« The War on Executive Compensation--Skeel | Main | Where are the Burkeans?--Stuntz »

Bailout Stories--Skeel

One reason the current financial crisis seems so mystifying is, I think, the absence of a simple, coherent story that explains what the crisis is about. The Enron and WorldCom scandals earlier in the decade could be distilled to a plausible story about greed and the failure of the accounting firms and other gatekeepers who are supposed to police Wall Street. With the current crisis, by contrast, three main narratives seem to be competing for attention. And each is deeply flawed.

The first, which has been offered by Senator Bernie Sanders and others, attributes the crisis to Wall Street greed, and demands that Wall Street be punished and ordinary Americans helped. Wall Street greed certainly is a major factor in the crisis, most visibly in the pushing of exotic, mortgage-related securities that now have come back to haunt many financial institutions. But the greed story has at least two problems.

First, the greed wasn't limited to Wall Street executives. Borrowers and real estate speculators also seem to have been a little too acquisitive in the days of cheap money and soaring real estate values. Second, it seems clear that adopting the Wall Street greed story and punishing the banks and their executives would end up hurting ordinary Americans, by making banks even more reluctant to lend money to individuals and small businesses than they are now.

The second story is a story about deregulation gone amok. The bete noir of this story is the 1999 legislation, co-sponsored by former McCain adviser Phil Gramm, that reversed the New Deal era Glass-Steagall regulation that had prevented commercial banks (the ones that take deposits) from combining with investment banks. The problem with this story, which Obama has credited at times, is that the reversal of Glass Steagall seems to have nothing to do with the current crisis. Rather than causing the trouble, commercial banks and banks that combine commercial and investment banking (such as Bank of America and Citigroup) are the ones that have so far best weathered the storm. Two of the most visible collapses, Bear Stearns and Lehman Brothers, were standalone investment banks.

The House Republicans who temporarily torpedoed the bailout bill on Monday have offered a very different story, a narrative about the need to trust the markets and stay the course, rather than adding to the government's new role as the nation's investment bank. McCain has given some succor to this view, although he has tended to emphasize the greed narrative of late and favors the bailout. The problem with the stay the course narrative is that it seems likely that the crisis in the credit markets, and banks' reluctance to lend, will get radically worse unless the government steps in.

The one narrative that strikes me as more plausible than any of these three, but which no one seems willing to raise, is a story about our preoccupation with homeownership in this country, particularly since World War II. The desire to expand homeownership is in many respects a wonderful thing- I certainly have benefitted from it myself- but it also has serious downsides. Homeowners are privileged by comparison with renters, most obviously in the tax deduction for interest. And the efforts to pump up the housing market in recent years, in part by keeping interest rates low and in part by protecting Fannie Mae and Freddie Mac from reform, seem to have spawned much of behavior that is now being criticized. It is hard to imagine a serious conversation about whether our commitment to subsidizing home ownership has gone too far. Everyone from prominent interest groups to ordinary American has a stake in continuing to promote homeownership in every way possible. But the costs of this commitment strike me as the one story that best explains the current crisis.

TrackBack

TrackBack URL for this entry:
https://apps.law.upenn.edu/weblog/mt-tb.cgi/270

Comments ( 7 )

I think you are exactly correct. I cannot think of anyone under 30 who was not trying desperately to buy a home for the past few years and most of them have been allowed to even though they, at their current level of income, clearly could not afford the payments on the loan. What is strange to me is that they would say they were trying to buy a home for some of the reasons you mention but these were clearly just veneer on deeper cultural drivers. You buy a home because that is what you do and what everyone in your peer group is doing.

Your comments above are well taken but let me add to the threads of causation/blame:

1. Catalyst: The Community Reinvestment Act and the related push on financial institutions to lend to anyone, particuarly those who would not otherwise afford a house.
2. Accelerant: [This should really be tagged onto the greed area since it stems from that] The mortgage brokers and the appraisers, neither of which evidenced any ethics or in most cases cared about them. They just want to make a killing and move on. Remember, without poor underwriting at the grass roots level (and the appriaisers as accomplices), you don't get such poor loans. At base, the mortgage debacle and its fallout are the result of the worst underwrting failure in history.
3. The Intensifier: Whenever you make poor underwriting or investment judgments, leverage will accentuate the degree of damage. That is the just dessert of leverage. Whatever hurts at 5:1 leverage hurts at 10:1 and dramatically more so at 25:1 (used by some investment banks). Leverage is not the direct cause of the crisis its just the degree of leverage versus history that makes it worse (particularly when you rely on a wholesale funding model).

A few more additions to the greed cohort: (a) Anyone who took cash out in a refi and splurged on material goods or other lifestyle enhancements; (b) Anyone who reached for a house by buying it with a loan to value (LTV) of less than 80%, the traditional standard for making sure an adequate cushion of safety existed; and (c) Anyone who traded up to the better house they always desired because their house has appreciated so much.

