A Thought on the Sub-prime Debacle

Most of the NYT’s recent coverage of the subprime mess focused on Greenspan and the Federal Reserve System.

However, it’s clear that regulation was deficient along other fronts. From the NYT:

The Fed was hardly alone in not pressing to clean up the mortgage industry. When states like Georgia and North Carolina started to pass tougher laws against abusive lending practices, the Office of the Comptroller of the Currency successfully prohibited them from investigating local subsidiaries of nationally chartered banks.

Virtually every federal bank regulator was loathe to impose speed limits on a booming industry. But the regulators were also fragmented among an alphabet soup of agencies with splintered and confusing jurisdictions. Perhaps the biggest complication was that many mortgage lenders did not fall under any agency’s authority at all.

But by 2005, federal banking regulators were beginning to worry that mortgage lenders were running amok with exotic and often inscrutable new products.

The agencies, however, were like a Rube Goldberg machine with parts moving in different directions. The Office of the Comptroller of the Currency was in charge of nationally chartered banks and their subsidiaries. The Federal Reserve covered affiliates of nationally chartered banks. The Office of Thrift Supervision oversaw savings institutions. The Federal Deposit Insurance Corporation insured deposits of both state-chartered and nationally chartered banks.

Because each agency receives its funding from fees paid by the banks or thrifts they regulate, critics have long argued that they often treat the institutions they regulate as constituents to be protected. All of them are wary about stifling new financial services.

Ms. Bair was an exception, especially for the deregulation-minded Bush administration. As a former assistant secretary of the Treasury in 2001 and 2002, she had worked with Mr. Gramlich to raise concerns about abusive lending practices. Indeed, she tried to hammer out an agreement with mortgage lenders and consumer groups over a tough set of “best practices” that would have covered subprime mortgages.

But that effort largely stalled because of disagreement. Though some big lenders did endorse a broad code of conduct, she recalled, they soon began loosening standards as competition intensified.

I think that as we learn more and more about the run-up to current situation, we will find out that “looting” was the relevant phenomenon. From George Akerlof and Paul Romer’s 1993 discussion of the S&L crisis, in the Brookings Papers in Economic Activity:

“Our theoretical analysis shows that an economic underground can come to life if firms have an incentive to go broke for profit at society’s expense (to loot) instead of to go for brok (to gamble on success). Bankruptcy for profit will occur if poor accounting, lax regulation, or low penalties for abuse give owners an incetive to pay themselves more than their firms are worth and then default on their debt obligations.

Bankruptcy for profit occurs most commonly when a government guarantees a firm’s debt obligations. The most obvious such guarantee is deposit insurance, but governments also implictily or explicitly guarantee the policies of insurance companies, the pension obligations of private firms, virtually all the obligations of large or influential firms. These arrangements can create a web of companies that operate under soft budget constraints. To enforce discipline and to limit opportunism by shareholders, governments make continued access to the guarantees contingent on meeting specific targets for an accounting measure of net worth. However, because net worth is typically a small fraction of total assets for the insured institutions (this, after all, is why they demand and receive the government guarantees), bankruptcy for profit can easily become a more attractive strategy for the owners than maximizing true economic values.

Unfortunately, firms covered by government guarantees are not the only ones that face severely distorted incentives. Looting can spread symbiotically to other markets, bringing to life a whole economic underworld with perverse incentives. The looters in the sector covered by the government gurarantees will make trades with unaffiliated firms outside this sector, causing them to produce in a way that helps maximize the looters’ current extractions with no regard for future losses….”

Now instead of arguing against Fed intervention to try to mitigate the credit crunch, on the grounds of discouraging “moral hazard”, (in Krugman’s lexicon, that horse is already out the barn door) I would say we need to think now about how to prevent the next bout of “looting”.

That involves a much more complicated and difficult task of insulating the regulatory authorities from political pressures (see “avoiding regulatory capture“). It also probably requires expanding and integrating regulatory charters.

