They’re back!
The usual crowd of ne’er-do-wells are seeking to divert attention from their own roles in the crisis, and shift blame elsewhere. These people make up a big chunk of the Its All Fannie’s Fault! crew. By muddying the waters, they hope to avoid retribution for their own roles in what occurred. As the mid-term election approaches, we should expect to hear more from this crowd.
The reality of crisis causation is far more complex and nuanced. Looking at the many factors that independently contributed to the collapse, and prioritizing them by degree of causation is not easy. A sophisticated approach is required to separate the prime and secondary factors.
Rather, than just repeat my list of factors what were the causal factors, today I want to try a different approach. Let’s do a “Causation Analysis” of the biggest factors to see if we can determine not just the various elements that contributed to the credit collapse, but which factors actually caused it to occur and what merely exacerbated the collapse, making it worse.
Understand that this is a theoretical discussion based on counter-factuals — what is likely to have occurred if various elements leading up to the crisis were different. We are trying to discern the differences between primary and secondary factors, separating the causes from the exacerbators.
Whenever someone asserts as a cause an event or force relative to a particular outcome, you should always ask: “Is this a “BUT FOR cause of that outcome?” In terms of a specific result or outcome, “But for” this factor, how would the outcome have changed? Would the result have been the same or different?
My top 3 list of crisis “BUT FORs” are:
1) Ultra low rates; 2) Unregulated, non bank, subprime lenders; 3) Ratings agencies slapping AAA on junk paper.
Why are these “But Fors?” But for these things occurring, the crisis would not have happened:
-If it wasn’t for ultra low rates, the housing boom would likely have been much more modest; further, bond managers would not have been scrambling for yield, and searching for alternative products to low yielding Treasuries;
-If it wasn’t for the sub-prime lenders, the credit bubble would not have inflated; further, millions of unqualified borrowers would not have been able to purchase homes they could not afford;
-If it wasn’t for the ratings agency fraud, the enormous market for this high yielding junk paper — mislabeled as AAA — would not have existed; further, the primary purchasers were firms that were only permitted to buy investment grade bonds. No A+ or better rating, no sale.
Hence, these factors are huge causative elements — BUT FOR them, there is no boom and bust, no crisis and collapse. Bond managers could not have owned all of these securitized sub-prime mortgages; the credit default swap market would have been much smaller, perhaps 1/10 its size; Sovereign wealth funds around the world could not have purchased all this bad paper; Iceland does not collapse. That is these are the big 3 — why I label them the prime cause of the crisis.
There is a secondary list of things that might or might not be prime causal factors; at the very least, they made the crisis significantly worse:
1) The Commodity Futures Modernization Act of 2000 2) Net Cap Rule Change of 2004 (aka Bear Stearns exemption) 3) Repeal of Glass Steagall (1998)
Lets look at each of these:
1) The Commodity Futures Modernization Act of 2000 (CFMA) exempted derivatives from all oversight and regulation. It allowed derivatives to be traded in the shadows, unreserved for, off exchanges, no disclosures of counter parties, no capital requirements. Did that cause the crisis? I do not think it is the primary cause, but I am not sure.
-It certainly allowed AIG FP to destroy the parent company; -Did it make things much worse? Definitely! -Is it a “But For”? Would the collapse have happened without this? I believe its inconclusive, and could easily go either way.
We can easily accept that the collapse of AIG was a major cause of the crisis, but if you were to argue that it didn’t cause it, but only served to make mattes much worse, I’m not sure I really disagree with you.
2) The 2004 Net Cap rule exemption that allowed banks to go from 12 to 1 leverage to 25, 35 even 40 to 1 leverage — again, I am unsure if it is a direct causation of the credit freeze. The basic argument pro is that BSC and LEH might not have been in as dire straits BUT FOR this leverage, and each might have survived, this making the crisis more manageable. No doubt that the increased leverage certainly made the damages much greater.
Is it a BUT FOR? I have a hard time deciding, as it can go either way . . .
3) The repeal of Glass Steagall allowed banks to get much bigger than they would have — which made their losses that much bigger; Another maybe/maybe not on whether it is a BUT FOR.
Citi, Bank of America, and the rest of the TARP recipients would have losses — but for Glass Steagall repeal, they most likely would have been much smaller.
~~~
Here’s the kicker — when I do the same BUT FOR analysis on Fannie/Freddie, It get different results.
-Were they an accounting fraud run by weasels? Yes. -Did they securitze mortgages? Yes, for decades. -What about securitizing sub-prime mortgages? Primarily after late 2005. By then, the die had been cast.
So are Fannie & Freddie a “BUT FOR” ?
