Author: James Kwak

Community Reinvestment Act Makes Bankers Stupid, According to AEI Research

One might have hoped that one collateral benefit of the end of the election season would be the end of the attempt to pin the financial crisis on the Community Reinvestment Act, a 1970s law designed to prohibit redlining (the widespread practice of not lending money to people in poor neighborhoods). Unfortunately, Peter Wallison at the American Enterprise Institute (thanks to one of our commenters for pointing this out) has proven that some people will never give up in their fight to prove that the real source of society’s ills is government attempts to help poor people. Regular readers hopefully realize that we almost never raise political topics here, but sometimes I just get too frustrated.

Many people who are more expert than I in the housing market have already debunked the CRA myth. Here are just a few: Janet Yellen, Menzie Chinn, Randall Kroszner, Barry Ritholtz, David Goldstein and Kevin Hall, and Elizabeth Laderman and Carolina Reid. Mark Thoma does a good job keeping track of the debate.

One of the main arguments against the CRA-caused-the-crisis thesis is that the large majority of subprime loans, and delinquent subprime loans, and the housing bubble in general, had nothing to do with the CRA; it was done by lenders who are not governed bythe CRA, and was done in places like the exurbs of Las Vegas or the beachfront condos in Florida, not poor neighborhoods (which generally saw less price appreciation than average). So Wallison comes up with a new argument: relaxed lending standards, encouraged by the CRA, caused lending standards to be relaxed in the rest of the housing market. Really, I’m not making this up.

Continue reading “Community Reinvestment Act Makes Bankers Stupid, According to AEI Research” →

The Lawsuits Begin, Part 2

Yesterday I mentioned a lawsuit against Goldman Sachs (article by HouseingWire) alleging that Goldman misled investors in its mortgage securitizations. Here’s the complaint. It’s a fun read.

The allegations are pretty simple. As part of each securitization, Goldman had to produce a registration statement and prospectus. In theory, as any investor knows, you are supposed to read the prospectus before buying a security. The claim is that these statements and prospectuses (someone help me with that plural) contained false statements regarding the underwriting standards used when making the underlying mortgages. The bulk of the complaint (pages 12-28) goes originator by originator and compares the statements made about that originator’s lending practices in the prospectus to information that has since emerged about how these lenders actually made loans.

One thing that struck me was how open these prospectuses were about what was going on. For example, here’s a passage on Countrywide’s “no income/no asset” loans:

Continue reading “The Lawsuits Begin, Part 2” →

Causes: Subprime Lending

Other posts in this occasional series.

Six months ago, this post would have been unnecessary. Back then, for most people, the crisis was the “subprime crisis:” subprime lending had become too aggressive, many subprime mortgages were going to go into default, and as a result securities backed by subprime mortgages were falling in value. Hedge funds, investment banks, and commercial banks were in danger insofar as they had unhedged exposure to subprime mortgages or subprime mortgage-backed securities (MBS). Still, if you were to stop the average reader of the New York Times or the Wall Street Journal on the street and ask what caused the current financial and economic crisis, there is a good chance he or she would start with subprime lending.

Asking whether subprime lending caused the crisis raises all the questions about agency and causality that I’ve raised before. On the agency question, insofar as there was a problem in the subprime lending sector – and few would deny that there was – does the fault lie with borrowers who took on loans they had no chance of repaying, perhaps sometimes without understanding the terms; with the mortgage lenders who lent them the money without doing any due diligence to determine if they could pay them back; with the investment bankers who told the mortgage lenders what kinds of loans they needed to package into securities; with the bond rating agencies who blessed those securities while taking fees from the investment banks; with the investors who bought those securities without analyzing the risk involved; or with the regulators who sat on their hands through the entire process? Note in passing that it may have been perfectly rational, as well as legal, for an investor to by an MBS even knowing that the loans backing it were going to default, but making a bet that he could resell the MBS before the price fell, under the “greater fool” theory of investing. (It may have been rational for an investment bank to do the same, but not necessarily legal, given the disclosure requirements relating to securities. Goldman Sachs is being sued over precisely this question.) Readers of this blog know that my opinion is that, although there is blame to be shared along the chain, the greatest fault lies with the regulators, for a few reasons. First, although the desire to make money may cause problems, it can be no more be said to be a cause of anything than gravity can be said to be the cause of  a landslide; second, bubbles are inevitable, at least in an unregulated market;  and third, there is a difference in kind between the mistake made by an investor, who is foolish and loses some money, and the mistake made by a regulator (or a legislator who votes to reduce funding for regulators), whose job is to serve the public interest.

