A Trap Baited with 3 Kinds o

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A Trap Baited with 3 Kinds oTasty Cheese REAL
Causes of Panic 2008

• Michael C. Munger
• Director, Philosophy, Politics, and Economics
  Program
• Duke University

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Why have private financial corporations in the
first place?

• Liquidity
• Prices
• Intermediation --transactions costs

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A Question

• Should we bail out firms that are too big to fail?

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The Question

• Should we bail out firms that are too big to fail?

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The Question

• Should we bail out firms that are too big to fail?

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The Question

• Should we bail out firms that are too big to fail?

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The Question

• Should we bail out firms that are too big to fail?

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Greenspan's Mea Culpa (10/23/08)

• "Those of us who have looked to the self-interest
  of lending institutions to protect shareholder's
  equitymyself especiallyare in a state of
  shocked disbelief... I still do not fully
  understand why it happened and obviously to the
  extent that I figure where it happened and why, I
  will change my views. If the facts change, I will
  change."

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Why was Greenspan Wrong?

• The only reason we need a policy of bailing out
  losers is that we have a policy of bailing out
  losers.
• Greenspan assumed a limited kind of rationality.
  A "rational" investor would recognize that
  bailouts allow large losers to play with house
  money.

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Why was Greenspan Wrong?

• Merton's distinction
• Investors vs. Customers.
• FDIC and FSLIC "bail out" customers of bad
  banks. Liquidity crisis protection
• Moral hazard (I look for high returns, don't care
  if bank is solvent) is real, but manageable.

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Why was Greenspan Wrong?

• Merton's distinction needs to be expanded
  Investor/Owners vs. Customers vs. CUSTOMERS.
• The bailout in 2008-9 was a bailout of
  investorsin other firms that were major
  counterparties in exotic products (derivatives,
  CDS, CDO). Unlike moral hazard for traditional
  depositors, this moral hazard problem is not
  manageable, but unlimited.

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Some definitions

• Bailout The use of taxpayer funds either to buy
  assets, or to guarantee the value of assets, of
  insolvent firms.

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Definitions TBTF

• Systemically Important Financial Institutions
• SIFIs will always be bailed out
• Two features
• Solvency/Size
• External effects of failure

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Problem

• Systemically Important Financial Institutions
  Externality more important than solvency
• SIFI status is therefore endogenous. Yes,
  investors lose, but competitive advantage in
  selling to CUSTOMERS
• My choices to select extra risk, and more
  leverage, make it more likely that my
  counterparties will be bailed out. Larger
  insolvency makes bailout MORE likely

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Problem

• The SIFI designation is found in the Dodd-Frank
  legislation, and the language in that law says
• (a) Liquidation required--All financial companies
  put into receivership under this subchapter shall
  be liquidated. No taxpayer funds shall be used to
  prevent the liquidation of any financial company
  under this subchapter.
• (b) Recovery of funds--All funds expended in the
  liquidation of a financial company under this
  subchapter shall be recovered from the
  disposition of assets of such financial company,
  or shall be the responsibility of the financial
  sector, through assessments.
• (c) No losses to taxpayers--Taxpayers shall bear
  no losses from the exercise of any authority
  under this subchapter.

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Problem

• Mutual benefit Exists a contract, or agreement,
  under which everyone would be better off. Looks
  like this
• Governments will not bail out firms
• Therefore, firms choose best guess risk/leverage
  for portfolios
• Insolvency reflects bad production choices,
  prices allocate scarce resources accurately

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Problem

• The Problem?
• That agreement, on previous page, is
  unenforceable, because the incentives facing the
  enforcer (the state) are time-inconsistent
• But we tried. Set up the Fed as a Lender of Last
  Resort
• Bagehot (1897), Lombard Street.

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Bagehot's Lender of Last Resort

• Bail out only for liquidity crises, not equity.
  LLR Regs do 3 things
• Lend as much money as necessary directly to
  troubled banks
• At a penalty rate
• And only for good collateral (the institution
  must be technically solvent)

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Problem III

• Lender of last resort Bagehot (1897). But our
  standard is different externalities!
• The size of the externality has (at best) nothing
  to do with solvency, and may (at worst) be
  correlated with externality
• In other words, using size of externality causes
  larger externalities

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Problem is Time Inconsistency

• "what to do once there is a crisis?"
• Answer there would be no crises if we could
  credibly commit to a policy of no bailouts.
• (Might or might not be true, need empirical
  cases)
• Ann is right, of course, in 2008-9. But what now?

