James Pethokoukis

Politics and policy from inside Washington

FCIC report: 10 causes of the financial crisis

Jan 27, 2011 18:40 UTC

The other dissent (written by Keith Hennessey, Douglas Holtz-Eakin, and Bill Thomas) to the main Financial Crisis Inquiry Commission report identifies 10 causes for the meltdown. They run through them in a WSJ op-ed:

Starting in the late 1990s, there was a broad credit bubble in the U.S. and Europe and a sustained housing bubble in the U.S. (factors 1 and 2). Excess liquidity, combined with rising house prices and an ineffectively regulated primary mortgage market, led to an increase in nontraditional mortgages (factor 3) that were in some cases deceptive, in many cases confusing, and often beyond borrowers’ ability to pay.

However, the credit bubble, housing bubble, and the explosion of nontraditional mortgage products are not by themselves responsible for the crisis. Our country has experienced larger bubbles—the dot-com bubble of the 1990s, for example—that were not nearly as devastating as the housing bubble. Losses from the housing downturn were concentrated in highly leveraged financial institutions. Which raises the essential question: Why were these firms so exposed?

Failures in credit-rating and securitization transformed bad mortgages into toxic financial assets (factor 4). Securitizers lowered the credit quality of the mortgages they securitized, credit-rating agencies erroneously rated these securities as safe investments, and buyers failed to look behind the ratings and do their own due diligence. Managers of many large and midsize financial institutions amassed enormous concentrations of highly correlated housing risk (factor 5), and they amplified this risk by holding too little capital relative to the risks and funded these exposures with short-term debt (factor 6). They assumed such funds would always be available. Both turned out to be bad bets.

These risks within highly leveraged, short-funded financial firms with concentrated exposure to a collapsing asset class led to a cascade of firm failures. The losses spread in two ways. Some firms had large counterparty credit risk exposures, and the sudden and disorderly failure of one firm risked triggering losses elsewhere. We call this the risk of contagion (factor 7). In other cases, the problem was a common shock (factor 8). A number of firms had made similar bad bets on housing, and thus unconnected firms failed for the same reason and at roughly the same time.

A rapid succession of 10 firm failures, mergers and restructurings in September 2008 caused a financial shock and panic (factor 9). Confidence and trust in the financial system evaporated, as the health of almost every large and midsize financial institution in the U.S. and Europe was questioned. The financial shock and panic caused a severe contraction in the real economy (factor 10).

Me: I really like that they looked globally to try to find the common elements between the crises here and there. It is pretty hard to ignore this graphic:

housing

COMMENT

The list of “causes” should have included comparisons to previous great financial manias. This would have observed that since the 1825 example the final phase ran some 12 to 16 months against an inverted yield curve.

The problem during such a boom is not rising interest rates. This confirms that the boom is on. The problem arrives when the curves reverses to steepening, with T-bill rates declining.

This fateful reversal started in May 2007, which was the 15th month of inversion.

The rest, as the saying goes, became history. There are two “rules” that worked. Short rates plunge during the initial bear market and economic contraction. The notion that “cuts” in the Fed rate will reignite a boom is not supported by history.

The other “rule” is that the post-bubble recession starts virtually with the bear market. Using NBER determinations, the 1873 bubble ended in September and the recession started that October. The 1929 bubble ended in that September and the recession started that August. The 2007 bubble ended in October and the recession began in that December.

There are other “rules” but that would take a lot of space.

Posted by Subtle | Report as abusive

FCIC report: So why did U.S. have a financial crisis?

