Revisiting the Financial Crisis

This video below is pretty good, though it addresses only one of the two major distortions created by government.  In addition to the incentives, even mandates, to issue risky mortgages discussed below, Basel II capital standards created really strong incentives for banks to prefer holding mortgage-backed securities.

  • SamWah

    Bad incentives lead to bad results.

  • stan

    Don't forget that govt basically mandated that banks and financial institutions use the risk models that said real estate couldn't decline in price. These risk models led to the creation and purchase of so much of the sliced and diced tranches of mortgage crap.

  • sean2829

    Think about this in terms of the higher education market now. The government makes massive loans with little concern for the ability of students or the value of a degree. Sure for able student getting marketable degrees these loans are a great investment even with the increased tuition prices brought about by cheap student loan money and diversion of state tax dollars toward Medicaid. But for many who may not be able to complete a degree program or will get a degree that makes them only marginally more employable than someone with a high school diploma, the loans they obtain will cause them to put off starting families or buying their first home. This "indentured" generation, who will have difficulty building wealth and equity in the 40+ years that most adults work. They are looking to Bernie Sander's socialism for salvation in the hope that new government intervention can unburden them from old government intervention.

  • Not Sure

    " They are looking to Bernie Sander's socialism for salvation..."

    "Government is the great fiction through which everybody endeavors to live at the expense of everybody else." - Frederic Bastiat

  • mx

    While some government incentives were certainly factors in creating the crisis, the idea that the Community Reinvestment Act and fair housing mandates were to blame is a myth that will not die. Numerous research (see, e.g., https://www.washingtonpost.com/news/wonk/wp/2013/02/13/no-marco-rubio-government-did-not-cause-the-housing-crisis/) has debunked this. Many of the worst loans (interest only mortgages, subprime, low to no down payment, etc...) were issued by companies not subject to the CRA and were non-conforming mortgages not bundled by Fannie and Freddie. The Financial Crisis Inquiry Commission spent a lot of time investigating the American Enterprise Institute's research, compared their data to the AEI data, and roundly rejected these claims.

  • joe

    A lot of the blame was placed on the lack of regulations, a lot of the blame was placed on the predatory lending, a lot of the blame was place on the Community Reinvesment Act, Lending to non viable creditors etc. Yet somehow the Fed escaped its share of the blame. To a very large degree, the excess funds in the system was one of the primary reasons for the financial crisis.

    Reduction in prudent lending practices (increases in risky lending ) almost always follows increases in available money, Rarely does increases in risky lending precede increases in available money. The 2008 financial crisis has many of the same characteristics of the 1980's S&L crisis.

  • Ann_In_Illinois

    We seem to have different ideas of research, if you're citing a newspaper. What about the academic research showing, for example, that banks that were coming up for a CRA review lowered their standards, taking on riskier loans that later had higher default rates, relative to otherwise similar banks that were not expecting a CRA review soon? We can't learn much from the analysis of people like Ritholz, because they're too sloppy with the data.

    Also keep in mind that banks such as Countrywide, which were not subject to the CRA, made at least some risky loans in order to sell them to banks that needed them to meet the CRA standards.

    Many of the defenses of government's role (again, particularly by Ritholz) are based on straw-men arguments. The affordable housing activists and politicians used a variety of tools - including the CRA, Fannie and Freddie - to push banks to lower their lending standards. There are quotes in, for example the New York Times in 1999, where the head of Fannie is taking credit for inducing banks to lower downpayments, but the NYT reporter hastens to add that the Clinton administration has also played a strong role in inducing banks towards lower standards.

    Now we have all this historical revisionism, claiming that private lending in 2003 and 2004 somehow forced government to start its push in the 1990s. Were affordable housing activists in the 1990s lying when they took credit for inducing lower lending standards?

