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Wednesday, April 07, 2010

Great Recession (1): Crisis overview & bad loans

Many factors contributed to the Great Recession: unchecked GSEs(Fannie and Freddie), monetary policy in a few ways, moral hazard in several ways on several levels, regulatory problems - not so much deregulation but poorly conceived changes and failure to deal with a changing financial environment and innovations as well as assorted lesser factors.

The general key point is captured here:

Our point isn't that bankers didn't make stupendous blunders. It is that the roots of the mania and panic are so much larger than any single financial security, compensation practice or regulation. And those roots are found as much in Washington as on Wall Street.

Start with the Federal Reserve, which for years kept interest rates below the rate of inflation and thus created a global subsidy for credit. Bankers and investors had an incentive to sell and take on more debt. A Journal survey of economists this week found that a majority now think Fed policy was a major culprit. Providing a rare source of wisdom at yesterday's hearing was FDIC Chairman Sheila Bair, who explained how the Fed's monetary policy helped inflate the housing bubble.

If the commissioners are looking for historical guidance, they might consult the late Charles Kindleberger's classic, "Manias, Panics, and Crashes: A History of Financial Crises." On page 10 of the Fifth Edition paperback, the good professor declares that "The thesis of this book is that the cycle of manias and panics results from the pro-cyclical changes in the supply of credit." (Our emphasis.) An inquiry that ignores the sources of credit that fed the mania is like a history of the Civil War that ignores slavery.

Also missing this week was anyone from Fannie Mae and Freddie Mac, the mortgage giants that turbocharged the housing boom. With their implicit taxpayer backing, Fan and Fred held or guaranteed more subprime and Alt-A loans than anyone—much more than the combined holdings of the four bankers represented this week.

So long as Fan and Fred kept increasing mortgages to low-income borrowers, the dynamic duo's political protectors kept fighting off efforts to cap the size of Fan and Fred's mortgage portfolios. The pair would ultimately hold or guarantee mortgages amounting to more than $5 trillion. That sum is greater than the annual GDP of Japan, the world's third largest economy, and yes, a whole lot bigger than the balance sheet of Goldman Sachs. A serious inquiry will examine the business practices of Fan and Fred, the long battle to rein them in, and the Members of Congress who blocked reform.

There is more of an overview here and a rebutting of blame on EMH:

But is the Efficient Market Hypothesis (EMH) really responsible for the current crisis? The answer is no. The EMH, originally put forth by Eugene Fama of the University of Chicago in the 1960s, states that the prices of securities reflect all known information that impacts their value. The hypothesis does not claim that the market price is always right. On the contrary, it implies that the prices in the market are mostly wrong, but at any given moment it is not at all easy to say whether they are too high or too low. The fact that the best and brightest on Wall Street made so many mistakes shows how hard it is to beat the market.

This does not mean the EMH can be used as an excuse by the CEOs of the failed financial firms or by the regulators who did not see the risks that subprime mortgage-backed securities posed to the financial stability of the economy. Regulators wrongly believed that financial firms were offsetting their credit risks, while the banks and credit rating agencies were fooled by faulty models that underestimated the risk in real estate.

From 2000 through 2006, national home prices rose by 88.7%, far more than the 17.5% gain in the consumer price index or the paltry 1% rise in median household income. Never before have home prices jumped that far ahead of prices and incomes.

This should have sent up red flags and cast doubts on using models that looked only at historical declines to judge future risk. But these flags were ignored as Wall Street was reaping large profits bundling and selling the securities while Congress was happy that more Americans could enjoy the "American Dream" of home ownership. Indeed, through government-sponsored enterprises such as Fannie Mae and Freddie Mac, Washington helped fuel the subprime boom.

Our crisis wasn't due to blind faith in the Efficient Market Hypothesis. The fact that risk premiums were low does not mean they were nonexistent and that market prices were right. Despite the recent recession, the Great Moderation is real and our economy is inherently more stable.