Jan 27, 2011 16:40 UTC

The Financial Crisis Inquiry Commission report is out, and it also includes two separate dissents. There’s a metaphor contained in the dissent by Peter Wallison of the American Enterprise Institute which does a pretty good jobof  describing the majority take and his critique of it:

In a private interview with a few of the members of the Commission
(I was not informed of the interview), Summers was asked whether the mortgage
meltdown was the cause of the i nancial crisis. His response was that the i nancial
crisis was like a forest i re and the mortgage meltdown like a “cigarette butt” thrown
into a very dry forest. Was the cigarette butt, he asked, the cause of the forest
i re, or was it the tinder dry condition of the forest?
44
h e Commission majority
adopted the idea that it was the tinder-dry forest. h eir central argument is that the
mortgage meltdown as the bubble del ated triggered the i nancial crisis because of
the “vulnerabilities” inherent in the U.S. i nancial system at the time—the absence
44
FCIC, Summers interview, p.77.470 Dissenting Statement
of regulation, lax regulation, predatory lending, greed on Wall Street and among
participants in the securitization system, inef ective risk management, and excessive
leverage, among other factors. One of the majority’s singular notions is that “30
years of deregulation” had “stripped away key safeguards” against a crisis; this
ignores completely that in 1991, in the wake of the S&L crisis, Congress adopted the
FDIC Improvement Act, which was by far the toughest bank regulatory law since
the advent of deposit insurance and was celebrated at the time of its enactment as
i nally giving the regulators the power to put an end to bank crises.
h e forest metaphor turns out to be an excellent way to communicate the
dif erence between the Commission’s report and this dissenting statement. What
Summers characterized as a “cigarette butt” was 27 million high risk NTMs with
a total value over $4.5 trillion. Let’s use a little common sense here: $4.5 trillion in
high risk loans was not a “cigarette butt;” they were more like an exploding gasoline
truck in that forest. h e Commission’s report blames the conditions in the i nancial
system; I blame 27 million subprime and Alt-A mortgages—half of all mortgages
outstanding in the U.S. in 2008—and a number that appears to have been unknown
to most if not all market participants at the time. No i nancial system, in my view,
could have survived the failure of large numbers of high risk mortgages once the
bubble began to del ate, and no market could have avoided a panic when it became
clear that the number of defaults and delinquencies among these mortgages far
exceeded anything that even the most sophisticated market participants expected.
h is conclusion has signii cant policy implications. If in fact the i nancial
crisis was caused by government housing policies, then the Dodd-Frank Act was
legislative overreach and unnecessary. h e appropriate policy choice was to reduce
or eliminate the government’s involvement in the residential mortgage markets, not
to impose signii cant new regulation on the i nancial system

In a private interview with a few of the members of the Commission (I was not informed of the interview), [Obama economic adviser Larry] Summers was asked whether the mortgage meltdown was the cause of the financial crisis. His response was that the financial crisis was like a forest i re and the mortgage meltdown like a “cigarette butt” thrown into a very dry forest. Was the cigarette butt, he asked, the cause of the forest fire, or was it the tinder dry condition of the forest?

The Commission majority adopted the idea that it was the tinder-dry forest. Their central argument is that the mortgage meltdown as the bubble deflated triggered the financial crisis because of the “vulnerabilities” inherent in the U.S. financial system at the time—the absence of regulation, lax regulation, predatory lending, greed on Wall Street and among participants in the securitization system, inef ective risk management, and excessive leverage, among other factors. One of the majority’s singular notions is that “years of deregulation” had “stripped away key safeguards” against a crisis; this ignores completely that in 1991, in the wake of the S&L crisis, Congress adopted the FDIC Improvement Act, which was by far the toughest bank regulatory law since the advent of deposit insurance and was celebrated at the time of its enactment as finally giving the regulators the power to put an end to bank crises.

The forest metaphor turns out to be an excellent way to communicate the difference between the Commission’s report and this dissenting statement. What Summers characterized as a “cigarette butt” was 27 million high risk [non-traditional mortgages] with a total value over $4.5 trillion. Let’s use a little common sense here: $4.5 trillion in high risk loans was not a “cigarette butt;” they were more like an exploding gasoline truck in that forest. The Commission’s report blames the conditions in the financial system; I blame 27 million subprime and Alt-A mortgages—half of all mortgages outstanding in the U.S. in 2008—and a number that appears to have been unknown to most if not all market participants at the time. No financial system, in my view, could have survived the failure of large numbers of high risk mortgages once the bubble began to del ate, and no market could have avoided a panic when it became clear that the number of defaults and delinquencies among these mortgages far exceeded anything that even the most sophisticated market participants expected.

