Greed and Stupidity

Last week, I had lunch with an old friend who told me that he was very upset because he had lost so much money on his investments. He said that he was of two minds about the people who caused his pain. On the one hand, he wanted to forgive them, but on the other hand, he wanted to get even. Both, perfectly natural feelings. Of course, the problem with the revenge approach is the he did not know exactly whom to blame. Like many people, he really didn’t understand how we got into this economic mess in the first place.

Well, as previous posts have discussed, it’s a complicated tale in that there are a lot of culprits and more than enough blame to go around, including lax government regulation, unscrupulous mortgage brokers and mortgage lenders, overoptimistic rating agencies and everyone who thought real estate prices could only go up. But focusing on the banking system tells a large part of the story.

Recently, David Brooks wrote a column, Greed and Stupidity, which references some very good articles and contrasts the two theories of why and how bankers screwed up. Here are some relevant quotes regarding the two explanations – greed and stupidity.

What happened to the global economy? We seemed to be chugging along, enjoying moderate business cycles and unprecedented global growth. All of a sudden, all hell broke loose.

There are many theories about what happened, but two general narratives seem to be gaining prominence, which we will call the greed narrative and the stupidity narrative. The two overlap, but they lead to different ways of thinking about where we go from here.

The best single encapsulation of the greed narrative is an essay called “The Quiet Coup,” by Simon Johnson in The Atlantic.

Johnson begins with a trend. Between 1973 and 1985, the U.S. financial sector accounted for about 16 percent of domestic corporate profits. In the 1990s, it ranged from 21 percent to 30 percent. This decade, it soared to 41 percent.

In other words, Wall Street got huge. As it got huge, its prestige grew. Its compensation packages grew. Its political power grew as well. Wall Street and Washington merged as a flow of investment bankers went down to the White House and the Treasury Department.

The result was a string of legislation designed to further enhance the freedom and power of finance. Regulations separating commercial and investment banking were repealed. There were major increases in the amount of leverage allowed to investment banks.

The second and, to me, more persuasive theory revolves around ignorance and uncertainty. The primary problem is not the greed of a giant oligarchy. It’s that overconfident bankers didn’t know what they were doing.

Many writers have described elements of this intellectual hubris. Amar Bhidé has described the fallacy of diversification. Bankers thought that if they bundled slices of many assets into giant packages then they didn’t have to perform due diligence on each one.

Benoit Mandelbrot and Nassim Taleb have explained why extreme events are much more likely to disrupt financial markets than most bankers understood.

To me, the most interesting factor is the way instant communications lead to unconscious conformity. …Global communications seem to have led people in the financial subculture to adopt homogenous viewpoints. They made the same one-way bets at the same time.

Jerry Z. Muller wrote an indispensable version of the stupidity narrative in an essay called “Our Epistemological Depression” in The American magazine. … Banks got too big to manage. Instruments got too complex to understand. Too many people were good at math but ignorant of history.

The Remedies

The greed narrative leads to the conclusion that government should aggressively restructure the financial sector. The stupidity narrative is suspicious of that sort of radicalism. We’d just be trading the hubris of Wall Street for the hubris of Washington. The stupidity narrative suggests we should preserve the essential market structures, but make them more transparent, straightforward and comprehensible. Instead of rushing off to nationalize the banks, we should nurture and recapitalize what’s left of functioning markets.

Both schools agree on one thing, however. Both believe that banks are too big. Both narratives suggest we should return to the day when banks were focused institutions — when savings banks, insurance companies, brokerages and investment banks lived separate lives.

We can agree on that reform. Still, one has to choose a guiding theory. To my mind, we didn’t get into this crisis because inbred oligarchs grabbed power. We got into it because arrogant traders around the world were playing a high-stakes game they didn’t understand.

Conclusion

I agree with Brooks’ belief that the main cause of our economic meltdown was stupidity – not understanding the real risks in using “outsized” leverage to buy risky assets. On the other hand, investment bank managers were receiving “outsized” bonuses based on short-term results, and the long term risks and ramifications was someone else’s problem.

Who says we have to choose between greed and stupidity?

Financial Crisis for Beginners

I recently had dinner with my cousin who said, “I don’t understand how the economy was fine for so many years and now it isn’t fine. How did this happen? I don’t understand.”

Well, this is much too complicated a subject to discuss over just dinner, but I would imagine that many people feel the same way and are asking the same question as my cousin. “Why?”

Besides this blog, which has quite a few posts on this topic, I recommend checking out The Baseline Scenario, a web site whose tagline is “What happened to the global economy and what we can do about it.”
The founder of The Baseline Scenario is Simon Johnson, 46, currently a professor at the Massachusetts Institute of Technology’s Sloan School of Management. Previously, he was chief economist of the International Monetary Fund. Peter Boone and James Kwak also contribute to the site’s articles and posts.