But this does not mean that risks have disappeared. To use an analogy, the fact that automobiles today are safer than they were years ago does not mean that you can drive at 120 mph. A small bump on the road, perhaps insignificant at lower speeds, will easily flip the best-engineered car. Our financial firms drove too fast, our central bank failed to stop them, and the housing deflation crashed the banks and the economy.

Important lessons were ignored as relayed in a conversation with Vernon Smith:

Money is a problem both in the world and in the asset trading markets in the laboratory.

So the laboratory results make it very clear that it’s cash flopping around in the system that tends to give you these runaway asset market bubbles.

I think of the housing bubble as the asset bubble that blindsided the economy. If you look at bubbles in stock markets they do not cause general problems in the economy. We had the dot com stock bubble that ran all through the nineties and peeked out in 2000 and crashed and you had about 10 trillion dollars loss in asset market value as a result of that stock market bubble and it had a minor affect, small affect on the banking system and the economy generally. On the other hand, if you look at 2007 when we lost about three trillion dollars in value in the housing market it devastated the banking system and the reason for this is really I think quite clear.

And so what that means is that bubbles in the stock market if there is a problem the problem is borne by the investors in the market. On the other hand if you have people buying houses with very low or zero down payments and the prices of homes starts to decline right away those homes, those loans that the banks have made are underwater, the banks start then to get into trouble. They have a balance sheet problem and as soon as the banks are in trouble it puts all kinds of people into difficulty that may have had nothing to do or they may not have had anything to do with what was going on in the stock market. So if the banks are under pressure and not making loans all sorts of people may be hurt and they may not even be homeowners. They rent and they haven’t been contributing to the problems, but they nevertheless may suffer. So there is a big difference here between asset market bubbles where people are required to collateralize all of their borrowing and cases as in the housing market where they’re inadequately collateralized and so there is no cushion, no nothing to protect sort of the systemic risk in the banking system if those asset prices decline.

I don’t think there is anything you can do to prevent bubbles. I think we’ve had frequent stock market bubbles that have self corrected and the burden of those bubbles and the pain is basically borne by the investors in those markets and you do not have collateral damage to the economy from bubbles in stock markets like you have in bubbles with housing and generally with consumer durables and I think the solution in the housing and the consumer durables markets is the same as the solution that we’ve worked out institutionally in stock markets and that is require these purchases to be reserved, collateralized.

We learned all about amortizing loans. We learned about having 25 or 30% down payments for homes. We learned that in the 1920s and 1930s because if you go back to the 1920s there were lots of bank loans being made. The state banks were making loans on real estate that were interest only loans. They tended to be short term loans, three and four years. You paid only the interest and then when they came due you rolled them over and that turned out to be part of the difficulties, certainly not all of them. A lot of them the problems in the twenties were not only credit financing of home sales, but all sorts of consumer durables. You had for the first time in the twenties the development of buy now pay later for all sorts of durables like furniture and automobiles and that credit binge in the twenties was an important part of the collapse that took place in 1929 and 1930. And one of the things that you saw in the 1930s was the disappearance of the unamortized housing loan. If you compare for example 1928 and 1938 mortgage loans by banks. In 1938 they’re amortized and in 1928 many, half of them were not amortized, so there is an example where we had institutional learning, but somehow that memory faded. We forgot that lesson in the case of the housing markets and that’s what gave us a recurrence you see of a lot of the same conditions of the 1920s and ’30s. We’ve seen repeat of that from about 1997 to 2006 was the boom period in the housing market and then the collapse since then. And you know we have kind of a nice controlled experiment in one of the states. I don’t think it’s generally realized that Texas law (and this law dates back I think to about 2001 or 2) prohibits lending, making unamortized loans on a home. They prohibit balloon payments. There is a provision requiring that whatever the payment and loan stream conditions are the principle has to rise. That is as you pay of a loan you more and more of the money is going in to reduce the amount of the loan and what is interesting is that when if you look at the Case-Shiller Housing Index and how it blossomed up from 2000 to 2006. It was rising 75 or 80%. In Texas prices only rose 30 percent. And so it’s clear that this Texas law made a substantial difference there and it seems to me those are very reasonable kind of property type regulations in which you say that people don’t have a right to buy homes without putting up some, a reasonable cash down payment and that the loan be amortized. And so that’s not a heavy handed regulation. It’s a very reasonable benign type of regulation: give people rights to take action that are consistent with sustainability and stability.

