October 06, 2008

Stupid, Sebastian. Very Stupid.

Those who comprise the pseudo-intellectual backbone of the right are mounting a stirring, if misguided and thoroughly wrong, defense of deregulation. First up today, Sebastian Mallaby in the WaPo which is apparently trying to compete more vigorously with the WaTimes.

If that doesn't convince you that deregulation is the wrong scapegoat, consider this: The appetite for toxic mortgages was fueled by Fannie Mae and Freddie Mac, the super-regulated housing finance companies. Calomiris calculates that Fannie and Freddie bought more than a third of the $3 trillion in junk mortgages created during the bubble and that they did so because heavy government oversight obliged them to push money toward marginal home purchasers. There's a vigorous argument about whether Calomiris's number is too high. But everyone concedes that Fannie and Freddie poured fuel on the fire to the tune of hundreds of billions of dollars.

OK, first off it's clear that Mallaby is completely ignorant of this. This WAS an absolute failure of deregulation at all levels. Mallaby wishes to cast the final blame on cheap money from the Chinese (their recycled trade profits) and the investors all over the world with an appetite (Mallaby stupidly assumes) for risky sub-prime credits. First off, money is money and whether it's cheap or expensive, prudent underwriting standards are a constant. The rules don't really change. You can't justify, ever, giving someone a loan with a balance more than 20 times their annual salary. Needless to say, you can blame China all you want but it's still a decision that someone IN THE UNITED STATES made to make these loans.

Second, Mallaby's ignorance of structured finance and the sales plans for these securities really should disqualify him from writing on this topic. Of course, the WaPo doesn't know any better so they'll let any idiot fill their pages with pap. As long as they work for the Competitive Enterprise Institute, the AEI or (in Mallaby's case) the CFR. But I digress... Back to blaming the buyer. The reality is that these investors DO deserve some of the blame. These are folks who manage billions in assets and frankly should have been a little more concerned with the tranching, the credit classes (and homogeneity) in those tranches and the overall credit profile. They should have been concerned about the credit enhancements... why WERE they needed? Who was the counterparty on those insurance policies? What was their reserve? In their defense, some managers DID dig into these questions. They received assurances that the pools in the CDO were perfectly constructed, the enhancements (credit default swaps) were solid which brought the credit rating (according to the ratings agencies) up to A and the counterparties on the CDS were all well rated. None of that was a lie... well, not exactly, The consistency in the pool was at issue, as was the historic risk on low documentation loans (not to mention those which added to that layer of risk with a high loan to value ratio and relatively low FICO scores). However, even some of the issuers didn't understand the risks they had ultimate underwriting responsibility for at the pool level. That aside, these investors were paying A paper prices on C credits. When these credits began to perform like C credits, THEN they started asking questions which caused the systemic breakdown because the answers weren't what they were expecting.

Not to mention the fact that the enhancements became effectively worthless as issuers folded up shop.

As a side note, Mallaby should maybe take a look at this. While the NYT did a pretty piss poor job on the story, it's still pretty clear that the decisions made by FNMA and FHLMC weren't forced by regulation. They weren't even coerced, despite the tilt of the reporter. In reality, Fannie (in this case) was trying to compete with aggressive investment and commercial banks who were offering extremely risky loans. In other words, this was a failure of the leadership who made the decision to chase the market rather than stay the rational course.

The interesting thing is the argument that these 'toxic mortgages' , or at least the ones clogging balance sheets, are always made to poor and minority borrowers. Which isn't true... Alt A (which comprises the vast majority of these 'toxic mortgages') wasn't much for low income or risky credit profiles. And of course, Mallaby (much like the NYT) makes no mention of the fact that the majority of these loans, the overwhelming majority, are still performing. Which means this is all more a panic than an actual financial avalanche. It's obvious why Mallaby doesn't want to talk about the failure of the market because it acknowledges Mr. Market's #1 flaw... it's made up of PEOPLE. Irrational, sometimes stupid, people.

Finally, all this talk on both sides ignores one simple fact... if tax policy had been different, restructured to really promote wage growth and low inflation (you can have both), this probably wouldn't have happened. This was a case of the mortgage industry trying to find ways to make loans to a populace that really couldn't afford them anymore. Sure, eventually something would have stopped up the system and at some point we'd have had a day of reckoning. However, it would have been a lot easier. If you really want to tack this disaster on an economic theory or concept, supply-side economics is a pretty great scapegoat because of it's unerring ability to concentrate wealth at the top.

Posted by mcblogger at October 6, 2008 09:59 AM

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