(b) I’m concerned with the moral hazard problem created when companies become “too big to fail”. Those (like progressoverpeace) who think Fannie/Freddie’s implicit asset guarantee played a significant role in this debacle should concur. I’m not sure about the most suitable measures to deal with this problem.

Jazzman on November 18, 2008 at 1:24 PM

That’s a tough issue. No banking system can withstand a run on the banks, so all banking systems are open to drops in confidence causing a failure/collapse of the system the same way that no free government can survive a loss of confidence in its institutions (which we are also getting very close to, as our government has declined to carry out many of its most basic duties and has insisted on inserting itself into areas that it has no business messing around with). But we have to have banking and have to be open to the risk of systemic failure with a loss of confidence in the banks, no matter what restrictions are placed on banks.

I do concur that any company whose failure would be considered a serious threat to our monetary system presents a problem that must be addressed. But we already have more than enough regulators and structures that can deal with that, not the least of which being the Fed which is charged with maintaining the stability of our monetary system (not tweaking our economy).

Unfortunately, those regulators and structures have been abusing their power in order to hassle businesses who were never too big to fail and not even anything close to monopolies (as in the idiotic, sham case against Microsoft – which was never a monopoly and always had competition that was free for those who put a little time in – Linux, for example). At the same time we were not using these existing structures to mitigate the real threats that were around, but instead promoting and helping them become even more dire threats, especially the quasi-government entities.

I think the clearest lesson about this whole debacle is that no one has been held responsible. Barney Frank is still running his committee. Maxine Waters used her time questioning Paulson (when this all first started) to try and extort money and work for minority and women-owned businesses managing the pile of assets that was going to come through the bailouts – for which she should have immediately been thrown out Washington and possibly jailed (I kid, but not much). Recipients of mortgage rejiggering have had to give up nothing for the free money from Washington. I think that, if someone made a cost of having the Feds come in and help them out (losing their voting rights for 30 years, for an example of a non-monetary cost that many would consider dear and many others would consider benefical to the rest of us) then others would not be so incensed at these people getting paid for their irresponsible behavior that imperiled us all. People still have a legitimate right to be mad about what is happening, but if there was at least a cost of some sort to those benefitting it would not tick people off so much and would help instill some confidence in government rather than draining it – which will destroy us all.

That was kind of rambling on my part. I hope I addressed the actual point somewhere in all that.

philwynk on November 18, 2008 at 10:50 AM

When I say that there is a need for regulation, I don’t mean that I think the government should be involved in pricing assets, and it’s bizarre that you’d think I’d mean that. I’m thinking more along the lines of (a) disclosure requirements for CDS contracts should be strengthened, and (b) securities should be standardized, sort of like commodity futures contracts, so that prices are truly set by supply and demand rather than by computer models. Neither of these regulatory suggestions is motivated by any sort of tyrannical impulse. The motivation is to mitigate problems involving lack of information, so that the market can work the way it’s supposed to.

The crisis was triggered by the subprime collapse, but it was the product of unregulated finance. CDSs in particular were basically beyond any sort of public oversight, a disaster waiting to happen.

Jazzman on November 17, 2008 at 10:15 PM

There are some errors in the discussion, but this is the one that fries my gizzards.

The failure was due mostly to the failure of the buyers and sellers of assets to properly recognize the value of those assets. These buyers and sellers are professionals in a highly technical market. Both, but particularly the buyers, have powerful incentives to understand and properly assess the true value of the assets they’re trading.

If the professional buyers and sellers, who have incentives to accurately value the assets they’re trading, did not value them correctly, what possible element would magically equip a passel of bureaucrats to value the assets correctly?

The call for regulation is a knee-jerk, a reflex by incipient tyrants and control freaks to bring all things under their personal control, on the certifiably demented notion that they, the anointed, understand what the most intelligent and intimately affected cannot understand. It’s bunk from the first syllable.

There is nobody to blame for the purchase of improperly valued assets but the purchasers of the assets, except in those few cases where the valuation was the result of deliberate fraud.