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• Here is Circes dire warning to Odysseus (Chapman
  2000 Chap. XII, lines 56-89 emphasis added)
• First to the Sirens ye shall come, that taint
• The minds of all men, whom they can acquaint
• With their attractions. Whomsoever shall,
• For want of knowledge moved, but hear thcall
• Of any Siren, he will so despise
  
• Both wife and children, for their sorceries,
• That never home turns his affection's stream,
• Nor they take joy in him, nor he in them.
• The Sirens will so soften with their song
• (Shrill, and in sensual appetite so strong)
  
• His loose affections, that he gives them head.
• And then observe They sit amidst a mead,
• And round about it runs a hedge or wall
• Of dead men's bones, their wither'd skins and all
• Hung all along upon it and these men
  
• Were such as they had fawn'd into their fen,And
  then their skins hung on their hedge of bones.

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Federal Trade Commission, Washington, DC
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ButDid That Big Horse Get Loose, and Pull Us Off
a Cliff?

• Youve heard it Worst economic downturn since
  the Great Depression (not remotely true, not even
  as bad as 73, or 81, in terms of GDP decline.)
• Huge financial losses, bankruptcies of hundreds
  of companies
• Government bailouts (unprecedented!)
• Record postwar unemployment (okay, THATs true)
• WHY a crisis? PricesNo Prices, No Liquidity

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Document Problem House Prices
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Stock Prices Volume, 04-09
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Unemployment Rates, end 2008
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Unemployment Rates, end 2011
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Unemployment Rates, 11/074/09 2009
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Three Deficits

• Federal
• Consumer
• Trade

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US Federal Debt/capita (07)
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110 is the Worry Line
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Consumer Debt
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Student Loan Debt (US Govt)
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Trade Deficit
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Fiscal Deficit and Trade Deficit are CONNECTED
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Competing Diagnoses

1. Greed, Especially Predatory Lending
2. Too Much Government Interference in Housing
   Markets
3. Too Little Government Regulation of Financial
   Markets
4. Too Much Debt, Not Enough Saving
5. Death Throes of a Dying Capitalist / Consumerist
   Order
6. Space Aliens (The Cordato Thesis)
7. Normal fluctuations of business cycle,
   exacerbated by policy mistakes. Inherent in
   capitalism

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The Answer (correct in all unimportant respects)

• Problem Too much leverage, too little margin
  for error in investment and real estate markets.
• To take an example, a company with a net worth of
  US 25 billion borrowed 26 times its net worth
  and creates leveraged funds of US 650 billion to
  invest or lend them.
• When a small portion of the company's
  investments turns bad, as is the norm for the
  industry, the company's capital is under threat.
  To put things in perspective a 3.8 percent
  misjudgment in their books was enough to wipe out
  their shareholders' capital of US 25 billion.
• And leverage ratios of 40, or 50, to 1 were not
  uncommon. Prudence? No more than 2 to 1. (May
  not be comparable, since derivatives seem
  different from borrowing outright)

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The Answer (correct in all unimportant respects)

• The reason this is correct in all unimportant
  respects is that it makes us want to ask WHY?
  WHY DID IDIOTS DO THAT? LETS KILL THEM ALL!
• Well, even in the U.S. being an idiot is not a
  capital crime. In fact, if you are a BIG idiot,
  the government will bail you out!

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My View A Trap Set by the US Government, and
Baited with three types of tasty Cheese
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For the first time in history, you could be
trapped even if you never leave the house. Just
a computer was enough
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Effective? Unfortunately Each trap could catch
many!
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Hard Not to Feel Sorry for those poor mice.

• But blaming markets for the financial crisis is
  a lot like blaming the CHEESE!
• The Bush Administration, and Clinton
  Administrations, did not realize they were
  setting a trap.
• But they were. This is a crisis where markets
  ran wild, and where government did nothing to
  control the problem. Government actually made
  things much worse than was necessary.

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To Repeat A Trap Set by the US Government, and
Baited with three types of tasty Cheese
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Many Traps--Three Kinds of Cheese, No
Waiting!!!!!

1. Equity Purchase Subsidies
2. Artificially Low Interest Rates
3. Guarantee of Permanent Price Increases

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1. Equity Purchase Subsidies Homes

• Home ownership policy of Bush, also Clinton Pay
  low-income people to make a risky investment that
  they would otherwise rationally avoid.
• Mortgage Agencies treated like public utilities
  (Bernanke, Paulson).
• Banks/financial entities both threatened, and
  bribed, to make loans that could not possibly be
  paid back.
• Community Development Block Grants subsidize
  the down payment.