Well the evidence that the Federal Reserve System, the Federal Open Market Committee and Bernanke did not anticipate the kind of trouble we were in is indicated by looking at the difference between the press release they put out in August 7, 2007 and the one three days later on August 10th. On August 7th they were reiterating that they would hold the federal funds rates steady and I think at that time it was five and a quarter percent and that they still anticipated the possibility of inflation and then three days later the press release points out that a number of financial markets are likely to experience considerable stress. And well, tell me about it. The mortgage market had completely collapsed and it was the derivatives market that was the tipoff. And its collapse was the first indication that the whole mortgage market was in serious trouble and no one has I think better expert econometric and economic analysis than the Federal Reserve, but it doesn’t mean that they can predict was is not predictable and so it’s clear that the experts were surprised and blindsided by that development, but I think it’s to Bernanke’s credit that he moved in what seemed to be a pretty decisive way at that time to dramatically enhance the liquidity of the banking system.

The problem is that what was happening I think in the mortgage market indicated that what the banks faced was a solvency problem, not just a liquidity problem. Now sometimes of course it’s hard to tell the difference. You have a solvency problem you see if the fundamental value of your assets are less than the value of your obligations that’s different from a liquidity problem in the sense that you just have a short term need for funds and of course you can have if you have a short term need for funds and a lack of liquidity that can cause distress sales and create a solvency problem, but and I think that’s the way that Bernanke saw the situation he was in, in August 2007 and it’s also I think pretty much how he saw the developments in the early thirties, in the early part of the Great Depression that the Federal Reserve System had simply not supplied sufficient liquidity to keep the system from creating an insolvency problem. I don’t really agree with this. I think in both cases that both in 1930 there is evidence that the banks had a solvency problem because of the loans that had been extended on residential and also commercial properties and those prices had started to, had come down and in fact that had been developing for already for three or four years in the late 1920s just as it had been developing, the defaults were starting to move up in our economy already by 2005, 6 and 7. It started to become then critical in 2007.

A lot of the knowledge in the economy is this kind of can do practical knowledge learned by practice and the same thing is true at the level of experts and formulating central bank policy. It’s a matter of practice and you can have a good understanding of say the 1930s about what happened then, but it doesn’t mean that when you’re in the middle of a storm you will recognize that it’s happening around you because it’s just a different kind of understanding based upon practice and not necessarily the kind of academic analysis and knowledge that we get through econometric analysis and studies. And I think that’s basically a problem, and it means that you shouldn’t have too high expectations as to what the ability of our experts to deliver is. They’re going to be fallible and what we’ve seen I think and throughout this crisis is both in the Federal Reserve and also in the U.S. Treasury and other agencies of government you’ve had people learning as they go and a lot of the policies are being made up as they go. And that’s I think and inevitable consequence of the imperfection of our knowledge and the limits of our ability to practically manage complex systems like the U.S. economy.

Various devices were used to encourage private lenders to more aggressively make loans on homes to be purchased by people of modest income and what we got from that was a particularly strong demand for homes at the low end of the pricing tier. If you look at the Case-Shiller Housing Index and if you divide that index into three tiers, the low price tier, the middle price tier and the high price tier from 2000 to 2006 the prices that went up the most were the low price tier. The low price tier of homes rose the most, the greatest percentage and fell by the greatest percentage after the collapse and so those policies didn’t actually help those people in the sense that it ended up in many ways we hurt the people we most had a most heartfelt desire to help and the middle price tier homes rose less rapidly than the low and the higher priced tiers rose the least. So the impact of the housing bubble was felt disproportionately in the lower income buyers of homes, so I think I would begin not with any notion that we need a radical reexamination of the regulatory framework, but just introduce some of the institutional learning that we’ve already achieved and let that institutional learning stand and not interfere with it.

Compare the path of a US home price index with the path of a Canadian home price index see here . A less radical undermining of lending standards requiring meaningful down payments matters.


