Greenspan Spins the Housing Bubble
In his latest effort to escape the blame for the housing bubble in the Wall Street Journal last week, Alan Greenspan pointed his finger at the collapse of the Soviet Union. There is no reason to go through the details. If anyone other than Greenspan had put forward this argument, it would never have found its way onto the pages of a serious newspaper.
If we (meaning those of us who warned about the bubble on the way up) couldn’t do anything to prevent this train wreck, we can at least try to ensure that the right lessons are learned in the bubble’s aftermath.
The easiest way to lay out the right lessons is to present the Greenspan doctrine on financial bubbles and show why it is wrong. The central tenets of the Greenspan doctrine (adjusted as needed for political circumstances) are:
1) bubbles cannot be recognized before they burst;
2) there is nothing that the Fed could do even if it did recognize a bubble; and
3) collapsing bubbles are no big deal anyhow.
Taking these points in turn, for some of us, it just does not seem to be very hard to recognize financial bubbles. The basic methodology is to note when prices of assets like stocks or houses have diverged from long-term trends. When there is such a divergence, you go to step two, which is to see whether there is a plausible explanation in the fundamentals of the economy.
In the case of the stock market bubble we saw the average price to earnings ratio for the stock market, which had historically been around 14 to 1, rise above 20 to 1 in the mid-nineties. Returns on stock are directly related to price to earnings ratios (this is third grade arithmetic, not complex economics). This meant that unless investors had hugely more optimistic views about the future growth of profits than the overwhelming majority of economic forecasters or they were prepared to accept really low returns on the stock they held, then the market was being driven by an irrational bubble.
Since neither of these explanations seemed plausible, some of us (including on certain days Alan Greenspan) recognized the stock bubble for what it was. Similarly, in the years from 1995 to 2006, when house prices rose by 70 percent after adjusting for inflation, some of us were prepared to call the run-up a bubble, since house prices had just kept even with the overall rate of inflation for the prior hundred years. These bubbles were recognizable and some of us did recognize them at the time.
Greenspan’s next line of defense is that there is nothing that the Fed can do about a bubble even if it did recognize it. The story of the powerless Fed is really hard to accept. First it has enormous regulatory powers. For starters, it could have tightened up the rules on the predatory subprime mortgages. More importantly, Alan Greenspan could have used his enormous megaphone as Federal Reserve Board chair to lay out the evidence for the existence of a stock or housing bubble.
This does not mean mumbling “irrational exuberance” on rare occasions. The point is to use congressional testimonies and other public appearances to carefully explain how stock or housing prices are unsustainable.
If Alan Greenspan had followed this route, every financial manager would have been forced to carefully assess his arguments. All the bankers and fund managers who now must own up to multi-billion dollar losses for their companies and clients would be forced to explain why they ignored Alan Greenspan’s analysis. Anyone who said that they paid no attention to the Fed chairman’s words would be sued for the full value of their personal wealth, including their 401(k)s and their homes.
Would this Fed talk have been sufficient to deflate the bubbles? Would the airheads at places like Citigroup, who bought tens of billions of near worthless mortgages in the secondary market, still have been as foolish if they had an explicit warning from the Fed chair that they were throwing their money in the toilet? My guess is that such warnings would have stemmed the madness, but talk is cheap, why not try?
Finally, Greenspan would have us believe that it is easy to repair the damage from a burst bubble. This is a ridiculous claim in light of recent experience. In the wake of the stock crash in 2002 and 2003, Greenspan and others were worried about the threat of deflation and mass unemployment for the first time since the Great Depression. The fallout from the housing crash is likely to be even more severe.
The moral of the story is that the Fed must try to combat asset bubbles before they do serious damage to the economy. Greenspan’s tenure was a disastrous failure because he was AWOL when it came to the most important dangers the economy faced on his watch. He is not the "Maestro" or the greatest central banker who ever lived. He is a Washington hack with a great PR machine.
