"The Road to Depression"

Brad DeLong says two big mistakes made the crisis worse:

The Road to Depression, by Brad DeLong, Project Syndicate: For 15 months, the United States Federal Reserve, assisted by the financial regulators of the US Treasury, have been trying..., above all, to avoid a deep depression.

They have also had three subsidiary objectives:

• Keep as much economic activity as possible under private-sector control, in order to ensure that what is produced is what consumers really want.
• Prevent the princes of Wall Street ... from profiting from the systemic risk that they created.
• Ensure that homeowners and small investors do not absorb too much loss, for their only "crime" was to accept bad risks, which they would not have done in a world of properly diversified portfolios.

Now it is clear that the Fed and the Treasury have lost the game. If a depression is to be avoided, it will have to be the work of other arms of the government, with other tools and powers.

The failure to contain the crisis will ultimately be traced, I think, to excessive concern with the first two subsidiary objectives: reining in Wall Street princes and keeping economic decision-making private. Had the Fed and the Treasury given those two objectives their proper - subsidiary - weight, I suspect that we would not now be in this mess...

The desire to prevent the princes of Wall Street from profiting from the crisis was reflected in the Fed-Treasury decision to let Lehman Brothers collapse... The logic behind that decision was that, previously in the crisis, equity shareholders had been severely punished...

But this was not true of bondholders and counterparties, who were paid in full. The Fed and Treasury feared that the lesson being taught in the last half of 2007 and the first half of 2008 was that the US government guaranteed all the debt and transactions of every bank and bank-like entity that was regarded as too big to fail. That, the Fed and the Treasury believed, could not be healthy.

Lenders to very large overleveraged institutions had to have some incentive to calculate the risks. But that required, at some point, allowing some bank to fail...

In retrospect, this was a major mistake. ... With that guarantee broken by Lehman Brothers' collapse, every financial institution immediately sought to acquire a much greater capital cushion..., but found it impossible to do so. The Lehman Brothers bankruptcy created an extraordinary and immediate demand for additional bank capital, which the private sector could not supply.

It was at this point that the Treasury made the second mistake. Because it tried to keep the private sector private, it sought to avoid partial or full nationalization of the components of the banking system deemed too big to fail. In retrospect, the Treasury should have identified all such entities and started buying common stock in them - whether they liked it or not - until the crisis passed.

Yes, this is what might be called "lemon socialism," creating grave dangers for corporate control, posing a threat of large-scale corruption, and establishing a precedent for intervention that could be very dangerous down the road.

But would that have been worse than what we face now? The failure to sacrifice the subsidiary objective of keeping the private sector private meant that the Fed and the Treasury lost their opportunity to attain the principal objective of avoiding depression.

Of course, hindsight is always easy. But if depression is to be avoided, it will be through old-fashioned Keynesian fiscal policy: the government must take a direct hand in boosting spending and deciding what goods and services will be in demand.

Comments

[Bruce Wilder]

Subsidiary points one and three are about the reluctance to accept that someone is going to take a large loss, and that loss is unavoidable. (Subsidiary point 2, I simply do not believe.)

Trying to ameliorate or limit losses handicapped Fed policy. The right thing to do would have been, if anything, to accelerate the realization of losses. Press hard to realize losses, and to force their acceptance and acknowledgment.

The total losses were very large, but finite. Once the losers were identified, and the losses realized, further uncertainty would be reduced.

By pursuing an ad hoc policy, and allowing for the possibility that the Fed or Treasury or FDIC would selectively accept some losses, it became a giant game, to so manipulate the system to avoid losses and, possibly, gain a windfall. Uncertainty in this game multiplied and expanded.

[anne]

http://delong.typepad.com/sdj/2008/11/why-i-was-wrong.html

November 29, 2008

Why I Was Wrong...
By Brad DeLong

Let me say what things I was "expecting," in the sense of anticipating that it was they were both likely enough and serious enough that public policymakers should be paying significant attention to guarding the risks that it would create:

(1) A collapse of the dollar produced by a panic flight by investors who recognized the long-term consequences of the U.S. trade deficit.

or:

(2) A fall back of housing prices halfway from their peak to pre-2000 normal price-rental ratios.

I was not expecting (2) plus:

(3) the discovery that banks and mortgage companies had made no provision for how the loans they made would be renegotiated or serviced in the event of a housing-price downturn.