Harry Eagar said...

Did you see Rubin's testimony to the recession inquiry?

He got $100 million from Citi to be on their board, and chaired the executive committee, but he had no operational tasks, the committee met infrequently and did not take important decisions and he did not give advice.

I am conflicted in how I feel about this.

On one hand, it confirms my view that American business leaders are, on balance, no more competent than a random collection of winos hanging out around the Salvation Army.

On the other, I guess Citi shareholders should be glad he wasn't doing anything.

On the third hand, hard to blame that on Washington.

The bankers (and banklike managers) begged not to be overseen. They got their way. The markets failed. QED

Howard said...

He got $100 million from Citi to be on their board, and chaired the executive committee...

I've been waiting for institutional investors with the knowledge and resources to push back against this kind of behavior from members of corporate boards, nothing yet. confirms my view that American business leaders are, on balance, no more competent than a random collection of winos hanging out around the Salvation Army.

Perhaps a slight overstatement, but I know what you mean. I see most of the political class that way.

The bankers (and banklike managers) begged not to be overseen. They got their way. The markets failed.

We'll see if you're willing to stand by this statement after the post on rules and regulations in this series.

AVeryRoughRoadAhead said...

The Teranet Index will soon be following Case-Shiller down into the abyss, down payments or not...

"The [Royal LePage Real Estate Services] survey found the average price of detached bungalows in Toronto climbed to $459,107 in the first quarter, up 13.3 per cent from a year ago. Standard two-storey homes in Toronto were up 13.2 per cent, rising to $562,150 while condo prices rose a more moderate 10 per cent to $317,579. In the Vancouver area, detached bungalows climbed an eye-popping 21.8 per cent to $906,045 while two-storey homes were up 19.2 per cent to $987,500 and standard condos were up 15.7 per cent from early 2009, rising to $470,000."

Incomes aren't rising to support such prices...

Howard said...


Yes, such a disconnect between incomes and property prices can't last indefinitely. However, with Ponzi home finance (ala Minsky) in the U.S. the ride is wilder and financial turbulence is more likely to (did) translate into significant real economic shock.

Harry Eagar said...

I have no expectations that the financial 'reforms' will be any less of an unworkable mess than health 'reforms,' although it is easy to see what ought to be done.

Glass-Steagall worked very well. Bring that back.

Howard said...


I have a reasonable knowledge of Glass-Steagall and some modifications all the way through to Graham-Leach-Bliley but have been unable to figure out how these changes caused or allowed for the mess. Nor has anyone yet provided a cogent explanation. Assertions and hand-waving don't count. If you can provide a detailed explanation, I'd love to learn.

Harry Eagar said...

Obviously, G-S was a dead letter by the '90s, since most banklike functions had escaped from the regulated banks.

It didn't help that even the regulated banks weren't being regulated seriously, since the people in charge did not believe in regulation.

Bankers are really really stupid, as they keep demonstrating.

It's a question now, with borders down and entities well hidden in the Cayman Islands and elsewhere, whether a 21st c. G-S is even possible.

We now have enough experience with unsupervised financial markets to understand that these ramifying idiocies will recur and some indication that the recovery time between deflationary incidents is collapsing.

I used to say they came every 5 years. It's about half that now, I think.

Hey Skipper said...

Bankers are really really stupid, as they keep demonstrating.

Not all bankers.

My bank (USAA), has had a continuous net-worth rate of growth since its inception, including through the latest financial schlamozzle.

So, either they are not stupid, or something about their business prevented stupidity's exercise.

erp said...

Skipper, I think it has something to do with the quality of their clientele.

Harry Eagar said...

A very small bank with a select clientele.

Perhaps the fact that your deposits are not insured has something to do with its conservative approach.

AVeryRoughRoadAhead said...

"My bank (USAA), has had a continuous net-worth rate of growth since its inception..."

I make no claim, assertion or implication directly regarding USAA, but, a continuous growth of net worth isn't a definitive indication of lack of stupidity anymore, because the banking and insurance regulators have relaxed the rules to allow bad loans and investments to be carried as "money-good".

