure on subprime mortgages,
    but, it’s the truth.

  8. “Pure garbage. Remember the problem began with Fannie Mae and Freddie Mac? Who runs those institutions, hmm? Who set them up? That would be government. The “regulation” we need the most is regulation against interference by lawyer sods who went to Washington because they couldn’t make a living otherwise, and who are too stupid to realize they don’t know WTF they’re doing.”

    Carl is incorrect, the people who run Fannie/Freddie
    are the Board of Directors and the Managers,
    As public corporations, they have to answer to
    a lot of shareholders, one of which is the treasury,
    so it’s not the Government.

    Now the more interesting question, is
    Fanne and Freddie did not sell bonds guaranteed
    by the Government. So why did Hank Paulsen
    go out and guarantee the Fannie/Freddie Paper?

    why would any government official take liability
    for their crap?

  9. Carl: We’ve had bubbles before, but we haven’t had one bring down the financial system since 1929. Understanding how we got here requires understanding what was different in the 2000s from the 70s, 80s and 90s.

    What matters is what Greenspan did — and the fact that he directed a massive government interference in the economy.

    Umm, Greenspan was Fed chair. His job is to interfere in the economy! The fact that unwise Fed actions can cause major problems is not news to anyone. But I don’t think anyone is seriously proposing we do away with the Fed. Rather, the idea is to make the Fed’s job easier, and to provide safeguards against the inevitable sub-optimal Fed decisions.

    Remember the problem began with Fannie Mae and Freddie Mac?

    Saying or wishing does not make it so. Fannie and Freddie were late to sub-prime loans, had modest market share in that business, and had nothing to do with credit default swaps. If Fannie and Freddie had not issued a single sub-prime loan their competitors would have gladly taken up the slack, and we’d be in the same place today. Horwitz makes a feeble attempt to blame them for coming up with “low down-payment instruments that came into vogue during the boom.” That’s pretty thin stuff, and false to boot (I had such a mortgage in 1992, long before Fannie/Freddie started offering them). Once there was a big and profitable business selling mortgage-based investment instruments with false risk assessments those mortgages were going to be issued, one way or another — the market abhors a vacuum.

    You ask for what sort of regulation we should have. I’m no expert, but one thing I’d suggest is a limit on the size (in terms of total liabilities) of financial institutions. When banks and other such firms reach a certain size they should have to split or sell off some of their obligations to other institutions. That way no one can get “too big enough to fail,” and the consequences of poor decisions in one firm (e.g. Lehman or AIG-FP) can not threaten the entire system.

  10. From Walter Williams article dated 1/14/09.

    So here’s my question: What are we to make of congressmen, talking heads and news media people who tell us the financial meltdown is a result of deregulation and free markets? Are they ignorant, stupid or venal?

    A New York Times article, “Fannie Mae Eases Credit To Aid Mortgage Lending” (9/30/99), reported, “Fannie Mae, the nation’s biggest underwriter of home mortgages, has been under increasing pressure from the Clinton Administration to expand mortgage loans among low and moderate income people …” The pressure was the 1977 Community Reinvestment Act that was beefed up during the Clinton Administration. It required banks to make high-risk loans they would not have otherwise made. Failure to comply meant fines and difficulty in getting approval for mergers and branch expansion.

    When questions began to arise about government policy that intimidated lenders into making high-risk loans, we received congressional assurances. At hearings investigating the solvency of Fannie Mae and Freddie Mac, Rep.
    Barney Frank said, ”The more people exaggerate these problems, the more pressure there is on these companies, the less we will see in terms of affordable housing.” In a speech to the Mortgage Bankers Association, Frank advised, “People tend to pay their mortgages. I don’t think we are in any remote danger here. This focus on receivership, I think, is intended to create fears that aren’t there.” Protesting against greater controls against lax mortgage lending, Sen. Harry Reid said, “While I favor improving oversight by our federal housing regulators to ensure safety and soundness, we cannot pass legislation that could limit Americans from owning homes and potentially harm our economy in the process.”

    One-third of the $15 trillion of mortgages in existence in 2008 are owned, or securitized by Fannie Mae, Freddie Mac, Ginnie Mae, the Federal Housing and the Veterans Administration. Wall Street buyers of repackaged loans didn’t mind buying risky paper because they assumed that they would be guaranteed by the federal government: read bailout from the taxpayers. Today’s housing mess can be laid directly at the feet of Congress and the White House.