I think these are terrific insights, Bill. On the leverage issue, there's a remarkable article in the NY Times this morning reporting that the SEC removed capital restrictions on the investment banks in 2004, and then essentially outsourced oversight to the banks themselves thereafter, under SEC Chair Christopher Cox. When McCain called for Cox to resign a few weeks ago, I thought the idea was silly. But if the article is accurate, it makes me think he may be right. (The link is: http://www.nytimes.com/2008/10/03/business/03sec.html?pagewanted=1&_r=1&hp).

Very good (and surprisinlgy a mostly non-partisan)analysis). Ironically, it also shows two somewhat contradictory things: Government regualtion can be necessary in certain instances but we can't trust government to do it right.

David, I agree wholeheartedly with your remarks. Of course, this post would make you an instant loser in a popularity contest. And that's part of the problem (America's, not yours): The high level of affluence that we've become accustomed to since at least 1945 makes it difficult for our political and business leaders to shout, "Slow down!" Not that many of them even seem to be interested in questioning the shallowness of our national priorities.

I also can't avoid wondering if the quest for homeownership, especially as we've seen it in the last quarter century, has been about realizing characteristically American, individualistic notions of personal identity. Is homeownership not a way that many seek to establish and demonstrate their self-worth? It's as if one of the worst things you can be in America is dependent, in this case on landlords. Perhaps the homeowner's possession broadcasts one's independence in a particularly troublesome way.

Not that universal homeownership is necessarily a bad thing. But could we not live with smaller, less expensive houses in physical arrangements that better reflect ideals of personal and corporate humanity that prevailed before the advent of modern industrial capitalism? (I have in mind the new urbanism and experiments in co-housing. Also consider Jay Shafer's Tiny Houses.)

Complex problems never have simple explanations or solutions. Greed was a major factor in this crisis, but not the only factor. You don't seem to understand that from the originating mortgage broker to the purchasing entity to its upper management everyone made money, the most at the top. Everyone in the system did not think that that party would last but were determined to make as much personal money as possible. It is true that many ordinary people exploited the system or tried to or thought that they could. I do not think that there is moral equivalence however.
Second, you claim that because Citibank is surviving the deregulation could not be the cause. It is part of the cause. Deregulation allowed the vast unregulated "banks" to grow and flourish. If you were more careful ,you would realize the Citibank and B of A are far more regulated - not that regulation saved many other banks, Wachovia most recently.
Third, you do not consider that, in the eyes of many observers, the corporate finance industry broadly defined has "captured its regulators" so that even existing protections softened or disappeared. Where was the SEC? Where is it now?
Fourth, you ignore (or perhaps do not know) the fact that a number of thoughtful and professional observers of Wall Street predicted exactly this crisis for more than a year before - Warren Buffet is the best known, but see Nouriel Roubini, Dean Baker and others cited therein.
So we have a crisis that was foreseen by some. No action was taken. No interest was taken in the critical analyses. No politician took on Wall Street. Some medium level players - PIMCO, Oppenheimer got out or stayed out of these markets to their profit, and a few individuals made a lot of money betting against it. We still don't know how much effect the shorts had on the market in the past few weeks.
If you read The Black Swam you will find not only a prediction of this crisis written a couple of years ago, but a plausible explanation of the coming crisis in terms of previous Wall Street crises. I do not think that your offered explanation can be squared with these facts and urge you to read more and rethink it.

Didn't JP Morgan seize $17 billion worth of cash and other collateral from Lehman? (http://www.reuters.com/article/rbssFinancialServicesAndRealEstateNews/idUSN0336744420081004). In other words, Lehman underwrote complex financial derivatives (such as CPDO's) (http://www.ft.com/cms/s/0/1e48a64e-7363-11db-9bac-0000779e2340.html?nclick_check=1), lost and then couldn't pay its bills because JP Morgan, the counterparty to many of these transactions, refused to provide it with liquid collateral.

Wall street greed, or financial innovation, needs to be regulated to ensure the public's interest in a sound financial system. I agree. But how is the government going to encourage an investment bank to hold its bankers accountable and to take on intelligent risks? Rating complex derivatives is tough enough when the risks aren't fully understood. The complexity only increases when the risks depend on market forces and other variables that one bank can't predict or measure. The recent market failures demonstrate a market spiral and not unethical conduct as many financial companies suffered losses. When bond funds defaulted, credit spreads quickly widened. This caused banks such as Lehman that bet against credit spreads to default, which quickly escalated the problem. (http://www.reuters.com/article/bondsNews/idUSN1049499720080310) I wonder how Lehman could have appreciated the risk of default when it couldn't predict how quickly credit indices would widen. Should managers and regulators make decisions regarding the viability of financial derivatives, and risk stifling the engine that drives the nation's economy? CPDO's provided investors with unique advantages (http://riskopedia.files.wordpress.com/2007/03/cpdo.pdf). Prohibiting them would foreclose these.

The street has an ethical code that answers tough questions like these. Perhaps we should intervene by providing its players with valuable information that will help investors appreciate the true nature of the risks they undertake.