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Tuesday, August 5, 2008

Partisanship and the Mortgage Crisis

A few days back I wrote a piece about the villains of the aftermath of the mortgage crisis, one group that should have been included but wasn't was the partisans. One of the most pernicious activities I have witnessed was watching partisans on both sides spew propaganda that attempted to paint the fault of the mortgage crisis as some sort of activity most associated with the other side.

The left's favorite mantra to the mortgage crisis is that it was caused by deregulation. One great example of this is this piece by John McCarron in which he defends fannie and freddie as helpless victims and pins the blame on greedy banks that exploited deregulation.

Amazing, isn't it, how deftly the Republican right plays the blame game?

The nation is plunging into an economic recession the depths of which are scarily uncertain. We were pushed into this ditch by a craven pattern of private-sector greed and exploitation that reads like the story line of a Marxist comic book.

There has been widespread predatory lending by hustle-a-buck mortgage brokers who grabbed fees upfront. There has been wildly intemperate speculation by major banks and Wall Street investment houses hellbent to squeeze extra yield from fixed-income portfolios. There has been malfeasance by rating agencies that stamped "investment grade" on bundles of trick mortgages destined for default.

Yet even as our neighborhoods get pocked with repossessed board-ups, even as the value of our individual retirement accounts plunges and as the unemployment rate rises, we hear no widespread calls for reform. Hardly anyone is demanding restoration of usury laws to protect us from the likes of Ameriquest, Countrywide or IndyMac. Nor is the public demanding restoration of the Glass-Steagall Act, the Depression-era law that forbade banks from making speculative investments, until it was repealed by a Republican Congress in 1999.

E.J. Dionne made a similar point in this piece.

The biggest political story of 2008 is getting little coverage. It involves the collapse of assumptions that have dominated our economic debate for three decades.

Since the Reagan years, free market cliches have passed for sophisticated economic analysis. But in the current crisis, these ideas are falling, one by one, as even conservatives recognize that capitalism is ailing.

You know the talking points: Regulation is the problem and deregulation is the solution. The distribution of income and wealth doesn't matter. Providing incentives for the investors of capital to "grow the pie" is the only policy that counts. Free trade produces well-distributed economic growth, and any dissent from this orthodoxy is "protectionism."

The old script is in rewrite. "We are in a worldwide crisis now because of excessive
deregulation," Rep. Barney Frank, D-Mass., the chairman of the House Financial
Services Committee, said in an interview.

In fact, Dionne's allusion that the mortgage crisis was caused by deregulation is all part of a piece that makes a larger point that deregulation fails in general. Anyone that thinks that deregulation was the problem in the mortgage business clearly knows little about it and likely was asleep when they closed on their own loan. During the loan process, a borrower will sign more than one hundred documents. These documents disclose such thing as their RIGHT to receive a copy of an appraisal, their RIGHT to refuse a loan (within three business days of closing), along with dozens of other rights and responsibilities.

All of these disclosures are not in the loan process by accident. They are there in response to numerous prior regulations. The reality is that the mortgage industry is hyper regulated. For instance, one regulation forces a mortgage broker to prepare disclosures within three business days of pulling a borrower's credit report. This regulation is difficult enough to follow, and it is even more difficult to enforce. This regulation is one of thousands that has been created to regulate the mortgage industry.

Furthermore, most of the troubled loans were in fact done outside of regulations. No one is allowed to lie on their application. When borrowers simply made up incomes on stated loans, that was against regulations already created. The problem was not the regulations but rather enforcement. The dynamic that lead to this obscene amount of mortgage fraud that wasn't enforced is extremely complicated, and it cause and solutions are both well beyond any partisan ideas.

Beyond that, another liberal mantra becries the deregulation in financial services and links that to the mortgage crisis.

Mortgage brokers, who occupy an unregulated niche of the lending world, made a commission for every borrower they handed over to a mortgage lender. These brokers are like the drug dealers on the street corner. They are the smallest link in a lending chain that includes some of the largest and most respectable Wall Street firms.

