Freitag, Februar 20, 2009

Causality and Inevitability...

I'll come out and say it: the CRA didn't cause the subprime crisis, which generated the world-wide recession.

But it did make it inevitable.

What's the difference?

To understand why the CRA didn't cause - cause in the sense of having a clear causal chain from 1977 to today - the subprime crisis, go here. While I don't agree entirely with what Ellen Seidman writes there, she does make a decent case for the relative innocence of the CRA, strictly speaking, for direct responsibility for the subprime crisis. What don't I agree with? The creation of the subprimes as such was a very, very bad idea, one that I've covered on this blog before.

In short, the CRA created a situation where

But let's go here where Phil Gramm looks at the problem.

I believe that a strong case can be made that the financial crisis stemmed from a confluence of two factors. The first was the unintended consequences of a monetary policy, developed to combat inventory cycle recessions in the last half of the 20th century, that was not well suited to the speculative bubble recession of 2001. The second was the politicization of mortgage lending.

This second aspect is what terrifies the Democrats: it just didn't happen on their watch, it was their policy. Frank Raines, Chris Dodd and Barney Frank, to name just the major players, pushed Fannie Mae/Freddie Mac into backing mortgages for political reasons. This is the true scandal of our current recession.

The 2001 recession was brought on when a speculative bubble in the equity market burst, causing investment to collapse. But unlike previous postwar recessions, consumption and the housing industry remained strong at the trough of the recession. Critics of Federal Reserve Chairman Alan Greenspan say he held interest rates too low for too long, and in the process overstimulated the economy. That criticism does not capture what went wrong, however. The consequences of the Fed's monetary policy lay elsewhere.

In the inventory-cycle recessions experienced in the last half of the 20th century, involuntary build up of inventories produced retrenchment in the production chain. Workers were laid off and investment and consumption, including the housing sector, slumped.

In the 2001 recession, however, consumption and home building remained strong as investment collapsed. The Fed's sharp, prolonged reduction in interest rates stimulated a housing market that was already booming -- triggering six years of double-digit increases in housing prices during a period when the general inflation rate was low.

So, yes, the Fed - and Greenspan - deserve some blame: money was (and remains) very cheap and readily available. The easy availability of money for the average company means that they can invest for relatively little cost; the problem with cheap money is that it also reduces the risk threshhold, because of the relative lack of cost involved. This is what helped trigger the housing boom: a lack of proper risk controls.

Buyers bought houses they couldn't afford, believing they could refinance in the future and benefit from the ongoing appreciation. Lenders assumed that even if everything else went wrong, properties could still be sold for more than they cost and the loan could be repaid. This mentality permeated the market from the originator to the holder of securitized mortgages, from the rating agency to the financial regulator.

This is what caused the boom: the irrational belief that housing prices would always go up, driven in part by the suppresed realization that a drop in housing prices would cause the house of cards to collapse. Everyone had an interest in keeping the spiral going, which is something that the rating agencies should have caught: while they did their mechanistic jobs providing ratings for things no one understood, the qualitative risks were ignored and even denied.

Meanwhile, mortgage lending was becoming increasingly politicized. Community Reinvestment Act (CRA) requirements led regulators to foster looser underwriting and encouraged the making of more and more marginal loans. Looser underwriting standards spread beyond subprime to the whole housing market.

This is for me the critical point: the CRA didn't cause marginal loans, but it did make them necessary and inevitable:

As Mr. Greenspan testified last October at a hearing of the House Committee on Oversight and Government Reform, "It's instructive to go back to the early stages of the subprime market, which has essentially emerged out of CRA." It was not just that CRA and federal housing policy pressured lenders to make risky loans -- but that they gave lenders the excuse and the regulatory cover.

Bingo: now you can understand why the CRA made the financial crisis inevitable. It gave those issuing subprime mortgages the excuse to do so, and the moment that Fannie and Freddie took over the guarantees, the issuing institute was risk-free.

