Subprime crisis : the overall picture

In many aspects, the current financial meltdown that brought many banks and insurers to insolvency may be compared to the nuclear meltdown that affected the Chernobyl power plant. And whatever Big Government pundits may tell us endlessly - without real in-depth arguments - inappropriate state intrusions in the economy are as much responsible for the financial crisis as poor state management of nuclear facilities by USSR was for the Chernobyl disaster.

If the mechanisms of the so-called “Chinese syndrome” can be described as a process of ignition, amplification, and then propagation of atomic reactions, likewise, the current crisis is a story of state interventions in the economy, that ignited, amplified, and then propagated the meltdown from its original core to the whole financial system.

Ignition

The main factor that ignited the current crisis is how politicians forced two state regulated enterprises, Fanny Mae and Freddie Mac , to refinance a growing part of unsecured loans to low and very low income families. In exchange, Fannie and Freddie were exempted from some accounting requirements generally expected from ordinary firms, allowing them to leverage too much credit compared to their equity, by an extensive use of off balance “special purpose vehicles.” All these operations were made under an implicit taxpayer provided safety net, as the statutory rules of the department of Housing and Urban Development made possible the nationalization of Fannie and Freddie in the case of bankruptcy.

These government provisions, coupled with a law mandating banks to find ways to originate loans to some high risk-profiled borrowers (the much discussed and controversial Community Reinvestment Act), reversed the usual prudential rules governing company CEOs: first, don’t fail, and then, make a profit. Due to their government backing, Fannie and Freddie only had to expand their volume of business, without too much consideration of the underlying risks. The purchase of so many bad loans by two state-backed giants encouraged reckless lending by banks and mortgage brokers to many risk-unaware families.

This behavior was greatly helped by Alan Greenspan’s decisions to lower and maintain very low interest rates in the early 2000s without consideration of the obvious asset bubble that was emerging in the housing sector. When credit is too cheap, borrowers tend to be less careful in their investments.

Amplification

But these facts do not explain by themselves how big the housing bubble has become. The average Joe, in the mortgage broker’s office, was not as unsophisticated as generally described. He could lose his common sense and succumb to easy credit only because the brokers could show him impressive Case-Schiller index curves, which seemed to show that any housing investment could gain more and more value every year, making the purchaser richer even while he was sleeping. Without this apparent housing inflation, many people wouldn’t have jumped so recklessly onto the easy credit bandwagon.

But this housing inflation did not occur everywhere in the country. Some of the most dynamic metro areas, in terms of population growth, haven’t experienced any housing bubble. Recent Nobel Prize Paul Krugman, supported by several research papers, notably from academics like Ed Glaeser or Wendell Cox, explained it by land use regulations : when these regulations are flexible and tend to be respectful of the property rights of the land owner, housing bubbles cannot even get started. But when regulations allow the existing real estate owners to prevent farmland holders to build the houses required to satisfy all housing needs, housing prices start skyrocketing.

Housing mortgage debt owed by families grew from 4.8 to 10.5 trillion USD (in french) from early 2000 to late 2007. But had every city in the USA had the same flexible land use regulations that they had in the fifties, and that still exist in fast growing areas like Houston or Atlanta, this exposure to risk would have been much lower, by 3 to 4 trillion. More borrowers would have qualified for the prime credit market and its less risky loans, since the lower price of the purchased homes would have resulted in better credit ratings. So, despite the bad lending practices mentioned above, the risk of a general collapse of the credit market would have been nearly equal to zero.

Propagation

At this point, we just explained the roots of a mortgage crisis. What is still missing is the way it has spread throughout the financial system. Once again, bad laws are to blame.

First, this crisis shows how risky the bank’s business model, grounded on low equity and very high leveraging ratios, has become unsound in these time of high volatility of some assets. Some will blame banks for this, but you should be aware that before the creation of the FED in 1913, most banks’ business models were based on equity levels over 60%: the shift from a high equity to a low equity model comes first from tax policies which have, in nearly every country of the world, severely taxed capital gains, but encouraged debt by deducting the interest payment from the corporate tax base. The second reason is that central banks, as “last recourse lenders,” usually with a state’s warranty, have themselves favored this shift to a highly leveraged model: borrowing money was de facto a cheaper resource than raising capital to finance operations.

But of course, this doesn’t explain how a 10% default risk on a credit niche market (the subprimes), totaling less than 10% of the total housing debt (12 trillion at the end of 2007), itself less than one fifth of the total assets being exchanged on American financial markets, generated such turmoil.

The culprits must be sought within a set of rules --- whose latest version is known as “Basel II” --- and their declinations in local laws in most countries, aimed at regulating the activities of banks or insurance companies. In some cases, poorly designed accounting rules may have contributed, too.