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1. Equity Purchase Subsidies Homes

• PROBLEM Behavioral economics--people
  overestimate their prospects, poor people
  shouldn't take too much risk, because they have
  little to fall back on. The natural market
  tendency is too much home ownership, not too
  little.
• BACKGROUND US Federal Reserve Bank Study on the
  dangers of Home Ownership Subsidies, (Published
  August of 2008!)
• http//www.richmondfed.org/publications/research/r
  egion_focus/2008/fall/pdf/cover_story.pdf

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1. Equity Purchase Subsidies Homes

• Two New York Times Articles
• I. Fannie Mae Eases Credit To Aid Mortgage
  Lending, By STEVEN A. HOLMES, September 30,
  1999
• In a move that could help increase home
  ownership rates among minorities and low-income
  consumers, the Fannie Mae Corporation is easing
  the credit requirements on loans that it will
  purchase from banks and other lenders. In
  moving, even tentatively, into this new area of
  lending, Fannie Mae is taking on significantly
  more risk, which may not pose any difficulties
  during flush economic times. But the
  government-subsidized corporation may run into
  trouble in an economic downturn, prompting a
  government rescue similar to that of the savings
  and loan industry in the 1980's.
• Why do it? Clinton Admin and House Democrats..

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1. Equity Purchase Subsidies Homes

• Two New York Times Articles
• II. New Agency Proposed to Oversee Freddie Mac
  and Fannie Mae, By STEPHEN LABATON, September
  11, 2003
• The Bush administration today recommended the
  most significant regulatory overhaul in the
  housing finance industry since the savings and
  loan crisis a decade ago...The plan is an
  acknowledgment by the administration that
  oversight of Fannie Mae and Freddie Mac -- which
  together have issued more than 1.5 trillion in
  outstanding debt -- is broken.... (Oxley) ''The
  current regulator does not have the tools, or the
  mandate, to adequately regulate these
  enterprises. We have seen in recent months that
  mismanagement and questionable accounting
  practices went largely unnoticed by the Office of
  Federal Housing Enterprise Oversight,'' the
  independent agency that now regulates the
  companies. (CONTINUED ON NEXT SLIDE)

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1. Equity Purchase Subsidies Homes

• Two New York Times Articles
• II. New Agency Proposed to Oversee Freddie Mac
  and Fannie Mae, By STEPHEN LABATON, September
  11, 2003
• Among the groups denouncing the proposal today
  were the National Association of Home Builders
  and Congressional Democrats who fear that tighter
  regulation of the companies could sharply reduce
  their commitment to financing low-income and
  affordable housing.
• ''These two entities -- Fannie Mae and Freddie
  Mac -- are not facing any kind of financial
  crisis,'' said Representative Barney Frank of
  Massachusetts, the ranking Democrat on the
  Financial Services Committee. ''The more people
  exaggerate these problems, the more pressure
  there is on these companies, the less we will see
  in terms of affordable housing.''
• Representative Melvin L. Watt, Democrat of North
  Carolina, agreed.
• ''I don't see much other than a shell game going
  on here, moving something from one agency to
  another and in the process weakening the
  bargaining power of poorer families and their
  ability to get affordable housing,'' Mr. Watt
  said.

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1. Equity Purchase Subsidies

• Government-guaranteed home mortgages, especially
  when a negligible down payment or no down payment
  whatever is required, inevitably mean more bad
  loans than otherwise. They force the general
  taxpayer to subsidize the bad risks and to defray
  the losses. They encourage people to buy houses
  that they cannot really afford. They tend
  eventually to bring about an oversupply of houses
  as compared with other things. They temporarily
  overstimulate building, raise the cost of
  building for everybody (including the buyers of
  the homes with the guaranteed mortgages), and may
  mislead the building industry into an eventually
  costly overexpansion. In brief, in they long run
  they do not increase overall national production
  but encourage malinvestment. (my emphasis)From
  Chapter VI "Credit Diverts Production" in Henry
  Hazlitt's "Economics in One Lesson," first
  published in 1946

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Artificially Low Interest Rates
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Another Way of Computing It
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Artificially Low Interest Rates