This conclusion has significant policy implications. If in fact the financial crisis was caused by government housing policies, then the Dodd-Frank Act was legislative overreach and unnecessary. The appropriate policy choice was to reduce or eliminate the government’s involvement in the residential mortgage markets, not to impose significant new regulation on the financial system

COMMENT

Regarding the FCIC’s report, there is another looming issue that contributed to economic crisis & as yet goes unexplored.

Robert Wood Johnson Foundation (RWJF) activism was a major contributing factor to the home foreclosure meltdown and subsequently our economic crisis. More here:

http://cleanairquality.blogspot.com/2009  /03/worldwide-economic-meltdown-and.htm l

Posted by mwernimont | Report as abusive

Fannie and Freddie could need $363 billion in taxpayer funds by 2013

Oct 21, 2010 14:32 UTC

Ugh.

The Federal Housing Finance Agency (FHFA) today released projections of the financial performance of Fannie Mae and Freddie Mac (the Enterprises) including potential draws under the Preferred Stock Purchase Agreements (PSPAs) with the U.S. Department of the Treasury. To date, the Enterprises have drawn $148 billion from the Treasury Department under the terms of the PSPAs. Under the three scenarios used in the projections, cumulative Enterprise draws range from $221 billion to $363 billion through 2013.

The FFHA ginned up three different underlying economic forecasts:

ffha1

And then ran the numbers:

ffha2

A bank tax? Really?

Oct 18, 2010 16:36 UTC

I just did a CNBC  spot debating whether robust banks profits should spur new efforts to tax them. Here were my talking points:

1. My Hill sources tell me the bank tax is not going to happen, at least not the Geithner version.

2. That being said, Dems will surely raise it again both as a way of paying for high-end tax cuts and a way of making banks less reliant on short-term funding. The whole idea might also be coupled with a transaction tax.

3. The TARP rationale for the bank tax has collapsed with banks paying back their bailout funds.

4.  What banks do need to worry about is a future bank tax that would pay for Fannie and Freddie losses. There are Republicans who would vote for that.

5.  Is is a good idea? Given all the uncertainty raised by Dodd-Frank, do we really want to add a punitive bank tax? To begin with, this idea came from David Axelrod, not Tim  Geithner or the Obama econ team. And how would it add one decimal point to GDP or create one job?

Obama vs. the hedgie

Sep 21, 2010 16:53 UTC

Here is a bit-o-goodness from my Reuters Breakingviews column on the Obama-CNBC town hall yesterday .

The Sept. 20 exchange between President Barack Obama and Anthony Scaramucci of SkyBridge Capital illustrates the severity of the rupture between the president and the financial community. … Scaramucci is a guy who was in on the ground floor of Hope and Change, Inc. He’s a former Harvard law school classmate of Obama’s who contributed early and often to Obama’s presidential campaign. …  But Scaramucci also gave the impression of a hedgie scorned, even though it’s debatable to what extent new financial regulations have “whacked” hedge funds. More funds must register with the Securities and Exchange Commission, they’re subject to greater state supervision and they may have to give more info to the SEC. Then again, limits on bank trading desks should allow hedge funds to compete more effectively.

What may really be bugging Scaramucci and his colleagues is that when Obama speaks about the Wall Street “fat cats” who almost toppled the economy, the condemnation is sweeping. Hedge funds didn’t need a bailout like the big banks, used far less leverage and are almost always small enough to fail. … Wall Street is never going to get Main Street’s sympathy. Better to talk softly and carry a big wallet. And that seems to be just what Scaramucci is doing. Filings show he’s only contributed to Republicans so far this year, including $5,000 to Free and Strong America. That’s the political action committee of potential 2012 Republican presidential candidate — and potential Obama challenger — Mitt Romney.