Johnson is interviewed and quoted frequently, both in the mainstream media and on the internet. He has published many, many opinion pieces and articles on the global economic situation and possible solutions. He also writes for the New Republic and has been interviewed on NPR radio and the Charlie Rose program. Whew! It’s exhausting just following him around on the Internet!

In my opinion, The Baseline Scenario web site is so much more than just a simple blog. Rather, it’s a free online lesson on macro, monetary, and global economics.

The section, Financial Crisis for Beginners, quite effectively lessens the confusion. It covers pretty much everything, from old-fashioned bank runs to new-fangled credit default swaps. There are also very informative and helpful articles such as The Federal Reserve for Beginners and Interest Rates for Beginners. You’ll also find links to a thought-provoking article and radio interview, National Debt For Beginners.

Worth noting is the Japan’s Lost Decade article. While many economists, analysts and financial writers compare our current economic situation to the Great Depression, The Baseline Scenario suggests that “in many ways, a more relevant comparison may be the Japanese ‘lost decade’ of the 1990s, when the collapse of a bubble in real estate and stock prices led to over a decade of deflation and slow growth.”

It’s quite amazing that a single web site, and one ubiquitous observer, can have such an impact on the national debate. I highly recommend that you follow the articles and posts at The Baseline Scenario.

P.S. This is my 100th post. For some reason, this is supposed to be significant.

Lessons Learned from the Housing Bubble, Part 2

In my previous post, I started with Henry Blodget’s belief that we are all to be blamed for the housing boom and bust.

It was purely greed, or to put it more kindly, as we shall read – self interest.

Here’s where we left off:

How on Earth did we get into this mess?

The exact answer is different in every case, of course. But let’s round up the usual suspects:

• The predatory mortgage broker? Well, we’re certainly not happy with the bastard, given that he sold us a loan that is now a ticking time bomb. But we did ask him to show us a range of options, and he didn’t make us pick this one. We picked it because it had the lowest payment.

• Our sleazy real-estate agent? We’re not speaking to her anymore, either (and we’re secretly stoked that her BMW just got repossessed), but again, she didn’t lie to us. She just kept saying that houses are usually a good investment. And she is, after all, a saleswoman; that was never very hard to figure out.

• Wall Street fat cats? Boy, do we hate those guys, especially now that our tax dollars are bailing them out. But we didn’t complain when our lender asked for such a small down payment without bothering to check how much money we made. At the time, we thought that was pretty great.

• The SEC? We’re furious that our government let this happen to us, and we’re sure someone is to blame. We’re not really sure who that someone is, though. Whoever is responsible for making sure that something like this never happens to us, we guess.

• Alan “The Maestro” Greenspan? We’re pissed at him too. If he hadn’t been out there saying everything was fine, we might have believed that economist who said it wasn’t.

• Bad advice? Hell, yes, we got bad advice. Our real-estate agent. That mortgage guy. Our neighbor. Greenspan. The media. They all gave us horrendous advice. We should have just waited for the market to crash. But everyone said it was different this time.

Still, except in cases involving outright fraud—a small minority—the buck stops with us. Not knowing that the market would crash isn’t an excuse. No one knew the market would crash, even the analysts who predicted that it would. (Just as important, no one knew when prices would go down, or how fast.) And for years, most of the skeptics looked—and felt—like fools.

Everyone else on that list above bears some responsibility too. But in the case I have described, it would be hard to say that any of them acted criminally. Or irrationally. Or even irresponsibly. In fact, almost everyone on that list acted just the way you would expect them to act under the circumstances.

The most expensive words in the English language, by the way: it’s different this time. You can’t have a bubble without good explanations for why it’s different this time. If everyone knew that this time wasn’t different, the market would stop going up. But the future is always uncertain—and amid uncertainty, all sorts of faith-based theories can flourish, even on Wall Street.

In the tech bubble of the 1990s, the differences were low interest rates, low inflation, a government budget surplus, the Internet revolution, and a Federal Reserve chairman apparently so divinely talented that he had made the business cycle obsolete. In the housing bubble, they were low interest rates, population growth, new mortgage products, a new ownership society, and, of course, the fact that “they aren’t making any more land.”

In hindsight, it’s obvious that all these differences were bogus (they’ve never made any more land—except in Dubai, which now has its own problems). At the time, however, with prices going up every day, things sure seemed different.

In fairness to the thousands of experts who’ve snookered themselves throughout the years, a complicating factor is always at work: the ever-present possibility that it really might have been different. Everything is obvious only after the crash.

Which brings us to the last major contributor to booms and busts: self-interest.

When people look back on bubbles, many conclude that the participants must have gone stark raving mad. In most cases, nothing could be further from the truth.

