Wednesday, September 24, 2008

Reality intrudes upon politics

John McCain will spend the next six weeks or so hearing it said that he has admitted that he does not understand the economy and, while that's not quite what he said, I think it's fair to say that economics is not his strength. He is far more concerned with foreign policy and that is much more important in electing a President.

So is Obama the "economics" candidate? Hardly. Faced with the financial difficulties that came to the fore last week, he blamed the deregulation and encouragemet of greed in the past eight years. Now, I know that W., whatever his faults, did not invent greed so I have been searching these internets and asking my Obamaphilic friends - what deregulation do you have in mind? So far, the best answer I've got is a bipartisan repeal of certain lingering restrictions of the Glass-Steagall Act passed in 1999 and signed into law by Bill Clinton. What I have yet to hear is an explanation of how that law had anything to do with the present state of affairs.

Obama and, to a lesser extent McCain, wants to paint this as a catastrophe visited by the bad guys on the good guys; as a morality play to be resolved by an altar call. I don't think so.

I don't know that I completely understand the cause of this mess, but this is the best I can gather from wht I have read.

Deregulation of interest rates and financial instruments - not in the past eight years or even the past twenty - led to the rise of the subprime market. Lenders had the freedom to price loans to reflect the risk that they were assuming and this lead to a wider availability of credit. People who had not been able to get a mortgage in the past could now do so because lenders were able to price the loan to reflect the increased risk. Things that were unheard of when I last bought a house - no money down and no income verification loans - became common place.

This was not all bad. It allowed many more people to buy homes and the overwhelming majority of them have managed to make their payments.

The process seems to have been fueled by Freddie and Fannie who were willing buyers of these loans,spurred in part by political pressure to make home ownership more widely available.

In recent years, interest rates went incredibly low. Lenders could borrow cheap and lend at least a bit more dearly into the subprime market. Often borrowers were obtained through lower initial rates and originators fudging on their qualifications. Sometimes borrowers were fooled by this and sometimes they knowingly went along. Everyone believed that a growing economy and, most importantly, rising real estate prices would make it all good.

Except that it didn't, too much money flowed into housing inflating values beyond sustainable levels. Interest rates had to ultimately rise. Lenders could not offer refinancing at rates approximating the original ones. Borrowers who were in trouble could not unload their property and many chose to walk away - they had no skin in the game (they had paid nothing down) and did not wish to throw good money after bad.

Because some purchasers of this debt were highly overleveraged, the fact that 10-15% of this subprime paper went south had a devastating impact.

Much of this had nothing to do with government policy. It's far from clear that government superintendence of loan portfolios would have resulted in a better outcome without mandating a conservatism that would have resteicted home ownership. There may be policy improvements (that may include tightening of some and loosening of other regulations) that will help.

But a lot of what we are hearing has nothing to do with it. The crisis has little to do with CEO compensation. Improved disclosure requirements for mortgage loans may be a good idea but are not going to help the present emergency. Permitting bankruptcy judges to modify the terms of subprime loans will only interfere with disposing of securities backed by those loans. Potential purchasers will have a hard time essentially buying a bunch of loans that can be rewritten by the courts.

What does seem clear to me is that the resolution of this does not fit into the narrative of our political campaigns. It's not government vs the private sector. It turns on issues about which most people know little and are probably not very willing to attend to. I'm not sure that I like McCain's suspension of his campaign and postponement of the debate as a political move, but it does convey an important message. This stuff is too serious to become a political football. It must be dealt with in an incredibly short period of time and playing our our normal political games at the intensity with which we play them during presidential elections will probably hurt more than it helps.

8 comments:

Anonymous said...

McCain believes that, for the good of the country, "something" must be done immediately about the credit markets crisis. However, whatever deal is agreed to by Congress and the President will necessarily be unpopular and easy to attack. McCain wants to make sure that the deal that emerges can't be attacked by Obama as the "McCain-Bush Plan," so he's trying to get everybody in DC to sign on (or at least publicly state why they won't support the plan). Obama would rather continue to not take a clear stance, and allow himself leeway to criticize whatever comes out. McCain wants to force Obama to take a stance.

gnarlytrombone said...

What I have yet to hear is an explanation of how that law had anything to do with the present state of affairs

Ok, you seem to be genuinely interested in an answer, so I'll take a stab.