(4) the discovery that the rating agencies had failed in their assessment of lower-tail risk to make the standard analytical judgment: that when things get really bad all correlations go to one.

(5) the fact that highly-leveraged banks working on the originate-and-distribute model of mortgage securitization had originated but had not distributed: that they had held on to much too much of the risks that they were supposed to find other people to handle.

(6) the panic flight from all risky assets--not just mortgages--upon the discovery of the problems in the mortgage market.

(7) the engagement in regulatory arbitrage which had left major banks even more highly leveraged than I had thought possible.

(8) the failure of highly-leveraged financial institutions to have backup plans for recapitalization in place in the case of a major financial crisis.

(9) the Bush administration's sticking to a private-sector solution for the crisis for months after it had become clear that such a solution was no longer viable.

We could have interrupted this chain that has gotten us here at any of a number of places. And I still am trying to figure out why we did not.

[sustain_ability]

http://londonbanker.blogspot.com/2008/11/what-we-value-is-what-we-save-in-crisis.html
Brilliant, including the comments.

Another link worthy of consideration:
http://www.operationnoah.org/resources/religiousinspirations/changing-climate-spiritual-steps-sustainability
Climate change is a major stumbling point, I know. Perhaps there is a general over-reliance on "our" science and derived technology.

[anne]

There is another reason why Brad DeLong was wrong, and that was failing to be capable of paying attention to Hillary Clinton when she was calling attention to the damage being done to communities and need for immediate redress while Barack Obama was assuming the problem would be "naturally" solved. Clinton was especially concerned with the early damage being done in middle to lower income communities, communities often with significant numbers of African American and Latino and older residents. Walking back the problems she was pointing to could have shown the perspective general seriousness. But, the vehemence directed to Clinton was too much to allow for paying attention.

[Bruce Wilder]

If Hillary Clinton had been concerned with the "immediate damage" being done by predatory lending schemes in, say, 2004 or 2005, I would have been impressed. Populist demagoguery, which kicked in, only when it became clear that she wasn't going to win the nomination, was not something I wanted to listen to (not speaking for anyone else).

[anne]

Hillary Clinton was of course talking about the housing-mortgage problem, meeting with community representatives on the problem, when there was every reason to believe she would win the nomination, but a little demeaning nastiness is always in order.

[anne]

http://www.nytimes.com/2007/03/29/business/29scene.html?ex=1332820800&en=9a15c212b118d691&ei=5090&partner=rssuserland&emc=rss

March 29, 2007

'Irresponsible' Mortgages Have Opened Doors to Many of the Excluded
By AUSTAN GOOLSBEE

"We are sitting on a time bomb," the mortgage analyst said — a huge increase in unconventional home loans like balloon mortgages taken out by consumers who cannot qualify for regular mortgages. The high payments, he continued, "are just beginning to come due and a lot of people who were betting interest rates would come down by now risk losing their homes because they can't pay the debt."

He would have given great testimony at the current Senate hearings on subprime mortgage lending. The only problem is, he said it in 1981 — when soon after several of the alternative mortgage products like those with adjustable rates and balloons first became popular.

When Senator Christopher J. Dodd, Democrat of Connecticut, gave his opening statement last week at the hearings lambasting the rise of "risky exotic and subprime mortgages," he was actually tapping into a very old vein of suspicion against innovations in the mortgage market.

Almost every new form of mortgage lending — from adjustable-rate mortgages to home equity lines of credit to no-money-down mortgages — has tended to expand the pool of people who qualify but has also been greeted by a large number of people saying that it harms consumers and will fool people into thinking they can afford homes that they cannot.

Congress is contemplating a serious tightening of regulations to make the new forms of lending more difficult. New research from some of the leading housing economists in the country, however, examines the long history of mortgage market innovations and suggests that regulators should be mindful of the potential downside in tightening too much....

[anne]

Please remind me, who is this Austan Goolsbeee anyway, I am so forgetful? Austan Goolsbee, I know I have heard the name before, but where? Hard name to forget, but I am all forgetting.

says...

in reference to the last sentence, what will be in demand aint't houses. But yet, that is already what government seems to think we want.

