That’s the title of an article I wrote for the UCSD Economics Department’s Economics in Action, which I reproduce below.
As the unemployment rate climbed to the highest levels in a generation and the nation’s output fell in an eighteen-month dive, it became clear that this was no ordinary recession. Why did the economy get so badly off track? What needs to be done to return to solid growth?
There was almost $8 trillion in new U.S. household mortgage debt issued between 2004 and 2006. A significant number of these loans had poor documentation of the borrowers’ incomes, required little or no money down, and called for huge increases in the borrowers’ monthly payments a few years into the loan.
As long as house prices continued to skyrocket, few of even the most dubious loans went bad because the borrower enjoyed a big enough capital gain to be able to refinance at a profit. And precisely because lenders were diverting such huge sums of money into housing, U.S. house prices continued to climb rapidly, doubling between 2000 and 2005.
But house prices could not continue to rise forever, and the recession that began in December 2007 helped to set the process into reverse. Rising oil prices reduced consumer spending and clobbered important sectors like the auto industry in early 2008. Unemployment from the recession tipped many of the mortgages into default, and house prices began to fall rapidly. As house prices fell, more borrowers found themselves underwater and unable to refinance their loans or to meet their monthly payments. The many derivative financial instruments constructed from U.S. mortgage debt suffered a big loss in market value. This precipitated a classic bank run on financial institutions that counted on being able to roll over short-term debt in order to finance their long positions in mortgage-related securities. The result was a freezing of the interbank lending market and a severe contraction in credit that brought the world economy to its knees.
What were the market failures that led to the destabilizing expansion of credit in the early part of the decade? The institutions that originally made the loans sold them off to private banks or to the government-sponsored enterprises Fannie Mae and Freddie Mac. This system created moral hazard incentives for the originators, encouraging them to fund unsound loans. When private banks bought the loans, they packaged them into complex securities that were in turn sold off to private investors, an additional step that permitted the securitizers to profit, even if the loans were poor quality. In the cases of Fannie and Freddie, the government created an asymmetric payoff structure in which the profits went to private investors while the losses were picked up by the taxpayers. Compensation schemes gave the individuals within the financial institutions that authorized unsound gambles a “heads I win, tails you lose” incentive structure that also favored excessive risk taking. Entities like the insurance giant AIG were allowed to write huge volumes of credit default swaps that purportedly would insure the holders of these mortgages against losses, even though AIG did not remotely have the financial ability to fulfill all the commitments it made.
What can be done to address the problems that came out of this mess? Aggressive fiscal stimulus has been implemented in the hopes that an increase in federal spending would make up for the decline in demand from the private sector. So far, the economic performance has been significantly worse than the architects of that fiscal stimulus had originally anticipated. Our monetary stimulus gun ran out of bullets when the Fed funds rate was pushed essentially to the zero lower bound. The Fed also pursued less conventional tools of monetary policy, creating a huge volume of new types of loans and purchasing assets such as mortgage-backed securities. The new Fed policies make sense for addressing the bank-run aspect of the crisis. But to the extent that the low market prices on these securities represent a rational assessment of their true value, the Fed may have simply absorbed some of these losses onto an account that ultimately will be paid by the taxpayers.
Whatever the success of these fiscal and monetary measures, part of the response to the problems must come in the form of fundamental reforms to the financial system. The Treasury has recently proposed a number of ideas that make sense:
- Introduce a legal mechanism whereby large financial institutions that are not commercial banks (such as AIG or Bear Stearns) can be liquidated in an orderly manner without bankruptcy or bailouts, analogous to the authority that the FDIC currently has to take over failing banks.
- Subject the banklike functions of investment banks and structured investment vehicles (that is, the activity of borrowing short and lending long) to the same capital requirements as standard banking.
- Require either mortgage originators or the mortgage securitizers to retain 5 percent of the product they create. I would take that idea a step farther, endorsing Princeton Professor Alan Blinder’s proposal that originators and securitizers should each hold 5 percent.
- Move the trading of financial derivatives like credit default swaps to centralized exchanges where they would be subject to a robust regime of regulation including conservative capital requirements, margins, and reporting requirements. To the Treasury’s proposal, I would also recommend adding stop-loss provisions that regulators could use to limit the promises made and losses suffered by systemically important financial institutions as a result of their trading in financial derivative contracts.