Greenspan’s next line of defense is that there is nothing that the Fed can do about a bubble even if it did recognize it.
Unless I misconstrue the purport of the chairman's discretionary control over the reserve requirement, was it not within Greenspan's power to wake up one morning and decide to move the reserve requirement up some fraction of a point, thus imnediately crowding out of existence the most risky mortgages likely to be written over the next six months?
December 16, 2007 4:36 PM | Reply | Permalink
Unlikely. The "most risky mortgages" were bundled into MBSs and CDOs and sold to (financed by) non-banking facilities, that is, money market funds, hedge funds, et als., none of which are constrained by any reserve requirement.
December 17, 2007 6:57 AM | Reply | Permalink
none of which are constrained
This is true of mortgages initiated by brokers and mortgage companies, but many of the loans that were later securitized surely were made by banks, whose exhuberance was subject to the chairman's intervention.
Moreover, to the extent that the bubble represented cheap credit chasing equity, a rise in the reserve requirement at the bank lending window should ripple through the markets, decreasing the liquidity in general and, by cutting off the less credit worthy from cheaper (bank) money, they might be expected to displace the very less credit worthy from the bottom of the queue.
December 17, 2007 9:51 AM | Reply | Permalink
. . . many of the loans that were later securitized surely were made by banks . . . .
Assuming that's true, the banks off-loaded these mortgages lickety-split.
. . . a rise in the reserve requirement at the bank lending window should ripple through the markets, decreasing the liquidity in general . . . .
Twenty or so years ago, I wouldn't argue with that proposition, but today, banks and fractional banking are far from the most significant creators of money. Government deficits and GSEs now occupy that role.
December 17, 2007 10:26 AM | Reply | Permalink
lickety-split
thus, of course, obviating any reserve requirement implications.
Part of the staggering increase in velocity that attends cybertime in so many economic activities. I guess. I haven't been able to get my arms around just what are the full implications of a money supply so exponentially magnified by hypervelocity, but I suppose hypervolatility is one of them.
December 18, 2007 9:08 PM | Reply | Permalink
I think the fundamental problem is the Economics which has been taught and practised over the last 30 years in this country. This has resulted in the inequality of wealth away from "Physical Economic" activity to the investment model, which seems to create wealth for people just because they have money.
Financial "Instruments", "Derivatives" and "Products" are really the problem as we seem to create wealth basically out of no real economic activity. Till we do not get back to real economics where wealth can only be equated with "Physical Products", there is no real hope for people doing actual work.
But the problem created over the last three decades is that our best minds have been now conditioned into this "easy" way of becoming wealthy and not the science and technology that is needed to better this world. Hence the rest of the world will take over the leadership as their people are now much more knowledeable and advanced on the "real world" ...
December 16, 2007 7:36 PM | Reply | Permalink
I think this "easy" way to get money started with a stock market where dividends are a sign of stodgy management, and not the fruits of the investment. When I first entered the stock market dividends were one of the most important factors in determining a stock's worth. But, for many years now the sole reason for buying a stock is the belief that there are always going to be people who will be dumb enough to pay a lot more for that stock than you did.
Back when I started, those kinds of people were called speculators, not investors. We have now had a whole generation of "internet" or "high tech" stocks issued by corporation which had never once made a profit, let alone paid a dividend. And the primary money making product of most of those companies was its own stock. That is the product the company spent its energy selling.
American business schools taught that this was the road to wealth, and such wealth was honest money. The real estate bubble was just the latest of that type of "investment".
Hoppy in Sacramento
December 16, 2007 8:48 PM | Reply | Permalink
It was the road to wealth to quite a few people. And it's why the Fed chairman will never burst a bubble, because it's going to burst at some point anyway, so why pop it before you and your rich friends can make as much money as possible from it. The only real question for them is when to get out.