[anne]

http://www.nytimes.com/2005/09/14/business/14lend.html?ex=1284350400&en=8a63d70db58adbe3&ei=5090&partner=rssuserland&emc=rss

September 14, 2005

Blacks Hit Hardest by Costlier Mortgages
By EDMUND L. ANDREWS

WASHINGTON - Regardless of income levels, blacks were about three times as likely as whites to borrow through more expensive "subprime" mortgages last year, according to a nationwide lending survey released Tuesday by the Federal Reserve....

[anne]

http://www.cepr.net/content/view/1358/45/

November 12, 2007

Homeownership: The Fast Path to Poverty
By Dean Baker

The Commerce Department reported last month that homeownership among African Americans had dropped to 46.7 percent in the third quarter, three full percentage points below its peak level in 2004. This is a remarkably fast decline. In the last three years, the decline in homeownership among African Americans has destroyed almost half the gains in the decade from 1994 to 2004.

The situation is sure to get much worse....

[anne]

http://krugman.blogs.nytimes.com/2008/11/17/after-the-stimulus/

November 17, 2008

After the Stimulus
By Paul Krugman

For the coming year, and probably well beyond, the economy will be on life support — sustained by massive fiscal stimulus. (Either that, or we'll be in a very deep slump.) But eventually the economy will have to come off life support. What will take the place of the stimulus?

I don't really know the answer, but one thing that may be useful is to compare the sources of demand in 2007 with those over a longer period. Here's a table showing C (consumer spending), N (nonresidential investment), R (residential investment), G (government purchases), and NX (net exports) as percentages of GDP in 2007 and on average over the period 1979-2007.

Sources of Demand

2007 - Average

C (70.3) (66.7)
N (10.9) (11.3)
R ( 4.6) ( 4.5)
G (19.4) (19.4)
NX ( -5.1) ( -2.4)

What stands out is the combination of high consumption and a large trade deficit. By 2007 residential investment had already fallen to normal levels, and nonresidential investment was also fairly normal.

Consumption probably isn't going back to a 2007 share of GDP — savings are back. So what will fill the gap, once the stimulus is gone? Housing? Not for a long time. Business investment? Hard to see why. The natural thing would be to trade lower consumption for a smaller trade deficit.

But that's going to be hard if the rest of the world is also in a slump, and in particular if emerging markets are facing currency crises.

What all this suggests — and it's a very rough cut — is that our emergence from the era when massive fiscal stimulus is needed may hinge crucially on getting the world financial situation, not just our own, under control.

[ken melvin]

Why would weee the people want markets to decide goods and services?

[lark]

well the mass layoffs are going to come and another hidden truth of the American economy will burst into the open. One that we all know and have observed, but one which has not taken us down to the depths - yet.

And that is how our 'free market' system has aided and abetted multi-national corporations as they have strip mined this economy of well-paid jobs, in the interest of the global labor arbitrage.

[RW]

I'm inclined to doubt the latter two subsidiary objectives of Fed policy outlined by DeLong too, not only because they seem glaringly inconsistent with conservative policy as currently practiced, but because I can not imagine any reason a Bush administration would care.

But it also seems possible the point is moot if we assume that monetary policy by itself could be incapable of preventing economic depression; e.g., Fed policy has been aggressively expansive but with very little effect thus far (http://tinyurl.com/5rfd65).

[Trig Palin]

Where did he dream these three subsidiary objectives up? The first may be remotely true, but the second and third are laughably untrue.

[chris]

Large sectors of the banking system should have been nationalized immediately. Instead Paulson went the route of taking the toxic waste off their hands, to avoid nationalization. Then when that didn't work at all, he dipped his toes into nationalization. But it has not been enough and by no means soon enough. Now the only way out is massive government spending. And isn't it odd that faced with that need we are still wasting billions in Afghanistan and Iraq where we never should have gone in the first place? Brainless Washington.

[Lafayette]

Herd instincts

This bit of news from Bloomberg, here, has only a tangent relationship to economics. But, it is a sorry tale that shows how crass human behaviour can be when times are tough in America.

And, from Wal-Mart, regarding the incident: “The safety and security of our customers and associates is our top priority.”

Yeah, right, some more word-spin. If their top priority were safety, the incident would not have happened. They obviously need training in herd instincts.

