Thursday, September 25, 2008

The Current Financial Mess

I have been a little reluctant to post on this subject, since I have no special expertise in mortgage markets or financial matters. But at this point I think the basics of what happened are fairly clear. The following is a brief and somewhat simplified account. Readers are welcome to correct any factual errors.

Fanny Mae was established during the New Deal by the federal government for the purpose of making mortgages more readily available and so encouraging home ownership. In 1968 it was "privatized." In the late 1990's, under Clinton, lending standards were relaxed in order to make it easier to obtain loans. The basic mechanism was fairly simple. Fanny Mae bought mortgages from the lenders who issued them and bundled them into mortgage backed securities to be resold to investors on the secondary mortgage market.

The problem with mortgages as investments is the risk that the borrower will default, a risk which depends on the detailed facts of that particular mortgage—the borrower's income, the state of the local housing market, and similar matters. That makes a single mortgage a very poor investment. Not only is it risky, the risk is hard for the investor to measure. A bundle of mortgages is less risky, but the problem still remains. To solve it and make the securities attractive to investors, Fanny Mae guaranteed them. If the borrower did not pay off on the mortgage, Fanny Mae would make good the investor's loss.

An insurance company can afford to insure houses against fire because the risk of my house burning down is unrelated to the risk of your house burning down, assuming we are not neighbors. If the probability is one in a thousand the and the insurance company insures a million houses, it can expect to have to pay off on about a thousand a year.

That does not work so well for mortgages. The chance that I will default on my mortgage depends, among other things, on the state of the economy and the state of the housing market. If house prices are going up, I can borrow more money against my house to make payments. If they are going down, I can't—and, for reasons discussed in my previous post, it may be in my interest to default on the mortgage, getting rid of a $95,000 debt at the cost of an $80,000 house. That means that the same circumstances that make me likely to default make you likely to default.

Which raises an obvious problem for Fanny Mae: If enough borrowers default, the amount it will owe to holders of its securities may be more than its total assets. If Fanny Mae were an ordinary private firm, buyers of its securities would take that risk—the possibility that the seller would go broke and be unable to make good its guarantees—into account in pricing them.

But Fanny Mae is not an ordinary private firm. It was established by the government and it has generally been assumed that, although the government has no legal obligation to pay its debts, the government will be unwilling to let it go bankrupt and default on its obligations. That fact gave it an advantage over ordinary private firms in the same business. The result was that it could sell its securities for a higher price than they could sell theirs, which explains why it held a dominant position in the mortgage market. It also explains why I put "privatize" in quotation marks.

Housing prices are now going down, quite a lot of mortgages are defaulting, and Fanny Mae is unable to make good on its guarantees. The proper outcome, in my view, is that firms that bought risky securities on the theory that if they went up the firm would make money and if they went too far down the government would step in to limit their losses should have to pay the price of a losing gamble. The alternative, a massive bailout, simply encourages firms in the future to take risks that are worth taking only because, if they lose, someone else will pay for it. That applies both to firms dealing with government established entities such as Fanny Mae, and to firms that may reasonably believe that they, like Fanny Mae (and Freddie Mac and ...) are "too big to fail."

One disturbing feature of the present situation is the widespread view that this collapse is a failure of unregulated capitalism. Fanny Mae was created by the Federal government for the explicit purpose of lending money to people who wanted to buy houses and could not borrow the money to do so on the private market. It has continued to pursue that purpose, first with explicit and later with implicit government support, throughout its term of existence, has repeatedly boasted of doing so, and has now gone broke as a result. That is indeed a failure, but not a failure of unregulated capitalism.

[I have simplified the story by focusing only on Fanny Mae, but I think have described the essential features of the situation]


Joe said...

Do you have an understanding of how this relates to the failure of private investment banks? I was explaining my understanding (similar to yours) to a far-lefty classmate, and he said that this may be correct, but that he didn't think mortgages actually played a big part in this crisis. He cited "bank deregulation that occurred under Reagan," but I'm not sure what he meant.

(He also said this crisis had turned him from a moderate liberal into a hey-socialism-may-not-be-so-bad guy... heh.)

dWj said...

Joe: Mortgages played a huge role in getting this crisis going, though it has acquired a certain amount of self-reinforcement at this point. Bear and, to a lesser extent, Lehman ended up with a lot of mortgage debt exposure on their balance sheets. It's really that direct. (Goldman and Morgan Stanley are mostly at risk only to 1. losses due to credit exposures to other financial firms and 2. self-fulfilling credit runs -- people fear their credit for no good endogenous reason, but that leads customers to cease doing business with them.)

They ended up with most of that exposure because they, too, were doing some of what the GSEs were doing, though of course without the ability to finance it quite as cheaply as FM could. Here the "Community Reinvestment Act" plays a heavy role: banks were, to a large extent, required to make sub-prime loans. I've been saying for the last year or two that it's only a matter of a decade until we have political figures cheering on "credit access" for poor credit risks, but based on the latest add-ons to the bailout, it looks like we're getting that right in the middle of the disaster it wrought.