But that was all the preamble, because today I want to talk about the question of causality.

Continue reading “Causes: Subprime Lending” →

Sign of the Apocalypse: Bush Administration Ready to Use TARP to Bail Out Automakers

I’m probably misusing the word, but I just think it’s incredibly ironic that, thanks to the Senate Republicans who blocked the compromise worked out between the White House and the Democratic majority to extend short-term loans to the automakers, the Bush Administration has now reversed its position and is open to using TARP money to keep GM and possibly Chrysler alive. Who ever thought we would see the day that this administration would prop up the Big 3 – and who thought it would happen because they were forced into it from their right?

Free Market Ideology, Epilogue

In the most recent post in the Causes series, I expressed a fair amount of agreement with Joseph Stiglitz’s criticism of an excess of faith in the free market and the lax regulation that results. With the Bernard Madoff scandal (New York Times; WSJ has more information but requires subscription), Felix Salmon is asking, where were the regulators?

(By the way, if you’re wondering how the Madoff fraud was possible, remember that a hedge fund is like a bank in the sense that you put your money in and you generally leave it there for a while, and although you may take some out now and then you may also put some more in now and then, and other people are putting it in, and so on. With a bank, not all depositors can get their money out at the same time because it is tied up in long-term loans that the bank can’t call in. With Madow’s fund, investors couldn’t get their money out because he had, effectively, burned it. They had been getting periodic paper statements showing returns, but there were no real returns, and hence no assets behind that paper.)

Causes: Free Market Ideology

Other posts in this occasional series.

Joseph Stiglitz, the 2001 Nobel Prize winner and the most cited economist in the world (according to Wikipedia) has an article aggressively titled “Capitalist Fools” in Vanity Fair that purports to identify five key decisions that produced the current economic crisis, but really lays out one more or less unified argument for what went wrong: free market ideology or, in his words, “a belief that markets are self-adjusting and that the role of government should be minimal.”

The five “decisions,” with Stiglitz’s commentary, are:

  1. Replacing Paul Volcker with Alan Greenspan, a free-market devotee of Ayn Rand, as Fed Chairman. (Incidentally, when I was in high school, I won $5,000 from an organization of Ayn Rand followers by writing an essay on The Fountainhead for a contest.) Stiglitz criticizes Greenspan for not using his powers to pop the high-tech and housing bubbles of the last ten years, and for helping to block regulation of new financial products.
  2. Deregulation, including the repeal of Glass-Steagall, the increase in leverage allowed to investment banks, and the failure to regulate derivatives (which Stiglitz accurately ascribes not only to Greenspan, but to Rubin and Summers as well).
  3. The Bush tax cuts. Stiglitz argues that the tax cuts, combined with the cost of the Iraq War and the increased cost of oil, forced the Fed to flood the market with cheap money in order to keep the economy growing.
  4. “Faking the numbers.” Here Stiglitz throws together the growth in the use of stock options – and the failure of regulators to do anything about it – and the distorted incentives of bond rating agencies – and the failure of regulators to do anything about it.
  5. The bailout itself. Stiglitz criticizes the government for a haphazard response to the crisis, a failure to stop the bleeding in the housing market, and failing to address “the underlying problems—the flawed incentive structures and the inadequate regulatory system.” (There’s regulation again.)

Continue reading “Causes: Free Market Ideology” →

Auto Bailout Update

I admit – I have auto bailout fatigue. But given the amount of virtual ink that has been spilled on this topic here, I think I owe you a place where you can express your thoughts on the current plan.