Talk about feeding-frenzies is something different when it actually happens.This country has to be careful. It could come apart at the seems with people killing one another for a dollar of savings. Just what sort of consumer have we created. One willing to kill to save a buck?

[Lafayette]

anne: Please remind me, who is this Austan Goolsbeee anyway,

He was Obama's chief economic adviser during the campaign.

He did not make it onto the Final Team, since Obama seems to prefer the immodest Larry Summers to chair the NEC. We shall see how the two get along.

It's a bit of good luck that Obama is not female. Summers might actually take him for a peer (amongst we lesser mortals in this lower world).

[lonesome moderate]

Senator Clinton has been talking a lot about problems with mortgages to subprime borrowers since the middle of 2007 or so. She has advocated slowing foreclosures, forcing lenders to provide subprime borrowers more and clearer information, a five year freeze on interest rates on outstanding mortages, and a strengthened FHA. To me, it is difficult to see how any of the changes she advocated would have headed off or significantly reduced the crisis (at least at the time she was talking about them), although at least some of them are worthy on their own merits: July 2007 speech, January 2008 press release.

[Lafayette]

km: Why would weee the people want markets to decide goods and services?

They don't. It just appears that they do.

Markets propose goods and services. We the people decide whether we want them or not.

The key factor is media manipulation. Humans are animals with herd instincts and can be manipulated as such, easily in fact, by the right media approach -- specifically a mix of advertising, infomercials, peer-pressure amongst the young, etc.)

Who doesn't like walking around with the Levis Brand Patch beaming off their right backside buttock? Or whatever brand-name is the jeans-flavor of the day. In fact, it is ALL about branding.

Thorstein Veblen would not be the least bit amazed at what was going on in modern merchandising.

[mmckinl]

Brad DeLong sounds more idiotic everyday. Buy bank stocks?

What we need is FDR's Bank Holiday or a Swedish Plan.

De Long has lost his marbles, there are still trillions in derivatives coming on the banks balance sheets in Jan. Why should the tax payer throw money at these thieves?

[Lafayette]

Pogo was right

mmc: ... there are still trillions in derivatives coming on the banks balance sheets in Jan.

DeLong is not all that wrong. But, his advice is applicable to the market as a whole. It IS a good time to buy stocks. Cash is king.

As for the ultimate solution, some think that no solution is workable until ALL the toxic waste is taken off their books and placed in another banking entity -- likely owned by you and me (meaning the Treasury).

Meaning we take the hit. How could the solution be otherwise? We always knew that the Lender of Last Resort was us. Or should have. The banker's knew that, why didn't we?

(Pogo was right all the while ... ;^)

[anne]

http://www.nytimes.com/2007/03/29/business/29scene.html?ex=1332820800&en=9a15c212b118d691&ei=5090&partner=rssuserland&emc=rss

March 29, 2007

'Irresponsible' Mortgages Have Opened Doors to Many of the Excluded
By AUSTAN GOOLSBEE

"The main thing that innovations in the mortgage market have done over the past 30 years is to let in the excluded: the young, the discriminated against, the people without a lot of money in the bank to use for a down payment." It has allowed them access to mortgages whereas lenders would have once just turned them away.

The Center for Responsible Lending estimated that in 2005, a majority of home loans to African-Americans and 40 percent of home loans to Hispanics were subprime loans. The existence and spread of subprime lending helps explain the drastic growth of homeownership for these same groups. Since 1995, for example, the number of African-American households has risen by about 20 percent, but the number of African-American homeowners has risen almost twice that rate, by about 35 percent. For Hispanics, the number of households is up about 45 percent and the number of homeowning households is up by almost 70 percent.

And do not forget that the vast majority of even subprime borrowers have been making their payments. Indeed, fewer than 15 percent of borrowers in this most risky group have even been delinquent on a payment, much less defaulted.

When contemplating ways to prevent excessive mortgages for the 13 percent of subprime borrowers whose loans go sour, regulators must be careful that they do not wreck the ability of the other 87 percent to obtain mortgages.

For be it ever so humble, there really is no place like home, even if it does come with a balloon payment mortgage.

http://www.cepr.net/content/view/1358/45/

November 12, 2007

Homeownership: The Fast Path to Poverty
By Dean Baker

The Commerce Department reported last month that homeownership among African Americans had dropped to 46.7 percent in the third quarter, three full percentage points below its peak level in 2004. This is a remarkably fast decline. In the last three years, the decline in homeownership among African Americans has destroyed almost half the gains in the decade from 1994 to 2004.

