Friday, October 10, 2008

Another task for a Commission on the Financial Crisis

A little while ago, I posted on an Australian perspective on the US housing market, and how Australian rules differed from the US's.

Today comes an article from George Soros on the Danish housing market, and the lessons it has to offer the US:

To reconstruct our mortgage system on a sounder basis, we ought to look to the Danish model, which has withstood many tests since it was brought into existence after the great fire of Copenhagen in 1795. It remains the best performing in Europe during the current crisis. First, it is an open system in which all mortgage originators can participate on equal terms as long as they meet the rigorous regulatory requirements. There are no GSEs enjoying a quasimonopolistic position.

Second, mortgage originators are required to retain credit risk and to perform the servicing functions, thereby properly aligning the incentives. Third, the mortgage is funded by the issuance of standardized bonds, creating a large and liquid market...

Finally, the asymmetric nature of American mortgages is replaced by what the Danes call the Principle of Balance. Every mortgage is instantly converted into a security of the same amount and the two remain interchangeable at all times. Homeowners can retire mortgages not only by paying them off, but also by buying an equivalent face amount of bonds at market price.

I wouldn't pretend to know whether Soros's proposals make sense. What I DO know is that we should take a long look at how other nations that have successful housing markets have done it, which is one more great task for the staff of A COMMISSION.

We don't need no stinkin' commission!

Sadly, it appears that once elected President, Senator Obama will not have any use for a commission to examine what led to the financial crisis. He has publicly stated:
Just today, Senator McCain offered up the oldest Washington stunt in the book you pass the buck to a commission to study the problem. But here's the thing this isn't 9/11. We know how we got into this mess. What we need now is leadership that gets us out. I'll provide it, John McCain won't, and that's the choice for the American people in this election.
There you have it. McCain's for it, so I'm against it. I can't admit that the other guy came up with a good idea first, so I'll attack the idea.

Here's what Freakanomics blogger, and business school (and law school) professor Ian Ayres has to say to Senator Obama:
It’s one thing to criticize McCain for inaction, but I disagree with Obama’s claim that we know how we got into this mess. In fact, if pushed, I would say I knew a lot more about the causes of 9/11 than I do about the causes of the mortgage crisis...

But to my mind, there are still dozens of important unanswered questions.

How much of the crisis was caused by subprime borrowers who made mistakes by borrowing (i.e., would not have borrowed if they had better information)


Was this a failure of Super Crunching? Was it a failure of corporate governance (in that the managers of the buying firms had incentives to unprofitably grow their empires)? Was the failure caused by originator fraud (or the moral hazard of substituting bad-doc loans for what historically had been high-quality loan pools)?

I think it is probably some mixture of all three — with poor corporate-governance incentives particularly explaining the failure of the rating agencies to start downgrading the debt earlier.

Knowing the answers to these causal questions is important if we are going to craft useful policy responses.
Study the causes, and THEN regulate (or more likely re-regulate). What a novel idea. Usually, the Democrats complain about Republicans' contempt for reflection and learning. We can safely say that such disdain is bi-partisan.

The British Are Coming!

The hottest topic of debate relative to the handling of the financial crisis is a proposal put on the table by Her Majesty's Government (that's their finance minister to the right).

The plan essentially calls for injecting capital in the banks in exchange for equity (stock). It also calls for increasing the guarantees on despositors' funds.

Paul Krugman weighs in, favoring the British proposal:
on Wednesday the British government, showing the kind of clear thinking that has been all too scarce on this side of the pond, announced a plan to provide banks with £50 billion in new capital — the equivalent, relative to the size of the economy, of a $500 billion program here — together with extensive guarantees for financial transactions between banks. And U.S. Treasury officials now say that they plan to do something similar, using the authority they didn’t want but Congress gave them anyway.
I heard a similar sentiment on NPR's Planet Money podcast, with Wall Streeters voicing their opinions that if the government would simply guarantee ALL desposits and other forms of bank savings, the credit markets would get moving again.

Such a move is currently under consideration here in the US.

But we need to act quickly.

Thursday, October 9, 2008

A Sound Proposal

There is a growing concensus that the US needs to move quickly to help recapitalize banks (that is, give them money to keep operating while taking shares of stock in return). The question is how best to do this? How will the government know how much to pay, and how will it avoid wasting funds on banks that are beyond salvage (so-called "Zombie banks")?

Economist Greg Mankiw has a sound proposal:

Whenever any financial institution attracts new private capital in an arms-length transaction, it can access an equal amount of public capital. The taxpayer would get the same terms as the private investor. The only difference is that government’s shares would be nonvoting until the government sold the shares at a later date.This plan would solve the three problems. The private sector rather than the government would weed out the zombie firms. The private sector rather than the government would set the price. And the private sector rather than the government would exercise corporate control.