The repeal wasn't so much an unwise policy move as it was reckless in its implementation. The free marketeers didn't think through all the implications, partly because key players like Graham and Rubin had sweetheart payoff gigs awaiting on Wall Street. But it was also because the free marketeers have an abiding belief that the market isn't intelligently designed; it just magically evolves and self-organizes.

The repeal effectively eliminated the investment banking industry in an instant, because it unleashed the big commercial banks into the defenseless indy brokerages' theretofore protected pen. The latter's fate was sealed; it just took eight years for them to suffer a slow and painful death.

The brokerages' immediate response was of course panic. Their new, uber-capitalized competitors could grab their traditional bread and butter by dangling sweet loans in front of customers to get equity offerings and public debt financials, etc. etc. (the banks had "promised" Congress they wouldn't do this; that lasted about 10 seconds).

The brokerages' mistakes were twofold, and both had big consequences for the market. First, they believed they could compete with the banks' size using their wits (and outsized egos), inventing complex derivatives out of whole cloth. That in turn made the market unfathomably more complex and, more importantly, more opaque.

They also began to dabble in the banks' traditional territory. They were babes in the woods, yet they soon went nuts...private equity, investing in ginormous California real estate developments, on and on. And, being undercapitalized compared to their bank competitors, they went into hock. Deeply. Lehman, for example, increased its leverage from 28-to-1 in 2003 to 45-to-1 in 2008.

All this was viewed as "innovation," not "desperation," so the gubmint stayed out of the way, letting everyone make the rules up as they went along. At least as long as everyone was making money.

When the music stopped, the complex and opaque tangle of "innovation" prevented anyone from quickly determining why and making necessary adjustments. And the once nimble, liquid brokerages that 10 years ago were able to weather bear markets were now up to their eyeballs in debt.

Again, Gramm-Leach-Bliley was not a horrible idea on its face; financial conglomeration in Europe has been relatively successful, especially when it comes to efficiency/cost (but it also has its tradeoffs). It was also a recognition and formalization of many changes that had taken place anyway (thanks to stupid exceptions granted by Congress in exchange for cash).

BUt GrahamRubin's recklessness translated into recklessness in the market. Conglomeration takes a lot of time - and regulation - to get right.

gus said...

Anonymous, in case you haven't noticed, Democrats control Congress and the Senate. NO BILL gets brought up nor voted upon without the approval of Harry Reid or Nancy Pelosi.
Clearly and without any doubt, the LEFT created this financial problem. Pelosi and Reid would be subpeona-ing the heads of Fannie and Freddie demanding explanations and demanding jail terms if the Democrat party wasn't fully responsible for this.
Greed didn't cause the collapse here. Bad loans and liberal demands/social engineering caused this. People who shouldn't have gotten loans DID GET LOANS because Carter, Clinton and Democrats in Congress created laws to require it.
The usual libtards here will spin and spin and spin, but that won't change the truth.
Liberalism is a disease.

Anonymous said...

Gus -- My post merely attempts to explain why McCain is suspending his campaign/etc. to try to address the crisis. It is not at odds with the fact that Dems control Congress, or even with your opinion regarding who caused the mess, much of which I agree with. Anon 9:46.

Anonymous said...

Gus. . .in case YOU haven't noticed, the Republicans have been in the White House the last 8 freakin' years and controlled Congress for the last 6 of those years. Yeah, Gus, go ahead and blame the Democrats. While you're at it, why don't you blame Clinton, Carter, et al.

Jay Bullock said...

John McCain will spend the next six weeks or so hearing it said that he has admitted that he does not understand the economy and, while that's not quite what he said ...

In the interest of fairness, this is what he did say:
“The issue of economics is not something I’ve understood as well as I should,” he said. But, “I’ve got Greenspan’s book."

I won't quite say you're splitting hairs, but it seems like you're taking hairs and making two equal parts out of them.

gnarlytrombone said...

Heh.

Clinton said the commercial banks were an important moderating force on the risk-taking of the big investment firms that collapsed this week.

Anonymous said...

You're not looking very hard if you can't find good info on Glass-Stegall's connection to the current securitization crisis. The connection--and prediction--has been made by many for years. Sen. Dorgan is one source--good speech from him today:

http://www.nytimes.com/2008/09/28/magazine/28wwln-reconsider.html?_r=1&ref=business&oref=slogin

Much detail:

http://tinyurl.com/46eape

http://tinyurl.com/4px282