Jazzman on November 18, 2008 at 12:26 AM

It was a good discussion, and an important one. I thoroughly enjoyed it. Thanks.

progressoverpeace on November 17, 2008 at 11:19 PM

Fair enough. This has been an interesting discussion and I’m glad we’ve clarified our areas of agreement and disagreement. Before going to bed though, I’d like to apologize to you for being so aggressive. I reread my second post and realized I should not have come out with guns blazing. In particular, I apologize for insinuating that you lacked an understanding of the financial situation. While I still disagree with much of what you’ve said here, I think you’ve amply demonstrated that you haven’t approached this issue in a thoughtless manner. So please accept my apology and have a good night.

The folly of this should be obvious. Banks should not be casinos.

I would sum up my position by comparing CRA/Fannie/Freddie’s impact on the credit markets to Affirmative Action’s effect on our judiciary. Much of our judicial system was skewed by the need to have the clearly biased and unconstitutional rules of Affirmative Action (and minority set-asides …) pass Constitutional muster. There are many areas and rulings that had nothing to do with AA that were skewed because of precedents set by silly AA rulings that had to twist the underlying logic in order to arrive at the desired ruling.

This is only a rough analogy, but it expresses the larger picture of what I see having happened in our credit markets – though the propagation of distortions is much more fluid and much quicker in the financial system.

What I can do (and have done) is provide arguments that even in the absence of Fannie/Freddie and their implicit asset guarantee, the market was set up for a crisis.

I have no argument with that. We disagree on how the market got so skewed.

The burden of proof is on you, then, to show that the explanation involving Fannie/Freddie is more plausible. And just gesturing at shadowy arbitrageurs is not sufficient.

You can throw the ratings agencies into that mix. I think we can both agree that the ratings were off for almost the entire debt market. Now, how could that happen? Was it a political or a mathematical mistake?

One can look to the example of the brokerage houses and their insane recommendations for stocks in the 90′s – when for years not a single major brokerage had even one sell recommendation. Now, I am not saying that credit ratings and stock recommendations are the same – I understand they are very different – but the underlying mechanisms that lead to ratings bubbles in each are much the same. Credit ratings agencies must apply the same standards across the board (though stock analysts used to think that they were free to pick and choose among a set of independent models to use for any individual stock – which was a total joke) and must be sure that their ratings are consistent. I do not know the models or algorithms used by the credit ratings agencies so I can’t go into any detail on this. Perhaps you can.

In fact, I don’t even think the subprime crisis was a necessary condition for the credit crisis.

I agree. Any slowdown in the economy could have served to start a cascade of calls on CDS’s. But the subprimes anchored a huge part of the market and, by themselves, generated enough losses (and corresponding non-existent profits from CDS’s that couldn’t pay off) to cause our Treasury Sec to talk about being “500 trades from Armageddon”.

High-yielding asset classes were mispriced by unrealistic risk models in many different markets.

Yes. And the only point we really seem to disagree on is why this market-wide mispricing happened. I say it came due to a small mispricing that forced the rest of the credit markets (which competed with it) to come into line (which was a mispriced line). You disagree. You think the mispricing came from people trading instruments who didn’t know what they were trading and knew they didn’t know what they were trading (from your other post – though correct me if I misstated your position on this) through all the securitized credit markets.

If the subprime meltdown hadn’t triggered the crisis, it might eventually have been triggered by private equity or emerging market equity or any of a number of other assets/commodities.

Perhaps, as I acknowledged above. But we really have no way of knowing. It depends on what credit markets failed, how bad the failure was, how the instruments and CDS’s were distributed through other businesses … But I am in general agreement with you, here, though a little less certain than you seem to be.

The lethal cocktail of securitization, credit default swaps (which I’m glad you mentioned) and massive leverage is inherently unstable in the absence of perfect information.

Considering the fact that we never have perfect information about even the present, let alone the future, it seems that you would never allow these elements (not all of them, at least).

The crisis was triggered by the subprime collapse, but it was the product of unregulated finance. CDSs in particular were basically beyond any sort of public oversight, a disaster waiting to happen.