- Set guidelines for individual compensation systems at systemically important financial institutions in order to better align the personal rewards of traders with the interests of shareholders and the public.
It appears that the worst of the recession of 2007-09 is now behind us. But that should not cause us to lose interest in ensuring that this costly tragedy is never repeated.
This may not be fair, because this article is short, and can’t deal with everything, but I disagree with this:
“When private banks bought the loans, they packaged them into complex securities that were in turn sold off to private investors”
One of the problems was that these securities were not sold off. As I understand it, some of the highly rated securities were held because of their low capital requirements.
Also, I’m still struggling with this issue:
“Require either mortgage originators or the mortgage securitizers to retain 5 percent of the product they create. I would take that idea a step farther, endorsing Princeton Professor Alan Blinder’s proposal that originators and securitizers should each hold 5 percent.”
The originiators were not indifferent about the fate of their loans. They, for example, earned fees on servicing the mortgages, and when someone defaulted, they lost these fees. Gary Gorton discusses this issue in one of his papers, and he is broadly skeptical of stories that argue the originators didn’t have skin in the game.
Still, for such a short piece, a good summary I think.
Excellent comments on regulatory structure. I very much agree.
However, I have to take issue with:
Worst of recession is over … oh you do have tenure, don’t you? GDP growth is positive only due to fiscal stimulus (and growth effects of that stimulus are over). Structural growth has not started and it isn’t easy to see what sector might lead us out of recession. Unemployment hasn’t peaked and housing prices haven’t bottomed (unless we get some future effective policy on preventing additional foreclosures, as so far we’ve just kicked the can down the road a little). What ‘worst’ is behind us?
Where academics would see:
A perfect market, pricing mechanism at the intersection of the LM /IS curve, they would tend as well to take as granted liquidity and risk assessment and therefore pricing.
Please see God s works (In Europe the invisible hand) as hereunder:
http://www.occ.treas.gov/ftp/release/2009-161a.pdf (more derivatives and more paper profits outstanding)
How would one explain, again banks generating now more profits or at least the same as the non financial corporate sectors?
Total corporate profits
http://research.stlouisfed.org/fred2/series/CP
Nonfinancial Corporate Business: Profits After Tax
http://research.stlouisfed.org/fred2/series/NFCPATAX
There has been and there is, a long lasting permittivity between the states,central banks and the banks. The end result is defeating the separation of duties among institutions designed and set up for these purposes (see central banks, BIS,failures to meet with their mandates).
How would one think that institutions may regain their credibility and credentials among public and financial intermediaries?
The private sector has been under the influence of the same (rating agencies,banks,brokers). The risk assessment by the financial intermediaries has been kept loose, driving them out of balance in the performance of their inner duty that is their own financial life preservation.
The economics components (interest rates..) are and were designed to entice the savers to take more risks in total absence of fundamental knowledge . The Banks financial statements are dubious, their liquidity ratios the same.
There is and has been more unspecified knowledge within the financial intermediaries than markets fundamentals would plead for.
http://www.bloomberg.com/apps/news?pid=20603037&sid=aZWcAYwYzP_0
The risk and funded loans syndication is a trivial interbank or financial intermediaries operation,where agent,fund manager(s), duties are well laid out. Banks would not agree to take a risk without being pari passu with the agent,that is syndication leader would keep a share of the loan(s) and would manage it on behalf of the participants throughout the life of the risk,funded loan(s).
The syndication of risks used to be a widespread prudential financial intermediaries policy. The leverage buy out, leverage management buy in, have been more leveraged than ever through derivatives prices distortion together with the willingness of brokers to fund the whole amount of the LBO.
More thoughts and ink need to be given to the features of this unprecedented financial crisis,where leverages, prices dislocation,derivatives and complicities need to be more thoroughly addressed.
“Introduce a legal mechanism whereby large financial institutions that are not commercial banks (such as AIG or Bear Stearns) can be liquidated in an orderly manner without bankruptcy or bailouts, analogous to the authority that the FDIC currently has to take over failing banks.”
I am not an expert in economics so please help explain how granting such powers to regulators would ensure fairness.