Countrywide Financial Corp. cloaked itself in righteousness and silenced any troubled regulator by being the first mortgage lender to sign a HUD "Declaration of Fair Lending Principles and Practices." Given privileged status by Fannie Mae as a reward for "the most flexible underwriting criteria," it became the world's largest mortgage lender -- until it became the first major casualty of the financial crisis.

To reiterate: the CRA didn't cause the financial crisis: it made it possible. The politicization of loan-making is, if anything, the prime cause of the exploitation of the CRA by mortgage institutes who were interested in one thing only, the one thing that the CRA approved and wanted: increasing the number of subprime loans.

The 1992 Housing Bill set quotas or "targets" that Fannie and Freddie were to achieve in meeting the housing needs of low- and moderate-income Americans. In 1995 HUD raised the primary quota for low- and moderate-income housing loans from the 30% set by Congress in 1992 to 40% in 1996 and to 42% in 1997.

This is where the direct culpability of Congress comes into play. This is where the politicization starts: raising the primary quota made no economic sense, but was done as a matter of policy under Clinton. This is where the rot starts.

By the time the housing market collapsed, Fannie and Freddie faced three quotas. The first was for mortgages to individuals with below-average income, set at 56% of their overall mortgage holdings. The second targeted families with incomes at or below 60% of area median income, set at 27% of their holdings. The third targeted geographic areas deemed to be underserved, set at 35%.

The first quota is absurd: 56% of mortgages were, by law, aimed at people with less than 50% of income. This is, simply, madness: it means that Fannie and Freddie were condemned to taking on the risks.The math also doesn't add up: of the Fannie/Freddie holdings, 56% were reserved to individuals below average income, 27% for those below the 60% area median income, and 35% underserved: this adds up 118%, which requires double-counting to work.

The results? In 1994, 4.5% of the mortgage market was subprime and 31% of those subprime loans were securitized. By 2006, 20.1% of the entire mortgage market was subprime and 81% of those loans were securitized. The Congressional Budget Office now estimates that GSE losses will cost $240 billion in fiscal year 2009. If this crisis proves nothing else, it proves you cannot help people by lending them more money than they can pay back.

This is the law of unintended consequences writ about as big as you can get. The CRA, which when properly interpreted aimed at improving loans to the lowest decile - 10% - expanded and expanded and expanded until it ran up against system limits.

Blinded by the experience of the postwar period, where aggregate housing prices had never declined on an annual basis, and using the last 20 years as a measure of the norm, rating agencies and regulators viewed securitized mortgages, even subprime and undocumented Alt-A mortgages, as embodying little risk. It was not that regulators were not empowered; it was that they were not alarmed.

This is the massive failure, the abject and fundamental failure of the rating agencies. This is where the fundamental failure of the anglo-saxon rating agencies is apparent: you cannot use the past to rate the future. Loans aren't made in the past: you have to look forward. The regulators failed in their jobs because they didn't understand the fundamentally risky nature of the subprimes: on the other hand, how could they have, given the outstanding ratings given by the rating agencies?

With near universal approval of regulators world-wide, these securities were injected into the arteries of the world's financial system. When the bubble burst, the financial system lost the indispensable ingredients of confidence and trust. We all know the rest of the story.

When the bubble burst, it showed the failure of the rating agencies: the ratings were worthless. Given the incredible importance of these, this is one of the major secondary causes of the crisis.

The principal alternative to the politicization of mortgage lending and bad monetary policy as causes of the financial crisis is deregulation. How deregulation caused the crisis has never been specifically explained. Nevertheless, two laws are most often blamed: the Gramm-Leach-Bliley (GLB) Act of 1999 and the Commodity Futures Modernization Act of 2000.

GLB repealed part of the Great Depression era Glass-Steagall Act, and allowed banks, securities companies and insurance companies to affiliate under a Financial Services Holding Company. It seems clear that if GLB was the problem, the crisis would have been expected to have originated in Europe where they never had Glass-Steagall requirements to begin with. Also, the financial firms that failed in this crisis, like Lehman, were the least diversified and the ones that survived, like J.P. Morgan, were the most diversified.