Jazzman on November 17, 2008 at 10:15 PM

I’m not sure we lack for oversight, here. Companies that sold CDS’s had to be clearing (for other trading activity) through many markets and their balance sheets were open, I believe, to examination by those clearing corporations (whichever ones) and probably a good number of regulators, though I am just guessing, here. It was not as if no one knew the humungous size of the CDS liabilities and the obligations that were being taken on. One had only to look at the obligations a company would have if interest rates rose 2%, say, to see the exposure and the possibility of defaults. A few friends of mine used to trade convertibles and they have been aware of the devastation caused by a small default for a long, long time.

Now, if these questions of possible liability were put to companies and they lied in their answers, that is one thing, but I don’t think the fact that everyone actively ignored the question means that regulation would help much of anything. Regulators can ignore facts as well as anyone and they are usually much better at it.

I am all for standardization and centralization of markets (and getting CDS’s out in the open, as much as possible) but that is different from implementing some new regulatory structure. I really don’t know how one can stop two companies from making private contracts if they want. And, when that happens, it is the responsibility of the companies to know what they are signing and take on the responsibilties and risks involved in the contract.

Of course these programs are a way to funnel funds to left wing groups: just watch Obama pass legislation that will restore funding to Acorn, but this time under the table.

progressoverpeace on November 17, 2008 at 9:20 PM

Look, the fact of the matter is that in 2005 and 2006, when subprime lending really exploded, over 60% of mortgages were securitized by private institutions, and these include the most risky assets. Much of this risk was mispriced. You claim that this wouldn’t have happened in the first place if it hadn’t been for the implicit government guarantee behind Fannie/Freddie’s debt. This is an assertion that I can’t disprove because you haven’t suggested any mechanism for the propagation of mispricing beyond some vague mention of arbitrage. What I can do (and have done) is provide arguments that even in the absence of Fannie/Freddie and their implicit asset guarantee, the market was set up for a crisis. The burden of proof is on you, then, to show that the explanation involving Fannie/Freddie is more plausible. And just gesturing at shadowy arbitrageurs is not sufficient.

In fact, I don’t even think the subprime crisis was a necessary condition for the credit crisis. High-yielding asset classes were mispriced by unrealistic risk models in many different markets. If the subprime meltdown hadn’t triggered the crisis, it might eventually have been triggered by private equity or emerging market equity or any of a number of other assets/commodities. The lethal cocktail of securitization, credit default swaps (which I’m glad you mentioned) and massive leverage is inherently unstable in the absence of perfect information. The crisis was triggered by the subprime collapse, but it was the product of unregulated finance. CDSs in particular were basically beyond any sort of public oversight, a disaster waiting to happen.

They have figured out how to fund their idiotic, country-wrecking schemes through means that don’t alert the proletariat.

The CRA is one example. Billions redistributed to sloths with their hands out (but each hand only counts as one vote). As a bonus, Capitalism comes close to cratering!!! or maybe it does crate – can’t tell yet.

Tax cuts for 95% is another means. Orwellian. Taxes go up while the dummies in the trenches think theirs went down.

But the biggie is cap and trade. If the country isn’t destroyed by then, that’ll do it.

A more cosmic question: why would “regulation” be the answer to the derivatives market situation? Why does the mortgage-backed derivative market need any more regulation than it already has? So long as market players are free agents, and information is on the table, how is this market different than any other on Earth?

And I still don’t understand why Glass-Steagall repeal really had any role in this. Seems to me essentially the same problem could have developed with G-S in force.

The credit market is no different from any other market on Earth, and so it is just as susceptible to market failure as any other market on Earth. Asymmetric information at every step of the process (between borrowers and lenders, between lenders and companies purchasing CDOs) is a major reason for the failure of this particular market.

I am with you on Glass-Steagall. It it unclear to me that Gramm-Leach-Bliley played anything more than a marginal role in the crisis, and I’ve yet to see a good argument on why it’s to blame. I do think, though, that there is a need to come up with a new regulatory framework, one that is responsive to the technological advances that have made a market in highly customized securities (and the corresponding informational problems) possible.