December 17, 2007 9:37 AM | Reply | Permalink
. . . some of us (including on certain days Alan Greenspan) recognized the stock bubble for what it was. Dean Baker
Unfortunately for the economy, Greenspan did, in fact, follow Baker's advice. Between July 1999 and June 2000 Greenspan raised the federal funds target rate from 4.75% to 6.50% (a 37% increase in less than a year). Greenspan held this rate constant until Jan 2001 by which time the 2001 recession was baked in the cake.
Now, open up; I have some nice cod liver oil for what ails you.
December 17, 2007 3:02 AM | Reply | Permalink
Also, don't think this wasn't done deliberately in order to dampen Gore's election prospects. Frankly, the dishonesty Greenspan showed in pushing through such a large, rapid increase provided demonstrable proof that he was one of the most political Fed chiefs this nation has ever had. Combine that with his subsequent statements on the tax cuts and the surplus prospects and you have a man who deserves rough treatment in Gitmo to learn the truth about who told him to act the way he did. Sweat it out of the bastard.
December 19, 2007 7:02 AM | Reply | Permalink
This seems to me to put way too much weight on what they used to call jawboning or the fed's public statements. I know the market listens to every sigh from the fed chair, for hints of where interest rates will go. But do consumers and borrowers? And even those market moves are transient.
John
http://www.haberarts.com/
December 17, 2007 9:40 AM | Reply | Permalink
In my opinion, there's one unrecognized reason why the housing crash has had such huge reverberations. Sure, there are billions of worthless loans out there.
But there's also billions in property out there that can't be properly valued. In any economic downturn, there are people with money slavering over all the great real estate deals left flopping on the beach as the economic tide recedes. But right now, nobody is buying because nobody knows how far the tide will recede. It's the opposite of a bubble - the same spirit of speculation is there, they just don't want to buy in before the prices hit rock bottom.
But countering the falling prices is the glut in available properties. I imagine the vultures who feed off the bones of recession are rather dismayed by it all.
If you have good credit and you're currently renting, it's a buyer's market, and it's only going to get better. But you have to be careful and not buy into a neighborhood that's doomed for blight. New homes are the worst. Existing home in stable neighborhoods are where I'd buy - if I didn't already own a dog of a house that gets a little closer to upside-down every day.
December 17, 2007 9:50 AM | Reply | Permalink
Greenspan actively contributed to the meltdown by encouraging borrowers to get into adjustable-rate mortgages. He really is the consumate Republican, isn't he? He directly caused 20% of the problem and failed to address the remaining 80%. But he denies 100% of the responsibility.
December 17, 2007 11:03 AM | Reply | Permalink
Ellen,
July of 1999 was a bit late -- and I still would have much preferred talk to raising interest rates (margin requirements would have helped too). In any case, the bubble was near bursting by the summer of 1999 regardless. Even if Greenspan had wanted to, I doubt he could have kept it going much longer -- after all, there are only so many morons willing to spend billions on worthless stock.
December 17, 2007 2:29 PM | Reply | Permalink
Always glad to see interaction here.
Use the "reply" link at the bottom of a posted comment. This puts your comment underneath and linked to the one to which you're replying.
December 17, 2007 5:54 PM | Reply | Permalink
I wonder to what extent demand for CDOs drove the promiscuous marketing of mortgages in the sub-prime market, many of which the originators knew when writing them that they would probably default.
It seems that there was a substantial increase in mortgages brokerages in the years following the development of a model to value CDOs, and such, earlier this decade.
Strive for the ideal, but deal with what's real.
December 17, 2007 3:29 PM | Reply | Permalink
Its so much more than just a housing bubble. It is a systemic collapse of the whole financial system. And yes, "Bubbles" Greenspan bears a great deal of the responsibility for his creation and enabling of multiple bubbles over the span of his chairmanship.
David Ignatius, Washington Post, Dec. 16: The coordination action by the central banks "is a sign of their nervousness.... The aim isn't so much to prevent a downturn – the bankers aren't sure that's possible, or even desirable – as to mitigate its effects.... What scares the central bankers now is the evaporation of trust from the system. Banks don't believe each others' numbers; since nobody knows the real value of some of the mortgage-backed securities everyone is holding, they assume the worst."
