Still Worth Arguing About the Financial Crisis

 

shutterstock_73682491Who controls the past controls the future. — George Orwell, 1984

The candidates who are announcing for president will be cheered to know that the Democratic Party has been hemorrhaging popularity the way the housing market lost value in 2008. In 2009, 62 percent of Americans had a favorable view of the party. In January, only 46 percent said the same.

But the Democrats’ loss has not been the Republicans’ gain. A 2015 Pew survey found that 40 percent of Americans had a favorable opinion of Republicans in 2009, and just 41 percent do today.

Republicans might profitably ponder two things. First, this question from a Pew poll: Which party “cares about the problems of the middle class”? Sixty percent said the phrase applied to Democrats. Only 43 percent thought it accurately described Republicans.

The second thing they might consider is revisiting that housing collapse. According to the Federal Reserve, the median net worth of American households fell by 39 percent between 2007 and 2010. Not only was a Republican administration in office when the bottom fell out — that alone is usually enough to convince voters to lay blame — but the Democrats seemed to win the intellectual argument.

The Republicans’ case went like this: Unwise federal government policies that urged lenders (and purchasers of those mortgages) to make loans to people who could not repay them tampered with the normal risk management of the housing sector and led to a system-wide collapse.

The Democrats’ explanation was that “out-of-control” bankers, recently liberated from regulation, made risky investments in complex financial instruments that they didn’t even understand themselves and tanked the financial system. Worse, they received taxpayer bailouts.

The Democrats’ interpretation naturally was echoed by the press and, because they won the 2008 race, became enshrined in law. The Dodd-Frank legislation ignored government’s role in the crisis completely, merely layering new levels of regulation on banks and other businesses.

A new book by Peter J. Wallison, Hidden in Plain Sight, offers a comprehensive and thoroughly convincing case for why the received version of the financial crisis is wrong and why Dodd-Frank is such a serious mistake. Not only does Dodd-Frank virtually guarantee that another financial crisis eventually will envelop the economy, but it also is responsible for the extremely slow recovery we’ve been mired in since 2009.

Did deregulation, credit-default swaps, low interest rates, “shadow banking” or “predatory lending” cause the crisis? Wallison, who served on the Financial Crisis Inquiry Commission, offers detailed rebuttals to each of these theories.

Government policy created the financial crisis at every step. Congress and HUD demanded that more and more loans be provided for “underserved” communities. Fannie Mae and Freddie Mac, responding to this pressure, diminished underwriting standards. The promotion of homeownership was a bipartisan mistake. Both the Clinton and George W. Bush administrations backed it (though Bush did attempt, unsuccessfully, to rein in the GSEs).

“By 2008,” Wallison writes, “57 percent of all U.S. mortgages were nontraditional.” Seventy-six percent of those were on the books of government agencies or entities controlled and regulated by the government. This was much higher than other nations that also experienced housing bubbles. Even Barney Frank has acknowledged that “it was a great mistake to push lower-income people into housing they couldn’t afford.” By 2008, the GSEs and HUD included mortgages as high as $729,000 as “conforming.” Even purchasers of million-dollar homes were to benefit from government encouragement, apparently.

Private bankers made their share of mistakes. In a saner world, the market itself would have punished them. But as Wallison shows, another government blunder — the bailout of Bear Stearns — lulled financial firms into complacency. They failed to take precautions because they assumed the government would provide a safety net.

What this book makes clear for the first time is that neither private financial institutions nor regulators could accurately evaluate the risks to the system, because Fannie Mae and Freddie Mac disguised the percentage of their holdings that were nontraditional mortgages. Not even the Federal Reserve, with its regiments of economists and analysts, saw what was coming.

Have we learned all the wrong lessons from the financial crisis? Here’s The Washington Post from January 7: “The White House announced Wednesday that the Federal Housing Administration will significantly lower the fees it charges borrowers, a move designed to save individual home buyers hundreds of dollars annually and help jump-start the housing market.”
Voters need to know that the greatest risk to their financial security is benign-sounding government assistance.

Published in Economics
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  1. Ricochet Inactive
    Ricochet
    @PleatedPantsForever

    Mona (sorry, that was probably sexist to use a first name), I mean Madam Charen (sorry, that was probably insensitive to all those who suffered under French colonial rule), Some person who contributes greatly to Ricochet (there, that seems safe) – You are spot on! This idea we sometimes have on our side that big finance operates in some Randian capitalist utopia these days is a bunch of bunk. Privatized gains and socialized loses is not a free market. And, the borrowing environment created by federal regulations makes it even worse.

    Since I like to nitpick, the only thing I would add is the Federal Reserve’s artificially low interest rates also contributed to the housing crisis as people could borrow at below market rates. In addition, these low rates contribute to the wealth gap our friends on the other side love to point out. I think we need to throw their hypocrisy back at them (politely, of course) since their support of 0% interest rates contributes to the wealth gap they so love to decry. Just to shamelessly self promote, I wrote a post on this very subject.