The situation is sure to get much worse. The foreclosure rate in the third quarter of 2007 was double the rate of 2006. At the third quarter foreclosure rate, more than 1.5 million families are on a path to lose their home over the course of the year. African Americans will be a disproportionate share of the home losers.

[anne]

http://clinton.senate.gov/news/statements/details.cfm?id=270717

March 15, 2007

Initiative to Address Growing Crisis Facing Subprime Mortgage Holders

Washington, DC - In an address to the National Community Reinvestment Coalition, Senator Hillary Rodham Clinton today announced an initiative to address the growing crisis facing those holding subprime mortgages. Underscoring the need to make the rules clear and level the playing field for homebuyers, Senator Clinton outlined a plan to break down barriers to owning a home and build up protections against unfair and unscrupulous lending practices. Senator Clinton's plan will provide more borrowing options for lower income, minority and first-time homebuyers before they sign on the dotted line; more information and safeguards against abuses when signing a mortgage; and smart reforms to reduce foreclosures.

In her remarks, Senator Clinton emphasized the urgent need to act. "The subprime problems are now creating massive issues on Wall Street. It is a serious problem affecting our housing market and millions of hard working families buying a home, many of them for the first time. We need to expand the role of the Federal Housing Administration to issue more mortgages at better rates to these homeowners. And we need to give consumers more counseling and information, prevent families from being trapped in high interest loans with pre-payment penalties, and in some cases allow more breathing room from foreclosure. This market is clearly broken, and if we don't fix it, it could threaten our entire housing market," said Senator Clinton.

The market for subprime loans has expanded rapidly, growing from $20 billion in 1993 to over $600 billion today. Subprime now represents 23 percent of all new mortgage loans and 13 percent of all mortgages outstanding. The subprime mortgage market serves mostly people with poor or limited credit histories, and the rates and fees on subprime mortgages are higher than those on traditional mortgages. According to Department of Housing and Urban Development (HUD), subprime borrowers are disproportionately African-American and Latino....

[bakho]

The discussion seems to focus only on #3, the homeowners that are the least of the problems. If the financial crisis were ONLY the housing bust, the losses are easily identified, programs to keep people in homes could readily be crafted and the mess cleaned up in short order.

However, the housing mess was only ONE of many runs on an overleveraged finacnicial system. Like 1929 investors who had "borrowed" money they did not have to invest in the stock market and lost more than their net worth during the collapse, so has BigFinance "invested" or "loaned out" far more capital than is readily available. So when the run on BigFinance started, like the 1929 investors they are unable to adequately cover their positions. If the amounts involved were ONLY the amounts lost in the housing market, those could be easily covered. However, the amounts involved are apparently much more extensive. BigFinance cannot recover, because its returns going forward are dismal. Investors want to move to the next area of "above average returns". Housing may have started the run but it only the tip of the iceberg.

The run changed the capitalization requirements overnight. The problem is how to de-leverage the mess? Responsible entities need to come up with a structure that can contain the financial mess while keeping credit flowing elsewhere in the economy. People need incentives to stay in the system rather than walk away. One structure that might work is to set up an international fund that would assume the liabilities that would be paid off over time by surtaxes on financial transactions. The losses are so big, that when they are dumped on one entity (Lehman for example) it just folds and the creditors up the line are now holding the bag. The domino effect could collapse the entirety of BigFinance. It will not be easy and it is not something that anti-interventionist Republicans like Paulson are likely to pull off.

[RW]

What bakho said: wash, rinse, repeat.

Our attention is snatched from one horror show to another but as far as I can tell the central trope of this crisis was not housing, as terrible as the consequences of that collapse have been, because housing and those who bought houses were merely another addition to the flotsam captured in an ever growing maelstrom of debt and what made this bubble so big and magnified its collapse so catastrophically was a quantum leap in leverage permitted by derivatives reconstrued as bonds and the derivatives that insured them.