I’m not sure how one would do that. But I know how not to do it. From the WSJ:

Regulators appointed by President Bush often have been more sympathetic to industry concerns about red tape than their Clinton administration predecessors. When James Gilleran, a former California banker and bank supervisor, took over the OTS in December 2001, he became known for his deregulatory zeal. At one press event in 2003, several bank regulators held gardening shears to represent their commitment to cut red tape for the industry. Mr. Gilleran brought a chain saw.

He also early on announced plans to slash expenses to resolve the agency’s deficit; 20% of its work force eventually left. When he left in 2005, Mr. Gilleran declared that the OTS had “exercised increased diligence in its review of abusive consumer practices” while reducing thrifts’ regulatory burden. But his successor, Mr. Reich, a former community banker, has reversed many of Mr. Gilleran’s cuts. Citing “understaffing,” he hired 80 examiners last year and plans to add 40 more this year. A spokeswoman for Mr. Gilleran, now chief executive of the Federal Home Loan Bank of Seattle, said he wasn’t available to comment.

So, let’s think constructively about preventing the next bout of looting, even as we deal with the after-effects of the current bout.

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11 thoughts on “A Thought on the Sub-prime Debacle

  1. James I. Hymas

    I suggest that Step #1 is to end revolving door regulation:

    The troubled Federal Home Loan Bank of Seattle has named a former federal regulator as its next president and chief executive.

    James Gilleran will begin his new job June 1. He replaces interim CEO James Faulstich, who took the helm in February after former Seattle Mayor Norm Rice announced he would leave the post.

    Gilleran, 72, stepped down last month as director of the Office of Thrift Supervision, a job he had held since 2001. That office regulates U.S. savings and loans. Previously, Gilleran was superintendent of banking for California from 1989 to 1994, and CEO of the Bank of San Francisco from 1994 to 2000.

    I do not mean to suggest that Mr. Gilleran has ever done anything improper; but a certain amount of “gardening leave” should be mandatory for all employees of regulators, the term dependent upon their authority.

  2. Steve

    Both the Comptroller of the Currency and the Office of Thrift Supervision are part of the Treasury Dept. They are subject to direct political pressure. The Fed, as regulator of bank holding companies, and the FDIC are somewhat more independent. The approach taken by OTS under the current administration is remarkably similar to the FSLIC disaster of the 1980’s. Even now, several large, mortally wounded federal thrifts regulated by OTS are being permitted to grow assets by attracting insured deposits when all market sources of funding have been cut off for them. It’s easy to see that at some point, FDIC will need to draw on the Treasury to finally shut these insolvent dinosaurs down (at $50B, the insurance fund won’t be sufficient when two or more of these things finally have to be closed). The administration will do all it can to throw the problem over into the next administration, while the liability to the taxpayers keeps growing.

  3. Buzzcut

    You guys are missing the forest for the trees.
    How can your “failure to regulate” meme jibe with the fact that so many of the loans in default are in default less that 12 months after they were originated, and without a reset in the interest rate?
    One word: FRAUD.
    Somebody was ripping off someone, and it wasn’t the lender ripping off the borrower. It was more likely a conspiracy between brokers and borrowers to rip off lenders.
    Now, we could ask the question as to why lenders became so… stupid… as to allow themselves to be ripped off. But does that require regulation of any kind by the Bush Administration? To protect lenders from themselves?
    I don’t see the argument.

  4. calmo

    Could it B the so very sad and disappointing decline in (unregulated) stratospheric house prices instead, Buzzy, to splain the defaults in less than 12 months? They were supposed to keep rising stratospherically weren’t they?
    And now that they have turned seriously south, it just doesn’t make sense to pay the mortgage on a depreciating asset with rent being a cheaper option.
    Such is my look at the trees in the forest, the bark on the trees and the forests on the planet: fraudulently high house prices.