Thank you.
Case in point: Wamu
http://seattle.bizjournals.com/seattle/blog/2009/12/the_fight_for_wamu_documents.html
“‘Under the Freedom of Information Act, the Business Journal has received several hundred pages of government emails about WaMu, written during its final months, in which almost all of information is blacked out.’
[From Comment Section]
‘I’m enclosing a few more documents filed through the BK court in regards to a declaration of Thomas M. Blake (http://www.crai.com/ProfessionalStaff/listingdetails.aspx?id=1276 ).
The declaration can be found in 103-4.pdf at http://www.mediafire.com/?sharekey=3b830df9f3d0e6fce7c82ed4b8f0c380aff12395630f22f3ce018c8114394287
‘Quoting:
12. Based on my review to date, there is no indication that the OTS performed a solvency analysis consistent with the test for insolvency specified in the Bankruptcy Code. There is no indication that the OTS assessed the fair sale-able value of the assets of WMB (or WMI). Nor is there an indication that OTS compared the fair sale-able value of the assets of WMB (or WMI) to the total amount of either company’s respective liabilities. There is no indication that the OTS performed a comprehensive cash flow analysis of WMB (or WMI). Instead, the OTS found that “WMB met the well-capitalized standards through the date of receivership.’ 8 Thus, without a thorough analysis of the assets, liabilities and capital of WMI and WMB, it is not possible to come to a reliable conclusion concerning the financial solvency of either entity, whether on a consolidated or stand-alone basis.'”
If OTS allegedly didn’t perform any solvency analysis and FDIC allegedly didn’t follow prompt corrective action, how could they seize and sell a bank at the expense of so many Americans, including losses of thousands of jobs and billions of investments?
“’The Washington State Investment Board’s funds will lose about $47 million because of the failure of Washington Mutual’
http://www.kirotv.com/money/17566614/detail.html
‘•The administration board’s total unrealized or ‘paper loss’ from WaMu holdings:
$195 million
•Pension Fund (Florida Retirement System): $42.18 million in Wamu holdings; $8.8 milion was in stock
•Florida Hurrican Catastrophe Fund: $41.28 million, all bonds and related securities, no stock’
cftlaw.com/news.php?category=Insurance+I…
‘At least seven pension funds lost their private equity investments in Washington Mutual, following its failure and subsequent purchase by JPMorgan Chase… Investors in the $19.8 billion TPG VI include CalPERS, New York State Common Retirement Fund, Illinois Teachers’ Retirement System, Washington State Investment Board, Los Angeles City Employees Retirement System and the San Francisco City & County Retirement System.’
http://www.pionline.com/article/20080929/PRINTS…”
*imho*
When the the houses on either side of mine are empty lots or the Banks that now own them are renting them out. I will believe this downturn is contained. With so much pie flying around the sky, it is hard to spot where the clouds end and the silver linings begin.
(a) “Introduce a legal mechanism…”
The current legal mechanism of bankruptcy works quite well. The demise of Lehman was not a policy failure; but misleading the markets to believe that there would be a bail-out definitely was just such a failure.Without bankruptcy there can be no management accountability–nor will there be any financial reform. Your supposed need for an additional legal mechanism extends automatically to every hedge fund, which GS, MS, etc. were. It was their hedge fund activities that were bailed out, not their traditional fee-generating IBank business (M&A, IPOs, etc.). Parenthetically, TBTF doctrines and “systemic risk” shibboleths also extend automatically to every “large” firm, all of whom can point to their importance for the economy, for a region, for the national security, for…
(b)”Subject the banklike functions of investment banks…to the same capital requirements…”
This is a prescription for merely more subterfuge by investment bankers in their roles as protected hedge fund. You seem to have forgotten that structured products were created to evade such requirements. They will be evaded again and with yet more vigor as long as the Greenspan/Bernanke put is writ is stone with TBTF guarantees. See (a).
(c) “…originators and securitizers should each hold 5 percent…”
Excellent idea.