Basel II rules — and the like — mandate banks and insurers to hold a diversified portfolio of assets aimed at providing them the liquidities they need to face hard times: for a bank, a major loss of customers; for insurers, a series of major disasters. These rules were supposed to “protect” investors from reckless diversification policies. So institutional investors were mandated to own only high quality bonds, or to value some kinds of assets, like stocks, with a weighting that de facto prevented their securities from handling such assets directly.

But banks and insurers needed the yields of “lower quality” bonds, or even stocks, to remain attractive to private investors. Otherwise they wouldn’t have been able to beat the performance of state labeled bonds, and thus wouldn’t bring any added value to their customers, forcing them out of the market.

So the late 80’s and the 90’s saw the onset of a huge market of “derivatives,” all based on the following principle: lower quality assets (like subprime based securities bonds) are put together in another security, which itself sells new bonds sliced into several “tranches.” The first slice, the “z-tranch,” is a very risky one, which is aimed at bringing a higher yield to unregulated investors as hedge funds but must absorb primarily the first percentages of any losses of the security. Other tranches bear a lower risk but serve a lower yield. The “cushion effect” of the high risk tranch allows the lower tranch bonds to receive an AAA rating from rating agencies, particularly if they are covered against credit default by a special derivative called a “credit default swap,” allowing lender and borrowers to reinsure themselves against defaults on their bonds. And there can be other “derivatives of derivatives” involved in these designs. In many cases, institutions issuing AAA tranches guaranteed the payment of the corresponding bonds.

So the current situation is that many institutional investors do not hold many real stocks or bonds in their portfolios. They mostly hold a majority of derivatives.

But all this incredibly complex financial engineering not only is extremely costly, but has one perverse effect: while reducing the probability of AAA tranches to default, it actually makes the amount of the risk higher in the event that losses are high enough to impact the AAA tranches. And all these complex designs of derivatives make it increasingly difficult to understand where the risks are located in complex securities mixing prime mortgages, subprime mortgages, and other kinds of credits. So when an AAA tranch is impacted by higher than forecast losses, nobody really knows what is the resulting worth of the best tranch if it has to be sold. Is it 95% of the nominal? 60%? Nobody seems able to value these bonds reliably.

So when the mortgage debtors began to be insolvent in a higher proportion than usual, the losses on subprimes derivatives began to exceed the “cushion” effect of Z-tranches. AAA bonds were impacted. Some holders of these bonds, forced to sell off in panic in order to get cash, couldn’t find purchasers, except some highly speculative funds that toughly negotiated the price.

But then, because of inflexible accounting laws, all institutions holding the same kind of toxic assets had to write down the values of these assets in their balance sheets, even if their treasury level didn’t force them to proceed to a fire sale of these assets. So they might have been declared virtually insolvent even if actually they were not. This affected their ability to borrow on short term liquidities markets, and thus led some of them ultimately to file for bankruptcy.

If no regulatory limitations had been placed on the assets that banks and insurers could hold, it is likely that they would not have found the use of exotic derivatives so attractive, and that early difficulties in subprime credits would have resulted in clear signals prompting securities managers to recompose their portfolios. Some investors’ failures could have occurred earlier, but would not have reached such proportions.

Big Government is the culprit

So, at the root of every mechanism identified as a catalyst of the current crisis, we can find a bad federal or local regulation.

Does this mean that private institutions have no moral and technical responsibility in the current mess? Certainly not. They’ve deliberately chosen to take advantage of these poisonous regulations instead of fighting them, even though some of the underlying risks were clearly identified. Many of them ifnored warnings issued by economists like Nouriel Roubini, or atypical politicians like Ron Paul, and preferred to listen to reassuring assessments of the soundness of the system written by star economists like Joseph Stiglitz. People don’t like dream breakers.

Competition to overturn bad regulations doesn’t exonerate financial private institutions from having failed to do so properly. Whatever conditions are created by the states, firms must act wisely. Many of them obviously did not. But in the ranking of responsibilities, states’ inaccurate and inordinate regulations obviously rank highest. Had its diverse regulations and interventions focused on principles (honesty in contracts, no concealment of malpractice, full disclosure of operations, respect of property rights) and court litigation; had they let private individuals or enterprises decide what was good for them without trying to curb their behaviors in particular directions, none of the elements that allowed this crisis would have been in place.

Government’s economic interventions in human interactions once again have proved counterproductive and finally wrought havoc. This should make people very careful about government claims that new interventions are necessary to solve the crisis and avoid the next one!

