The Four Horsemen of the Financial Panic
From Americans for Tax Reform: No matter what one thinks of the financial bailout package, we ought to at least agree how we got here. Below are the real actors behind the mortgage panic of 2008:
1. Government-sponsored enterprises (GSEs). Fannie Mae, et al, bears a large share of the responsibility.
2. Easy money from the Federal Reserve. On January 3, 2001, the Federal Reserve cut the federal funds rate by 50 basis points, to 6.00%. They continued to do so until the rate hit a bottom of 1.00% on June 25, 2003.
3. Community Reinvestment Act (CRA). This legislation, first passed in 1977, gave federal regulators the power to encourage banks to issue loans to high-risk households and small businesses.
4. Mark-to-market accounting rules. This refers to an accounting practice that forces a balance sheet to value an asset at its current market price (that is, what it could be sold for at the time). Mark-to-market is an arbitrarily-restrictive accounting practice that should be scrapped for assets like securities which generate current income. Doing this alone would solve much of the problem.
33 Comments:
Dr. Perry,
You unfortunately left off number 5: Miscalculation of risk factors which led to high leveraging of mortgage backed securities investments on the part of the investment banks. I do agree with 1 through 4, but the investment banks completely got the risk calcs wrong.
You are going to blame the Community Reinvestment Act (CRA). which passed in 1977 for the greedy lendors who wrote sub-primes loans within the last few years.
If the CRA was one of the root causes of the current financial panic the mortage foreclosures would not have happened 30 years later.
What a completely ridiculous comment by the author, put the blame where it belongs NOT on your personal biased views. Many forclosures are also from people who were flipping homes because of the easy money available.
Without the government quasi-guaranteeing mortgages where they lowered the allowable income needed to qualify and allowed zero percent down (a sure fired way to get foreclosures) your numbers 2-4 wouldn't have happened.
And we are still in the soup as the mortgage/banking bill of a few months ago allows 3.5% down (more foreclosures coming) for an allowable $740,000 mortgage.
Anonymous,
Click here and learn the facts on the CRA, complete with about 50 substantiating links.
P.S.) “about 50 substantiating links” does not include approximately 20 posts I have done on the topic (to date).
Mark Thoma disagrees:
"Yet Again, It Wasn't the Community Reinvestment Act..."
Business Week disagrees:
Community Reinvestment Act had nothing to do with subprime crisis
Media Matters disagrees:
Media conservatives baselessly blame Community Reinvestment Act for foreclosure spike
"Mark Thoma disagrees"...
"Business Week disagrees"...
"Media Matters disagrees"...
O.K. then, three for three LIBTARDS agree they collectively have at best a tenuous grip on reality...
So what?
Each one of these commentaries were easy targets for a thorough fisking...
Even the Financial Accounting Standards Board’s couldn't figure out how to deal with the mark-to-market accounting shortly after the Enron debacle. Even the Arthur Andersen accounting firm had problems with it which led to its failure too. Enron filed for bankruptcy 2001. The Financial Accounting Standards Board’s has had 7 years and they did nothing. nomedals.blogspot.com
Hubris by quantitative model developers and the executives who believed in them, who used inappropriate statistical methods without proper consideration of the linkages and feedback loops embedded in the system.
The agency problem, in many guises, specifically the disconnection of the person/institution making the loan from any long-term responsibility for the outcome.
You might also consider adding the following to your list:
5. The rating agencies who assigned AAA ratings to mortgage backed securities and derivatives that had sub-prime exposure; these professionals did a job that was comparable to the intelligence on weapons of mass destruction in Iraq yet we hear virtually nothing about their lack of performance on risk assessment
6. Investment banks engaging in leverage of as much as 30:1 without any regulatory oversight
7. Basell II international banking rules that applied increased capital requirements for conventional mortgages but NOT to mortages held in the form of securities
8. Financial advisers advocating home equity loans/mortgages so that the money could be invested on the stock market
9. Failure of government to regulate emerging hybrid securities in the investment banking industry
10. Anyone who believes that elevators only ever go up.
There are lots of folks who enjoyed the spiked punch at this party.
Carpe Diem is an ivory tower twit. He is so wet behind the ears that he has never experienced a consumer led recession in real life or behind the lecturn.
Maybe it's time he stood up and spoke instead of hiding behind his heroes.
Juandos, the steward for Carpe Diem, either Southwest or TWA, in St. Louis, is truly a friggin' flying twit.
Not a single mention of 8 years of Bush43 administration.