In my example from the housing boom, for instance, each participant’s job was not to predict what the housing market would do but to accomplish a more concrete aim. The buyer wanted to buy a house; the real-estate agent wanted to earn a commission; the mortgage broker wanted to sell a loan; Wall Street wanted to buy loans so it could package and resell them as “mortgage-backed securities”; Alan Greenspan wanted to keep American prosperity alive; members of Congress wanted to get reelected. None of these participants, it is important to note, was paid to predict the likely future movements of the housing market. In every case (except, perhaps, the buyer’s), that was, at best, a minor concern.

Conclusion

When everyone is under the (mis)conception that housing prices can move in only one direction, namely up, it’s not unexpected that people react in a way that seems perfectly rational. Of course, it is only later that we see the folly of that reaction.  Indeed, the most expensive words in the English language are “it’s different this time.”

Next up: How Wall Street was swept along in the “bubble” mentality and how incentives shaped the behavior of its executives.

photo credit: laurgasms

Lessons Learned from the Housing Bubble, Part 1

“We got greedy; we went nuts; we heard what we wanted to hear.” – Henry Blodget.

In the December issue of The Atlantic, Why Wall Street Always Blows It  by Henry Blodget provides a thought provoking view on what went wrong with the housing market. Blodget has two simple arguments to underscore what went wrong: (1) We are all to be blamed, and (2) Wall Street had powerful incentives which compelled it to keep playing musical chairs until the music eventually stopped.

How are we all to blame? According to Blodget, in a word: Greed.

Here’s what Blodget has to say on that point.

Well, we did it again. Only eight years after the last big financial boom ended in disaster, we’re now in the migraine hangover of an even bigger one—a global housing and debt bubble whose bursting has wiped out tens of trillions of dollars of wealth and brought the world to the edge of a second Great Depression.

Millions have lost their houses. Millions more have lost their retirement savings. Tens of millions have had their portfolios smashed. And the carnage in the “real economy” has only just begun.

What the hell happened? After decades of increasing financial sophistication, weren’t we supposed to be done with these things? Weren’t we supposed to know better?

Yes, of course. Every time this happens, we think it will be the last time. But it never will be.

I experienced the (housing) bubble differently—as a journalist and homeowner. Having already learned the most obvious lesson about bubbles, which is that you don’t want to get out too late, I now discovered something nearly as obvious: you don’t want to get out too early. Figuring that the roaring housing market was just another tech-stock bubble in the making, I rushed to sell my house in 2003—only to watch its price nearly double over the next three years. I also predicted the demise of the Manhattan real-estate market on the cover of New York magazine in 2005. Prices are finally falling now, in 2008, but they’re still well above where they were then.

Live through enough bubbles, though, and you do eventually learn something of value. For example, I’ve learned that although getting out too early hurts, it hurts less than getting out too late. More important, I’ve learned that most of the common wisdom about financial bubbles is wrong.

Who’s to blame for the current crisis? As usually happens after a crash, the search for scapegoats has been intense, and many contenders have emerged: Wall Street swindled us; predatory lenders sold us loans we couldn’t afford; the Securities and Exchange Commission fell asleep at the switch; Alan Greenspan kept interest rates low for too long; short-sellers spread negative rumors; “experts” gave us bad advice. More-introspective folks will add other explanations: we got greedy; we went nuts; we heard what we wanted to hear.

All of these explanations have some truth to them. Predatory lenders did bamboozle some people into loans and houses they couldn’t afford. The SEC and other regulators did miss opportunities to curb some of the more egregious behavior. Alan Greenspan did keep interest rates too low for too long (and if you’re looking for the single biggest cause of the housing bubble, this is it). Some short-sellers did spread negative rumors. And, Lord knows, many of us got greedy, checked our brains at the door, and heard what we wanted to hear.

But most bubbles are the product of more than just bad faith, or incompetence, or rank stupidity; the interaction of human psychology with a market economy practically ensures that they will form. In this sense, bubbles are perfectly rational—or at least they’re a rational and unavoidable by-product of capitalism (which, as Winston Churchill might have said, is the worst economic system on the planet except for all the others). Technology and circumstances change, but the human animal doesn’t. And markets are ultimately about people.

House prices, we are told by our helpful neighborhood real-estate agent, almost never go down. This sounds right, and they certainly didn’t go down in the stock-market crash. In fact, for as long as we can remember—about 10 years, in most cases—house prices haven’t gone down. (Wait, maybe there was a slight dip, after the 1987 stock-market crash, but looming larger in our memories is what’s happened since; everyone we know who’s bought a house since the early 1990s has made gobs of money.)

We consider following our agent’s advice, but then we decide against it. House prices have doubled since the mid-1990s; we’re not going to get burned again by buying at the top. So we decide to just stay in our rent-stabilized rabbit warren and wait for house prices to collapse.

