Understanding the Financial Crisis, Part 4

“The right blames the credit crisis on poor minority homeowners. This is not merely offensive, but entirely wrong.”… “Lending money to poor people doesn’t make you poor. Lending money poorly to rich people does.” – Daniel Gross.

In previous posts, I covered the causes of the Financial Crisis: poor mortgage lending standards, excessive risk taking by investment banks, and inadequate transparency and regulation. Not discussed in any detail is the role of government policy in causing the financial meltdown.

According to Daniel Gross writing on the web site Slate, the right wing claims the cause of the current problems is government intervention, i.e. “well meaning” social programs that encouraged home ownership by poor and middle class consumers. Gross strenuously objects to this conclusion.

Since fixing any problem necessitates truly understanding the causes of the problem, I am posting the entire article Subprime Suspects published October 7, 2008. (The original post contains links to various referenced articles.)

We’ve now entered a new stage of the financial crisis: the ritual assigning of blame. It began in earnest with Monday’s congressional roasting of Lehman Bros. CEO Richard Fuld and continued on Tuesday with Capitol Hill solons delving into the failure of AIG. On the Republican side of Congress, in the right-wing financial media (which is to say the financial media), and in certain parts of the op-ed-o-sphere, there’s a consensus emerging that the whole mess should be laid at the feet of Fannie Mae and Freddie Mac, the failed mortgage giants, and the Community Reinvestment Act, a law passed during the Carter administration. The CRA, which was amended in the 1990s and this decade, requires banks—which had a long, distinguished history of not making loans to minorities—to make more efforts to do so.

The thesis is laid out almost daily on the Wall Street Journal editorial page, in the National Review, and on the campaign trail. John McCain said yesterday, “Bad mortgages were being backed by Fannie Mae and Freddie Mac, and it was only a matter of time before a contagion of unsustainable debt began to spread.” Washington Post columnist Charles Krauthammer provides an excellent example, writing that “much of this crisis was brought upon us by the good intentions of good people.” He continues: “For decades, starting with Jimmy Carter’s Community Reinvestment Act of 1977, there has been bipartisan agreement to use government power to expand homeownership to people who had been shut out for economic reasons or, sometimes, because of racial and ethnic discrimination. What could be a more worthy cause? But it led to tremendous pressure on Fannie Mae and Freddie Mac—which in turn pressured banks and other lenders—to extend mortgages to people who were borrowing over their heads. That’s called subprime lending. It lies at the root of our current calamity.” The subtext: If only Congress didn’t force banks to lend money to poor minorities, the Dow would be well on its way to 36,000. Or, as Fox Business Channel’s Neil Cavuto put it, “I don’t remember a clarion call that said: Fannie and Freddie are a disaster. Loaning to minorities and risky folks is a disaster.”

Let me get this straight. Investment banks and insurance companies run by centimillionaires blow up, and it’s the fault of Jimmy Carter, Bill Clinton, and poor minorities?

These arguments are generally made by people who read the editorial page of the Wall Street Journal and ignore the rest of the paper—economic know-nothings whose opinions are informed mostly by ideology and, occasionally, by prejudice. Let’s be honest. Fannie and Freddie, which didn’t make subprime loans but did buy subprime loans made by others, were part of the problem. Poor Congressional oversight was part of the problem. Banks that sought to meet CRA requirements by indiscriminately doling out loans to minorities may have been part of the problem. But none of these issues is the cause of the problem. Not by a long shot. From the beginning, subprime has been a symptom, not a cause. And the notion that the Community Reinvestment Act is somehow responsible for poor lending decisions is absurd.

Here’s why.

The Community Reinvestment Act applies to depository banks. But many of the institutions that spurred the massive growth of the subprime market weren’t regulated banks. They were outfits such as Argent and American Home Mortgage, which were generally not regulated by the Federal Reserve or other entities that monitored compliance with CRA. These institutions worked hand in glove with Bear Stearns and Lehman Brothers, entities to which the CRA likewise didn’t apply. There’s much more. As Barry Ritholtz notes in this fine rant, the CRA didn’t force mortgage companies to offer loans for no money down, or to throw underwriting standards out the window, or to encourage mortgage brokers to aggressively seek out new markets. Nor did the CRA force the credit-rating agencies to slap high-grade ratings on packages of subprime debt.