• Why would this matter? Reasons
• Subsidy to long term borrowing
• Subsidize risk-taking, lender of last resort
• ARMs and Balloons Non-standard loans, because
  money was free

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Guarantee of Permanent Price Increases

• If there is no risk, people take too many risks.
• Buy a house, zero down, 4 year lock-in of 4
  interest, then balloon payment or ARM
• If house was 200,000, and it appreciates at 5
  per year, thats more than 40,000 capital gain.
  You can refinance, with a 40,000 down payment
  and a standard fixed rate mortgage. Its all
  free!
• And so housing prices went up forever

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Guarantee of Permanent Price Increases

• Example Interview with Henry Paulson (T-Sec,
• 2006-Jan 2009), in 2007
• Paulson I think what were doing is avoiding a
  market failure that would have forced housing
  values down in a way that was not in the
  investors interest, and in a way that the market
  wasnt intended to work.
• Interviewer How can you force values down? Why
  arent values finding their natural level?
• Paulson The way values would go down is, as
  Ive said, youd have market failure. After
  Treasury Department intervention we wont have
  housing prices driven down in ways that distort
  the market.
• The Guarantee Government SHOULD, and CAN,
  maintain orderly permanent increases in housing
  prices.

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History Four Influences

• How did it actually happen?
• I have said that the trap was baited with
• Equity purchase subsidies
• Artificially low interest rates
• Government guarantee of intervention to prevent
  market failure of housing price decline
• But how did the trap close? How did it actually
  happen?
• This is as simple as I can make it. Like any
  simple account, it leaves out a lot of important
  details.
• But, it captures the primary moving parts of the
  crisis.

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History 4 Influences, 4 Slides

• SECURITIZED DEBT
• Fannie Mae (1938) and Freddy Mac (1970) set up to
  rationalize the mortgage marketSecuritize.
• At first, worked pretty well. Repackaged and
  commoditized mortgages, so that people with money
  could loan to people who wanted to borrow money.
  Didnt need banks, except as intermediaries.
• Home ownership is highly illiquid debt more
  extensive loan market, with reselling, allowed
  for increased liquidity among both borrowers and
  lenders. Reduced transactions costs, lower rates
  for borrowers, higher rates for lenders.
• Problems Risk status endogenous, increase
  asymmetric information about repayment rates

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History 4 Influences, 4 Slides

• INCREASE HOME OWNERSHIP, CONFIDENCE IN MANAGEMENT
  OF ECONOMY
• It seemed home ownership was the stairway to the
  American dream. Encourage home ownership through
  (a) tax subsidies, (b) explicit subsidies, (c)
  pressure banks and regulatory agencies to certify
  subprime loans as conforming. Conforming
  loans require 20 downpayment and 30 cap on
  monthly income. Both relaxed by regulators,
  1994-1997.
• Problems None, as long as home prices go up.
  But investors either didnt know, or didnt care,
  that regulators were expanding the definition of
  conforming loans. Appeared to be good loans,
  certified by government agencies as being
  investment grade assets.

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US Homeownership Rates
The new loan products are known as the combo /
ballon loan, and have lower down payment
requirements. Combo loans are the contract of
choice for nearly 40 of new loans, explaining
much of the increase in homeownership rate since
1994.
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Longer TermHome Owner Rates
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US Homeownership Rates
At the same point in time, 1997, housing prices
started to skyrocket in real terms. Before,
housing had been a hedge against inflation, but
wealth was built through accumulating equity.
Now, with the new loan regime from the Congress
and the Clinton administration, and Fred and Fan
helping, there was a huge rush of cash chasing
houses.
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Real Housing Prices
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Housing Prices vs. CPI
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Overall, Shiller Index
Not hard to figure out 1997
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Buying vs. Renting
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History 4 Influences, 4 Slides

• COLLATERALIZED DEBT OBLIGATIONS
• Collaterlized Debt Obligations (CDO)90
  repayment rate means an accurate price for
  bundles, even if no one security could be priced
  accurately.
• Problems 90 repayment rate is endogenous,
  assumed old regulatory structure. And assumed
  steady increase in home prices. When repayment
  rates plummeted, no idea how to price these very
  complex assets. Imagine what the bankers
  thought they must have been incredulous! We
  can certify these lousy risks as investment
  grade, and then we can sell them in bundles at
  full price to FM/FM, and then bear NO
  responsibility for anything that happens later?
  COOOOOL!