Unfortunately, they don’t. A year later, they’ve risen at least another 10 percent. By 2006, we’re walking past neighborhood houses that we could have bought for about half as much four years ago; we wave to happy new neighbors who are already deep in the money. One neighbor has “unlocked the value in his house” by taking out a cheap home-equity loan, and he’s using the proceeds to build a swimming pool. He is also doing well, along with two visionary friends, by buying and flipping other houses—so well, in fact, that he’s considering quitting his job and becoming a full-time real-estate developer. After four years of resistance, we finally concede—houses might be a good investment after all—and call our neighborhood real-estate agent. She’s jammed (and driving a new BMW), but she agrees to fit us in.

We see five houses: two were on the market two years ago for 30 percent less (we just can’t handle the pain of that); two are dumps; and the fifth, which we love, is listed at a positively ridiculous price. The agent tells us to hurry—if we don’t bid now, we’ll lose the house. But we’re still hesitant: last week, we read an article in which some economist was predicting a housing crash, and that made us nervous. (Our agent counters that Greenspan says the housing market’s in good shape, and he isn’t known as “The Maestro” for nothing.)

When we get home, we call our neighborhood mortgage broker, who gives us a surprisingly reasonable quote—with a surprisingly small down payment. It’s a new kind of loan, he says, called an adjustable-rate mortgage, which is the same kind our neighbor has. The payments will “reset” in three years, but, as the mortgage broker suggests, we’ll probably have moved up to a bigger house by then. We discuss the house during dinner and breakfast. We review our finances to make sure we can afford it. Then, the next afternoon, we call the agent to place a bid. And the house is already gone—at 10 percent above the asking price.

By the spring of 2007, we’ve finally caught up to the market reality, and our luck finally changes: We make an instant, aggressive bid on a huge house, with almost no money down. And we get it! We’re finally members of the ownership society.

You know the rest. Eighteen months later, our down payment has been wiped out and we owe more on the house than it’s worth. We’re still able to make the payments, but our mortgage rate is about to reset. And we’ve already heard rumors about coming layoffs at our jobs. How on Earth did we get into this mess?

To be continued …

photo credit: Joe Shlabotnik

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.

Understanding the Financial Crisis, Part 3

In a previous post, I highlighted Barry Ritholz’s article on how the financial crisis was caused by an “enormous change in lending standards … that took place during the 2002-2007 period. It was more than a subtle shift — it was an abdication of the traditional lending standards that had existed for decades, if not centuries.”

In the November 1st New York Times, Gretchen Morgenson gives details on just how badly one bank behaved during the housing boom. Was There a Loan It Didn’t Like? goes behind the scenes of mortgage lender Washington Mutual.

Briefly, senior mortgage underwriter, Keysha Cooper says she was pressured by bank managers and mortgage brokers “to approve loans, no matter what.”

“At WaMu it wasn’t about the quality of the loans; it was about the numbers,” Ms. Cooper says. “They didn’t care if we were giving loans to people that didn’t qualify. Instead, it was how many loans did you guys close and fund?

When underwriters refused to approve dubious loans, they were punished, she says.

Ms. Cooper started at WaMu in 2003 and lasted three and a half years. At first, she was allowed to do her job, she says. In February 2007, though, the pressure became intense. WaMu executives told employees they were not making enough loans and had to get their numbers up, she says.

“They started giving loan officers free trips if they closed so many loans, fly them to Hawaii for a month,” Ms. Cooper recalls. “One of my account reps went to Jamaica for a month because he closed $3.5 million in loans that month.”

One loan file was filled with so many discrepancies that she felt certain it involved mortgage fraud. She turned the loan down, she says, only to be scolded by her supervisor.

Brokers often tried to bribe Ms. Cooper to approve loans, she says. One offered to pay $900 to send her son to football summer boot camp if she would approve a loan that had been declined by a host of other lenders. “I told him no and not to disrespect me like that again,” Ms. Cooper says.

Hidden fees meant brokers could easily make between $20,000 and $40,000 on a $500,000 loan, Ms. Cooper says.

Ms. Cooper says that loans she turned down were often approved by her superiors. One in particular came back to haunt WaMu.

Vetting a loan one day, Ms. Cooper says she became suspicious when a photograph of the house being bought showed one street address while documents deeper in the file showed a different address. She contacted the appraiser, and recalls that he said that he must have erred and that he would send her the correct documents.

“I was so for sure that it was fraud I wanted to get on an airplane,” Ms. Cooper says.

The $800,000 loan was approved, but not by Ms. Cooper. Six months later, it defaulted, she says. “When they went to foreclose on the house, they found it was an empty lot,” she recalls.

Conclusion

• Ms. Cooper says she was pressured by her managers to approve mortgage loans “no matter what” including  loans that turned out to be fraudulent.
• Kerry K. Killinger, the WaMu chief executive was paid “tens of millions of dollars.”
• “WaMu was seized by federal regulators in late September, the biggest bank failure in the nation’s history.”

photo credit: Jimmy2000

The Financial Crisis: Why Were The Experts Wrong?

