Friday, May 4, 2012

The Fed Gets One Right

Thanks to The Life of Julia and today’s crappy unemployment report, this story got lost in the shuffle. But it’s a big one.

Remember John McCain’s explanation for the mortgage crisis?: “The regulators were asleep at the switch.” The crisis handed him an opportunity to give the voters a clear choice between capitalism and socialism, and he chose to join Obama in embracing the socialist narrative. No wonder he lost.

Now, an unlikely source calls the socialist narrative into question. Christopher L. Foote, Kristopher S. Gerardi, and Paul S. Wille—three economists at the Federal Reserve—have issued “The Causes of the Foreclosure Crisis”. According to the abstract, “This paper presents 12 facts about the mortgage market. The authors argue that the facts refute the popular story that the crisis resulted from financial industry insiders deceiving uninformed mortgage borrowers and investors.”

Two theories of the mortgage crisis

Source: Federal Reserve

The twelve facts are:

Fact 1: Resets of adjustable-rate mortgages did not cause the foreclosure crisis.
Fact 2: No mortgage was “designed to fail.”
Fact 3: There was little innovation in mortgage markets in the 2000s.
Fact 4: Government policy toward the mortgage market did not change much from 1990 to 2005.
Fact 5: The originate-to-distribute model was not new.
Fact 6: MBSs, CDOs, and other “complex financial products” had been widely used for decades.
Fact 7: Mortgage investors had lots of information.
Fact 8: Investors understood the risks.
Fact 9: Investors were optimistic about house prices.
Fact 10: Mortgage market insiders were the biggest losers.
Fact 11: Mortgage market outsiders were the biggest winners.
Fact 12: Top-rated bonds backed by mortgages did not turn out to be “toxic.” Top-rated bonds in collateralized debt obligations (CDOs) did.
Instead of the “Insiders” theory, the authors offer a much simpler explanation for the mortgage crisis: the “Bubble Fever” theory. Everything lenders, borrowers, and investors did during the housing bubble can be explained by their belief that housing prices would continue to rise.

Systematic failure requires systematic explanation.

The full report is rather long (62 pages) but I strongly recommend reading at least the introduction. It is available on the Federal Reserve Bank of Boston website.

5 comments:

  1. Excellent article and loved the illustrations. Here is a compliment to this article:

    Why no top executives have been prosecuted for the financial crisis: The real answer

    http://www.gather.com/viewArticle.action?articleId=281474979899599

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  2. The beauty of a free society, without an all powerful government handing out favors, is that we would not have to care much about how much credit people are using. Say AnyBank is loaning too much money to Mike. Mike can't pay it back. Who cares, except AnyBank and its stockholders? AnyBank will be out of business soon, and its stockholders will be poorer, but it doesn't affect me much.

    I would prefer that AnyBank had made better decisions, but that is its business. Almost all companies like AnyBank will make good decisions, if they lack government backing.

    The bug in the soup is that we do have an all powerful government which hands out favors, contrary to our Constitution. It is willing to bail out AnyBank using our money, and did so before our eyes. Now, bad decisions are encouraged (moral hazard) by the political guarantees of the government. When AnyBank loses money, the cry goes out that we have to save it (sniff, tears).

    Politicians are robbing us blind, under the guise that they are only taking the money of the other guy (the rich guy). Wake up. They are taking the future from us all and stuffing it into their pockets.

    Our recession was promoted by collapsing home prices and mortgage losses, after an extended period of government providing easy money and guarantees to support Fannie Mae, Freddie Mac, and the entire banking system. The government is still doing this. The bad housing policy was designed, encouraged, and required by government, mostly by Democrats.

    The government's ability to issue guarantees is an unlimited, off-budget, extremely dangerous power. Guarantees were granted to Fannie Mae and Freddie Mac (among other institutions) above and below the table. They used these guarantees to borrow and lend massive capital resources. This power was used unwisely to build houses that could not be paid for. This has caused our financial crisis.

    The government guarantees bank deposits. Depositors think that this is good, but this encourages system-wide risk taking. Bank executives benefit from high risk, high return investments, until they hit a bad patch and the government pays back the losses of the depositors (but not the investors). There is a major banking crisis every 20 years.

    Here is what the guarantees mean: "Heads I win, tails you lose". Our politicians ("the government") made good on their promises with the bailouts, while saying "We're the Solution".

    The recent debt limit negotiations mean nothing when the government can make guarantees off-budget which send us into poverty. The Solyndra failure cost the government nothing until it failed spectacularly. Now, the government guarantee of $535 million has cost the taxpayer real money, just as if the government had spent it up front, on-budget. If Solyndra had succeeded, the taxpayer would have gotten nothing.

    We Guarantee It - The Government Caused the Economic Crisis

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  3. Andrew: I agree wholeheartedly with almost everything you said, so let me comment on the one thing that - I wouldn't say I disagree - but that I'm not certain about.

    As much as I dislike government involvement in the economy, it does seem that federal deposit insurance has worked. Yes, there is a banking crisis every 20 years or so, as you pointed out, but the magnitude of these crises is small compared to what we had seen prior to FDIC. The run on the bank is now just something we see in movies like It's a Wonderful Life.

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  4. To Michael Isenberg,

    Most importantly, thank you for your support.

    About banks and government guarantees. Any good effect has to be balanced against the cost and the systemic bad effects. The FDIC is in trouble and has cost $100+ billion from time to time above the insurance premiums which it collects from banks.

    "It's a Wonderful Life" is interesting. In the bank run scene, James Stewart explains to the crowd that their money isn't really in the bank, it has been lent out to build houses. So, this is news to them! They thought their money was safe in the back room, and now they are told it is gone, dependent on the bank staying in business. That is reassuring.

    Consider, would anyone loan money to a bank (make deposits) without the government guarantee? I wouldn't. I would find a pure vault and checking services institution and pay them $100 per year for the service.

    One could argue, this shows that the guarantee is absolutely necessary. I say that it shows the primary instability of US banking and the fundamental fraud that keeps banks going in their current form.

    If you want interest on a loan, then there is risk. Banks have transfered their risk onto the government to the extent that their FDIC premiums are not sufficient to pay for bank failures. They have transferred a lot of risk. Worse, each bank is encouraged to take excess risk both to meet political pressure and to make extra profits. Heads they win, tails we lose.

    Government is not merely intermediating, that is enabling a voluntary market which might not otherwise exist. Instead, government is subsidizing an industry where the depositers are ignorant of what is going on.

    So, have two types of account,
    • Checking: The money is in the back room and the bank handles checks or debit cards for the depositers for a fee.
    • Investment: (Dont' call it savings) The bank accepts your money on terms that match its investment portfolio and you recieve interest, dividends, gains, and losses as earned, like a mutual fund.

    Under this system, everyone gets the results which they expect and there are no bank runs. Yes, there would be much less investment through banks. The availability of capital would match the preferences of depositors, and government would not be a shadow investor commandeering resources to support a favored industry.

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  5. "Would anyone loan money to a bank (make deposits) without the government guarantee?"

    Not at today's interest rates!

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