How the Crisis Happened

One good summary of how the current financial crisis came about can be found at Jerry Pournelle's Chaos Manor Reviews. Following are some highlights, but read it all here.

In the past month, investment banks managed to lose more money than all the banks in history cumulatively have made as profit on risky investments. Lehman Brothers, which survived the Civil War, the turbulence of the late 19th Century, World War I, the Crash of '29 and the Great Depression, has vanished. Major stockbroker houses, which used to know that the first rule was never to gamble with house money, collapsed. Note that the crisis was easily predicted by anyone except the smartest guys in the room who controlled America's financial centers. They, apparently, couldn't see it coming. ...

As often (but not always) happens when government interferes with economics, the origin of the collapse was due to good intentions. Aristotle tells us that democracy is rule by the middle class, and the middle class are those who possess the goods of fortune in moderation. Most political scientists, economists, and intellectuals in general are agreed that ownership of one's home is a key element in defining the middle class in America. It's neither necessary nor sufficient, but it's still important, and the more people who own homes, the more people with a stake in America and the existing social order. People who own houses work hard to keep them. Home ownership is good for the owners, and it's good for America.

It was decided that the usual market forces weren't sufficient to spread the joys and benefits of home ownership, and government help would be needed. There are several ways that might be done including taxing the rich, buying houses, and giving them to those who couldn't afford them, and that was actually proposed at one time; but sanity prevailed. After all, if you could get a free house by being poor, why work hard to save a down payment and take out a mortgage? Better to spend yourself poor...

Eventually a solution was found. Private corporations called Fannie Mae and Freddie Mac were established with government backing, and by implication, government guarantees. These firms, managed by executives paid on the modern scale (millions to hundreds of millions in 'incentives' and bonuses), were sent forth to make it easier to own a house by making it easier to get a mortgage loan on that house.

This meant that people who couldn't convince bank loan officers that loaning them money would be profitable were able to borrow money because the government guaranteed the repayment. Fannie Mae and Freddie Mac could obtain money at low interest from the Federal Reserve System. Of course the Feds don't have any money — the budget runs a deficit — but it's easy to print some and borrow more by selling Treasury bonds, so Fannie Mae and Freddie Mac were well financed at low interest. Given those loan guarantees to lenders, people who otherwise would not be able to buy a house were enabled to do so. And of course as more people were able to enter the housing market, more bids were made on houses, and housing prices rose. ...

A note here from Pastor Zip, who from 1985-1987 worked for a Savings and Loan in California. We made only Fannie Mae conforming (what Pournelle calls "guaranteed" and, indeed, that was the effect) loans, which became in those years a difficult thing as the prices of homes throughout California (especially LA) were rising well over Fannie Mae limits. In that way we were one of the more conservative S&Ls. But also couldn't be profitable, so Sears abandoned the business at the end of 1987, selling their accounts to other institutions on a largely piecemeal basis. Legal "reforms" of the industry (largely after we'd closed) dramatically raised out-of-date limits, making home loans easier and the industry profitable again. Pournelle describes what happened, but one key he leaves out is that by the mid-1990s "community organizers" were getting really involved. And the market adapted, as it will, to the new rules. Back to Pournelle.

Note that this was not deregulation.

Pastor Zip again, for that sentence simply cannot be repeated enough. Yes, we are hearing stories of greed, the failure of due diligence, etc. Pournelle highlights that in a moment. They have happened. But one of the Big Lies of the last 2-3 decades is that there has been deregulation of industries in the US. Every significant government act of "deregulation" in one area has been accompanied by higher, and more complicated, regulation on that area's flip side. Think of public utilities where, in exchange for deregulating user prices, the supply was even more highly regulated. "Deregulation" has, in every instance, been deliberately designed by legislatures and industry for immediate profits in exchange for long-term failure. In others words, "deregulation" has been anything but. But I digress. Returning to Pournelle...

Note that this was not deregulation. The Community Reinvestment Act of 1977 was amended in 1995 to increase regulatory supervision to guarantee that CRA loans were not confined to high and middle income borrowers, and that more sub-prime loans would be made. For the history of the Act and its modifications see this Wikipedia link or use Google to find your own sources. And the bubble grew and grew.

So far we have a foreseeable crisis in housing and construction, serious enough, but still, nothing that could bring down the whole financial system; but at that point the smartest people in the room got really creative. They realized they had a lot of assets in real estate. As the bubble expanded these assets were valued higher than the mortgages held on them. They were, in a word, really first class securities. Perhaps some of them were a bit shaky — after all, when you loan $500,000 to a $40,000 a year gardener so that he can buy a house with a thousand dollars down and interest only payments, there's a chance he's going to default when it comes time to pay the principal — but many of them were solid as a rock.

What Pournelle describes here didn't happen everywhere, but that was a significant part of the housing market for at least the last 5 years, perhaps a decade or more. The only way most home loans in California (and other large markets) were going to be paid off was by the the home owner selling at an inflated price. How else does one pay off an interest-only payments, or a negatively amortized, home loan? Pournelle continues.

The obvious remedy was to bundle the gardener's loan with a nearly paid off loan by a college professor whose house had appreciated like mad over the years, and sell that package as a "mortgage guaranteed" loan to an investment bank. Now the loan company has even more money to loan out on even more questionable sub-prime deals.

At some point the investment banks began to realize that they'd bought a pig in a poke, and got creative by selling bundled packages of "mortgage guaranteed loans" to retirement funds, other investment banks, and anyone else they could find. After all, a mortgage guaranteed loan was as safe as a Treasury bond, and paid higher interest. Great investment, with no risk.

They sold a lot of those bundled mortgage guaranteed loans; and that is how the entire financial system was endangered. To learn how many bankers were caught by surprise because they didn't look very hard or didn't want to look, see "How Wall Street Lied to Its Computers" by Saul Hansell. Note that some of the lies were deliberately ordered by management who wanted the bubble to continue (and who departed their ruined companies with enormous bonuses). Given incorrect models to work with, the computers continued to forecast profits right up to the crash. For a cartoon summary of the above, see this Sheldon Comics strip.

So: that's where we are. As to what can be done, it may not matter. That is, it's important what we do, but the chance that it will be done sanely and rationally is very small. What will be done must be decided by the most unpopular Administration in nearly a century in connection with the most unpopular Congress in history; and everyone involved in finding a remedy was in one way or another a part of creating the mess. By everyone, I mean everyone: the Administration, the Treasury, the Congress under Carter and Clinton, Congress under Reagan and Bush, Congress controlled by both Democrats and Republicans, the regulatory agencies, and the "experts" now out of jobs who will be hired to manage the new institutions that will be set up to buy bad debts: every one of them. What will be done will be settled by politics, not by economics.

I say this because those who did foresee this disaster tried repeatedly to rein in Freddie Mac and Fannie Mae, but the Fred and Fan lobbyists were easily able to defeat those efforts. Moreover the leaders of Fred and Fan were fired, but left with multi-million dollar bonuses, as did the leaders of various firms ruined in the disaster. The remedies being proposed aren't going to do much more than create a bureaucracy. Once that happens, Pournelle's Iron Law of Bureaucracy will take over, and whatever is required to keep that bureaucracy healthy will be done. One thing is certain: the people who must pay for this debacle will largely be those who took out sensible loans and have kept up their mortgage payments; those who did nothing wrong, but will be handed the bill. Depend on it.

Again, read it all here.