Category Archives: economics

Chain of Voodoo

I just read Chain of Blame, How Wall Street Caused the Mortgage Crisis“.  Financial reporters Paul Muolo and Mathew Padilla do a laudable job of describing the mortgage mess and how it happened. Long story short:  it seems that Wall Street’s best and brightest transformed a heretofore niche market for subprime and non-conventional loans into a economy-transforming beast.

The book has an interesting cast of characters, some famous, some not.  Alan Greenspan makes an appearance as libertarian ideologue in chief; Angelo Mozillo the chief of Countrywide is prominent; but has anyone ever heard of Roland Arnall?  Arnall was the founder of Long Beach Mortgage and one of the first practitioners of the subprime on the grand scale.  His progeny are everywhere.

Arnall essentially expanded a business model originated by subprime lenders of long ago like Household Finance.  Remember those guys?  Operating a couple of steps above loan-sharking they had offices around the country and loaned money to folks who wanted to  buy some furniture or a car and couldn’t get financing through conventional means (banks, GMAC, whatever).  Of course they charged high interest, but that made sense, they were taking high risk.

Arnall and friends took this model into the residential mortgage market, but with some significant twists.  One, the Household Finance guys loaned their own money, made the collection calls, and even did the repo if necessary.  Not so the modern day subprimers.  Divide and outsource was their plan.  They were interested in the high interest rates that could be charged, but wanted to pass off the high risk to others.

Of course the desire to earn high interest and take little risk has been around since the invention of money.  But the subprimers like Arnall succeeded.  How did that happen?

That’s the subject of the book and the short answer is Wall Street.  Major Wall Street firms like Merrill Lynch, Bear Stearns and Lehman Brothers sliced and diced the loans into various types of bonds, convinced ratings agencies that the repackaged loans were safe enough for everyone up to and including widows and orphans;  then sold them to investors around the world.  People just didn’t believe that companies like that would put their reputations on the line by covering huge, steaming piles of financial dogshit with a their company logo.  But they did.  And here we are.  To paraphrase Richard Clarke’s apology to the 9/11 Commission:  “America, your capital markets failed you”.

On the political side, there seems to be two general reactions to the financial meltdown.  One is to observe that enterprises like Bear Stearns, Countrywide, Lehman Brothers, Merrill Lynch behave like banks, take risks like banks, and can create risk for the economy like banks.  Maybe they should be regulated like banks.  At one time there was a plausible argument that they would regulate themselves (this was Greenspan’s expectation).  But that hasn’t worked out.

Another reaction (conservative) is to claim that government caused the problem.  Banks, they say, were forced to loan to unqualified borrowers because government, in it’s zeal to help low income people, forced them to.  This view is unsupported by the evidence, as this book makes clear.


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One thing that mystifies me about the current economic crisis is the inability of the big banks to get their house in order.  Or the inability of us (the government) to force them to get their house in order.  We are not talking about very many banks:  Citi, Chase, Bank of America, and Wells Fargo.  Together they own something on the order of 60% of all banking assets.  But for six months they’ve been sitting on assets that everyone knows are worth much less than the banks have them recorded at.  They need to be written down to prices that will let the market clear.  However management doesn’t want to do it.  They prefer to wait for “things to turn around”; maybe some day those assets will be worth more.  They don’t want to have a fire sale.

When this happens to smaller banks the FDIC shows up at the bank on Friday, closes the doors, look over the books, and sells off the assets to another bank at whatever price they can get from the other bank.  Then they use the proceeds to payoff depositors.  If anything is left over, they pay off debt holders and shareholders, but usually, since the the FDIC is there because the bank has bad assets, shareholders get nothing.  Management is asked to polish up their resumes and look for a job.  On Monday, the bank re-opens and everyone gets on with their life.

But with the big banks, it apparently can’t happen this way.  For one thing, they are so big, no one can buy them, and when there are this many bad assets, assigning price to the assets is a real problem.  Still, can’t we get the key players together, come to some agreement, and move on?

As Thomas Friedman said the other day

“I wake up every morning hoping to read this story: “President Obama announced today that he had invited the country’s 20 leading bankers, 20 leading industrialists, 20 top market economists and the Democratic and Republican leaders in the House and Senate to join him and his team at Camp David. ‘We will not come down from the mountain until we have forged a common, transparent strategy for getting us out of this banking crisis,’ the president said, as he boarded his helicopter.”

One of the problems with this approach is that the holders of the banks’ debt aren’t just depositors in this country.

As Michael Mandell at Business Week observed

The international angle is very important. Geithner and Bernanke keep saying that the problem is that no one knows how much the toxic assets are worth. But that’s not the full story. If the counterparties and beneficiaries of the toxic assets held by American banks are also American, it would be relatively easy for Geithner and Bernanke to gather them in a room and make them come to a ‘reasonable’ agreement about how much these securities were worth. After all, even the most powerful hedge funds must ultimately bow to the power of the Fed and Treasury, especially in a crisis.

But with most of the counterparties in other countries, the job becomes much more difficult. There’s no way for Bernanke and Geithner to force European banks, for example, to accept any particular valuation of derivatives or bank bonds—not without the cooperation of the foreign regulators.

So, if this is correct, this will all come down to a big international deal in which it is finally decided who is going to take the hit when these assets are finally written down.  If only W were still president.  He was so awesome at getting international cooperation.