I don’t see how. Wall Street had been securitizing most of the sub-prime mortgages for years without the GSEs — Fannie and Freddie jumped in very late because they were losing market share. Their timing was perfect they started doing nonconforming mortgages just as the market peaked.
And if Fannie & Freddie didn’t exist, mortgage securitization would have happened anyway, the way it did in areas where their were no GSEs — securitized credit card receivables, auto loans, small biz loans, etc. took place without GSEs. I assume there would likely have been a private sector version for conforming loans, the way there was a private sector securitizing response to the demand for non-conforming (sub-prime) loans.
That’s how I end up saying they were not a prime cause of the crisis.
Of course, they certainly made things worse — but so did a lot of other entities. But the key question for the blame Fannie/Freddie crowd is “Would the crisis has happened without them?” The answer is yes — FRE/FNM were not BUT FORs, because all of this was happening anyway, prior to their participation in subprimes late 2005.
If not for 40-1 leverage change in Aug. 04 brokerage houses could not have held the supply that they eventually sold too others, thus, they could not factually buy crap, and thus no crap would have been sold, without buyers, prices do not go up. As soon as the sales maching got rolling they wanted more product.
i find the fannie/freddie crap laugable, the numbers in low income area’s were puney in proportion, in certain ways we’ve lost the ability to discern facts in a yell louder and yell longer world
If not for insasiable securitization of everything that moved credit expansion off the charts would have ceased for above reasons. If you don’t hold the product you don’t care how crappy it is.
Keep in mind subprime lending contributed to a huge speculative wave of borrowing by flippers, added by appraisal fraud, and a near global mindset that housing prices “only go up!” I felt like I was going insane talking about the housing bubble to people back in 04-5 only to have people stare at me as if I was insane.
Bottom line: the ascendancy of the financial sector and the decline of manufacturing in the U.S.
The creation of tangible products whose utility/quality can be more objectively measured were phased out in favor of “financial products,” whose utility/quality is much easier to conceal behind legal/technical jargon and junk economics.
N.B.: Elizabeth Warren’s consumer protections are for financial products, not manufactured goods. Ralph Nader and others pioneered the product liability field 45 years ago.
I can feel the frustration in posts like this – like why the hell isn’t transparency & financial reform being taken seriously and on the front page of every MSM paper every day until it’s fixed.
My theory is this simple: most people aren’t econ-geeks like the ones who visit sites like this. More people find economics boring. And, most people *might* believe there really is a problem but either don’t understand it, or somehow believe the people in power won’t let it happen again.
We all seem to know it will.
My solution is simple – make the non-econ-geeks raise hell by making the FCIC do their job:
The Curious Case of Benjamins Missing. Where did the trillions go? http://solanic.com/wordpress/the-curious-case-of-benjamins-missing-where-did-the-trillions-go/
Fanny and Freddie along with the CRA are easy targets since they are faceless GSE type organizations. This is all coming from the usual deniers who will never change that opinion regardless of facts. While Blankfein is out claiming that GS is doing God’s work who would ever claim the same for a GSE.
People like Rick Santelli and Larry Kudlow among others need to support their deep rooted belief system.
I disagree with your “but for’s”. The market is governed by fear and greed. What mitigated the fear? I got into a house early in my life because of low rates and subprime lending. However, I am still in my house due to fear of financial failure. Why is this fear not governing other loan applicants, subprime lenders, buyers of complicated securities (if you didn’t understand it, why did you buy it?), etc.?
I don’t know the details but was it gov guarantees on bad loans? Did the companies trading the securities know they were “too big to fail”?
If you feel the breeze on your rear end like I do, it is amazing how you make the right decision.
Your second list is the correct list of primary causes. A financial panic of some ilk would have occurred precipitated by some event in any case. Bubbles happen; this one happened to be in subprime, etc. The CFMA created the environment for the huge overhang of naked CDSs that magnified the panic. Its bankruptcy provisions giving counter-parties ultra-senior priority directly enabled a “run on the bank” atmosphere. Your observations on Glass-Steagall and leverage without regulatory limit are dead on. Glass-Steagall enshrined two principles that were abandoned: The first is that there should be financial firewalls between institutions to contain the spread of a panic. The second was the that guarantees are limited to sectors with heavy accountability to regulators and with marked financial conservatism in their operations to assure solvency. The violation of the second principle directly leads to a regulatory capture in which anything goes and a corresponding observed “need” to accomodate indiscretions, as with the Greenspan/Bernanke put. It perhaps should be identified as THE primary cause, since it left Wall Street with the well-founded (LTCM, Latin America debt crisis,etc. ) and since-proved belief that prudence and capital were quite unnecessary.
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