(d)”Move the trading of financial derivatives like credit default swaps to centralized exchanges”
Better to ban naked CDS’s and similar products entirely. These are bucket shop products, pure and simple. Bucket shops were outlawed by the states due to their exacerbation of the effects of the Panic of 1907. In 2000 Congress exempted Wall-Street-blessed products from the states’ prohibitions in the Commodity Futures Modernization Act. Repeal the exemption. Even better, learn from the lessons of our ancestors and immunize commercial banking and insurance from the cowboys by reinstating Glass-Steagal as well.
(d)”Set guidelines for individual compensation systems…”
How well has that worked so far? Bankruptcy has teeth, jaw-boning does not. See (a).
Tax incentives-based measures to tackle the financial sector overgrowth and the Too Big To Fail problems:
http://raphaelkahan.blogspot.com/2009/12/tax-incentives-based-measures-to-tackle.html
The Science of Debt Dependent Saturation Macroeconomics
Terminal Quantum Fractal Progressions – Identifying the Wilshire’s 11 October 2007 Secondary High
The Huffington Post prospectively ‘published’ the exact high day for the Wilshire; the world’s highest valuation equity composite index.
The exact high for the Wilshire on October 11 2007 was prospectively predicted by the science of saturation macroeconomics. The science of saturation macroeconomics as defined by quantum fractal growth and decay of macroeconomic system’s countervailing debt, on the one hand, and commodity and equity, on the other ‘investment’ instruments has now retrospectively indicated the final secondary high for the Wilshire.
Speculative money rotating from equity and commodity speculative instrument that flowed into global debt instruments driving the US ten year note, as way of a sovereign debt proxy, to its 150 year low at 2.04 percent on 18 December 2008 well matched the Wilshire’s initial nodal low at 7400 on 21 December 2008. With the 150 year low long term interest, speculative money began flowing back into equities which had lateral growth and thereafter downward growth until 6 March 2009, completing a 7/16 week x/2-2.5x fractal sequence.
With the US central bank’s counterfeiting 350 billion dollars in the short term treasury market to incrementally absorb short term US roll over debt that had insufficient real economy buyers, the US equity market and the entire global equity markets achieved growth valuations beyond that which would have occurred if competing short term debt instruments were placed on the existing capital market table.
Since 6 March 2009 the Wilshire completed a fractal sequence formed by the earlier 7/16 week first and second fractal series. A 7/16/19 week fractal series completed the first of two final fractal growth periods.
The 19 weeks of the 7/16/19 first fractal series were composed of a daily fractal series of 17/38/35 days :: x/2-2.5x/2x with a nonlinear drop seen on the minute unit charts on the 38th day of the second fractal.
The second fractal series is composed currently of 6/12/7 weeks :: x/2x/1x or 27/55/33 days. The 27th day of the third fractal is nested in a cup 5 days from the likely secondary Wilshire high on 4 December and the secondary high on 16 December 2009.
Since 9 December 2009 the Wilshire has followed a 15/32/15 hour :: x/2-2.5x/x fractal growth series ending on Friday 18 December 2009 with the characteristic nonlinear drop on the 31st hour of the second fractal. The final 15 hour is composed of a 3/8/6 hour fractal x/2.5x/2x or a 12/24/20 :: x/2x/1.6x 15 minute fractal.
On Friday 18 December the Wilshire reached its second and (relatively) final lower high of a 27/55/27 day x/2x/x fractal followed by a 15/32/15 hour : x/2x/x
fractal. Incipient nonlinearity of a major degree is expected on Monday 21 December 2009.
Possible fractal decay progressions using the 6/12/7 week fractal sequence (decay is confluent with and begins in terminal apical growth) are: 6/12/12 weeks or 6/12/12/9 weeks with the third fractal (of the latter fractal series) 12th a final third much lower high.
Bernanke and Geithner create the biggest moral hazard that the bad people get reward from governments help but the good people get punishment from higher tax, higher cost of living (reducing public benefit like education, healthcare and any infrastructure) and higher inflation (now inflation is high from too much loosening policy). At the end, everyone will be bad and need help and no one will be good because if you are good, you will get only punishment and this will create the bigger crisis because of moral hazard creation by Fed and Geithner.
