Usually when a company removes its do-nothing workers, the stock price goes UP because the investors are happy to see their company operating more efficiently. If the government did the same thing, I expect that Wall Street would react with a positive upswing.
In general, I'd agree with you that anything we can do to make any organization more efficient is a good thing. We might do well to consider the demand shock that a HUGE and instant uptick in unemployment would cause to an economy that has already had the bottom fall out of aggregate demand. Sometimes it's wise to take things slowly.
This is not the first or only time they have blamed Bush for failures that were actually someone elses responsibility. Learn the purpose of the government department that is at hand, and what powers they actually have before you assume.
You do realize that, per the constitution, the President has a great deal of say in what laws and regulations get passed, and that per tradition, the President has a lot of political power to push an agenda, yes? Not to mention the appointments to regulatory posts...
So by "one" you actually meant "lots and lots" in this case? Anyway, I'm sure that guy will be thrilled to know that at least he's one of only a few people who are totally screwed for no good reason.
However, rather than wasting societies time and money keeping them locked up, letting them out and tracking them, or whatever, I would be perfectly ok with convicted of rape or on offense with a child = placed in small box and buried.
As I see it, there's a small game theory problem with that. It gives you no reason not to kill your victim to eliminate witnesses. This type of punishment often results in a reduction in the rate of crime X accompanied by an increase in the rate of "crime X plus murder afterward."
I'm not an economist, but my only econ class taught me about "elasticity of demand". For gasoline, demand is very much not elastic, which means that if the price goes up or down, demand will only change a little bit. The price of gas had to go way way way up before driving habits changed. Remember ten years ago when gas was $1.30? Gas had to *triple* in price before driving decreased, and driving decreased by under three percent.
The important thing to remember about those elasticities is that they are short run entities. If the price of gas doubles tomorrow, you're unlikely to be able to make the expensive changes to your life to adjust to it tomorrow. You just suck it up.
If the price of gas doubles tomorrow and stays that high in real terms for the next 10 years, your elasticity of demand looks remarkably different. You'll restructure the way you live your life to avoid the new expense, and the quantity of gas purchased over time will decrease. That's why it's possible that this summer's oil shock, while resulting in windfall piles of cash for oil producers in the short run, may very well harm them significantly in the long run. It depends on how good our memories are over the next few years.
They do, and they can get loans without the CRA. The illegal aliens without jobs who get mortgages on $400k McMansions? Not so much. But wait, those were fly-by-night operations, you say. BUZZ. WRONG. It was all backed up by Fannie/Freddy aka the Feds through various roundabout channels.
Freddy and Fannie were *losing* market share to "non-bank lenders" during the sub-prime run up. Look it up. That's because "non-bank lenders" (not regulated by the CRA *at all*) were loaning out bad paper, wrapping it up, and selling it on the commercial paper market. FM/FM were just doing what they normally do.
Remember, when they failed, Fannie and Freddie held 1/2 the country's mortgage assets, whether by direct lending or by buying up these fly-by-night deals with the defacto full faith and credit of the federal government. That policy made it profitable to operate fly-by-night operations, contributing overwhelmingly to the credit bubble.
No, no, no. They didn't fail because they bought riskier portfolios than the lending market at large. In fact, their portfolios were in slightly better shape than the market at large (not that they wouldn't have done it if they could--they were on a tighter regulatory leash than the market at large). They failed because they were less well capitalized than the market at large. That is where blame can reasonably be placed on the government for their implicit guarantee. But that blame only goes as far as the failure of the GSEs. It shouldn't be stretched to imply that the GSEs were driving the subprime market. The numbers show that they simply weren't.
Did you not notice that he said (factualy) that the government forced these institutions (not just F&F) to lend their money to people who cannot afford the loans?
The problem is that it's not factual. The CRA does not force such lending. CRA loans did not underperform. CRA loans were not among the higher priced sub-prime loans. CRA regulated institutions made up an ever smaller portion of the lending as non-CRA institutions took over. The CRA is a red herring.
You want to blame the market for high risk lending but that wasn't the markets problem. The markets problem was that they were forced to do it by the government (ie: the markets problem was the government intrusion.)
OK, thought experiment. You're a bank. The big bad liberal government shows up and says, "Lend money to poor black people so they can get houses and you lose money." You have to comply, but you just know that each of those loans will be unprofitable. Do you:
a) Do the bare minimum to comply and then spend a fortune lobbying Congress to get them to stop.
b) Leverage yourself out the wazoo and loan money to anybody with a pulse.
You seem to be implying that the rational thing for banks to do was (b). I don't know how that syncs up with your belief that the free market will do the right thing given the circumstances, because (a) seems a lot more rational.
The fact that neither of these things actually happened in any great volume because the CRA doesn't apply to the lenders who lent most of the garbage kind of moots the whole thing, but I think it's an instructive thought experiment.
And you assume that the government has been given the power to 'invest' in anything. The government is a notoriously awful investor.
I'd be interested in seeing this quantified, given that the same set of state and federal governments that give us overpriced tools in the DoD also brought us the interstate highway system and countless other pieces of infrastructure we base our society around.
Wait, what? You could just as reasonably say after women's suffrage, the state had the *power* to allow women to vote. Before suffrage, the state did not have that power.
Only if you're willing to say things like, "the Fourth Amendment gave the state the power to require warrants to search a citizen's home" or "ripping the wings off of a fly enhances its inability to fly."
It doesn't really change the point though, and even the money supply factors into risk calculations.
I assume you mean that assumptions about future changes in the money supply factor into risk calculations.
How could they? It is the Fed who is controlling interest rates, not the market.
Nominal interest rates don't reassert themselves. Real interest rates tend to. In fact, that's one of the points of the Austrian critique of interest rate manipulation.
More importantly, individual interest rates on different investments will move out of concert with Fed activity depending on perceived risk (risk which is calculated *entirely* independently of, say the federal funds rate).
You only made money because the Fed depressed interest rates below market. There was not enough value in the investment itself to make it worthwhile in its own right. You should have kept the liquidity for a more worthy investment.
If there was a more worthy investment, you would have made it. The fact that you made the investment indicates that there was no worthy investment, and you were keeping the money because you simply preferred liquidity. Nothing in your example shows that you were "right" to prefer liquidity. The problem is that you're defining the "right thing to do" as "the thing I would have done in the absence of Fed activity." With that definition, of course you're going to show that the Fed causes mistakes. The problem is that those don't actually appear to be mistakes by any other objective measure.
