The Federal Housing Administration seems intent on repeating one of the key policy errors that played a major role in causing last year’s financial crisis. One of the main causes of the mortgage crisis that led to the broader financial crisis of 2008 was government subsidization of risky mortgages for people who were unlikely to be able to pay them back if real estate prices fell. Investors bought up dubious mortgages supported by Fannie Mae and Freddie Mac because they correctly perceived these “government-sponsored entities” as having an “an implicit government guarantee.” See this account by Charles Calomiris and Peter Wallison. Wallison also presciently warned of the possible dangers back in 2005. Government backing for dubious mortgages was a bipartisan policy backed by many Republicans as well as Democrats. President Bush, for example, sought, in his words, to “use the mighty muscle of the federal government” to expand homeownership by giving GSEs incentives to ease credit requirements.
Unfortunately, policymakers have still not learned their lesson. As columnist Steve Chapman points out, the FHA is again subsidizing the same types of dubious mortgages that the federal government backed with disastrous results in the years leading up to 2008:
Watching Washington policymakers in action, I sometimes think they make mistakes because of unrealistic goals, flawed thinking, blind obedience to party, or dubious information. And sometimes I think they make mistakes because they are—how to put this?—clinically insane.
There is no other way to explain what is going on at the Federal Housing Administration, which provides federal guarantees for home mortgages. Given the collapse in real estate prices, the weak economy, and the epidemic of foreclosures, banks are acting with more caution than before. They now commonly require home buyers to make down payments of 20 percent to qualify for a loan. But the FHA often requires only 3.5 percent.
That’s the equivalent of playing pool with a guy named Snake, and it’s had two predictable effects. The first is that the agency is insuring about four times as many home loans as it did just three years ago. The other is that the number of FHA-approved borrowers who are not repaying their loans is climbing. Since last year, the default rate has jumped by 76 percent.
Another likely consequence looms: you and I eating the losses. A former executive of mortgage giant Fannie Mae told a congressional subcommittee that the FHA “appears destined for a taxpayer bailout in the next 24 to 36 months.” Commissioner David Stevens had to assure the subcommittee that it would not need help—well, unless there is a “catastrophic home price decline.” But who says there won’t be? It’s not as though anyone at the FHA foresaw the housing bubble or the housing bust. Yet now it feels confident betting its $30 billion cash reserve that prices won’t fall.
Unlike Chapman, I don’t think the policymakers are “insane.” They are responding rationally to perverse incentives. If another mortgage crisis occurs, they hope to shift the blame to a supposedly insufficiently regulated private sector — which is more or less how many of them managed to escape blame the last time around. The public did punish the Republican Party in the 2008 presidential election. But most of the members of Congress and federal bureaucrats who supported the GSEs got off scott-free. Moreover, the full negative effects of risky government-backed lending may not become evident for years to come — perhaps at a time when some other administration and Congress will be in office. In the meantime, the administration, the FHA, and key members of Congress can reap the political benefits of getting support from grateful borrowers, real estate developers, and other interest groups that benefit from easy credit. This vicious circle could be forestalled if voters understood what is happening and punished the offending pols at the polls. However, widespread voter ignorance of both the details of federal policy and Economics 101 makes this unlikely.
I wish there were an easy solution to the problem of recurring bad policy caused by perverse political incentives. Sadly, I fear there is not. However, the beginning of wisdom is to at least recognize the nature of the problem.
bchurch says:
Federally insured mortgages were actually behind the curve in terms of subprime loans– unlike purely private loans, federally insured loans have to meet certain minimum regulatory standards as to terms. The big problem was private lenders like CountryWide intentionally creating and riding a bubble they knew wouldn’t be sustainable to get short term investment money. But, of course, blame the federal government and/or poor people is the only tool in modern Republican belts.
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October 15, 2009, 4:23 pmIlya Somin says:
Federally insured mortgages were actually behind the curve in terms of subprime loans– unlike purely private loans, federally insured loans have to meet certain minimum regulatory standards as to terms. The big problem was private lenders like CountryWide intentionally creating and riding a bubble they knew wouldn’t be sustainable to get short term investment money.
No single private lender or small group of them could “intentionally create” a bubble of the size we had. Moreover, many of the private issuers put out these loans in part because they knew that the GSEs would buy them up — relying on their federal guarantees. It’s true that federally insured loans had to meet some regulatory standards. But those standards still allowed loans to buyers with risky credit ratings that would probably be unable to pay if the real estate market turned south.
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October 15, 2009, 4:27 pmbchurch says:
Also, if you really want to create some stability in the FHA, you can encourage Congress to pass meaningful enforcement requirements for foreclosure mitigation. Right now, the banks are all to happy to declare defaulted mortgages unsalvagable (with no explanation) and run to the government for their claim. HUD has explicitly said they are only enforcing complaints regarding foreclosure mitigation for certain predetermined offenders– meanwhile, just try to get a hold of someone at Wells Fargo or Deutsche about mitigation on an FHA insured loan. Good luck.
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October 15, 2009, 4:27 pmIlya Somin says:
Also, if you really want to create some stability in the FHA, you can encourage Congress to pass meaningful enforcement requirements for foreclosure mitigation. Right now, the banks are all to happy to declare defaulted mortgages unsalvagable (with no explanation) and run to the government for their claim.
Maybe. Of course this problem wouldn’t exist if the government didn’t subsidize the claim to begin with. Once a government guarantee is created, it is more or less inevitable that private interest groups will take full advantage of it.
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October 15, 2009, 4:29 pmbchurch says:
http://www.mcclatchydc.com/251/story/53802.html
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October 15, 2009, 4:34 pmbchurch says:
I think there’s something to be said for offering some incentives to banks to lend to low and middle income borrowers, so long as there’s adequate regulation and enforcement of those regulations. At least, it’s an achievable policy goal without necessarily creating another crisis. We can disagree about the value of the policy, but I don’t think it’s fair to say that it a priori leads to disaster (not sure if this is what you’re saying).
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October 15, 2009, 4:37 pmloki13 says:
Again, here’s the problem I have with libertarians. Revisionist history so suddenly everything, magically, is the government’s fault. If Prof. Somin had written a post about GSE’s in general, and how they were a bad thing, I would COMPLETELY AGREE. The implict government backing was insane; it allowed the GSEs to become government sinecures, with outrageous amounts spent on lobbying and salaries (for the poltically connected) and created distortions in a housing market that didn’t need it.
But then we get this...“One of the main causes of the mortgage crisis that led to the broader financial crisis of 2008 was government subsidization of risky mortgages for people who were unlikely to be able to pay them back if real estate prices fell. Investors bought up dubious mortgages supported by Fannie Mae and Freddie Mac because they correctly perceived these ‘government-sponsored entities’ as having an ‘an implicit government guarantee.’”
Um, no. F&F were late to the game. F&F lost a lot of market share. This was a demand-driven problem. There were many problems going on, s way too many to list, but the mere existence of F&F as GSEs were near the bottom. In fact the health of F&F was well above that of other lenders and it wasn’t until the broader market collapsed and their *own costs went up* that they failed.
It’s not enough that you can make a good point (that these GSEs were a bad idea). Instead, you make an overly broad, wrong point to advance an ideological goal.
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October 15, 2009, 4:40 pmIlya Somin says:
However, the GSEs were still “the largest buyers of subprime and Alt-A mortgages between 2004 and 2007, with total GSE exposure eventually exceeding $1 trillion.” Even private lenders who didn’t sell their dubious loans to the GSEs issued them in the knowledge that such a sale was a backstop possibility if things went bad.
During those same explosive three years, private investment banks — not Fannie and Freddie — dominated the mortgage loans that were packaged and sold into the secondary mortgage market. In 2005 and 2006, the private sector securitized almost two thirds of all U.S. mortgages, supplanting Fannie and Freddie, according to a number of specialty publications that track this data.
This doesn’t differentiate between mortgages as a whole (most of which were sound) and the relatively small subset of of dubious mortgages that went bad. The GSEs tended to specialize in the latter.