“Speculative bubbles are caused by contagious excitement about investment prospects. I find that in casual conversation, many of my mainstream economist friends tell me that they are aware of such excitement, too. But very few will talk about it professionally.” – Robert Shiller.

Robert Shiller is a Professor of Economics and Finance at Yale University and the author of “Irrational Exuberance,” a book that was first published in 2000. In his book, Shiller warned that the stock market had become a bubble and could have a sharp decline, which, of course, it did. In the 2005 update of that bestseller, he stated clearly, “that a catastrophic collapse of the housing and stock markets could be on its way.”

If someone is right once, you could chalk it up to pure luck. But when you’re spot on twice – well, that looks a lot like skill to me.

In today’s edition of The New York Times, in a column entitled Challenging the Crowd in Whispers, Not Shouts, Shiller writes how he felt about going against the consensus, and how many economists might “pull their punches” to avoid being ostracized or at least, losing credibility. This column helps to answer the question Gary Becker and Richard Posner asked: The Financial Crisis: Why Were Warnings Ignored?

Alan Greenspan, the former Federal Reserve chairman, acknowledged in a Congressional hearing last month that he had made an “error” in assuming that the markets would properly regulate themselves, and added that he had no idea a financial disaster was in the making. What’s more, he said the Fed’s own computer models and economic experts simply “did not forecast” the current financial crisis.

Mr. Greenspan’s comments may have left the impression that no one in the world could have predicted the crisis. Yet it is clear that well before home prices started falling in 2006, lots of people were worried about the housing boom and its potential for creating economic disaster. It’s just that the Fed did not take them very seriously.

According to Shiller, the bubble was obvious even to the casual observer.

For example, I clearly remember a taxi driver in Miami explaining to me years ago that the housing bubble there was getting crazy. With all the construction under way, which he pointed out as we drove along, he said that there would surely be a glut in the market and, eventually, a disaster.

But why weren’t the experts at the Fed saying such things? And why didn’t a consensus of economists at universities and other institutions warn that a crisis was on the way?

For the answer, Shiller turns to social psychology and behavioral economics. Briefly, even experts fear ostracism, and many economists use only a limited set of tools regarding speculative bubbles.

The field of social psychology provides a possible answer. In his classic 1972 book, “Groupthink,” Irving L. Janis, the Yale psychologist, explained how panels of experts could make colossal mistakes. People on these panels, he said, are forever worrying about their personal relevance and effectiveness, and feel that if they deviate too far from the consensus, they will not be given a serious role. They self-censor personal doubts about the emerging group consensus if they cannot express these doubts in a formal way that conforms with apparent assumptions held by the group.

Members of the Fed staff were issuing some warnings. But Mr. Greenspan was right: the warnings were not predictions. They tended to be technical in nature, did not offer a scenario of crashing home prices and economic confidence, and tended to come late in the housing boom.

From my own experience on expert panels, I know firsthand the pressures that people — might I say mavericks? — may feel when questioning the group consensus.

I was connected with the Federal Reserve System as a member the economic advisory panel of the Federal Reserve Bank of New York from 1990 until 2004… In my position on the panel, I felt the need to use restraint. While I warned about the bubbles I believed were developing in the stock and housing markets, I did so very gently, and felt vulnerable expressing such quirky views. Deviating too far from consensus leaves one feeling potentially ostracized from the group, with the risk that one may be terminated.

In 2005, in the second edition of my book “Irrational Exuberance,” I stated clearly that a catastrophic collapse of the housing and stock markets could be on its way. I wrote that “significant further rises in these markets could lead, eventually, to even more significant declines,” and that this might “result in a substantial increase in the rate of personal bankruptcies, which could lead to a secondary string of bankruptcies of financial institutions as well,” and said that this could result in “another, possibly worldwide, recession.

I distinctly remember that, while writing this, I feared criticism for gratuitous alarmism. And indeed, such criticism came.

I gave talks in 2005 at both the Office of the Comptroller of the Currency and at the Federal Deposit Insurance Corporation, in which I argued that we were in the middle of a dangerous housing bubble. I urged these mortgage regulators to impose suitability requirements on mortgage lenders, to assure that the loans were appropriate for the people taking them.

The reaction to this suggestion was roughly this: yes, some staff members had expressed such concerns, and yes, officials knew about the possibility that there was a bubble, but they weren’t taking any of us seriously.

I based my predictions largely on the recently developed field of behavioral economics, which posits that psychology matters for economic events. Behavioral economists are still regarded as a fringe group by many mainstream economists. Support from fellow behavioral economists was important in my daring to talk about speculative bubbles.