Washington Times editorial, Dec. 16: The actions being taken by the central banks "leave no doubt that their policy-makers believe times are desperate. Indeed, the worldwide liquidity/solvency crisis has worsened in recent weeks... fear and panic have engulfed the markets.... Given that nothing so far has alleviated the stresses in the financial markets, there is no certainty that the desperate efforts being undertaken by the world's largest central banks will be sufficient. These are, indeed, desperate times."
Wolfgang Munchau, Financial Times, Dec. 16: Rather than reassuring the markets, the central banks' actions "had the opposite effect. It turned out that market participants are not infinitely stupid. They know by know that this is not a liquidity crisis at its core.... It is a fully fledged solvency crisis that has arisen because two giant and interlinked bubbles burst simultaneously – one in property, one in credit – leaving banks and investors on the brink of bankruptcy, some hanging by their fingertips. Yet there is nothing the central banks are offering at this stage to alleviate a solvency crisis. So the message from last week is that central banks have no game plan."
Anatole Kaletsky, Times of London, Dec. 17: The central banks' actions is "likely to be just the precursor to a much more important, but controversial, operations to ensure the 'solvency' of the international financial system. The distinction between the problems of illiquidity and solvency, which looks like the next challenge for monetary authorities around the world," is illustrated by Northern Rock, which "looked initially like a liquidity crisis" but has now been revealed as a "solvency problem." "The hope since last summer has been that the process of establishing a new lower value for mortgage assets would take until the year-end, after which the banks that were severely hurt would raise capital from investors and return to normal operations next year.... this assumption was over-optimistic... the summer liquidity crisis has been turning into a loss of confidence in the long-term solvency of the global banking system banks."
The only way to stop this "vicious circle" is for banks to convince investors that their year-end books "offer an honest picture of their potential losses and new capital needs." Failing that, "governments will almost certainly have to intervene directly to put a floor under mortgage values, thereby underwriting the solvency, as well as the liquidity, of banks.... If the banks, their auditors and shareholders, cannot quickly do this, then government intervention will become inevitable to underwrite the solvency, as well as the liquidity, of the banks."
John Waples, Times of London, Dec. 16: "This is the worst financial crisis since 1972," said the chairman of one of the biggest British banks in a "deeply disturbing" off-the-record conversation. The $100 billion bailout from the central banks would not be enough, he said. A lot of the companies bought over the past two years are no longer worth what they were acquired for, which will lead to further write-offs from banks.
Roger Bootle, Daily Telegraph, Dec. 17: "At the bottom of this question lies the distinction between liquidity and solvency, and the links between the two.... a liquidity crisis can arise from irrational fears and herd behavior... [and] Such a general liquidity crisis can then cause real economic difficulties. In the financial world banks can be pushed to the edge of insolvency, or beyond... the central bankers can lend money until they are blue in the face but it will not deal with the fundamental problem. The fundamental problem is lower asset values."
"Banks provide the lifeblood of the economy – credit. So when the banking system is damaged the impact potentially spreads across the economic system as a whole. It is the equivalent of shutting down the electricity supply.... That is why, at key points in financial history, governments have had to step in and effectively nationalize banks. And it is why, in structuring a financial recovery, bad old debt has to be separated from the continuing business of new lending.... The current situation has the makings of one of those major economic events which, like the ERM debacle, not only wreak havoc in the financial system but alter the lives of millions, break reputations, reshape institutions and overturn the political consensus."
Gillian Tett and Paul J. Davies, Financial Times, Dec. 16: Parts of the "hidden world" of banking are "imploding" -- the plethora of off-balance-sheet SIVs, CDOs and other vehicles which have never been part of the "official" banking system but are one of the "key causes of the turmoil." The role of this "'shadow' banking system" has expanded rapidly in recent years, allowing banks to package their loan portfolios into bonds and move them off their balance sheets, and this shadow system "is now shrinking at an even faster rate than it grew."