There were private participants at banks and investment houses making a variety of unforced errors as well, but the CRA and FM played a big, big role, and without them I can't imagine it would have gone nearly so far.

Anonymous said...

Hoping on Dean's comment on self-reinforcement, even though I find the explanations of contemporary Austrians very relevant to understand what is going on, I have seen very little mentioned on the marginal value concept being used to explain why institutions which were "too big to fail" were denied liquidity by their creditors, which are supposed to be the most sophisticated of investors.

Those who believe that prices and value can be achieved quantitatively seem to have a hard time explaining why market players would deny credit to Lehman or Bear when quantitatively they seemed to have assets to back their short term liquidity needs.

Events seem to show that in the end the investment banks were subject to the qualitative judgment of their counterparts delivered on their capability of long-term income, rather than on more "tangible" or "scientific" justifications.

If so, one may reach interesting conclusions, such as:

1. Decision mechanisms on risk-taking for sophisticated investors ultimately do not vary as significantly as those of ordinary consumers. Hence, there is no quantitative method to pin-point how much incentive is needed to change aversion to risk, which is necessarily a subjective perception;

2. The proposed bail-out solution is therefore aimed at the wrong target and loaded with inaccurate bullets: buying assets for their "book" (as in "ultimately discretionary") price limits losses for creditors but does not restore the "marginal" or "qualitative" valuation of financial institutions by their counterparties. This may be seen as the main cause for the current over-the-board liquidity crunch, which has become resilient to "rational" assessments of financial health, interest rate adjustments and inflationary policies (which is what the bailout proposal really is).

Non-interventionists (including Paulson on his past life) have rightfully being concerned with moral hazard, but they should be even more concerned (particularly Paulson in his present incarnation) with the fact that the source of moral hazard produces the same ill effects and guarantees none of the results.

Should we say welcome to stagflation? This is a good time for policy-makers to look again at South America's lost decade and see how mirror-like the country is about to get.

Anonymous said...

Here's a footnote to the mortgage mess which is infuriating. Lehman Brothers recently went bankrupt, due to its bad mortgage bets, and as it happens some money market mutual funds held Lehman debt.

Now, money market funds are not guaranteed against loss any more than other funds. But there is a tradition in the money market business of fund managers absorbing losses, even though they are not obligated to do so. It's done out of pure self-interest to maintain a good reputation. This is what happened in the case of the Lehman bankruptcy, with one exception. One money market fund decided not to absorb the loss, and as a result the fund investors took a 3% loss.

There is nothing extraordinary or shocking about any of this, and yet the fact that one money market fund lost money (something that is expected to happen occasionally) is being widely cited as a sign of financial Armageddon and a reason for a massive Wall Street bailout. "Even money market funds that invest in [risky] corporate bonds aren't risk-free! Oh my God!"

Anonymous said...

On top of what David said, the end-game to the sub-prime crisis and the resulting fallout goes like this:

Bush passes Regulation FD and the Sarbese-Oxley acts that put the responsibility of checks and balances on incompetent government bureaucrats instead of the private sector. As a consequence, whistleblowing becomes de facto illegal. This is a result of overregulation, not deregulation.

Bush cuts income taxes, institutes a $250K/$500K real estate capital gain exemption, and the Federal Reserve cuts the Fed Funds and Discount Rates. With the marginal cost of capital and returns on equity so low, in accordance with Gresham's Law, the cheap capital all flows into real estate because that's where the money and yields are.

Spurred by lax lending policies from mortgage lenders and outright incompetence, if not fraud, at the Big Three rating agencies that securitize mortgages into mortgage-backed securities, they are sold as AAA investment grade bonds to foreigners who finance our capital account deficit. Some savvy domestic companies borrow short and buy only Fannie and Freddie and leverage the difference multiple times as it is allegedly "risk free" (since found out to be implicit).

Now that the chickens have come home to roost on yet another market distortion caused by government interference, Wall Street -- is trying to engineer a bail-out plan that screws the taxpayer by placing them even behind the bondholders in the pecking order. Because the troubled insitutions DO have enough other non-mortgage backed assets to cover their liabilities, the proper recourse is dissolution or bankruptcy by selling off the valuable assets which will wipe out the stockholders but give to the bondholders whatever is left, if anything. It's important to note that in dissolution or bankruptcy, the counterparties, the clients, the customers, the depositers, etc. everyone BUT the bondholders and the shareholders are protected and not at risk. As a consequence, in the subsequent failures taxpayers will receive nothing just like the shareholders, i.e. socializing the losses but privatizing the proftis to the bondholders, the directors and the executives, aka socialist corporatism. Instead, the bailout plan wants to preserve the companies intact and sell off just the bad assets to the government in a reverse auction scheme which will then price the illiquid mortgage-backed securities systemwide and cause a chain reaction of even more defaults as other institutions can finally "mark to the market" their mortgage-backed securities and their stockholders finally get wiped out for real. Aside from the fact a reverse auction is another opportunity to take the government to the cleaners in setting the pricing.

