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Author Topic: An interesting take on the F'ers
flydye45
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Source

All emphasis is hers.

quote:
The current financial crisis definitely resulted from government generated moral risk. The massive federal-government-created and -managed enterprises, Freddie Mac, Fannie Mae and the Federal Home Loan Banks, aka Flubs, (henceforth, collectively the GSEs) are ground zero for the crisis. They were simply too big not to dramatically impact the market. Collectively, the GSEs purchase half of the mortgages issued in the U.S. Collectively, they issued most of the mortgage-backed securities (MBSs) currently in circulation. By design, these institutions created a vast moral hazard that built up over four decades until the system collapsed under the weight of risky behavior.

The GSEs created moral risk in several ways.


(1) By design, the GSEs separated the profit earned from a particular mortgage from the risk of issuing that mortgage. Prior to the GSEs most institutions who issued a mortgage had to hold the mortgage, because few people would trust a private institution’s judgment about the safety of the mortgages it issued but did not keep in-house. If the borrower defaulted then the mortgage issuer lost money. This created a strong feedback system that tied benefit and risk tightly together. Politicians decided that this aversion to risk caused lenders to loan too conservatively, so they created the GSEs to remove the risk from issuing mortgages. Now the only feedback on the risk of mortgage came from the GSEs, and with their government backing they paid far less attention to risk posed by mortgages.

By analogy to autos, this is the same effect you would get if the government started providing free, full coverage, no-fault collision insurance. Suddenly, the economic risk from dangerous driving would disappear. People would no longer have a financial incentive to avoid fender benders, nor would they worry that risky driving would raise their insurance rates. Everyone can see this kind of moral hazard clearly but most have a problem seeing the same moral hazard in the financial system.

(2) By design, the GSEs hid the hazard of buying their MBSs by using their implied government guarantee. With private MBSs, the purchaser of the MBS has to trust that the seller has correctly calculated the risk of the collection of individual mortgages that back each unit of the security. Again, prior to the GSEs, few people would take that risk. Privately issued MBSs covered only a few percent of the residential real estate market, and those few percent dealt with high-value properties that historically held their value in good times and bad. The GSEs solved this “problem” in two ways. First, they used the presumption of political oversight and regulation (which in fact turned out not to exist) to convince buyers that the GSEs would properly calculate the risk of the mortgages the GSEs bought. Second, they used the implied guarantee to assure buyers that even if the GSEs made a mistake, the government would make good the payout on the securities.

By analogy with autos, this is the same effect you would get if the government claimed to protect against lemons at an auto dealer. Imagine if an auto dealer could claim that (a) the government checked the dealer’s car inventory for lemons and that (b) the government implied it would make good any financial loses that a buyer might incur if he got a lemon anyway. How carefully would people check out cars before they bought them?

(3) By design, the GSEs had much better credit ratings than did any private actors. All credit-rating agencies, both in America and overseas, rated the GSEs as much safer than their private-sector counterparts, due solely to their presumed government oversight and backing. This in turn made insurance against their defaults, called Credit-Default Swaps (CDSs) much cheaper than it should have been. Since most CDS issuers hedged by bundling GSE-based CDSs with private ones, this artificially lowered the prices of all CDSs.

By analogy with autos, this is the same effect you would get if the government generated the actuarial tables for auto insurance to make accidents seem less common than they actually are. Auto insurance would be cheaper but the entire industry would be built on a flawed understanding of the risk of driving. Also, imagine that it turned out that the government wouldn’t pay for damages and lemons and that the insurance companies had to take up the entire slack.

So, by extended analogy, imagine an automobile-based transportation system in which people (a) paid no financial penalty for reckless driving, (b) paid little attention to the mechanical quality of the cars they purchased and (c) private insurance companies operated on faulty accident statistics. Eventually, such a system would collapse. People would recklessly drive unsafe cars and the auto insurance companies would go bankrupt trying to pay damages.

This vast moral hazard explains most of the financial collapse. Lenders issued increasingly risky mortgages because, like government-insured drivers, they paid no penalty for making risky loans. Buyers of MBSs ignored the dangers of MBSs because, like drivers protected against lemons, they assumed that the MBSs were safe. Insurers charged too little for MBS default insurance because, like insurance companies using government statistics to price risk, they misjudged the true risk of MBSs.

I can’t repeat this often enough: By design, the GSEs were intended to distort the markets in favor of more-risky lending and that is exactly what we got. The private institutions that failed did so because they (a) mimicked the business model and practices of the GSEs, (b) bought GSE-issued MBSs, and GSE stock, based on their high ratings and/or (3) issued insurance against the default of the GSEs’ MBSs based on their high ratings.

Without the GSEs, the circumstances of the collapse would have never developed. To use automotive metaphors, fewer of us would have cars and we would pay higher insurance, but the cars we did have would be mechanically safer, we would drive them more safely and our auto insurance could pay out any damage claims if we had an accident. Instead, our political impulse to get something for nothing has led us to the financial equivalent of a nationwide pile-up of rust heaps driven by meth-crazed teenagers.