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October 15, 2009, 4:42 pmwfjag says:
According to a story on NPR this morning (and I’ve heard this elsewhere, too), one of the ARM options that Fannie & Freddie began approving in 2005 were those which adjusted after 5 years. They will start adjusting rates next year. According to this and similar stories, with the high unemployment and underemployment rates, the default rate and default numbers on these mortgages will likely exceed the default rates and numbers last year on the subprime mortgages. The TARP and Stimulus money has been completely ineffective (or ineffectively used) to refinance these mortgages.
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October 15, 2009, 4:43 pmDuffy Pratt says:
Are there hordes of people who are underestimating the risks of FHA loans, and inventing investment instruments around those mortgages? If not, then it might just be that the government has decided that home ownership is worth subsidizing, knowing the risk up front. There might be something wrong with that, but it’s not the same thing as what caused the mortgage crisis.
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October 15, 2009, 4:45 pmIlya Somin says:
Are there hordes of people who are underestimating the risks of FHA loans, and inventing investment instruments around those mortgages? If not, then it might just be that the government has decided that home ownership is worth subsidizing, knowing the risk up front.
The problem is that the risk is to the taxpayers and the financial system, not the government decisionmakers who decided to back the loans. Moreover, it doesn’t require special “investment instruments” for investors to decide to overinvest in mortgages that carry an explicit government guarantee.
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October 15, 2009, 4:54 pmIlya Somin says:
Again, here’s the problem I have with libertarians. Revisionist history so suddenly everything, magically, is the government’s fault. If Prof. Somin had written a post about GSE’s in general, and how they were a bad thing, I would COMPLETELY AGREE. The implict government backing was insane; it allowed the GSEs to become government sinecures, with outrageous amounts spent on lobbying and salaries (for the poltically connected) and created distortions in a housing market that didn’t need it.
I did not claim that “everything” was the government’s fault. I merely claimed that it was a large part of the cause of the crisis, a point supported by the data in the linked Calomiris-Wallison article.
But then we get this…”One of the main causes of the mortgage crisis that led to the broader financial crisis of 2008 was government subsidization of risky mortgages for people who were unlikely to be able to pay them back if real estate prices fell. Investors bought up dubious mortgages supported by Fannie Mae and Freddie Mac because they correctly perceived these ‘government-sponsored entities’ as having an ‘an implicit government guarantee.’”
Um, no. F&F were late to the game. F&F lost a lot of market share. This was a demand-driven problem. There were many problems going on, s way too many to list, but the mere existence of F&F as GSEs were near the bottom.
As the linked article points out, F&F were major players who expanded their support of such mortgages — and their willingness to buy them up from private lenders at the very time (2004–2007) when the bubble got really big. Private lenders made mistakes of their own, of course, but the GSEs’ involvement was a big part of what made the crisis as large as it was.
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October 15, 2009, 4:57 pmPeteP says:
“This was a demand-driven problem.”
No, this problem is driven by the whole concept of an ‘entitlement society’, as envisioned by the left. They equate ‘the right to the pursuit of happiness’ with ‘a government guarantee of acheiving same’. And that at a young age, to their lights.
I’m reminded of an interview I saw on TV — brief synopsis : mexican lady, speaks barely understandable English, 2 young girls, no husband, living in a GORGEOUS 2,500 sq ft house, which she is about to lose to foreclosure. Nicer than any place I ever lived, all new, hardwoods and granite countertops everywhere, souble-width arches between rooms with high ceilings, etc. Nice digs !
They asked her what it cost : $ 800,000
They asked her what she did for a living, to support herself and two young girls : part time school bus driver. ( hint — the job doesn’t pay very much, to put it mildly ).
They asked why she thought she should be allowed to stay there, deeply in arrears on the mortgage and with a paltry income. Answer : ‘Now that I am in America, I’m entitled to it. This is an American house’.
This entire mode of thinking, by the socialist left and their supporters, is largely what put us in the situation we’re in today as a country. America is SUPPOSED to be a land of ‘endless opportunity’, not ‘endless government largess and guarantees’.
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October 15, 2009, 5:00 pmTim says:
I don’t think it’s accurate to say that the gov’t backing of these loans created the assumption that they would be there to back it up...
I think it’s more like, we own the government and we can take these secondary risks on the mortgages no matter what because if the risks don’t pan out, our influence over washington will save us. Your analysis is totally ignorant of the widespread corporate greed and what’s worse, you try to say that it was the government, and not wall street who is to blame for the risks that wall street took with other people’s money!
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October 15, 2009, 5:08 pmloki13 says:
Ilya,
I will, of course, trust a backwards-looking report from the AEI that makes the following conclusion: “they [Fannie and Freedie] played a major role in weakening or destorying the solvency and stability o other financial institutions and investors in the United States and around the world.”
Let’s see... how do they address the CDO market? Other than *never dealing with it”, they put in this:
“Without their commitment to purchase the AAA tranches of these securitizations, it is unlikely that these pools could have been formed and marketed around the world.”
Notice– no support for that statement. Notice– “unlikely”. If I had a dollar for every weasel word used in this report, I could take AIG off of the Government’s hands.
So, this is how you do it–
make a reasonable case: GSEs are bad
put in some really bad facts that are irrelevant to make them look worse: GSE accounting scandals in 2003-04
ignore all of the evidence about what really happened: timeline of other financial institutions, CDOs, CDSs, agency problems in the mortgage industry
toss in unsupported conclusions...
voila! libertarian souffle.
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October 15, 2009, 5:23 pmDuracomm says:
bchurch and loki13,
This is the problem I have with liberals, revisionist history so suddenly nothing, magically, is the government’s fault.
The housing disaster and the resulting economic meltdown would not have occurred without active government intervention in the market.
Government caused the problem, government made it worse, and government continues repeating the same actions that caused the problem in the first place.
Private lender countrywide and the favorable loans they provided to Dodd and Conrad are gone but idiot government housing policies continue unabated.
Obsessive Housing Disorder Nearly a century of Washington’s efforts to promote homeownership has produced one calamity after another. Time to stop.
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October 15, 2009, 5:26 pmsecond history says:
Owning a home was also a central tenent of Bush’s Ownership Society,” with programs like the “zero-down-payment initiative:”
We can see how well that worked out. This encouraged the development of the various exotic mortgage products which have come to haunt the American economy. As Prof. Somin pointed out, this has bi-partisan roots.
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October 15, 2009, 5:36 pmgeokstr says:
Absolutely. The entire society of America has been slowly but surely lefticized for the last 50 years. What was that quote attributed (rightly or wrongly) to Norman Thomas?
And we will have given them the rope.
The only thing Orwell got wrong was the year.
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October 15, 2009, 5:46 pmloki13 says:
Duracomm,
This is where we disagree. I’m not sure if, in your eyes, I’m a librul, liberal, leftist, communist, marxist, or run-of-the-mill socialist. I would consider myself to the center-right on most economic issues (which puts me, I guess, to the far left on Volokh....). You see, I believe that markets are good, and taxation should be (relatively) low. I also think that government can do good but, more importantly, it is a reality of our social existence (and has been since we were in caves and the guy with the biggest club became el jefe and appointed his buddy el jefe jr.). So I look for effective government that aids freedom, free markets, and basic services on a case-by-case basis.
The problem I have with TBIL (true believers in libertarianism) is the same one I have with Marxists– your beliefs are not falsifiable. Just as any true Marxist will counter the failures of Marxism with “it just wasn’t done *right* that time” so will TBIL counter any possible market problems with “but somewhere, somehow, there was a government (go figure).” You guys can never lose– it’s a great racket if you can get it. Not so good for the reasonable discussions, though.
So yes, I agree with you that the government has all sorts of distortions on the housing market, from GSEs to tax credits for mortgages, to the way our legal system is set up vis-a-vis owners and renters. But just saying the government is involved in something doesn’t make it per se bad. The free market is mainly to blame for the recent problems, and I think your energy would be better spent organizing to prevent a government overreaction than to recast history yet again.
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October 15, 2009, 5:47 pmloki13 says:
geokstr,
No Alinsky today? I am disappointed. I will get more lefticized after my aerobics.
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October 15, 2009, 5:48 pmJoseph Slater says:
lok13 is ruling it on this thread.
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October 15, 2009, 5:51 pmJoseph Slater says:
loki13, that is.
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October 15, 2009, 5:51 pmsashal says:
loki
and do not forget libertarians who are purely theoretical constructs. They do not exist in a universe that contains both matter and energy.