If interest rates are high and nobody is lending because they fear that all debts will be erased during the imminent alien invasion and government action somehow gets lending to start, was it the "wrong" thing to do? Only if they were right about the invasion and the market was wrong.
To chose a more realistic example, if we reach a dead end in which it is rational for the market to lend as a whole and irrational for each individual lender to lend, we're going to be stuck in a credit freeze for a very long time until somebody in the market does something irrational or some external player changes the incentives.
*STILL* did not say this.
So your position is that the Federal Reserve does not contribute to excess volatility, but this time they screwed the pooch? I'd say that's reasonable. Over the long haul, central banking has been good for the business cycle. In this case, I'd argue that they misread the market because their normal indicators (eg core inflation) were confounded by a housing bubble and they decided incorrectly that it would be easier to clean up the mess than to pop the bubble.
We already covered this. Interest rate manipulation + legislative obsession with increasing demand on homes.
No, you've already *asserted* this. In fact, *I'm arguing with you* that interest rate manipulation *cannot* explain the preference for sub-prime lending over any other risky lending in the absence of another mitigating factor.
As for the legislative obsession with increasing home demand, I'm against it, but I also disagree that it explains a bubble. Let's take an example: You're allowed to write off interest on your mortgage. OK, that causes house prices to go up across the board. Is that a bubble or irrational? No, it simply increases the market valuation of the homes forever. If they allowed an interest write off and then removed it 10 years down the road, that would be a contributor, but that's not what happened. The same thing goes for the GSEs and any number of other activities designed to inrease home ownership. The would drive up home prices above their natural market level, but that by itself doesn't constitute a bubble.
That's like saying that prices don't reflect market value. Yes they do, if government is out
How? You keep talking about risk and how investors didn't assess risk properly. Well, that is what interest rates are!
No, that's not true at all. A *part* of the interest rate is a risk premium. If risk goes to zero, interest rates don't go to zero.
I don't know how you can say that fixing interest rates outside of market valuation won't cause malinvestment.
I think that the more fundamental question is why it necessarily follows that they do. It seems to be based on the assumption that real interest rates don't reassert themselves over time or that the market interest rate at any given time will somehow produce the most successful investments.
Think of the individual business decision. Should I invest in widgets? It will cost me $1 billion over the lifetime of the loan, and I will reap $900 million from it. I should not make the investment. The market is indicating that it is too risky. Let's now rewind and assume the Fed, in efforts to increase spending levels higher than they otherwise would be, depressed interest rates such that it will only cost me $850 million over the lifetime of the loan. I would now decide to make the investment, even though absolutely nothing about how the market would accept the investment has changed.
Exactly how was this a malinvestment? You invested $850M and got $900M back. It would only be a malinvestment if it turned out to return less than you expected it to. The market wasn't necessarily indicating that it was too risky. In fact, there was no risk premium implicit in your description.
Relatively predictable based on... our understanding of the personality and economic philosophy of the regulator in charge? Or relatively predictable based on our understanding of market fundamentals?
Relatively predictable based on historical norms. A savy investor should be able to look at long term yield curves and decide on an investment that minimizes exposure to interest rate risk.
Actually, I only meant to point to the historical rate chart to point out that it's not very predictable. I'm not trying to suggest that page explains the housing bubble.
Well, the article purports to. But I agree with you that it doesn't.
I'm not suggesting that the GSEs didn't invest in risky securities. I'm pointing out that attempting to scapegoat them for the bubble is quantitatively wrong. There are a few problems with the theory that the GSEs drove the bubble, the two most obvious being that their portfolios didn't underperform the national average and that they were losing market share through the worst excesses of the market. It's blaming the canary for the mine explosion.
I didn't say volatility didn't exist. I said the Fed creates unnatural volatility. Volatility in interest rates is a natural part of the market changing its willingness to lend money when risk changes. You can't separate interest rates from risk and then wonder why interest rates are no longer regulating risk.
Suggesting that volatility has increased since the Federal Reserve system came into effect is somewhat historically tone deaf. But more importantly, you're not drawing the distinction between the risk premium portion of an interest rate and the interest rate as a whole. If the "risk free" interest rate (let's say, good quality US government debt) drops, other interest rates will drop with it, but their spreads will still reflect the relative risk. Nothing about the change of the "risk free" rate should change those s
Inflation is not price increases. Prices increase as a result of inflation, which is why it is often used as one measure of inflation.
The problem here is the overloading of the word. You're probably referring to monetary inflation. That's not totally out of left field, but most economists are talking about a general increase in price levels when they use the word.
That's because I didn't make that argument. I am not sure what gave both you and the other responder the impression that I was talking about inflation.
Because you can't talk about manipulating interest rates and their effect on asset prices (local or global) and not talk about inflation. The subjects are inherently intertwined.
It is the manipulation of interest rates and the legislative obsession with increasing home ownership that kicked off the price appreciation.
I'd agree with that to some extent, but it assumes that low interest rates will necessarily cause those malinvestments. That's what I'm quibbling with. I would say that assuming a malinvestment is going to occur, low interest rates increase the incentive to pour money into it, especially if the malinvestment is though to be low risk.
Then, once there was consistent price appreciation, investors jumped in looking for those same high returns. That continued to fuel the bubble.
Sure.
What is "consistent monetary policy"? The Fed is manipulating the cost of capital at its will. How is that consistent or predictable?
A consistent monetary policy is one that produces relatively predictable price inflation.
http://mises.org/story/3130 [mises.org]
Let me pretend to be surprised that the link is from mises.org. I don't think that most of mainstream economics will disagree with the idea that the Fed's credit expansion enabled the housing credit bubble. I take issue with the Austrians' assumption that it was a necessary consequence of credit expansion. The question is, why housing, specifically?
Under normal circumstances, a credit expansion would cause an increase in capital investment across the board. Eventually, we would have seen an uptick in the overall price level and the Fed would have taken its foot off the gas. In this case, we saw a largely isolated bubble. That reeks of poor risk assessment rather than a bad call on future interest rates. The money shot in your link is here:
Fannie Mae, Freddie Mac, mortgage-backed securities, and credit derivatives were simply the conduit that made all these bad loans and investments seem less risky than they really were. In this manner the Federal Reserve can fool the market, at least temporarily. In the end the market always reasserts itself.