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Vincent BENARD is the president of the "Institut hayek", a French speaking think tank based in France and Belgium - http://www.fahayek.org/ . French-savvy readers who enjoyed this article might be interessed in my 16 other articles (and counting) dealing with the subprime crisis; some of them also having been published by the Institut Hayek.

Thanks to Don Hank for the language corrections brought to my initial draft.----

Making the worst of it

Kevin Libin, National Post
Published: Saturday, February 07, 2009


By the time President Franklin Delano Roosevelt addressed his nation in his first radio fireside chat one March evening in 1933, America's banking system was on the brink of collapse. A fifth of the country's financial institutions were out of business. Citizens, nervous about losing their savings, had started a run on the remaining banks' cash, preferring the safety of mattresses. Roosevelt, having ordered the banks closed, spoke to a rattled and frightened nation. There was, to be blunt, not much stirring in his words.

He explained the basics of how banks worked, why they needed cash deposits, why most remained sturdy and the plan to gradually reopen them. He concluded: "You people must have faith; you must not be stampeded by rumours or guesses. Let us unite in banishing fear. We have provided the machinery to restore our financial system, and it is up to you to support and make it work," he said. "Together, we cannot fail." When the first banks began to reopen the following day, thousands of clients were lined up outside, ready to redeposit their money. America was soothed.

We are told now, repeatedly, that we are in the teeth of the "worst" financial crisis since that time of Great Depression. And while the public understands vastly more about the financial system and its cycles, today's leaders -- egged on by around-the-clock media eager for high drama, buoyed by a society with a self-absorbed nature that seems to erase any context of longer-term troubles --have traded Roosevelt's cool reassurances and we'll-weather-this-too approach for dark forecasts of worst-case scenarios and panicky appeals. U. S. President Barack Obama warned this week that the U. S. economy could become a "catastrophe for families and businesses across the country."

He recently described this as "a crisis unlike any we have seen in our lifetime." Last week, our own Conservative government's Throne Speech insisted we are in "a time of unprecedented economic uncertainty." British Prime Minister Gordon Brown this week said the world was in a "depression" and days earlier, his treasury financial secretary warned that the U. K. could suffer worse than it did during even the war years, "facing some of the harshest economic conditions for decades, perhaps for a century."

If you're not hysterical yet, you must not be paying attention: Political leaders have clearly made it their task to convince you this is the absolute worst of economic times. So much so, that they have all taken to revising history and exaggerating today's troubles. The mystery is: why?
Because, these times are not "unprecedented." This is not unlike anything we've seen. Serious economists do not call this a "depression," or predict a return to bread lines, work camps and street urchins peddling apples on the streets. There will be no rationing, as there was in wartime London.

"That's bulls--t," says Chris Thornberg, a principal at Beacon Economics in California, one of the first economists to foresee America's housing meltdown in early 2007. "All the numbers we see right now are in line with what you would call a normal, bad recession. The increase in unemployment, the drop in payroll employment: this all looks like 1975. It looks like 1982. Not the Great Depression."

This is a hard time for many families, certainly. But outside, things look familiar: We wait in line at Starbucks; this past Christmas the average American shopper spent US$120 just on themselves. Wall Street managed to dole out US$18.4-billion in bonuses, despite 2008's annus horribilis. American economist Paul Krugman was left telling NBC's Hardball recently that "you've got luxury cars landing at the dock in Los Angeles and then just sitting there because no one could buy [them] ... this is functionally a lot like the Great Depression." Because Lexus sales are down.

Today's younger generations had been led to believe, in the face of an impending labour shortage and employers' clamouring for Web-savvy Facebook virtuosos, that the economy was their oyster offering so many rewarding, comfortable jobs up like pearls, suggests Lianne George, co-author of the recently released Ego- Boom: Why the World Really Does Revolve Around You.
"Well-intentioned attempts to make this generation feel good about itself have, in fact, left them poorly prepared to weather a tough economic storm," Ms. George recently wrote in Maclean's.
When even Google -- epitome of the last decade's blissful, dry-cleaning serviced workplace revolution -- began laying off, as it did in November, many younger workers' worlds surely quaked.

The tendency to frame this in historic terms must be a tempting one for anyone feeling betrayed by the sudden reappearance of long forgotten hardships. With seniors, their retirement funds ravaged, promising to hang on to their desk jobs many years longer than planned, and many starter homes purchased in the last few years worth less than their purchase price, this can only seem like a dustbowl to those accustomed to nothing but bumper crops.

