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john

uk mortgage

LN:[...]the banks that were willing to follow the law to the letter would FAR outgrow the ones that were prudent.But these issues come up all the time when you get compensated upfront for assuming long-term risk. [...] For example, insurance companies that underprice risk obviously have an easier time accumulating premiums than conservative insurers.

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.

This is not limited to the government trying to encourage broader homeownership.

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.

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.

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.

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.

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

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.

This is exactly what happened to Lloyd’s of London.

Nick

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.

LN: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.

Are you saying that you do not expect regulations to affect people’s behaviors?

In general, the responses reveal that Econ 101 is pretty off the mark.

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”.

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?

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.

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.

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).

In other words, the banks were short-sighted and stupid.

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.

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.

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?

I guess I don’t understand how the government caused them to miscalculate.

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.

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).

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

Wm Tanksley: 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.

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.

scattergood: 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.

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?

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.

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).

Who would have guessed?

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…

LN: But AIG collapsed specifically because it chose to profit…Stop right there.

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 very complicated world. The case for free markets is that they produce socially desirable outcomes even though each market actor is self-interested.

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.

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.

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.

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?

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.

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.

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

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?

LN: So in other words blaming AIG’s collapse on government action is based on…

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

Ricardo: 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.

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.

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.”

Nick

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?

AIG was bailed out, wasn’t it?

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.

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

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.

Steve: 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.

\

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!

Steve:
I didn’t hear “big business made us take out mortgages we couldn’t afford” until housing prices started dropping.

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.

Ricardo says:
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.”

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.

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.