January 28, 2011
The Zippo Lighter theory of the financial crisis (or, who do we want to blame?)
The Economist summarises who the Financial Crisis Inquiry Commission of USA's Congress would like to blame in three tranches. For the Democrats, it's the financial industry and the de-regulation-mad Republicans:
The main report, endorsed by the Democrats, points to a broad swathe of failures but pins much of the blame on the financial industry, be it greed and sloppy risk management at banks, the predations of mortgage brokers, the spinelessness of ratings agencies or the explosive growth of securitisation and credit-default swaps. To the extent that politicians are to blame, it is for overseeing a quarter-century of deregulation that allowed Wall Street to run riot.
For the Republicans:
A dissenting report written by three of the Republicans could be characterised as the Murder on the Orient Express verdict: they all did it. Politicians, regulators, bankers and homebuyers alike grew too relaxed about leverage, helping to create a perfect financial storm. This version stresses broad economic dynamics, placing less emphasis on Wall Street villainy and deregulation than the main report does.
Finally, one lone dissenter:
A firmer (and, at 43,000 words, longer) rebuttal of the report by the fourth Republican, Peter Wallison, puts the blame squarely on government policies aimed at increasing home ownership among the poor. Mr Wallison argues that the pursuit of affordable-housing goals by government and quasi-government agencies, including Fannie Mae and Freddie Mac, caused a drastic decline in loan-underwriting standards. Over 19m of the 27m subprime and other risky mortgages created in the years leading up to the crisis were bought or guaranteed by these agencies, he reckons. These were "not a cigarette butt being dropped in a tinder-dry forest" but "a gasoline truck exploding" in the middle of one, Mr Wallison says.
Yessss..... That's getting closer. Not exactly a gasoline truck, as that would have one unfortunate spark. More like several containers, loaded with 19m fully-loaded zippo lighters driven into the forest of housing finance one hot dry summer, and distributed to as many needy dwellers as could be found.
Now, who would have driven that truck, and why? Who would have proposed it to the politicians? Ask these questions, and we're almost there.
Posted by iang at January 28, 2011 05:39 AM | TrackBackslightly shorter version of my earlier comments
turning loans into toxic CDOs created huge new set of transactions for wallstreet being able to take possibly 15-20% in fees and commissions
reference to possibly $27T in triple-A rated toxic CDOs done during the bubble (possibly $5.4T for wallstreet?)
http://www.bloomberg.com/apps/news?pid=20601109&refer=home&sid=a0jln3.CSS6c
there are reports that the industry tripled in size (as percent of GDP) during the bubble. also NY comptroller reported that wallstreet bonuses spiked more than 400% during the bubble.
mortgages had been packaged as CDOs during the S&L crisis (obfuscate the underlying value); but w/o the triple-A ratings had very little market.
this time unregulated loan orginators found that they could pay for triple-A ratings (even when both the originators and rating agencies knew they weren't worth triple-A ... from the congressional rating agency hearings, fall2008) ... which exploded the market for the toxic CDOs ... and eliminating any reason for the loan orginators to care about loan quality or borrowers qualifications. Since they could immediately unload everything at triple-A ... they just turned into loan/mortgage mills ... their revenue only limited by how many & how fast they could turn over the loans.
no-documentation, no-down, 1% interest-only payment ARMs found an exploding market among speculators; with real-estate inflation running 20-30% ... it met possibly 2000% ROI (flipping before the rates adjusted ... further churning transactions and boosting inflation). These mortgages become the equivalent of the '20s "Brokers' Loans" ... allowing the real-estate market to be turned into the equivalent of the '20s stock market.
Individual compensation on the loan originator and the wall street sides (of packaging loans as triple-A rated toxic CDOs) was so great that it overrode any possible concern as to the effects on the institution, the economy, and/or the country (with being able to buy triple-A ratings sitting in the middle).
The triple-A rating made the toxic CDOs appear acceptable to large number of institutions that wouldn't otherwise deal in the instruments. At the end of 2008, the four too-big-to-fail regulated, "safe" institutions were carrying $5.2T of the toxic CDOs "off-balance" (courtesy of repeal of Glass-Steagall and their "unregulated", risky investment banking arms). ref
http://www.bloomberg.com/apps/news?pid=20601039&sid=akv_p6LBNIdw&refer=hom
GSE lost a major portion of the mortgage market share as mortgages were being packaged up as triple-A rated toxic CDOs and sold in these other markets.
Earlier in 2008, a number of toxic CDO sales ... totaling several tens of billions had gone for 22cents on the dollar. If the too-big-to-fail institutions had to bring their off-balance toxic CDOs back onto the balance sheet, they would have been declared insolvent and forced to be liquidated. TARP funds had supposedly been to buy up these toxic assets but they obviously didn't know the magnitude of the problem (the amount appropriated wouldn't have made a dent in the problem).
It took more than a year of legal efforts to get Federal Reserve to disclose what it has been doing; buried in the information is reference to them buying up these assets at 98cents on the dollar.
now this is archaic, long-winded post from 1999 discussing several of the problems ... including the fact that in 1989 CITI was nearly taken down by its ARM mortgage portfolio (it got out of the business and required a private bailout to stay in business)
http://www.garlic.com/~lynn/aepay3.htm#riskm
role forward and CITI is holding the largest share of the $5.2T in triple-A toxic CDOs (effectively mostly an ARM mortgage portfolio) and requires another bailout to stay in business. Repeal of Glass-Steagall didn't directly cause the problem, repeal of Glass-Steagall just allowed several of these too-big-to-fail institutions to enormously help fuel the (triple-A rated toxic CDO) loan/mortgage and side-step the regulations designed to keep them out of risky behavior.
Posted by: Lynn Wheeler at January 28, 2011 01:38 PMrelated to the ZIPPO theme ... regulations had kept the hotspots of greed and corruption separate and damped down ... then the period of extremely lax regulation and de-regulation ... allowed the greed and corruption hotspots to merge and create a financial firestorm.
one of the suggestions has been to RICO wallstreet
http://en.wikipedia.org/wiki/Racketeer_Influenced_and_Corrupt_Organizations_Act
for three times the $27T involved in the triple-A rated toxic CDOs.
Posted by: Lynn Wheeler at January 29, 2011 11:44 AMbaseline article today:
http://baselinescenario.com/2011/01/30/my-most-libertarian-post-ever/
note the above skates on the fact that fall2008 congressional hearings into the rating agencies had testimony that rating agencies were "selling" triple-A ratings (when both the seller and rating agencies knew they weren't worth triple-A).
Posted by: Lynn Wheeler at January 30, 2011 05:16 PM