Second, many of the biggest flameouts in real estate have had nothing to do with subprime lending. WCI Communities, builder of highly amenitized condos in Florida (no subprime purchasers welcome there), filed for bankruptcy in August. Very few of the tens of thousands of now-surplus condominiums in Miami were conceived to be marketed to subprime borrowers, or minorities—unless you count rich Venezuelans and Colombians as minorities. The multiyear plague that has been documented in brilliant detail at IrvineHousingBlog is playing out in one of the least-subprime housing markets in the nation.

Third, lending money to poor people and minorities isn’t inherently risky. There’s plenty of evidence that in fact it’s not that risky at all. That’s what we’ve learned from several decades of microlending programs, at home and abroad, with their very high repayment rates. And as the New York Times recently reported, Nehemiah Homes, a long-running initiative to build homes and sell them to the working poor in subprime areas of New York’s outer boroughs, has a repayment rate that lenders in Greenwich, Conn., would envy. In 27 years, there have been fewer than 10 defaults on the project’s 3,900 homes. That’s a rate of 0.25 percent.

On the other hand, lending money recklessly to obscenely rich white guys, such as Richard Fuld of Lehman Bros. or Jimmy Cayne of Bear Stearns, can be really risky. In fact, it’s even more risky, since they have a lot more borrowing capacity. And here, again, it’s difficult to imagine how Jimmy Carter could be responsible for the supremely poor decision-making seen in the financial system. I await the Krauthammer column in which he points out the specific provision of the Community Reinvestment Act that forced Bear Stearns to run with an absurd leverage ratio of 33 to 1, which instructed Bear Stearns hedge-fund managers to blow up hundreds of millions of their clients’ money, and that required its septuagenarian CEO to play bridge while his company ran into trouble. Perhaps Neil Cavuto knows which CRA clause required Lehman Bros. to borrow hundreds of billions of dollars in short-term debt in the capital markets and then buy tens of billions of dollars of commercial real estate at the top of the market. I can’t find it. Did AIG plunge into the credit-default-swaps business with abandon because Association of Community Organizations for Reform Now members picketed its offices? Please. How about the hundreds of billions of dollars of leveraged loans—loans banks committed to private-equity firms that wanted to conduct leveraged buyouts of retailers, restaurant companies, and industrial firms? Many of those are going bad now, too. Is that Bill Clinton’s fault?

Look: There was a culture of stupid, reckless lending, of which Fannie Mae and Freddie Mac and the subprime lenders were an integral part. But the dumb-lending virus originated in Greenwich, Conn., midtown Manhattan, and Southern California, not Eastchester, Brownsville, and Washington, D.C. Investment banks created a demand for subprime loans because they saw it as a new asset class that they could dominate. They made subprime loans for the same reason they made other loans: They could get paid for making the loans, for turning them into securities, and for trading them—frequently using borrowed capital.

At Monday’s hearing, Rep. John Mica, R-Fla., gamely tried to pin Lehman’s demise on Fannie and Freddie. After comparing Lehman’s small political contributions with Fannie and Freddie’s much larger ones, Mica asked Fuld what role Fannie and Freddie’s failure played in Lehman’s demise. Fuld’s response: “De minimis.”

Lending money to poor people doesn’t make you poor. Lending money poorly to rich people does.

Stabilize House Prices, Part 1

“We are in a vicious cycle: falling housing values cause losses on securities, which reduce bank capital, thereby tightening lending and causing house prices to fall further. The cycle has spread beyond housing, but housing is the place to fix it.” – R. Glenn Hubbard and Chris Mayer.

