What Happened in the Markets
Sep. 23rd, 2008 12:03 pm![[personal profile]](https://www.dreamwidth.org/img/silk/identity/user.png){kind=small}
ymarkovA Mortgage Fable
Once upon a time, in the land that FDR built, there was the rule of "regulation" and all was right on Wall and Main Streets. Wise 27-year-old bank examiners looked down upon the banks and saw that they were sound. America's Hobbits lived happily in homes financed by 30-year-mortgages that never left their local banker's balance sheet, and nary a crisis did we have.
Then, lo, came the evil Reagan marching from Mordor with his horde of Orcs, short for "market fundamentalists." Reagan's apprentice, Gramm of Texas and later of McCain, unleashed the scourge of "deregulation," and thus were "greed," short-selling, securitization, McMansions, liar loans and other horrors loosed upon the world of men.
Now, however, comes Obama of Illinois, Schumer of New York and others in the fellowship of the Beltway to slay the Orcs and restore the rule of the regulator. So once more will the Hobbits be able to sleep peacefully in the shire.
With apologies to Tolkien, or at least Peter Jackson, something like this tale is now being sold to the American people to explain the financial panic of the past year. It is truly a fable from start to finish. Yet we are likely to hear some version of it often in the coming months as the barons of Congress try to absolve themselves of any responsibility for the housing and mortgage meltdowns.
Yes, greed is ever with us, at least until Washington transforms human nature. The wizards of Wall Street and London became ever more inventive in finding ways to sell mortgages and finance housing. Some of those peddling subprime loans were crooks, as were some of the borrowers who lied about their incomes. This is what happens in a credit bubble that becomes a societal mania.
But Washington is as deeply implicated in this meltdown as anyone on Wall Street or at Countrywide Financial. Going back decades, but especially in the past 15 or so years, our politicians have promoted housing and easy credit with a variety of subsidies and policies that helped to create and feed the mania. Let us take the roll of political cause and financial effect:
- The Federal Reserve. The original sin of this crisis was easy money. For too long this decade, especially from 2003 to 2005, the Fed held interest rates below the level of expected inflation, thus creating a vast subsidy for debt that both households and financial firms exploited. The housing bubble was a result, along with its financial counterparts, the subprime loan and the mortgage SIV.
Fed Chairmen Alan Greenspan and Ben Bernanke prefer to blame "a global savings glut" that began when the Cold War ended. But Communism was dead for more than a decade before the housing mania took off. The savings glut was in large part a creation of the Fed, which flooded the world with too many dollars that often found their way back into housing markets in the U.S., the U.K. and elsewhere.
- Fannie Mae and Freddie Mac. Created by government, and able to borrow at rates lower than fully private corporations because of the implied backing from taxpayers, these firms turbocharged the credit mania. They channeled far more liquidity into the market than would have been the case otherwise, especially from the Chinese, who thought (rightly) that they were investing in mortgage securities that were as safe as Treasurys but with a higher yield.
These are the firms that bought the increasingly questionable mortgages originated by Angelo Mozilo's Countrywide and others. Even as the bubble was popping, they dived into pools of subprime and Alt-A ("liar") loans to meet Congressional demand to finance "affordable" housing. And they were both the cause and beneficiary of the great interest-group army that lobbied for ever more housing subsidies.
Fan and Fred's patrons on Capitol Hill didn't care about the risks inherent in their combined trillion-dollar-plus mortgage portfolios, so long as they helped meet political goals on housing. Even after taxpayers have had to pick up a bailout tab that may grow as large as $200 billion, House Financial Services Chairman Barney Frank still won't back a reduction in their mortgage portfolios.
- A credit-rating oligopoly. Thanks to federal and state regulation, a small handful of credit rating agencies pass judgment on the risk for all debt securities in our markets. Many of these judgments turned out to be wrong, and this goes to the root of the credit crisis: Assets officially deemed rock-solid by the government's favored risk experts have lately been recognized as nothing of the kind.
When debt instruments are downgraded, banks must then recognize a paper loss on these assets. In a bitter irony, the losses cause the same credit raters whose judgments allowed the banks to hold these dodgy assets to then lower their ratings on the banks, requiring the banks to raise more money, and pay more to raise it. The major government-anointed credit raters -- S&P, Moody's and Fitch -- were as asleep on mortgages as they were on Enron. Senator Richard Shelby (R., Ala.) tried to weaken this government-created oligopoly, but his reforms didn't begin to take effect until 2007, too late to stop the mania.
- Banking regulators. In the Beltway fable, bank supervision all but vanished in recent years. But the great irony is that the banks that made some of the worst mortgage investments are the most highly regulated. The Fed's regulators blessed, or overlooked, Citigroup's off-balance-sheet SIVs, while the SEC tolerated leverage of 30 or 40 to 1 by Lehman and Bear Stearns.
