Genetically Engineered Chickens Coming Home to Roost

by Don Boudreaux on September 23, 2008

in Current Affairs, Financial Markets, Politics, Regulation, Seen and Unseen

In today’s Wall Street Journal, Columbia University economist Charles Calomiris (one of the most respected money and banking economists of our era) co-authored this essay with Peter Wallison that argues that Congress pushed Fannie and Freddie to make high-risk mortgage loans.  Here are a few passages from the article:

The strategy of presenting themselves to Congress as the champions
of affordable housing appears to have worked. Fannie and Freddie
retained the support of many in Congress, particularly Democrats, and
they were allowed to continue unrestrained. Rep. Barney Frank (D.,
Mass), for example, now the chair of the House Financial Services
Committee, openly described the "arrangement" with the GSEs at a
committee hearing on GSE reform in 2003: "Fannie Mae and Freddie Mac
have played a very useful role in helping to make housing more
affordable . . . a mission that this Congress has given them in return
for some of the arrangements which are of some benefit to them to focus
on affordable housing." The hint to Fannie and Freddie was obvious:
Concentrate on affordable housing and, despite your problems, your
congressional support is secure.

……

In 2005, the Senate Banking Committee, then under Republican
control, adopted a strong reform bill, introduced by Republican Sens.
Elizabeth Dole, John Sununu and Chuck Hagel, and supported by then
chairman Richard Shelby. The bill prohibited the GSEs from holding
portfolios, and gave their regulator prudential authority (such as
setting capital requirements) roughly equivalent to a bank regulator.
In light of the current financial crisis, this bill was probably the
most important piece of financial regulation before Congress in 2005
and 2006. All the Republicans on the Committee supported the bill, and
all the Democrats voted against it. Mr. McCain endorsed the legislation
in a speech on the Senate floor. Mr. Obama, like all other Democrats,
remained silent.

Now the Democrats are blaming the financial crisis on
"deregulation." This is a canard. There has indeed been deregulation in
our economy — in long-distance telephone rates, airline fares,
securities brokerage and trucking, to name just a few — and this has
produced much innovation and lower consumer prices. But the primary
"deregulation" in the financial world in the last 30 years permitted
banks to diversify their risks geographically and across different
products, which is one of the things that has kept banks relatively
stable in this storm.

As a result, U.S. commercial banks have been able to attract more
than $100 billion of new capital in the past year to replace most of
their subprime-related write-downs. Deregulation of branching
restrictions and limitations on bank product offerings also made
possible bank acquisition of Bear Stearns and Merrill Lynch, saving
billions in likely resolution costs for taxpayers.

If the Democrats had let the 2005 legislation come to a vote, the
huge growth in the subprime and Alt-A loan portfolios of Fannie and
Freddie could not have occurred, and the scale of the financial
meltdown would have been substantially less. The same politicians who
today decry the lack of intervention to stop excess risk taking in
2005-2006 were the ones who blocked the only legislative effort that
could have stopped it.

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{ 35 comments }

Per Kurowski September 23, 2008 at 8:46 am

This is indeed a very insightful article that shows how easy it is to fool around with terms such as deregulation.

You must now by now that for me it has become almost an obsession to point out the incredible madness of talking about de-regulated financial markets when the credit rating agencies have been given monopolistic rights over risk assessments.

Please imagine the credit rating officials of the credit rating agencies working for the Fed… because that is exactly what they do.

Blackadder September 23, 2008 at 8:58 am

There's something about the "the government caused it by encouraging cheap loans" explanation for the housing bubble that I don't quite get. If the government were to decide, for example, that to encourage farmers to sell wheat more cheaply, this would presumably not lead to a wheat bubble. Farmers would either ignore the government or, if this was impossible, would cut back on production. In other words, the general effect of government action to keep the price of something artificially low is not a bubble but a shortage.

I don't see why the same wouldn't be true of loans. If a bank ordinarily wouldn't make certain loans, encouragement from the government is unlikely to make them do so, and even if government encouragement did effect banks behavior, the overall effect should be to make them less likely to extend credit to people.

What am I missing?

muirgeo September 23, 2008 at 9:26 am

Enough already. This mad scramble to find governmental regulatory culpability is a quixotic adventure for the protectors of ideology.

So how did the government make AIG do what it did?

How did the government make Wall Street come up with opaque toxic asset backed products?

How did the government force repackaging of mortgages on private institutions?

How did the government force these too big to fail companies to take on such huge liabilities?

