Category Archives: Meltdown

Not Subprimes, But Not Flippers Either

As most readers know, the Antiplanner never bought in to the story that subprime loans were responsible for the 2008 financial crisis. “Low interest rates, the Community Reinvestment Act, and subprime lending were equally available in all 50 states,” I wrote in American Nightmare, “but bubbles occurred in only some of those states,” namely those that were practicing growth management or had some other artificial land-use restrictions.

Several research papers have confirmed the Antiplanner’s view that subprime loans were not the problem. Unfortunately, some have interpreted these papers to place blame on another class of borrowers: flippers, that is, people who bought homes simply to resell them at higher prices. Yet they are no more responsible for triggering the financial crisis than subprime borrowers.

A paper from Wharton’s Business School argues for “a reinterpretation of the U.S. foreclosure crisis as more of a prime, rather than a subprime, borrower issue,” say Wharton economists Fernando Ferreira and Joseph Gyourko. “Housing traits, race, initial income, and speculators did not play a meaningful role.” This absolves subprime borrowers, but also flippers (“speculators”).

A Federal Reserve Bank of New York staff report may be the one that supposedly places the blame on flippers. “In states that experienced the largest housing booms and busts, at the peak of the market almost half of purchase mortgage originations were associated with investors,” the report concluded. That may be true, but that doesn’t mean that flippers triggered the financial crisis.

As a paper by MIT finance professor Antoinette Shoar and two of her former graduate students found, “homebuyers and lenders bought into increasing house values and borrowers defaulted after prices dropped.” In other words, prices began dropping before flippers defaulted. After all, as long as prices were rising, why would speculators default?

So what did trigger the crisis? As chapter 13 of American Nightmare shows, the trigger was pulled by the bond ratings agencies: Standard & Poor’s, Moody’s, and Fitch. Up until January, 2007, these companies had been giving AAA ratings to bonds made up of individual mortgage loans. This was because, as one writer observes, “never in history [had] prices for housing market gone down nationally.” Because of this, the ratings companies believed that, even if individuals defaulted on their loans, the banks could resell the homes to someone else without losing money.

What the ratings companies failed to realize, however, was that growth management had made housing prices far more volatile, and such growth management had extended from three or four states in the previous recession to nearly 20 in the mid-2000s–and those 20 states contained close to 45 percent of American housing.

It only took a very small decline in housing prices to wake the companies up to their mistake. Between the third quarter of 2006 and the second quarter of 2007, prices in key markets such as Los Angeles and the San Francisco Bay Area fell by about 1 percent. One percent doesn’t sound like much, but prices had grown in those markets without interruption since 1994.

Starting in June, 2007, the bond ratings companies responded by downgrading bonds issued in 2002 through 2004 from AAA to AA- or A; bonds issued in 2005 from AAA to BBB-; and bonds issued in 2006 from AAA to as low as CCC+. Anything below BBB- is considered junk. More important, reduced ratings increased the cash reserves banks were required to keep.

Buying a bond is the same as lending money, and banks are required to keep cash reserves when they lend money in case their depositors want some of their money back. A bank buying $1 billion of AAA bonds had to keep $16 million in cash. When the grade of those bonds was reduced, that reserve requirement might grow to $80 million. Since all of these bonds totaled to trillions of dollars in value, the banks that owned billions of dollars worth of bonds had to scramble to come up with billions of dollars in cash overnight. Some banks–Bear Stearns, Lehman Brothers, Washington Mutual–went out of business; others, notably Citibank and AIG, were deemed “too big to fail,” so the federal government stepped in. With or without federal involvement, the credit market tightened, leading to financial problems nationwide.

If the banks had not gotten in trouble, credit wouldn’t have tightened and defaults would not have been a problem. If the ratings agencies had correctly rated the bonds in the first place, the banks would not have gotten trouble. If growth management had not made housing more volatile, the original ratings on the bonds would have been correct.

This sidesteps the question of what triggered that 1 percent decline in housing prices in 2006. One story is that builders responded to high prices by oversupplying the market, leading prices to fall. That might have happened in Arizona where it was easy to subdivide land and built new homes, but I doubt that it happened in California, where it can take many years to get permits to build new homes.

Instead, I think homebuyers, whether speculators or not, were spooked by rising prices and fears that a bubble would soon burst. In 2005, The Economist predicted that the bubble would inevitably collapse. “The whole world economy is at risk,” the magazine-that-calls-itself-a-newspaper accurately noted. “It is not going to be pretty.” By early 2006, there were whole websites devoted to monitoring the housing bubble and to debunking those who claimed there was no bubble.

