The ongoing turmoil in the financial markets has diverted me from my usual tax academic pursuits, including this blog, for which I apologize. This post explores the causes of that turmoil. My next post will explore solutions currently under consideration, including aspects of the so-called “$700 billion bailout.”
The current financial crisis has many causes, some long-term and structural. I focus here, however, on three immediate aspects of the crisis: the trigger, how problems generated by that trigger spread through the markets, and how this produced the liquidity freeze that persuaded Mr. Paulson and Mr. Bush to act (unsuccessfully thus far).
Read it all. This is a pretty good basic analysis. It is missing some important pieces, especially the 1999 decision to expand Fannie Mae and Freddie Mac’s purview and the role that had in encouraging more risky mortgages. Also, I disagree with him about Lehman, he is way too kind– it was a big mistake by the Fed. More about credit default swaps would have helped too.
Anyway, you take a look and see what you think–KSH.
While there is a lot of good information in this article, there are many errors. It reflects the fact that few financial professionals have a real knowledge of the ground level mortgage market.
Yes, the 1% teaser rate ARMs are a growing problem. But the crisis was precipitated by subprime.
Lehman was a very active lender in both A/alt-A (Aurora) and subprime (BNC).
The CRA discussion omits many related laws and regulations, such as HMDA, which, contrary to the author’s assertions, did apply to all lenders, including subprime and did apply substantial pressure to lenders to make riskier loans.
The popularity of the teaser rate ARMs exploded when interest rates dropped to ridiculously low levels as as result of the overall drop in rates Greenspan and the Fed used to combat the dot-com meltdown.
Extremely superficial analysis designed to justify a government rather than a market-based solution.
And government as the “beast we starve?” You can tell which side this man’s bread is buttered. Americans work half the year to support their government.
TaxProf provides excellent analysis. He rightly emphasizes the role of debt chains and teaser mortgages, neither of which has received adequate public attention.
I would add, as background causes of the real-estate boom and the ensuing mortgage debacle, loose monetary policy and massive federal budget deficits. Low interest rates encouraged borrowing and inflated property values. They also prompted money-managers to incur additional risk so as to earn more-than-paltry returns. Federal budget deficits over the past 7 years have amounted to a massive national credit-card binge (spend now, pay later), much of which found its way into real estate.
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TaxProf rightly rejects right-wing blather about lenders being compelled to make unsound loans by the Community Reinvestment Act (CRA) and left-leaning regulation. As I have pointed out on other threads:
— Bank examiners, who are robustly nonpolitical, scrutinize CRA-eligible loans just as they scrutinize other loans. CRA loans have, moreover, been profitable.
— The political-pressure theory is baseless. Most mortgages originated from 1993 through 2000 have already been fully repaid. So even if you believed that the Clinton Administration pressured banks to make unsound (which it did not), the fact remains that the mortgage debacle centers on loans originated from 2002 through 2006. Do you really believe lenders were pressured to make bad loans by the Bush Administration or by the Republicans who held most major governorships before 2007? I see no evidence of that. Lenders lowered credit standards in an effort to maximize their profits.
— Investors, although not subject to political pressure, willingly bought securities backed by subprime mortgages. They did so in the expectation of profit.
— The worst loans were originated by the least-regulated firms.
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Bill Matz [#1] asserts that the Home Mortgage Disclosure Act (HMDA) resulted in intense political pressure on the least-regulated lenders. The HMDA is a disclosure statute. Bill fails to explain how it could create intense pressure on lightly regulated firms.
The very worst lenders tended to engage in predatory practices (e.g., misleading borrowers about loan terms or the ease of refinancing teaser mortgages; or high-fee refinancing that left borrowers worse off than before). These firms were hardly worried about their reputations.
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The fundamental problems of Fannie Mae were minimal capital (e.g., $1 in shareholders equity for every $40 of borrowed money), minimal market discipline, a hamstrung regulator, and (until too late) no mechanism for dealing with the two firms if they did fail. Both firms entered the subprime market with gusto, in an effort to increase their market share and maximize their profits.
Irenaeus,
The fundamental problem is one of moral hazard, caused by government’s loose monetary policy and implicit (now explicit) guarantee from the taxpayer. Remove the moral hazard and the problem never gets this big. Of course, this means removing government which is why tenured academics tend to talk about things like financial practices instead and recoil in horror from the very idea that maybe minimally educated people with fungible skills shouldn’t be getting $300K mortgages, or even buying a home at all.
There are numerous articles dating back to the late 1990’s on the intense push to democratize home loans. This reached its apogee in California, where hotel maids were given mortgages in the mid six figures. Now, when Maria the housekeeper gets this kind of deal, Fred the insurance salesman wants the same one, only for the high six figures, and a dozen mortgage brokerages will sprout up to give it to him. And so loans across the board inch up and the death spiral begins. One cannot say CRA had everything to do with it, but it is equally absurd to say it had nothing to do with it.