The New York Sun reports that an SEC rule change that allowed more leverage was made in 2004 under then Chairman William Donaldson, one of the most aggressive regulators in SEC history. Of course the SEC's task was only to protect the investor assets at the broker-dealers, not the holding companies themselves, which everyone thought were not too big to fail. Now we know differently (see Bear Stearns below).
Meanwhile, the least regulated firms -- hedge funds and private-equity companies -- have had the fewest problems, or have folded up their mistakes with the least amount of trauma. All of this reaffirms the historical truth that regulators almost always discover financial excesses only after the fact.
- The Bear Stearns rescue. In retrospect, the Fed-Treasury intervention only delayed a necessary day of reckoning for Wall Street. While Bear was punished for its sins, the Fed opened its discount window to the other big investment banks and thus sent a signal that they would provide a creditor safety net for bad debt.
Morgan Stanley, Lehman and Goldman Sachs all concluded that they could ride out the panic without changing their business models or reducing their leverage. John Thain at Merrill Lynch was the only CEO willing to sell his bad mortgage paper -- at 22 cents on the dollar. Treasury and the Fed should have followed the Bear trauma with more than additional liquidity. Once they were on the taxpayer dime, the banks needed a thorough scrubbing that might have avoided last week's stampede.
- The Community Reinvestment Act. This 1977 law compels banks to make loans to poor borrowers who often cannot repay them. Banks that failed to make enough of these loans were often held hostage by activists when they next sought some regulatory approval.
Robert Litan, an economist at the Brookings Institution, told the Washington Post this year that banks "had to show they were making a conscious effort to make loans to subprime borrowers." The much-maligned Phil Gramm fought to limit these CRA requirements in the 1990s, albeit to little effect and much political jeering.
We could cite other Washington policies, including the political agitation for "mark-to-market" accounting that has forced firms to record losses after ratings downgrades even if the assets haven't been sold. But these are some of the main lowlights.
Our point here isn't to absolve Wall Street or pretend there weren't private excesses. But the investment mistakes would surely have been less extreme, and ultimately their damage more containable, if not for the enormous political support and subsidy for mortgage credit. Beware politicians who peddle fables that cast themselves as the heroes.
Bad Accounting Rules Helped Sink AIG
The decision by the Federal Reserve to loan insurance giant AIG $85 billion in return for as much as 80% ownership of the company is by any measure dramatic. The takeover early last week of Fannie Mae and Freddie Mac represented the culmination of years of intermingling of public and private interests. But the AIG move is de facto a government nationalization of an ailing private company, which, if not unprecedented, has rarely happened in the United States. Even if the intervention was imperative, its scope is startling.
[Karabell] Corbis
The crisis on Wall Street has, of course, become a political football. Cries of "moral hazard" and "socialism" on one side are drowned out by charges that the current mess is the result of deregulation, and too cozy a relationship between "Wall Street fat cats" and the current administration in Washington. If only reality were that simple. The blame game will continue, but it won't do much to fix what's broken.
Let's get a few canards out of the way: First, yes, stupidity and cupidity and complacency and hubris are involved, and yes, there is gambling in Casablanca. Second, the idea that there is this thing called "the free market" that governments tame or muck up with regulation is a fiction. Governments create the legal conditions for markets; markets shape what governments can do or are willing to do. Regulation versus free-market is a false dichotomy. Maybe in some theoretical universe, if we could start with a blank slate and construct society anew, it wouldn't be. But we exist in a web of markets and regulations, and the challenge is to respond to problems in such a way so that we decrease the odds of future crises.
And that is where AIG becomes instructive. Even good regulations can't prevent all future crises, especially ones that are the result of new technologies and changes that result from them. The capital flows, derivatives contracts and nearly frictionless interlinking of global markets today are the direct result of the information technologies of the 1990s. The implications weren't known until very recently, so it would have been nearly impossible for regulations to have prevented what is happening. But if good regulation can't prevent crises, bad regulations can cause them.
The current meltdown isn't the result of too much regulation or too little. The root cause is bad regulation.
Call it the revenge of Enron. The collapse of Enron in 2002 triggered a wave of regulations, most notably Sarbanes-Oxley. Less noticed but ultimately more consequential for today were accounting rules that forced financial service companies to change the way they report the value of their assets (or liabilities). Enron valued future contracts in such a way as to vastly inflate its reported profits. In response, accounting standards were shifted by the Financial Accounting Standards Board and validated by the SEC. The new standards force companies to value or "mark" their assets according to a different set of standards and levels.
The rules are complicated and arcane; the result isn't. Beginning last year, financial companies exposed to the mortgage market began to mark down their assets, quickly and steeply. That created a chain reaction, as losses that were reported on balance sheets led to declining stock prices and lower credit ratings, forcing these companies to put aside ever larger reserves (also dictated by banking regulations) to cover those losses.