In short, the government should put on the table a standing offer to match private investors dollar for dollar when they offer to invest in a bank. If Warren Buffett offers to buy shares of bank X, the government matches the offer. This way, the market sets the price rather than having the government determining what to buy and how much to pay.

I hope someone who matters is listening. Mankiw is a former Chair of the Council of Economic advisors and can probably still get his calls returned even though he has been back in Cambridge, MA, for several years now.

Wednesday, October 8, 2008

The Chattering Classes Were Not Amused

The Politico asks whether last's night debate was the "worst ever."

Northwestern Journalism Professor Alan Schroeder:

The Nashville event was not the worst debate ever, but it definitely qualifies as the worst of the five general election town hall meetings that have taken place since 1992.

New York University Historian Diane Ravitch:

Both candidates spouted the same by-now stale slogans and rhetoric. Neither had anything new to say. Both pointed fingers to blame the other for everything that is wrong in the nation and the world. Neither xpressed a genuine emotion or uttered an original thought or expressed a memorable line for future generations. This "debate" was just plain boring.

And the most memorable quip from Washington lobbying powerhouse Tom Korologos:

Probably, but can’t say THE worst, since I didn’t see any of the Martin Van Buren debates.

I certainly didn't feel the same way. I thought it was a low key, fairly civil discussion where the candidates talked to real people rather than some self important journalists or a studio audience.

Instead, I agree with Harvard Business School prof Rosabeth Moss Kanter:

What’s the standard for a good debate? Memorable zingers? Blood on the floor? Instant solutions to crises, in 2-minute packages? That’s not my standard. What this debate lacked in reality TV entertainment, it made up for in showing the contrasts between how the candidates think and therefore their instincts as potential leaders in troubled times.

Tuesday, October 7, 2008

What Went Wrong with Fannie

Competition from other market players, pressure from Congress and other causes of Fannie Mae going off the tracks are well chronicled in this New York Times story. If you're looking for one thing to read to understand what Fannie Mae is and what happened to bring it down, necessitating a federal government takeover, this is a great place to start.

What Is Fannie Mae?

Fannie Mae (an acronym for Federal National Mortgage Association) is a private company that began life as a New Deal federal government agency but was privatized in the 1960s by President Johnson, who wanted to move its debt off the federal government's books. Its role was (is) to purchase mortgages from lenders, bundle them into investment securities and sell them into the market. This allowed the home lenders to take the loans off their books and make new ones. Fannie Mae also guaranteed those securities. Because it had special status under federal law, lenders were willing to lend to Fannie at lower rates, believing that the federal government would stand by should Fannie ever go belly up - a belief that turned out to be true.

What Went Wrong?

As the home loan market grew, more and more actors in the financial community were willing to take on this role. This forced Fannie to take bigger risks. At the same time, Fannie was faced with increasing pressure from Capitol Hill, which began to worry that its activities might lead to either problems in the market, cost taxpayers large sums of money if it needed to be bailed out, or both. To ward off more oversight and regulation, it sucumbed to legislators' demands that it increase the amount of lending it did to lower income groups, which are by nature riskier. The increased risks it took to compete in the hot housing markets and placate federal law makers (and regulators) put it in a precarious position. After years of tremendous growth (any payments to its top executives), federal regulators discovered accounting fraud at Fannie in 2004. In recent years, as many of the loans Fannie bundled and resold go into default, its had to make good on its guarantees, leading to staggering losses.

About one year ago, Congress and federal regulators, knowing Fannie's state, pressured them to buy up a lot of bad subprime loans - in other words to act in much the way the US Treasury proposes to do under the bailout. Despite being a supposedly private entity, Fannie sucumbed and did so, making its balance sheet even worse.

Why is All This Important to the Current Situation?

By packaging these bad loans, Fannie helped take what should have been a crisis in one market - housing finance - and distributed all over the world as investors purchased them. Precisely how much of the fault should be placed on those who operated Fannie and those who pressured it into riskier and riskier activity remains the subject of much debate.

Anyway, the article is well written, in plain English and worth the time it takes to read.

Debate Reminder

The Presidential candidates are back at it tonight at Belmont University. There will be plenty to talk about now that the rescue has passed.

Kick off is earlier tonight than the previous debates - (CORRECTION ( 9 pm EST / 8 pm CST)

Monday, October 6, 2008

An International Perspective on the US Financial Crisis

In today's Wall Street Journal, columnist Janet Albrechtson of the Australian discusses the how bias towards "home ownership for all" helped to create a fast and loose environment with home loans in the US. She notes that Australia's banks are still sound, and that the relatively small country's 4 largest banks are among the only 20 AA rated banks around the world and that the International Monetary Fund's (IMF) latest report gives the Australian banking industry a clean bill of health.