This is market failure based on a lack of regulatory oversight. This is financial cowboys given free roam to stack a pyramid scheme to make themselves filthy rich regardless of the fall out. And th guys in the Fed and the Treasury are the same guys. They don't count as government. These are guys who's whole lives have been bound to a bankrupt ideology and they were the enablers who transfered from private practice to help their fellow believers get everything they wanted.

And as our country is brought to its knees these pushers of paper will remain super rich while the productive class works a little harder and while the ideologues continue to provide cover the same thing which will repeat over and over again as it has in the past.

The ideology needs to die because it IS really really killing people and destroying lives.

gappy September 23, 2008 at 9:32 am

Very interesting piece, and Calomiris is indeed respectable, although he always seems to know *everything* (international finance, regulatory policy, macroeconomics, etc), which I find a bit suspicious.

There is a well-documented trail of democratic policies aimed at making housing affordable. What I don't get though, is how come the risk posture of the GSEs changed for the worse so much during the Bush Administration. I imagine that subprime mortgages fit well in the "ownership society" vision, but that's not an explanation.

But I also want to comment on the crux of the WSJ article, namely:

If the Democrats had let the 2005 legislation come to a vote, the huge growth in the subprime and Alt-A loan portfolios of Fannie and Freddie could not have occurred, and the scale of the financial meltdown would have been substantially less.

Even in this weak form ("could" not have occurred), this conclusion is unwarranted and probably false. First, there would have been a lag time of at least one-two years until the bill could go into effect. At that stage, the bulk of Alt-A and Jumbo mortgages had been underwritten already. Second: economic capital requirements are not an exact science. Just change prepayment and default models just a bit (maybe calibrate them to a different set of data), and you can get very different capital requirements. If you don't believe me, just look at the scores of banks suffered tens of billions of write-downs: they all had complex models and strict capital requirements in place.

In the past two weeks every economic blogger is fibrillating and everyone seems eager to push his agenda. Although I am quite confident that deregulation has nothing to do with the current situation, I also believe that, before passing judgments, one as to gather all possible facts and understand the relationships between them. I am skeptical of this or that anecdote pointing at the culprit.

Don Boudreaux September 23, 2008 at 9:32 am

Muirgeo,

You should read the historical details and pay attention to the facts as they are (rather than as you imagine them to be) before accusing others of being blinded by ideology.

Bill Mill September 23, 2008 at 9:59 am

If I may make a request, I'd love to read a direct response to this post at CalculatedRisk: http://economistsview.typepad.com/economistsview/2008/09/it-wasnt-the-co.html

markg8 September 23, 2008 at 10:05 am

http://www.bloomberg.com/apps/news?pid=20601070&sid=aQIOOr9klOnE

McCain Transition Head Lobbied for Freddie Mac Before Takeover

By Jonathan D. Salant and Timothy J. Burger

Sept. 23 (Bloomberg) — The lobbying firm of the man Republicans say John McCain has chosen to begin planning a presidential transition earned more than a quarter of a million dollars this year representing Freddie Mac, one of the companies McCain blames for the nation’s financial crisis.

Timmons & Co., whose founder and chairman emeritus is William Timmons Sr., was registered to lobby for Freddie Mac from 2000 through this month, when the federal government took over both Freddie Mac and Fannie Mae.

Newly available congressional records show Timmons’s firm received $260,000 this year before its lobbying activities were barred under terms of the government rescue of the failed mortgage giant. Timmons, 77, is listed as a lobbyist for Freddie Mac on the company’s midyear financial-disclosure form.

Sam Grove September 23, 2008 at 10:14 am

Really muirgeo,

You should carefully read what is written so you may be able to make a relevant comment.

It appears your modern education, in addition to leaving you with weak spelling skills, has also affected your reading comprehension.

"Weather" you admit it or not.

Oil Shock September 23, 2008 at 10:25 am

Ron Paul was pretty much ignored by the media during the presidential campaign. If they didn't ignore him, they certainly ridiculed him. Now, the media is giving him more attention as a consistently dissenting voice to the bail out plan. Here he writes commentary for CNN>

Bill September 23, 2008 at 10:34 am

Blackadder,

I think what is missing is the role of the Federal Reserve and its inflationary monetary policy (when I say inflation I mean easy money). Easy money gives banks the incentive to make loans. Also, those banks knew they could offload the loans in packages to Fannie and Freddie.

Per Kurowski September 23, 2008 at 10:59 am

"Enough already. This mad scramble to find governmental regulatory culpability is a quixotic adventure for the protectors of ideology."
Posted by: muirgeo | Sep 23, 2008 9:26:57 AM

Ignoring the facts that our banks had to have equity dependent on the risk determined by the credit rating agencies; and that insurance companies were not even allowed to go where the credit rating agencies ratings allowed them to go, and think this empowerment of the credit rating agencies has nothing to do with regulatory culpability, sound also like a quixotic adventure for the protectors… of the other ideology.