Pathetic neocon libertarian losers.
I'll give you a pass, q-tip.
How about #5 - excessive leverage in the investment banks and #6 - off-balance sheet vehicles with near infinite leverage. With about 8% equity like commercial banks instead of 2.5% or less with SIVs, a 3% default rate on mortgages would be bad, but would not have sunk companies.
For those Democrats still in denial:
You should know that even Bill Clinton knows who is to blame for the housing mess (as he freely acknowledges at the end of the second video in this post).
What is the best course of action:
1. Buy assets that private companies will not buy that will need to be administered by a massive staff and hope that we can create a bottom to the market and contain the crisis;
2. Change the mark-to-market rule so that the securities reflect the stream of payments rather than the most recent fire-sale trade; thereby easing capital requirements
3. Inject capital in return for large equity stakes in major players
4. Let companies that took excessive risks go bankrupt and risk a systemic collapse of the financial system
Quo vadis?
I have been in the rental business in Los Angeles for more than 25 years.
During that time I have managed an average of 75 units.
There is a "personal" relationship with each tenant.
In all those years I have only had to evict five tenants.
My last eviction was more than five years ago.
qt: "What is the best course of action"
i don't know.
somehow, we need to 'save the financial system' while at the same time leaving those companies 'saved' as impoverished as possible, thus not rewarding their gross mismanagement.
qt, thanks for this bit of information:
7. Basell II international banking rules that applied increased capital requirements for conventional mortgages but NOT to mortages held in the form of securities
I did not know that.
great post today about why 'mark to market' is not to blame for the credit crisis
"Blaming fair-value accounting for the credit crisis is a lot like going to a doctor for a diagnosis and then blaming him for telling you that you are sick.
-Dane Mott , JPMorgan Chase & Co.
. . . Banks don't want to lend to each other because they are not sure how much explosive dreck is in the other guy's balance sheet. Hiding the junk isn't going to help this at all . . . "
from "The Big Picture"a>
Bobble,
The other possibility is that cash is king in a downturn. A bank does not wish to lend capital it may itself need due to the instability of the market.
As Fasbinder would say "Every man for himself and God against all"
qt, I hope you're still reading this. I don't get the Basel II issue with mortgages and securities. The way I read it, Basel II had some agency assign risks to investments and then forced banks to keep reserves according to risk. It doesn't seem that the mortgages were different from the securities only that the bundling concealed the risky nature of the underlying mortgages.
Can you throw me a link to further describe this?
OK, I found a link, but it kind of goes against what qt said.
For residential mortgages, this resulted in a 50% risk weight, or 4% capital charge. The Committee's risk weighting reflected relative risk between asset categories, not within them, and there appears to have been very little empirical analysis to determine whether this risk weighting was appropriate. Equally, there was no recognition that the quality of mortgage process management (from underwriting to loan administration to default management) had any effect on the relative risk of the mortgage lending operations to the bank. Instead, the Committee's decision rested on simple common sense - residential mortgage lending was secured by mortgage collateral; lending practice required substantial borrower equity; lending activity was predominantly local, not national or international, so there was little risk of competitive inequality or contagion; and governments frequently intervened in property markets to soften market downturns3. As the English saying goes, the Committee assumed residential mortgage lending was "as safe as houses."
That indicates to me that the mortgages required less capital behind them than securities. Bundling the mortgages as securities would seem to require more capital behind them, not less.
Clearly I'm missing something.
Bobble:
1) Thank you for the link to the Big Picture. The comments by the head of the site are on target, and --- to my delight --- the quality of the posts in that thread was impressively laudable.
The Big Picture: http://bigpicture.typepad.com/comments/2008/09/fair-value-acco.html
....
2) I particularly liked the post by Greg.
Namely? Well, if banks that refuse to lend to one another now --- fearful, you see, that the other guy is hiding the junk on his books --- then redo their accounting and suddenly find that they are all solven: nothing to worry about, evrything magically in the black!~ --- they will take one another's revisions as sound guides and, full of self-delusion, begin to lend to one another huge sums of their (few) non-toxic assets.
And yes, as an earlier poster there notes, we will then be truly in an Alice-in-Wonderland financial utopia.
.....
3) Final quick-draw observation:
Those posters in Mark's thread here who refuse to blame a failure of regulation on the runaway derivative market and sky-high leveraging of the investment banking system --- as well as in other financial entities --- might ask why the head of the SEC, Chris Cox admitted that his agency had failed terribly in believing that financial markets were self-regulating.