So until such time as all of the bad loans and investments have finally been flushed from the system, which will be many years from now, and USAA continues to stand tall, then it can be said without question that they're non-stupid. Maybe they're just good with accounting tricks, like Bank of America or Wells Fargo, to name only two transgressors.

Based on their stock prices, those companies seem to also have been judged as non-stupid, and yet they're the walking dead, technically insolvent and within a few years, practically as well.

Wells in particular has been very, very, very, very, VERY stupid. Their homegrown Cali HELOCs alone might be enough to sink the company; add in the Golden West Financial/World Savings Bank trash that they became responsible for after purchasing the shady & slipshod Wachovia, and they have zero chance of surviving as an independent organization - unless Cali property values increase by 70% within the next two years...


Point being, balance sheets are now untrustworthy, and USAA's become far less select about their clientele in a bid for growth.

Essentially, anyone who's ever served in the U.S. armed forces, any branch, any time, active, Reserve or Guard, officer or enlisted, is now eligible. That's in many ways an above-average group, but hardly "elite".

And danger abounds whenever any person or organization decides to seek growth by lowering their standards. Today's USAA isn't your father's USAA.

AVeryRoughRoadAhead said...


"Last week I, Vince Veneziani, had the opportunity to visit Kynikos Associates in Manhattan and speak with its President, famed short-seller James S. Chanos.

"The billionaire hedge funder is the stuff of legend. He made a killing shorting companies like Tyco, Worldcom, and of course, Enron. Chanos spoke with us at length on everything from how he discovered Enron's problems to the issues at hand with Greece to the ongoing problems in China.

"We'll be running several posts on our Q&A sessions with Chanos throughout the week... Chanos part 2: China's High-Rise Property House Of Cards"

Jim Chanos: What we're simply saying is you are seeing an epic building boom in China and more interestingly, an epic high-rise building boom in China.

It's not just high speed rail and airports and new roads. That's only a very small part of their infrastructure spending. This is primarily a story about people putting up high rise office buildings and condos in the big cities. That's what it is. [...]

We've seen similar bubbles in Dubai, Miami - scores of other entities have gone through this and it never ends well. [...]

The other interesting thing about the boom here is that it is completely high end. When people talk to me about China's "migration of people" into the cities and the population and blah blah blah, and the growth of the economy, I said "That's all and good but they're putting up the equivalent of New York City highrises at almost New York City prices for a populous that is 1/10th of that per-capita income." So this building boom is aimed at: A) the corporate market, corporate highrises and office buildings or B) very high end of the residential market. It's not the masses - it's for people speculating.

Business Insider: I've heard that a lot of families in China are maxing out as much as they can in terms of credit and borrowing in order to get into this.

JC: They have to! Keep in mind that the average median income in China, and it's only slightly higher in the cities, is something like $3500 per person. Typical second-tier city real-estate prices have now gone above $100 a square foot. So a typical 100 square meter condo is probably going to cost you after all your expenses (if you build it out to live) $120,000 to $140,000 US. Well say you're a dual income couple and you make $7000 to $10,000 a year total. OK? Even if you put down the 20% down that everyone's pointing to, that's 20% on your purchase price. You're still paying mortgage interest of probably ... 60 to 100% of your income, pretax.

BI: Pretax?

JC: Pretax. And that's not super high end - that's an urban couple, dual-wage earners in a second-tier city. So it's already getting to the absurd in terms of prices relative to incomes. And the problem is construction is 50-60% of China's GDP. And of that, the vast majority is this type of construction. There's going to be a real brick wall here being hit at 200 MPH - it's just a matter of when.

AVRRA: Getcha popcorn here, peanuts - hot peanuts, hot dogs...

Bret said...

Rough quoted: "We've seen similar bubbles in Dubai, Miami - scores of other entities have gone through this and it never ends well."

Oh? How did it end in Miami?

Yes, some people did quite poorly, but last I looked Miami was still doing okay.

In China, some people will do quite poorly, but they'll still have a lot of additional infrastructure that I doubt will go to waste in the mid to long run.

AVeryRoughRoadAhead said...