"What we are witnessing is essentially the breakdown of our modern-day banking system," said Bill Gross, head of Pimco, the world's largest bond fund.
UA
December 17, 2007 3:59 PM | Reply | Permalink
So --- Bernanke will simply loan the big banks as much money as they need for as long as they need it. What's the prob?
And the sovereign wealth funds ($3 trillion and counting) are there at hand to back-stop him.
December 17, 2007 7:22 PM | Reply | Permalink
I assume you are being facetious when you say "what's the prob?" Otherwise what you say is true, but it won't work. Papering over all these worthless or near worthless mortgages, SIVs, CDO's, and various other derivative vehicles is already creating a hyper-inflationary spiral. Weimar, here we come. In addition, re-capitalizing all the bankrupt investment banks and chartered banks won't work in and of itself because they have to sell off or write off all these bad loans. They KNOW they are bad, so who are they going to sell them to? That leaves the gov'ts to buy them up. The only thing that will work is an orderly bankruptcy procedure along the lines of the FDR program, in which you protect home-owners, the chartered banks, pensions, etc. Along with that you need to re-assert national sovereignty over credit creation and outlaw (or heavily regulate) the casino economy of the Hedge Funds. That means outlawing the last 30 years of "Free Trade" ideology and all the insane destruction that ideology has wreaked upon the productive capacity of the economies of the (formerly) industrial west. You re-start the productive economy by directing credit ONLY to needed infrastructure and productive enterprises.
None of the presidential candidates is equipped to understand the problem, let alone implement the needed remedies, so I don't know how we will get out of this mess. But we either follow FDR's model, or we all go to hell.
UA
December 17, 2007 7:55 PM | Reply | Permalink
I'm afraid I can't agree. Loaning to banks which are writing off assets is not particularly inflationary. The money loaned simply replaces the money destroyed in the write-down process, a process which is, if not countered, deflationary.
Nor do we know what the banks' exposure to bad home mortgages and more importantly, bad commercial loans is. Currently, all CDOs and most MBSs are under pressure; there are, as you say, few ordinary buyers and many vultures. But that appears to be a problem of lack of risk transparency and the information to resolve that fear of the unknown should be forthcoming, voluntarily or by mandate of the Fed.
While the equity tranches and the mezzanine tranches may be write-offs, those tranches constitute only a small percentage of the total MBSs and CDOs. The senior tranches, while perhaps not returning quite what their buyers anticipated, should be good.*
The real problem is not the hedge funds; it's the banks and specifically, the particular risk models they employed when deciding whether or not to loan monies to hedge funds or anyone else. It's obvious, now, that the models were faulty; perhaps, it always should have been obvious. It will take some very, very smart people to determine 1) what was wrong with the models and 2) what models should replace the ones that failed.
* One of Bernanke's purposes in lowering the discount rate is to support the price of these tranches, a price which is deteriorating because newly risk averse investors are demanding a greater spread/premium over a risk-free investment. If the risk-free interest rate is reduced the spread increases but the tranche's original interest rate is perceived as adequate and the tranche's price stays where it was before the spread changed.
December 17, 2007 10:05 PM | Reply | Permalink
So we subsidize shyster business practices?
Its the S$L criminals back for a second bite of the greed apple. The 'leveraged buy out gang' rearing their ugly heads again.
Weren't a number of banking laws (regulations) enacted after the crash of 29 to protect banks, savers and investors? And didn't they work for a number of years? And haven't these laws been under assault since the Reagan years?
Deregulation, that's the way to go, get government out of the way!
Self-regulation will keep things in order.
heh heh heh.
I leave the answers to those more qualified than I.
December 18, 2007 7:04 AM | Reply | Permalink
The real estate problems originate from the fact that mortgage lenders had no incentive to account for affordability... what I find disappointing about the various responses from regulators, many of whom are economists by training, is that they ignored a warped incentive that is at the root cause of the market failure.