We feel poorer, particularly in the U. S., because our largest asset -- our home -- has lost value. But unemployment rates today are lower than they were in recessions in the '70s and '80s. Projected to peak in the United States somewhere shy of 9%, jobless rates won't match the nearly 11% reached in 1981-82, let alone the peak of 25% during the Depression. Even after yesterday's ugly job loss numbers --129,000 layoffs in January -- Canada's 7.25% unemployment rate still hovers below the average rate over most of the past 30 years. And Dale Orr, managing director in Toronto at Global Insight, says that 2009 in Canada will still be mostly better than 1991. The International Monetary Fund expects U. S. GDP to shrink 0.7% this year; during the Depression, the U. S. economy was cut by a third.

"We don't have enough rhetoric of faith, the rhetoric of confidence," says Amos Kiewe, a professor specializing in presidential rhetoric at Syracuse University. "I wish they would induce more confidence."

There may be a number of reasons for the hyperbole. The most evident is the recent and current environment of heightened political partisanship. The full weight of the recession crashed over North America at a time of concurrent election campaigns in Canada and the United States, ensuring the economy would be the top issue. Politicians who seemed too serene-- recall John McCain's maligned "the fundamentals of our economy are strong" -- were torched by rival spin-doctors. As the Democrats noticed worsening economic news correlating to larger gains in support, the Obama team had motive to paint a worrisome picture.

"The fact that it was an election year forced Obama to be more negative," says John Huizinga, an economics professor at the University of Chicago.

The Democratic candidate even resorted to citing statistics that don't exist: Last summer, he said the "percentage of homes in foreclosure and late mortgage payments is the highest since the Great Depression."

Actually, there exist no foreclosure data that far back. No wonder that by December, a CNN poll showed six in 10 Americans convinced a depression was nigh.

Of course, we have never before had the influence of that 24-hour all-news network, and a parade of other channels and Web sites, to help us worry as we have this time, since the last major U. S. recession happened before the First Gulf War, and the birth of the "CNN Effect."

These are outlets hungry for high drama to fill their hours, notes Greg Elmer, a media studies professor at Ryerson University in Toronto, and are often moved to continually ask, 'how bad will it get?' as a way of keeping the story moving. It doesn't help that any journalist younger than 40 has never seen anything like this before, and may be willing to believe, therefore, that it resembles the Great Depression.

"I think it's a trope, it's a way to talk about any downturn in the economy," says Mr. Elmer. While the cynical say it's a way to sell more papers, more likely, he says, it's comparable to the habit of sticking the suffix "gate" on any government transgression, as though a rumoured sex-scandal like Troopergate was anything as serious as the felonious Watergate. Still, Alison Milward, a marketing manager at Business News Network says audience numbers have shown a "significant increase" as the economic news has soured.

That Mr. Obama hasn't let up is probably partly due to the fact that he has been battling Congress over the stimulus bill. The more urgent the situation seems, suggests Mr. Kiewe, the more pressure he can put on rivals to play ball. "If we don't pass this thing, it's Armageddon," hyperventilated one Democrat this week. Yet, careful observers note that the bulk of initiatives within the latest bundle of emergency measures won't create jobs --at least not anytime soon -- and that hundreds of billions are earmarked for expanding the federal government. That might suggest that the Obama administration sees advantage in exaggerating its urgency in order to smuggle through a number of otherwise unpopular policies. "You never want a crisis to go to waste," Mr. Obama's chief of staff, Rahm Emanuel said in November. "It's an opportunity to do things you couldn't do before."

The starkest transformation has come from our own Prime Minister who in October of last year was lambasted by opposition leaders, in the thick of a campaign, for offering optimism about the economy, telling the CBC's Peter Mansbridge that there was "probably some great buying opportunities emerging in the stock market as a consequence of all this panic." In fact, in that same month, U. S. investing sage Warren Buffett had said the very same thing. But Mr. Mansbridge was incredulous: "Do you really want to say that?" he checked.

Within two months, with the opposition threatening to topple his government, claiming the Prime Minister was insufficiently alarmed over the economy, and forced to justify the first impending federal deficit in over a decade, Mr. Harper was using the word "depression," adding "I've never seen such uncertainty.... I'm very worried about the Canadian economy."

Ever since Bill Clinton reached out to unemployed Americans in the 1992 election campaign, riding his "I feel your pain" empathy to the White House, politicians have been less focused on unflappable leadership and more anxious about seeming out-of-touch not only with the concerns of voters, but their feelings. "Instead of telling them what you think they need to hear, you tell them what they want to hear," says Mr. Kiewe.

Determined to out-empathize their political opponents, political leaders may have trapped themselves in a rhetorical cycle of Depressiongrade doom. That worries Mr. Kiewe: too much panic in the ranks could aggravate things, as businesses hesitate to invest and consumers get too scared to spend. Today's political leaders may find that, unlike Roosevelt's comforting words, the more they prophesize the economic end-of-days, the more likely they are to come true.