The prevalence of these loans is entirely attributable to private-label securitization, fuelled by a faith in the persistence of the bubble. CDOs backed by these loans were over-rated, but that paper could not have passed through the hands of Fannie/Freddie. So your claim that Fannie’s AAA rating is solely or primarily to blame for the mispricing of risk is just evidently false.

You cannot misprice risk in one section of the market and not expect it to propagate through the rest of the instruments. The arbs will effect this, and given the size of the markets we’re talking about, there was a ton of money to arb out of the mispriced risk in the government/pseudo-government/crypto-government fueled market. Think of it as if the government had decided to lower the sea level on the East Coast by 3 feet, and expected sea levels around the world to remain unchanged.

Second, the claim that securitization has nothing to do with this crisis is even more absurd. Now that we’ve dispensed of the myth that the GSEs are responsible for the failure of credit rating, we should ask, “Why were products backed by such dodgy assets given such good credit ratings?” And the answer is that the products were ingeniously created so that the risk was extremely diversified and massively overcollateralized. But the models used to calculate the risk didnt completely account for the ludicrously lax underwriting standards in the home loan market, or anticipate the country-wide housing slump.

Oh, please. I knew what was going on. My trader friends knew what was going on. People wrote about the whole situation over and over. We all saw the 100% mortgage offers from all over the place and everyone knew the frothiness of the market and the loan situation. We all saw the skyrocketing prices, and remembered the last time prices had skyrocketed in the same fashion (just before the last housing bust).

As far as not anticipating the housing slump, I don’t know how young you are, but we have a rich history of housing slumps and had just come out of one not too long ago. We all knew that housing was in a bubble and we all knew it was going to pop – how many covers of Barron’s talked about the problems with housing? The only question was ‘when?’ To that end, we started seeing the best indicator of the end of a housing boom, which was the high-profile entrance of foreigners into the market. (Not many look at this part of foreign participation, but it’s one of the indicators that I like). If that wasn’t good enough, then the rise of oil prices should have alerted the less astute. That wasn’t secret information and, again, anyone with a memory remembers what happened the last time oil was doing that.

No. Ignorance of the market and the underlying instruments is not an excuse. Neither is relying on the models – as we all know that these valuation models all have large amounts of misvaluations in them, and the number of open parameters is always quite large and often filled in with guesses.

People were stuck in the mispricing and had no choice but to keep going. But everyone knew what was happening – everyone with a brain.

So the creation of these complex securities, and the consequent transfer of risk from agents actually involved with the housing market and aware of the subprime situation to institutions with nothing to go on but the rating agencies’ inadequate models, is a crucial factor in the credit crunch.

As I said above, everyone knows that the models are inadequate. Anything that involves future pricing is dependent on too many parameters that are unknown and impossible to know, while the actual value often diverges from the theoretical value – especially at the extremes!

Into this system the government decided to dictate risk pricing … so they could feel good about themselves and get reelected.

To blame it on Fannie/Freddie or the CRA is to betray either a lack of understanding of the financial situation or a hyperpartisan lack of concern for the facts.

Jazzman on November 17, 2008 at 8:27 PM

The CRA, and the subsequent intimidation and threats that were brought down on lenders kick-started a deadly mispricing of risk that was thrown into overdrive by Fannie and Freddie and spread throughout the debt markets.

In all your analysis, it’s amazing that you never saw any need to mention the credit default swaps, which served as the reservoir and secondary engine for the mispricing that had propagated up.

Can either of you provide examples of actual predatory lending? Obama’s web site had some verbiage about how lenders tricked borrowers by telling them they could afford more than they could actually afford? Who are the lenders to be telling who can afford what? The borrowers should know how much they make and how much they can afford.

Can you point us to any examples of actual predatory lending?