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October 15, 2009, 5:56 pmMCM says:
So when GWB renamed it the “ownership society”, that was ok then? Expanding home ownership rates was popular with the left and the right.
Although I guess the current trend in right-wing revisionism is to pretend that Hitler was a left-winger, so why not GWB, too?
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October 15, 2009, 5:58 pmMark Field says:
That’s a low bar considering the quality of the OP and the “defenses” offered of it. It’s a mystery to me why anyone would expect cogent and/or accurate analysis of economic issues on a law blog. I sure wouldn’t go to Barry Ritholtz for legal advice, even though he has a law degree (I believe). I assume the converse point is pretty obvious.
Not to take anything away from loki13, who’s an excellent commenter.
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October 15, 2009, 6:00 pmThomas Farrell says:
I agree, the mortgage crisis is only in the middle of what it is doing. When 40% of housing sales are foreclosures, you know that there are going to be a lot more home that people are going to want to sell. This will flood the markets with more homes and suppress prices for years. The next phase of all of this will be commercial loans which maybe more devastating than the housing crisis.
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October 15, 2009, 6:00 pmThe Volokh Conspiracy » Blog Archive » Repeating the Mistakes of … (Latest Update) | Kantaas.Com says:
[...] The Volokh Conspiracy » Blog Archive » Repeating the Mistakes of … [...]
PeteP says:
“So when GWB renamed it the “ownership society”, that was ok then?”
I never have, and do not, consider GWB to be a ‘conservative’, nor ‘on the right’, nor do I admire the man, nor do I defend him. IMO, on domestic and economic policy, he was a complete disaster.
obama is ten times worse, and he’s hosing foreign policy, too.
It’s kind of like 2 AM at the bar — would you rather go home with the plain girl, or the fugly one ? Myself, I choose ‘neither’.
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October 15, 2009, 6:42 pmXanthippas says:
Sort of like Wall Street is, but I guess that’s a topic for another post.
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October 15, 2009, 6:58 pmWm Tanksley says:
When you see the entire market making a new mistake at the same time, you know it’s not “the market”; it’s a regulatory problem.
–Wm
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October 15, 2009, 7:44 pmHarryEagar says:
If they ‘correctly perceived’ an implicit government guarantee, then what are all those foreclosure actions I see advertised in my daily newspaper?
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October 15, 2009, 7:45 pmloki13 says:
Wm Tanksley,
Really? What Dutch regulation on tulips caused that little fiasco? Was there excessive Crown regulation that caused the South Sea bubble? I hope you could point those out to me– really! I’m a big fan of the book learnin’.
The free market is basically to blame for the problem. I could get all detailed, but many of the issues are well-known if you care to edumacate yourself. These are well-understood issues, things like agency problems (not having a skin in the game for the people selling mortgages), self-dealing (allowing rating agencies to accept fees from the companies whose products they were rating), human ignorance (I don’t know how this works, but I’ll sell it!), human optimism (real estate never goes down!), complex math (no one ever told me at Harvard I’d have to learn risk analysis!), and, of course, greed. Kind of like many bubbles.
I mean, you could make a more measured comment like, “Well, the market tanked, but ya gotta love the bust with the boom! Can’t have yer pudding if ya don’t eat yer meat!” But I love the wild-eyed simplicity of immediately going to “if the economy tanks, it has to be the gummint, um regulations... because free markets *never go down*” You know... there were people not to long ago who thought that!
How’s that working?
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October 15, 2009, 7:52 pmSteve says:
Really? Who? Got a link?
I don’t know any free market economist who thinks that free markets can never go down. The very definition of “free market” means said market must be able to go down, otherwise it’s not very free, now, is it?
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October 15, 2009, 7:59 pmScotch says:
Ah, I see PeteP is using the time-honored “No true Scotsman” line.
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October 15, 2009, 7:59 pmSteve says:
They not = people taking out home loans.
They = people who bought Fannie Mae/Freddie Mac bonds.
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October 15, 2009, 8:05 pmloki13 says:
Steve,
I apologize if it wasn’t apparent from the rest of my post, but it was a joke. There were several problems with the housing models:
1. Individuals were purchasing houses on the assumption that the housing prices would always go up, so they could sell if they got into trouble with their mortgage. See also, flipping. Hard to criticize that too much because, after all, we’re all optimistic idiots. The economy counts on it.
2. People “selling” mortgages would tell individuals not to worry because, again, housing prices always go up.
3. Sophisticated investors doing commercial real estate took on onerous debt amounts on the assumption (again) that real estate prices always go up.
4. Models for CDOs used historical data that showed real estate prices that always went up.
5. The measure used for risk for the CDOs did not sufficiently account for the fact that the underlying assets (usually mortgages, but any constant income stream) were not sufficiently diversifed. IOW, if there was one foreclosure, it was more likely that there was multiple foreclosures (economy heading south) making the CDOs MUCH RISKIER than it was assumed. Again, not a problem if real estate always goes up.
But yes, part of freedom is the freedom to lose. And the market (overall and in real estate) will go down. People just forget that lesson in a bubble.
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October 15, 2009, 8:09 pmSteve says:
No True Scotsman
In what way was Bush a conservative? Certainly not fiscal.
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October 15, 2009, 8:17 pmbgates says:
MCM, the left is in favor of greater government control. The right is split. The German National Socialist Worker’s Party was solidly in favor of greater government control, as were the Fascists, as are the Communists.
Of course the Nazis aren’t identical to the American left, but there are more similarities between them and you than between them and us.
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October 15, 2009, 8:32 pmloki13 says:
Steve,
Here’s the problem with your scotsman analysis. As much fun as it is to have your cake and eat it to (is there an app for that), wordsbegin to lose meaning when we redefine words to mean whatever the heck we want.
For example: conservative = things I like
liberal = things I don’t like
socialist = center-left
fascist = communist
This seems to be especially in vogue around here. While it could be argued that not all of Bush’s policies were “conservative”, what would you have us call him? Do we simply wait– since he seems less-than-successful now, he’s not a conservative, but if he’s ever vindicated (not that I’m holding my breath), he’s conservative again? You have to take some bad with the good, unless the label of conservative simply means “people who agree with everything I agree with, which means me.” And one... is the loneliest number....
To give you an example, I left the GOP shortly after they (IMO) went batshit crazy during the 90s. I’ve been firmly opposed to the National GOP since (although I will support them, in *some* cases, as individuals running for state office). That said, I can look to some national Democrats that I think are also batshit crazy in some areas– Chuck Schumer for example. He has some positions that are *conservative* (hard to believe, huh?- the business lobbying does pay off!) but I wouldn’t say he isn’t a liberal. Why? Because to call him a conservative would divest the word of its meaning.
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October 15, 2009, 8:36 pmSteve says:
Loki, you’ve forgotten a few important facts.
6. Cheap money made possible by low Fed rates throughout most of the decade fueled speculation. Cheap money fuels speculation; it fueled the housing bubble, (to a lesser extent) the commodity bubble, the dotcom bubble, etc. The idea people have is that they can borrow money cheaply, invest it for a decent return, and make (risk free!) money on the difference. This behavior goes up dramatically when interest rates are low.
7. In addition, most homebuyers effectively buy the mortgage, not the price of the house. In other words, whatever $1000/mo will get them. When rates are low, that can buy you more house. It also fuels increase in housing prices. Eventually those rates will go back up, and even without a bubble, housing prices will fall. I doubt that was factored into the models, either.
7. The government was also telling people that housing prices wouldn’t go down — or at the very least, a safe ‘investment.’ Sample cite: Washington Governor Christine Gregoire telling people to buy homes in 2008.. Heck, much of what HUD and FHA did was encourage/subsidize homebuying.
8. Supposedly it is the job of the Fed to “take the punch bowl away just as the party is getting started.” That didn’t happen, and much of it was political pressure to keep the party rolling.
As an aside, if the housing bubble was solely due to the sin of free markets, why was there a real estate bubble in places such as Spain, Ireland, the UK, and China?
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October 15, 2009, 8:40 pmLN says:
It’s amazing how a liberal like Bush could get elected twice even though the conservatives hated him and all the liberals had Bush Derangement Syndrome. Truly remarkable.