    Thanks much! Also, please press some more of Jay’s button’s on the next Need to Know. He keeps saying that he loves how your inner right winger is coming out but I think if he can be caught in the right mood he will start swearing like a sailor on shore leave about the other side.

    • #1
  2. user_278007 Inactive
    user_278007
    @RichardFulmer

    John Allison’s book, The Financial Crisis and the Free Market Cure, also provides a very clear, easy to read explanation of the housing collapse.  One of the book’s more interesting revelations was the reason for the odd way in which rating agencies S&P, Moody’s, and Fitch are compensated.

    Originally, they were paid by the  buyers of the bonds that the companies were rating.  “Tragically,” Allison writes, “In the early 1970s, the SEC… forced Moody’s and the other rating firms to fundamentally change their compensation model in a way that created serious conflicts of interest.”  Under the influence of “union and government pension plans that did not want to pay the cost of the ratings” the SEC required that bond sellers now pay the agencies.

    “Under government-mandated ‘issuer pays’ rules, the rating firms were motivated to lower their standards, fearing that issuers who were displeased with their ratings would yank their business and move it to a competitor rating firm.”

    Just as you point out, Mona, the government was in every nook and cranny of the crisis.

    • #2
  3. user_1008534 Member
    user_1008534
    @Ekosj

    Thanks for the reminder. It wasn’t de-regulation but mal-regulation that brought about the financial crisis. I look forward to reading Wallison’s book.

    • #3
  4. user_1008534 Member
    user_1008534
    @Ekosj

    Hi Richard Fulmer. Excellent point! I did not know that about the rating agencies.

    • #4
  5. Mona Charen Contributor
    Mona Charen
    @MonaCharen

    Peter Wallison will join us on the podcast tomorrow.

    • #5
  6. user_48342 Member
    user_48342
    @JosephEagar

    Mona, there is no question that the GOP (or rather, George Bush) was at fault for the 2008 crisis (there’s a reason the Great Bush Purge happened).

    The good news is that the GOP will have six years of a vastly improved track record by 2016, including what has to be one of history’s most perfectly executed post-BOP-crisis economic adjustments.  Not only did the U.S. reduce both its fiscal and trade deficits, it did it without the sort of economic and social calamity you see in countries like Italy or Spain.  I’ve not checked the numbers, but I suspect that wages fell less in American than they have in adjusting European economies, with less associated unemployment.

    2008 was a  classic (if unusually mild) balance of payments crisis brought on by reckless fiscal policy.  These crises have been happening to countries for hundreds of years; there are literally thousands of examples in history.  There was nothing different or special about our case (except in how mild the recession was, compared to what usually happens to countries that suffer BOP crises).
    The GOP of 2016 will be a different party than the one in 2008, and I think voters are going to notice.

    [edit: decided to put “good news” paragraph after potentially incendiary one, to avoid wrong impression]

    • #6
  7. user_3444 Coolidge
    user_3444
    @JosephStanko

    Joseph Eagar:Mona, there is no question that the GOP (or rather, George Bush) was at fault for the 2008 crisis (there’s a reason the Great Bush Purge happened).

    2008 was a classic (if unusually mild) balance of payments crisis brought on by reckless fiscal policy.

    Sorry, could you dumb that down a bit for me?  What exactly do you think Bush should have done differently to avoid the crisis?

    • #7
  8. user_139157 Inactive
    user_139157
    @PaulJCroeber

    If parties A and B welcome and embrace an interceding government, you can be damn sure it’s at the expense of an unrepresented party C.

    I purchased my home back in early 2007 and could not believe my ears at what lenders and agents were saying.

    There is no amount of nominal appreciation or clever securitization that can hide the effects of legislated market distortions.

    • #8
  9. Steve C. Member
    Steve C.
    @user_531302

    Why isn’t Franklin Raines in jail?

    • #9
  10. user_48342 Member
    user_48342
    @JosephEagar

    Joseph Stanko:

    Joseph Eagar:Mona, there is no question that the GOP (or rather, George Bush) was at fault for the 2008 crisis (there’s a reason the Great Bush Purge happened).

    2008 was a classic (if unusually mild) balance of payments crisis brought on by reckless fiscal policy.

    Sorry, could you dumb that down a bit for me? What exactly do you think Bush should have done differently to avoid the crisis?

    Spent less.  Basically, Bush spent too much, and the economy crashed.

    • #10
  11. user_3444 Coolidge
    user_3444
    @JosephStanko

    Joseph Eagar:2008 was a classic (if unusually mild) balance of payments crisis brought on by reckless fiscal policy.