Blackadder September 23, 2008 at 11:08 am

Bill,

You may be right. It could very well be that the housing bubble was the result of an inflationary monetary policy by the Fed. But if Fed policy is the culprit, then attention should be focused there, not on government efforts to promote homeownership.

muirgeo September 23, 2008 at 11:47 am

Here is a history lesson.

We can go back to the pre-government financed housing and a lot of you would NOT be in homes. There would be depressions every 5-7 years. You would need as much as 50% down and would maybe get a 10 year loan. Or we could go back to the well regulated time in history when home ownership was supported by well regulated government agencies and home ownership and the economy soared. Or we can enter the modern Cowboy finance era of homeownership infiltrated by corporate raiders and banksters where paper pushers set up the rules get rich and destroy the system.

My history beats up your politics!!

(Borrowed from the My History Beats Up Your Politics blog and podcast)

Bill September 23, 2008 at 11:58 am

Muirego,

Your reasoning is a post hoc fallacy. What specific regulations lead to specific rises in home ownership and on what economic basis?

Bill September 23, 2008 at 11:59 am

Blackadder,

I agree, we should focus attention on Fed policy. Otherwise we will be in this boat again before too long.

BoscoH September 23, 2008 at 12:19 pm

George, so what kind of regulation would you have liked? No lending to poor people? No lending into predominantly minority areas? With the exception of Oil Shock, who is parroting the Lew Rockwell line that this is all about fiat money (FTW?!?), I don't think anyone here is denying that there was some failure in the market to assign risk correctly assuming that the government would not be the guaranteer of last resort for securities packaged by Fannie and Freddie.

Hayek said that markets and prices are about information. So it should not be surprising that the forensic analysis of this debacle by Hayek fans focusses on information injected into the system that throws it off. I see what Frank and others did from the committee room to influence Fannie and Freddie much the same way I see Congress' continuing use of the anti-trust exemptions to "influence" MLB, the NFL, and the NBA. Lost in the steroid debate, for example, was the fact that they were anything but a shortcut! There could be no airing of the issue because Congress already knew what its goals were and how the leagues would toe the line under implicit threat of losing anti-trust exemptions.

muirgeo September 23, 2008 at 12:23 pm

I agree the Fed needs to become a completely government run entity likely incorporated into the Treasury department. It needs a further degree of separation from the Banksters who try to infiltrate it.
Monetary policy should be more automated and dollars should be tied to true increases in productivity and SHOULD not be given with attached debt.

muirgeo September 23, 2008 at 12:28 pm

Hayek said that markets and prices are about information.

Posted by: BoscoH

Absolutely!! And Wall Street left to its own to create instruments to reduce risk and properly allocate capital came up with the most opaque products you could imagine. They purposely withheld information from the markets to steal the crap out of the productive economy. They new dam well what they were doing… they were going for the easy money instead of doing the responsible thing.

"Capitalism is the astounding belief that the most wickedest of men will do the most wickedest of things for the greatest good of everyone."

Keynes

Bill September 23, 2008 at 12:44 pm

"Capitalism is the astounding belief that the most wickedest of men will do the most wickedest of things for the greatest good of everyone."

Give me the wicked man trying to sell me something over the "good" man forcing me to do be "moral."

Elections don't make men pure.

Oil Shock September 23, 2008 at 12:50 pm

"Socialism is an orgasmic belief that the most wickedest of men will do the most generous of things for the greatest good of everyone" -Oil Shock

And Keynes wanted to bail out the crooks who withheld the information and the fools who invested without the information. Liquidate bad debt. Say no to fascist Keynesian bail out.

"The Italian Charter of Labour says that private enterprise is responsible to the state . . . [but] it is the state, i.e., the taxpayer, who has become responsible to private enterprise . . . . Profit is private and individual. Loss is public and social."

–Gaetano Salvemini, Under the Axe of Fascism(1936), p. 380. (Salvemini was a brave critic of Italian fascism under Mussolini).

( from LRC blog )

colson September 23, 2008 at 12:57 pm

muirgeo:

The answers to most of your questions can be found in the full-length article from the WSJ that Don quotes from.

Look at where the incentives were: FMae and FMac created the incentives by purporting to be what it wasn't, then when banks balked at swallowing any more sub-prime debt, they started doing what they shouldn't have done which is to become a holder of these mortgage obligations. The reality is that some people in Congress tried to stop this while others in Congress did nothing.