  11. The link at my name has a brilliant discussion from a “polymorph” at the Hoover Institute on what’s going on with BHO and the economy. He is a strong believer that bankrupcy procedures are superior to political solutions. Except for Jim, consider listening to all 4 sections at NRO.

  12. I realized later that my link is the audio portion of the Richard Epstein NRO link posted by Rand. Also, its “polymath,” not “polymorph”… That’ll teach me to go away during spring break…

  13. We’ve had bubbles before, but we haven’t had one bring down the financial system since 1929.

    Oh nonsense. First of all, look around you. Do you notice the financial system being “down?” Your neighbors trying to buy stuff at the store with barter instead of debit cards? Your credit card no longer working? I hear home sales bumped up last month — what, is that only people paying cash, ’cause there are no mortgages to be had? Your idea of a system being “down” is pretty….well, hysterical, I’d say. In my lifetime, I’m still going with 1982 as a rougher ride financially. A prime rate of 18% wow! That was a lot uglier than what we’ve got now. (And before you get to it, unemployment was about 50% higher then, too.)

    Understanding how we got here requires understanding what was different in the 2000s from the 70s, 80s and 90s

    Only if nothing like this every happened before. If this is simply another version of a bubble, somewhat larger, then that’s ridiculous. If I see a 3-car accident on the freeway, and all that’s happened in the last ten days is 2-car accidents, I don’t think OMG must be something totally new going on

    Umm, Greenspan was Fed chair. His job is to interfere in the economy!

    RIght, Jim. That’s why his personal economic philosophy is utterly irrelevant. He’s just doing a job, the goals of which are set by government. So when you said Greenspan helped bugger things up and HE’S personally a free marketeer –that means free market principles are wrong! you were, as I said, logically incoherent.

    the idea is to…provide safeguards against the inevitable sub-optimal Fed decisions.

    That is the perfect statement of Obama philosophy. Goodness, the king screwed up! Well, he’s only human. I know! Let’s appoint a czar to oversee the king, guard against the inevitable bad decision. Oh wait…the czar is human, too, he might screw up. I know! Let’s appoint a dictator to oversee the czar…

    Does it not occur to you at some point that if Alan Greenspan, one of the smartest and most respected financial wizards of the century, MIT professor, with decades of experience on the job, with zero poltical pressure (he’s not elected), with enormous information resources at his fingertips, and with nearly unlimited power to implement his decisions can still screw up — there’s nothing and nobody that can do better?

    Saying or wishing does not make it so. Fannie and Freddie were late to sub-prime loans, had modest market share in that business, and had nothing to do with credit default swaps.

    No, but facts do make it so. They were late to subprime loans — er, yes, and so was the bubble pop. Subprime loans are not all a bad idea, and one would suspect the earliest ones were the most conservative and most justified, and the latest — issued by our friends F&F! — were the wildest and silliest, the top of the bubble insanity. They had nothing to do with CDS? You mean, other than providing the underlying security? The one that started to go tits over ass and thus triggered the meltdown in the CDS market? What would have happened to the CDS market had there been no subprime mortgage default spike? Why, nothing at all.

    You ask for what sort of regulation we should have…[suggestion on limiting size]

    How about you point to some regulation we don’t already have, like a Sherman Antitrust Act? If there’s a company that dominates a certain industry to the detriment of the economy, government already has the tools to cut it down to size. Remember the AT&T breakup? The Microsoft suit? The government could have taken down AIG or whomever anytime they liked.

    They wouldn’t even have needed an antitrust suit. You talke about increased regulation as if those financial institutions weren’t already regulated up to their eyeballs. Here is a transcript of Congressional testimony by Scott Polakoff, Director of the Office of Thrift Supervision. Here is the key exchange:

    —-

    HENSARLING: So there were not limits on your power. Perhaps, there were limits on your knowledge or insight, but there was not limits on your power to stop what you cite, as I believe AIG’s liquidity — I’m reading from your testimony — was the result of AIG’s business lines. So you did have the power to stop those business lines. Is that correct?

    POLAKOFF: Yes, sir.

    HENSARLING: Again, it appears, if this is correct, it was not a lack of supervisory authority that caused you not to take action with respect to these two lines. Is that correct?

    POLAKOFF: Yes, sir.

    HENSARLING: And I think I also heard you say in your testimony that you did not have [in]sufficient manpower and expertise. Is that correct?

    POLAKOFF: Yes, sir.

    HENSARLING: So, again, in retrospect, it wasn’t the lack of authority. It wasn’t the lack of resources. It wasn’t the lack of expertise. You just flat made a mistake. Is that a correct assessment?