The NYT has a an overview of the handwringing here, and a more pathetic spectacle is hard to imagine.
I would say this however, that on the real estate bubble, Greenspan is not the arch villain. His warnings could have been more stark (though this would have been against Greenspan's natural style), and he could have argued for other regulators to get on the case. And in hindsight, he probably should have. But in terms of actual policy tools at his disposal, I would argue quite strongly that the Chairman of the Fed was one of the less well-equipped public officials to deal with the bubble. That's not excusing him for what he did not do, but aside from using his bully pulpit to explain the hazards, I would disagree that the Fed was best placed to address this particular market failure. The Federal government had those "enormous regulatory powers" spread across a number of agencies, although as the Times article points out:
I will say however, that since the crisis broke, I think the policy response to the crisis has been pretty ordinary. I wrote this post back in August, and I would today change only one paragraph. A scary proportion of this stuff is Enron-esque junk. Even the triple As are toxic. But this is not a liquidity crisis, it is a solvency crisis, that much has been plain from the outset.
Krugman laid it out in layman's terms on Friday, and Nouriel Roubini goes into more technical detail here.
I can't for the life of me figure out why the likes of Paulson and Bernanke have continued to treat the problem - at least publicly - as a liquidity crisis. Injecting liquidity and cutting rates has done literally nothing to alleviate the situation; all it seems to have done is propped up the stock market, in my opinion, until this shoe drops.
Behind the scenes, there is more activity in getting financial institutions to put a realistic mark on their mortgage-backed assets, but this work is taking far too long. The MLEC head-fake slowed up the correction, and bankruptcy proceedings are by their nature drawn out, but there's no excuse not to recognize the giant turds in the system for what they are.
I read recently a psychology article on terminal illness and death, which described five stages of traumatization, and it didn't take a huge leap of imagination to compare it to the credit crisis and the response to it. The five stages are:
1. Denial (this is a minor, i.e. short-term, liquidity problem and there is little contagion risk)
2. Anger (Give me heads on stakes. O'Neal, Prince, Cruz, it's on you people)
3. Bargaining with God (okay, invisible hand, if we dump trillions into the wholesale market, you allocate it and we ride out the turbulence together and 2008 is happy days again)
4. Depression (Nothing is working. In fact, things seem to be getting worse.)
5. Acceptance (Okay then, we have a major solvency problem and this is going to hurt like hell. We might even lose a big bank. Let's do everything we can to prepare for this.)
That's what we face in 2008. A big bank could well run into serious difficulties, the unknown for me is how prepared the authorities are to deal with it (the folks in Britain weren't well prepared at all).
December 18, 2007 4:15 AM | Reply | Permalink
Greenspan is the all time master of excuses. However, if he had laid out the case against the bubble, instead of actively insisting there was no bubble, it almost certainly would have had a large effect on the housing market. (In any case, what possible excuse is there for not doing this -- what more important use did he have for his time?)
On the regulation -- everyone follows the Fed. If the Fed had put the regulations into effect that Gramlich was pusihng back in 2000, it would have prevented most of the nonsense loans. The Fed would be setting the standards for what could passed into secondary markets. No one would buy the crap loans that did not meet these standards.
December 18, 2007 5:32 AM | Reply | Permalink
Dean,
I am not giving Greenspan a pass. But I would not lay this particular crisis squarely at his feet.
Perhaps the issue here is what one understands to be the key function of a Central Bank. For me, it is price stability (on which I think Greenspan's record is mixed); whilst conduct in financial markets is the responsibility of other regulatory agencies.
Perhaps that is an artificial distinction, and perhaps we need a more centralized regulatory framework, but this is the way the system is. I think there's a quite reasonable argument that had Greenspan gotten vocal about the housing bubble, he would have been straying from the reservation in the much same way he was inclined to do when he opined on fiscal policy.