  • ColoComment

    If anyone is truly interested in reading a comprehensive recapitulation of all of the factors that went into the "crisis," Gretchen Morgenson's book, "Reckless Endangerment" is a great place to start.
    http://amzn.com/1501263463

    You cannot reduce the complexities to one or two items to "blame" for the financial mess. The politicians set the table with bank regulations (e.g., Basel II) and implicit if not explicit pressure targeted toward social engineering (e.g., CRA); the mortgage brokers, lenders, securitizers, ratings agencies, and Fan/Fred served up a 7-course meal (where no one kept any of his own "skin" in the game, and everything was a AAA investment); investors greedy for return scarfed it all up like pigs at a trough; and home owners were ecstatic to buy a house with no money down and to thereafter use the ever-increasing equity as an ATM to buy boats, RVs, vacations, and other fun stuff.

    It was all great. Until it wasn't.

    And, yeah, as sean2829 says, the student loan "industry" looks to be replicating the basic pattern: pols buying votes with overly generous loan programs; higher ed using subsidized higher tuition to buy fancy student amenities and profs' & presidents' salaries (but not TA's you'll notice); students borrowing like there's no tomorrow for "___ studies" degrees that have no market value in the real world; and taxpayers looking at ~30% default rate. Oh, and when a student loan is forgiven after 10 years of "public service/employment" who is the loser there, eh? Everyone wins, except Mr. Taxpayer. Again.

  • Nehemiah

    I heard someone recently that said the university should have to guarantee the student loan. That would give them a vested interest in directing the student toward more marketable studies/degrees.

    Not only do some degrees have marginal value over a high school diploma, but some actually diminish the individual because the nature of the degree evidences an immaturity or frivolous character.

  • TruthisaPeskyThing

    mx, I read the Washington Post's article years ago and the report from the Financial Crisis Inquiry Commission, and I assure you that they do not give you a reliable analyses on the impact of the Community Reinvestment Act. These analyses were typically often self-serving. For example, the Washington Post was instrumental in media outrage over President Bush's attempt in the early 2000s to curb the excesses being fostered in the name of the CRA. The media (and Democrat) outrage stopped those attempts, and the Washington Post certainly does not want to share the blame in the 2008 Crisis.

    The Financial Crisis Inquiry Commission obscured the issue by saying that the loans in banks directly affected by the CRA were too small to have led to the crisis. First of all, no one will say that the CRA is solely to blame. The CRA was an example of federal housing policy. In fact, the Clinton administration had a dozen cabinet-level initiatives to augment the CRA. Second, to meet the requirements of the CRA, lending institutions needed to develop creative mortgages to get individuals to qualify. These innovations included low introductory rates, no-doc loans, negative amortization, piggy back loans, low-to-no down payments and others. But it was impractical to limit these loans to a certain segment of the population; they became available to others. Third, the federal government encouraged the sale of loans from .
    Federal housing policy as exemplified by the CRA was one key cause of the 2008 Financial crisis. (I will include in federal housing policy the securitization and sale of home loans -- an idea that the federal government pushed for decades.) Another cause was the widespread belief that real estate prices would continue to rise for the foreseeable future. The federal government was instrumental in this belief. Remember that Barney Frank claimed that warnings to the contrary were based in racism. A third cause the FED's easy money policy which made money available for all these questionable loans. Finally, regulations encouraged financial institutions to hold assets in real estate loans -- since they were considered high quality, secure assets and banks got a bonus in calculating asset quality if they held them.

    ,

  • Not Sure

    If they're old enough to vote for Bernie Sanders, they're old enough to pay their own debts- waitaminute... never mind.

  • Dave Cribbin

    Why is it that the FEDS monetary policy is always left out of these discussions? When home prices aren't being pushed higher by a weaker dollar people don't clamor to speculate on 2nd and third homes to live in or to flip.the Feds fingerprints are all over the housing crisis.

  • Ann_In_Illinois

    As you said, the argument is not that the CRA single-handedly resulted in most of the low-quality loans, it is that the CRA was one tool used to push banks towards lower lending standards.

    One comparison is that it's as if a company required all employees to smoke for 3 hours a day in the office, and after a couple of years, it was discovered that more than 90% of the employees had become heavy smokers who even smoked at home. Would it be legitimate for the company to say that this was unrelated to their policy, since the policy only required 3 hours a day in the office?