Once that essential move was made these quasi-bonds could claim actual underlying assets no matter how they were sliced up or leveraged further so more money for loans of all types became available and incentives to move those loans out faster and faster grew apace to feed the derivative creation machinery with its marvelously high fees; so loan brokers sold loans to anyone they could and housing prices reflected the simple fact that credit was flowing like water and non-bank-brokers and banks-as-brokers alike could create even more money (credit) without any need to clear the transaction or even directly engage the Federal money control apparatus if they didn't feel like it.

And because those derivatives could be repackaged and releveraged again and again for even more fees the eventual result were instruments thrice divorced from the debt-assets they purported to have a claim upon yet so highly leveraged against these quadruply sliced and diced underlying assets that a default rate of less than half a percent could wipe out 100% of the equity in the quasi-bond and a default rate only slightly above 'normal' (for sub-prime, alt-a, credit cards, what have you) could wipe out virtually everything including a hunk of the most senior, AAA-rated tranche (some SIV and CDO senior tranches were even rated as if they had zero risk, like a T-bond, unbelievable).

But, oh happy days, an investor in this insanity -- excuse me, innovative financial product -- could 'insure' against loss by buying yet another derivative, a default swap (ah, more fees), and leverage that again by buying even more swaps for asset-backed quasi-bond derivatives they didn't own; this came in handy when default rates began to climb, allowing a few to profit more for awhile, until even the most greedy or obtuse began to suspect there might not be enough money on the entire planet to cover all the claims.

And so here we are: Time to print a lot more money and nationalize or liquidate the rest. JMO FWIW

[Lafayette]

Finance nerds

RW: so loan brokers sold loans to anyone they could and housing prices reflected the simple fact that credit was flowing like water and non-bank-brokers and banks-as-brokers alike could create even more money (credit) without any need to clear the transaction or even directly engage the Federal money control apparatus if they didn't feel like it.

Yes, the systemic failure was due to lack of regulatory control. Was that brought about by the abolishing of the Fire Wall by repealing the Glass-Steagal Act? (Thank you, Larry Summers.)

Or not?

My point: What is necessary in terms of Regulatory Control to prevent this Ugly Beast from ever rearing its ugly head once again? (You know these Finance Nerds ... if there is ever again a Free Lunch out there worth a megabuck, they'll find it and eat it. They must be muzzled.)

[swells]

Lafayette, well as far as it goes it is a "good time to buy stocks". You just have to remember when to sell them; i.e., when one has turned a profit. The stock markets are still to volatile for investing. They are perfect for trading. It will be some time before the time is right to invest again. In the meantime, trade and take profits when available.

[Patricia Shannon - multi-page comment sections]

And we will never know how much the fact that Lehman brothers contributed more to Democrats than Republicans was a factor in deciding not to bail them out.

[Lafayette]

Keynes, from his book The Great Slump of 1930: This is a nightmare, which will pass away with the morning. For the resources of nature and men’s devices are just as fertile and productive as they were. The rate of our progress towards solving the material problems of life is not less rapid. We are as capable as before of affording for everyone a high standard of life—high, I mean, compared with, say, twenty years ago—and will soon learn to afford a standard higher still. We were not previously deceived. But to-day we have involved ourselves in a colossal muddle, having blundered in the control of a delicate machine, the working of which we do not understand. The result is that our possibilities of wealth may run to waste for a time—perhaps for a long time.

Poignant, don't you think? Also prescient - how did he know we'd be so foolish as to fall into the same trap once again, eighty long years later?

Because we still have no vaccine for human cupidity.

[anonymous]

[quote]The desire to prevent the princes of Wall Street from profiting from the crisis was reflected in the Fed-Treasury decision to let Lehman Brothers collapse[/quote]

Cant agree with this. That was one incident of many. Friends of hank seem to be well care for. Lehman was just a sacrificial lamb..err pig

[Lafayette]

swells: The stock markets are still to volatile for investing.

Yes, but so what? Despite the volatility they are near historic lows. The P/E ration of the DJ is almost ridiculous.

Only the courageous should be in the market (or the Day Trippers, as you suggest). But, for those willing to take the plunge with only a fraction of their net worth, then the market is opportune. Methinks.

[Lafayette]

For "swells": The S&P Moving Average Chart.

Look at the the dip in the three coloured moving average lines ... they do does not indicate an historic stock market opportunity?

So, keep watching till they bottom out. Then buy! Simple, huh?

PS: Where do I send the bill for the consultancy fee ... ;^)