Sunday, September 21, 2008

The blame game

The latest meme on the financial crisis from the right: it's all the fault of Carter, Clinton, and "socialists", who forced the banks to make all these subprime loans via the Community Reinvestment Act in 1975. I actually listed to this piece of right-wing hate radio from Mark Levin where this theory is expounded.

For someone who rarely listens to this stuff like me, the tone is downright scary. Levin has a voice like a dentist's drill. I have a hard time imagining the audience for this stuff -- I imagine bitter, hate-filled members of the downwardly mobile white sub-working class -- Joe Pesci, minus any charm or charisma. I hesitate once again to throw out the f-word but I can't help but think of Hitler's speeches and the Two Minute Hate from 1984.

The thing is, there may even be some truth in what he's saying. No doubt Democrats have had a hand in this crisis; they are just as much in bed with Wall Street as the Republican party (not sure how that squares with them being "socialists"). But how can you take someone seriously who not only sounds like that but writes things like this:
I want to congratulate the attorneys who work with me at Landmark Legal Foundation for tenaciously pursuing the untold story of the systematic abuse of American MPs by the al-Qaeda terrorists at Guantanamo Bay.
Here's a counterattack to this sort of theory; the most commonsensical refutation is that most of the bad subprime loans were made in the last five years; so if a bill passed in 1975 is responsible why was there a 25-year lag time?

And also this report (via) which says:
CRA Banks were substantially less likely than other lenders to make the kinds of risky home purchase loans that helped fuel the foreclosure crisis.
Oh well, so much for alternative points of view. The facts don't matter too much, what matters is whether Levin et al are going to succeed get this notion into the minds of the populace.

If things get really ugly economically, I mean ugly in people's real lives, not just the financial markets, don't be surprised if this sort of hate boils out of the backwoods of AM radio and into the mainstream, wherever the hell that is. People are going to be looking for someone to blame, and the right has been honing their eliminationist rhetoric on progressives and Democrats for many years now. Fuck, I feel like stringing someone up myself, and while I'd start on the other side of the political divide there is plenty of blame to go around.


Michael said...

The Community Reinvestment Act is not a great factor in the current mortgage and real estate collapse.

Most of the problem's real source can be summarized by the colloquialism "no skin in the game."

Let's consider, first, the old-fashioned "conventional" mortgage. Such a mortgage is secured only by the collateral pledged; there are no guarantees from third parties. Conventional mortgage lenders such as community banks traditionally held, and many still do hold these mortgages in their loan portfolios to maturity. Any delinquency or default is therefore a direct charge to their earnings or capital. The lender thus has "skin in the game" and is suitably cautious. The loan is typically made for no more than 80% of the appraised value of the property that serves as collateral. The borrower must come up with the other 20%. As an example, if a house is appraised at $250,000, the lender will lend no more than $200,000, and the buyer has to raise $50,000 from savings, the sale of other assets, etc. His $50,000 equity in the house has two important effects: 1) it provides a substantial cushion against loss on the part of the lender at the sale of the property in event of a foreclosure, even if real estate values fall; and 2) it is "skin in the game" for the borrower, since if he fails to make payments on his mortgage debt according to terms, the house will be foreclosed and he will lose his equity.

So far, so good. But what about folks who cannot find money to make a 20% down payment?

Enter the Federal government. It has long been public policy to encourage home ownership. This is accomplished in a variety of ways, among the deductibility of mortgage interest from taxable personal income, but also by more direct subsidy. There are a variety of Federally guaranteed loan programs that enable buyers of residential housing to borrow more than 80% of a property's appraised value.

The Federal Housing Administration (FHA), created in 1934 under the National Housing Act, today allows purchase of a residence with as little as a 3% down payment. Qualifications for buyers and pledged collateral are relatively strict. The Veterans' Administration (VA) allows 100% financing. The buyer must be a veteran or the surviving spouse of a veteran, and, again. there is an extensive qualification of buyer and property. These programs are government guarantees of mortgages exceeding the conventional loan-to-value (LTV) ratio of 80%.