Thanks for the education. :-)

Politicians on right, being so eager to avoid charges of racism, were clearly set up and exposed largely as McCain-like naive chumps when it comes to understanding subversive political movements in general, and Marxist thought specifically. This is going to end very poorly. The goal, hard as it is to grasp, was never to build a greater America and is not now to recover America’s former glory. Those on the right who think it’s time to “move on” in McCain-like fashion while Barack takes it from here are going to experience another rude awakening. The political downhill slope will be more slippery and steep than the financial one.

econavenger on November 17, 2008 at 5:52 PM

Agreed…and this is worth watching (for those who haven’t seen it yet)

Seems that several key points remain as they were, even if the picture you painted is more accurate than p-over-p’s picture: social-engineered loans are (surprise) almost always a bad idea; market participants are responsible for their own due diligence, which will generally be vastly superior to any regulatory regime – the bad risk-pricing models you cite must have been rejected by some institutions, because not all of them played in this area, but gave it a wide berth, I believe.

Thanks for the discussion – let’s step back for a moment and consider how this little informal chat is 1,000 times as substantive as anything one typically hears in the MSM or from elected officials, of either party ….. very troubling.

But didn’t the magic evil touch of the GSEs, as you noted, actually provide the key link here? Did the GSEs provide the implicit USG guarantee to the sub-prime paper that was NOT CRA-related, and didn’t that play a role in the AAA rating?

As I stated in my previous post, the GSEs could not have backed loans that required no downpayment or proof of assets. So GSE involvement cannot account for the AAA rating of paper involving the high-risk loans.

Every aspect of the subprime crisis, from the behavior of borrowers and lenders to the creation of massively complex and over-rated financial products, to the cavalier assessment of risk, can be accounted for as the product of agents behaving more or less rationally given the information available to them. Hypothesizing some kind of external coercion is not just unsupported by evidence but also explanatorily superfluous.

A few questions.

Jazzman states that CRA-related sub-prime paper wasn’t involved in the packaged derivatives that made this turn-down so vicious and widespread; he also says that fully half of sub-primes had no inherent basis in CRA-related activities.

But didn’t the magic evil touch of the GSEs, as you noted, actually provide the key link here? Did the GSEs provide the implicit USG guarantee to the sub-prime paper that was NOT CRA-related, and didn’t that play a role in the AAA rating?

A more cosmic question: why would “regulation” be the answer to the derivatives market situation? Why does the mortgage-backed derivative market need any more regulation than it already has? So long as market players are free agents, and information is on the table, how is this market different than any other on Earth?

And I still don’t understand why Glass-Steagall repeal really had any role in this. Seems to me essentially the same problem could have developed with G-S in force.

The picture you have of the subprime crisis is wrong on so many levels that I don’t even know where to begin responding to you. So I apologize if this ends up being a little long and rambling.

First, it seems like you’re saying that CDO’s were over-rated because of investors’ unwarranted confidence in Fannie/Freddie. This is absurd. The truly disastrous sub-prime loans (no downpayment, no proof of income, etc.) could not legally have been backed by the GSEs, since they fail to meet federal underwriting standards. The prevalence of these loans is entirely attributable to private-label securitization, fuelled by a faith in the persistence of the bubble. CDOs backed by these loans were over-rated, but that paper could not have passed through the hands of Fannie/Freddie. So your claim that Fannie’s AAA rating is solely or primarily to blame for the mispricing of risk is just evidently false.

Second, the claim that securitization has nothing to do with this crisis is even more absurd. Now that we’ve dispensed of the myth that the GSEs are responsible for the failure of credit rating, we should ask, “Why were products backed by such dodgy assets given such good credit ratings?” And the answer is that the products were ingeniously created so that the risk was extremely diversified and massively overcollateralized. But the models used to calculate the risk didnt completely account for the ludicrously lax underwriting standards in the home loan market, or anticipate the country-wide housing slump.
So the creation of these complex securities, and the consequent transfer of risk from agents actually involved with the housing market and aware of the subprime situation to institutions with nothing to go on but the rating agencies’ inadequate models, is a crucial factor in the credit crunch.

To blame it on Fannie/Freddie or the CRA is to betray either a lack of understanding of the financial situation or a hyperpartisan lack of concern for the facts.