In the case of AIG, the issues are even more arcane. In February, as its balance sheet continued to sharply decline, the company issued a statement saying that it "believes that its mark-to-market unrealized losses on the super senior credit default swap portfolio . . . are not indicative of the losses it may realize over time." Unless one is steeped in these issues, that statement is completely incomprehensible. Yet the inside baseball of accounting rules, regulation and markets adds up to the very comprehensible $85 billion of taxpayer money.
What AIG was saying then, and what others from Lehman to Bear Stearns to the world at large have been saying since, is that the losses showing up aren't "real." Yes, the layer upon layer of derivatives built on the foundation of mortgages is mind-boggling. One reason that AIG had floated beneath the radar screen of the business media (relative to Wall Street investment firms) is that its business model is so complex and opaque that it is impossible to describe simply. It was briefly in the news in 2005, after it was accused of improper accounting by the SEC and the New York attorney general. Then it faded from view, until now.
Among its many products, AIG offered insurance on derivatives built on other derivatives built on mortgages. It priced those according to computer models that no one person could have generated, not even the quantitative magicians who programmed them. And when default rates and home prices moved in ways that no model had predicted, the whole pricing structure was thrown out of whack.
The value of the underlying assets -- homes and mortgages -- declined, sometimes 10%, sometimes 20%, rarely more. That is a hit to the system, but on its own should never have led to the implosion of Wall Street. What has leveled Wall Street is that the value of the derivatives has declined to zero in some cases, at least according to what these companies are reporting.
There's something wrong with that picture: Down 20% doesn't equal down 100%. In a paralyzed environment, where few are buying and everyone is selling, a market price could well be near zero. But that is hardly the "real" price. If someone had to sell a home in Galveston, Texas, last week before Hurricane Ike, it might have sold for pennies on the dollar. Who would buy a home in the path of a hurricane? But only for those few days was that value "real."
The regulations were passed to prevent a repeat of Enron, but regulations are always a work of hindsight. Good regulatory regimes can mitigate future crises, and over the past hundred years, economic crises world-wide have become less disruptive. The panics of the late 1800s, the bank runs, the Great Depression in Europe and the United States, were all far more severe than what is unfolding today in terms of business failures and jobs, homes and savings lost.
But bad regulation is something to be feared, especially as industries become more complicated. Legislators and agencies would be wary of passing rules regulating how a semiconductor chip is programmed; they would recognize that while the outcomes those chips produce might be simple, the way they produce them is not. Yet financial service regulations sometimes act as if we still live in a time when deposits consisted of sacks of money in a vault.
A few years from now, there will be a magazine cover with someone we've never heard of who bought all of those mortgages and derivatives for next to nothing on the correct assumption that they were indeed worth quite a bit. In the interim, there will almost certainly be a wave of regulations designed to prevent the flood that has already occurred, some of which are likely to trigger another crisis down the line. Until we can have a more rational, measured public discussion about what government and regulations can and should do vis-à-vis financial markets, we are unlikely to break the cycle.
There is one final irony: AIG was founded in Shanghai in 1919, when China was emerging from millennia of imperial rule. Over the next century, China turned away from capitalism. Almost 90 years later, AIG is now being taken over by the U.S. government just as the Chinese government is moving as quickly as possible to divest itself of control of major companies. One of those countries is growing fast; one isn't. Perhaps that is a coincidence; perhaps not.
Mr. Karabell is president of River Twice Research. His "Chimerica: How the United States and China Became One," will be published next year by Simon & Schuster.
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no subject
Date: 2008-09-23 04:32 pm (UTC)no subject
Date: 2008-09-23 05:11 pm (UTC)There is still a good chance that this will not spill over into the real economy. The question is how quick confidence in the commercial lending markets can be restored. So far it hasn't been bad, actually, but if a bank is pressed to keep extra reserves because part of its assets is being devalued, it has to curtail lending across the board...
no subject
Date: 2008-09-24 08:49 am (UTC)People have been living, as Stiglitz said, "on borrowed money and borrowed time". In other words, spending real resources inefficiently. And that can affect the economy in a way that may not be easily corrected. After all, money is a fiction. So it is relatively easy to deal with. But food is not.
no subject
Date: 2008-09-24 12:55 pm (UTC)no subject
Date: 2008-09-24 03:31 pm (UTC)But for the sake of an argument: being a food exporter does not mean that people in your country eat well. It just means that people in other countries pay more for it, enough to justify the transportation costs, etc. For example, the best food grown in Israel is for export. And we are left mostly with shit, pardon my French.
no subject
Date: 2008-09-24 09:50 pm (UTC)I remember, when I mentioned on a newsgroup about 10 years ago that the best Soviet products were for export only, several American participants were shocked.
no subject
Date: 2008-09-23 10:15 pm (UTC)-FI
no subject
Date: 2008-09-24 03:33 am (UTC)thank you.