Large mortgage finance companies and banks made big bucks on sub-prime loans. Last year, 10 lenders -- Countywide, New Century, Option One, Fremont, Washington Mutual, First Franklin, RFC, Lehman Brothers, WMC Mortgage, and Ameriquest -- accounted for 59 percent of all sub-prime loans, totaling $284 billion.

Wall Street investment firms set up special investment units, bought the sub-prime mortgages from the lenders, bundled them into "mortgage-backed securities," and for a fat fee sold them to wealthy investors around the world. According to The New York Times, China's second-largest bank, Bank of China Ltd, held almost $9.7 billion of securities backed by U.S. sub-prime loans. These investors, who bought the collateralized securities, were happy as long as they got paid their higher interest on the bonds or other investments.

With the bottom falling out of the sub-prime market, more than 80 mortgage companies went under in the past six months. Major Wall Street firms took billion-dollar losses as the crisis ripped into foreign money markets, from London to Shanghai. Lehman Brothers underwrote $51.8 billion in securities backed by sub-prime loans in 2006 alone; as of September, 20 percent of those loans were in default, the Times reported. Similarly, about one-fifth of the sub-prime loans packaged by Morgan Stanley, Barclays, Merrill Lynch, Bear Stearns, Goldman Sachs, Deutsche Bank, Credit Suisse, RBS, Countrywide, JP Morgan, and Citigroup are 60 or more days delinquent, in foreclosure, or involve homes that have already been repossessed.

The executives and officers of some mortgage finance companies cashed out before the market crashed. The poster boy is Angelo Mozilo, the CEO of Countrywide Financial, the largest sub-prime lender. He made more than $270 million in profits selling stocks and options from 2004 to the beginning of 2007. And the three founders of New Century Financial, the second largest sub-prime lender, together realized $40 million in stock-sale profits between 2004 and 2006. Paul Krugman reported in The New York Times that last year the chief executives of Merrill-Lynch and Citigroup were paid $48 million and $25.6 million, respectively.

First, this particular mortgage broker will take issue with the idea that my business is unregulated. I only wish I didn't have to deal with the mountain of regulations that engulfs my business. The particular attack tried here is extremely sneaky. That's because it is true that financial services companies were deregulated. It is also true that many financial services companies began to dabble in mortgages. It is further true that when things got hot many of them dabbled in sub prime. That said, no one that uses this line of attack can find the link between the deregulation and the mortgage crisis itself. Furthermore, all of these banks, brokers, and other financial services companies have felt the after effect of the mortgage meltdown. This idea that all of these greedy monsters made out with people's money and sailed into the sunsets while folks were left holding the bag is inaccurate. Many of these financial institutions were devastated. Yes, many of these CEO's made out like bandits while their companies struggled however that isn't exclusive to the financial services industry.

Finally, again, no one making this attack can point to the cause and effect between deregulation of the financial services industry and the mortgage crisis. This argument turns a correlation into a causation. What those peddling this argument never explain is how and why all of this deregulation lead to the mortgage crisis, and that's because it didn't. In fact, if anything, what deregulation did was perpetuate the crisis. It caused more players to be involved in bad loans, but deregulation didn't cause the bad loans in and of themselves.

Of course, liberals aren't the only ones guilty of using this crisis for demagoguery. Many conservatives have found their own target of demagoguery. They blame the Community Reinvestment Act.

a United States federal law that requires banks and thrifts to offer credit throughout
their entire market area and prohibits them from targeting only wealthier neighborhoods with their services, a practice known as "redlining." The purpose of the CRA is to provide credit, including home ownership opportunities to underserved
populations and commercial loans to small businesses.

They see this bill and other legislation that forced banks to make more efforts to lend in low income areas as leading directly to the loosening of restrictions. These conservative pundits make the assertion that banks loosened their restrictions to avoid bogus discrimination charges.

A lot of subprime mortgage loans are defaulting. A big reason why is that, to avoid discrimination charges, lenders gutted their traditional lending standards in order to loan money to people with bad credit (bad credit is more common in some minority communities, so refusing to lend money to people with bad credit is alleged to have a racially “disparate impact”). The Community Reinvestment Act, which punishes banks that don’t make loans in high-risk areas, is also a key reason why (it was enacted and then made even more onerous by the very politicians who are now
shrieking about the mortgage crisis they helped create).