And to be able to support FMac's and FMae's mortgage-crack habit, banks had to create some complicated financial instruments to mitigate the amount of risk involved in taking on these debts.

So who really gives a rat's behind if someone made a billion dollars in 2006. It is irrelevant. Or maybe it is relevant. Those paychecks are recognition of many factors aside from the piece of paper it is written on. Second, how much do you think the government takes from that? Probably more than every reader of this blog makes combined. And that is *not* obscene?

Is it obscene that he continues to give away large amounts of money to fund a variety of philanthropic pursuits? It must be disgusting to think that he contributes to the health care system in Nepal. Or that he runs a nature preserve. Or how about the obscene amounts of money given to Stony Brook to fund and promote math and physics education? I won't even tell you how much disgusting money he's poured into autism research.

I could keep going down your list of wealthy people but I think you'd be disgusted by knowing the size and scope of their philanthropy and the taxes they paid on that wealth.

BoscoH September 23, 2008 at 1:01 pm

George, how about addressing my point rather than deflecting it? You've yelled "stop" at the notion that Congress might have exerted some influence on lending practices through its oversight of the GSEs, despite all sorts of evidence to the contrary. Russ has dished it up the ton in the past few days. In your first post today, you pretty much said it was an invalid line of inquiry and that it was clearly just market failure requiring more regulation. Politicization played no roll, according to you, and the market went wild lending money to poor people. Were they hoping to make it up on volume?

Sam Grove September 23, 2008 at 1:02 pm

And Wall Street left to its own to create instruments to reduce risk and properly allocate capital came up with the most opaque products you could imagine.

Please tell us of this fabulous world where Wall Street is left to its own. Certainly it's not in this world.

Oil Shock September 23, 2008 at 1:08 pm

Just making an attempt to fix the HTML error with blockquote

Sam Grove September 23, 2008 at 1:16 pm

There, I've closed the block quote tag.

Sam Grove September 23, 2008 at 1:17 pm

2 demerits Oil Shock

Per Kurowski September 23, 2008 at 1:20 pm

"And Wall Street left to its own to create instruments to reduce risk and properly allocate capital came up with the most opaque products you could imagine. They purposely withheld information from the markets to steal the crap out of the productive economy."
Posted by: muirgeo |

Suppose this is all true… but then what about the responsibility of the risk surveyors, the credit rating agencies, and what about the responsibilities of those regulators that empowered the credit rating agencies with so much credibility that everyone forgot to do their own homework!

Sam Grove September 23, 2008 at 1:24 pm

Let us not forget the central bank for the false signals created by easy credit.

Oil Shock September 23, 2008 at 2:31 pm
muirgeo September 23, 2008 at 3:37 pm

Give me the wicked man trying to sell me something over the "good" man forcing me to do be "moral."

Posted by: Bill

You got the wicked man and you'll be paying him some $5,000 dollars in taxes and about as much in cost of living increases and fall in the value of your dollar.

Oil Shock September 23, 2008 at 4:26 pm
vidyohs September 23, 2008 at 5:52 pm

"If a bank ordinarily wouldn't make certain loans, encouragement from the government is unlikely to make them do so, and even if government encouragement did effect banks behavior, the overall effect should be to make them less likely to extend credit to people.

What am I missing?

Posted by: Blackadder | Sep 23, 2008 8:58:46 AM"

Your exchange with Bill was instructive but I have a simple explanation for the "What am I missing?"

Advertisers "encourage" and thus persuade or not because they have no way of forcing you to respond to their encouragement.

Government "encourages" with all the full force that only government can bring. If one does not respond to the "encouragement" we see things such as Ruby Ridge, the Branch Davidian compound, Elian Gonzales episode, IRS audits, license revocation, regulatory harassment, etc etc.

If you own a bank and government "encourages" you to do a certain thing and you do not….perhaps you won't be a banker tomorrow.

maximus September 24, 2008 at 2:14 am

There's an excellent video on the AEI website of Peter Wallison being interviewed by Brian Lamb of C-SPAN regarding the Freddie and Fannie controversies. He talks about how Barney Frank and others were using them as a slush fund for political purposes.

Sam Grove September 24, 2008 at 9:05 pm

There is a reason for laws against huge monopolies, the banks should be no different.

We do? Can you cite?

Actually, we have laws that create huge monopolies. There used to be one called ATT.
Here in CA, we have PG&E and Pacific Bell.

There are huge monopolies created by law all over the country.

But perhaps you are thinking of the Sherman Anti-trust act, which was created at the whining of extant oil companies when the production efficiencies of Standard Oil threatened their existence.

Sam Grove September 24, 2008 at 9:18 pm

You should question everything you think you know about economics

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