I find it very interesting that conservative economists, who have been and are, in general, against government regulation and interference, and who believe that government should allow a free market system to be free, are coming up with ideas to save us from the financial crisis. That these plans include and revolve around the U.S. government, and ultimately the tax payer, in a very big way can be construed as an indication of the economists’ new-found flexibility or an indication of how bad the financial crisis really is.  Or it may be the recognition that the U.S. government is already so heavily involved in the financial system that these economists are seeking to do the least amount of harm.

First, Let’s Stabilize Home Prices by R. Glenn Hubbard and Chris Mayer, which appeared in the October 2nd issue of The Wall Street Journal, is a good example.

Millions of homeowners owe more on their mortgage than their house is worth. Foreclosures are accelerating. House prices continue to fall, weakening household balance sheets and the balance sheets of financial institutions.

But this can stop. The price of a home is partially dependent on the mortgage rate — a lower mortgage rate raises house prices.

We propose that the Bush administration and Congress allow all residential mortgages on primary residences to be refinanced into 30-year fixed-rate mortgages at 5.25% (matching the lowest mortgage rate in the past 30 years), and place those mortgages with Fannie Mae and Freddie Mac. Investors and speculators should not be allowed to qualify.

While the net cost is modest compared with many plans on the table, it would require that the government could assume trillions of dollars of additional mortgages on its balance sheet. But we have already crossed this bridge with the explicit “conservatorship” of Fannie Mae and Freddie Mac. In any event, these mortgages would be backed by houses and the verified ability to repay the debt by millions of Americans. In addition, by putting a floor under house prices, this proposal would raise the value to taxpayers of trillions of existing home mortgage assets already owned or guaranteed by the FDIC, the Fed, the Treasury, Fannie Mae and Freddie Mac, among others.

In addition to focusing on the very real problem in the housing market, the plan could be implemented immediately. As a result of the U.S. government’s conservatorship of Fannie Mae and Freddie Mac, origination of new mortgages can be financed quickly. Congress would have to raise the overall borrowing limit and approve the new federal purchases of negative equity loans. But it will likely take the Treasury much longer to buy troubled assets than Fannie and Freddie, and it would have to seek the involvement of many additional private actors, as opposed to using vehicles already in place.

To be continued …

“Mr. Hubbard, dean of Columbia Business School, was chairman of the Council of Economic Advisers under President George W. Bush. Mr. Mayer is a professor of finance and economics and senior vice dean of Columbia Business School.”

photo credit: TheTruthAbout…

The Fannie Mae & Freddie Mac Takeover

“Fannie Mae and Freddie Mac are so large and so interwoven in our financial system that a failure of either of them would cause great turmoil in our financial markets here at home and around the globe.” – Treasury Secretary Henry Paulson, Jr.    

Last night’s Charlie Rose TV show had a panel discussion of the Federal Government’s takeover of U.S. mortgage giants, Fannie Mae and Freddie Mac. The panel included Nouriel Roubini of New York University, Mohamed El-Erian, co-CEO of PIMCO and Gretchen Morgenson and Floyd Norris, both of The New York Times. (I faithfully record the Charlie Rose show every night, knowing that, most of the time, he will have an enlightening, or at least interesting, program. Tonight, he will have Thomas Friedman, who will discuss his new book.)

Nouriel Roubini was, as expected, the most pessimistic about the future direction of the economy. He has been called, among other things, “Dr. Doom,” but the truth is that he has been prescient about the various crises we have seen. It is his belief that, because the government “subsidized” home ownership, we invested too much in housing, instead of more productive assets.

Things are so bad, Roubini said that “we have a subprime financial system, not a subprime mortgage market.” This has led to a systemic banking crisis.

Roubini listed various simultaneous shocks to the U.S. economy:

• Consumers are “shopped” out
• Housing prices are falling and will continue to fall
• Stock prices have fallen
• Consumers are facing a large debt burden
• Banks are less willing to lend
• Consumers are dealing with rising oil and food prices

Roubini thinks that this is an unusual, if not unprecedented, confluence of events, as bad as we have seen since the Great Depression. He believes that the U.S. recession will get much worse and will last for 12 to 18 months, and that there is the strong possibility of a global recession and a “vicious circle.” He does not go so far, though, as to predict another Great Depression.