I'd argue against FM/FM being a major player in the low grade debt bubble, but the key here is that rather than a uniform expansion in investment and consumption of big ticket items as expected, we saw a bubble because the financial industry had managed to find a way to create an asymmetry in risk premiums for home loan backed assets. The last sentence makes no sense as the "fooling" and reversion to reality were with regards to risk and not the discount rate. He points it out himself. If the "government intervention" theory is to be borne out, it has to explain this asymmetry.
How can you realistically value an asset if the Fed can change interest rates tomorrow and completely invalidate your valuation?
You can't, assuming the Fed moves things willy nilly all over the place with no connection to reality. If it did that, I imagine it would be abolished fairly quickly. As it stands, most investors seem to have a pretty easy time predicting the general direction of the Fed's actions over time. If t
If gas prices are like this for the next 4 years, he can go ahead and have orgies in the Oval office for all I care. Now, if gas prices go back to $3 or so... then he can burn in hell for bringing us the bad gas prices, but until then I'd give him free reign to do what ever he wants.
How will you vote next election if the weather gets really bad over the next four years? Or if we have more earthquakes than usual? Sunspots?
At some point, what goes up must come down. Consistent price appreciation absent any value creation is NOT SUSTAINABLE. I do not understand how mainstream economics can be so short-sighted.
I think you're misreading the mainstream economics position on inflation. Consistent increases in the overall price level are completely sustainable. Consistent increases in one sector (e.g. housing) are not. The problem with bubbles is a misallocation resources because the players in the market did a bad job of assessing risk and predicting future prices of that asset. I can't think of a rational argument that could make a good causal relationship between uniform price increases and an asset price bubble.
That's not to say that the Fed acted correctly here. The credit expansion clearly allowed the misallocation of money to the housing market to grow far larger than it would have otherwise. I'm just suggesting that misallocation of investments are not a necessary consequence of consistent monetary policy.
What you propose (and Obama) is the same as FDR... but the New Deal didn't get the economy going again, WW2 did.
I'm consistently amazed at the common refrain that World War II restarted the economy used as an argument that public spending can't restart a stalled economy.
Somewhat true. But by saving, people make the money available to others to borrow (assuming they don't literally store it under their mattress - which few people do) -- this additional capital simulates the economy.
This is true in the general case, but we're not in one of those situations right now. At this point, anybody with extra money appears to be holding cash or government debt rather than private debt. The credit markets are frozen. The yield on the 4-week treasury dipped negative yesterday. Putting cash back into the hands of lenders isn't going to change that.
The side effect of this frozen state is that the government can take up the slack by borrowing and spending. It can borrow at ridiculously low rates now, so while we would normally cut taxes and let private industry use the extra money to invest, in this case you'll probably get a significantly bigger bang out of pubic deficit spending.
As I see it, the real problem is that there aren't many good infrastructure projects that are worth doing that could start *right now*. At least, not many when compared to the excess capacity that the slack in our economy has created.
Probably the best solution would have been to bail out the bad mortgages themselves, and let the resulting trickle-up keep the banks solvent.
The problem with that solution is that it isolates the worst players (both borrowers and lenders) and pours money directly into their pockets with no strings attached. There aren't a lot of good ways to make a bailout work, but I don't think that this method would work out well in the long run.
However, that would be seen as handouts to the middle and lower classes, and the current generation of politicians thinks only handouts to the rich are morally acceptable.
The solution I favor suffers from a similar problem. As I see it (and as *lots* of economists see it), we should be going the pure capital injection route (the route they're just starting to figure out was the right way to go from the beginning). Let insolvent banks issue stock, buy that stock, and take partial control of the banks. Recapitalize them and keep them under adult supervision until they've recovered enough to buy that extra stock back.
The problem, of course, is that this looks like the Evil Red Hand of Socialism, so it's hard to sell. It's much easier to convince them to spend hundreds of billions of dollars overpaying for bad assets. Yikes.
WRONG>.. The nation debt exists because the government foolishly allowed the creation of a central bank! If such a bank did not exist the government would have take in enough revenue at tax time to pay for its expenses for the comming year. In troubled times some short term bonds might get bought an sold but no way would investors or the public allow trillions in debt to be racked up.
That's a very interesting theory... Exactly how does having a central bank do this?
You were not condescending at all, another plus! I know it's not a "few" mortgages, but this didn't happen over night. Hence my question about "3%" increase. That was just an arbitrary # but I am sure you know, it takes a geological event to raise a lake a few degrees 10' down. I am glad you saw later what I was frustrated about.
I generally agree with you. As somebody who is renting and has been waiting for home prices to crash for a few years, I don't have a lot of pity for the lenders in this situation. I only have the same personal interest in the market that any potential home owner might have, and my formal background is limited to a BS in economics, and it was blindingly obvious to me. The real economists I know said the same thing (I know one with a PhD from Harvard whose wife is an investment banker who was still renting). If your job hinges on the ability to see value and trends in the housing market and you kept making those loans, you deserve to get wiped out.
At the end of my post, you didn't answer the question that has been on my mind most. Why would a company dealing in subprime loans abandon their customers when they grow out of the subprime "market."
If I understand you correctly, your question is, Why couldn't people with good credit get loans from sub-prime lenders? I don't know for sure, but I suspect that some of them had a business model that had them specializing in very high yield securities, which would require that they securitize mostly (or entirely) loans with a really high interest rate. Nobody with good credit would need those loans, so they were stuck bottom feeding.
Remember, the sub-prime mess was largely caused by a huge demand for high interest rate securities with "low risk" attached to them. The rates on US treasuries was kept low for a long time by the Fed, so literally trillions of dollars that might have been kept in treasuries was out looking for an alternative. When it looked like mortgaged backed securities could fit the bill (high yield and "safe" due to CDSs), people couldn't make mortgages fast enough to meet demand. In fact, there was more money out there than there were qualified borrowers. It was a race to the bottom. Anybody with any economic sense should have known that if a security has a low risk rating and a high yield, one of those things is wrong.
I may not be an econ major, but I found my Econ survey class fascinating. Almost enough to major in it instead of Comp stuff, but I had been in computers so long, I knew I would be successful there.
I started with econ as an elective as a Comp Eng major and decided to do a second degree. My area of interest in engineering was signal processing, so dealing with data and trends and squiggly lines naturally drew me to macroeconomics, banking, and stuff like that. I pay the bills with the engineering degree, but the econ classes have at least helped me keep more of my money. Well worth the time to study.