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October 15, 2009, 8:40 pmDuracomm says:
loki13 says,
I appreciate your civil discussion of this issue but the quote above makes me think that you have not thought about the root cause of the problem. Apologies if my sarcasm meter needs calibrated.
Ilya posts a link to an article describing how the government agency FHA is continuing many of the bad policies of the government-sponsored enterprises fannie and freddie.
I supply a link to an article describing decades how decades worth of government actions have distorted the housing market and some of the resulting problems.
Yet you still think the market is basically to blame for it.
Xanthippas is right, wall street and businesses and consumers respond to incentives.
The problem is the federal government has provided many incentives for stupid behavior by private actors in the housing market.
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October 15, 2009, 8:43 pmWm Tanksley says:
I think we could both use a good dose of clarity. I spoke hazily when I said that there were regulatory problems; and what I meant was NOT that there was too little regulation (I understand why you thought that was what I meant, because that’s allegedly the position of the “libertarians” that this thread was railing against). Rather, I meant that the regulation encouraged the wrong thing on a systemic scale. Most of those libertarians actually claim the same thing; they go further than I, to say that it’s harder to design good regulations than it is for the free market to recover from economic disaster. (Again, that’s not my belief.)
By the way, the systemic nature of this problem was a sure sign that it was regulatory in nature. Sure enough, banks are allowed to count securities against their deposit requirements, and banks are allowed to count mortgage-backed securities — but they’re only allowed to count their own loans at a fraction of that value. Bingo — full incentive to convert one’s own loans to securities and sell them to other banks.
“Allowing”? You mean this was a regulatory problem?
It’s question-begging to blame “the market” for a disaster. It’s more so to blame “greed” and “ignorance” (and “complex math”). All of those things are present in any economy, and yet this disaster happened HERE, not constantly.
If the problem is simply the presence of greed, we’re all hosed.
Now, if the problem truly was “the market”, there’s only one solution — abolish the market entirely. Convert to full price-setting immediately. Let’s see if that helps.
If the problem is merely the “free” in “free market”, I’m not sure what to do — my first guess would be to design better regulations, but obviously that’s not something you accept, since you disagreed with me.
That is indeed wild-eyed simplicity, but you’re the one indulging in it. Your opponents do not make that argument.
–Wm
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October 15, 2009, 8:43 pmloki13 says:
Wow Steve,
1. Cheap money from the Fed was a broad-based problem. A broad based-problem seeking a solution. Luckily, the market cranked up CDOs (and CDSs) as a solution. Didn’t work so well. But again, it’s an issue of demand; there was demand for more assets to back the CDOs with, which is what pushed more motgages down.
2. Really, a politican saying a stupid thing? Do you have a Schumer quote too? Please..... I am shocked... shocked and appalled that a politician would be saying dumb things to try to keep people from panicking and having the housing market collapse while they’re in office. Is there no Santa Claus?
3. Alan Greenspan avowedly pursued a policy of NOT BURSTING THE BUBBLE. He has since said that was his greatest regret. That, and five dollars, will get him a cuppa joe at starbucks.
4. Yes, there was a housing bubble in so many other countries as you noticed. Countries that were clearly listening to the Guvnor of Washington. Countries that were financed by Freddie and Fannie. Countries that had to follow the CRA. Um... wait.... what? I do appreciate the point, but I’m not sure it means what you think. :)
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October 15, 2009, 8:50 pmmattski says:
Umm, he tried to privatize SS? He pushed tax cuts benefiting primarily the wealthy? He hired OLC lawyers to promote the “unitary executive” theory? He chose to run with Dick Cheney?
I guess you could add that he was chosen by the GOP establishment to represent them.
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October 15, 2009, 8:51 pmDuracomm says:
MCM,
Bush was many things but he certainly was not fiscally conservative.
Bush Turns More Into Less
The president’s tax-driven deficit reduction is worse than nothing
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October 15, 2009, 8:53 pmLN says:
As an aside, if the housing bubble was solely due to the sin of free markets, why was there a real estate bubble in places such as Spain, Ireland, the UK, and China?
I consider the global reach of the real estate bubble to be evidence that market mechanisms did play a role.
This government=bad/market=good (or vice versa) dichotomy seems off-track to me. At any rate, as any good market evangelist knows, markets are supposed to have corrective powers. When something is overpriced, market actors quickly come in and sell. When something is underpriced, market actors quickly come in and buy. All the emphasis on sins of the GSEs ignores the fact that the market did not foresee the bubble popping until it did.
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October 15, 2009, 8:55 pmloki13 says:
Wm Tanksley,
In my haste to be snarky (one of my few remaining pleasures) I believe I misunderstood you. If I may be so bold, I think we agree on the following:
1. Free markets have natural cycles.
2. However, this was a particularly bad and unnecessary “bad” cycle.
3. Better regulations or policies would have been able to mitigate the worst effects of it.
I think that is correct. We might disagree on what those regulations or policies are, but I am all for finding agreement.
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October 15, 2009, 8:56 pmmattski says:
Mind blowing.
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October 15, 2009, 8:59 pmAllan Walstad says:
The governmental pressure on financial institutions to make dubious loans, and the availability of Fannie and Freddy to buy them, was no doubt part of the problem. But nobody else here (up to a few minutes ago when I started writing) has mentioned the Fed’s pushing down of interest rates. Monetary inflation is a source (perhaps THE main source) of financial bubbles. Here we’ve got all this easy money, which makes things look affordable that aren’t. When interest rates go back up, reality reasserts itself.
This looks to me like a classic example of Austrian business cycle theory, in which inflationary monetary policy stimulates capital investments that cannot be maintained and have to be liquidated. Hence, boom and bust. For families (as well as some speculators), houses are capital investments. Low interest rates stimulate buying, which drives up prices, which makes bad investments look good for awhile, but the actual underlying wealth to keep that going isn’t there. Depending on the details of your loan, you can’t pay it off. So then what?
If the market is allowed to work, lenders have a big disincentive simply to foreclose on everything in sight, because then they are left with a huge stock of houses that can’t be sold. Common sense suggests limiting losses by renegotiating some loans down to terms that the occupants can meet, while foreclosing on others where the over-extension is too great. This is how unsound capital investments are liquidated in an orderly way. The worst thing the government can do is exactly what the pols have done and appear still to be doing, namely, to try to prevent the sorting-out process. Ultimately, taxpayers are soaked, moral hazard is promoted, and multiple repeats of the bubble are likely.
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October 15, 2009, 9:00 pmSteve says:
I’d argue that the reverse is happening here. One can’t argue Bush is a conservative solely because one dislikes conservatives, either.
I don’t think being successful per se should have anything to do with it. Even if his policies in the long run turn out to have been wise (of which I am equally doubtful), that doesn’t make him a conservative.
The scientist in me says to use a grading system, using various litmus tests of what conservatives have traditionally stood for. On many of these issues — fiscally prudent, small-government — Bush would earn an F. “No True Scotsman” would hold if we decided to add Bush-specific tests to the list (“Didn’t get involved in a land war in Asia”.)
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October 15, 2009, 9:03 pmAllan Walstad says:
Sorry, Steve–I acknowledge your priority.
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October 15, 2009, 9:06 pmLN says:
Once again, can someone explain Bush’s political success? I know it’s hard to believe, but the guy was governor of Texas and then spent 8 years as President. As any Volokh reader knows, all liberals had Bush Derangement Syndrome and simply reflexively opposed everything that he did and blamed him for everything. So what happened? What were America’s five true conservatives doing over the last decade?
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October 15, 2009, 9:12 pmSteve says:
Part of the problem, IMHO, was that it was difficult for those of us who foresaw the bubble to wager on that. We had a system where people could bet on prices going up, but not prices going down.
Of course, one could sell your house if you had one and wait to buy at lower prices, or sell/short bank stocks or REITs, but nothing quite like being able to short a stock if you think it is going to drop in price.
In fact, the government actively dislikes people who short stocks — note the uptick rule. I’d say that they are taking sides in the market — the side of those who want prices to go up. They shouldn’t take any side.
