Sunday, January 3, 2010

What Has Caused the Current Economic Crisis?

Marla Singer at Zero Hedge writes:
It has become conventional wisdom, perhaps even cliche, to pin the origins of the credit crisis on the big banks or, AIG or even the practice of financial modeling. Certainly, these actors have received the most play in the media, and have now endured the focus of populist ire for more than a year. We now think that the analysis leading commentators to focus blame on these entities is fatally flawed.

We have seen no credible data that any of the large banks or other underwriters of mortgage backed securities ("MBSs") or collaterized debt obligations ("CDOs") or firms like AIG selling protection on same actually misrepresented the character of underlying collateral. This is in direct contrast to the allegations of Edward Pinto as printed by the Wall Street Journal. If Pinto is correct such that the mis-marking of mortgages by the GSEs and the discovery thereof destroyed confidence in the accuracy of ratings in mortgage backed securities and their derivatives (and it seems probable to suspect that he is) then it seems almost beyond question that the policies (or policy malfeasance) of Fannie and Freddie, and not the actions of large banks or firms like AIG are the proximate cause of not just the credit crisis, but also the continuing multi-act, multi-bailout farce that continues to be passed off to the public as necessary "stimulus."
By adopting this position, she has essentially delinked the crisis from any past crises and any future crises. For if the "policies (or policy malfeasance) of Fannie and Freddie...are the proximate cause of...the credit crisis...", and these policies have only been going on for the last two decades or so, then there is nothing to learn from, say, the Great Depression, since it occurred before the birth of Fannie and Freddie.

What she is saying, by her argument that Fannie and Freddie caused the crisis, is that there is no fundamental factor behind all the crises. She thus falls into the very large camp that does not believe in a business cycle theory that is the fundamental factor behind these crises.

On the other hand, the printing of money that ends up sponsoring the specific details of each boom cycle is always there when we see such a "cluster" of errors. This, therefore, must be considered at the heart of the crisis, and a guide as to what to watch out for in detecting future crises.

Singer is correct in identifying Fannie and Freddie as problems, but she is dangerously incorrect in identifying these problems as the proximate cause of the cycle. If there was no Fannie or Freddie and the Fed printed money, it most assuredly would have found waiting hands somewhere in the economy, causing the bubble and the ultimate crisis. On the other hand, without the Fed printing money, there is no way that Fannie and Freddie would have grown to the size that they did. It was the money supply that was the driver in this crisis, and at the center of every business cycle.


  1. You're really missing what the GSEs did. they effectively became the universal credit standard. The GSEs put their computers into all the oringinator offices.. if GSE would buy the loan, the loan was issued.

    I doubt very much that a corporation would have been able to have that much power over everyone else's credit decisions as well as the resources to keep pumping in the cash.

    I recommend the book "Architects of Ruin" for a good explanation of how the GSEs were used along with CRA to turn the mortgage industry into an ATM for groups like ACORN.

  2. Right on. But don't expect zero hedge or any of those folks to get into that...

    Their whole raison detre is to steer populist rage toward fixing the symptoms...

    eg. the recent post about einhorn on banning cds's.

    And today Bernanke came out in favor of stronger regulations as though regulations were the main problem.

    Confused language.
    I think Conant is having a break down over the same thing..

  3. Lila,


    Yes, thank you!

    And thank you Bob for highlighting this. I am coming to see the ZeroHedge people as incredibly bright, talented and witty people, but people who are nonetheless dangerously ignorant and with a vindictive agenda to control the financial world and make it "work like it's supposed to" according to their textbook model of what a financial system should or should not do. Their tools: regulation overhaul.

    Disaster, straight-ahead!

  4. I note that Mr. Bernanke is out today saying it wasn't the Federal Reserves fault. The fact of the matter is that it is ALWAYS the fault of the central bank, and for one reason - it is the only authority that can create market-wide malinvestment in each and every sector. Obivously there can be friends-in-crime like F&F, but without a central bank - how would it be possible? Or am I wrong?

  5. Folks, I'm not so sure. I want to End The Fed as much as anybody (I understand Bob's argument, and I agree totally), but maybe they weren't the root cause of this particular crisis.

    Let me ask it this way: Is there any way the housing bubble could have been created if, as VinceP1974 points out, F&F weren't GSEs and hadn't destroyed the credit standards? Could an illegal immigrant making $14K/year have been able to get a $500K mortgage? Could people have levered up 125% of their house value? Would a bank originate a liar loan if they couldn't push it out the door to a GSE? Without those buyers, I don't see how housing could not have possibly ballooned the way it did.

    The Fed is responsible for the Banks and their activities. Not the GSEs.

    Look, it was a ship of fools, and maybe this is just an argument over who the bigger fool was, but I'm not so sure. Could this have happened without F&F?

  6. Here are some numbers I got from a C-SPAN hearing

    House Committee
    Oversight and Government Reform

    Fannie Mae and Freddie Mac, Industry Analysts and Academics

    Edward Pinto
    Former Chief Credit Officier , Fannie Mae 1989

    "Witnesses testified about business practices and operations at Fannie Mae
    and Freddie Mac that eventually led to their takeover by the federal
    government. They focused on risk management practices and warnings to key
    company executives about the hazards of the subprime mortgage markets and
    over extension of credit to home buyers. They also talked about the housing
    industry and its role in the current financial crisi"

    This is from that hearing I watched today (from transcript)

    there are a total of 25 million subprime and Alt-A loans outstanding in the United States

    an unpaid principal balance of $4.5 trillion.