Look at money that government and help spend, they use money to give to Goldman Sach, Citi etc by injecting money at cheap cost, no corporate tax and a lot of support from Fed but ordinary people get no job and no support and get higher tax and higher expenditure. Government and Fed know only wealth transfer and the fiscal and monetary policies are to help the wall street and there is no way they think to help people. Job creation is not the first priority of Obamas policy but the first is Wall street, wealth of investor and the rich. If they want to create job, they need to transfer wealth back to people to have more income and more purchasing power. They should tax financial sectors and stop support any privilege like cheap funding cost to Goldman Sach, Citi etc. and use that money to help the American people.
A lot of economists forecast next year is the year of global government-funding crisis from too much spending and most spending benefits the rich. Now government should have the policy to tax the rich and the people who cause the crisis including banking, Wall Street and the speculators to fund the poor and middle-class people. This can help the stability of economy and avoid funding crisis.
When large organizations such as AIG perform insurance like activities shouldn’t they be regulated like insurance companies?
re “It appears that the worst of the recession of 2007-09 is now behind us.”
This description is an implicit forecast for a “V” shaped recovery, not the “L” shaped one that is implicit in debt recovery/household balance sheet adjustment. In the latter case, the worst is ahead of us.
Professor Hamilton,
What would have happened to the housing bubble in 2003-2007 had the FOMC followed the Taylor Rule in setting the amount of reserves available to a quantity more in line with the productive vs the speculative economy, and had the Basel accord not biased capital requirements in favor of securitized mortgages?
I do not dispute that the wild houring ride was made easier by the deterioration of lending standards. But had reserves been in line with the Taylor Rule and had there been rational rules on capital requirements for securitized mortgages, wouldn’t banks have prioritized lending to solid borrowers? The alternative, as I see it, would have been to starve the best borrowers of low-cost capital in order to fund asset speculators.
Your recent post on commodity inflation said that it cannot be wise for U.S. policy-makers to ignore commodity price changes as an indication of concerns about inflation. Would housing price changes also be such an indicator, especially considering the international market for securitized mortgages? How would a proactive Fed interest rate policy on asset inflation from 2003 on have affected housing prices, home equity extraction and subprime and Alt-A lending? In other words, does the motto, “Don’t fight the Fed” apply to housing bubbles as well as equities?
My only regret about this blog is that there is far too much information and far too many excellent links to allow me to take it all in and also teach….Thanks.
Basically, I agree, although…
– I am curious about what a 5% retention of mortgages means in practice for the capital structure of the origination business. Does that mean that origination becomes a capital-intensive industry? Is this a good thing?
– Let’s ban naked CDS’s. The externalities simply seem too great to me for the benefit conveyed.
– No proof that incentive packages for bankers made a difference. See losses of Fuld, Cayne, respectively.
– Where are the government incentives? Does the Fed not deserve the lion’s share of the blame here? I think the evidence strongly suggests it does. Who was fired as a result? Who lost bonuses? What kind of incentive structure exists at the Fed to align the actions of the decision-makers there with the health of the economy? Isn’t that the single most important issue here?
The solution to the current recession (though it looks more like a depression to me) is the same as it was for the Great Depression. Jobs and wage growth have to return ahead of consumer spending. Because this results in lower returns on investment and lower quarter-over-quarter and year-over-year growth in returns to the investor class they will be reluctant – actually obstinate right up until their capitulation. The consumer has retrenched and they are not sitting there with pent up demand just itching to borrow money at 29 percent to spend their way into financial ruin. This is the sobering reality that the investor class must face but won’t.
All of the re-regulation and fancy Treasury and Fed programs won’t amount to a hill of beans. Our problem isn’t lending nor is it the capacity to lend since there is plenty of private investor class money sitting on the sidelines. The fact of the matter is that the investor class wants only risk-free investments and the financial sector up to its collapse and the moral hazard actions of the government have allowed them to hang on to the fantasy of having risk-free investments to infinity. Its why the losses keep getting shoved to the bottom until the bottom and will continue until they can’t absorb anymore.
So the fix isn’t government programs or new laws that still preserve much of the investor class perceives as reality it is getting the investor class to grasp the new reality that the bottom 90 percent has started to define for them. We haven’t even bottomed to the “new” normal yet.
Oh well. That is just my opinion, I could be wrong.
Of course, saving the economy is important. But I think there is a more critical matter requiring analysis and comment, and one–as history has shown–particularly suited to our fine poltical institutions.