    There's plenty of blame to go around, but it's pretty far-fetched to claim that forcing banks to find ways to make loans to those who wouldn't normally qualify had nothing at all to do with banks getting used to making loans to those who wouldn't normally qualify.

  • Seekingfactsforsanity

    Let’s not forget one major driver that put it all in the fast lane - deceptive accounting practices that were designed to fraudulently escalate profits that would generate hundreds of millions of dollars of bonuses for Raines, Howard and other senior executives simply by growing the portfolio of loans – any loans – thus the need for “No Doc” loans to speed up the bookings. Amazing what great damage will result from so-called regulatory oversight combined with collusion. Imagine what has been going on for decades in all branches of government through "oversight"

  • Tom Lindmark

    Morgenson's book is excellent. I would also recomment "All The Devils Are Here" by Joe Nocera. It's a largely a non-biased look at all the factors which let to the crisis. Particularly interesting in that it eschews an attempt to explain the end as a reaction to actions over a relatively short-term as opposed to taking an historical look at all the policy decisions and market developments over decades which ultimately worked together to bring the system down.

  • ColoComment

    That's now on my list for my next library trip. Thx!

  • jma

    Add to your analysis 1) the complete idiocy of the ratings agencies when all those loans were sliced, diced and repackaged into tranches for sale to… 2) other groups of inane "experts" at pension funds, endowments, etc. who were so anxious to make a "killing" they didn't investigate the product beyond what the three major ratings agencies and their cronies in the market suggested to be "great buys" with no risk.

  • http://devilish-details.blogspot.com/ mesaeconoguy

    The problem with the “CRA didn’t cause the meltdown” meme is that it is false. Do not expect this information from willfully ignorant or corrupt outlets like WaPo.

    There is ample economic evidence that CRA drove risky lending

    http://www.nber.org/papers/w18609

    And that HUD (led at that time by Andy Cuomo, (now NY gov.) and Fannie and Freddie all drove the risky lending express train

    http://www.villagevoice.com/news/andrew-cuomo-and-fannie-and-freddie-6395833

    One oft cited “fact” that the CRA didn’t play a role in the crisis was that CRA loans did not exhibit a higher default rate than other housing loans. But that doesn’t mean what defenders think it means, and as Wallison observes in the clip above, it simply reflects the perfusion of reduced lending standards throughout lending markets.

    The FCIC got none of this right, for a variety of reasons. As Ed Conard wrote,

    The report makes no attempt to analyze the trade-offs at stake from imposing one regulatory regime versus another, and steadfastly refuses to make any recommendations, which avoids having to consider any real-world trade-offs. It similarly fails to put issues into an evolving economical, historical, or political context, as if context were wholly irrelevant. It is simply a chronological narrative of selected anecdotes and accusations, rather than an analysis of the various issues. The report is oddly extreme in this regard.

    [Unintended Consequences, p.120]

    Government caused nearly every aspect of the crisis. This is possibly the greatest financial crime coverup in history, and the main perpetrators will never be pursued.

    PS, I’ve read the Big Short, and while it is very entertaining, Michael Lewis is a storyteller only, and not a
    financial markets or services expert, and should not be taken seriously. His latest book, Flash Boys, contains numerous errors and misstatements/mischaracterizations, particularly with regard to things like order routing and payment for order flow.

    Unfortunately, most of the public now shares his highly skewed and inaccurate view of financial services.

  • http://devilish-details.blogspot.com/ mesaeconoguy

    Basel II wasn’t enacted in the US, but the Recourse Rule was, and that caused massive problems –

    http://www.realclearmarkets.com/articles/2012/01/13/searching_for_the_causes_of_the_financial_crisis_99457.html

  • John O.

    The Fed's hand is no doubt there but from an analysis of the incentives of the market in play, it's influence is not as strong as the influence of policy that Congress enacted with all the changes in the 1990s in the goal of promoting home ownership. The market incentives were primarily driven by statute and regulations not by interest rates.