1) CDS's were around for many before the exponential growth in their trading took off, which suggests, but does not prove, that it was their use as a method of unregulated gambling that comprised much of that growth.
I'll grant that. But let's go one further: Even if we're talking about "betting" being the vast majority of these things, they're still assets on the books of very real entities, many of which are too big to fail without causing serious repercussions. Does it really matter if, say, Bear Stearns was "betting" when it took a CDS position if the failure of AIG results in the failure of Bear? The end result is still a *lot* of legitimate lenders lose money when it goes under.
2) So far, we've only seen a bank "break the buck" once and it seems unlikely to happen again in the near term. As insurance against that kind of bank failure has apparently been the primary purpose of legitimate CDS's it appears to me that letting the insurance fail is unlikely to have the predicted doomsday results as the banks are expected to remain solvent and thus the insurance against them defaulting will be immaterial.
I assume that you meant a money market fund breaking the buck. The problem is that it only takes one, as we saw with the fallout from Lehman. It precipitated a run on the money market in general. That's a *bad* situation to be in. Anybody who borrows short and lends long (i.e. anybody who acts like a bank) gets hit *hard* when the short term money markets freeze up. The problem isn't everybody losing 5% off of their money market fund. The problem is a few big funds losing 5% and causing all of the other ones to collapse sympathetically.
Further, insurance against the default of a debtor who doesn't default is not immaterial. Sure, it is in the long run once those debts have been paid, but you can't forget that the insurance backing those debts is part of their market value. Having the debt of all of those major players suddenly devalue across the board would not be good for anybody's balance sheet. If you were on the edge of solvency and "safe" assets like that suddenly take a haircut, it could put you under. If you happen to be one of those big players, so much the worse.
Which is why I believe that letting the market fail and recover on its own would not be the apocalyptic event it has been reported to be in the nightly news. Perhaps I am wrong, but until its over, no one can prove it and my way saves a shit load of taxpayer money.
Is it really that much taxpayer money if you consider the bite out of GDP that even a short recession takes? We're talking about a huge economy here, so a few percentage points of GDP over a few years is staggering amounts of money.
I'll say this: When I was in college, we used to speculate about what would happen if a really big player in the banking industry (either a major issuer of debt or a major guarantor of debt) went bust. None of the stories ended well, and in retrospect, we weren't even assuming as much interconnectedness as there appears to be today. They all played out in roughly the same way: One major player goes down and the subsequent freezing of various credit markets bring more players down with them. The feedback loop should be obvious. This is a large-scale version of the types of things we see in other banking crises. I could be wrong (and I would be in good company with a lot of excellent economists who have no vested interest in this answer), but I don't know of any situation where rolling the dice as you suggest has paid off, and I don't think that this one is any different.
How about propping the economy up by giving money to the people who were trying to pay back the loans, so they won't foreclose, so the lender won't run into trouble in the first place?
The problem there is moral hazard. What you've proposed is essentially a targeted gift specifically for the worst players in the industry (both borrowers and lenders). If you're going to put money in to bail out failed business ventures, you have to do it in such a way that you're not rewarding bad behavior.
Ideally, you recapitalize the bad lender, taking it over and diluting or wiping out the sharedholders in the process. Restructure what loans you can (and it's a nasty trick--probably not very doable in this environment) and let the bad ones go bust. Keep the lender alive and paying its debts until things start to return to normal and sell it back off. The end result is that you avoid a system-wide collapse, the people who did dumb things generally didn't make out very well, and you--the bailer--end up only putting in about as much money as is required to keep things moving. This solution often freaks people out because it looks like The Evil Red Hand of Socialism, but it's less catastrophic than the free-market model and less likely to repeat itself than the corporate welfare model.
I was an econ major, so let me see if I can help...
How come a bank is "suddenly" in trouble if it hits a few foreclosures?
There are a few things in play here. First, banks are huge leverage machines. They borrow money on the short term market (that is, they borrow deposits from you and sell commercial paper to lenders like money market funds) at low interest rates and then they loan that money out at high interest rates on the long-term market (e.g. mortgages, car loans). From accounting, assets = liabilities + owner's equity, right? Assets are your loans, liabilities are the loans they took out (the cash in your savings account is a liability, not an asset), and then whatever's left is the bank's equity. Banks are leveraged high enough that the owner's equity is very small relative to the assets and liabilities, so if the assets drop a few percentage points, they're easily wiped out.
Second, we're not talking about a few foreclosures. We're talking about a *lot* of foreclosures. Worse, we're talking about the market realizing that there are likely to be even more foreclosures in the future. That lowers the market prices of the loans that banks have that *haven't* been foreclosed upon. Loans across the board become less valuable. If it's bad enough, banks can become undercaptialized simply because a of a major swing in the market for debt.
It looks like one of the big precipitating factors was the failure of Lehman Brothers. Lehman was allowed to fail, it defaulted on a lot of debt, and a few money market funds started to lose value. That signaled to everybody in the world that money market funds are not necessarily safe, so there was a massive run on them. People pulled out of the market for short term debt and dumped their money into government bonds and cash for safety. Suddenly, if you're a bank whose short term debt is turning over and you need to borrow more money, you find that the money you would have borrowed on the commercial paper market isn't there any more. At least, not without paying a ridiculous interest rate. This sort of thing happens across the board, stopping most loan transactions between businesses. That's why you hear that the credit markets "froze up".
It'll still get it's money from property value right? This property is a tangible asset right? It's just not liquid.
That's true. But there's a chain reaction going on here. A bubble is popping. Credit markets tighten up, causing house prices to plummet. People weren't paying cash for houses. Now the asset backing the bad loan may not be enough to cover the bad loan. Banks are stuck with a choice between owning huge swaths of land that won't cover their debts (not to mention the operational problems of essentially becoming real estate companies, and the fact that if they flood the market with property, the problem will only get worse), or dealing with people who aren't paying their debts on time, causing the value of their loan portfolios to drop. Again, remember that these guys are *hugely* leveraged, so they can't afford to take much of a haircut.
How come they didn't say "hmm, mortgages have been defaulting 3% more than normal... maybe we should tighten standards for a bit to reduce our income loss?