    POLAKOFF: In 2004, we failed to assess how bad the mortgage economy, the real estate economy would become in 2008. Yes, sir.

    —-

    Got that? The key regulator said we lacked neither the authority, the manpower, or the information to stop this mess. We just made the wrong judgment. Kind of like everybody else did, during the bubble. Kind of like everyone always does, during a bubble, and always will. Unless you want to empower a dictator who can always ignore majority opinion — unless you want a king back — there is no “regulation” solution to the problem of periodic madness among the majority. That’s the nature of democracy, and putting still more power in the hands of the majority, by giving power to a democratically-elected government, is sheer madness.

  14. Mac: Most of the loans in question were not issued by Fannie/Freddie, in fact they were issued by institutions that weren’t covered by the CRA. They weren’t the result of government bullying. Why then were these risky loans made? Because there was enormous demand for (supposedly) low-risk investment instruments based on them. Think about it: what do you think is more effective in getting a mortgage broker to write riskier loans, government hectoring or investment firms that will happily buy up any mortgage you write?

    Carl: Greenspan’s philosophy influenced how he used his power as Fed chair. His misguided belief in banks’ ability to regulate themselves is part of what got us here.

    My suggestion regarding maximum bank size is not to forestall monopolies (we have laws for that), but to reduce systemic risk. Citibank is far from being a monopoly, but we’d be better off if we’d never let it get to 10% of its current size.

    If you are right that there is no point in trying to avoid bubbles and panics then we might as well get rid of the FDIC and SEC. The impossibility of perfect regulation is no argument against better regulation.

  15. The impossibility of perfect regulation is no argument against better regulation.

    But the advisability of more regulation when the regulation we already have is contributing to the problem? That might be.

  16. > The impossibility of perfect regulation is no argument against better regulation.

    And we’re going to get better-than-nothing regulation, let alone “better” regulation because we really, really, really believe this time….

    > If you are right that there is no point in trying to avoid bubbles and panics then we might as well get rid of the FDIC and SEC.

    Actually, regulation doesn’t have to “avoid” to be worthwhile, it merely has to reduce the product of cost and frequency of said bubbles and panics while costing less than the improvement in said product.

    Unfortunately, it doesn’t seem to meet that low bar.

    BTW – It’s not necessarily clear that avoiding bubbles and panics is a good thing. Stable systems often have lower performance than unstable ones.

  17. Here’s a question. On the Index of Economic Freedom, Hong Kong rates 90 on both investment and financial freedom; US scores 80 percent in both categories. That means HK’s financial markets regulation is less byzantine than ours. Why didn’t HK’s finance industry ever spawn such a problem?

    Regarding the comment that CRA has existed for decades…its current form has been around since 1995; the original act didn’t have any regulatory teeth. It takes time for legislation, good or bad, to have its fullest effect.

    The housing bubble was a host to two diametrically opposed memes: affordable housing and rapidly appreciating home investments. A property can’t do both. I’m old enough to remember when the rule of thumb was house list price = annual salary. The job paying 30K in 1975 was not paying 75K in 1990 or anywhere NEAR six figures today. We’ve been hosed.

  18. “Mac: Most of the loans in question were not issued by Fannie/Freddie, in fact they were issued by institutions that weren’t covered by the CRA.”

    And this information came from where?

  19. Countrywide Financial? DiTech? There were plenty of mortgages that were financed by non-bank entities. It was easy to do when an investment bank would buy them up for packaging into RMBS securitisations that were going to be sold to 144A investors.

    Man, if you could see some of the loan documentation I’ve seen. Jack Lee’s probably closest to the essence of what’s going on. Certainly not the guy who wrote the paper Rand cited. I’d never take an economics course from him if the paper is any indication.

    I got CRA indoctrination as part of my bank teller training in 1993, and it has followed me since, even after I moved out of retail banking.

    Fannie and Freddie are like flea bites on the rump of the economy, causing a response entirely disproportional to their actual effect. Now we’re starting to see all of the looted companies roll into bankruptcy, and that’s the process that has to be worked through before the economy can heal and start growing again.

  20. Alan: The Bush administration reversed the Clinton-era CRA enforcement efforts in 2001, and yet subprime lending accelerated.

    Bill: Google “Michael Barr CRA” or “CRA subprime”. In 2008 Barr testified to Congress that about one in four subprime loans were made by companies fully covered by the CRA, and that “the worst and most widespread abuses occurred in the institutions with the least federal oversight”.

Comments are closed.