Cox was appointed in 2005. Why?
Well, his predecessor --- the Bush appointed William Donaldson --- actually believed the job of the SEC was to regulate as the law required. He particularly wanted to reign in the starting-to-run-away derivative explosion and extend regulations to hedge funds and others not regulated before a financial crisis emerged.
...
The reaction in the Republican controlled Congress? Off with his head! And so we handed the SEC over to a man who fully shared President Bush's well-known contempt for regulation.
And the result? Si monumentum requis, circumspice
.....
Michael Gordon, AKA, the buggy professor
kt cat,
More on capital requirements under Basel II international banking rules from David Wesell
What about clueless homebuyers and Realtors on commission drinking Koolaid from the National Association of Realtors?
Don't entirely blame WallStreet. Blame every greedy link in this chain. This is our hangover from ten years of easy credit.
Markets are self-regulating. Stupid companies go bankrupt, somebody buys their assets cheap and makes a bundle of money. Life goes on.
Calling mark-to-market "fair-value accounting" is grossly misleading (as many uses of "fair" are). MTM rules trigger unnecessary bankruptcies in companies that are profitable and can make their debt service. MTM creates liquidity traps. MTM can trigger a cascade of unnecessary business failures of businesses in related industries, when ordinarily another company's bankruptcy doesn't affect mine. There is nothing "fair" about MTM.
If mark-to-market devalues assets and creates huge 'losses', does holding on to these assets result down the road in huge profits if the assets perform?
If mark-to-market devalues assets and creates huge 'losses', does holding on to these assets result down the road in huge profits if the assets perform?
That's one of the problems with mark-to-market. It creates spurious non-cash gains as well as non-cash losses. Non-cash gains are a big problem: you can't pay your taxes with equity, the IRS only accepts cash. If you don't have the cash, what if you're forced to liquidate your assets at an inopportune time (like right now) in order to raise that cash? Might that be a financial disaster for your company?
> anonanonanon said...
...a huge line of name-calling BS, with no facts, no arguments, nothing of any value.
Funny how so many without names seem to be liberal idiots with no arguments, and no facts.
> The reaction in the Republican controlled Congress? Off with his head! And so we handed the SEC over to a man who fully shared President Bush's well-known contempt for regulation.
Uh, yeeah, prof, that's why Bush & the GOP attempted to extend and strengthen the oversight (another word for "regulation") over Fannie Mae and Freddie Mac something like 17 times during his admin.
Here's video of those damned GOP bastards attacking one of the regulators.
Also, lessee -- who said this:
I, just briefly will say, Mr. Chairman, obviously, like most of us here, this (Fannie Mae) is one of the great success stories of all time.
And this?
I'll lay my marker down right now, Mr. Chairman. I think Fannie and Freddie need some changes, but I don't think they need dramatic restructuring in terms of their mission...
And this?
I believe there has been more alarm raised about potential unsafety and unsoundness than, in fact, exists.
And this?
Mr. Chairman, we do not have a crisis at Freddie Mac, and in particular at Fannie Mae, under the outstanding leadership of Mr. Frank Raines. Everything in the 1992 act has worked just fine.
And this?
However, I have sat through nearly a dozen hearings where, frankly, we were trying to fix something that wasn't broke.
And this?
The more people, in my judgment, exaggerate a threat of safety and soundness, the more people conjure up the possibility of serious financial losses to the Treasury, which I do not see.
And lastly, this:
I do think I do not want the same kind of focus on safety and soundness that we have in OCC [Office of the Comptroller of the Currency] and OTS [Office of Thrift Supervision]. I want to roll the dice a little bit more in this situation towards subsidized housing. . . .
Connect the dots, here.
On the other hand, who said this:
Congressman, Ofheo did not improperly apply accounting rules; Freddie Mac did. Ofheo did not try to manage earnings improperly; Freddie Mac did. So this isn't about the agency's engagement in improper conduct, it is about Freddie Mac. Let me just correct the record on that. . . . I have been asking for these additional authorities for four years now. I have been asking for additional resources, the independent appropriations assessment powers.
And this?
What we're trying to avert is we have in our financial system right now two very large and growing financial institutions which are very effective and are essentially capable of gaining market shares in a very major market to a large extent as a consequence of what is perceived to be a subsidy that prevents the markets from adjusting appropriately, prevents competition and the normal adjustment processes that we see on a day-by-day basis from functioning in a way that creates stability. . .
And this?