This is the key lesson: to quote Heinlein, specialization is for ants.

Moreover, GLB didn't deregulate anything. It established the Federal Reserve as a superregulator, overseeing all Financial Services Holding Companies. All activities of financial institutions continued to be regulated on a functional basis by the regulators that had regulated those activities prior to GLB.

When no evidence was ever presented to link GLB to the financial crisis -- and when former President Bill Clinton gave a spirited defense of this law, which he signed -- proponents of the deregulation thesis turned to the Commodity Futures Modernization Act (CFMA), and specifically to credit default swaps.

Yet it is amazing how well the market for credit default swaps has functioned during the financial crisis. That market has never lost liquidity and the default rate has been low, given the general state of the underlying assets. In any case, the CFMA did not deregulate credit default swaps. All swaps were given legal certainty by clarifying that swaps were not futures, but remained subject to regulation just as before based on who issued the swap and the nature of the underlying contracts.

While I was - and remain - a fan of Glass-Steagall because it regulates the banks to keep them out of the business of flogging their own products, inherently risky and at best opportune (and at worst downright criminally fraudulent), Gramm is right (even if a tad self-serving, given that he helped write the bill).

In reality the financial "deregulation" of the last two decades has been greatly exaggerated. As the housing crisis mounted, financial regulators had more power, larger budgets and more personnel than ever. And yet, with the notable exception of Mr. Greenspan's warning about the risk posed by the massive mortgage holdings of Fannie and Freddie, regulators seemed unalarmed as the crisis grew. There is absolutely no evidence that if financial regulators had had more resources or more authority that anything would have been different.

Correct: the problem wasn't one of deregulation, but rather one of the regulators believing in the ruddy health of Potemkin villages and the assurances of the local mayors - the rating agencies - that everything was fine.

Since politicization of the mortgage market was a primary cause of this crisis, we should be especially careful to prevent the politicization of the banks that have been given taxpayer assistance. Did Citi really change its view on mortgage cram-downs or was it pressured? How much pressure was really applied to force Bank of America to go through with the Merrill acquisition?

Good luck on that one: knowing Congress, they will try to white-wash their incompetence and venality by politicizing the banks: after all, it's probably the only way to continue a cover-up of Congress' abject failure to do what it is supposed to do.

Restrictions on executive compensation are good fun for politicians, but they are just one step removed from politicians telling banks who to lend to and for what. We have been down that road before, and we know where it leads.

Do we really? I dare say that there is an entire generation of Democratic Congressmen who are just champing at the bit to find out where that road leads and are more than happy to discount the warning signs as remnants of older days.

Finally, it should give us pause in responding to the financial crisis of today to realize that this crisis itself was in part an unintended consequence of the monetary policy we employed to deal with the previous recession. Surely, unintended consequences are a real danger when the monetary base has been bloated by a doubling of the Federal Reserve's balance sheet, and the federal deficit seems destined to exceed $1.7 trillion.

This goes to the core of the problem: causality and inevitability.

While causality, either in its legal form or any other form, is a slippery beast at best (if you're honest: if you're not, then you can "prove" anything) and more than difficult to lay out, inevitability is easier, especially because you don't have to be specific.

In this case, it was inevitable that bad things would happen when lax money met politic influence in mortgage lending. Add to that the complicity of those who were supposed to be providing objective assessments - and who were, in reality, colluding with their clients to make as much money as possible while not appearing to be selling their ratings to the highest bidder - and we enter the realm of Rumsfeldian "known unknowns": any good, honest economist could have told you that political interference, cheap money and bad information leads to poor allocation of scarce resources.

The problem today is that no one listens to good, honest economists. The snake-oil sellers, the lawyers and the accountants, the sophists of the markets, are much more attractive, much more entertaining and much easier to understand.

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