The future of Fannie and Freddie? None

Aug 19, 2010 13:13 UTC

Bond guru Bill Gross warned on Tuesday that without U.S. government guarantees, only mortgage bonds backed by super-safe loans, would interest him. He frets too much. The funeral of Fannie Mae and Freddie Mac may be coming, but housing support from D.C. will live on. The key question is how much.

The Gross plan would see the two mortgage giants evolve into a fully nationalized, mega-securitization engine. That, along with his suggestion for a massive home loan refinancing plan, could mean an even bigger role for Washington in U.S. housing.

But President Barack Obama’s administration has little appetite for that kind of approach. As it is, an annual $250 billion in government subsidies, according to the Congressional Budget Office, gives a poor return on investment. In a normalized housing environment, mortgage interest rates might be only 0.2 percentage points higher without it, according to studies from Ohio State University and a former Freddie Mac economist. And international comparisons hint that home ownership rates might not owe much to the government’s role, either.

Of course, politics means Washington won’t completely leave the stage. Yet even a middle-course would result in a radically restructured system.

Here’s what the Obama plan might well look like:

1) The feds explicitly backstop mortgage-backed securities issued by government-blessed entities who – in exchange – pay Uncle Sam an insurance fee (counted by budget scorekeepers as revenue.)

2) Fannie and Freddie – whom Rep. Barney Frank says should be “abolished” – are wound down.

3) Under a “Let a thousand flowers bloom” approach, private companies, nonprofits and even cooperatives get government charters to securitize low-risk mortgages for middle-class homes.

4) Mildly more racy loans for McMansions are handled by private issuers, but sans government guarantee.

Any such plan would need GOP support. This outline has the advantage of eventually eliminating Fannie and Freddie — directly blamed by many Republicans for the housing crisis — as well as narrowing and decentralizing the government’s participation in mortgage finance.

Then again, limbo could persist until 2013. With home ownership a political hot button, the matter could become a 2012 election battleground. And both parties would love to have a big issue at play that affects the financial sector to help raise campaign cash. Still, eventually change will come. But Gross shouldn’t worry: there will still be plenty of guaranteed mortgage-backed securities for him and other investors to buy.

COMMENT

Bill Gross has flipflopped on his ‘main direction’ at least four times this year… hardly a man of vision anymore! Maybe he’s priming for a seat on a CNBC show?

Posted by CDN_finance | Report as abusive

Did Obama just sign a bailout out bill?

Jul 21, 2010 19:58 UTC

I think on this matter, this American Banker interview with Sheila Bair is instructive: But does this bill stop them from happening?

BAIR: It makes them impossible and it should. We worked really hard to squeeze bailout language out of this bill. The construct is you can’t bail out an individual institution — you just can’t do it. In a true liquidity crisis, the FDIC and the Fed can provide systemwide support in terms of liquidity support — lending and debt guarantees — but even then, a default would trigger resolution or bankruptcy.

Would the Fed’s 13-3 emergency powers allow a bailout?
BAIR: Not for an individual institution, no. This is more like the debt guarantee program, or the Transaction Account Guarantee program, which we just extended yesterday. It’s for those types of programs. … This would only help healthy institutions. And if there were a default on those programs, it would automatically trigger resolution or bankruptcy and the government would have priority claim off the top.

But if we ran into the same kind of situation as 2008, won’t the government find some way to prop up the big banks if several were in danger of failing?

BAIR: If there is a true systemwide problem, that’s why you have systemwide liquidity support — through either a debt guarantee program or lending program by the Fed. It would have to be generally available. Again, if there is a default on it, that automatically triggers a bankruptcy or resolution; regulators can decide which.

Me: If multiple banks get in trouble, government does have the option of giving them support. But more importantly, does Wall Street believe it would be bailed out, even if it meant Congress bypassing the law or changing it on the spot? If you look at the cost of bank funding, it seems clear that the implicit Too Big To Fail guarantee still exists. And a gaggle of regional Fed bank presidents agree.