But no question he could have said more, and he could have lobbied the Establishment to do more. I just don't think, given the pervasive free market fundamentalism in DC, that much would have changed, bar Greenspan having a clearer conscience today and perhaps the class-action lawyers having more potent weapons to aim at their targets. But this credit crunch is the product of a broken system; and Greenspan's Fed was not unilaterally empowered to intervene.
December 18, 2007 6:48 AM | Reply | Permalink
I am not giving Greenspan a pass. But . . . .
Well said. There are an awful lot of people who should be directing their anger at the financial media who for years uncritically put Greenspan on a pedestal but who, for whatever personal or political reasons, are aiming their anger at Greenspan himself.
To paraphrase Pedro Martinez talking about the Yankees, too many people in the past tipped their hats to Greenspan and called him their "Daddy." Now, it's the time of revenge -- or to call it by its proper name, the time of unbridled ressentiment.
December 18, 2007 7:35 AM | Reply | Permalink
For everything that the Fed is what it is not is a social welfare agency.
Gramlich, who headed the Committee on Consumer and Community Affairs, was properly concerned in protecting his constituency -- the poor and people of color against whom the banks had historically discriminated. But to claim that he was in any way prescient in respect to the banking crisis presently being experienced is wishful thinking.
Where the Fed (and most certainly, Greenspan) let the country down was in its failure to responsibly supervise the banks, a failure largely the result of the incompetence of the Fed staff. They failed to understand the credit risk models the banks were employing and failed to judge the adequacy or inadequacy of the stress-testing those models were supposedly undergoing. And so it goes.
December 18, 2007 6:59 AM | Reply | Permalink
Decent article in the Tuesday Times faulting the Fed. Its focus, though, is on regulation that should have been in place. I could not help thinking that a lot of the regulation and oversight should have come from Congress and the executive, meaning they couldn't come with Bush in office. Not to let Greenspan off the hook, but good to broaden beyond, well, warning people.
John
http://www.haberarts.com/
December 18, 2007 11:45 AM | Reply | Permalink
BOOKMARK
December 18, 2007 3:11 PM | Reply | Permalink
Good to see Dean quoted in the paper today on new regulation that looks overdue.
John
http://www.haberarts.com/
December 19, 2007 8:24 AM | Reply | Permalink
Krugman commented that there were a lot of regulations about issuing loans that were abolished by Bush appointees.
I do not know who regulates THAT, but mortgage loan with zero owner equity is risky, and such collateralized securities did not deserve AAA ratings, and without above junk rates most mutual funds would not touch them etc. For decades there were standards to evaluate a loan as risky or not, those standards were broken and thus loans were junk by pre-existing standards, not by "looking back is 20/20".
Another issue is that lenders moved a lot of risk on the shoulders of borrowers by changing the bancruptcy laws, and that gave them illusion that the risk was eliminated or something. A combination of extremally high interest rates and aggressive marketing made credit cards enormously profitable, and resulting euphoria perhaps spread to mortgage divisions.
December 21, 2007 4:35 PM | Reply | Permalink
. . . mortgage loan with zero owner equity is risky, and such collateralized securities did not deserve AAA ratings . . . .
I'm not sure what you mean by the term "collateralized securities," but generally, the ratings agencies (Moody's, Fitch, Standard & Poor) rated the tranches within the CDOs or MBSs which included various types of residential mortgages (AAA, Alt-A, subprime).
Unless you believe that every single subprime mortgage will default, then, depending upon how the senior tranche is designed, there's no reason why it couldn't be AAA rated. For example ---
Suppose we have a $100 million MBS secured by 500 subprime mortgages obligated to pay $7.5 million per year in interest. The claims on the interest received are then sliced up (there could be 5, 10, 18, 20 --- "tranches"). And suppose Tranche #1 purchased for $20 million has first dibs on the first $1 million of interest paid by the subprime mortgagors (a 5% return).
Tranche #1 will get full payment as long as 13.3% of the total interest due is paid. Is there any reason to suppose that Tranche #1 is risky or doesn't warrant a AAA rating?
December 21, 2007 5:18 PM | Reply | Permalink