The subprime meltdown

Well Karl has finally baited me enough to get me to weigh in here on the subprime mess. Unfortunately what may seem to many an interesting discussion topic has been for me the cause of many many late nights and a great deal of stress recently. The financial sector is reeling though fortunately my fund has so far weathered it all just fine.

I'll ignore some of the "talking points" I've read here and try and briefly summarize what I view as the source of the problems. I think it's worth remembering that at the heart of all this is of course a huge bubble in residential real estate. It turned out to be self-reinforcing---individuals saw gains in home prices as indications of future gains and piled in---but how did it start and why did it develop? What is clear today is there was a significant increase in consumer demand largely caused by a reduction in the cost of buying a home. There were 3 main culprits here:

1. Excess liquidity provided by the Fed after the tech bubble crash (and 9/11). This kept rates much lower than they would have been without Fed intervention.

2. Securitization. This is the least understood by most people and one I'd like to highlight. I will do my best to do this briefly:

For decades mortgages in the U.S. were serviced by banks who then sold the loans to investors of some kind. Low mortgage rates as well as increased transparency and information flow to potential buyers (the internet helped here) started to increase the size of the mortgage pool held by these "investors" in the last 1990s and early 2000s.

At the same time there were large pools of capital held by "regulated" institutions. These included investment and commercial banks as well as pension funds, insurance companies, etc. Long earlier these institutions had at least partially abdicated the responsibility for risk management to the government. The government told them which assets they were allowed to own and how much of different asset types they were permitted to hold. This was accomplished through the rating agencies---various assets were given ratings by these 3rd party companies and the government regulated how much of various "rated" assets an institution could own. Once "regulated" these institutions became much less concerned about risk management---if the rating agency said it was "AAA" it must be low risk. After all, the government says I can own X% of "AAA" and I own less than that, so my investments are safe.

Some smart trader on Wall St one day figured out how to turn this into a money machine. The answer was "securitization". Here's how it worked: Take a pool of mortgages. By themselves these mortgages might have been too risky for the regulated institutions to own---the rating agencies would not give them a high enough rating. So the smart trader split them into pieces called "tranches". From each pool there would be a series of securities created each paying a particular yield and bearing some part of the losses from the pool. For example the "equity tranche" would pay a high yield but would be exposed to the first 10% of losses in the pool. A "junior tranche" might pay less but would only be exposed to losses from 10% to 30%. Eventually you'd have a "senior tranche" that paid a smaller yield but would only start to lose money once pool losses reached, say, 50%. Now you ask the rating agencies to examine the credit risk of THAT security and they might decide, given the low probability of the pool suffering such steep losses, that it was "AAA". The unregulated guys could own the risky parts while the regulated institutions could own the rest.

Effectively this is just taking advantage of stupid regulation. The government told these institutions they could own a lot of "AAA" securities. The rating agencies didn't have a direct stake in the securities' performance and were not set up to understand the risk of mortgage pool losses reaching 50% (their core competency being evaluation of credit risk in companies). The institutions were foolish to believe the rating agencies and the government. And the smart trader figured out a way to profit off the mistakes of these other institutions.

This process of securitization further reduced mortage rates. Having ready pools of capital prepared to buy securitized mortgage pools meant banks could issue mortgages at lower rates and to less credit-worthy borrowers.

3. Government support for housing. Fannie and Freddie grew their balance sheets and the government pushed an agenda of "housing for everyone". Congress threatened lenders who appeared to discriminate by race (obvious correlations with socio-economic status notwithstanding), geography (though obviously a key variable in housing value), and even income (!). There is no question the administration and congress supported and enabled an aggressive expansion in home ownership. Though I said I would ignore the "talking points" I will say that perhaps the most absurd is that the GSEs (Fannie and Freddie) could not have caused this because they've been around so long. I look forward to its use when Medicare and Social Security become officially insolvent (it must be...er...something else...I mean these programs have been around so long!)

This expansion in demand caused by the above factors set the bubble in motion and, as I mentioned, it was self-reinforcing. This bubble, like all others, eventually cannot be sustained and must pop. The painful correction we have been experiencing and all of the economic carnage derive from this housing problem.

With that, on to the recriminations! In light of the above it is worth asking anyone who points a finger of blame to put it in the context of this housing bubble.

1. Was Bush to blame? Well he did encourage home ownership, the Fed did dramatically lower rates under his administration (though I think it's grossly unfair to blame him for any of that), he did not reduce the ineffective regulation that enabled the securitization disaster. He did try to reform the GSEs which would have made a big difference here. Overall I'd say partial blame. I'd like to understand Karl's claim that the "last 8 years" were particularly culpable---beyond the vague "too little regulation" which I admit I view as empty talking points. I'd also love examples of Bush being hostile to regulation---as a conservative and fan of deregulation I'd love to hear I haven't given him credit where due!

2. Was congress to blame? It failed to reform the GSEs as Bush advocated (this was bi-partisan though certainly majority dem). It certainly encouraged aggressive lending. It failed to address the idiotic regulation of financial institutions. Partial blame.

3. Was Greenspan to blame? Yes, partially, for maintaining aggressive monetary policy longer than needed. Though hindsight is 20/20.

Overall I'd say far too much blame has been thrown around without basis here. The pieces were in place long before all this happened---the GSEs, the regulations on financial institutions, the reliance on aggressive monetary policy to solve every cycle. Those that put all those pieces in place were probably well intentioned and we've all learned much about "unintended consequences" here.

Books can and will be written about all this and I unfortunately don't have the time to mention everything I'd like to. But I would like to briefly examine the issue of regulation specifically here.

I'm afraid this issue is starting to parallel the arguments over schools in the US. Most of us would agree public schools in this country are not great. Some people believe the system is sound but just needs more money. They react to failures by advocating doing what we're doing now, but just more of it. Others argue the system itself is the problem and should be reformed.

Both sides use the failure of schools to claim vindication in their argument. I would argue failure in itself proves neither. In the same way I do not believe the subprime meltdown in any way proves deregulation to be right or wrong. What it proves is that bad regulation, like bad schools, cause problems. You can respond by further increasing regulation (adding funding to the current school system) or by throwing it out (reforming the system itself).

On both issues I obviously favor less government involvement as I view that as a more efficient outcome. Had the government not regulated these institutions as it did would they have bought as many securitized mortages as they did? Would they have actually examined the risks of what they were buying and demanded higher yields (which would have then passed down the line to ultimately higher mortgage rates)? Without government support would the mortage market have grown as dramatically as it did?

The answer is not necessarily deregulation. But one of the principles most clearly evidenced by this crisis is that regulation has unintended consequences---it distorts incentives and markets in ways we cannot foresee. We cannot know that the wave of regulation now being considered will not sow the seeds of the next crisis.