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October 15, 2009, 9:13 pmAllan Walstad says:
It looks improbable in retrospect because what Bush ran on in 2000 wasn’t what he did as president, at least not in the essential respects. He promoted limited government and a “humble” foreign policy, but what he delivered was massive spending, more federal meddling in the market and education, and war, war, war. The country is not left-liberal, recent successes of Obama and the Democrats notwithstanding. Gore was clearly left-liberal, so he came up short in 2000. Kerry was left-liberal and highly unlikable, so he lost in 2004. Bush ultimately squandered all his advantages, to the detriment of his party, who played their own part in their undoing by sticking with him on those goddammed wars.
That’s my explanation, anyway.
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October 15, 2009, 9:32 pmmattski says:
He came up short by getting more votes than Bush, and that despite being pummeled by the so-called liberal media. See Bob Somerby for details...
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October 15, 2009, 9:58 pmRicardo says:
Investors bought up dubious mortgages supported by Fannie Mae and Freddie Mac because they correctly perceived these “government-sponsored entities” as having an “an implicit government guarantee.” See this account by economists Charles Calomiris and Peter Wallison.
The Calomiris and Wallison article is overall a good overview of the collapse of Fannie and Freddie. But this statement seems to be based on one statement in the article and is not supported by the facts. Here’s the quote from the article:
This quote is entirely accurate. But then they go on to say it is unlikely (in their opinion) that investment banks would have marketed subprime private label securities without Fannie and Freddie’s purchases. This is wrong. By the authors’ own numbers Fannie and Freddie bought $200 billion worth of subprime and Alt-A private label securities between 2005–7*. According to numbers quoted by Gary Gorton (who in turn quotes Inside Mortgage Finance) $990 billion dollars worth of subprime MBSs were issued just in 2005 and 2006. I don’t have the 2007 number but that means the GSEs held less than 20% of the market. That’s nowhere near an implicit guarantee. Fannie and Freddie were so highly leveraged how would they intervene in the market to support the price of these securities even if they wanted to?
* $134 billion for Freddie Mac plus $29.5 billion in Alt-A and $36.3 billion in subprime for Fannie Mae
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October 15, 2009, 10:23 pmscattergood says:
Um, even a cursory review of the South Sea bubble would have most people understanding that it was clearly and explicitly a government involved action.
Most people understand monoplies and holding of national debt as deeply involving the government and are the actions of a independent and free market.
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October 15, 2009, 10:42 pmRicardo says:
Michael Lewis’s excellent article on the rise and fall of AIG Financial Products is an excellent account of the credit default swap business and how misjudgments and mistakes in this business contributed hugely to the financial crisis.
Nobody who claims the GSEs created an “implicit guarantee” on subprime-related securities can explain the following: why would there be a demand from Wall Street for credit default swaps sold by AIG if the government was already implicitly guaranteeing subprime debt? It simply makes no sense. When Hank Greenberg resigned from AIG in March 2005, AIG was downgraded from AAA to AA. Yet it continued selling CDSs throughout 2005. If the government is already backstopping the market for subprime-related securities, why in the world would you pay good money for the guarantee of an AA-rated company? I know we are talking about Wall Street, but nobody is that stupid.
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October 15, 2009, 10:53 pmRicardo says:
Additionally, the Dallas Fed article Prof. Somin quotes above does not support the position that the GSEs were chiefly responsible for relaxing credit standards and the subsequent credit crunch:
It was those nonagency RMBSs and derivatives such as CDOs, CDO-squareds, synthetic CDOs, etc. which, of course, were chiefly responsible for the financial crisis. Indeed, if there was an implicit guarantee of these nonagency securities by the GSEs, why would they be viewed as having more liquidity and default risk?
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October 16, 2009, 12:02 amWm Tanksley says:
In general, yes. Let’s add that all economies have cycles. They’re an intrinsic result of unpredicted change, together with the inconvertibility of capital.
With that said, we DO truly disagree on what role regulations play. I believe that some of the major problems involved in the housing market during this crisis trace directly back to regulatory errors; I explained one, the increase in ownership of loans by the people who didn’t originate them (which you explain by saying that the lenders involved were stupid, and I explain by saying that two regulations together offered a larger income source in return for that action).
I also believe that this isn’t primarily a housing crisis; as you implied, it’s an economic cycle crisis. I therefore believe that the housing problems near the beginning of it were only a “house of cards” that happened to be in the way; a separable problem.
Finally, although I’m not a libertarian, I believe that their account is defensible: although better regulations, in hindsight, would have prevented (at least some of) the housing crisis, the political “market” in which regulations are made is no more perfect than the economic market, and is MUCH less self-correcting. I don’t believe there’s a such thing as a market without regulations, though, so I don’t support their overall politics.
Oh, by the way, I agree entirely with you that the CRA is an overblown boogieman. It has nothing to do with the systemic market distortions that I’m talking about; it’s merely a few dollars “wasted” here and there, no worse than any other known inefficiency.
–Wm
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October 16, 2009, 12:26 amNickM says:
IMO the CRA bears some blame in the following way:
Banks were pressured under the CRA to make riskier loans than they had traditionally made. [Empirical proof of this is shown by the fact that banks’ CRA loans had a higher default rate than the rest of the banks’ loan portfolios.] Those loans generally had been made (at somewhat higher interest rates) by non-bank lenders. Easing of bank lending standards eliminated a significant portion of non-bank lender business. These lenders made up for the loss of business and loss of profits by easing their own standards — and with the low interest rates pushed by the Fed, there looked to be a lot of profit in doing so.
Unfortunately, that new class of risky loans crossed into the range where ability to pay just wasn’t there for many borrowers.
By itself, that would have been just tough luck for the lenders. Couple it with the ability to resell those loans as AAA securities and add the government in as a major market-maker buying up those securities (20%+ bought by an entity with essentially unlimited resources drastically shifts the demand curve), and you have a significant component of the perfect storm.
IMO the CRA is not a good thing, but has been way overblown as a villain in the housing bubble.
On the topic of repeating the mistakes, it’s now effectively government policy that more bad loans should be made (when the chair of the House committee that serves as a chokepoint for any legislation on the topic says bad loans aren’t a bad thing, forget getting the problem fixed). This is insane.
If you really wanted to stabilize prices IMO, the best reform would be to alter banking regulations to allow banks to hold foreclosed homes and lease them out long-term.
Nick
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October 16, 2009, 1:25 amJanon2 says:
Ricardo has this exactly right. The Calomiris/Wallison article is pretty good until the one off-the-wall paragraph that Prof. Somin picked up on.
I didn’t hear the “government made us make bad loans” meme until the summer of 2008 when the House Republican Conference picked up on an almost comically bad article, I believe in the Manhattan Institute’s magazine. The article somehow blamed the explosion in practices like low-doc and no-doc lending and the Option ARM on Clinton’s slight strengthening of the CRA and a few other steps he took, ignoring the fact that Clinton’s CRA rules went into effect in 1996. The toxic practices didn’t really get going until late 2004–2005 and most of the loan volume was late 2005 through early 2007.
I do give Prof. Somin credit for alluding to the one government action that possibly contributed to the crisis, although it was far from the main cause. This is what many Fannie and Freddie sympathizers now blame for their failure–the significant expansion in the GSE’s affordable housing requirements that the Bush Administration’s HUD imposed as of Jan. 1, 2005. Many in the mortgage industry who aren’t associated with the GSEs are skeptical about the claim that affordable housing was a major factor–it seemed at the time that they were chasing higher yield and that the ability to meet their affordable housing goals with some of the investments was icing on the cake. The GSEs’ competitors actually supported an expansion of the requirements because they wanted to improve the secondary market for CRA loans, which are not “bad” loans but are not particularly profitable because of the high overhead associated with underwriting them. But the GSEs bought exotic securities–some of which did give them affordable-housing credit–instead, because of the higher yield. As Ricardo notes, the GSE’s investments were not in the mortgage pools themselves (they were generally not allowed to buy subprime mortgages directly) but in various securities synthesized from them.
This is not really a libertarian problem, it’s a law professor problem. Liberal law professors seem to be just as willing as Prof. Somin is to pick up on dubious, unsupported claims contained in studies in areas outside of their expertise, if the study supports the professor’s preconceived notions.
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October 16, 2009, 1:26 amSteve says:
I didn’t hear “big business made us take out mortgages we couldn’t afford” until housing prices started dropping.
