Thursday, September 25, 2008

... With Good Intentions II

In my last post, I focused on the ability of individuals to engage in massive self-deception about the morality of their personal actions. I used Judas as an example, and argued that it was plausible to believe that the root of Judas’ betrayal was not that he turned into some 1st century Darth Vader, but rather that he substituted his personal moral agenda for that of God. In today’s post, I would like to expand that discussion to societal level decisions and look at the current financial crisis.

I am not enthralled with the positions of either of the two major Presidential candidates on this topic. One of them appears completely clueless. The other has a better handle about the causes and potential remedies for the problem, but --- to stretch the Star Wars analogy to its breaking point --- insists upon casting his analysis as some kind of war between the Good Side versus Bad Side, with the implication that all of our present problems are the result of evil people doing evil things. I will let you, the reader, debate which candidate is which, but the one I wish to challenge today is the one who would like us to believe that these problems were entirely cooked up on the Death Star (there I go again).

There is a likelihood that, by the time that the definitive history of this episode is written, instances of actual fraud will be found. There was undoubtedly a culture of mutual reinforcement between what is now the late, lamented Wall Street and the corridors of power in Washington. (Let us not forget that the Old Testament is particular hard on any unholy alliance of injustice from the combination of wealth and political power). However, what I wish to emphasize today is how many people with good intentions were at work in developing this situation over a total of about 30 years. If the story of Judas is how an individual can disconnect between good intentions and actual outcomes, how much worse can this be in a complicated collective process?

At a minimum, the following good intentions help to contribute to disastrous results:

1 ) It is a good thing to want lower income families to be able to live in dignity in a house that they own and in which they can take pride of ownership.

2 ) It is a good thing to shape public policies that might control fraudulent behavior.

3 ) It is a good thing to want to keep the economy out of a recession.

Yet from each of these good intentions came a piece of the witches’ brew that became part of the current financial mess. Let me elaborate:

1 ( home ownership). Loans to buy houses are called mortgages, and banks have traditionally been very cautious about them. “Prime” home mortgages require significant down payments and credit analysis. In the 1970s during the Carter administration, federal regulators began watching banks to insure that they followed equal processes in considering mortgages from low income areas. By the 1990s, the Clinton administration and various community activism groups had shifted the regulatory emphasis to equal outcomes, which could only be accomplished by banks writing mortgages with much smaller down payments and looser credit requirements. To protect themselves from the concentrated risk of these loans, banks sought to re-sell the mortgages in a larger national market. The two “government sponsored” corporations, Fannie Mae and Freddie Mac, were more than willing to act as major players in the resulting massive securitization, with implicit government guarantees, of what we now call the sub-prime mortgage market. I suspect that if you were a politician between 1997 and 2006, and you waived warnings flags about the securitizations of mortgages to people with low down payments and risky credit, you would have been called an opponent of “affordable housing” and “community redevelopment.”

2 (keeping the economy out of a recession). In 2000, part of the U.S. stock market was tanking from the bursting of the “dot com” stock bubble. By late 2000 or early 2001, the U.S. economy had entered a (mild) recession. However, the terrorist attacks of 2001 sent a secondary shock through the U.S. economy, and the recovery from the recession seemed to be stalling. The response of the Federal Reserve System was to engage an aggressive expansionary monetary policy, possibly taking a cue from the lessons of the previous recession. The resulting low interest rates improved the climate for investing. Unfortunately, so many investors seemed stunned by the previous stock bubble that it seemed that just about everyone on the street decided to invest in what they thought was a “safe” asset --- housing. The result was a massive nationwide bubble in housing prices. The problem with this was that if John Doe, paying on a subprime mortgage (see above) lost his job, he could still get out of his house intact because of the hot housing market. Thus the housing bubble was masking the inherent riskiness of securities based upon subprime mortgages. This cut the legs out from any attempt by politicians to reign in the growing “toxic sludge” of securitized subprime mortgages being abetted by Uncle Sam’s own Frankenfirms, Fannie Mae and Freddie Mac.

3 (accounting regulatory reforms) Following the corporate scandals of the 1990s, federal regulators adopted new accounting standards that required certain types of firms to report their assets at market value, not at what the firms believed that the assets would actually return.

So how did this perfect storm of good intentions get us to where we are today? Well, when the Fed finally began to unwind their easy credit conditions, interest rates went up. This began to burst the housing price bubble. As housing price quit rising at their unsustainable levels, the next John Doe who lost his job was not able to get out from under his mortgage. More and more subprime mortgages went into default, which exacerbated the housing price slowdown, which led to more John Does having problems. All of this meant that suddenly sub-prime mortgage backed securities were not performing as advertised, and the prices of these assets began to fall. But as the prices of these securities began to fall, the new federal regulations on market pricing kicked in, and this threatened the balance sheets of many firms (including Fannie and Freddie). In order to raise cash, firms began trying to dump their toxic sludge mortgage securities, meaning that the prices began to fall faster, causing more firms to have balance sheet problems, and so forth. Companies that sold what was in essence “insurance” against such fluctuations got slammed, and their survival was threatened (AIG being the big example). When enough assets, now not just securitized sub prime mortgages but also insurance contracts, corporate debt, and equity, start crashing together, nobody can sell anything because no buyer can come up with enough liquid assets to make a purchase. This is the liquidity crisis panic that has hit the U.S. financial system.

There are plenty of lessons in humility to go around here. I suspect that a lot of people with economics training were mistaken in their analysis of six years or so of data on subprime mortgage securities. Federal accounting regulators didn’t see the broader effects of their new accounting standards. No adult in the United States should be excused from understanding that bad things can happen if you are paying 60 percent of your income in housing costs and your adjustable rate mortgage payment goes up or you lose your job. But, purely in terms of community “good intentions” gone awry, there is probably no better example than those who set the U.S. on a government-sponsored and enforced program of encouraging home mortgages for people with little down payment and shaky credit, all in the name of “community redevelopment” or “affordable housing” or “helping the poor.” This episode should be required reading for every Christian who reflexively argues that “that government” can, without cost or risk, fix every social problem that comes our way.

1 comment:

Paul said...

This article made me think of politics today. Specifically the policies of Barrak Obama.

Good Intentions:

1. Universal Healthcare
2. Increase taxes on wealthy for healthcare and other redistribution programs.
3. Increase Minimum Wage

1. If something comes free or cheap the quality goes down. It takes away incentives for private companies to find new medicines and Drugs. Also other countries with these types of programs do not have enough docters and people often die on waiting lists before they can be treated.

2. Taking money from the people who give people jobs makes absolutely no since. You take away money from employers, you take away jobs.

3. If labor is more expensive, we hire less labor.

All of these are examples of great intentions creating bad policies that hurt the people they were intended to help