Detroit has so much "additional infrastructure" that they can't give it away.

What's your prognosis for Detroit in the "mid to long run?"

How about the ghost Metropolis that China's built? Nobody lives there, so there aren't any jobs to be had...

I guess that eventually you could get some squatters that subsistence farm in the vacant apartments and industrial parks...

In any case, if it's true that construction accounts for over 50% of China's GDP, then when their RE bubble bursts the "some people that do quite poorly" will outnumber then entire population of No. America.

But hey, nothing wrong with looking for the silver lining - unless you can't perceive the cloud surrounding it...

Bret said...

Rough asks: "What's your prognosis for Detroit in the "mid to long run?""

Note that I commented on Miami, so you're basically changing the subject. The situation in Detroit is very different than the situation in Miami which is very different than the situation in Dubai which is very different than the situation in China.

Detroit is a mess for a number of reasons. One important reason is that it is pretty business unfriendly so the businesses left, then the people left, and left behind empty buildings. This is pretty much the opposite of Miami where the builders got ahead of demand, lost a bundle, took some banks and other investors with them, but people continued to move there, business continued to expand, and eventually most buildings have or will have reasonable occupancy rates.

China isn't like Miami or Detroit. China has huge problems which could easily lead to disaster, the building bubble might well be a factor, but it's insignificant relative to their other problems.

Bret said...

By the way, which ghost metropolis is that?

erp said...

Miami was saved from Detroit's and the other major cities' fate of creeping socialism and municipal union control by the influx of conservative Cubans.

AVeryRoughRoadAhead said...

"Note that I commented on Miami, so you're basically changing the subject."

Sorry, I thought that you were commenting on malinvestment in infrastructure, and its potential effects.

Chinese Stimulus Spending Constructed An Empty City In The Middle Of Nowhere

The China bears tell us that stimulus spending there is largely being wasted. This report from Al Jazeera offers startlingly strong support for that proposition:

[...] Al Jazeera’s Melissa Chan reports from Inner Mongolia, where a whole town built with government money is standing empty.

Shockingly, centrally planned government spending may not really be such a good idea.

[video clip]

Harry Eagar said...

erp, it wasn't municipal unions that cleaned out NYC.

Chanos has been whipping China for weeks now. Classic bear propaganda.

He might be right. But he's sure interested in pricking the bubble.

If the US double dips its way into a real recession (despite howls from some quarters, something -- probably stimulus spending -- buoyed US consumption of most things at levels only one-twentieth below boom levels), then China will feel our pain.

I can recall, during the S&L crash, that Houston had 39million square feet of unoccupied commercial space. It did fill up, but only because oil rose for reasons unrelated to banking in Texas.

The idea that Chinese overbuilding will be absorbed requires a belief in some outside source of revenue generation that is not so evident to me.

(USAA appears to have equity of around 5% of assets. If this is real equity, then it is an order of magnitude better than money center banks.

(But USAA is also only one-fifteenth the size of a money-center Bad Boy.)

erp said...


a. the creeping socialism of rent control had a lot to do with abandoned neighborhoods. Pesky, unreasonable landlords didn’t want to maintain their property when they couldn’t get rents to cover their costs and make a nice profit for their trouble so they walked away from their property. Unspeakable slums flourished under the control of drug lords and other criminals.

b. no union, including municipal ones, would hire blacks or Puerto Ricans* > they couldn't get jobs > went on welfare > families broken up > crime increased > more creeping socialism > criminals were coddled instead of incarcerated > neighborhoods were razed > enormous anti-human housing projects were built > crime went up > criminals were rehabilitated instead of jailed > people locked themselves in their homes > more socialism > schools became armed camps > Giuliani got elected > a lot of bad guys went to jail > things got a lot better > enter Bloomberg > high crime rates are back…

*the first Hispanics on the scene.

Bret said...

Harry wrote: "It did fill up, but only because..."

You have a very simplistic view of the world if you think that many millions of square feet became occupied for one and only one reason. That explains why you think government solutions are so likely to succeed: there's only one reason for any event occurring so of course government can foresee that and formulate a sane policy to optimize the situation.