A glib dilettante explains the credit crisis, part 2

(Continued from A glib dilettante explains the credit crisis, part 1)

Then the Gods of the Market tumbled, and their smooth-tongued wizards withdrew,
And the hearts of the meanest were humbled and began to believe it was true
That All is not God that Glitters, and Two and Two make Four-
And the Gods of the Copybook Headings limped up to explain it once more.
— Rudyard Kipling, “The Gods of the Copybook Headings”

The core fuckup in the credit crisis is that a whole bunch of credit, valued very highly, is really, really bad.  In the next post, I’ll rant about how that bad credit got itself everywhere, but for now let’s see if we can’t figure out just why the blue-veined blazing fuck banks would issue subprime mortgages in the first place.

Let’s start by defining terms.  A subprime mortgage is a mortgage sold to someone who’s a bad credit risk.  Because subprime mortgages are by definition more likely to fall through than regular mortgages, banks generally charge higher interest rates on subprime mortgages to compensate for the increased risk.  In aggregate, they expect to earn enough interest on the good subprime mortgages to compensate for the money they lose on the bad mortgages.

Those of you with a bit of mathematical intuition will recognize a problem.  The riskier the loans a bank’s willing to give, the more people will default; the more people default, the higher interest rates have to be to compensate.  If interest rates get too high, banks won’t get enough customers to justify making the loans in the first place.  So if that’s the case, how the hell did we end up with such bare-faced idiocy as NINJA* loans?

FDR gets government into the mortgage business

One place to start is with everyone’s second-favourite President who was really a raging asshole: Franklin Delano Roosevelt.  The economic thinking behind the New Deal was that if the government magics enough money into existence and dumps it on the market, it can make the Depression go away.  The populist rhetoric behind the New Deal was that fat-cat business magnates were taking cruel advantage of the disenfranchised People.  Stop me if this sounds familiar.

Put those things together and you end up with the Federal National Mortgage Association, also known as Fannie Mae.  Fannie Mae was a government sponsored enterprise; roughly the American equivalent of a Crown corporation**.  Its mandate was to make it easier for the unfairly exploited families of the working class to live the American dream and own a house.  It did this essentially by buying mortgages from banks, guaranteeing the interest and principal, and reselling them as investments (mortgage-backed securities, upon which more in part 3).

If you’re a bank, you can sell a mortgage to someone with bad credit, then sell that debt to Fannie Mae in return for what passes for cash money in the banking world.  Sounds like a great way to make a quick buck, right?  You get a nice shot of liquidity, and Fannie Mae assumes the risk.  It’s a pretty good incentive (there’s that word again: pay attention) for banks to offer mortgages to bad credit risks.

The problem with Fannie Mae isn’t necessarily that it opened the floodgates to shitty mortgages: sure, it contributed, but more importantly it introduced the notion that bad debt could be repackaged as an investment opportunity.  (This is the sort of thing that Ron Paul’s talking about when he brings up “moral hazard“.)  Because Fannie Mae had a government mandate to subvert the usual credit market, it ended up with a bunch of rather dubious loans — but it was at least implicitly backed by the federal government, so it was seen as a good investment.  (And now it’s backed explicitly by the feds.)

Fannie Mae may have been the eight-hundred-pound gorilla of the dubious mortgage market, but that’s not to say that it didn’t have any competition.  Competition is one of those things that’s supposed to make free markets work: if I’m spending a lot of my bank’s capital backing idiotic mortgages, and you’re not, then eventually either I’ll catch on that you’re making money while I’m racking up debt or you’ll end up buying me out.***  People run their businesses differently; the successful ideas eat the bad ones for lunch.

Carter, the CRA, and government-mandated risk tolerance

Then you get people like Jimmy Carter, who look at the notion that banks have different thresholds for risk — some of which involve dealing only with wealthy people, who are perceived to be better able to pay off their mortgages — and decide that it’s just not fair.  Carter signed the Community Reinvestment Act into law, which was designed to prevent those evil fat-cat bankers from discriminating against the downtrodden.  (As with Fannie Mae, it’s a noble goal.)  Essentially, when a bank applies for deposit facilities, the FDIC vets the bank’s lending practices for “fairness”.

So if you own a bank, and you want to play in the market, the federal government insists that you make a certain amount of credit available to people who really have no business getting accepted for a loan or a mortgage.

Bush and Clinton turn the CRA into a monster

To be fair, this isn’t entirely Carter’s fault.  In 1989, Bush 41 increased “public oversight” of banks’ CRA ratings, which was supposed to make the banks more “accountable” in the wake of the Savings and Loan crisis (remember that?) but also handed plenty of power to lobbyists of all stripes to control banks’ lending habits.