Speculative bubbles are caused by contagious excitement about investment prospects. I find that in casual conversation, many of my mainstream economist friends tell me that they are aware of such excitement, too. But very few will talk about it professionally.

Why do professional economists always seem to find that concerns with bubbles are overblown or unsubstantiated? I have wondered about this for years, and still do not quite have an answer. It must have something to do with the tool kit given to economists (as opposed to psychologists) and perhaps even with the self-selection of those attracted to the technical, mathematical field of economics. Economists aren’t generally trained in psychology, and so want to divert the subject of discussion to things they understand well. They pride themselves on being rational. The notion that people are making huge errors in judgment is not appealing.

In addition, it seems that concerns about professional stature may blind us to the possibility that we are witnessing a market bubble. We all want to associate ourselves with dignified people and dignified ideas. Speculative bubbles, and those who study them, have been deemed undignified.

In short, Mr. Janis’s insights seem right on the mark. People compete for stature, and the ideas often just tag along.

Understanding the Financial Crisis, Part 2

Barry Ritholtz, who writes a very popular blog, The Big Picture, often discusses the causes of the financial crisis. How Lending Standard Changes Led to the Housing Boom/Bust, posted on October 21st, blames the problem squarely on the lax standards of lenders. I agree with his main point, which he makes persuasively. Maybe it is a question of emphasis, but I believe that there is enough blame to go around.

Many of us acted as if housing prices could only go in one direction – up. Individuals bought as much house as they could get approved for. Some investors/speculators bought several condos when they were under construction. They hoped to “flip” the apartments as they were completed, thereby making exceptional profits.

With the very low interest rates promoted by the Federal Reserve, there was a big demand for any investment that promised higher returns. Investment banks packaged questionable mortgages, and investors bought the complicated financial instruments without asking enough questions. Rating agencies blessed the securities with triple A ratings, never imagining that home prices could actually fall substantially.  Regulation did not keep up with the changing markets for securitized debt instruments.

This housing bubble or mania could not go on forever, and it did not.

Here is Ritholtz’s article.

There is a general lack of understanding as to how the Housing boom and bust occurred, and why it led to the subsequent credit freeze. The situation is complex, and that is why we are still explaining this 3 years into the housing bust.

Let me take another shot at clarifying this:

Underlying EVERYTHING — housing boom and bust, derivative explosion, credit crisis — is the enormous change in lending standards. I am not sure many people understand the massive change that took place during the 2002-07 period. It was more than a subtle shift — it was an abdication of the traditional lending standards that had existed for decades, if not centuries.

After the Greenspan Fed took rates down to ultra-low levels, home prices began to levitate. More and more mortgages were being securitized — purchased by Wall Street, and repackaged into other forms of bond-like paper. The low rates spurred demand for this higher yielding, triple AAA rated, asset-backed paper.

In this ultra-low rate environment, where prices were appreciating, and most mortgages were being securitized, all that mattered to the mortgage originator was that a BORROWER NOT DEFAULT FOR 90 DAYS (some contracts were 6 Months). The contracts between the firms that originated mortgages and the Wall Street firms that securitized them had explicit warranties. The mortgage seller guaranteed to the mortgage bundle buyer (underwriter) that payments were current, the mortgage holders were valid, and that the loan would not default for 90 or 180 days.

So long as the mortgage did not default in that period of time, it could not be “put back” to the originator. A salesman or mortgage business would only lose their fee if the borrower defaulted within that 3 or 6 month contractually specified period. Indeed, a default gave the buyer the right to return the mortgage and charge back the lender the full purchase price.

What do rational, profit-maximizers do? They put people in houses that would not default in 90 days — and the easiest way to do that were the 2/28 ARM mortgages. Cheap teaser rates for 24 months, then the big reset. Once the reset occurred 24 months later, it was long off the books of the mortgage originators — by then, it was Wall Street’s problem.

This was a monumental change in lending standards. It created millions of new potential home buyers. Why? Instead of making sure that borrowers could pay back a loan, and not default over the course of a 30 YEAR FIXED MORTGAGE, originators only had to find people who could afford the teaser rate for a few months.

This was a simply unprecedented shift in lending standards.

And, it is why 293 mortgage lenders have imploded — all of these bad loans were put back to them. Note that the fear of this occurring is what was supposed to keep the lenders in line. The repercussions of this is why Greenspan believed the free market could self-regulate. (After all, people are rational, right?) One of the many odd lessons of this era is that, under certain circumstances, companies and salespeople will pursue short term profits to the point where it literally destroys the firm.

If you want to point to the single most important element of the Housing boom and bust, this is it. Ultimately, these defaulting mortgages underlie the entire credit freeze. And, it would not have been possible without the Greenspan ultra-low rates, which made the teaser portion (the “2″ of the 2/28) of these mortgages so attractive.