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October 16, 2009, 2:04 amRicardo says:
Strawman. No one here who is contending with Somin’s claim that Fannie and Freddie were a “main cause” of the financial crisis has said the cause was instead “big business [making consumers] take out mortgages [they] couldn’t afford.”
I would say the main causes were an almost wholesale abandonment of risk management on the part of ratings agencies, investment banks, lenders, institutional investors and AIG as well as low long-term rates and a declining risk premium made possible mostly by the savings glut in Asia and huge capital inflows by sovereign wealth funds and central banks into the U.S.
The entire market for MBSs and their derivatives was based on the simple proposition that local housing markets are uncorrelated and we will never have a nationwide decline in housing prices. Nothing about anyone making anyone else do anything. Lenders made loans because they were profitable in the short-run. Borrowers took out loans because they were profitable in the short-run. In the long-run, everyone (except for those clever enough to short real estate and financials) got screwed because nobody wanted to think about housing prices declining in the long-run.
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October 16, 2009, 2:30 amTo Hayek With You says:
If you don’t think the government was the primary cause of the meltdown I suggest you go to a casino and personally guarantee that you will pay for everyone’s losses while allowing them to keep their winnings. To the extent that the people there believe you have the will and the resources to back up your words you will get behavior exactly like that which we just witnessed in the mortgage industry.
Will the catastrophe that ensues be the fault of the people who take you at your word or will it be yours? Would rational people bet more or less? Would riskier bets be more or less attractive? Would more people be attracted to the casino? If a person lost everything and couldn’t wait to be reimbursed for his losses why would he not sell his debts at 90 cents on the dollar to someone who could wait... effectively pumping even more money into the casino? Why wouldn’t everyone try to securitize their gambling to provide even more money with which to make bigger bets? Your guarantee has effectively made debt an asset — right up until the point where you run out of money.
When it comes to setting standards for the loans it guarantees, the government has only three options — tighter, looser or the same as what the market sets. If tighter or the same then there is no effect at all... and no justification for the government to act at all. If looser then we get what we just saw in direct proportion to how loose the standards are set. There is thus by definition no way in which government intervention can do anything but make things worse. If one lender makes bad decisions that is a self-correcting problem and they will pay. If the government makes bad decisions then we ALL pay and there is no limit to the amount. And the only decision the government can make that will have any effect at all is a bad one.
All of this was at one time common sense.
I am in the advertising business and I can tell you that the lenders are out there doing it all over again. The only loans that are advertised are FHA loans and the rates are ridiculous. 90% of our business used to be car advertising before the bailouts. Now payday loan companies and FHA lenders make up 90% of the mix. Indeed that was the stated purpose of the stimulus... to get people lending again and pump the bubble back up... or in other words to throw good money after bad. Who needs real prosperity when we can have the artificial kind? NOTHING, has been done to fix the problem... the government is still guaranteeing loans and the architects of that disaster are now plotting to do the same thing for health care.
This country has never had a worse ruling class and economic illiteracy is at a level usually only reserved for those with graduate degrees in economics from Ivy League institutions.
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October 16, 2009, 6:15 amFriday Highlights | Pseudo-Polymath says:
[...] mortgage crises was so much fun … let’s line up another. And not unrelated … more bailout problems noted. Here [...]
Stones Cry Out - If they keep silent… » Things Heard: e89v5 says:
[...] mortgage crises was so much fun … let’s line up another. And not unrelated … more bailout problems noted. Here [...]
geokstr says:
And no one is looking back at what happened in the decade or so before Fannie/Freddie became major players in the subprime market either. The feds were actually making “big business” go out and find poor credit risks and offer them mortgages they couldn’t afford.
That was when federal regulators, egged on by ACORN (who in one lawsuit was represented by none other than the Community Organizer in Chief himself) and other leftist groups, were forcing lenders to give tons of mortgages to people who could not meet the lenders’ normal credit standards. This helped push up the demand for homes and artificially kept real estate prices rising. Once it looked like these trends were sustainable and that the feds were backing this type of activity through Fannie/Freddie, it was Katie bar the door to all sorts of poor business decisions by lenders.
As To Hayek says above, if the feds are guaranteeing your losses but letting you keep the winnings, who gives a rat’s behind about sound business practices. But it was more than just guaranteeing the losses, the feds were also forcing the casinos to let anybody play, including the near-homeless and the destitute.
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October 16, 2009, 9:03 amJanon2 says:
You’re absolutely right. This is the left-wing meme, and it’s just as wrong as the right-wing meme. There were undoubtedly some people who were victimized, but there were also plenty of “consumers” who rolled the dice and came up short.
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October 16, 2009, 9:55 amRyan Waxx says:
\
But... But... surely, if we had more regulation, the same people who were praising the performance and blocking investigations into FM/FM would magically have reversed course. So CLEARLY it’s a free market failure!
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October 16, 2009, 10:05 ampassingthru says:
Where are people getting these 3.5% FHA loans now?
I purchased a condo a year ago September with an FHA loan. I had to come up with 5% down payment. I got a great mortgage rate, and a good price on the condo (though it would have been better if I’d waited another six months). As a result of the FHA loan, I had to document every single penny of income and outgo for the months leading up to the closing, as well as, of course, be qualified for the loan.
Since then, since mortgage rates have dropped, I spoke with my loan officer about refinancing. He told me that FHA loans have gotten harder to get, and I’d have to come up with a bigger down payment on the refi. This is not some guy at a tiny bank. He’s got a wall covered with awards for bringing in millions of dollars in mortgages to his company. And he’s not one of the mortgage lenders I avoided like the plague—the ones who told me I could buy a house with no money down at all, and it didn’t matter if I had a high debt load.
I went through a pretty rigorous screening for an FHA loan. I’m at a loss as to how people are getting these loans without one.
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October 16, 2009, 10:06 amWm Tanksley says:
I mentioned before that this view (from my own side) is utterly wrong-headed, so I had to respond to it as soon as I saw it. (Unfortunately, I can’t find it in the comments; perhaps the author deleted it.)
It’s true that the CRA was stupid and part of a regular, long-standing policy of economic illiteracy. But it’s utterly ridiculous to blame it for an economic consequence that didn’t appear until years after the law was de-emphasized, and a consequence that is FAR out of scale with the alleged cause. The “tons” of mortgages that were given under the CRA are a tiny, tiny fraction of the size of the problem, and in theory should have actually become a problem long before this crisis (they should have been foreclosed on during the 2000–2002 recession). Furthermore, blaming the CRA results in absolutely no model for what caused the crisis; it leaves enormous amounts of bad decisions absolutely unexplained.
The problem isn’t people being forced to do unwise things; the problem is people being incentivised to do unwise things to the extent that an institution not participating in the unwisdom couldn’t compete. Banks that bought and sold securitized home loans could in turn make more loans than banks that didn’t securitize, because that’s what the regulations said. It was still wise to NOT do that (and apparently there were local banks which didn’t); but anyone not participating would become a bit player, small in comparison with anyone who DID participate.
–Wm
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October 16, 2009, 10:18 amAllan Walstad says:
Ricardo:
AIG was bailed out, wasn’t it?
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October 16, 2009, 10:19 amNickM says:
passingthru — the New York Times last Friday had an article about people getting FHA loans with 3.5% down. Yes, it’s anecdotes, but it also had revealing quotes by policymakers, including Barney Frank’s defense of making bad loans.
Nick
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October 16, 2009, 11:44 amLN says:
As I said above, market evangelists normally make a big deal about the corrective power of markets. Propose a bad policy like rent control, and the market defender points out that artifically depressing rents will lead to a decline in the supply/quality of rentals. Propose a minimum wage, and the market defender points out that artifically increasing wages will lead to a decline in business’s appetite for cheap labor. The market has its own logic; you can’t mess with supply and demand and market prices without suffering from adverse effects.
The market defenders here are sticking with the “adverse effects” conclusion, but the precise economic logic has vanished. If I were to propose a government intervention that said that banks had to sell a certain number of bad investments in order to stay in business, what would the reaction here normally be? We would assume that the banks would sell as little as these investments as possible, and that financial innovation would occur to allow banks to sneak around these economically harmful requirements. We would not normally expect that these investments to be incredibly popular and profitable (at least in the short run), and we would not expect banks to sell more of these investments than they had to.