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History 4 Influences, 4 Slides
Billions
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History 4 Influences, 4 Slides

• DERIVATIVES, especially Credit Default Swaps
• Similar to other hedging derivatives.
  Invented by JP Morgan analysts in 1997, in 2000
  became exempt from most regulation. (Pres.
  Clinton supported). Like insurance, but NOT
  insurance. Neednt own asset, not regulated, and
  no requirements for reserves or structures of
  hedged risk layoffs.
• Problems Insurance aspect of these
  derivatives meant that no one cared about the
  underlying assets, and no one investigated
  repayment rates. And AIG (with its physicists)
  made huge amounts of money writing these
  contracts. But like a one-sided betting shop
  did not hedge the risk. For many companies,
  their only assets were these swap contracts after
  the primary assets defaulted.

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Credit Default Swaps
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Now, Just One Slide Cause?

• Bad regulation Focus on identities rather than
  instruments. Market failure, government at least
  negligent, possibly complicit. CDSs are NOT
  insurance.
• Really, really bad regulation Government caused
  the crisis, by subsidizing housing prices, and
  using government prestige to hoodwink small
  investors. Certified junk as conforming, allowed
  fast resale at full price, facilitated by Freddy
  and Fanny. Investment houses turned into
  Animal Houses.
• The dilemma Bad regulation can be worse than no
  regulation. But good regulation is better still.
  Test When you say, Government should regulate
  markets, take out the word Government and
  substitute Politicians. You sure you still
  believe that?
• Confidence, Transparency, Liquidity required for
  accurate pricing and functioning markets

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What Has Obama Administration Done?

• TARP (carried over from Bush Administration)
  3 Trillions of ?
• Porkulus (Stimulus for Reelecting Congressmen)
  Again, 3 Trillion (If not temporary)
• He is NOT George Bush, a positive worldwide
• Proposed new regulations of executive
  compensation
• Stress tests, not a bad idea, because they
  finesse mark to market valuation
• Takeovers of large manufacturers, directing
  bankruptcy
• Proposed Financial Product Safety Commission

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What SHOULD have been done?

• 1.  The George W. Bush presidency was not an era
  of deregulation, but overregulation and failed
  financial supervision. Sarbanes-Oxley, 10,000
  Commandments, attempts to prop up housing
  prices. So, Republicans were primary cause.
• 2. Dont bail out! At most, offer lender of last
  resort function for banks, and liquidity of last
  resort function for CDOs. 40 cents on the
  dollar, take it or leave it. Bailing out AIG was
  just pouring money down a rat hole. Now, again
  for PIGS? Amazing.

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What SHOULD have been done?

• Stop changing things. Why is unemployment so
  high? Why wont banks lend? Its because no one
  knows what is going to happen to taxes,
  regulations, or health care.
• Regime Uncertainty regime uncertainty pertains
  to the likelihood that investors private
  property rights in their capital and the income
  it yields will be attenuated further by
  government action. Such attenuations can arise
  from many sources, ranging from simple tax-rate
  increases, to the imposition of new kinds of
  taxes, to outright confiscation of private
  property. Many intermediate threats can arise
  from various sorts of regulation, for instance,
  of securities markets, labor markets, and product
  markets. In any event, the security of private
  property rights rests not so much on the letter
  of the law as on the character of the government
  that enforces, or threatens, presumptive rights.
  (Higgs, 1997, Independent Review)
•  

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What SHOULD have been done?

• 4. Depend on greed and information to get us out
  of this. If banks are self-interested, not
  necessary to bribe them to make loans.
• 5. Stop politically motivated industry
  take-overs. Buying debt may be justified (though
  Im skeptical.) But buying debt is WAY better
  than buying, or seizing, equity shares.
• 6. Announce freeze on new regulations, and end
  constant threats of new taxes on profits.  

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What Will Happen Now? US

• Securities based on risky mortgages are what
  toppled financial institutions but it was the
  government that made the mortgages risky in the
  first place, by making home-ownership statistics
  the holy grail, for which everything else was to
  be sacrificed, including commonsense standards
  for making home loans.
• Politicians and bureaucrats micro-managing the
  mortgage sector of the economy is precisely how
  today's economic disaster began. Why anyone would
  think that their micro-managing the automobile
  industry, or executive pay across a wide sweep of
  other industries, is likely to make things better
  in the economy is a mystery.
• THOMAS SOWELL, Cheap Political Theater,
  http//townhall.com/columnists/ThomasSowell/2009/0
  3/24/cheap_political_theater