The Balloon Finally Pops

I often compare regulating the free market to pushing on a balloon... there will always be a reaction.  You just don't know where.  Well last week, as presumably most of us felt in our wallets, one big balloon finally popped.

Before anyone accuses me of some form of political pandering, remember that I can think for himself and don't blindly follow a party.  Fiscally conservative, socially liberal... thereby finding major fault with both parties, and having voted, and not voted, for both in the past.  Often leaving only one, still rather unacceptable, alternative.  I'd encourage everyone to attempt similar introspection and not just follow in the brain-numbing dust of a herd of elephants or asses.

But already I'm tiring of the ignoramous among us claiming "see, government wasn't the problem after all, it's the solution" as the political illiterati contemplate bailouts and more regulation.  There's another side of this story, suspiciously unreported with a couple of exceptions, that should be thought about before spending a trillion or so.

Try as you might you can't completely regulate certain aspects of human nature.  But let's see what else created this debacle.

Washington is as deeply implicated in this meltdown as anyone on Wall Street or at Countrywide Financial. Going back decades, but especially in the past 15 or so years, our politicians have promoted housing and easy credit with a variety of subsidies and policies that helped to create and feed the mania.

The Community Reinvestment Act. This 1977 law compels banks to make loans to poor borrowers who often cannot repay them. Banks that failed to make enough of these loans were often held hostage by activists when they next sought some regulatory approval.

Robert Litan, an economist at the Brookings Institution, told the Washington Post this year that banks "had to show they were making a conscious effort to make loans to subprime borrowers." The much-maligned Phil Gramm fought to limit these CRA requirements in the 1990s, albeit to little effect and much political jeering.

Twisting the risk/reward ratio by pushing the acceptance of more risk.  But what about Fannie Mae and Freddie Mac?  Well, they weren't exactly private institutions.

Created by government, and able to borrow at rates lower than fully private corporations because of the implied backing from taxpayers, these firms turbocharged the credit mania. They channeled far more liquidity into the market than would have been the case otherwise.

These are the firms that bought the increasingly questionable mortgages originated by Angelo Mozilo's Countrywide and others. Even as the bubble was popping, they dived into pools of subprime and Alt-A ("liar") loans to meet Congressional demand to finance "affordable" housing. And they were both the cause and beneficiary of the great interest-group army that lobbied for ever more housing subsidies.

Fan and Fred's patrons on Capitol Hill didn't care about the risks inherent in their combined trillion-dollar-plus mortgage portfolios, so long as they helped meet political goals on housing. Even after taxpayers have had to pick up a bailout tab that may grow as large as $200 billion, House Financial Services Chairman Barney Frank still won't back a reduction in their mortgage portfolios.

How about the guys that rated credit?  Oops... also tied to government regulators.

The major government-anointed credit raters -- S&P, Moody's and Fitch -- were as asleep on mortgages as they were on Enron. Senator Richard Shelby (R., Ala.) tried to weaken this government-created oligopoly, but his reforms didn't begin to take effect until 2007, too late to stop the mania.   Thanks to federal and state regulation, a small handful of credit rating agencies pass judgment on the risk for all debt securities in our markets. Many of these judgments turned out to be wrong, and this goes to the root of the credit crisis: Assets officially deemed rock-solid by the government's favored risk experts have lately been recognized as nothing of the kind.

And banks?  Weren't they already heavily regulated?

In the Beltway fable, bank supervision all but vanished in recent years. But the great irony is that the banks that made some of the worst mortgage investments are the most highly regulated. The Fed's regulators blessed, or overlooked, Citigroup's off-balance-sheet SIVs, while the SEC tolerated leverage of 30 or 40 to 1 by Lehman and Bear Stearns. The New York Sun reports that an SEC rule change that allowed more leverage was made in 2004 under then Chairman William Donaldson, one of the most aggressive regulators in SEC history.

Yes the most aggressive regulator actually created the rule change that fueled this crisis.  And what about the least regulated aspects of this industry?  How did they fare?

Meanwhile, the least regulated firms -- hedge funds and private-equity companies -- have had the fewest problems, or have folded up their mistakes with the least amount of trauma. All of this reaffirms the historical truth that regulators almost always discover financial excesses only after the fact.

Hmmm... that can make you wonder a bit.  Some people tried to warn Congress.  We've heard of McCain talking about Fannie Mae many years ago, even the king of excessive spending, George Bush, warned Congress 17 times that action needed to be taken.  There was even a bill in the Senate a couple years ago that could have prevented all of this.