What’s missing from the story? Investor savviness. To think that the CRA could by itself damage the entire world’s economy requires a belief that investors will buy whatever crap is put in front of them. If that is true, then government regulations are irrelevant; the real problem is that investors are short-sighted idiots who are prone to create bubbles and busts. The government is clearly not necessary to produce a bubble if investors are that dumb.
Now it is true that some commenters have a response to this. They claim that the investors were behaving rationally, because the government promised to cover any losses. This story would make more sense if the costs of the financial crisis had been borne primarily by taxpayers, and if investors had emerged from the housing bubble collapse scot-free. This story completely fails to explain how AIG shares went from $70 to $1 in a few months, for example, or what happened to Bear Stearns. If investors irrationally assumed that their investments were risk-free — when in reality they were extremely risky — then that’s their fault for misperceiving risk. It doesn’t become the government’s fault just because the investor’s sad excuse mentions the word “government.”
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October 16, 2009, 11:53 amDotar Sojat says:
Unlike the other people here, I actually make a daily living in mortgage lending, albeit commercial lending. I just returned from an annual meeting of mortgage loan correspondents for a major life company’s real estate loan department. The subject of the FHA mortgage loan push came up, and it was unanimously judged to be a horribly stupid idea, and absolutely doomed to go into the Fan/Fred tank.
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October 16, 2009, 12:53 pmscattergood says:
This is actually very easy to explain. The purchasers and sellers of CDS don’t have to be participants in the credit instrument itself. They can be purely speculating and not using it as a hedge for an existing position they have.
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October 16, 2009, 1:27 pmLN says:
So in other words blaming AIG’s collapse on government action is based on...
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October 16, 2009, 2:05 pmWm Tanksley says:
AIG is responsible for their own mismanagement, of course. The government didn’t owe them a bailout (and didn’t claim to — they claimed to be doing it to protect all of us). But AIG collapsed specifically because it chose to profit from a horrific regulatory imbalance which told banks that securitized loans bought from someone else were worth more than the loans they originated themselves.
The fact is that if AIG hadn’t done this, another insurance company would have. And the fact is that if the regulation didn’t artificially allow banks to hold comparatively fewer securities than loans, AIG would have done very little business in that market.
–Wm
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October 16, 2009, 2:22 pmObama administration promotes junky, risky mortgages at taxpayer expense, ignoring history’s lessons | OpenMarket.org says:
[...] Mason University Professor Ilya Somin explains how the Obama administration is expanding the awful policies that caused the mortgage crisis, like having taxpayers effectively underwrite risky-mortgage loans [...]
LN says:
But AIG collapsed specifically because it chose to profit...
Stop right there. We live in a very complicated world. The case for free markets is that they produce socially desirable outcomes even though each market actor is self-interested. AIG’s job was to generate as much profit as possible without taking on too much risk. Whether the risks they face are generated by climate patterns or the government doesn’t matter. There’s nothing magical about the government that compels insurance companies to understate risk. If an insurance company collects $100 in premiums and then winds up with $1 billion of earthquake losses, does it make sense to say “Well if they didn’t write those policies another insurance company would have”? No. Market fail.
Similarly, consider how illogical this is: if the regulation didn’t artificially allow banks to hold comparatively fewer securities than loans, AIG would have done very little business in that market. Regulations are about bare minimums; it is absolutely ridiculous to blame them for excess. If the government bans clove cigarettes but allows you to chew tobacco, and then you spend your whole life chewing tobacco until you die of mouth cancer, how on earth is the government to blame?
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October 16, 2009, 3:30 pmLN says:
One more thing: these government interventions are all public information. As everyone here seems to know, it’s perfectly obvious that when the government creates a housing bubble, a financial crisis is inevitable. One would think that this self-evident knowledge would actually allow market players to steer clear of a financial crisis. But apparently market players (like AIG executives) are all liberal ideologues who cared too deeply about minority homeownership to watch their own pockets.
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October 16, 2009, 3:57 pmWm Tanksley says:
That’s a poor way to interact with an argument: soundbiting it and then ignoring the entire thing. I see the point you’re trying to make, and it’s a worthy argument, but please don’t pretend you’re responding to my argument when doing so.
We live in a complicated world; the case for free markets includes a good deal more than that bullet point. In particular, it includes some concept of the tradeoffs that are involved. When you attempt to reject a free market, you don’t get an economic system in which people aren’t self-interested; rather, you get a non-free market.
A business failure is not the same thing as a market failure. AIG’s failure to judge risk doesn’t mean the free market doesn’t work — particularly when the systemic failure at hand is specifically traceable not to AIG’s bad decisions, but to ill-conceived government intervention in the banking and real estate loan markets.
The problem wasn’t localized in AIG, although AIG did make errors. The problem was spread across the entire lending market. Many, many banks made loans, securitized them, and sold them. People bought them without having any control of the internal cashflows. Smart people realized that was a problem, and thought they could fix it by aggregating the loans so that no one failure would do too much cashflow damage. And so on; you know the background. The grassroots driver was the perverse incentive to sell a mortgage you know about and buy an MBS you don’t know about, because when you did so the regulations allowed you to make more loans than you could otherwise.
Let’s suppose, counterfactually, that AIG and all other insurance companies were wise enough to not get into this; let’s suppose they were only trivially involved, enough to cover their own losses. Okay. Would the crisis be gone? No — there would still be a widespread, grassroots banking failure.
I don’t think you understand my point at all. The reason this regulation was disastrous was that it included a positive feedback multiplier on the very system it’s supposed to regulate. Fractional reserve banking is a fragile system at all times; that’s why the US government insures it. The regulation didn’t specify a minimum; it allowed a higher multiplier. Furthermore, it provided a feedback loop.
There are several different issues you’re conflating.
First, this crisis was indeed precipitated by the popping of a bubble. Time will lend us perspective, but considering that all the previous major economic crises were caused by improper monetary policy, this one probably will be found to be as well. Right now, this is still disputable.
Second, bubbles are hard to detect and — so far — impossible to predict. You can’t simply shut down your business when you know there’s a bubble; you’d miss all the best times to do business while waiting for the bubble to pop.
Third, what we’re discussing now isn’t how the government caused the bubble (it’s probable that it did so only VERY indirectly, though the policy that they required the Federal Reserve to implement, and it’s certain that I can’t blame them for it, because nobody has an adequate grasp of economics to prevent bubbles); rather, we’re discussing how the government regulation destabilized an industry that it was specifically supposed to stabilize.
–Wm
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October 16, 2009, 4:47 pmLN says:
Smart people realized that was a problem, and thought they could fix it by aggregating the loans so that no one failure would do too much cashflow damage. And so on; you know the background. The grassroots driver was the perverse incentive to sell a mortgage you know about and buy an MBS you don’t know about, because when you did so the regulations allowed you to make more loans than you could otherwise.
Mortgage securization was not supposed to turn crap into gold; it was supposed to carve up risks so that investors could pick up exactly as much risk as they wanted. If the entire pool is going to lose money, then best you can do by carving up the risks is to pass the losses on to a stupid sucker. If you then think it’s worthwhile to buy crap that you don’t know in order to sell stuff that you do, then you’re the stupid sucker.
Gotta run, more later...
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October 16, 2009, 4:59 pmreadery says:
Welfare programs result in the government spending rather than making money?
Who would have guessed?
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October 16, 2009, 5:23 pmLN says:
Wm — reading over your past comments, it looks like I agree with you much more than I do many other commenters on this thread.
This is my point. Whenever we say that the government affected the incentives of market actors, we should step back and think about what the market actors’ response to particular incentives reveals about them. In general, the responses reveal that Econ 101 is pretty off the mark.
So for example, you say that banks were incentivized to make bad investments so that they could do more sales. In other words, banks had to make a calculation: should they make bad long-term investments for short-term profit? And for the most part they said yes, that is a good idea, even as it was apparent that underwriting standards were flying out the window. In other words, the banks were short-sighted and stupid. And if banks are short-sighted and stupid when faced with incentives partly created by government actions, they will be short-sighted and stupid in other situations when faced with the prospect of immediate gain and long-term loss.