  5. Buzzcut

    Calmo, that very well could be the situation.
    But is it likely? You think that home prices declined so much is less than 12 months that people just walk away from a house? What does that do to their credit? That’s hardly a costless course of action.
    Of course, these are subprime people with crappy credit to begin with. I guess anything is possible.

  6. Unsympathetic

    ” It was more likely a conspiracy between brokers and borrowers to rip off lenders. ”
    Um, no. You’re really claiming that the private market that creates debt didn’t know what they were funding? It’s far more pernicious than that, actually.. the people who funded these loans are sociopaths. Why are they clamoring for buyouts and taxpayer absorption of the debt instead of bouncing it back to them? If you expect them to take their defaults lying down, you dont understand much about the essential dynamics of sociopathology.
    ” these are subprime people ”
    If by that you mean every person in the world, then yes, I agree with you. If the problem is confined to one segment, I-banks wouldn’t have a giant overhang of LBO debt that they can’t get funded. Time to brush up on your mortgage market knowledge.. before 03, subprime lenders only did 30-yr fixeds as well. Subprime historically is simply where you go to refi at a slightly higher rate because of a medical condition, a job loss, etc.
    “What does that do to their credit?”
    Credit card companies got the bankruptcy law changed in 05. Look at the rates.. 18% on a CC, 7% on a house. Pick one to keep current. It used to be that people would keep the mortgage current and walk away from the credit card.. but that was when 20% down was the norm for house loans. With zero money down, when home price drops, there’s no reason to remain in a depreciating asset.
    “You think that home prices declined so much in less than 12 months”
    Google the Case-Shiller price index. This isn’t a question of opinion, it’s a material fact. The only other dataset is HPI, which uses only conforming loans.. so you’re only looking at the sub-417k house price market. Not shockingly, the largest declines are found in the larger house prices.
    Despite all attempts at invective, the problem won’t ever become “those people” — the problem is that money was lent without regard to its prospect of ever being repaid.. across the board. To everyone. Middle class families got approved (by the private market credit originators) for $1M+ mansions they shouldn’t have been in, private equity got bridge loans for acquisitions they shouldn’t have been making, etc.

  7. Anonymous

    Now, we could ask the question as to why lenders became so… stupid… as to allow themselves to be ripped off.
    Because they were able to sell off the risk through the magic of securitization. The only reason that they’re in trouble now is that the last batch of ugly loans got stuck on their books because everyone finally noticed the quality of paper that they had been pushing.

  8. Unsympathetic

    Just to be clear on precisely what happened:
    There was a belief that the “risk” of default of the various structured finance creations was something that could actually be shifted to the monoline insurers. Through the magic of the CDS, they convinced themselves that they’d created easy money.
    Since August, all the insurers who actually have the risk of those swaps (the monolines – ambac, mbia, etc) are in big trouble from the various rating agencies to withstand the systemic challenge to their AAA ratings.
    Today, Buffett pulled the pin on the grenade within all that. He started his own insurer – but only for muni bonds, which is the cash cow of the monolines and the side of their business that enables the structured finance products to retain the AAA rating despite all the silliness they represent.
    As Buffett takes more of a bite out of the muni bond insurance business, he’s also directly destroying the CDS business. Without the default swap, structured finance will die a slow death.
    As he said many years ago, derivatives are a WMD.

  9. calmo

    ‘Hope Buffet is as important a part of this (puzzle, rat’s nest, debacle, looming catastrophe) solution as you think he is *Unsympathetic*.
    So you think the problem was not some little horde of ‘subprimers’ infecting a much wider population, but the faulty financial instrument, CDS.
    What of the complacency of that population that reveled in that new found source of income, the house and went on a wild shopping spree?
    What of that spending habit that included other properties and investments that is now being constrained with falling house prices?
    ‘We are all subprime now.’ from Tanta at Calculated Risk means more than a few bad apples in the cart are suspect.
    This means more than wise investors are suspect. Pension funds, municipalities, states…such is the impact of this little line on me at any rate.

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