Tuesday, September 30, 2008

The Credit Crisis: How we got here

There have been a lot of reasons bandied around for the current credit problem. There were a lot of causes of this, so many of them are right, but some more than others.

The preferred Democrat reason seems to be corporate greed. Certainly there is an element of that, but greed is always with us. You can't rationally claim that this whole thing was caused because the heads of some corporation are greedy and if we replaced them it would all get better. There are essentially two ways to run an economy. You can give power to the government or to business. At least with business you have to choose to give over your money. There were certainly instances out there of banks doing things like lying about the terms of a loan or preparing duplicate contracts so the buyer didn't sign what they read, but these instances were already illegal and I would imagine that they're fairly uncommon (though more common than they should be). The overwhelming majority of problem mortgages aren't people who were cheated, they are people who took a subprime ARM on a house where they could barely pay the artificially low teaser rate. It might be scummy that banks did this but it's not a surprise that a adjustable rate offered with a half point discount from the lowest rates in history is going to go up. The information that this was a bad deal has been around for ever and, as I'll show later, the government not only didn't discourage this, they actively encouraged it.

Barack also submitted the Gramm-Leach-Billey act, which he falsely claims McCain voted for (his running mate, by the way, actually did vote for it). That bill removed a restriction that "savings" banks couldn't also do "investment". The obvious problem with this in the current climate is that when Wachovia's investment side takes a hit, their savings side is also put at risk. I haven't delved very deeply into how much FDIC is impacted by the potential change in Debt-to-Equity (hereafter DE) ratios that this poses, but so far my savings at Wachovia is fine even though their investment side had problems and none of the major federal bailouts were operating as banks, so this can't possibly be the main culprit.

There are two actions by the Fed that have come up as issues. By far the most common is the assertion that Greenspan and later Bernanke lowered interest rates too much to avoid corrections. Certainly this seems valid. The dollar is very obviously weak even relative to other currencies that are themselves inflating. And when dollars are cheap the natural thing to do is to spend as many of them as you can, encouraging all sorts of speculation. In particular in this case it encourages people to buy houses they can't afford because the cost of the house and the interest rate (on an ARM) both look better than they are.

The other Fed action, which I was unaware of until this morning is something Bernanke implemented called the "Term Auction Facility". This was put in place at the beginning of the problems with credit. I don't know much about it, but at least one economist states that among other things it hides who is borrowing money from the Fed from other banks, which makes banks skittish about interbank loans. As I said, I haven't looked very far into this, but it's potentially a really huge deal. Anything that hides loans to banks is going to necessarily mean you can't tell how much the bank is worth. If you don't know how much banks are worth that's going to screw up interbank loans, and interbank loans are where a lot of credit comes from in our system.

The final potential problem I've seen is the Community Reinvestment Act of 1977. This is a bill that went after mortgage banks because they were only offering loans to relatively well off people. The bill requires brokers to make loans across the income spectrum and carries stiff penalties if they "redline", or only offer them to people who are well off. It was updated in 1995 to allow Fannie Mae and Freddie Mac to buy subprime loans, to allow subprime loans to be repackaged as securities. It was then weakened in 2004. There are those who argue, reasonably, that this did not contribute to the current debacle because 75% of subprime loans are made by banks not covered by the CRA and because subprime loans escalated after the bill was weakened. I'll admit this probably wasn't the prime mover, but a huge percentage of those loans were still almost certainly underwritten by Fannie or Freddie, which are quasi-government agencies authorized, by the CRA, to buy the loans. So yes, the loans were made by non-CRA banks who thought they could rake in the dough (and probably did) by using funds from a government sponsored entity and selling the bad loans off as equity for a profit later. But that GSE gave them money because of the CRA.

The last contributor is the existence and mismanagement of Fannie Mae and Freddie Mac. Fannie and Freddie are quasi-private companies that make a profit for their shareholders but are theoretically overseen by congress and had an implicit guarantee that the taxpayers would bail them out if they got in trouble. It was frequently argued that the taxpayers would not bail them out, because otherwise there would be a strong incentive to take huge risks since the potential profit from them is high and the loss would be insured by the taxpayer, but as we have seen in the last 2 weeks, we're going to pay the loss. We have known for at least 5 years that both of these government sponsored entities were behaving in ways that are clearly irresponsible and would be illegal for a private corporation. Their DE ratio was 65:1 (banks maintain 10:1), they frequently took actions that would have violated Sarbanes-Oxley if they weren't the government, and their management was known to manipulate accounting data to maximize bonuses. I know this because it was all brought up in hearings in 2003 and 2004. As you can find all over YouTube several congressman, most notably Barney Frank and Chris Dodd, thought this was much ado about nothing and fought hard to let Fannie and Freddie continue doing the great work they were doing securing bad loans for people at great risk to the taxpayer. After all, as Franklin Raines, Fannie CEO and Obama advisor, said "These assets are so riskless that the capital for holding them should be under 2%". The Republicans may not be free from fault for this, though. Though opposition to increasing oversight of Fannie and Freddie were Democrat concerns, the Republicans controlled the Congress in 2004. I haven't been able to find the bill number or roll call on the call to regulate them more heavily, but if it didn't pass the House it's the Republicans fault. They could have done it with no Democrat help so Democrat stupidity should not have prevented it from passing. (The Senate, of course, is another matter)

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