The Times says we are close to a vote, although Senate Republicans may block it. Here is the draft bill. The news article says it would take the form of $15 billion in short-term emergency loans. Reading the bill itself, though, I can’t find the number “$15 billion” anywhere. This is what I read:

  1. The President can appoint a person (or persons) to implement the bill, apparently colloquially known as the car czar.
  2. Once the bill passes, the car czar can make bridge loans or lines of credit right now. Those loans can be for as much as is needed under the plans submitted to Congress last week.
  3. The money is coming from “section 129 of division A of the Consolidated Security, Disaster Assistance, and Continuing Appropriations Act, 2009, relating to funding for the manufacture of advanced technology vehicles,” which I’m guessing is the pre-existing bill providing $25 billion in loans for R&D for fuel-efficient vehicles. That money will be then be replenished. It’s not clear whether this creates a $25 billion cap or not (how many times can the car czar draw on that money after it’s been replenished?).
  4. The loans are at 5%, increasing to 9% after 5 years. The government also gets a warrant to buy up to 20% of the loan amount in stock, at a price equal to the average price during the 15 days prior to December 2.
  5. The short-term loans are conditional on the government, the automakers, and all interested parties (including unions and creditors) being able to agree on a comprehensive, long-term restructuring plan by March 31, 2009. The car czar can extend this deadline by 30 days, but that’s it.
  6. The car czar has a lot of power to monitor the auto companies and make sure they are meeting the targets of their restructuring plans; if they aren’t, he can call in the loans.
  7. There are some other fun but peripheral provisions, like getting rid of corporate aircraft, dropping lawsuits against state greenhouse gas regulation, and executive compensation limitations.

The big point is #5 (in my list). In short, this isn’t a comprehensive bailout: it’s a bridge loan to buy time to come up with a comprehensive bailout. This is roughly what Simon predicted (although I can’t remember where). It enables the Bush administration to avoid having a car company fail on its watch, and enables the Democratic majority to say that they are doing something for the automakers, while deferring the hard questions. I assume that all of the controversial questions, like how big a concession the unions have to make, and whether or not it’s possible to force creditors to take equity in place of debt, will re-emerge over the next few months.

Of course, we may still have the live TV drama of not quite knowing if the Republicans will provide the needed votes, like we had with the first TARP vote. I would also be shocked to see President Bush sign a bill that requires car companies to drop their lawsuits against greenhouse gas regulation.

Let me know if I read the bill wrong.

Update: More from Felix Salmon on why it may be hard to get bondholders to agree to restructuring short of bankruptcy.

To Lend or Not To Lend, Fed Edition

This is so brilliant I’m going to just copy Mark Thoma’s entire post right here:

Tim Duy emails:

Discordant headlines in Bloomberg:

Fed’s Kohn Says Regulators Should Encourage More Bank Lending Amid Turmoil: U.S. regulators should rise to the “challenge” of encouraging an expansion in bank lending amid a weakening economy and continuing financial-market turmoil, Federal Reserve Vice Chairman Donald Kohn said.

Fed’s Kroszner Urges Banks to Increase Capital Reserves to Buffer Losses: Federal Reserve Governor Randall Kroszner urged banks to hold more reserve capital to protect themselves from future “cascading losses,” as potential market fixes are “no guarantee” against another credit crisis.

It’s nice to see the Fed getting its communication problems under control.

This is the inconsistency I pointed out in the goals of the financial sector bailout. Banks need new capital to protect themselves against falling values of their existing assets. But if they use the new capital to make new loans, you defeat the purpose of the new capital, because that new capital is no longer helping support the existing assets. These are two separate and somewhat contradictory goals. Note that, according to Bloomberg (see the second link above), financial institutions have taken $978 billion in writedowns – so far – and raised only $872 billion in new capital. So while politicians rail against banks that took TARP money but haven’t expanded lending, the banks at least have logic on their side. I’ve been surprised that no one in Washington that I’m aware of has been willing to point this out.

(And do visit Mark’s blog – it’s a great place to get a variety of perspectives, updated throughout the day.)

Causes: Maybe People Are Just Like That

This is the second in my new occasional series of reflections on some of the root causes of the global economic crisis. As is probably evident from the first one, I’m not going to try to identify the cause of the crisis, or even render particularly analytical judgments about the relative importance of various contributing factors. Instead, I’m more just presenting and thinking about some of the forces that were at work.