Contrary to the cliche, failure is not an orphan in the current crisis — it has 100s of fathers. But these four are the primary movers, the key to everything else. The perfect storm of ultra-low rates, securitization, lax lending standards and triple AAA ratings — these are the key to how we ended up with the previous boom, followed by a bust, and ultimately, the credit freeze.

photo credit: eron_gpsfs

The Financial Crisis: Why Were Warnings Ignored?

“Prediction is very difficult, especially about the future” – Niels Bohr

Gary Becker an economist and Richard Posner a judge, both at the University of Chicago, write a joint blog. It is frequently very thoughtful and worth reading, although usually long and a bit academic for some.

Their October 12th post The Financial Crisis: Why Were Warnings Ignored? asks a very important question. Here is a summary of their thoughts.

Richard Posner’s Opinion

Posner thinks the problem was a failure to synthesize all of the warnings. His analogy is the failure to foresee the attack on Pearl Harbor, although there were indications from 1941 on that something like that could happen.

He singles out “a perfectly reputable academic economist, a professor at New York University named Nouriel Roubini who for years had been predicting with uncanny accuracy what has happened.”

In September of 2006–two years ago–he had “announced that a crisis was brewing. In the coming months and years, he warned, the United States was likely to face a once-in-a-lifetime housing bust, an oil shock, sharply declining consumer confidence and, ultimately, a deep recession. He laid out a bleak sequence of events: homeowners defaulting on mortgages, trillions of dollars of mortgage-backed securities unraveling worldwide and the global financial system shuddering to a halt. These developments, he went on, could cripple or destroy hedge funds, investment banks and other major financial institutions like Fannie Mae and Freddie Mac.

Until mid-September, the magnitude of the crisis was greatly underestimated by government, the business community, and the economics profession, including specialists in financial economics.

Why were the warnings ignored rather than investigated? First, preconceptions played a role. Many economists and political leaders are heavily invested in a free market ideology which teaches that markets are robust and self-regulating. The experience with deregulation, privatization, and the many economic success stories that followed the collapse of communism supported belief in the free market. The belief was reinforced, in the case of the financial system, by advances in financial economics, and relatedly by the development of new financial instruments that were believed to have increased the resilience of the financial system to shocks.

Second, doing something to reduce the risks warned against would have been costly. Had banks been required to increase their reserves, this would have reduced the amount they could lend, and interest rates would have risen, which would have accelerated the bursting of the housing bubble…

The deeper problem is that it is difficult and indeed often impossible to do responsible cost-benefit analysis of measures to prevent a contingency from materializing if the probability of that happening is unknown.

Which brings me to the last and most important reason for the neglect of the warning signs, because it suggests the possibility of responding in timely fashion to future risks of financial disaster. That is the absence of a machinery (other than the market itself) for aggregating and analyzing information bearing on large-scale economic risk.

In any event, no effort to determine the probability of financial disaster was made and no contingency plans for dealing with such an event were drawn up. The failure to foresee and prevent the 9/11 terrorist attacks led to efforts to improve national-security intelligence; the failure to foresee and prevent the current financial crisis should lead to efforts to improve financial intelligence.

Becker’s Opinion – Why the Warnings Were Ignored: Too Many False Alarms

Becker has “a somewhat different take than Posner on why warning signals were ignored.”

The period since the early 1980s until the crisis erupted involved both rapid economic growth for most of the world, and unprecedented stability in this growth. Inflation rates were low and fluctuations in real output, as measured by the size and duration of recessions, were modest compared to the past. Economists and central bankers like Greenspan believed that we had learned how to keep inflation low, and also had the capacity to smooth out fluctuations in output and employment.

The second relevant development has been advances in financial instruments, such as derivatives, securitization, credit-backed swaps, and other even more esoteric instruments. These instruments seemed to work quite well in managing, spreading and even reducing the risk of the assets held by banks and other institutions. However, in the process they encouraged greater risk-taking ventures, as reflected by the large increase in the leverage-that is, in the ratio of assets to capital- of banks and financial institutions like Fannie Mae and Freddie Mac. What has been insufficiently understood is that the growing use of these instruments, and the growing leverage of financial institutions, created considerable aggregate risk for the system as a whole that could not be diversified away.

This combination of growing central bank confidence in its ability to iron out various wrinkles in economic performance, and the belief that the new financial instruments would help manage and reduce risk, blinded the vast majority of economists (I include myself), bankers, and government regulators to the vulnerability of the whole system. This vulnerability was especially important for aggregate shocks akin to a classical run on banks. When institutions are highly leveraged, they have great difficulty coping with a massive loss of confidence in the system.

While giving credit to Roubini, Becker lists several disasters during the past several decades that were predicted but never happened:

After the huge one-day stock market collapse in October 1987, Business Week and other magazines and newspapers warned that a Great Depression might soon be coming. These dire forecasts turned out to be completely wrong. Similar highly negative, but wrong economic forecasts, were made during the Asian financial crisis of 1997-98, the internet bubble, and the aftermath of the 9/11 attack.