Was anyone besides me a bit miffed that the Saints and Colts games were on the NLF Network? “If you want the NFL, go to the NFL.” Well, I do, and I don’t. Given that the NFL is a monopoly with extraordinary influence over the male population of this country, should not our public officials nip NFL channel business in the bud and compel the NFL to provide the really good games on basic cable? I think we need a blog entry on this.
Hi, This is off topic. Sorry if this is contrary to etiquette but I don’t comment very often — love the blog though. I wondered if you knew the answer to this question that I posted on my own blog:
“Inventory Rebuild
I keep seeing stories about inventory rebuilding having contributed sinificantly to Q3 US GDP. When I saw the preliminary breakdown, it was clear that it was not the most significant contributor; now the Q3 Flow of Funds report appears to show continued reduction of inventories (report here; see page 15 (22 of the PDF), section F.8, line 26).
Does anybody know what is going on? Is it just that the inventory rebuild idea has taken hold?”
Best wishes,
JB
Good summary.
I find it curious that the summary excludes all mention of the Sept. 11, 2001 box cutter-airplane attacks on New York City or the fact that western armies now occupy not one but three regions in the Mid-East/Near-East. Note that the USA is picking up a big share of the costs in all three locations.
Should we conclude that that either colonialism does indeed still make the colonizing country richer or that the drag on wealth is insignificant?
Or should we conclude that prominent American economists are well socialized to avoid this subject at all costs? Take Herr Paul Krugman who spent a better part of the decade ranting against the invasion and occupation of Iraq but never once mentioned the on-going settlement of the occupied Palestinian territories. Are elite readers of Nobel-prize winning Herr Krugman that ignorant and misinformed or simply that partisan?
Professor,
Good analysis of the problem. I would not separate the housing crisis from the recession as you seem to do and the freezing of interbank lending was primarily because prices could not be determined because of the bundling of different qualities of loans.
This is a great: “The new Fed policies make sense for addressing the bank-run aspect of the crisis. But to the extent that the low market prices on these securities represent a rational assessment of their true value, the Fed may have simply absorbed some of these losses onto an account that ultimately will be paid by the taxpayers.”
I agree with others that you seem to be slightly naive assuming that the contraction is over. It sounds like statements written by economists in 1930.
Concerning your recommendations.
Essentially you suggest that investment banks be turned into regular banks so they can be regulated. I think that is what they did to receive TARP money.
While you recognized the role Fannie and Freddie played in creating the problem you totally ignore them in your recommended solution.
Your analysis, and even the analysis of others, does not show that there were any serious violations of government regulations. Most of the regulations you now propose are “fighting the last war.” What has to be understood is that investment banks grew as they did becasue they were no regulated. Money flowed out of the stagnant regulated institutions to the growing unregulated ones.
If regulations expand the money will just move beyond the expansion. If regulations are expanded such that there is no where to go outside the regulations the investors will simply not invest adding to the contraction.
Now I know that according to Keynesian theory government should step in to make up for the shortage of private investment, but most people clearly understand that the government is not able to invest profitably. With government there is no profit or loss so there are no signals to guide investment. It is totally a guess. The result is waste which actually compounds the contraction exactly as happened in the Great Depression.
The better solution would be almost the reverse of your suggestion. Remove regulations that force businesses to create methods on the fringe of what is legal. Remove wedges between traders, especially government wedges, and the economy will grow.
I like Volker’s recommendation that we go back to utility banking and separate risk investing so that risk investors know that they are risk investors, and have the appropriate expectations for risk/reward. In other words we need the separation and firewalls that we had with Glass Steagal.
The way things were, my half percent money market fund was funding investment bank 30:1 leverage and they would buy whatever with it. The only thing that changed is they are now all commercial banks, so leverage is now 12:1. But your savings account or CDs can still fund the oil and pork belly division.
The problem we have right now is we can’t even say the word “bank”, and know what we are talking about. I think first we need to separate “bank” from “hedge fund”, then we can get into the details of regulation.
Bernanke also mentioned in his confirmation hearing that 30% of the lending in the US is done thru securitization, and we need to restart that. I would give that an emphatic NO, not with the level of obfuscation/confiscation we got with the system. It is possible that many others feel the same way, and it does not restart.
