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.
Many writers point to the high leverage rates — that is, the ratio of loans to cash on hand — among the investment banks such as Bear Stearns and Lehman Brothers. Banks that accept deposits typically have about 10 to 1 leverage, but writers report that leverage at the investment banks was 20, 30, or even 40 to 1. This increases risk: if you have leverage of 20 to 1, a 5 percent fall in the value of the collateral backing your loans will essentially wipe out all of your cash.
The problem with this explanation is that such high leverage rates among the investment banks are nothing new. Deposit banks are required to have low leverage because their deposits are insured by the federal government. Investment banks have more leeway. As Cohan describes in House of Cards, “the ratio of assets to equity capital in investment banks—one measure of leverage—often approached 50:1 during the middle of a quarter. (Before the ratio was published at the end of each quarter, investment banks would take the necessary steps to sell enough of their assets to get the leverage down to a more ‘acceptable’ 35:1 ratio.) Commercial banks, by contrast, had leverage ratios of around 10:1” (p. 61).
Another claim is that the growth of mortgage bonds, collateralized debt obligations (bonds made up of mortgage bonds), credit default swaps, and other complex securities so distanced the buyers of those securities from the underlying assets that they could not accurately judge the real value of those assets. This allowed mortgage companies to lend without worrying about whether the buyers would eventually pay up because they could sell the mortgages to someone else, who also didn’t have to worry because they would package the mortgages in a bond and sell it to someone else.
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As I previously noted in my review of Freefall, proposals to regulate bonds and derivatives would not have prevented the crisis. My Cato colleagues agree: “Concerning swaps, although their introduction may increase financial inflows into risky sectors, their execution through a clearing-house or regulation via other means would not necessarily have avoided the mispric- ing of risks in underlying contracts. Capital requirements for the credit default swaps that were used to insure mortgage-backed securities would have been low because housing investments were not considered risky.”
A related issue is that the top executives of most of the major banks had no experience in derivatives or other new financial instruments, and so they were ignorant of the risks that their subordinates were taking. Lehman’s CEO, Richard Fuld, for example, gained his trading experience in commercial paper, which is supposedly even safer than mortgages were thought to be. However, it isn’t clear that JPMorgan’s Jamie Dimon’s experience was that much broader, yet he was able to largely steer his company away from the worst of the crisis.
Too big or too interconnected to fail: We seem to have at least one financial crisis every decade, and they are often followed by a new wave of regulations or other reforms. Yet those reforms fail to prevent the next crisis. It appears that regulators can’t keep up with financial innovations, so it might make more sense to figure out ways to minimize the impact of such crises on the average person than to try to prevent them in the first place.
One way of doing so, many argue, is to keep banks and other institutions from becoming too big to fail. Interstate banking, for example, was once forbidden, which prevented banks from becoming as large as, say Citibank, JPMorgan Chase, or Bank of America today. The problem with this is that there were plenty of crisis, such as the Panic of 1907, that took place before banks were as large as they are today. That panic wasn’t a result of any bank being too big to fail but a sense on the part of investors that, if one bank did fail, many others must also be vulnerable.
Lehman Brothers, for example, wasn’t too big to fail, and–contrary to some writers–it didn’t lead to a domino effect that caused AIG and others to fail. Instead, AIG, Citibank, and others were already failing for the same reason Lehman’s failed: they all made bad bets on the mortgage market. AIG had $2.7 trillion of liabilities, so it probably was too big to fail, but even if it had been smaller, its failure was really more a symptom than the problem itself.
Conclusions: Some of these things, particularly synthetic bonds and other derivatives, may have made the financial crisis more severe than it otherwise would have been. Most of the items listed above, however, didn’t really have much of an effect on the crisis, and none of them were the real cause. I’ll discuss that cause in detail in a future post.
I’ll discuss that cause in detail in a future post.
Interesting read. I look forward to reading about the cause of the crisis. I guess part of the problem has been that everyone is looking for one culprit, instead of a group of culprits, to point the finger at.
metrosucks says: “I guess part of the problem has been that everyone is looking for one culprit, instead of a group of culprits, to point the finger at.”
I couldn’t have said it any better. However, as a betting man, I bet Mr. O’Toole will be pointing one finger in one direction in his “future post.” We’ll see.