One of the singular features of the last decade was the U.S. housing bubble (replicated elsewhere, such as the U.K. and Spain, but nowhere on such a grand scale), which was accompanied by a broader though not quite as frothy bubble in asset prices overall, including the stock market. One of the standard explanations is that bubbles are created when greed takes over from fear: people see prices rising, and at first their fear of getting burned keeps them on the sidelines, but as the bubble continues and other people get rich their own greed increases until it wins out over fear, and they buy into the bubble as well. As a result, some say, we are bound to have bubbles periodically, especially when new investors (young people), who have never experienced a crash, come into the market.

There is psychological research that not only backs all of this up, but goes even further and says that bubbles are a virtual certainty. Virginia Postrel has an article in The Atlantic that centers on experimental economics research by people such as Vernon Smith and Charles Noussair. In one experiment, investors trade a security that pays a dividend in each of 15 periods and then vanishes; the dividend in each period will be 0, 8, 28, or 60 cents with equal probability, so the expected dividend is 24 cents, and there is no time value of money (the whole experiment takes an hour). Despite the fact that the fundamental value of the security is absolutely, completely, easily knowable, bubbles develop in these markets . . . 90% of the time. When the same people repeat the same experiment, the bubbles get gradually smaller; but simply change the spread of dividends and the scarcity of the asset, and the bubbles come back with full force (so much for experienced investors).

Continue reading “Causes: Maybe People Are Just Like That” →

Causes: Where Did All That Money Come From?

We’ve gotten some comments to the effect that, for all the discussion of the financial crisis and the various bailouts, we haven’t looked hard at the underlying causes of the financial crisis and accompanying recession. The problem, as I think I’ve hinted at various times, is that any macroeconomic event of this magnitude is overdetermined, on two dimensions. First, there are just too many factors at play to identify which are the most important: in this case, we have lax underwriting, lax bond rating, skewed incentives in the financial sector, under-saving in the U.S., over-saving in other parts of the world, insufficient regulation, and so on. How many of these did it take to create the crisis? There is no good way of knowing, because the sample size (one, maybe two if you add the Great Depression) is just not big enough. Second, there is still the conceptual problem of identfying the proximate cause(s). To simplify for a moment, we had high leverage which made a liquidity crisis possible, and then we had the downturn in subprime that made it plausible, and then we had the Lehman bankruptcy that made it a reality. Which of these is the cause? Leverage, subprime, or Lehman?

In any case, we’re not going to resolve these issues. But I want to start an occasional series of posts looking at one of the root causes at a time.

Today’s topic was inspired by this week’s meetings between U.S.-China meeting in Beijing, where, according to the FT, “the US was lectured about its economic fragilities.”

Zhou Xiaochuan, governor of the Chinese central bank, urged the US to rebalance its economy. “Over-consumption and a high reliance on credit is the cause of the US financial crisis,” he said. “As the largest and most important economy in the world, the US should take the initiative to adjust its policies, raise its savings ratio appropriately and reduce its trade and fiscal deficits.”

Continue reading “Causes: Where Did All That Money Come From?” →

How Can GM Avoid Bankruptcy?

With the Big 3 back in Washington, it seems like time to resuscitate the debate over the auto industry bailout. Luckily, Felix Salmon took the time to look through GM’s bankruptcy plan, which is being advertised on GM’s new, also gag-inducing GM Facts and Fiction website. Here’s one particularly gag-worthy claim from the plan:

GM has never failed to meet a Congressional mandate in the important areas of fuel efficiency and vehicle emissions, and sets the industry standard for “green” manufacturing methods.

Let’s not mention that GM has fought increased fuel efficiency standards with every dollar it could spend on lobbyists for decades.

Anyway, Salmon’s post focuses on one issue that has troubled me as well. One of GM’s biggest problems, along with plummeting demand for cars, is $62 billion in debt. In order to become a financially viable company, they have to reduce this debt, presumably by converting some of it into equity. But that debt is held by private entities, and no amount of pleading from the Big 3, the UAW, Jennifer Granholm, Congress, or Barack Obama HIMSELF can force them to restructure the debt. My worry is that in negotiations of this sort, where each side is holding a gun to the head of the other, debtholders could very well say: “Go ahead, go bankrupt, we’ll take our chances that we can get a better deal from a bankruptcy court or, worst case, we can recover more in cash than the value of the equity you’re offering today.” One of the points of a bankruptcy is to get a court that can force bondholders to accept a settlement rather than relying on their good graces.

