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Friday, December 26, 2008

The Many Lessons of the Mortgage Crisis

As we begin to try and pick up the pieces and attempt to find a way out of the economic crisis caused by the mortgage meltdown, we should also look at what lessons we can draw from the events that caused the crisis itself.

1) Government intervention is dangerous and should always be implemented with care.

The left is screaming about deregulation (something I will address in a bit), but it was in fact too much government intervention that played a far larger role in creating this crisis. When Alan Greenspan lowered the Fed Funds Rate to 1% and kept it there for about two years, he opened the door to allow banks to perform exactly the sort of risky behavior that caused this crisis. The Fed Funds Rate is an overnight borrowing rate. By making it so low, he literally invited banks to take risks they shouldn't have taken. Banks need to borrow overnight for one of two reasons 1) to make up for a mistake or 2) to take an unnecessary risk. Such borrowing should come with a price. Instead, Greenspan made it nearly free. As such, banks began to borrow short term and flush with cash, they put a lot more money into mortgages. The ball started to roll.

On a smaller scale, the Community Reinvestment Act and Congress' pressure on Fannie/Freddie to lend in low income areas also gave those entities even more license to create and support exactly the sort of loans that are causing trouble now.

In both cases, what we had was government intervention and manipulation into free markets. The free market would never have called for interest rates so low or to have these low income borrowers get loans, and yet the government insisted that all of these things are a good idea. All of this is very important for several reasons. For instance, Arianna Huffington proclaims that this crisis is proof positive that free market capitalism is a failure as a system. Given what I have shown about the role of government intervention in this crisis, that is a far too simplistic idea. Yet, we should expect folks like Huffington to continue this drumbeat. We can also expect the Obama administration to try and move this country dangerously far away free markets.

It's most important because currently the government is intervening in free markets in a much more active way than they ever did to create the crisis. The Federal Reserve has lowered the Fed Funds Rate to .25% and that's only the beginning. They are buying up Fannie bonds in order to manipulate mortgage rates lower. The Federal government is about to embark on trillions of Dollars worth of spending. Finally, the Obama administration has promised a new "regulatory framework". All of this amounts to significantly more government intervention than anything we had to get us here. We are in danger of allowing the government to manipulate the market into something much worse than it is now. We may allow it because we don't recognize one of the lessons of this crisis.

2) Government oversight and enforcement is key not regulations.

Anyone that claims that this crisis was caused by deregulation is 1) naive and 2) a partisan. This crisis wasn't caused by a lack of regulation. It was caused rather by a lack of oversight and enforcement of basic and common regulations. The financial industry is one of the most corrupt we have. Yet, the regulators in charge of watching the industry stood by while fraudulent loans were created en masse. The amount of fraud in mortgages increased exponentially in the last half a decade, and yet, the enforcement of this fraud was nearly non existent. From time to time, we would hear about Federal prosecutors busting up a ring of fraudulent mortgage schemers. In reality, it wasn't the sophisticated plot that caused this crisis. What caused this crisis was that it became common place to lie about income, assets, and occupancy. The bulk of the problem loans were done fraudulently. Yet, nothing was done even though it became nothing less than an open secret.

Business can't function unless there is an atmosphere of fairness. That can only happen if the regulators are aggressive in investigating and prosecuting fraud, theft, and other crimes. What happened in the mortgage industry for about three years was nothing less than a wholesale fraud and that fraud was looked the other way by those responsible for prosecuting it.

3) Speculative markets are always obvious and they always end badly

There is that gold rush mentality during any speculative market. What I mean is that everyone wants to get their piece because there is so much money to be made. This sort of behavior is born of greed and laziness. It is much easier to try and make the quick buck than to work hard for it. That's in part what creates a speculative market in the first place.

There was never any doubt by the end of 2004 that real estate was speculative. Yet, its speculative nature only only fueled more buying. Often people were buying properties to "flip" out of their own home state before they owned their own property. Does this really sound like a good idea? Yet, this sort of behavior was often encouraged. Real estate investment became the topic of water cooler and dinner conversation. In other words, novice real estate investors were sharing their non professional ideas in how to make money in a speculative market. Like all speculative markets, this one crashed and it crashed hard. Like all speculative markets, this one could easily be understood for its speculative nature throughout the speculative portion of the market. If your property suddenly became forty percent more expensive in a year, that is the hallmark of a speculative market. Instead, folks watched real estate prices go up literally with no end and saw this as a buying opportunity.

This will not be the last speculative market. The next one will be just as obvious and it will end just as badly. Hopefully, some will heed the lesson of this one and not join the gold rush of the next one.