Remember that in the early 2000s, California home buyers routinely bid 20 percent or more above the asking price for homes. It wouldn’t take much publicity about the bubble to lead some potential buyers to say, “Maybe we should wait until after prices fall before we buy.” That in turn would cool the market just enough to get the bond ratings agencies to take notice.

Today, home prices in the San Francisco Bay Area are a third higher than they were during the peak of the 2006 bubble. Even after adjusting for inflation, they are 12 percent higher. Clearly, we are in another bubble. The inevitable collapse of that bubble will cause many local hardships, but should not result in a major financial crisis because the ratings agencies and banks have presumably learned their lessons.


What Caused the Crisis: Greed or Volatility?

I haven’t seen The Big Short, which opens tomorrow, but I’ve read (and own a copy of) the book and cite it in American Nightmare. Based on the trailer, the movie appears to focus on the notion that the financial crisis was caused by greed and lack of bank regulation, an idea endorsed by Paul Krugman.

As both Krugman and New York Times writer Neil Irwin point out, the movie’s notion that only a few people were able to figure out there was a housing bubble is wrong; many people realized there was a bubble (or bubbles). What the heroes or antiheroes in Michael Lewis’ The Big Short figured out was a way to profit from the bursting of the bubble. While it is possible to “short” stocks, i.e., bet that their price will go down, it normally isn’t possible to short bonds, such as the packages of mortgage bonds that banks were selling.

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The Auto Bailout Failure

A new paper from the Buckeye Institute affirms what the Antiplanner has said about the Obama administration’s “bailout” of the auto industry: it did more harm than good. “The auto bailout transferred over $25 billion in taxpayer dollars to the United Autoworkers labor union,” says the paper, “while actually hindering the kind of ‘fresh start’ that is necessary for the industry’s future success and that normal bankruptcy procedures, without political meddling, provide.”

“When a public policy produces worse results than doing nothing, it properly should be described as a failure,” the paper adds. “The Obama Administration auto bailout is such a failure.”

The administration’s “claim that the auto bailout saved 1.5 million jobs is demonstrably false,” the paper continues, as it is based on an assumption that, not only would GM and Chrysler have completely shut down without the bailout, so would Ford, Toyota, Honda, and other U.S. factories owned by foreign carmakers. As the Antiplanner has done, the paper also accuses the administration of violating the rule of law in order to favor some interests (unions) over others (creditors).

By “injecting politics into the reorganization process,” the paper concludes, the administration actually hindered the industry’s recovery. The lesson is not that a Bush or Romney would have done any better, but that future administration’s should keep their hands off of floundering industry’s and let the bankruptcy process and rule of law sort things out.


Book Review: All the Devils Are Here

In the Antiplanner’s recent review of Margin Call, I wrote, “No bank secretly realized that mortgage-backed securities were worthless and unscrupulously sold them to unsuspecting buyers.” The authors of All the Devils Are Here would apparently disagree.

Unlike most of the books about the financial crisis that the Antiplanner reviewed last year, which each tended to focus on one slice of the crisis, All the Devils attempts to track the entire crisis, from the beginnings of the mortgage securities market in the 1980s to the crash in September 2008. It relies heavily on many of the same books the Antiplanner reviewed, including Tett’s Fool’s Gold, Cohan’s House of Cards, and more. However, the lack of footnotes makes it difficult to tell which claims are based on which sources. Although one of the co-authors claims that they interviewed lots of people, virtually all of them supposedly asked for anonymity, so little can be verified. The book doesn’t even come with a bibliography.

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Movie Review: Margin Call

Margin Call opened four months ago, so this review isn’t exactly timely, but for readers who haven’t seen it, it purports to be about the 2008 financial crisis. Since the Antiplanner has written extensively about this crisis, I found the movie intriguing enough to watch the DVD.

The entire picture takes place during about 27 hours in the life of an investment bank loosely modeled after Lehman Brothers, which went bankrupt in September, 2008. While the bank in the movie is never named, it has many parallels to Lehman. Lehman’s CEO, Richard Fuld, though out of touch with his employees, was at one time worth a billion dollars based on the value of his Lehman Brothers stock. The movie CEO, cleverly named John Tuld, is similarly remote but is also said to be worth a billion. Lehman’s chief financial officer in charge of risk management was a beautiful blonde who some whispered gained her position more because of a never-proven affair with the company’s executive VP than because of her skills. The movie’s chief risk manager, played by Demi Moore, is a beautiful brunette who apparently has a close but not fully disclosed relationship with the bank’s number two person. The blonde and her boss end up losing their jobs a few months before Lehman’s goes bankrupt; here the movie breaks from reality in that only Moore loses her job.