Mr. Chairman, what we're dealing with is an astounding failure of management and board responsibility, driven clearly by self interest and greed. And when we reference this issue in the context of -- the best we can say is, "It's no Enron." Now, that's a hell of a high standard.
In 2003, According to the NY Times, who called for greater oversight of the FMs?
In 2005, who attempted to introduce a reform bill for the oversignt of the FMs? (Note the sponsor and co-sponsors, BTW, under "Overview")
And where was Senator Dodd?
With his head located in its usual rather unsunny place, nestled cozily in there alongside Barney Frank, Dodd did an exceedingly credible Sgt. Schultz impersonation:
As recently as last summer, when housing prices had clearly peaked and the mortgage market had started to seize up, Dodd called on Bush to "immediately reconsider his ill-advised" reform proposals. Frank, now chairman of the House Financial Services Committee, said that the president's suggestion for a strong, independent regulator of Fannie and Freddie was "inane."
Perhaps someone needs to reexamine just who was advocating fiscal irresponsibility and who was attempting to reign in those who were fiscally responsible, n'cest pas?
P.S.: that applies to you, too, bobbie, although I'm sure you'll continue to parrot the Pelosi line like the rabid cockateel you've become.
The CRA was not the only cause of this, but it certain opened a Pandoras box! See below
The CRA was passed by the 95th United States Congress and signed into law by President Jimmy Carter in 1977 as a result of national pressure for affordable housing, and despite considerable opposition from the mainstream banking community. The CRA mandates that each banking institution be evaluated to determine if it has met the credit needs of its entire community. That record is taken into account when the federal government considers an institution's application for deposit facilities.
The Act charged the Federal Reserve System to implement the CRA through ensuring banks and savings and loans met their CRA obligations. The CRA is also enforced by the Federal Deposit Insurance Corporation ("FDIC") CRA Statute. Congress did not intend that CRA impose credit allocation and provided for flexibility in evaluating compliance.[3] Community groups only slowly organized to take advantage of their right to complain about law enforcement of the regulations.
The Financial Institutions Reform Recovery and Enforcement Act of 1989 (FIRREA) was enacted by the 101st Congress and signed into law by President G. H. W. Bush in the wake of the savings and loan crisis of the 1980s. As part of a general reform of the banking industry, it increased public oversight of the process of issuing CRA ratings to banks. It required the agencies to issue CRA ratings publicly and written performance evaluations using facts and data to support the agencies' conclusions. It also required a four-tiered CRA examination rating system with performance levels of "Outstanding," "Satisfactory," "Needs to Improve," or "Substantial Noncompliance."
In early 1993 President Clinton proposed new regulations for the CRA which would increase access to mortgage credit for inner city and distressed rural communities.[7] The new rules went into effect on January 31, 1995 and featured: requiring numerical assessments to get a satisfactory CRA rating; using federal home-loan data broken down by neighborhood, income group, and race; encouraging community groups to complain when banks were not loaning enough to specified neighborhood, income group, and race; allowing community groups that marketed loans to targeted groups to collect a fee from the banks.[5]
In a 1995 congressional hearing on proposed changes to regulation of the Community Reinvestment Act William A. Niskanen, chair of the Cato Institute, criticized the proposals for political favoritism in allocating credit, micromanagement by regulators and concerns about bank losses and soundness. He said it would be very costly to the economy and the banking system and that the primary long term effect would be to contract the banking system. He recommended congress repeal the Act.
In 2002 there was an inter-agency review of the effectiveness of the 1995 regulatory changes to the Community Reinvestment Act and new proposals were considered.[5] The Federal Deposit Insurance Corporation (FDIC), the Board of Governors of the Federal Reserve System, and the Office of the Controller of the Currency put new regulations into effect September of 2005.[11] The regulations were opposed by a contingent of Democrats because the action "undercuts the statutory purpose of the Act for institutions to meet the needs of low and moderate-income persons and communities by OTS.
In a piece for CNN, Congressman Ron Paul, who serves on the United States House Committee on Financial Services, partially attributed the current economic downturn to the Community Reinvestment Act, charging it with "forcing banks to lend to people who normally would be rejected as bad credit risks."
Was it the sole cause NO! Was it over both parties, yes! Were people greedy, of course! Does everyone have a right to a home, no!
The mark to market accounting rules refers to an accounting practice that forces a balance sheet to value an asset at its current market price. It is an arbitrarily-restrictive accounting practice that should be scrapped for assets like securities which generate current income.
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Victor
Credit Card Debt
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