On one hand, you're absolutely right. Loan standards were awful. The problem is especially bad when it comes to the "nonbank" entities that put out most of the subprime paper. At least normal banks were regulated to take some of the edge off the problem. Investment banks and little shops that loaned out money and then resold the debt--not so much. Not only that, those guys don't have any rules about how much they can leverage. That's why the first ones to die were the investment banks. Their positions were riskier and more heavily leveraged.
There's way more to it than this, but these are a few highlights. Those should at least cover the big picture
No, AIG was leveraged out the ass on CDS's many of them for 3rd parties. In those cases there are no "assets" just bets.
The fact that many of the CDS agreements were just "bets" is immaterial if the failure of those that aren't still causes catastrophic failure. It would be nice to be able to hurt the people who were just betting while rescuing the people who were hedging, but it doesn't work that way, so you have to pick one.
As I see it, the only sensible option is to take over insolvent operations, largely wipe out or at least devalue shareholder equity, and keep the system operating until things an unwind in an orderly fashion. After that, we need to look at how to regulate derivatives more sensibly. Done properly, we should be able to avoid the majority of the moral hazard problem and mitigate the rest with proper regulations.
The problem with mortgages is that just by the very virtue that sub-prime mortgages are more expensive means that they cannot be afforded. Especially negatively amortizing loans quickly became too expensive because the payments adjust even if the interest rate stays the same.
The problem with your explanation is that you're conflating things like sub-prime, negative amortization loans with loans made under CRA and other regulations that encouraged lending in poorer communities. Yellen explicitly demarcates between them because they're different. The paper deals explicitly with the CRA, because that's the most common scapegoat right now. The reality is that loans made under that program *did not* underperform on average, so there's no reason to blame that sort of regulation for this mess.
Also all lenders fell under the same rules.
This is simply false. Different rules applied to different lenders. For example, the CRA rules did not restrict small non-bank lenders that pumped out low quality mortgages and securitized them.
All Lenders have to be a part of the equal housing act and faced even tougher rules if they wanted to be licensed with HUD.
Specifically, which requirements are you referring to? That claim is very vague.
All lenders (especially big ones) faced scrutiny if they didn't have a certain percentage of their portfolio with under qualified borrowers.
I really don't think that you understand the regulations in question. How are you defining "under-qualified" and what was the regulation that imposed the rule you're talking about? Because the rules everybody seems to want to blame are designed not to force banks to loan to "underqualified" people but rather to make loans in the neighborhoods where they take deposits.
Further, the idea that banks had their arms twisted into making these loans is absolute nonsense. Let's do a thought experiment. The government orders you to make a certain number of loans that you wouldn't have otherwise made because you know that they'll be unprofitable. Do you:
1) Do the bare minimum and complain about the liberals in Congress.
2) Leverage yourself like crazy and make shitloads of them.
Because if I saw those loans as dangerous and unprofitable, I certainly wouldn't be doing (2). At least, not unless I could bundle those loans all into a pile, take out some unregulated insurance on them, and sell them as a high grade security to somebody else. And if that was the case, I wouldn't need the government pushing me to do it.
Now you are right that it was also greed. Nobody told New Century to be in the ONLY Sub-Prime business. Nobody told Washington Mutual to basically stop underwriting it's own loans and just approve whatever came it's way. The banks and brokers and other lenders all came together and made a giant mess out of the market by assuming way more risk then they could afford to cover.
If I was to blame two driving forces behind this, they would be:
1) Long term low interest rates by the Federal Reserve.
2) New financial instruments that allowed unwise and unscrupulous financial players to funnel all the extra money caused by (1) into something with an artificially high yield.
I would put "banks being forced by the government to make loans" just slightly ahead of "the communists and their pollution of our precious bodily fluids." The data doesn't bear out that explanation and there's a perfectly good economic explanation that seems to be popular among the financial experts, if not among partisan hacks.
For the record, I don't blame this purely on Republicans. Clinton's SEC chairman warned about speculation on credit default swaps years ago, and he was roundly shut down by members of both parties. Likewise, the looser and looser regulation that enabled this was largely applauded by both parties. Where I differ is on the idea that somehow too much regulation was a major (or even significant) player in this disaster. That idea is both ridiculous and dangerous.
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In general, I'd agree with you that anything we can do to make any organization more efficient is a good thing. We might do well to consider the demand shock that a HUGE and instant uptick in unemployment would cause to an economy that has already had the bottom fall out of aggregate demand. Sometimes it's wise to take things slowly.
You do realize that, per the constitution, the President has a great deal of say in what laws and regulations get passed, and that per tradition, the President has a lot of political power to push an agenda, yes? Not to mention the appointments to regulatory posts...
So by "one" you actually meant "lots and lots" in this case? Anyway, I'm sure that guy will be thrilled to know that at least he's one of only a few people who are totally screwed for no good reason.
As I see it, there's a small game theory problem with that. It gives you no reason not to kill your victim to eliminate witnesses. This type of punishment often results in a reduction in the rate of crime X accompanied by an increase in the rate of "crime X plus murder afterward."
The important thing to remember about those elasticities is that they are short run entities. If the price of gas doubles tomorrow, you're unlikely to be able to make the expensive changes to your life to adjust to it tomorrow. You just suck it up.
If the price of gas doubles tomorrow and stays that high in real terms for the next 10 years, your elasticity of demand looks remarkably different. You'll restructure the way you live your life to avoid the new expense, and the quantity of gas purchased over time will decrease. That's why it's possible that this summer's oil shock, while resulting in windfall piles of cash for oil producers in the short run, may very well harm them significantly in the long run. It depends on how good our memories are over the next few years.
Freddy and Fannie were *losing* market share to "non-bank lenders" during the sub-prime run up. Look it up. That's because "non-bank lenders" (not regulated by the CRA *at all*) were loaning out bad paper, wrapping it up, and selling it on the commercial paper market. FM/FM were just doing what they normally do.
No, no, no. They didn't fail because they bought riskier portfolios than the lending market at large. In fact, their portfolios were in slightly better shape than the market at large (not that they wouldn't have done it if they could--they were on a tighter regulatory leash than the market at large). They failed because they were less well capitalized than the market at large. That is where blame can reasonably be placed on the government for their implicit guarantee. But that blame only goes as far as the failure of the GSEs. It shouldn't be stretched to imply that the GSEs were driving the subprime market. The numbers show that they simply weren't.
The problem is that it's not factual. The CRA does not force such lending. CRA loans did not underperform. CRA loans were not among the higher priced sub-prime loans. CRA regulated institutions made up an ever smaller portion of the lending as non-CRA institutions took over. The CRA is a red herring.