Before I pillory Clinton, let’s have a look at what Bush 41 did.  Generally speaking, the only reason we’d ever trust those evil fat-cat bankers to make sensible loans rather than, say, what they did instead is because they’re somehow accountable for the success of their banks.  Make too many bad loans, and you lose money — and you lose your job, or your bonus, or your stock options.  That’s a perfectly rational incentive for bankers to make sensible loans.  It’s also perfectly absent in anyone who isn’t employed by the bank — like the people empowered by Bush 41’s revisions to the CRA.  Those lobbyists lose nothing if they coerce a bank into making bad loans.

And just a few years later, everyone’s favourite frat-boy President — Bill Clinton — cranked the credit-for-everyone dial on the CRA up to eleven, raising requirements and increasing enforcement.  According to the Wikipedia page linked above, “[t]he number of CRA mortgage loans increased by 39 percent between 1993 and 1998.”

So in part, the banks were giving out ridiculous mortgages because the federal government forced them to do so, all in the name of simple-minded populism.

Simple-minded populism, however, tends to be well-meant.  In this case, it was intended to make it easier for lower- and middle-class families to buy homes, even if (presumably through no fault of their own) they didn’t have good credit or weren’t able to scrounge up a 10% down payment.  Fannie Mae, the CRA, and a bunch of other chunks of legislation I haven’t mentioned surely helped them out.  If that’s all they did, one might be able to make a wild argument that it was worth it.  But as usual, when government tries to “fix” the economy to “help” the poor, it leaves the door wide open for people with the right resources to exploit the “fix”.

How government populism created the housing bubble

Real estate is usually seen as a good investment.  I’ve had dozens of people tell me that “real estate only goes up”, and I’m nearly overcome with schadenfreude at the thought of what’s happening to them now.  The theory is that since population (read: demand) keeps rising, but you can’t make new land (thus, supply stays constant), the price of any land you buy should eventually go way, way up.  It’s exactly the sort of compelling jackassery that leads otherwise sensible people to do really stupid things, and if you buy into the theory it’s a pretty good incentive for buying houses as investments rather than living quarters.

If you could afford to buy a second (or third, or eighth, or…) house in order to make a quick buck, here’s how you could proceed:

  1. Buy a house, preferably one that seems to be undervalued with respect to its neighbours
  2. Re-tile the bathroom, paint the kitchen, and generally kick in as few easy renovations as you can
  3. Sell (“flip”) the house for more than the cost of buying and renovating it
  4. Repeat until filthy rich

The careful reader will notice a positive feedback loop between steps 1. and 3.  If you buy a house and raise its value relative to its neighbours, then other houses nearby will drop in relative value… making those other houses more attractive to house flippers.  That reader will also notice that steps 3. and 4. depend upon a seller’s market: they only work if there’s an uninterrupted supply of people ready to buy your renovated houses.  (The same reader will already have guessed how house-flippers managed to get all the credit they needed to buy half a dozen or more new houses when they haven’t paid off their own mortgages.)

Thus was born the housing bubble.

This was just another market operating as markets do: a huge supply of anything-goes credit drove up demand for the same, and the focus on mortgage credit (along with some dubious folk wisdom about real estate investments) whipped up the housing market.  Banks responded to incentives: the possibility of turning mortgage debt into securities or even selling those mortgages wholesale to Fannie Mae made them perfectly happy to grant mortgages, and the threat of the CRA encouraged them to grant bad mortgages as well as good ones.  The house-flippers saw a huge demand for property and a huge supply of credit, and seized the opportunity to make a quick buck.

Well-meant but heavy-handed programmes and regulations from populist governments provided a twisted set of incentives, which the market’s players cheerfully obeyed.

There’s more to it than that, though, as there usually is.  As we’ll see in the next post, there were enough ways for banks to turn mortgages into profit that just about every mortgage lending standard slipped, for “prime” loans as well as subprime.  This of course had little to do with the originally-intended beneficiaries (who, pretty much by construction, didn’t qualify for prime loans), but worked out just fine for real-estate speculators.  Until the bubble burst, that is.

This is another positive feedback loop.  The more cheap credit is available, the more speculators will be able to use in order to buy and then sell houses.  As demand for cheap credit increases, banks are able to issue more of it at the same cost, and the longer this goes on the more “evidence” there is that mortgage-backed securities are solid investments.  (More on that later.)  These incentives (Fannie Mae, CRA-based lending standards, and the secondary mortgage market) may have been designed and intended to help struggling families buy into the American Dream, but they ended up helping speculators and investment bankers a hell of a lot more — and in the process gave the global financial system the credit equivalent of HIV.

(Continued in A glib dilettante explains the credit crisis, part 3)


* No Income, No Job or Assets — basically, no reason to assume the borrower could pay the mortgage.  Sound stupid?  You betcha.

** If little warning bells are going off in your head over possible conflicts of interest and a nearly total subversion of market competition, give yourself a gold star.

*** Except, of course, that I can turn my mortgages into investments and sell them for more money before the mortgages go bad.  But that’s a story for the next post.

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