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” →

Baseline Scenario, 12/15/08

Baseline Scenario for 12/15/2008: pdf version

Peter Boone, Simon Johnson, and James Kwak, copyright of the authors

Summary

1) The world is heading into a severe slump, with declining output in the near term and no clear turnaround in sight.

2) Consumers in the US and the nonfinancial corporate sector everywhere are trying to “rebuild their balance sheets,” which means they want to save more.

3) Governments have only a limited ability to offset this increase in desired private sector savings through dissaving (i.e., increased budget deficits that result from fiscal stimulus). Even the most prudent governments in industrialized countries did not run sufficiently countercyclical fiscal policy in the boom time and now face balance sheet constraints.

4) Compounding these problems is a serious test of the eurozone: financial market pressure on Greece, Ireland and Italy is mounting; Portugal and Spain are also likely to be affected. This will lead to another round of bailouts in Europe, this time for weaker sovereigns in the eurozone. As a result, fiscal policy will be even less countercyclical, i.e., governments will feel the need to attempt precautionary austerity, which amounts to a further increase in savings.

5) At the same time, the situation in emerging markets moves towards near-crisis, in which currency collapse and debt default is averted by fiscal austerity. The current IMF strategy is designed to limit the needed degree of contraction, but the IMF cannot raise enough resources to make a difference in global terms – largely because potential creditors do not believe that large borrowers from an augmented Fund would implement responsible policies.

6) The global situation is analogous to the problem of Japan in the 1990s, in which corporates tried to repair their balance sheets while consumers continued to save as before. The difference, of course, is that the external sector was able to grow and Japan could run a current account surplus; this does not work at a global level. Global growth prospects are therefore no better than for Japan in the 1990s.

7) A rapid return to growth requires more expansionary monetary policy, and in all likelihood this needs to be led by the United States. But the Federal Reserve is still some distance from fully recognizing deflation and, by the time it takes that view and can implement appropriate actions, declining wages and prices will be built into expectations, thus making it much harder to stabilize the housing market and restart growth.

8) The push to re-regulate, which is the focus of the G20 intergovernmental process process (with the next summit set for April 2), could lead to a potentially dangerous procyclical set of policies that can exacerbate the downturn and prolong the recovery. There is currently nothing on the G20 agenda that will help slow the global decline and start a recovery.

9) The most likely outcome is not a V-shaped recovery (which is the current official consensus) or a U-shaped recovery (which is closer to the private sector consensus), but rather an L, in which there is a steep fall and then a struggle to recover.

[Details after the jump]: Continue reading “Baseline Scenario, 12/15/08” →

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

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.)

Forecasting the Official Forecasts

The IMF is signalling that it will further revise down its global growth forecast. This is after cutting the forecast sharply in October and again in November. Their latest published view is growth in 2009 will be 2.2% year-on-year, and 2.4% fourth quarter on fourth quarter. This view is dated November 6, 2008, so you should think of it as reflecting what the IMF knew at the end of October.

I obviously can’t predict exactly what the next forecast will look like, as there is a lot of economic ground to cover between now and mid-January. But here are some considerations to keep in mind. Continue reading “Forecasting the Official Forecasts” →

Causes: Free Market Ideology

Remember Sovereign Wealth Funds?

An interview with Representative Jim Moran in the National Journal reminds me that we haven’t heard much about sovereign wealth funds recently. These are the large pools of money (in foreign currency) that were created as a result of large cumulative current account surpluses in some parts of the world (e.g., oil exporters, China, Singapore). They were quite controversial back in mid-2007, with concerns being raised – by Congress and others – regarding various aspects of their operation.

There are still some issues around the lack of transparency of these funds, although a great deal of progress on this dimension has been made (including in and around the IMF) and we learned to worry more about black boxes in other parts of the financial system. But these funds might be coming back as a discussion item; for example: can they, should they, would you want them to, invest in US banks to help speed a turnaround?

Personally, I think the underlying current account surpluses are going to fall – this is one likely implication of the decline in world trade for next year that the World Bank is forecasting and the counterpart of what must be an increase in US savings (and thus a fall in our current account deficit). The accumulated stocks, in the form of sovereign wealth funds, will remain but they are no longer on explosive growth paths and this should take most of the edge off the conversation. But how open the US remains to various kinds of capital flows – and on what exact terms – will be a prominent issue on the Congressional agenda as we move into 2009. We do, after all, want people to buy the debt we will issue to fund the fiscal stimulus.

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:

The President can appoint a person (or persons) to implement the bill, apparently colloquially known as the car czar.
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.
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?).
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.
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.
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.
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.)

Global Fiscal Stimulus: Will This Save Weaker Eurozone Countries?

Finally, the global economic policy ship begins to turn. We are now seeing fiscal stimulus package announcements every week, if not every day. And packages that we previously knew about are re-announced for emphasis and with an expanded mandate. In all likelihood, we are looking at a fiscal stimulus in the order of 1-2 percent of world GDP, which is exactly what the IMF has been calling for. Is this a modern miracle of international policy coordination?

The problem is – the IMF started calling for this in January 2008 when, with the benefit of hindsight, it would really have made a difference. Fiscal policy is slow. Even when everyone wants to move fast, when you can get the legislation through right away, and when there are “ready to go” projects, infrastructure spending will take at least 6-9 months to have perceptible effects in most economies.

In the US we have some additional ways to boost spending, most notably as support to local and state governments, extending food stamps and the like (see my recent testimony to the Senate Budget Committee for further illustrations), and in most other countries that kind of government activity comes by way of “automatic stabilizers,” i.e., it happens without discretionary packages of the kinds that make headlines. Still, the general point holds – the big fiscal stimulus package you put in place today is a bet on how the economy will be doing in a year or so. And a year ago would have been a good time to start – remember that the NBER has just determined that the US recession actually started in December 2007 (but they were able to make the call only now, demonstrating how hard it is to forecast the present, let alone the future.)

My concern today, however, is not about the appropriateness of the overall package in the US, China or other emerging markets – in a crisis, erring on the side of “too much, too late” is better than “too little, too little.” The problem is that in Europe we need not just a general fiscal stimulus (and more interest rate cuts), but also specific targeted measures that will provide appropriate, largely unconditional support to governments with weaker balance sheets (read: Greece, Ireland, Italy, but don’t exclude others from consideration).

Monetary policy was consolidated in Europe (i.e., there is one currency for the eurozone) but fiscal policy substantially was not. This imbalance is going to be addressed, one way or another, and perhaps under great stress. Much progress has been made towards sensible policies in the US and some parts of Europe over the past two months, and calamity can still be avoided. Let us not fall at the final hurdle.

Update: I talked with Madeleine Brand of NPR about some of these issues earlier today; audio recording and transcript are here.

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” →

Is This A Crisis Or Just A Recession?

The world seems quiet. Sure, we have record job losses in the US, a likely decline in global trade for 2009, and what seems like to be a Great Leap Downwards for Chinese growth. But no one is quite as worried as they were a month ago, let alone two months ago. It feels, perhaps, like a “regular” global recession (albeit not something we have seen in 20+ years), in which growth decelerates markedly, but then we start to rebound in a timely manner.

Now, I’m happy to accept that as part of my current baseline view (and we will revise our forecast accordingly). But there are serious downside risks to this forecast, i.e., we could move again into crisis mode. The three places I look at on a daily basis for crisis-promoting potential are: Continue reading “Is This A Crisis Or Just A Recession?” →

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?” →