OK, thought experiment. You're a bank. The big bad liberal government shows up and says, "Lend money to poor black people so they can get houses and you lose money." You have to comply, but you just know that each of those loans will be unprofitable. Do you:
a) Do the bare minimum to comply and then spend a fortune lobbying Congress to get them to stop.
b) Leverage yourself out the wazoo and loan money to anybody with a pulse.
You seem to be implying that the rational thing for banks to do was (b). I don't know how that syncs up with your belief that the free market will do the right thing given the circumstances, because (a) seems a lot more rational.
The fact that neither of these things actually happened in any great volume because the CRA doesn't apply to the lenders who lent most of the garbage kind of moots the whole thing, but I think it's an instructive thought experiment.
I'd be interested in seeing this quantified, given that the same set of state and federal governments that give us overpriced tools in the DoD also brought us the interstate highway system and countless other pieces of infrastructure we base our society around.
Only if you're willing to say things like, "the Fourth Amendment gave the state the power to require warrants to search a citizen's home" or "ripping the wings off of a fly enhances its inability to fly."
I assume you mean that assumptions about future changes in the money supply factor into risk calculations.
Nominal interest rates don't reassert themselves. Real interest rates tend to. In fact, that's one of the points of the Austrian critique of interest rate manipulation.
More importantly, individual interest rates on different investments will move out of concert with Fed activity depending on perceived risk (risk which is calculated *entirely* independently of, say the federal funds rate).
If there was a more worthy investment, you would have made it. The fact that you made the investment indicates that there was no worthy investment, and you were keeping the money because you simply preferred liquidity. Nothing in your example shows that you were "right" to prefer liquidity. The problem is that you're defining the "right thing to do" as "the thing I would have done in the absence of Fed activity." With that definition, of course you're going to show that the Fed causes mistakes. The problem is that those don't actually appear to be mistakes by any other objective measure.
If interest rates are high and nobody is lending because they fear that all debts will be erased during the imminent alien invasion and government action somehow gets lending to start, was it the "wrong" thing to do? Only if they were right about the invasion and the market was wrong.
To chose a more realistic example, if we reach a dead end in which it is rational for the market to lend as a whole and irrational for each individual lender to lend, we're going to be stuck in a credit freeze for a very long time until somebody in the market does something irrational or some external player changes the incentives.
So your position is that the Federal Reserve does not contribute to excess volatility, but this time they screwed the pooch? I'd say that's reasonable. Over the long haul, central banking has been good for the business cycle. In this case, I'd argue that they misread the market because their normal indicators (eg core inflation) were confounded by a housing bubble and they decided incorrectly that it would be easier to clean up the mess than to pop the bubble.
No, you've already *asserted* this. In fact, *I'm arguing with you* that interest rate manipulation *cannot* explain the preference for sub-prime lending over any other risky lending in the absence of another mitigating factor.
As for the legislative obsession with increasing home demand, I'm against it, but I also disagree that it explains a bubble. Let's take an example: You're allowed to write off interest on your mortgage. OK, that causes house prices to go up across the board. Is that a bubble or irrational? No, it simply increases the market valuation of the homes forever. If they allowed an interest write off and then removed it 10 years down the road, that would be a contributor, but that's not what happened. The same thing goes for the GSEs and any number of other activities designed to inrease home ownership. The would drive up home prices above their natural market level, but that by itself doesn't constitute a bubble.
No, that's not true at all. A *part* of the interest rate is a risk premium. If risk goes to zero, interest rates don't go to zero.
I think that the more fundamental question is why it necessarily follows that they do. It seems to be based on the assumption that real interest rates don't reassert themselves over time or that the market interest rate at any given time will somehow produce the most successful investments.
Exactly how was this a malinvestment? You invested $850M and got $900M back. It would only be a malinvestment if it turned out to return less than you expected it to. The market wasn't necessarily indicating that it was too risky. In fact, there was no risk premium implicit in your description.
Relatively predictable based on historical norms. A savy investor should be able to look at long term yield curves and decide on an investment that minimizes exposure to interest rate risk.
Well, the article purports to. But I agree with you that it doesn't.
I'm not suggesting that the GSEs didn't invest in risky securities. I'm pointing out that attempting to scapegoat them for the bubble is quantitatively wrong. There are a few problems with the theory that the GSEs drove the bubble, the two most obvious being that their portfolios didn't underperform the national average and that they were losing market share through the worst excesses of the market. It's blaming the canary for the mine explosion.
Suggesting that volatility has increased since the Federal Reserve system came into effect is somewhat historically tone deaf. But more importantly, you're not drawing the distinction between the risk premium portion of an interest rate and the interest rate as a whole. If the "risk free" interest rate (let's say, good quality US government debt) drops, other interest rates will drop with it, but their spreads will still reflect the relative risk. Nothing about the change of the "risk free" rate should change those s
The problem here is the overloading of the word. You're probably referring to monetary inflation. That's not totally out of left field, but most economists are talking about a general increase in price levels when they use the word.
Because you can't talk about manipulating interest rates and their effect on asset prices (local or global) and not talk about inflation. The subjects are inherently intertwined.
I'd agree with that to some extent, but it assumes that low interest rates will necessarily cause those malinvestments. That's what I'm quibbling with. I would say that assuming a malinvestment is going to occur, low interest rates increase the incentive to pour money into it, especially if the malinvestment is though to be low risk.
Sure.
A consistent monetary policy is one that produces relatively predictable price inflation.
Let me pretend to be surprised that the link is from mises.org. I don't think that most of mainstream economics will disagree with the idea that the Fed's credit expansion enabled the housing credit bubble. I take issue with the Austrians' assumption that it was a necessary consequence of credit expansion. The question is, why housing, specifically?
Under normal circumstances, a credit expansion would cause an increase in capital investment across the board. Eventually, we would have seen an uptick in the overall price level and the Fed would have taken its foot off the gas. In this case, we saw a largely isolated bubble. That reeks of poor risk assessment rather than a bad call on future interest rates. The money shot in your link is here:
I'd argue against FM/FM being a major player in the low grade debt bubble, but the key here is that rather than a uniform expansion in investment and consumption of big ticket items as expected, we saw a bubble because the financial industry had managed to find a way to create an asymmetry in risk premiums for home loan backed assets. The last sentence makes no sense as the "fooling" and reversion to reality were with regards to risk and not the discount rate. He points it out himself. If the "government intervention" theory is to be borne out, it has to explain this asymmetry.