In an atmosphere where the world economy showed great capacity to withstand difficult shocks, it is not at all surprising that some forecasts of disaster that turned out to be more correct were ignored.

In addition, one should not minimize the great economic achievements of the past 25 years in the form of rapid growth in world GDP, low world inflation, and low unemployment in most countries. Perhaps these achievements will be overshadowed by a deep world recession, but that remains to be seen. If the impact of this financial crisis on the real economy is not both very severe and very prolonged, and time will answer that question, the combination of the past 2 1/2 decades of remarkable achievement, and the economic turbulence that followed, may still look good when placed in full historical perspective.

Conclusion

I appreciate Becker’s perspective that for more than 25 years, the world has seen substantial growth and short recessions. However, this long term success led to overconfidence and excessive risk taking. While everything was working well, investment banks and other financial institutions could achieve large profits. With interest rates so low, borrowing money to increase profits seemed to make sense.

Cassandras are often wrong. The prevailing belief is that markets are usually right in sorting out risks and rewards. (George Soros disagrees with this ideology.)

The problem is that too many people based their decisions on the belief that housing prices could only go up. Unfortunately, too many houses were built and too many people who could not afford the houses were able to get mortgages, often with artificially low “teaser rates.” Now we are dealing with the fallout.

To see how Wall Street took on too much risk, see How Wall Street Became a Giant Hedge Fund.

photo credit: pangalactic gargleblaster

Criticism of the U.S. Bailout Plan, Part 5

“The unblinkable fact is that Americans own too much house. We overpaid and overborrowed, and many of us are ‘upside down,’ as the car dealers say. What to do? Recognize the losses and write them off. What not to do? Inflate the currency and debase accounting standards.” – James Grant.

An October 5th Washington Post editorial entitled Bad Medicine by James Grant, the editor of Grant’s Interest Rate Observer, criticizes the Government’s bailout plan. He blames our current problems on the bursting of the housing bubble exacerbated by the Federal Reserve’s low interest policy.

Grant’s main points are:

• The bubble was brought on by too low interest rates and too much optimism.
• Wall Street investment banks were quick to cash in on the boom, but were slow to recognize the turn in the market and the attendant losses in their portfolios.
• The answer is to let prices reflect their market values, not to mask those reduced values by artificial government intervention.

Low interest rates, easy money and malleable accounting rules are what plunged Wall Street into crisis. Yet it is low interest rates, easy money and malleable accounting rules that top the list of federal fixes.

The unblinkable fact is that Americans own too much house. We overpaid and overborrowed, and many of us are “upside down,” as the car dealers say. What to do? Recognize the losses and write them off. What not to do? Inflate the currency and debase accounting standards.

But inflation and debasement are the very policies being put in place. The Federal Reserve, not waiting for Congress, embarked last month on a radical program of money-printing. Reserve Bank credit — the raw material of bank lending — is growing at the year-over-year rate of 61 percent.

After the stock market broke in 2000, then-Fed Chairman Alan Greenspan set about easing policy. In company with Fed Governor Ben S. Bernanke, the man who wound up succeeding him, Greenspan warned against “deflation.”

So it pushed the “federal funds rate” — the interest rate that the Fed directly controls — to 1 percent in mid-2003 and kept it there for a full 12 months.

American consumers pinched themselves. Could they really borrow more than 100 percent of the price of a house at an unimaginably low teaser rate without so much as presenting proof of employment? Indeed, they could. House prices went up and up.

When, in 2006, the roof began to fall in, Wall Street was in a quandary. It held outsize volumes of triple-A-rated mortgage-backed securities (MBSs). That they were not, in fact, triple-A, had become painfully obvious.

Prices can be unwelcome pieces of information. When an especially unwelcome batch wells up after a financial collapse, governments try to quash it. So it is today. The SEC has suppressed short selling. The bailout bill will open the door to the suspension of market-value accounting. The Fed is moving heaven and earth to cheapen the value of the dollar.

Long after the crisis burst into the open, the Fed and Treasury downplayed it. It was, they insisted, “contained.” Last week they asserted that, unless the House voted “yea,” the wheels would come off this $14 trillion economy. President Bush himself has broadly hinted that the nation is on the cusp of disaster.

How can they be so sure? And how can they know that the unintended consequences of the radical policies they are pushing through won’t be worse than the panic that they themselves are helping to foment? When the Fed insists it has no choice but to print up hundreds of billions of new dollars and when the keepers of accounting standards bend in the face of criticism that market prices hurt, what they are really saying is the that financial truth is too awful to bear. Heaven help us all if they’re right.

photo credit: Matti Mattila