    These 25 million default- prone loans constitute 44 percent of all mortgage loans by count in the United States

    This is the largest percentage that has ever happened in our history

    they are currently defaulting at unprecedented rates

    They loosened credit standards for mortgages, which encouraged and extended the housing bubble

    Fannie Mae/Freddy Mac trapped millions of people into loans they knew were unsustainable. And they destroyed the equity savings of tens of millions of homeowners spread throughout every congressional district in the United States.

    permitted to operate at a 75-to-1 leverage ratio that makes Lehman Brothers look like they were operating conservatively

    Fannie Mae and Freddie Mac may deny it, there could be no doubt that they now own or guarantee $1.6 trillion in subprime, Alt-A and other default-prone loans and securities

    They were responsible for 34 percent of all the subprime loans made in the United States

    59 percent of all the Alt-A loans made in the United States

    These 10.5 million non-prime loans are experiencing a default rate that's eight times the level of their 20 million traditional quality loans

    These 10.5 million loans include 5.7 million subprime, 3.3 million Alt-A, and 1.5 million loans with other high-risk characteristics

    This 10.5 million total does not include FHA's obligations, which add another 3 million to the total and bring it to 13.5 million out of the 25 million subprime and other default-prone loans. That's more than half

  7. PART 2:

    I estimate that 1 million of the GSEs' Alt-A loans had no down payment.

    If the default rates I predict actually occur, U.S. taxpayers will have to stand behind hundreds of billions of dollars of Fannie Mae and Freddie Mac losses

    in the years 2005 to 2007, they bought over $1 trillion of these junk loans that are still on their books. Their purchases were a major factor in the development of the housing bubble and in the huge number of defaulted mortgages, which are now causing massive declines in house prices

    In late 2004, Richard Syron and Frank Raines both went to the meetings of the originator community and made clear that they were going to wrest back the subprime and Alt-A mortgage market from Wall Street.

    Syron said, "Our success in the future depends on our ability to serve emerging markets, and they've become the surging markets."

    Raines also said, "We have to push products and opportunities to people who have lesser credit quality."

    And this stimulated an orgy of junk mortgage development. Fannie and Freddie used their automated underwriting systems to divert subprime and Alt-A loans from private-label securitizers, driving up the value of these loans and making mortgage brokers even more eager to find borrowers, regardless of their credit standing.

    Why did Fannie and Freddie do this? First, they were trying to meet HUD's affordable housing goals, which by 2005 required 55 percent of all their loans that they purchased be affordable housing loans, including 28 percent to low-income and very low-income borrowers. Second, after their accounting scandals of 2003-2004, they were afraid of new and stricter regulation. By ramping up their affordable housing lending -- that trillion dollars I mentioned earlier -- they showed their supporters in Congress that they could be a major source, on a continuing basis, of affordable housing financing.

  8. It wouldn't necessarily have been a housing bubble if there wasn't an F&F - but hot money always finds somewhere to fly to. So the central bank is still one degree more guilty.

  9. This post immediately brought to mind that old adage: "guns don't kill, people do."

    As this blog correctly points out, Fannie and Freddie didn't "cause" this mess, rather they were one of (if not THE) primary vehicle(s) which was used by the Wall Street oligarchs to CREATE the U.S. housing bubble - and their concurrent toxic-bond scam.

  10. Hi again..

    Go back to how fannie and freddie were created...

    You'll see the gse's didn't just spring out of nowhere..

  11. I don't know, I guess I really don't see it that way Mr. Wenzel.

    I've been reading Zerohedge regularly for about 2.5-3 months now and they have had some really brilliant posts. They dig deep into the granularity of the data and find some really interesting facts. Though they really never explicitely cite ABCT or feature the standard "Austrian" line on most issues (like one would find on, here, on Richard Eberling's blog, etc.), the tone is very often in line with "Austrian" analysis.

    I read the post from Marla you refer to above, I don't really think she's saying "look at the shenanigans coming out of the GSEs. If they didn't exist, life would be awesome and we'd be at full employment and everyone would own a kindle." I read it as her arguing that much of this crisis's severity and protractedness can be attributed to the complete lack of any oversight of what the people at Fannie and Freddie were doing. And due to the sheer size of those two players, the problem has been made that much worse.

    Zerohedge seems, at least to me, to generally get "it". They regularly attack the central bank and the distortions that they create. Maybe they don't do it in an explicitly "Austrian" way (cordiproblem way?), but they definitely appear to be much closer to the Mises-Hayek paradigm than any of the mainstream Keynesian/DSGE stuff.

    But that's just my read on them.

  12. From Jesse over at his Cafe Americain:

    "Yes, Fannie and Freddie played a significant role in the US. But the Fed set the tone for banking regulation and they not only did not take away the punch bowl, they spiked it with high grain alcohol. The Fed was the 'cop on the beat' and they looked the other way. And they still are."

    Alright. I give.

    Bob, thanks for the post, it was great debate.

  13. If the theory offered had legs, only the USA would have the contagion.

    The world wide melt down happened because our investment bankers sold the world crap, which then defaulted.

    There has been no default on GSE paper--such paper was no the crap sold by Lehman, et al

    Our problems did not come from an excess supply of money--they arose because incomes have been stagnate or declining in the US for most people for 20 years.

    We have extraordinary structural problems in need of correction, problems which will not be solved by either tax cutters or gold bugs

    A first step would be some honesty in talking about out situation. Those with political agendas love to talk about unfunded social programs. It is time to recall that Defense is also an unfunded liability. We can no more stop defending ourselves than we can stop social security or medicare