You can't, assuming the Fed moves things willy nilly all over the place with no connection to reality. If it did that, I imagine it would be abolished fairly quickly. As it stands, most investors seem to have a pretty easy time predicting the general direction of the Fed's actions over time. If t
How will you vote next election if the weather gets really bad over the next four years? Or if we have more earthquakes than usual? Sunspots?
I think you're misreading the mainstream economics position on inflation. Consistent increases in the overall price level are completely sustainable. Consistent increases in one sector (e.g. housing) are not. The problem with bubbles is a misallocation resources because the players in the market did a bad job of assessing risk and predicting future prices of that asset. I can't think of a rational argument that could make a good causal relationship between uniform price increases and an asset price bubble.
That's not to say that the Fed acted correctly here. The credit expansion clearly allowed the misallocation of money to the housing market to grow far larger than it would have otherwise. I'm just suggesting that misallocation of investments are not a necessary consequence of consistent monetary policy.
I'm consistently amazed at the common refrain that World War II restarted the economy used as an argument that public spending can't restart a stalled economy.
This is true in the general case, but we're not in one of those situations right now. At this point, anybody with extra money appears to be holding cash or government debt rather than private debt. The credit markets are frozen. The yield on the 4-week treasury dipped negative yesterday. Putting cash back into the hands of lenders isn't going to change that.
The side effect of this frozen state is that the government can take up the slack by borrowing and spending. It can borrow at ridiculously low rates now, so while we would normally cut taxes and let private industry use the extra money to invest, in this case you'll probably get a significantly bigger bang out of pubic deficit spending.
As I see it, the real problem is that there aren't many good infrastructure projects that are worth doing that could start *right now*. At least, not many when compared to the excess capacity that the slack in our economy has created.
The problem with that solution is that it isolates the worst players (both borrowers and lenders) and pours money directly into their pockets with no strings attached. There aren't a lot of good ways to make a bailout work, but I don't think that this method would work out well in the long run.
The solution I favor suffers from a similar problem. As I see it (and as *lots* of economists see it), we should be going the pure capital injection route (the route they're just starting to figure out was the right way to go from the beginning). Let insolvent banks issue stock, buy that stock, and take partial control of the banks. Recapitalize them and keep them under adult supervision until they've recovered enough to buy that extra stock back.
The problem, of course, is that this looks like the Evil Red Hand of Socialism, so it's hard to sell. It's much easier to convince them to spend hundreds of billions of dollars overpaying for bad assets. Yikes.
That's a very interesting theory... Exactly how does having a central bank do this?
I generally agree with you. As somebody who is renting and has been waiting for home prices to crash for a few years, I don't have a lot of pity for the lenders in this situation. I only have the same personal interest in the market that any potential home owner might have, and my formal background is limited to a BS in economics, and it was blindingly obvious to me. The real economists I know said the same thing (I know one with a PhD from Harvard whose wife is an investment banker who was still renting). If your job hinges on the ability to see value and trends in the housing market and you kept making those loans, you deserve to get wiped out.
If I understand you correctly, your question is, Why couldn't people with good credit get loans from sub-prime lenders? I don't know for sure, but I suspect that some of them had a business model that had them specializing in very high yield securities, which would require that they securitize mostly (or entirely) loans with a really high interest rate. Nobody with good credit would need those loans, so they were stuck bottom feeding.
Remember, the sub-prime mess was largely caused by a huge demand for high interest rate securities with "low risk" attached to them. The rates on US treasuries was kept low for a long time by the Fed, so literally trillions of dollars that might have been kept in treasuries was out looking for an alternative. When it looked like mortgaged backed securities could fit the bill (high yield and "safe" due to CDSs), people couldn't make mortgages fast enough to meet demand. In fact, there was more money out there than there were qualified borrowers. It was a race to the bottom. Anybody with any economic sense should have known that if a security has a low risk rating and a high yield, one of those things is wrong.
I started with econ as an elective as a Comp Eng major and decided to do a second degree. My area of interest in engineering was signal processing, so dealing with data and trends and squiggly lines naturally drew me to macroeconomics, banking, and stuff like that. I pay the bills with the engineering degree, but the econ classes have at least helped me keep more of my money. Well worth the time to study.
I'll grant that. But let's go one further: Even if we're talking about "betting" being the vast majority of these things, they're still assets on the books of very real entities, many of which are too big to fail without causing serious repercussions. Does it really matter if, say, Bear Stearns was "betting" when it took a CDS position if the failure of AIG results in the failure of Bear? The end result is still a *lot* of legitimate lenders lose money when it goes under.
I assume that you meant a money market fund breaking the buck. The problem is that it only takes one, as we saw with the fallout from Lehman. It precipitated a run on the money market in general. That's a *bad* situation to be in. Anybody who borrows short and lends long (i.e. anybody who acts like a bank) gets hit *hard* when the short term money markets freeze up. The problem isn't everybody losing 5% off of their money market fund. The problem is a few big funds losing 5% and causing all of the other ones to collapse sympathetically.
Further, insurance against the default of a debtor who doesn't default is not immaterial. Sure, it is in the long run once those debts have been paid, but you can't forget that the insurance backing those debts is part of their market value. Having the debt of all of those major players suddenly devalue across the board would not be good for anybody's balance sheet. If you were on the edge of solvency and "safe" assets like that suddenly take a haircut, it could put you under. If you happen to be one of those big players, so much the worse.
Is it really that much taxpayer money if you consider the bite out of GDP that even a short recession takes? We're talking about a huge economy here, so a few percentage points of GDP over a few years is staggering amounts of money.
I'll say this: When I was in college, we used to speculate about what would happen if a really big player in the banking industry (either a major issuer of debt or a major guarantor of debt) went bust. None of the stories ended well, and in retrospect, we weren't even assuming as much interconnectedness as there appears to be today. They all played out in roughly the same way: One major player goes down and the subsequent freezing of various credit markets bring more players down with them. The feedback loop should be obvious. This is a large-scale version of the types of things we see in other banking crises. I could be wrong (and I would be in good company with a lot of excellent economists who have no vested interest in this answer), but I don't know of any situation where rolling the dice as you suggest has paid off, and I don't think that this one is any different.