The Federal National Mortgage Association (FNMA) was founded in 1938 as part of the New Deal to provide liquidity to mortgage markets. Its function was to act as guarantor of government-issued mortgages and to buy mortgages on the secondary market and re-package them as securities. The market in securitized mortgages, which have been at the center of the current collapse, was essentially created by FNMA when it was a government agency, and it enjoyed an effective monopoly on the secondary mortgage market. In 1968, by a Democratic congress under Lyndon Johnson's administration, FNMA was privatized to move its activities off the government balance sheet. It became a "government sponsored enterprise" (GSE) - a private sector, stockholder-owned company, with an implicit Federal guarantee, and subject not to the usual bank regulatory authorities but to special regulation under the Department of Housing and Urban Development.

The Federal Home Loan Mortgage Corporation ("Freddie Mac") is another GSE, created in 1970 by a Democratic congress under the Nixon administration, to expand the availability of mortgage money by creating a secondary market for conventional mortgages and eliminate what had been until then Fannie Mae's monopoly.

As a consequence of the broadened secondary mortgage market, non-bank mortgage companies arose in competition with the more traditional banks that held all their own loans to maturity. Furthermore, banks that had previously not done so began to sell mortgages they had originated. Between 1970 and the present, approximately 50% of all residential mortgages came to be either held directly by Fannie Mae or Freddie Mac, or bundled and sold as securitized mortgages through them. The secondary mortgage market created by Fannie Mae and Freddie Mac also attracted competition from enterprises that were not government-sponsored, e.g., Countrywide.

Several points are obvious:

1) the market for residential mortgages has been shaped by significant Federal government intervention for more than 70 years;

2) government programs intended to permit the purchase of houses with little or no down-payment have driven the demand for housing artificially. This has led to

3) a circumstance in which any fall in the price of residential real estate has a perverse effect. If a borrower has a 100% LTV mortgage, for example, a 5% fall in the price of real estate wipes out his equity. He has no incentive to continue paying off his mortgage, and nothing to lose by letting the lender foreclose.

4) Until the inflation in the 1970s, the typical residential mortgage was made for a term of 20 to 30 years at a fixed rate. This became impossible at that time. Inflation of the currency (which we must note here was a consequence of then current central banking practices, i.e., government policy) had necessitated the revocation of Regulation Q, the government-set limit on interest paid to bank depositors. If Reg. Q had not been revoked banks would simply have lost their deposits to disintermediation, and would have been unable to support the loans then on their books without them.

But the resultant new volatility in interest rates paid on deposits meant that offering 20 or 30 year fixed rates on mortgage loans was not easily possible. Mortgage lenders began to favor loans made for shorter periods, typically 5 years, with amortization schedules based on a 20- to 30-year pay-down, but having a balloon payment at the end, to be re-financed at whatever interest rate was prevailing at the time.

5) Combining mortgages of this sort, having rates adjustable every few years, with high LTV ratios, means that the market for mortgages- and hence real estate - is extremely vulnerable to changes in the central bank's discount rate, on which all other interest rates depend. During its first years, the monthly payment of a mortgage is substantially interest, and reduces the principal by only a little. If the prevailing interest rate at the end of a mortgage's first 5 years should be higher by (say) 2 or 3 percentage points than it was when it was originated, the refinancing of the balloon payment may require double the monthly payment.

It is not the price of a house that determines its affordability to a buyer so much as it is the amount of his disposable income consumed by the monthly mortgage payment. A doubling of the payment in any event will create considerable strain on the household budget. If the mortgage borrower has little or no equity in his house at such a point, the perverse effect mentioned under point 3 above comes into effect.

6) When this happens on a wide enough scale, the market goes into a cascading fall. More houses are for sale than have buyers; prices are reduced, lowering the value of comparable properties, and as their owners have to refinance they, too find it easier to walk away from a property in which they now have negative equity. Housing starts dwindle and people in the industries related to housing are laid off. Now they can't make payments on their own houses, and these properties become some lender's "OREO" (other real estate owned).