And to top things off, he commented that “Superpowers” should not be net debtors. Observing the huge and still growing U.S. deficit, Roubini said this could be indicative of the beginning of the decline of the “American Empire.” Whew! Heavy stuff.

Mohamed El-Erian’s analysis was somber, but not nearly as scary. He believes that the credit crunch had “morphed” into an economic crisis, which is in desperate need of crisis management. He sees the takeover of Fannie Mae and Freddie Mac as necessary, and as a bold attempt to change the “regime.” (Paradigm?) He believes that, in the next two years, the government will go from crisis management to an evaluation of the situation and, finally, to crisis prevention. He believes that a major reform effort will be required by 2010.

Speaking of reform, Gretchen Morgenson expressed her extreme disappointment at the failure of policy makers and regulators to address the problem earlier. Whether it was the SEC, the Federal Reserve Board, the U.S. Treasury or the bank regulators, she feels that there was a wholesale failure to recognize the problem. “Denial, upon denial, upon denial that there was a problem,” was how she described it. As a result, she sees a lack of credibility in the administration.

Morgenson commented that there was enough blame to go around, meaning banks, mortgage brokers, and consumers, in addition to the government, were at fault.

El-Erian “defended (!)” the regulators by saying that they knew that there was a problem, but they just didn’t know what the solution was, and they didn’t want to make things worse.

Somehow, this does not make me feel more confident.

Norris said that the takeover was necessary, to prevent the crisis from getting worse. He agreed with Roubini that the danger is a “negative loop,” where things just keep getting worse. He feels that we must do a much better job of regulation, especially in the “alternative financial system,” that has largely been unregulated. Norris was the only one to mention the fact that former Federal Reserve Bank Chairman, Alan Greenspan, was strongly against regulating financial markets, because he did not want to stifle innovation.

Norris highlighted the failure of top management of banks, who did not control risk. They may have thought they were making tons of money, but they weren’t, because they relied too heavily on models for reassurance that they were not taking on too much risk.

My interpretation is that they just did not think that we could have a nation-wide decline in housing prices. Bank management thought that the packaging of risky loans reduced the overall risk, through diversification. But, this could not be true if the underlying loans were extremely dicey, and in some instances, simply fraudulent. Everyone assumed that housing prices could go in only one direction – up — or if prices declined, it would be mild and temporary.

Take Home Message

One fear is that, if people are “underwater” or “upside down” with regard to their home mortgage (that is, their house is worth less than the outstanding balance of the mortgage) they will just walk away, leaving the bank to deal with a foreclosure and possibly a forced sale of the house. This is what the government is trying to avoid, or at least diminish the likelihood of it. It will not be an easy problem to solve. Roubini made the startling prediction that, of the people who have mortgages on their homes (and not everyone does, by the way), 40% will be “underwater.”

On the plus side, these recent actions by the Federal Government seem to have strengthened the confidence of foreign investors in the U.S. markets. El-Erian says that international investors view the U.S. markets favorably, because we have the deepest market in terms of liquidity, and we adhere to the rule of law. People living in the United States may take this for granted, but it is something to consider.

I would add that our dynamic, entrepreneurial “can-do” spirit is a huge advantage globally, so I am not quite ready to count the U.S. out, yet. We do have serious problems to address but, though long overdue, the Federal Government,seems, at last, to be on the case.

Postscript

For a fascinating portrait of Roubini, see this New York Times article.  In September of 2006, he was extremely pessimistic about the banking system, housing prices and the economy, and was mocked for his predictions. However, his critics dismiss his correct call because they point out that he was pessimistic about the economy back in 2004, as well. Read the article and judge for yourself whether it was “the broken clock being right twice a day” syndrome.