Another thing to note about being “too big” or “too interconnected” is that Canada has never had restrictions on branch banking or on mixing deposit banking with investment banking, and no Canadian banks failed during either the Great Depression (when US banks were by law small and not interconnected) or the recent financial crisis.
Similarly, US-centric views on bank regulation have the problem that many foreign banks and foreign housing experienced similar crises– again except in Canada. In addition, there’s a profound difference in the effects in different states of the USA as well.
So I think it’s right to try to look at causes of the housing volatility itself, and Ed Glaeser’s research is pretty clear on one cause (which agrees with what our author here says.)
San Jose Vs Houston
San Jose’s average home prices got almost up to $900,000 while Houston got to about $155,000.
San Jose is now down to about $500,000 and Houston about $150,000.
Could San Jose’s Zoning, Growth Control, SMART GROWTH, etc. and Houston’s NO Zoning have anything to do with the very different results???
Could San Jose’s Zoning, Growth Control, SMART GROWTH, etc. and Houston’s NO Zoning have anything to do with the very different results???
For the 139th time, no.
This has been another edition of Simple Answers to Purely Ideological Questions.
DS
Yes, the PLANNER (Peace be upon HIM) has spoken….smart growth has not contributed a single penny to the price difference. Discussion over!
No, the PLANNER has the sense to realize that Houston has essentially the exact same development controls that zoning provides. The don’t have a “zoning code” but control development the exact same way through deed restrictions. And yes, we’ve been over this numerous times on this site. Despite lgrattan’s implication, there is not an unrestricted free development market in Houston. You can’t build anything you want anywhere you want. They have zoning, they just colored it purple and call it something else.
Houston may have the equivalent of zoning, but they don’t have smart growth bennett.
In San Jose, there are examples of residential property valued at $50,000 an acre and adjacent across the street it is valued at $1,000,000 an acre. Many believe because of the Urban Growth Boundary this might increase housing costs.
I would think it fundamental to the issue that restriction of supply drives up cost. But in the magical world of planners, it doesn’t work that way.
metrosucks says: “Houston may have the equivalent of zoning, but they don’t have smart growth bennett.”
Really?
http://www.epa.gov/smartgrowth/pdf/houston.pdf
http://betterhouston.org/news/smart-growth-an-opportunity-to-transform-houston/
http://www.houstontomorrow.org/livability/story/baytown-master-plan-calls-for-smart-growth/
http://www.pps.org/blog/smart-growth-overhaul-at-university-of-houston-includes-converting-62-parking-lots-to-mixed-use-structures/
http://www.houstontomorrow.org/livability/story/recent-poll-amidst-struggling-economy-americans-support-smart-growth/
There’s much, much, much, much more. Funny enough Houston’s more open market for development, without euclidean zoning has given way to many MU, NU, SG style developments. It’s not in the same vein as say Maryland, but obviously metrosucks is waaayyyyyy off base with analysis. There IS smart growth in Houston and there would be more had Governor Perry not vetoed it.
That is a pathetic propaganda piece for a failure of a light rail system. Wasn’t even written by Houston area agencies, apparently. Doesn’t mean that the entire Houston area, or even a good deal of it, is governed by smart growth delusions as in say, Portland or the Bay Area.
If free markets produce what looks like smart growth and people like it, fine. But government social engineering, coercion, and subsidizing, such as in Portland, is unacceptable.
lgrattan says: “In San Jose, there are examples of residential property valued at $50,000 an acre and adjacent across the street it is valued at $1,000,000 an acre. Many believe because of the Urban Growth Boundary this might increase housing costs.”
Assuming the two properties are similar (sq ft) this sounds more like tax appraisers engaging in funny business. That won’t happen down here in TX because we have county judges that will not stand for such silliness. I know CA is all screwed up, but have residents ever considered litigation? The likely result would be that the cheaper adjacent properties will skyrocket, but hey, that’s American equity for ya.
metrosucks proclaims: “If free markets produce what looks like smart growth and people like it, fine. But government social engineering…”
So your against suburban style euclidean zoning. Great! We’ve found common ground. Again, funny how it’s social engineering when it’s what “we don’t like,” and it’s the free market when it’s what we like. Planning is planning. It inevitably results in changes in behavior. There’s no way around this, but it comical how some think non-SG/NU development is somehow void of this phenomenon.
