Dienstag, März 18, 2008

Keeping the Government Out Of Markets...and Putting the Blame Where It Belongs for Sub-Prime

We're all seeing all sorts of articles about the current credit crisis. But I have yet to see many that really analyze the roots of the problem.

The root of the problem is government interference in markets.

Now, when the government intervenes, it screws things up.

The sub-prime crisis is to a large degree the logical follow-up to the Community Reinvestment Act of 1977, which basically said that if banks wanted preferential credit conditions with the Fed (refinancing rates) - critical to remaining competitive - then they must make loans to borrowers that did not, under normal conditions, qualify for a mortgage according to the conditions that banking prudence would require.

Basically, the banks are tested to see if they are, in effect, cherry-picking their customers and lending only to the wealthy: if this was so, they were found in non-compliance, which affected their deposit requirements, which, as we all know, is the fundamental leverage the Fed has over the banks.

This meant that the banks were, by law, required to make loans to customers that would not normally have qualified, or, more exactly, who would have qualified only for rather expensive loans, either through a risk premium (front-loading) or higher interest rates. This is the birth of the sub-primes. The banks fought against this, back when, but lost to the activists and their Democrat supporters.

The CRA was tightened in 1995 under Clinton to ensure that the banks "properly" serviced their community, i.e. their geographic area, and didn't redline distressed economic districts to avoid making bad loans. How did they check this?

Why, the Home Mortgage Disclosure Act, which gathered the data that activists (hi, ACORN, that's you) then used to argue that the banks were, in fact, discriminating against minorities and lower-income communities. This dated from 1975, which preceded the CRA from 1977/1995.

The problem that you see here is simple: the banks haven't been making, strictly speaking, straight-forward mortgages, based on purely the numbers, since the late 1970s. This underscores how political pressure distorts the market: it created the sub-prime market as such. Previously, the banks didn't make the loans without proper risk premiums: they were then required by law to make the loans without the proper risk premiums, and in doing so, created the hole that became the sub-prime swamp.

To re-iterate: a significant part, the basis, of the current financial crisis was an intervention, politically motivated, to abrogate financial common-sense and the rules of economics. The banks didn't create subprimes: the CRA did. The banks, interested in keeping their refinancing costs down as much as possible, gave loans to people who didn't qualify, resulting, by the late 1990s, with banks having substantial portfolios of sub-prime loans.

Because the government wanted them to. Not just wanted: it required them to. Why?

Because liberal lobby groups felt it was unfair that poor people and minorities weren't able to buy a house at the same rate that rich people and WASPs were able to. They pushed through the laws, against the advice of the banks.

Where things really started going wrong was when the banks, interested in cleaning their books of the subprime loans - and they were interested because these loans were risky, but without the proper risk premium - found that new financial instruments allowed them to bundle the loans and get them off their balance sheets. You can't blame the banks for this: they were carrying only partially covered risks without any chance of reducing their liability otherwise.

Once the risk became uncoupled, the banks were happy to make the loans, especially with what I call Stupid Money. Investors who thought they were acquiring low-risk investments (gee, thanks, S&P, Moody, etc), when, in fact, they were acquiring structured investments with significant risks that were downplayed in order to sell the damn things.

There's more to be said about the risk side of business, and stay tuned for that.

The place to put the blame for the current financial crisis and the sub-prime mess is with politically motivated intervention in free markets. For the goal of preventing red-lining of districts and minorities as being poor risks - which they are, sorry - the liberal intervention required banks to amass significant portfolios of sub-prime mortgages, poor performers without the proper risk premium.

That is why you keep government out of markets. They only end up screwing things up royally.

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