The clear gravity of the situation pushed the legislation forward. Some might say the current mess couldn't be foreseen, yet in 2005 Alan Greenspan told Congress how urgent it was for it to act in the clearest possible terms: If Fannie and Freddie ``continue to grow, continue to have the low capital that they have, continue to engage in the dynamic hedging of their portfolios, which they need to do for interest rate risk aversion, they potentially create ever-growing potential systemic risk down the road,'' he said. ``We are placing the total financial system of the future at a substantial risk.''

What happened next was extraordinary. For the first time in history, a serious Fannie and Freddie reform bill was passed by the Senate Banking Committee. The bill would have required the companies to eliminate their investments in risky assets.

If that bill had become law, then the world today would be different. In 2005, 2006 and 2007, a blizzard of terrible mortgage paper fluttered out of the Fannie and Freddie clouds, burying many of our oldest and most venerable institutions. Without their checkbooks keeping the market liquid and buying up excess supply, the market would likely have not existed. But the bill didn't become law, for a simple reason: Democrats opposed it on a party-line vote in the committee, signaling that this would be a partisan issue. Republicans, tied in knots by the tight Democratic opposition, couldn't even get the Senate to vote on the matter.

Once again, both parties at fault.  Both tied in partisan knots, ignoring the effect of regulatory incentives, ignoring the many wise people from multiple political persuasions that predicted this problem.  The cognizant from both parties, and the President, could have made a much bigger stink about the upcoming crisis, but they didn't.  That's a crisis in leadership, from both parties.

And here we go again, beginning to blow up a new financial balloon, and readying a multitude of fingers to press on it.  We're already talking about "protections for homeowners" and "investor guarantees"... it doesn't take much history to realize the fallacy.  Just re-read my first quote earlier in this post.  Risk and reward.  Tamper with either side of that equation and you have a recipe for disaster.  You can't have your cake and eat it too, whether you're a homeowner with too little to truly afford a mortgage, or an investor anxious to make some interest return.

Comments

[Jason]

Concerning your point about the CRA loans, I found this study from another blog post (yeah, I know, much more reliable):

http://www.traigerlaw.com/publications/traiger_hinckley_llp_cra_foreclosure_study_1-7-08.pdf

* CRA loans constituted 23% of all loans and 9.2% of high-cost loans.
* CRA loans were twice as likely to be retained in the originating bank’s portfolio than loans made by other institutions.
* CRA loans were less likely to be foreclosed upon than other loans.

[Heartland Man]

The cornerstone of lean is Value for the customer, and Toyota's success is deeply embedded in the value proposition they offer, which has been far superior to that of their American competitors who have been more concerned with appearance and branding.

Where is the value creation in the real estate industry? It is in building quality homes and selling them for a fair price. Wall Street and far too many Americans put money into real estate without creating value. Their goal was to flip, spin, play shell games with interest rates and otherwise be clever enough to make money without creating value - and to do it quickly.

We cannot survive with an economy that not only encourages getting something for nothing - getting rich without creating value - but siezes money from the average taxpaying Joe to create a safety net for those whose 'something for nothing schemes' backfire.

388,000 construction workers - people who actually create value - are currently unemployed; well over a million if you toss in the building products manufacturers and the construction equipment makers. Where is their bailout? No safety net for value creators - but a huge one for the folks whose goal is to get rich quick from the sweat of their brows.

Nothing short of radical reform of Wall Street can save us - starting with the old Ross Perot proposal to put in a graduated capital gains tax - 80% or more on profits taken in the first year all the way down to 0% for profits taken after 5 years. At least we can drive the day traders and house flippers out of the core economy and back to the casinos where they belong.

[Stuart Berman]

Nicely detailed. I love the daily emails and plenty of coworkers are benefitting from your wisdom.

[Jim C]

Kevin,
Great post, and you're right those facts aren't presented in too many places. That one comment on "regulators almost always find financial excesses after the fact" and the info on how the least regulated have fared the best... classic. And sad it is under reported. Once again I know why I read Evolving Excellence!
J

[T Sutton]

Good post and glad to hear someone is actually thinking out there. So much political pandering from both parties it makes me sick. Ever think about running for office?

[Nguyen]

As always I appreciate your informative posts even when they aren't completely related to manufacturing; I learn something new every day. Thanks for clarifying this issue for me! I also forward your posts to most of my department.