On a related subject, a lot of people are throwing around the 80% number: supposedly, 80% of people will not buy a car from a company in bankruptcy. A GM spokesman said (to Felix Salmon) that GM’s sales were already falling because of fears about bankruptcy. Maybe. But I strongly suspect that 80% is just a poorly worded and interpreted poll question. If you ask people in the abstract if they would buy cars from a bankrupt car company, of course they will say no. But in the real world, if the car they want is made by a bankrupt company, and they get a good deal, they will buy it. Just look at the November auto sales. GM was down 41%; Toyota, Honda, and Nissan were down 34%, 32%, and 42%, respectively. And everyone buying a car in November must have been aware that bankruptcy for GM was a serious possibility. (Besides, haven’t we been talking about a GM bankruptcy on and off for years?) Sure, bankruptcy will hurt sales a little. But 80% is just not credible.

We Are All in This Together

Dani Rodrik has a short, clear post on (a) why countries are tempted to engage in protectionism during recessions and (b) why they shouldn’t. It only uses 1st-semester macroeconomics. The bottom line is that the preferred outcome is for all countries to engage in fiscal stimulus at the same time. The hitch is that most of the developing world can’t afford to. The implication is that it is in the interests of the wealthy countries to find a way to support the developing world.

How the SEC Could Have Regulated Subprime Mortgages

From a new paper (link below):

Kafka would have loved this story: According to our current understanding of U.S. law there is far better consumer protection for people who play the stock market than for people who are duped into buying a house with an exotically structured subprime mortgage, even when the mortgage instrument is immediately packaged and sold as part of a security.

The crux of the matter is that securities transactions – notably, the sale of a security to a customer by a broker – are governed by SEC regulations, which impose a fiduciary relationship on the broker, meaning, among other things, that the broker can only sell financial products that are suitable for that customer. However, no such rule governs the relationship of a homebuyer to a mortgage broker or company, meaning that behavior by the latter must be actually fraudulent before it can be sanctioned.

Jonathan Macey, Maureen O’Hara, and Gabe Rosenberg (two of whom are at my very own Yale Law School) have a new paper (abstract and download available) arguing not only that mortgage brokers should have a fiduciary responsibility to their customers, but that they already do under two reasonable interpretations of existing SEC regulations. (It has to do with whether a complex subprime mortgage is already a security or, failing that, whether it is related to a security transaction.) This means that the SEC could have been regulating these things all along.

More Danger for the Eurozone?

Back in the exciting days of October, Peter, Simon, and I wrote an op-ed in The Guardian about the potential for cracks to appear in the Eurozone, even possibly leading to one or more countries withdrawing from the euro. With so many other things to worry about, this scenario didn’t get a lot of attention. Since then, pressures have been slowly building. For example, the spread between the 10-year bonds of Greece and Germany has grown from around 30 basis points during most of the decade to over 1.5% now. (The picture below is from last week.)

Greece-Germany

According to an FT chart (sorry, can’t find the link), Greece also has to raise 20.3% of its GDP in debt next year (the equivalent figure for the U.S. is 10.3%), so the spread should only get bigger.

The Eurozone is based on the idea that a single monetary policy can serve the interests of all of the member countries. The problem is that when macroeconomic conditions vary widely between countries, they will have different interests. In a severe crisis, some countries may be tempted to (a) engage in quantitative easing (of the sort the Fed is beginning to do) or (b) implement a large fiscal stimulus (of the sort that Pelosi, Reid, and Obama are about to do). (a) is impossible for a Eurozone member, and (b) is constrained by limits on deficit spending, although I believe those limits are honored more in the breach than in practice.

In any case, the potential problems are getting big enough that Martin Feldstein has weighed in as well. Hopefully this will draw more attention to the issue. It may still be a low probability, but the economic and political consequences of undoing the greatest step toward European integration in, oh, the last thousand years would be huge.