  • John O.

    As I said above to Dave Cribbin above, the Fed's hands are no doubt as dirty as they have been in other crisis but the main incentives for why the crisis happened in the first place was driven by statute and regulations, if you are legally required to do something no matter how insane it is, you're probably going to do it to avoid the government's reprisals. Interest rates were not primary driver of the bad lending, it was bad policy in promoting home ownership that did that. Higher interest rates might have slowed this disaster but not prevent it entirely.

  • ColoComment

    Thanks for the correction. This, from your link: The Recourse Rule encouraged banks to hold highly-rated asset-backed securities and penalized them for holding other assets. Crucially, the Recourse Rule went into effect in 2001, and its introduction was immediately followed by an explosion of private-sector MBS growth.

    The regulators required "safety." The ratings agencies responded by bestowing "safe" ratings that were never re-evaluated in light of changing an ever-changing financial environment. The banks relied on the ratings and bought. And bought. And bought.

    Hubris, all 'round.

  • http://devilish-details.blogspot.com/ mesaeconoguy

    Yep.

    And a giant heaping helping of moral hazard to go with it...

  • Ann_In_Illinois

    You're absolutely right that the big failing of the ratings agencies was with figuring out the risk of the various tranches in complicated, (relatively) new products. I attended a seminar by an academic who explored whether the standards of the ratings agencies deteriorated for regular products during that time. The results would have been more striking, and gotten more attention, if they could have shown any slippage in the standards of the ratings agencies, but the authors just couldn't find it. Their ratings were consistent for regular products that they had long been rating.

    That particular research didn't look at all of the slicing, dicing and repackaging you mentioned, but I agree that the ratings agencies didn't handle that well. There really is a lot of blame to go around....

  • markm

    I see another way to connect the dots. The CRA required banks to make risky mortgage loans, although generally for low-priced houses. Financial instruments were invented that allowed banks to sell off those loans and avoid all risk (rather than the usual arrangement where an uncollectable note comes back to the original issuer), while making it difficult to assess the risk to the buyer of a tranch. Government agencies aided the CRA by encouraging buying these instruments, rating many of them as risk-free and countable as capital reserves.

    And the banks went nuts with no down payment loans to high-income (usually white) people for houses that were almost beyond their income, because they could make some money on these high-risk before they sold the loans in tranches and eliminated their risk...

    Yes, it wasn't the CRA loans that crashed the financial system. It was the larger mortgages that were moneymakers under two assumptions: that most of the house-buyers were on a rising income curve so they would be able to keep up payments in the long run, and that house market values would rise indefinitely. In other words, they assumed a continually rising economy, and for _them_ it was safe enough, because when the economy turned, the tranch system meant the original lenders were off the hook, but the other institutions that used those tranches as a capital reserve were in deep trouble. The tranches existed in support of the CRA, but were available for other mortgages, and those other mortgages lost enough money to put the whole big-bank financial system underwater.

  • Ann_In_Illinois

    I agree with pretty much everything you said - it's all part of the picture, and there is plenty of blame to go around. I first learned about securitization around the late 1980s, and was worried about the incentives. I asked bankers and others about how this could work, when banks seemed to have no incentive to be careful about who they lent to. The response I got was that it wouldn't be a problem, because the banks would still have to follow the usual lending policies on checking income, requiring 20% downpayment, etc. But then ACORN began to make some headway.....

    Combining securitization with lower lending standards was a bad idea. And I agree that the lower standards wouldn't have caused as much damage if they had been restricted only to the groups that the activists wanted to help, rather than having the newer standards opened up to others, also - but that's where my comparison comes in. If you force people to smoke for several hours a day, is it a surprise if they eventually make a habit of it?

    Bankers and others bear substantial blame for the crisis, as do borrowers who shouldn't have borrowed so much even if they could get the loan. But, in order to try to avoid similar problems in the future, it's important to acknowledge the huge role that government played in all of this.