    Balance of Payments Crisis

    This occurs when the current account deficit cannot be maintained. It means there will be a fall in foreign exchange reserves and the country can no longer attract sufficient capital flows to finance the current account deficit.

    The solution to a balance of payments crisis is usually to devalue the currency and slow down consumer spending on imports, usually by causing a recession.

    Russia experienced a balance of payments crisis in 1998, leading to devaluation of Rouble.

    That doesn’t sound like the 2008 crisis at all.  The problem wasn’t that Washington was unable to find investors willing to buy Treasuries, the crisis was in the private sector.  It was Wall Street firms that were unable to attract sufficient capital flows until the government stepped in to bail them out.

    I don’t see how you can pin the blame for Wall Street bankruptcies on Washington spending habits.

    • #11
  12. Ricochet Inactive
    Ricochet
    @WardRobles

    The elites running Washington and Wall Street lack common sense. Any small business person who has dealt with many households can tell you that underwriting standards need to include a minimum down payment. Simply require homebuyers to at least put 10% down (which we don’t, even now). When you let people purchase homes with only a few thousand dollars, they treat the transaction as an option, not a purchase.

    • #12
  13. user_3444 Coolidge
    user_3444
    @JosephStanko

    Ward Robles:The elites running Washington and Wall Street lack common sense. Any small business person who has dealt with many households can tell you that underwriting standards need to include a minimum down payment.

    Yes, but that’s because a small business owner has incentive, if he makes a bad loan and doesn’t get repaid he’s out a lot of money.

    Whereas if you are a banker who can make a bunch of zero-down adjustable rate loans, then turn around and package them up as a mortgage-backed security and sell it to someone else, if the loans go bad it’s the investors who lose their shirt, not you.  So the bankers are acting rationally.

    Only, the investors don’t end up losing their shirt, either, because Washington steps in with a bailout.  So it’s only the politicians who lack common sense.

    Except most of the politicians in Washington who caused the whole mess got re-elected anyway.

    So really, it’s the voters who lack common sense.

    • #13
  14. user_48342 Member
    user_48342
    @JosephEagar

    Joseph Stanko:

    Balance of Payments Crisis

    This occurs when the current account deficit cannot be maintained. It means there will be a fall in foreign exchange reserves and the country can no longer attract sufficient capital flows to finance the current account deficit.

    The solution to a balance of payments crisis is usually to devalue the currency and slow down consumer spending on imports, usually by causing a recession.

    That’s not a bad definition.   The U.S. had a current account deficit that could not be sustained (our savings rate dipped into negative territory in 2005).  We responded by devaluing the dollar and slowing consumer spending, and there was a recession.

    That doesn’t sound like the 2008 crisis at all.  The problem wasn’t that Washington was unable to find investors willing to buy Treasuries, the crisis was in the private sector.

    It’s something of a misnomer that BOP crises are always precipitated by a sovereign funding  crisis.  Spain, for example, had a fiscal surplus before the financial crisis.  Its sovereign debt problems were arguably a consequence of its BOP problems, not the other way around.

    European policy wonks usually put it this way: large U.S. deficits caused the U.S. sovereign risk premium to rise relative to Europe and Japan.  This precipitated a capital inflow bubble that then flowed into the real estate market.

    • #14
  15. Mona Charen Contributor
    Mona Charen
    @MonaCharen

    It wasn’t Washington’s spending (as terrible as that was/is) that caused the financial crisis. It was the push to put mortgages in the hands of ever more uncreditworthy borrowers. Further, when Washington bailed out financial institutions, it created moral hazard — discouraging the kinds of care and attention that creditors normally take with their money. We privatized profits and socialized losses.

    Finally, as Wallison shows in his book, Fannie and Freddie were not honest with the regulators or the markets about the true size of their NTMs, which led everyone into a false sense of equanimity about the risk of those securitized mortgages.

    More later on the podcast. Thanks for all the great comments!

    • #15
  16. Jager Coolidge
    Jager
    @Jager

    Joseph Eagar:Mona, there is no question that the GOP (or rather, George Bush) was at fault for the 2008 crisis (there’s a reason the Great Bush Purge happened).

    What was the “Great Bush Purge”?

    • #16
  17. user_385039 Inactive
    user_385039
    @donaldtodd

    Mona Charen: “In 2009, 62 percent of Americans had a favorable view of the party. In January, only 46 percent said the same.”

    What was the detective’s rule?  Follow the money!  The Democrats buy their grievance groups and the grievance groups reciprocate.

    • #17
  18. Tennessee Patriot Member
    Tennessee Patriot
    @TennesseePatriot

    I knew we were going to have a heck of a crash when I heard in 2007 or so that something like 90% of the mortgages in California were interest only, with no or very small down payments!