Financial reform meltdown

Jun 29, 2010 18:33 UTC

Democrats are reopening the House-Senate  conference committee to deal with GOP opposition to the $19 billion tax to pay for the bill.  This likely means that Dems not only didn’t have Scott Brown’s vote, but either Susan Collins, Olympia Snowe or Chuck Grassley went from “yes” to “no.”  Maybe all of them.

And maybe they will get the money from TARP or the FDIC. But banks had better hope U.S. Democrats have a Plan B. Yes, big lending and trading institutions face hard changes from the passage of U.S. financial reform. But legislative failure — suddenly less far-fetched than it seemed — might be worse. If they fail, the uncertainty, haggling and headlines could drag on into 2011. A few thoughts:

1) Lobbyists who started the July 4 holiday early following last week’s congressional compromise are probably regretting it.

2) Scuttling a major piece of legislation over such a trivial sum may seem unlikely in an era of trillion-dollar budget deficits. Then again, a similar fiscal debate is preventing the Senate from approving a new jobs bill despite high unemployment.

3) If reaching 60 proves impossible, the calculus will change. There’s an existing Republican counter-plan, and the party is apt to increase its ranks in the next Congress. The GOP reform plan isn’t all that different from what Democrats have put forward, but the banks consider the changes less onerous.

4) But 2011 Republicans, infused with Tea Party populism, might be a more combative lot. The House-Senate conference committee offered a preview. Conservatives tried to force banks to pay for the wind-down of $140 billion bailout recipients Fannie Mae and Freddie Mac. Incoming Republicans might also be more amenable to shrinking the banks as the only way to prevent the problem of “too big to fail.”

5) At the very least, the messy process would generate vast, new uncertainly for industry executives and investors. No wonder banks’ shares rose on news of the compromise agreement, despite its potentially heavy costs.

Is financial reform in trouble thanks to Brown and Byrd?

Jun 28, 2010 16:26 UTC

The political calculus for U.S. financial reform is suddenly more complicated. Last Friday’s 5 a.m. Capitol Hill compromise was meant to be the culmination of months of hard-fought wrangling. But Republican Scott Brown’s wavering and Democrat Robert Byrd’s death put the proposal back in jeopardy.  I think the assumption is that Dem “no” votes Cantwell and Feingold will both switch to “yes” so that in the end losing Brown and temporarily losing the WV Dems vote won’t matter. But even though the early spin was that the bill got tougher on Wall Street at the end, bankers aren’t jumping from the windows today. That might irk Cantwell and Feingold and keep them against it. But I doubt it. Give the  bill a 80-90 percent chance of passage.

COMMENT

Feel sorry for the death of Senator Byrd, but holy cow! How the hell can a 92 year old man be making policy for a country? If there can be term limits for most positions then please PLEASE make age limits too. 70 seems reasonable, ie can’t run for office if one would take office after one’s 70th B-day. Just my two cents…

Posted by CDNrebel | Report as abusive

For banks, financial reform taking turn for the worse

Jun 24, 2010 15:27 UTC

Wall Street always knew financial reform was coming. The big banks never really thought there was a chance of killing it, not that they really tried to. In fact, once the effort moved into 2009, they wanted it over sooner rather than later. The longer the process dragged out, the greater the chance of something crazy popping up and the more political and profit damage they took. For instance: The “break up the bank” movement was almost successful. As it is, the Volcker rules and derivatives reform may end up far tougher than their worst-case scenario.

But now things are going pear shaped. House negotiators want big banks to pay for any future wind-down of Fannie and Freddie and are trying to slip in a bank tax to repay TARP funds. And the hits keep on coming. Democrats have concluded that with the unemployment high and Obama’s approval falling, bashing the banks is the best ticket they have in the November midterms. Liberals have always suspected that despite Wall Street grousing about reform, they were actually quite happy that it was not tougher.  Maybe, but now the complains are real.

COMMENT

The fact is that “big” banks are “too big to fail,” “too big to regulate,” “too big to manage,” and therefore, “too big to keep around…” More at:

http://wjmc.blogspot.com/2010/04/too-big .html

Thank you for the opportunity to comment…

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