I guess I don’t understand how the government caused them to miscalculate. I’m not saying that the government regulated the financial industry correctly, just that it seems weird to think that all the critical drivers were in the gummint (and I know that you personally are not arguing that).
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October 16, 2009, 5:53 pmLN says:
I should add:
they will be short-sighted and stupid in other situations when faced with the prospect of immediate gain and long-term loss
... especially when they think that they can just pass risk on to ignorant suckers.
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October 16, 2009, 5:56 pmRicardo says:
This is true but if you read the Michael Lewis article or any other material on AIG, it is clear that AIG’s major counterparties were investment banks that were going long on CDOs. Moreover, AIG’s credit derivatives business played a significant role in the growth of the CDO market in the first place. Sure there were speculators making side bets with CDSs but they were not the main reason AIG was in this business.
I ask again, since nobody has a good answer yet: why would these investment banks hedge the subprime credit risk in their portfolios by buying swaps from AIG if the government was already implicitly guaranteeing credit risk?
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October 16, 2009, 10:15 pmRicardo says:
Merrill Lynch, Goldman Sachs, Lehman Brothers and Bear Stearns did not originate loans. That was not their business — they were investment banks, not commercial banks. They were also AIG’s main customers.
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October 16, 2009, 10:21 pmWm Tanksley says:
Are you saying that you do not expect regulations to affect people’s behaviors?
You’ll have to explain what you mean by “Econ 101″ before I can comment. I’m pretty well read in economics, although I don’t wind up agreeing with the mainstream schools I do agree on the “basics”.
Sure, but there’s more. Any bank that went along with the regulations would be able to make more and more loans, which would be bundled into more and more securities. Any bank that limited itself to mere prudence would stop, and simply make a living. In other words, as long as there were SOME banks that were willing to sacrifice prudence on the altar of compliance, the system was doomed, because the banks that were willing to follow the law to the letter would FAR outgrow the ones that were prudent. In every external measure they’d look like better-run banks.
Another way of looking at this is that banks are already creatures of federal regulation. They, unlike anyone else, can give people vastly more money than they can possibly repay (i.e. they can lend out almost all their deposits, even though the deposits are, in theory, callable on demand); and the government promises that if they’re ever called on it, the government will pay. This behavior in anyone else would be radically unwise; yet banks are required to operate that way. So now you’re saying that these banks that owe their entire existence to unwise yet regulated (for them) behavior should suddenly see that the new regulations are unlike the old, in that this time they went too far.
I don’t want to build up too much sympathy for the foolish practices of the banks, because they WERE foolish. But they were encouraged and taught by the people who were supposed to prevent exactly this kind of thing. Although we should punish the foolishness (and get rid of them), we can’t blame fools for playing the part; we should blame the people we put in to teach them wisdom.
The stupid banks should fail. And the regulators who set up the perverse incentives should be kicked out.
It seems to me that you’re expecting too much to be “apparent” before the fact. Banks are something of specialists, and they were suddenly being allowed and encouraged to make security investments. Naturally, they tended more to choose securities backed by their specialties (loans), and in order to get them they had to securitize and sell their own loans to provide cash to buy. On the surface, this *looks* prudent — assuming that the legal/social/regulatory structure has some means built into it to monitor those loans when they’re split apart from their originators (it didn’t).
There were short-sighted and stupid banks, and there were smart ones. Because of the short-sighted and stupid regulators, the smart banks were drowned out in the market. When disaster struck, instead of just striking the stupid banks, it hit everyone, precisely because the regulations rewarded, multiplied, and spread stupid behavior.
Replace the word “banks” with “people”, and we agree. I just don’t think we have a choice to replace people with something that’s not subject to short-sightedness and/or stupidity. In fact, I don’t know what positive use your statement has; how can we use it to decide ANYTHING?
There are many ways the government can cause economic calculations to go awry. The big thing to realize is that economic calculation is *hard*; notice how many Nobel laureates disagree with one another (that does NOT happen in Chemistry!). Even in a smoothly functioning economy little things (like someone else’s invention) can throw all your calculations off.
One way the government can disable economic calculation is by using its power to regulate the money supply, tax, and issue debt backed by “full faith and credit” to change the value of current cash, future expected income, and the cost of debt.
Another way is to use the fractional banking rules to allow banks to issue loans in multipliers on their actual assets, and change the multipliers based on the bank’s actions.
You’re right, that’s a little extreme, and I shouldn’t slant that far over.
One thing I haven’t mentioned in all my talk about how hard banking is, is that regulation is even harder. I just don’t see how we can fix that; it’s inherent.
–Wm
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October 16, 2009, 10:59 pmLN says:
In other words, as long as there were SOME banks that were willing to sacrifice prudence on the altar of compliance, the system was doomed, because the banks that were willing to follow the law to the letter would FAR outgrow the ones that were prudent. In every external measure they’d look like better-run banks.
But these issues come up all the time when you get compensated upfront for assuming long-term risk. This is not limited to the government trying to encourage broader homeownership. For example, insurance companies that underprice risk obviously have an easier time accumulating premiums than conservative insurers. If outsiders can’t evaluate insurance risk in a sophisticated way, and can only go by top-line growth, then incentives are set up for terrible long-term insurance performance.
Are you saying that you do not expect regulations to affect people’s behaviors?
Of course that’s not what I’m saying. I’m saying that a lot of the talk about incentives seems to treat market actors as being fundamentally rational; the idea is that the government created a situation where the prudent thing to do was to contribute to the likelihood of a financial crisis. For example, when people talk about rent control, the idea is that government intervention backfires because landlords rationally respond to incentives. But if it’s “rational” for financial institutions to blow themselves up in search of short-term profits, then we’re going to get bubbles and busts no matter what the government does.
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October 16, 2009, 11:26 pmNickM says:
This is exactly what happened to Lloyd’s of London.
Nick
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October 17, 2009, 1:23 amWm Tanksley says:
This is quite true; but those companies will suffer for their own errors. There’s no regulation needed to make sure of that. The problem is in a unique regulatory feature of banks, that they are allowed to loan out money that’s promised to be 100% available on demand.
Just to be clear, I’m not talking about any of that. Those things were, by and large, silly; but they’re valid policies, and they didn’t cause any of this mess. Well, some of the long-term stuff (mortgage interest deduction) has had some effect on the runup, but that’s an upward nudge to house prices, not the rankly awful stupidity that multiplied the crisis.
But the incentives also correct the error. Companies that underprice will be driven out of business when the risk strikes. Companies the underprice insurance on rare happenings will have to be careful, but again, the problem will be limited to them and to their clients.
Your metaphors are disastrously overblown here. The banks weren’t blowing themselves up in any sense. They were indeed violating a specific principle of financial prudence, but the level of risk it introduced wasn’t obviously high. They were actually, in measurable ways, reducing their risk concentration (especially local banks, which would be at risk from their own local loans in the more likely event of a local downturn). What WAS being blown up was the systemic risk, and that was something none of the banks could see — but it was exactly the only risk that COULD hurt them, due to their now-diversified loan/security portfolios.
This is a rational response. The best response is in some senses irrational: to give up a better strategy just because Ma and Pa taught you to take care of what you bring into the world. (Ma and Pa were right!) The banks that took care of their own loans wound up, long term, in a situation that was likely to be better; but only _likely_ (some localities had bad luck, some banks got hit by other factors), and only if they actually were better at managing their local loans.
And... Yes, we’re going to get bubbles no matter what the government does. That’s economics 101. The resulting collapses don’t have to be systemic, though.
–Wm
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October 17, 2009, 10:19 amThe Volokh Conspiracy » Blog Archive » Peter Wallison on the Role of Government in Causing the Mortgage Crisis says:
[...] a recent post, I discussed how the Federal Housing Administration’s subsidization of dubious mortgage loans [...]
Weekly Web Watch 10/12/09 – 10/18/09 « EXECUTIVE WATCH says:
[...] buy all these toxic assets; often as not, the buyers were government-backed agencies. Ilya Somin concurs and extends: Not only did government back the purchase of these bad mortgages, they also encouraged excessive [...]
Alex Williams says:
The mortgage crisis is really serious and repeat the mistake is something that won’t help.. The
foreclosures are out there with lists available for sale.. Plans have failed and Obama is trying to make another effort to reduce the filings
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October 21, 2009, 11:36 am