    • #18
  19. Rodin Member
    Rodin
    @Rodin

    It’s hard to get the cure right if the diagnosis is off. So the correct policies in the future will always be characterized (as has Obama) as “the policies that got us into this mess” unless it is broadly understood NOT to be true.

    The problem is a candidate’s sound bite opportunities. It will be a limited period for broadcast so there will be a constant decision of what to feature or not. Spending time persuading the public that everything they have learned about 2008 is wrong is in competition with every other argument against what is going on in the here and now.

    If the public’s understandings of 2008 is to be corrected it will have to occur outside of a single political campaign.  It will have to be something into which a candidate can plug rather than a core feature of that campaign.

    • #19
  20. Ricochet Member
    Ricochet
    @ArizonaPatriot

    Joseph Eagar:

    Joseph Stanko:

    Joseph Eagar:Mona, there is no question that the GOP (or rather, George Bush) was at fault for the 2008 crisis (there’s a reason the Great Bush Purge happened).

    2008 was a classic (if unusually mild) balance of payments crisis brought on by reckless fiscal policy.

    Sorry, could you dumb that down a bit for me? What exactly do you think Bush should have done differently to avoid the crisis?

    Spent less. Basically, Bush spent too much, and the economy crashed.

    I think that you are incorrect about the source of the financial crisis.  Perhaps the simplest way to disprove your thesis is to point out that if overspending by Bush caused the crisis, how did enormously greater overspending by Obama solve it?

    I’m sure that the book referenced in the OP makes the point in greater detail, but the short version is that unwise  government policies caused the US to build far too much housing.  It was a classic market bubble, and when it burst, it caused a cascade effect throughout the financial system.

    The problem was exacerbated by the repackaging of pools of mortgages as CMOs (collateralized mortgage obligations) and the development of derivatives based on such CMOs.  Many of these obligations appeared safe because they were essentially insured by AIG, one of the world’s largest insurers.  The mechanism for this insurance was the CDS (credit default swap).

    In addition, Fannie Mae (and I think Freddy Mac) were heavily involved in dubious mortgages, but backed by the implicit government guaranty (which was made explicit when they tanked).

    In short, housing was overpriced and overleveraged on a grand scale, and investors in mortgage-backed securities were lulled into a false sense of security by the AIG insurance and the Fannie/Freddy implicit guaranty.  When the extent of the problem became clear, AIG was unable to fulfill its CDS (insurance) obligation, and many financial institutions became suddenly insolvent.

    This led to extreme tightening of credit standards, the effect of which rippled rapidly through the economy.  Mortgage lenders started foreclosing at high levels on properties that were now “upside-down,” and the foreclosure frenzy drove real estate prices even lower.

    Frankly, while I was not a fan of the TARP bailout, it and the prompt actions of the Federal Reserve prevented a complete meltdown.  Most of the TARP bailout was repaid by the financial institutions involved.  The major exceptions were payments to GM and Chrysler, which ended up being effectively a handout to the unions; a bailout of AIG; and handouts to homeowners with upside-down mortgages.

    • #20
  21. user_48342 Member
    user_48342
    @JosephEagar

    Oh no, I definitely don’t think that Obama’a fiscal stimulus packages “solved” the crisis (the Federal Reserve did).  In fact, I think the only thing that prevented a double-dip recession was the fiscal tightening brought on by the GOP.  

    • #21
  22. user_48342 Member
    user_48342
    @JosephEagar

    I agree with all of the criticisms made by Peter Wallison; I think he’s correct that intrusive regulatory policy is what created the housing bubble.  I like to think of the housing bubble as a symptom and the U.S. balance of payments deficit (which, after all, is what financed said bubble) as the cause.  If those regulations hadn’t existed, the capital flowing in from abroad would have just inflated another bubble in another sector of the economy.

    Anyway, I’m not sure it really matters, the post-Tea-Party GOP has a great track record where fiscal issues are concerned.  By all measures our policy worked;  American exports, wages and general economic growth have all been higher than in Europe (rather dramatically so).  The Europeans tried to sustain  their bloated public sectors with massive tax hikes and got mass unemployment for their trouble; we cut spending, and our economy grew.

    • #22
  23. Z in MT Member
    Z in MT
    @ZinMT

    The Federal government was responsible for creating the housing bubble, but Wall Street was responsible for liquidity crisis at the end of it.

    I agree with most of Arizona Patriot’s analysis. However, by the end the housing bubble the demand for mortgages was not driven by home (or speculative home) buyers it was driven by Wall Street’s need for mortgages that they could repackage and sell off to investors. Wall Street’s models told them that if they packaged enough mortgages from different regions of the country into one package any losses would be uncorrelated and you could separate the default risk from the inflation risk and sell different tranches on the same asset. What they didn’t realize was that they were driving a bubble making the underlying assets highly correlated.

    • #23
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