Truly, this is upper class elitism at its finest. Only investment bankers could have cooked up such a scheme to screw everyone but themselves and their families, friends and cronies, and that just happens to be the two men advising Bush.

Will said...

You could also add the troubles with AIG and credit-default swaps. And money market funds breaking the buck.

Chris Hibbert said...

The piece of history that most commentors are apparently unfamiliar with is what caused the wave of defaults. Most analysis (like Krugman start with "the bursting of the housing bubble [which] led to sharply increased rates of default and foreclosure, which has led to large losses on mortgage-backed securities."

But the bubble didn't burst for unknowable reasons. What actually happened was that several years ago, the mortgage companies, under increasing pressure to provide more mortgage-backed securities to feed the investment banks apparently insatiable appetite, loosened their requirements for mortgage borrowers. Loan agents were rewarded for pushing weaker applications through the system by lying about people’s resources and ability to pay. The CRA was also pushing them to make more loans, but that had been in place since the late 70s.

Eventually, the borrowers reached the end of their introductory "teaser" rate (their loans “recast” to a higher rate). Since they’d stretched to qualify for the loan in the first place, they couldn’t afford the new rate. That’s what started the cascade of borrowers in default. And the reason it hasn’t stopped yet is that the marginal lending went on for several years. There are quite a few more borrowers in the pipeline who won’t be able to make their payments when their initial low rates expire, so there’s no imminent end to the defaults and foreclosure.

The defaults and foreclosure led to the bursting of the bubble, not the other way around. Housing prices fell because of the downward pressure from banks dumping foreclosed houses.

Anonymous said...

"The defaults and foreclosure led to the bursting of the bubble, not the other way around. Housing prices fell because of the downward pressure from banks dumping foreclosed houses."

This is like saying that margin calls cause stock market declines.

The basic issue is that a lot of people were betting heavily on increasing housing prices. These bets have gone bad and now the un-winding process exacerbates the decline.

Chris Hibbert said...

> This is like saying that margin
> calls cause stock market declines.

Margin calls come after initial price declines and cause some investors to have to react immediately to the declines when they had hoped to be able to wait for an increase. When prices don't rise, short sellers win.

The borrowers I'm talking about could barely afford their mortgages (and they weren't paying down principal) and were slated to fall way behind when their teaser rate ended. That's usually long before house prices have gone up enough to justify a refinance, so they weren't going to get out of the problem by that route. Many of them didn't understand the loans they were in, and didn't see that they were going to have to pay a higher mortgage two years after they took the loan. If prices had gone up 25% in the intervening two years, they could have sold and moved and kept the increase, but they couldn't capture the gain by refinancing; it was too soon after the purchase for that.

> The basic issue is that a lot of
> people were betting heavily on
> increasing housing prices. These
> bets have gone bad and now the
> un-winding process exacerbates
> the decline.

This part is true, but it omits the mechanism that caused prices to stop rising. That's what's missing from most accounts.

Whatever started the escalator, all the forces were still in effect: rates were low, employment hadn't fallen, the economy was doing alright, etc. The thing that started happening before we noticed the bubble bursting was that people in arrears, in default, and in foreclosure rose.

That happened because people had gotten loans 3 years previously that they couldn't afford. The value of mortgage-backed securities fell because payouts didn't match projections, so fewer investors were buying them, so banks had less money to lend, and that's when housing prices stopped rising, and eventually started falling.

Anonymous said...

Great post. But it is skips a passage that is not obvious for me.

It is the link between these facts:

(A) Fanny Mae was able to sell its securities at a higher price than it would have been able to on the free market.

(B) some people who would not have been able to borrowed money in the free market were able to borrow money.

How does B follow from A ? I can almost see it, but not quite.

Thanks for any explanation.


David Friedman said...

Anonymous asks for the link:

For a given interest rate/risk combination, Fanny Mae could get more money reselling. So they could buy a somewhat less attractive the mortgage than would otherwise be profitable. So somewhat less desirable borrowers could get mortgages.

To put it differently, the higher price for selling the securities means they want to sell more, which requires buying more mortgages, which requires someone lending more money to homeowners.

Anonymous said...

I found the second explanation totally clear. How could I not see it?

You rock.

Anonymous said...

In fact, it wasn't as if Fannie Mae took the economic decision of relaxing credit requirements. They were politically forced to do so by legislative fiat which ordered them to consider social security payments as steady income.

Wow, come to think about it, they don't have that sort of thing not even in Venezuela.

Unknown said...
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