Then there is FHA-Fannie-Freddie Inc. What a disaster. And General Chrysler.(employee buyouts coming) Have we mentioned health care, or is Krugman on top of that one? CNBC just mentioned that the health care sector was the best performer these last two months with a 30% gain for the sector. Odd way for the market to react to cost controls. (sarcasm)
Set information integrating/delay mechanisms in certain information channels where panic accumulation can lead to herd like behavior for too long time.
Example: China did not allow/spread widely information about imminent financial meltdown, so it did not happen there.
Dr. Hamilton-
Just a few opinions:
Whether or not the “worst of the recession of 2007-09 is now behind us”, depends on your point of view:
JDH, The article is a succinct recounting of a very selective view of events. If one read only this summary, one would never know that US financial institutions are regulated businesses, and that numerous severe regulatory failures occurred. These regulatory failures enabled and in some cases amplified the “purely economic” market forces that you selectively recount. Another blind spot in the summary is the omission of any mention that a minority of analysts in several fields warned of impending major problems and made public large amounts of data and analysis. The mantra among too many now is “Who could have known?”. Well, lots of people did, and no significant regulatory or political action was taken in advance. As someone else noted, you do not mention that no significant disciplinary action has been taken against the regulators and institutions who failed to act in advance. As an educator, it seems you should be recounting stories that set up the question – what have we learned?
A third major blind spot that I missed above, is that no mention is made of the fact that the Canadian financial system had no crisis. It is a similar economy with many links to the US, but has gone on a different trajectory, especially in its financial industry. Again, what important things have we learned?
For a more entertaining viewpoint on bank regulation and policy, I recommend the following comments by Stephen Colbert:
The Fed is Dead
I generally agree with your proposed regulations, especially stricter capital requirements and a seizure/rescue mechanism for non-banks. But I think the top priority is to address loose monetary policy, which is what really drives irresponsible, short-termist risk taking in the US financial system. A combination of strict regulations and loose monetary policy would be like leaving a big pile of sugar on your kitchen counter in mid-summer and then trying to solve your inevitable ant problem by standing over your counter and swatting each individual ant.
I understand why James made the recommendations he did, but I’ve been researching and studying what I call “EM08” (Economic Meltdown 2008) for a while now, and I don’t think his suggestions get to root causes.
For example, one of the main perpetrators in the cause of EM08 are the “Refs” – those charged with regulatory and/or oversight. A related problem is that there are tons of refs, from the alphabet soup of the CFTC, to the CRAs (more on them shortly) to the more standardly known Fed and Treasury, then to the (popularly unknown) analysts and fourth estate.
What’s startling about the fact that there are so many refs is THAT THEY ALL MISSED EM08, WHICH ABSOLUTELY ASSUREDLY WAS PREDICTABLE.
On to toxic mortgages; it’s wrong for James to single out homeowners. While I agree that purchasers must take responsibility, so too should sellers, and histgory’s ripe with producers manufacturing bad products and being caught, from asbestos to Bernie Madoff.
More to my point about causal roots, are one of the major refs, the CRAs. Think about it; the “complicated” and “exotic” financial packages that we now know were nothing more than ticking time bombs would NEVER have seen the light of day had the CRAs done their job and rated them the junk, or at the very best cautionary.
Instead, companies with huge name pedigrees like Standard & Poors and others less known to the public like Moody’s and Fitch, WERE IN ON THE FIX. By rat ing these time bomb products “AAA” – top-notch investment grade material – they set in motion the wheels for huge pools of money via the investment banks to go all in. That AIG came in and placed bad bets upon the already bad bets sealed our fate.
But make no mistake, the CRAs are key. Further, the CONFLICT OF INTEREST relationship they have with the Goldmans of the world are further troubling. WHY IS NO ONE POINTING THIS OUT???
By analogy, the refs being in on the fix is like Tim Donaghy, the NBA ref who was caught betting on NBA games. While Michael Vick of the NFL’s dogfighting and MLB’s roids scandal made consistent headlines, the most explosive story in pro sports quietly churned in the background. Why?