In the period before the stock market crash of 1929, it was possible to trade stocks on a very small margin - i.e., one could put up relatively little of one's own money, and borrow the rest to buy shares of stock, thus greatly leveraging one's own resources. This was well and good as long as stock prices rose. However, when they fell, the investor's equity would be wiped out, and he'd receive a 'margin call' - being required to put up additional money of his own. If he couldn't the stock had to be sold. In a falling stock market, this led to the same sort of cascade we have witnessed in the real-estate market, and for the same reason - too many participants in the market had "no skin in the game."

The current mortage and housing market was created by long-term legislative policy. Liquidity in the market has in turn been affected by the fluctuations of central banking policy. It is not a case of "market failure" - "Wall Street" is not responsible for either of these, and is not primarily to blame. It went with the flow, but the channel had been excavated by government.

Within government, I'm sure there's plenty of blame to go around. Let us note, however, that the principal apologists for Fannie Mae and Freddie Mac have historically been Democrats, e.g. Rep. Barney Frank and Sen. Charles Schumer. The critics of these GSEs have historically been conservatives, e.g., the editorial writers at the Wall Street Journal. It would be interesting to see to what politicians' campaingn funds the executives of Fannie Mae, Freddie Mac, and other secondary mortgage businesses have contributed.

mtraven said...

Thanks for the comment; this is an area where my knowledge is extremely sketchy. I am in fact an ignoramus at anything having to do with money (but at least smart enough not to get an adjustable-rate mortgage).

Two things I don't get -- government support for low-income mortgages has been around for a long time, as you noted. So why should this system run more or less smoothly for decades and only in the last few years spin out of control and lead to financial meltdown?

The other question, or maybe it's the same one, is why all these bad loans were bundled up, securitized, bought, and reinsured by people whose job is to understand risk and price securities accordingly??? Why did these wizards of Wall Street leverage these bad loans to the point where the whole system is in danger of a catastrophic, final collapse? Nobody held a gun to their head and forced them into this business model.

The only explanations I can think of:

- finance people are idiots who, in fact, have absolutely no expertise in structuring investments;

- they were fully aware of the risks, but were under so much competitive pressure from each other to show short-term profits that they ignored the near certainty of long-term downside;

- they were fully aware of the risks, but reasoned that they were taking the profits in bonuses and the eventual losses to the firm would not be born by them; if their firms go bankrupt or require government bailouts that's not that much downside for them personally (an agency problem, essentially).

These are obviously not mutually exclusive explanations.

goatchowder said...

Well I did startups during the tech bubble, and I can attest to the fact that greed and competition can cause perfectly ordinary and otherwise ethical people to completely defy logic and deny reality... as long as it pays.

As for right-wing hate radio, it seems that right-wing hate DVD's are even more dangerous.

werouious said...

i used to listen to rush limbaugh daily, i kind of enjoy right-wing talk radio, but i'm really a libertarian.

as soon as WABC radio in ny put mark levin on the air, i stopped listening. that guy really is like a dentist's drill. worse. far worse.

goatchowder said...

I had a fascinating conversation yesterday with someone who grew up in rural PA and then has lived here in Ecotopia for years, and finally returned to Red State America briefly to work with Christian Fundamentalists, and is now happily back in San Francisco.

The new insight was: there is a very strong appeal to viewing things in simple, absolute terms. It makes things easy, so that you can get on with life, and not have to think about it anymore. Good and evil, Us and Them, right and wrong, black and white. Simple and pleasant.

The people were very nice and friendly, and generally very ethical and non-threatening, but they were "god's soldiers" and cheerfully and benignly went about their bigotry, blissfully unaware of any shades of grey beyond "Christian American" and "evil". They considered themselves the good guys; living such a sheltered life kept them happy and fulfilled.

The question came up about hypocrisy and how it tends to thrive among those kinds of absolutes (i.e. teenage prengancy among "abstinence-only" proscriptions). The answer was: denial is not just a river in North Africa. They would simply excuse away "sins" against their absolutes, because they knew they were doing something "wrong", and being "saved" put them on the "good" team.

So "us and them" thinking does have an evolutionary benefit: it keeps things simple and shelters people from having to worry about it, like Aqua/Cocoa on a Macintosh or the InstallSheild on Windoze.

For some people, thinking is fun. For most people, it is a lot of unnecessary work.