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What an unbelievable relief to have Peter Orszag at the Office of Management and Budget.  Here he is introducing Obama’s first budget:

“The single most important thing we can do to improve the long-term fiscal health of our nation is to slow the growth in healthcare costs.  …the path to fiscal responsibility must pass directly through healthcare”

Orszag is one of the few people I’m aware of who really understands that the federal budget (and realistically everyone’s budget) depends on getting healthcare under control.  If McCain had won in November, we would be listening to someone railing against “entitlements” and “government waste, fraud, and abuse”, and the desperate need for tax cuts.

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Big news of the day (via AP):

WASHINGTON – President Barack Obama, sounding weary of criticism over federal earmarks, defended Congress’ pet projects Wednesday as he signed an “imperfect” $410 billion measure with thousands of examples. But he said the spending does need tighter restraint and listed guidelines to do it. Obama, accused of hypocrisy by Republicans for embracing billions of dollars of earmarks in the legislation, said they can be useful and noted that he has promised to curb, not eliminate them.

In a 910 word article that uses the word “earmark” 24 times we are never told exactly what an earmark is, and the spending on earmarks is never placed in context–in terms of the total appropriations now or in the past.  Furthermore, even though this is a report on a spending bill, people who read this entire article will likely have almost no idea what the spending is about or why Congress is voting on it.  What a reporting train wreck.

For some insight on earmarks I’d recommend that people read Thomas Mann’s recent piece for the Brookings Institution. Earmarks, he says, constitute “less that 1% of the federal budget”.  Further

In most cases, they don’t add to federal expenditures but merely allow Congress to direct a small fraction of program funding that would otherwise be allocated by formula or grant competition.

Yes, the expenditure would “otherwise be allocated by formula or grant competition”.  That’s why they call it an earmark.  Congressmen earmark it.  Now, those earmarks might be wasteful or wonderful, depending on your point of view.  The entire appropriation might be wasteful or wonderful depending on your point of view, but if you read the news (see AP report above) you will almost certainly have no idea what the spending is on.  And you will almost certainly be led to believe that any earmark is an absolute, total waste of money.

Is this informing the public?  I think not.  Meanwhile, (and I guess I’m doing some reporting here) 98% of the spending in the bill Obama signed goes to keeping government operating through the current fiscal year.  This is something the previous administration should have addressed, but didn’t.  Further, virtually every economist on the planet thinks government should be engaged in spending–earmarked or not– to counter the massive economic contraction we are living through.

And the AP is reporting on the appropriateness of earmarks.  Unbelievable.

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Upside down

According to the this chart from Calculated Risk 55% of homeowners in Nevada owe more on their house than it’s worth.


Somewhere I’ve read that 20-30% of homeowners do not have a mortgage, so it’s not this many homeowners who are upside down on their home.  Still, it’s a lot of people!  And what happened in Nevada?  It looks like people walked out of the casino and into the realtors office in the same “double down” state of mind.


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Feeding the Myth

What is the deal with Martin Feldstein?  He’s a conservative economist, but unlike the political funtionairies now operating what passes for a conservative party in this country, Feldstein understands that the government cannot just stand back and let the market work its magic.  He understands  that our economy faces a crisis, that government spending is the only plausible solution, and that we have to do something now.  But he just can’t let go of the Fannie Mae myth.  Here he is being interviewed on Frontline’s “Inside the Meltdown” last week:

Frontline:  The conservatorship of Fannie [Mae (Federal National Mortgage Association)] and Freddie [Mac (Federal Home Mortgage Corp.)], again, a surprise that this step would be taken, or a necessity?

Feldstein:  I think it was a necessity…. Their purpose on paper was to facilitate lower interest rates and the spread of mortgage availability to low-income individuals, but because there were no creditors watching, of course, why would you care what risks they were taking if you had a U.S. government guarantee? They were able to take outrageous risks, and that’s what we saw happen.
Frontline:  And they contributed to the problem in a sort of big and fundamental way.

Feldstein:  They did, yes.

It would have been nice if the interviewer had asked if he had any evidence to support that conclusion.  Yes, we know they are big, government sponsored enterprises involved in the mortgage market.  But if they were not involved in originating or securitizing junk mortgages (or even owning them as investments) until 2007–how exactly did they contribute to the problem in “a big and fundamental way”? Even Alan Greenspan acknowledges that Fannie and Freddie were not prime drivers of this fiasco.

Yet, Feldstein won’t give it up.  I know everyone has a story they tell themselves about how the world works, and we are always looking for ways to confirm the truth of our own personal story.  Conservatives tell themselves that government causes all problems.  Therefore our financial meltdown must have been caused by some government action.  Enter Fannie Mae. Evidence is irrelevant when the Myth Must Be Fed.

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Quote of the Day

Jonathan Chait on the need for government spending, wasteful or not:

The point of stimulus spending…  is simply to spend money–on something useful if possible, wasteful if necessary. Keynes proposed burying money in mineshafts, so that workers would be hired to dig it out. (Imagine what the GOP could do with material like that.) World War II was an effective stimulus that, economically speaking, consisted of 100 percent waste. If war hadn’t broken out, we could have enjoyed the same economic benefit by building all those tanks and planes and dumping them into the ocean.

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