Some say the amount of money bet on pro sports is like comparing the derivatives gambling casino to stocks; it dwarfs it. I believe it; ever go to Vegas for a Super Bowl? It’s insane – EVERYTHING is monetized, from the coin flip to who will fumble first. Now with online betting, no one really knows how huge this market is.
THAT’s why it was kept quiet – because a scandal like Tim Donaghy rips away the illusion of “reality” in sports. But anyone who pays attention knows that fixing has been on since the BLack Sox scandal of the 20’s, on through to spitballs and then roids as early as the Munich Olympics!!! Donaghy, though, said he never fixed games he refereed and bet on; RIIIIIGHT.
Bottom line; the refs are key in EM08, and form a central part of my thesis. If you go to my blog, there’s more.
This is only a part of what I have been researching and codifying for prosperity in terms of EM08 – the greatest historical event of our time.
You mention that government policy was a major cause of the housing collapse:
“In the cases of Fannie and Freddie, the government created an asymmetric payoff structure in which the profits went to private investors while the losses were picked up by the taxpayers. Compensation schemes gave the individuals within the financial institutions that authorized unsound gambles a “heads I win, tails you lose” incentive structure that also favored excessive risk taking.”
But then you propose to have more legislation and more regulation to fix it? I’m pretty sure the problem was too much regulation and interference from Washington in the first place, not that there wasn’t enough regulation.
http://executivereactionary.squarespace.com/
Well today it was reported new home sales were down month on month.. but after a deluge of dollar positive data this last few weeks it begs the question is this signs of “what went wrong” starting to be fixed..
Personally I don’t think it’s over. Here in Europe there are concerns a few countries are just about hanging on by a thread..
and the Pound rate is falling against the dollar once again.. last time it got some downside momentum the bottom fell out ofthe UK markets.
What went wrong was that consumers and speculators got to monetize four trillion dollars or so of fairy-tale home equity.
This home equity was not structural paydown on existing wealth (the replacement value of fixed improvements or the ground rent based on zoning and area incomes) but purely driven by feedback loops in the real estate sector.
The way I see it, the 1998 capital gains change and 2001-2003 income tax cuts got more speculator money into the market (and the increased after-tax income was naturally drawn into bidding up home prices). Then the 2002-2003 interest rate cuts lowered the cost of money, increasing “affordability”, which again resulted in homebuyers bidding up home prices.
This became a virtuous cycle. A bubble inflating itself that attracted more investment as land valuations rose and rose.
But all this money chasing real estate do not disappear from the economy, far from it. It drove increased sales of durable goods, as consumers were able to borrow against HUNDREDS OF BILLIONS of fake home equity EVERY YEAR during the bubble.
Regulators at OTS, the Fed, etc. either from ideology or idiocy (but I repeat myself) decided to let the mortgage orgy continue laissez faire. Subprime borrowers were encouraged to buttress the lower end, pushing the seller to move up the housing ladder that drove the market like a nuclear reaction. Middle-class borrowers benefited from lower or no-down programs, and lenders not verifying incomes or assets, allowing borrowers to over-extend themselves, plus of course lenders were allowed to qualify borrowers on the front-end teaser rates not the back-end reset rates of ARMs. Upper middle class borrowers could take advantage of negative-am up to 115% to 120%.
The supply curve of housing is fixed in time, and demand is damn near infinite, given the profit potential and quality of life land ownership brings. Increasing the “affordability” of land results in buyers bidding up the price back to unaffordability.
When the music stops, as it has every 15 years or so, there is crash-bang-boom. This time was different, because our collective behavior was off the scale, more like the 1920s land booms or the 1980s land boom of Japan.
That’s what we did wrong. Cycle trillions of dollars through the housing sector, assuming ephemeral valuations were actual value.
As “dynamicsoul” mentioned: “…consumers were able to borrow against HUNDREDS OF BILLIONS of fake home equity EVERY YEAR during the bubble.”
This was caused by a false demand for housing, in that one person was purchasing two or more dwelling units believing that he would sell one at a greatly increased amount and pay off the other.
Then there is the appraiser who has no integrety often fed by the mortgage broker who is pushing the appraiser to arrive at an inflated value.
Since you can’t legislate ethical behavior, checks and balances must be placed into the system again.