So your against suburban style euclidean zoning
People like the suburban lifestyle, so it’s those governments’ responsibility to zone in a manner reflective of their constituents’ desires.
We are all aware of areas such as Portland, where the Planning God METRO attempt to forcibly densify areas or build light rail/streetcars that the people don’t want. Are you OK with this? I can’t help but feel that you have a love for “smart growth” style development that isn’t supported by the facts.
Of course it’s not “social engineering” when we like it. That’s the whole point. Government is supposed to do what the people want it to do. Otherwise it’s a despotic entity, kind of like Metro and the Portland City Council.
metrosucks says: “People like the suburban lifestyle…”
I had no idea you speak on behalf of all humanity. Of coarse your analysis completely discounts the tens of millions of people that choose to live in urban areas… Do you really not think that “people” don’t like cities. Are you really that out of touch to not think that there is a difference of preference of lifestyle.
“Of course it’s not “social engineering†when we like it.”
The “we” I was referring to was Antiplanners. I know you engage in a lot of groupthink but your lack of understanding that others may like something that your group doesn’t like is utterly astounding. You need to get out more.
The issue at stake here is that suburbia isn’t trying to force anyone to convert to, or live in the suburbs, but the central cities and their “planners” want to force everyone to live in skyscrapers, or at least the vaunted mix-used housing. So your argument is invalid. I never claimed to say that everyone likes living in the suburbs, but the majority of the people who do live there, live there by choice, and enjoy it.
My point is valid, because despite your bogus claims, planners are as responsible as any group for suburban style development. So how can it be that they’re trying to force everyone to live a different way? Your “planner” label is way off.
Truth is, professional planners, by and large are about providing choices across regions, which include suburban style SF development and denser MF style development. Portland is somewhat of an anomaly, just like New York or Houston. Ironically, it’s the antiplanners that want to restrict freedom to the choices that they make, because they’ve convinced themselves that, 1: the things they like are void of subsidy, 2: the things they like are void of government intervention and are a result of the free market, and 3: most people prefer what they prefer (hence your comment re: suburbs “Of course it’s not “social engineering†when we like it. That’s the whole point. Government is supposed to do what the people want it to do.” strangely enough followed up by “I never claimed to say that everyone likes living in the suburbs” as you are contradicting yourself).
You like to say things to see if they stick. No data. No facts. Just statements. I’ll be here everyday trying to open your eyes to the bullshit that continually flows from your fingertips. Should be fun.
In San Jose, there are examples of residential property valued at $50,000 an acre and adjacent across the street it is valued at $1,000,000 an acre. Many believe because of the Urban Growth Boundary this might increase housing costs.
It’s happened every other time I asked on this site – the commenter runs away and never answers – but what the heck:
DS
Here’s an example of the top down tyranny in Oregon:
http://www.oregonlive.com/forest-grove/index.ssf/2011/04/cornelius_late-ditch_plea_for_more_urban-reserve_lands_falls_short_at_washington_county.html#incart_mce
I guess we need the Ministry of Land Use Planning telling what to do with all that precious farmland!
Typical planner hypocrisy at work. Planners uniformly disgust me with their arrogance and “I know better than thou” attitude, reinforced with the bureaucrat’s first refuge, the guns of government.
DS Adjacent to the south of San Jose is the flat Coyote Valley of 7,000 acres. Builders bought a large part of this 20 years ago to build on.
They have, in the last few years, been told to get an EIR report. For Two yesrs they spent 16 million on the report. The city said it is not complete so please start over again.
San Jose has been working on a new General Plan for the last 3 years and it is not finished but they have agreed that the Coyote Valley will not be developed.
DS — thousands and thousands of homes could be built here.
Randal O’Toole’s study ‘The Planning Penalty’ lists San Jose as $513,000. per home in the year, 2006
Thank you for not having the numbers, yet again, lgrattan. Appreciate it. One would think that as many times as I have asked the question, someone would have some detail by now. One would think…one think…one would…
…think…
DS
That’s interesting PLANNER, he quoted some numbers right there. Why don’t you run back to your suburban home and take a hit on the bong?