Please note (which she doesn't) that the design is prompted by what was felt to be a noble motive. So less rock throwing but more sober analysis of the consequences of the design. Also, I feel that the average American is let off the hook a bit too much for her greed. I heard three (3) realtors tell me in a short period toward the end of the bubble "just buy, it'll be worth more tomorrow". This didn't pass my sniff detector so I missed some (but not all) of the craziness. Other people should have been as wise. Many were! But not enough.
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RickyB
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"due solely to their presumed government oversight and backing."

oversight which was systematically demolished over the past decade (and a bit).

Seriously, I don't know how we can be arguing this. Republicans and many democrats spent the past 15 years demolishing the financial dams of the New Deal, and then many (especially the repubs, while the complicit dems do the "who me" act) point to the resultant mess as proof of flaws with the design! It's like the old joke: Fly with no wings...deaf!

(the joke really is about a fly. Nothing personal.)

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flydye45
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How exactly did this conversation morph into some hobby horse of yours regarding the New Deal? This is about Fannie/Freddie.

Quite frankly, there was complicity of Republicans signing onto a New Dealish policy of an incredible expansion of home ownership because of a conjunction between soft minded Liberal do-goodery and Republican thought on investment and responsibility. Folks attempted to punch way outside their fiscal weight class with the complicity of banks as a result of supposed "government security" on loans. After all, it wasn't on their books...

Try again.

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LetterRip
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Hmm apparently she didn't read any finance related magazine for the past two years.

While the government creating a moral hazard has some part, the vast majority can be laid at the feet of the ratings agencys creating bad models to give AAA ratings to derivatives that were not that strong. The model creators (the wonks who did the modeling) stated in a number of articles that they new the models were garbage, but they created them specifically to give AAA ratings to the MBSes, which they were being pressured to do by management. (My understanding is that for each AAA rated MBS the rating agencies received a significant fee for providing the rating).

Without the AAA ratings absolutely none of the rest of the crisis could happen (there wouldn't have been any pressure to make ridiculous housing loans since the finance companies could no longer make hundereds of billions off of selling the AAA rated MBSes - if the bonds had been rated A or AA which is the highest ratings that the MBSes were able to achieve under the original models then they could have sold only to less risk averse investors).

LetterRip

[ March 21, 2009, 12:54 PM: Message edited by: LetterRip ]

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Kent
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LetterRip, I agree that the credit ratings are the main culprits of our current mess.
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Pete at Home
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quote:
Originally posted by flydye45:
Quite frankly, there was complicity of Republicans signing onto a New Dealish policy of an incredible expansion of home ownership because of a conjunction between soft minded Liberal do-goodery and Republican thought on investment and responsibility.

Yes indeed. Bush #43 expressed great pride in the increase of proportion of homeowners, particularly African-American homeowners, during his presidency. I thought that he was right that it was something to be proud of; that it really would help more people join the middle class. Is that really part of what caused this mess? That would be depressing.
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flydye45
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Well Pete, it depends on whom you ask. As Meg McArdle said a couple months ago, anyone who knows anything about economics is humbled by this turn of events and those that know the least are pointing straight at those they opposed in the first place.

I believe in moral hazard and unintended consequences. Shrugs.

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Pete at Home
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Well I believe in unintended consequences too, but this particular one, if true, is too depressing. Makes me not want to say anything about economics anymore, since clearly I have no focking clue. [Frown]

[ March 22, 2009, 12:22 AM: Message edited by: Pete at Home ]

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Pyrtolin
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quote:
Originally posted by Pete at Home:
quote:
Originally posted by flydye45:
Quite frankly, there was complicity of Republicans signing onto a New Dealish policy of an incredible expansion of home ownership because of a conjunction between soft minded Liberal do-goodery and Republican thought on investment and responsibility.

Yes indeed. Bush #43 expressed great pride in the increase of proportion of homeowners, particularly African-American homeowners, during his presidency. I thought that he was right that it was something to be proud of; that it really would help more people join the middle class. Is that really part of what caused this mess? That would be depressing.
The one detail that the article doesn't bring to light is that the mentioned programs were strongly regulated out of the risky market until HUD dropped those regulations in 2004; that's why they worked so well until recently then just in the past few years went from stable to ruin.

It also doesn't talk about the much, much larger share of risky, deceptive loans that originated in the completely unregulated brokerage environment since GLB let the investment banks get into the game in 1999. (Some of which were, after 2004, given the extra boost by being backed of the GSEs)

It definitely skips the telling point that GSE backed loans as a share of the market declined from about half to about a quarter over that time; there was a slight absolute increase, but it was completely overshadowed by the overwhelming quantity of independent, unregulated loans that were made in that time- loans that went straight from shady brokerages who pumped them up for a large cut of the profits to the investment banks, without touching and government program on the way.

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