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Two Ways of Preventing the Crisis

One of the more common notions about the housing bubble is that it was caused by political pressures to increase homeownership. The Antiplanner’s view is that it would be more accurate to say that the bubble was caused by the conflict between policies aimed at increasing homeownership and policies aimed at reducing homeownership (or, at least, single-family home construction). It would be even more accurate to say that the policies aimed at reducing single-family home construction started the bubble, while some of the policies aimed at increasing homeownership made it worse.

As the Antiplanner noted in recent posts, a lot of factors contributed to the recent housing bubble and subsequent financial crisis. But only two factors were so crucial that, without them, the crisis would not have happened.

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Market Asymmetry

Along with Michael Lewis’ The Big Short, Gregory Zuckerman’s The Greatest Trade Ever shows that at least some investors were aware that the housing bubble of the mid-2000s was likely to collapse, with severe repercussions on the economy. The book (whose alternate subtitle is “How One Man Bet Against the Markets and Made $20 Billion”) focuses on John Paulson, whose Paulson & Company was considered a minor player until he shorted so many mortgage bonds that he made the company $14 billion (plus $4 billion for himself).

Believers in the “efficient market hypothesis” argue that there will always be investors willing to bet on both sides of any market. The resulting prices, they say, represent the most accurate possible evaluations of the true value of any investment. One problem with this hypothesis, Zuckerman shows, is that some investments are asymmetrical, which leads to a bias in the markets.

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Contributing Factors, Part Two

Be sure to read part one first.

Greedy bankers: Changes in the banking industry caused the crisis, many writers claim, by creating perverse incentives to earn short-term profits by making long-term risks. “High leverage and risk-taking in general was fueled by the Street’s indulgent compensation practices,” says Lowenstein (p. 287). A prime example is Joseph Cassano, who ran the division of AIG that sold the mortgage bond insurance that ultimately bankrupted the company. AIG paid Cassano $280 million over eight years, including large bonuses based on profits that Cassano boosted by failing to set aside funds to pay off insurance policies should those bonds fail. Eight months before it went bankrupt, the AIG board fired him, giving him a $34 million severance bonus and then immediately rehiring him as a consultant for $1 million a month (Lowenstein p. 122).

Such pay rates are certainly questionable if not obscene. Yet there is little reason to think that they led to the crisis. Remember that all the major players–the ratings agencies, the bankers, AIG and other insurers–agreed that mortgages and mortgage bonds were, as the saying goes, as safe as houses. It is hard to imagine that people who were only getting paid five- or six-figure salaries wouldn’t have made exactly the same decisions as those who did get paid seven- and eight-figure salaries and bonuses.

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Contributing Factors, Part One

Today and tomorrow, as a part of the Antiplanner’s continuing series about the 2008 economic meltdown, I am going to look at many of the supposed causes of the crisis and show that, while some of them may have made the crisis worse, none of them were the ultimate cause of the crisis. In some cases, I’ll quote a 2009 paper written by two of my colleagues at Cato. In doing so, I have to confess that, while we agree about what didn’t cause the crisis, I haven’t been able to convince all of my Cato colleagues, including at least one of the authors of this paper, about what did cause it.

I’ll also quote from William Cohan’s House of Cards, a book that is mainly about Bear Stearns. In fact, only the first third of the book is about the 2008 crisis; the rest is on the history of that company in the 75 years before that crisis. Unlike some financial writers, Cohan actually worked on Wall Street for 17 years, including a decade as a managing director at JPMorgan Chase. Perhaps this is why Cohan can supply of lot of insights and details missing from some of the other books I’ve read on the crisis.

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A Crisis of Reserves

The Antiplanner continues to read recent books about the 2008 financial crisis, but there are definite diminishing returns. I just finished Roger Lowenstein‘s The End of Wall Street and found it disappointing. It covered almost exactly the same ground as Too Big to Fail, but unlike the latter book, which was based mainly on interviews, Lowenstein’s book seems to be based heavily on articles and op eds in various newspapers and magazines.

The book is poorly referenced–sometimes a citation to a critical point lists nothing more than a person’s name–and somewhat superficial in its description of complex events. Lowenstein focuses heavily on subprime mortgages, but (as I’ll explain in detail in a later post) I don’t think they were the real problem. “Rampant speculation (and abuse) in mortgages was surely the primary cause of the bubble,” he concludes, but he doesn’t even sound like he believes it. There was just as much mortgage “abuse” in Texas as in California, yet Texas had no bubble. Rampant speculation only takes place after prices are already rapidly rising, so such speculation by itself can’t have caused the bubble.

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