[i]Bill Matz [#1] asserts that the Home Mortgage Disclosure Act (HMDA) resulted in intense political pressure on the least-regulated lenders. The HMDA is a disclosure statute. Bill fails to explain how it could create intense pressure on lightly regulated firms.[/i]
How about if I insist that you publish the percentage and amounts of business transactions you have with ethnic minorities? And wouldn’t that make a neat discovery tool in litigation with the Justice Department if I determine your level of minority involvement isn’t up to par?
Exactly, Byzantine. It is the climate created by bending the rules that leads to the snowball effect. The fundamental problem with Irenaeus’ methodology is that he take outcomes with multi-factor causation, looks only at one factor and concludes it does or doesn’t cause the outcome. E.g. Note that above I never claimed that CRA or HMDA (or any others) BY THEMSELVES caused the pressure. Rather, among many other factors they contributed to the climate of lowered standards. I have personally witnessed the lenders’ response to these pressures over the last 15 years.
Similarly, Irenaeus touts loan performance 1993-2000. But as I have pointed out, that was a period of rapid real estate appreciation that made all loan performance look good. Indeed, that very performance helped spur even more aggressive lending, with everyone seemingly forgetting that real estate has cycles.
Finally, if Tax Prof did not even know that Lehman had multiple mortgage companies (as I pointed out in #1) exactly how weight should we give his comments about the mortgage industry?
The underlying problem here is that these are complex problems that often have multiple, interrelated causes, but the public wants simple answers. We must resist the temptation to oversimplify.
How we **Really**got into this mess:
http://www.thislife.org/Radio_Episode.aspx?sched=1242
It takes about an hour, so get a mug of your favorite beverage before you start listening.
Byzantine [#4]: I agree that moral hazard is a fundamental problem. But I’d like to understand more clearly what you mean by “moral hazard” in this context. Deposit insurance creates moral hazard, as does the expectation of a government bailout. (Thus the market perception of Fannie and Freddie as “the government in disguise” largely shielded those firms from market discipline.)
But that sort of government-created moral hazard does not explain the behavior of mortgage brokers, nonbank mortgage companies, Wall Street securitizers, and the investors who purchased mortgage-backed securities that had no Fannie, Freddie, or government guarantee.
To encompass that behavior, you’d have to use the broadest economic definition of “moral hazard” (i.e., the extent to which your behavior changes when you don’t bear the full costs and enjoy the full benefits of your conduct). This definition is so broad that it encompasses pollution, employee slacking, and many other forms of economic inefficiency.
“How about if I insist that you publish the percentage and amounts of business transactions you have with ethnic minorities?”
—Byzantine [#5]
That’s hardly the same as coercing you to make bad loans. Business executives deal all the time with demands from civil-rights and other liberal groups. Sometimes executives say yes; more often they say no. You’d be hard-put to show across-the-board wilting at the prospect of criticism.
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“This reached its apogee in California, where hotel maids were given mortgages in the mid six figures. Now, when Maria the housekeeper gets this kind of deal, Fred the insurance salesman wants the same one, only for the high six figures, and a dozen MORTGAGE BROKERAGES will sprout up to give it to him” —Byzantine [#4]
That’s right: mortgage brokers, to which the Community Reinvestment Act does not apply.
“Irenaeus touts loan performance 1993-2000” —Bill Matz [#6]
I point out that loans originated during this period have largely been repaid. I do this as part of a larger argument that the current mortgage debacle did not result from political pressure to make bad loans [#3]. The mortgage debacle centers on loans originated from 2002 through 2006, when Bush occupied the White House and Republicans held most of the major governorships. You have adduced no evidence that these officials or their appointees pressured lenders to make bad loans. Nor did they (to my knowledge). Lenders made their own, profit-motivated lending decisions.
Listening to current talk about the Community Reinvestment Act (CRA), you might expect it to be the regulatory equivalent of a saber-tooth tiger.
Not so. The CRA contains essentially two rules, both of them squishy and process-oriented.
First, regulators must periodically “assess the institution’s record of meeting the credit needs of its entire community, including low- and moderate-income neighborhoods, consistent with the safe and sound operation of such institution.†12 U.S. Code § 2903(a)(1). This evaluation occurs annually for large banks and every for or five years for small banks.
Second, regulators must take account of that record—along with all other relevant factors—if the bank seeks certain kinds of regulatory approval: e.g., to acquire another bank or to establish a branch. §§ 2902(3), 2903(a)(2). Even when a bank has a problematic CRA record, the other factors usually prevail. On only a few occasions, during the entire 31-year history of the CRA, have regulators denied an application on CRA grounds.
Under a separate law, banks need to have a satisfactory CRA record in order for their corporate family to include an insurance company an investment bank. § 1841(l). Only the largest banks have those kinds of affiliates.
Federal bank regulators have a potent arsenal of enforcement tools (e.g., administrative orders and civil fines) to enforce most banking laws—but not the CRA. It can be enforced only in the very limited ways described above.