This is another sneaky charge. That's because this act did lead to more lending in depressed areas. Sometimes, banks probably did lend too aggressively, however that was merely a blip. It is a total distortion to say that CRA or any other act lead to the mortgage crisis. First, most of these laws were already on the books for years if not decades before the mortgage crisis hit. If there is a direct cause and effect why did it take so long between the enactment of the laws and the mortgage crisis? Second, this charge is made by those totally naive of the crisis, and made to those totally naive of the crisis. It's a nice story to make it seem as though pseudo affirmative action caused the crisis. It would be nice for conservatives to blame the crisis on the pseudo socialism of providing loans to those that didn't deserve it because they are poor. Too bad it's simply not true. The roots of the crisis are leveled in greed and recklessness. As I have said over and over, the roots of this crisis began when Alan Greenspan lowered the fed funds rate to .75%.

This loose money lead to irresponsible lending because banks had more money than loans. Once the money rolled in banks and Wall Street investors competed with each other in a fit of mad craziness. Each of them out did the other and soon enough we had loans with incredibly easy guidelines. None of this happened because the federal government forced banks to lend in low income neighborhoods. This happened due to unadulterated greed and irresponsibility.

Partisans on both sides have used this crisis not to learn or analyze but as an opportunity to try and reinforce a position. None of these partisans have the first clue what actually caused the crisis, and most don't care. This, however, doesn't stop them from bloviating endlessly about how ultimately it was their political opponent's fault that all this happened. Much like real life vultures these ideological vultures swoop up in the aftermath of misery to assign blame, not to those that are at fault, but rather to their ideological opponents. To use such a financial disaster for ideological gain is nothing short of reprehensible and all that peddle in it earn my scorn.

For a full summary of how we got here take a look at this piece.


Anonymous said...

This crisis is a perfect storm. You can't throw out the G&S act and the FSM act and greed and pin all the blame on Greenspan's move of lowering interest rates. The crisis is in the convergence of many factors. The one factor that economists and lawmakers tend to overlook is the reprehensible, incredibly destructive, and inhuman greed of some people who should be held accountable, stripped of their wealth, and placed in prison.

mike volpe said...

That maybe so, however this perfect storm was created by the irresponsible rate decreases by Greenspan. Every capitalist was reacting as any capitalist would to an unnatural stimulus. Greenspan should have known better. The laws were irrelevant in my opinion. had the rates not been lowered so much that it created much too much money in the system, the rest of the perfect story wouldn't have happened.

Anonymous said...

Great post; thanks for the attempt to be non-partisan in your criticism.

I'm curious, though. You say that the root cause is "greed and irresponsibility." I'm fairly sure that greed and irresponsibility have been with us a lot longer than any of the legislation you suggest couldn't have had anything to do with the crisis, due to the time elapsed between enactment and denouement.

I do believe the problem is lack of regulation, specifically regulation which would give enough oversight to prevent unfettered greed. Specifically, regulation both to allow greater external insight into the quality of the loans on the books, specific limitations on the amount of leverage any particular firm could adopt, and strictly limiting the use of shareholder equity (stock) as collateral. I would also propose requirements about the form of bonuses to executives in the financial industry, specifically that it come in the form of stock in the company with a vest date no less than four years after grant. These are aimed at helping investors evaluate the company; coupling greed to the long(er)-term success of the company; and reducing overall industry risk. Thoughts?

mike volpe said...

Yeah, as I think about it, I really don't like using vague words like greed and irresponsibility and you are correct that these character flaws have been around longer than regulations themselves.

The first problem I have with the more regulation meme is that the main problem here is that a basic regulation wasn't enforced. That was fraud. Many of these loans were fraudulent and yet the fraud was never very well prosecuted.

As for regulations, with the benefit of hindsight, one could easily now say that we needed stricter rules on capital funds available and especially on the use of margin in buying these products. Yet, before the fact, I find it hard to believe that a bureaucrat would have been able to set proper policy.