The problem there is moral hazard. What you've proposed is essentially a targeted gift specifically for the worst players in the industry (both borrowers and lenders). If you're going to put money in to bail out failed business ventures, you have to do it in such a way that you're not rewarding bad behavior.
Ideally, you recapitalize the bad lender, taking it over and diluting or wiping out the sharedholders in the process. Restructure what loans you can (and it's a nasty trick--probably not very doable in this environment) and let the bad ones go bust. Keep the lender alive and paying its debts until things start to return to normal and sell it back off. The end result is that you avoid a system-wide collapse, the people who did dumb things generally didn't make out very well, and you--the bailer--end up only putting in about as much money as is required to keep things moving. This solution often freaks people out because it looks like The Evil Red Hand of Socialism, but it's less catastrophic than the free-market model and less likely to repeat itself than the corporate welfare model.
There are a few things in play here. First, banks are huge leverage machines. They borrow money on the short term market (that is, they borrow deposits from you and sell commercial paper to lenders like money market funds) at low interest rates and then they loan that money out at high interest rates on the long-term market (e.g. mortgages, car loans). From accounting, assets = liabilities + owner's equity, right? Assets are your loans, liabilities are the loans they took out (the cash in your savings account is a liability, not an asset), and then whatever's left is the bank's equity. Banks are leveraged high enough that the owner's equity is very small relative to the assets and liabilities, so if the assets drop a few percentage points, they're easily wiped out.
Second, we're not talking about a few foreclosures. We're talking about a *lot* of foreclosures. Worse, we're talking about the market realizing that there are likely to be even more foreclosures in the future. That lowers the market prices of the loans that banks have that *haven't* been foreclosed upon. Loans across the board become less valuable. If it's bad enough, banks can become undercaptialized simply because a of a major swing in the market for debt.
It looks like one of the big precipitating factors was the failure of Lehman Brothers. Lehman was allowed to fail, it defaulted on a lot of debt, and a few money market funds started to lose value. That signaled to everybody in the world that money market funds are not necessarily safe, so there was a massive run on them. People pulled out of the market for short term debt and dumped their money into government bonds and cash for safety. Suddenly, if you're a bank whose short term debt is turning over and you need to borrow more money, you find that the money you would have borrowed on the commercial paper market isn't there any more. At least, not without paying a ridiculous interest rate. This sort of thing happens across the board, stopping most loan transactions between businesses. That's why you hear that the credit markets "froze up".
That's true. But there's a chain reaction going on here. A bubble is popping. Credit markets tighten up, causing house prices to plummet. People weren't paying cash for houses. Now the asset backing the bad loan may not be enough to cover the bad loan. Banks are stuck with a choice between owning huge swaths of land that won't cover their debts (not to mention the operational problems of essentially becoming real estate companies, and the fact that if they flood the market with property, the problem will only get worse), or dealing with people who aren't paying their debts on time, causing the value of their loan portfolios to drop. Again, remember that these guys are *hugely* leveraged, so they can't afford to take much of a haircut.
On one hand, you're absolutely right. Loan standards were awful. The problem is especially bad when it comes to the "nonbank" entities that put out most of the subprime paper. At least normal banks were regulated to take some of the edge off the problem. Investment banks and little shops that loaned out money and then resold the debt--not so much. Not only that, those guys don't have any rules about how much they can leverage. That's why the first ones to die were the investment banks. Their positions were riskier and more heavily leveraged.
There's way more to it than this, but these are a few highlights. Those should at least cover the big picture
The fact that many of the CDS agreements were just "bets" is immaterial if the failure of those that aren't still causes catastrophic failure. It would be nice to be able to hurt the people who were just betting while rescuing the people who were hedging, but it doesn't work that way, so you have to pick one.
As I see it, the only sensible option is to take over insolvent operations, largely wipe out or at least devalue shareholder equity, and keep the system operating until things an unwind in an orderly fashion. After that, we need to look at how to regulate derivatives more sensibly. Done properly, we should be able to avoid the majority of the moral hazard problem and mitigate the rest with proper regulations.
The problem with your explanation is that you're conflating things like sub-prime, negative amortization loans with loans made under CRA and other regulations that encouraged lending in poorer communities. Yellen explicitly demarcates between them because they're different. The paper deals explicitly with the CRA, because that's the most common scapegoat right now. The reality is that loans made under that program *did not* underperform on average, so there's no reason to blame that sort of regulation for this mess.
This is simply false. Different rules applied to different lenders. For example, the CRA rules did not restrict small non-bank lenders that pumped out low quality mortgages and securitized them.
Specifically, which requirements are you referring to? That claim is very vague.
I really don't think that you understand the regulations in question. How are you defining "under-qualified" and what was the regulation that imposed the rule you're talking about? Because the rules everybody seems to want to blame are designed not to force banks to loan to "underqualified" people but rather to make loans in the neighborhoods where they take deposits.
Further, the idea that banks had their arms twisted into making these loans is absolute nonsense. Let's do a thought experiment. The government orders you to make a certain number of loans that you wouldn't have otherwise made because you know that they'll be unprofitable. Do you:
1) Do the bare minimum and complain about the liberals in Congress.
2) Leverage yourself like crazy and make shitloads of them.
Because if I saw those loans as dangerous and unprofitable, I certainly wouldn't be doing (2). At least, not unless I could bundle those loans all into a pile, take out some unregulated insurance on them, and sell them as a high grade security to somebody else. And if that was the case, I wouldn't need the government pushing me to do it.
If I was to blame two driving forces behind this, they would be:
1) Long term low interest rates by the Federal Reserve.
2) New financial instruments that allowed unwise and unscrupulous financial players to funnel all the extra money caused by (1) into something with an artificially high yield.
I would put "banks being forced by the government to make loans" just slightly ahead of "the communists and their pollution of our precious bodily fluids." The data doesn't bear out that explanation and there's a perfectly good economic explanation that seems to be popular among the financial experts, if not among partisan hacks.
For the record, I don't blame this purely on Republicans. Clinton's SEC chairman warned about speculation on credit default swaps years ago, and he was roundly shut down by members of both parties. Likewise, the looser and looser regulation that enabled this was largely applauded by both parties. Where I differ is on the idea that somehow too much regulation was a major (or even significant) player in this disaster. That idea is both ridiculous and dangerous.
So, they had no problems getting short term funding on the commercial paper market? Overnight loans? None of that stuff?