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July 09, 2009

Minority Report: Government Interventional Largely Responsible for "Mortgage Tsunami"

Democrats aren't admitting this. And the media will not disturb their narrative wherein Dick Cheney crept out of the National Observatory at night to dose AIG's water-coolers with LSD so that they'd make financial derivatives out of hallucinatory fantasias.

But worth reading for anyone who cares about the truth.


The housing bubble that burst in 2007 and led to a financial crisis can be traced back to federal government intervention in the U.S. housing market intended to help provide homeownership opportunities for more Americans. This intervention began with two government-backed corporations, Fannie Mae and Freddie Mac, which privatized their profits but socialized their risks, creating powerful incentives for them to act recklessly and exposing taxpayers to tremendous losses. Government intervention also created “affordable” but dangerous lending policies which encouraged lower down payments, looser underwriting standards and higher leverage.

Finally, government intervention created a nexus of vested interests – politicians, lenders and lobbyists – who profited from the “affordable” housing market and acted to kill reforms. In the short run, this government intervention was successful in its stated goal – raising the national homeownership rate. However, the ultimate effect was to create a mortgage tsunami that wrought devastation on the American people and economy. While government intervention was not the sole cause of the financial crisis, its role was significant and has received too little attention.

The real tragedy of the government’s affordable housing policy is the impact on average Americans, particularly those of modest means. Millions of these borrowers, who were supposed to have been helped by federal affordable housing policy, have now been forced into delinquency and foreclosure, destroying their asset base, their credit, and in some cases their families. For example, Latino homeowners, who once appeared to be among the most frequent beneficiaries of affordable housing policies, are now the victims of the policies that their political representatives in Washington once championed.

The consequences of these policies have also brought the entire global financial system to the brink of collapse, destroying trillions in equity and untold numbers of lives. It is essential to reexamine the borrow-and-spend, high-leverage policies that became prevalent in the mortgage market as a result of well-intentioned-but-reckless decisions made by elected officials on behalf of the American people.

Washington must reexamine its politically expedient but irresponsible approach to encouraging higher levels of homeownership based on imprudently small down payments and too little emphasis on borrowers’ creditworthiness and ability to repay their loans. Without such a return to fiscal discipline and responsibility, we will continue making the same mistakes that led us to the current financial crisis.

Thanks to Dave at Garfield Ridge.

And On AIG: I've been reading Michael "Moneyball" Lewis' accounting of how, he says, AIG came to be the "dumping ground" for the exotic new risk instruments created by Wall Street.

Michael Lewis seems to have found a villain -- Joe Cassano, a bullying, insecure guy running the Financial Products division, who was pretty weak with actual math and stifled all debate over the direction of the unit. I doubt it's all so Hollywood neat and simple -- and so does Lewis, acknowledging that Cassano is a "cartoon despot" and perfectly cast for the role of villain. Too perfectly, he means, as in "misleadingly."

But having a Black Hat as part of the story makes it easier to read and understand. Even if that understanding is ultimately a little warped.

Anyway, a long piece but I think worth it. This is the most quotable passage:

The more subtle change inside A.I.G. F.P. occurred not long after Cassano assumed control. In 1998, A.I.G. F.P. had entered the new market for credit-default swaps: it sold insurance to banks against the risk of defaults by huge numbers of investment-grade public corporations. As Gillian Tett tells it in her new book, Fool’s Gold, bankers at J. P. Morgan, having invented credit-default swaps, went looking for an AAA-rated company to assume the bulk of the risk associated with them, and discovered A.I.G. The relationship began innocently enough, by Wall Street standards. The risk in these early deals was indeed small: it was unlikely that large numbers of investment-grade companies in different countries and different industries would default on their debt at the same time. (Even now A.I.G. F.P.’s $450 billion portfolio of corporate credit-default swaps, which dwarfs the $75 billion portfolio of subprime-mortgage credit-default swaps, has avoided losses.) But it made explicit what until then had only been implicit: A.I.G. F.P. was the most receptive dumping ground for new risks created by big Wall Street firms.

And in the early 2000s, the big Wall Street firms performed this fantastic bait and switch in two stages. Stage One was to apply technology that had been dreamed up to re-distribute corporate credit risk to consumer credit risk. The banks that used A.I.G. F.P. to insure piles of loans to IBM and G.E. now came to it to insure much messier piles that included credit-card debt, student loans, auto loans, prime mortgages, and just about anything else that generated a cash flow. “The problem,” as one trader puts it, “is that something else came along that we thought was the same thing as what we’d been doing.” Because there were many different sorts of loans, to different sorts of people, the logic applied to corporate credit seemed to apply to this new pile of debt: it was sufficiently diverse that it was unlikely to all go bad at once. But then, these piles, at least at first, contained almost no subprime-mortgage loans.

Toward the end of 2004, that changed dramatically—but just how dramatically A.I.G. F.P. was extremely slow to realize. In the run-up to the financial crisis there were several moments when an intelligent, disinterested observer might have realized that the system was behaving strangely. Maybe the most obvious of these was the effects of U.S. monetary policy on borrowing and lending. The combination of the dot-com bust and the 9/11 attacks had led Alan Greenspan to pump money into the system, and to lower interest rates. In June 2004 the Fed began to contract the money supply, and interest rates rose. In a normal economy, when interest rates rise, consumer borrowing falls—and in the normal end of the U.S. economy that happened: from June 2004 to June 2005 prime-mortgage lending fell by half. But in that same period subprime lending doubled—and then doubled again. In 2003 there had been a few tens of billions of dollars of subprime-mortgage loans. From June 2004 until June 2007, Wall Street underwrote $1.6 trillion of new subprime-mortgage loans and another $1.2 trillion of so-called Alt-A loans—loans which for some reason or another can be dicey, usually because the lender did not require the borrower to supply him with the information typically required before making a loan. The subprime sector of the financial economy clearly was responding to different signals than the others—and the result was booming demand for housing and a continued rise in house prices. Perhaps the biggest reason for this was that the Wall Street firms packaging the loans into bonds had found someone to insure against what turned out to be the rather high risk that they’d go bad: Joe Cassano.

A.I.G. F.P. was already insuring these big, diversified, AAA-rated piles of consumer loans; to get it to insure subprime mortgages was only a matter of pouring more and more of the things into the amorphous, unexamined piles. They went from being 2 percent subprime mortgages to being 95 percent subprime mortgages. And yet no one at A.I.G. said anything about it—not C.E.O. Martin Sullivan, not Joe Cassano, not Al Frost, the guy in A.I.G. F.P.’s Connecticut office in charge of selling his firm’s credit-default-swap services to the big Wall Street firms. The deals, by all accounts, were simply rubber-stamped by Cassano and then again by A.I.G. brass—and, on the theory that this was just more of the same, no one paid them special attention. It’s hard to know what Joe Cassano thought and when he thought it, but the traders inside A.I.G. F.P. are certain that neither Cassano nor the four or five people overseen directly by him, who worked in the unit that made the trades, realized how completely these piles of consumer loans had become, almost exclusively, composed of subprime mortgages.

Interesting, there: due to market distortions caused by government intervention -- subsidizing these loans by guaranteeing them (supposedly) through Fannie Mae and Freddie Mac, pressuring banks into issuing them, and, critically, getting a big company with unimpeachable credit to insure these very risky mortgages, thus removing any real incentive for the bans originating the mortgages to exercise any sort of discipline and discrimination whatsoever -- this sector of the economy behaved completely anomalously, immune to rising interest rates.

Market distortion by government intervention -- Works every time. But not in a good way.


Thanks to Arthur for that tip.

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posted by Ace at 12:28 PM

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