4) Moral hazards are real, dangerous, and corrosive to our economy

For years, borrowers bought properties they couldn't afford. Banks took on risky loans. Both were rewarded with good properties, and a basket of loans that they then sold at massive profits. Furthermore, borrowers were often able to refinance out of loans that were affordable into brand new loans only slightly less afordable. While these borrowers held onto unaffordable mortgages, they were also given access to an endless stream of credit to buy a new car, television, or to fix up their place. Meanwhile banks made so much money on these risky loans that the more risk they presented the more money they made. All of this is known as a moral hazard in which risky behavior that should have been punished was in fact rewarded. All this did was create even more risky behavior.

Today, our government continues to engage in even more risky behavior. Companies that suffered, finally, because of all this risk were rewarded with $700 billion bailout. The automakers, suffering from years of mismanagement, were also given a bailout. Now, borrowers are being given a bailout in the form of loan modifications in which borrowers struggling to make their mortgage payments are given brand new loans that are more affordable. All of this presents a moral hazard even more expansive than the ones that we had in place during the run up to the crisis. Given what the last set of moral hazards created, is there any doubt what is happening now will make a crisis even worse down the road.

5) Fannie Mae/Freddie Mac need a serious overhaul

Our entire mortgage market is perverted and most people don't know it because 1)it's always been this way and 2) because it happens behind the scene out of the view of the consumer. Much of the problem was created because Fannie/Freddie have a monopoly on mortgage securitization. By securitizing loans, these two make all the rules. As such, these two control the entire mortgage market. Such a dynamic is open to manipulation and corruption. Unless there is a major overhaul of both Fannie/Freddie, the mortgage market will be in constant threat to the kind of dynamic we saw over the last few years. In my opinion, these two must be broken up and fully privatized as soon as possible. Without such wholesale changes, they will continue to wreck havoc on the mortgage market indefinitely.

6) Major financial revolution must be performed carefully.

I don't believe that the bank deregulation bill of 1999 was in and of itself a bad idea. It was however, very revolutionary. Furthermore, those that created and oversaw its implementation had no idea its effect. The bill essentially broke down the figurative wall between banks, brokerage firms, and other financial services companies and allowed most of them to cross sell each other's products. One of the by products was that more financial services companies became involved in mortgages. Limits on capital and diversification were disregarded by regulators and so the end result was that far too many financial services companies got far too heavy into sub prime and all of them busted when it did.

There is something called the law of unintended consequences. It was on display with the bank deregulation bill of 1999. No one involved with its passage thought it would be used to get far too aggressively in one area of finance. More likely, its backers thought the exact opposite. This happened because those entrusted with overseeing the industry after its passage were totally blind to the monster it helped create. Had regulators taken more care to limit leverage, capitalization, and a lack of diversification, a lot of this wouldn't have happened. Instead, regulators looked on while nearly every single financial services company not only got far too heavy in sub prime, but many of them did it with an obscene amount of leverage. Such a lack of oversight cannot happen the next time any law revolutionizes any industry.


joe blowe said...

Could you explain exactly what happens when someone gets a Mortgage at a Bank (one which he will not be able to pay later on)and where Freddie and Fannie fit in ?
Most people like myself lack the knowledge of the mechanisms of the financial institutions' transactions.

mike volpe said...

Good question. First, let's assume that your loan is securitized by one of the two, and right now almost all are.

What essentially happens is that the bank packages your loan into a bundle of thousands then it sells them all to fannie/freddie. Then fannie/freddie packages those loans together and creates bonds. What happens is that your rate maybe say 6%. Meanwhile, your loan and millions more are packaged together into bonds that pay 5%. Meanwhile, Fannie/Freddie have also paid the bank a percentage of each loan to take it off their hands. Now, if you only go bad, that is all right because there are millions. If, on the other hand, you are millions of people then fannie/freddie don't have enough money to pay the bondholders.

Bluegrass Pundit said...

Have you been wondering who is responsible for the bank crisis and the failure of Fanny Mae and Freddie Mac? Every voting age American should be required to watch this video. The video is from 2004 Congressional hearings about regulating Fanny Mae and Freddie Mac. You will see Republicans pointing out problems and calling for more regulation of Fanny Mae and Freddie Mac. You will see Barney Frank, Maxine Waters and other Democrats denying there is a problem and criticizing the regulators and Republicans for trying to prevent the upcoming crisis. If this video doesn't make you ashamed to be a member of the Democratic Party, nothing will.
Proof positive that democrats are responsible for bank crisis

mike volpe said...

I've seen the video and like most conservative ideologues you make the mistake of equating the entire crisis with what happened at Fannie/Freddie. While it was Dems responsible for Fannie/Freddie, Fannie/Freddie is a small piece of a much bigger puzzle. It is this that folks like you don't want to grasp. Instead, you engage in partisan bickering and nonsense.

If you want to blame the Dems for the mortgage crisis that is one thing, but to say that Fannie/Freddie is the end all be all of the crisis is plain nonsense.

Anonymous said...

Regulators aren't "Blind". They know exactly what's going on. They look the other way because the RE industry contributes hundreds of millions to their campaigns, and "Sweetheart" loans to Congressmen and women.