First, US laws in many states give homes inordinate protection against debt collectors. Such loans are "non-recourse" meaning that the borrower can only be held liable up to the home's value. If the home proves to be worth less than the loan, there's little the lender can do to make up the difference. If that's the case, it certainly gives people a strong incentive to borrow more than is prudent, knowing that they can, at worst, only lose a home they couldn't afford anyway. Why not take a risk?

Next, mortgages in Australia tend to be fixed only for a short term, which protects banks from a situation where it makes a lot of long term fixed loans, but needs to finance them with shorter term loans more subject to variable interest rate markets. Banks won't find themselves having low interest streams of income from 30 year fixed mortgages while needing to pay high interest rates themselves. Further, US laws in many states prohibit lenders from charging home owners from pre-paying their mortgages. Banks are in a heads I win (interest rates go up and home owners keep their fixed rates), tails you lose (interest rates go down so home owners refinance) situation.

Finally, if bundling home loans and turning them into securities, getting them off the books of banks was such a prudent way of doing business, why did the government need to set up the operation by creating Fannie and Freddie? Apparently, this wasn't such a hot idea in the view of the private sector.

Frankly, I don't know whether her assessment is accurate, but it is very interesting, and its worth exploring whether the roles of these state laws in the US that protect home debt and fix mortgage terms have played a role in this mess. As I have stated below, I think there's a lot of causes to be examined, which is why we need a commission to thoroughly investigate before we regulate / re-regulate or deregulate further.

Congressional Hearings Already Underway

As I posted below, I knew Congress would need to hold hearings, but I didn't realize they would happen so soon given that Congress is actually not in session.

The odd thing is the committee that's holding the hearings. The House Government Oversight and Reform Committee (Chairman Henry Waxman) will hold 5 hearings:

October 6th: Lehman Brothers

October 7th: AIG

October 16th: Hedge Funds

October 22nd: Credit Rating Agencies

October 23rd: Federal Regulators

This Congressional activity actually reinforces why we need a commission. This particular committee has absolutely no jurisdiction over the activities in question, no jurisdiction over the laws that might need to changed and no expertise in the issues involved. Further, it is one of the most politically charged congressional committee.

Expect a lot of heat and little light.

A Necessary Commission

A Call for a Commission on the Financial Crisis

Congress has now acted to staunch the bleeding, passing the financial bailout bill on Friday.

The question is, where do we go from here?

There are many different hypothesis on how we got into this mess (it's the government's fault, it's our fault, it's Wall Street's fault).

We need to sort them out.

One suggestion I have is to form a commission to study the causes and report back to Congress on them. In an ideal world, this would be done as an alternate to Congressional hearings, which will be created around the preferred explanation that will yield the politically correct policy answer. Realistically, Congress will need to hold hearings regardless to just show it's busy trying to protect the voting public. That's fine, but we still need a commission (note: Senator McCain has suggested the creation of one as well)

Why a Commission?

First, the issues involved in the meltdown and the causes are highly technical. Doing the job right will involve bringing together top experts in finance, law, housing markets, economics and other disciplines. Even were Congress to bring temporary staff on board, it could not replicate the expertise needed to do the job.

Next, the Commission's work will necessitate the pronouncement of some harsh truths. For instance, to do its job, the commission will need to say, in effect, that many people shouldn't be in the homes they have. There will no takers for that role among our elected officials (thanks mostly to us for shooting the messenger). The medicine will best come from those who won't face those homeowners in the next election.

What Should the Commission Do?

The Commission should, in essence, write the narrative. It should explain as best it can how we got here. For instance, that was the best thing the 9/11 Commission did. It provided a clear, well written account of WHAT HAPPENED. Having a similar narrative for the financial crisis would help educate the public, and make it easier to swallow the sort of medicine that will be necessary to get us through the next year or so.

What shouldn't the Commission Do?

This is perhaps the most important question.

I think the Commission should avoid making any recommendations. The reason for this is because there is the danger that the recommendations will drive the narrative. In order to make a recommendation look justified, Commission members and staff will lean towards an explanation that supports it. That will interfere with the creation of an unbiased hard look at what happened.

Further, the need to avoid strife (e.g., public dissenting) will force compromises. Members will need to hold their nose on certain recommendations to get others. They will then feel bound to support a compromised product after its completion. This will reduce the informed opinion available to Congress after the report is issued.

Once the report on "why" is out, Congress can hold hearings and invite individual Commissioners to comment on what should be done going forward. It can then fulfill its role of listening to the experts and making the needed legal changes.

For a dissenting view, see here. Notably, the main argument against one is that McCain suggested one. Obama needed to attack McCain, so he criticized the idea. As a result, if you're for McCain, a commission is a good idea. If you're for Obama, it's a bad one. If a commission isn't created politics, not the merits of the idea, will be why.