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Tuesday, October 21, 2008

What Didn't Cause the Crisis?

Tyler Cowen, contradicting Anna Schwartz, says it was private sector imperfections, not government policy that caused the imperfection. In particular, the Fed's decision to kep interest rates low is no the culprit:

Is the low Fed Funds rate to blame?, by Tyler Cowen: ...I don't side with Austrian Business Cycle Theory in citing loose monetary policy as the main factor in the artificial boom which preceded the crash. I view the boom as having been fueled by new global wealth, most of all in Asia, and the liquification of that wealth through credit and the desire for additional risk.

Note that if an increase in real wealth fuels the investment boom, consumption can be robust or even go up at the same time as the rise in investment. Now, in the boom preceding the current bust, was American consumption robust? Sure. If the investment boom had been driven mainly by monetary factors, investment would have gone up and consumption would have gone down, as explained here. (Try a rebuttal here.)

Loose monetary policy did contribute to the bubble. In that sense I would defend a modified Austrian theory. But other reasons also suggest that monetary policy was not the main driver. Money has a much bigger effect on short-term rates than long-term rates. Even long-term real rates have only mixed predictive power over real economic activity, including investment. The Austrians have never developed much of a theory of bubbles. Ideally you would have a good bubble theory, with Austrian-like monetary factors stirring up the bubble even more. But you can't get away with pinning so much of the blame on the government, as modern Austrians are wont to do. "Bubbliness" is a private sector imperfection and relabeling it as "government distorting price signals through monetary policy" doesn't much change that.

Speaking of trying to reassign the blame to government, Menzie Chinn says it wasn't Fannie and Freddie, and it wasn't the Community Reinvestment act, two of the three main points of attack for the 'government caused the problems' crowd (the Fed is the third target for those who want to blame government policy rather that the private sector) I will focus on the second part of Menzie's post - there's more in the original:

CRA and Fannie and Freddie as betes noire, by Menzie Chinn: There is so much chaff floating around about the roles of Fannie and Freddie and of the Community Reinvestment Act in the current crisis, despite the best efforts of economists like Jim Hamilton [0] [1], Mark Thoma and Janet Yellen, that it seems worthwhile to once again go through some of the arguments that have been forwarded. ...

What about the charge that Fannie and Freddie "made" the market so that all these subprime loans could be securitized? There's a grain of truth in there, but I think keeping in mind which loans are going bad is useful, when reading this excerpt.

This much is true. In an effort to promote affordable home ownership for minorities and rural whites, the Department of Housing and Urban Development set targets for Fannie and Freddie in 1992 to purchase low-income loans for sale into the secondary market that eventually reached this number: 52 percent of loans given to low-to moderate-income families.

To be sure, encouraging lower-income Americans to become homeowners gave unsophisticated borrowers and unscrupulous lenders and mortgage brokers more chances to turn dreams of homeownership in nightmares.

But these loans, and those to low- and moderate-income families represent a small portion of overall lending. ... Between 2004 and 2006, when subprime lending was exploding, Fannie and Freddie went from holding a high of 48 percent of the subprime loans that were sold into the secondary market to holding about 24 percent, according to data from Inside Mortgage Finance, a specialty publication. One reason is that Fannie and Freddie were subject to tougher standards than many of the unregulated players in the private sector who weakened lending standards, most of whom have gone bankrupt or are now in deep trouble.

During those same explosive three years, private investment banks -- not Fannie and Freddie -- dominated the mortgage loans that were packaged and sold into the secondary mortgage market. In 2005 and 2006, the private sector securitized almost two thirds of all U.S. mortgages, supplanting Fannie and Freddie, according to a number of specialty publications that track this data. [Emphasis added -- mdc]

Now, again, consider which subprime loans, in the graph below, went bad...


Figure 1.8 from IMF, Global Financial Stability Report, Oct. 2008.

Notice that the delinquency rate is highest in the years after Fannie and Freddie are constrained in terms of their subprime holdings. So, more regulation of F&F was a good thing, I'll say, with the benefit of hindsight.

Now, there are more sophisticated, game-theoretic based arguments. In particular, Jim has observed that the mere existence of GSEs with substantial portfolios of MBS's meant that the government -- by insuring Fannie and Freddie -- would implicitly insure the private firms as they expanded their operations, supplanting F&F's market share:

what forces caused the explosion of private participation in a much more reckless replication of the GSE game? A year ago, I suggested one possible answer-- private institutions reasoned that, because the GSEs had developed such a huge stake in real estate prices, and because they were surely too big to fail, the Federal Reserve would be forced to adopt a sufficiently inflationary policy so as to keep the GSEs solvent, which would ensure that the historical assumptions about real estate prices and default rates on which the models used to price these instruments were based would not prove to be too far off.

This is by far the most intelligent and plausible interpretations of how F&F could have contributed in a significant way to the current housing crisis (as separate from the overall crisis, which would have been triggered by some other market given the mixture of securitization, credit default swaps and high leverage [2]). In fact, Mike Dooley and I have made similar arguments about the expansion of contingent liabilities, in the run-up to the East Asian crises [3]. The challenge here is how to test this hypothesis against others; we need to measure the implicit insurance that these private firms felt they had directly from the Fed's intent keep the monetary policy sufficiently expansionary to keep housing prices going up, separate from the insurance committed directly by the Treasury to prevent individual banks from going under. (By the way, this is a separate issue from whether F&F made sense economically in their circa 2006 form; see the analysis by Frame and White. I tend to think the answer is no.)

Interestingly, one of the corollaries of this argument is that it would be hard to disentangle the balance of blame of F&F and the "Greenspan put".

One question I do (or will) have is the following: if the credit card or auto loan securitized markets blow up [4], who are the equivalents to the GSE's?

I think all of this leads to a more nuanced view of the role of CRA and the two GSE's in the crisis. If I had to identify the central factors, I wouldn't point to F&F alone, or CRA alone (if at all). Rather, I'd look to (i) monetary policy (including whether it was lax, and the implications of the "Greenspan put"), (ii) what drove down the returns at the long end of the maturity spectrum ("the conundrum") thus inducing the desperate search for yield, (iii) securitization in the absence of countervailing regulation and (iv) the development of a completely non-transparent and unregulated over-the-counter credit default swap market.

What if credit cards blow up?:

Credit Cards Follow Mortgages Into Delinquency, RTE: Credit cards are increasingly going the way of home mortgages — into delinquency.


Four quarter change in credit-card delinquencies. Red = Conditions have worsened; Green = Conditions have improved; White = No change (Source: NY Fed)

The Federal Reserve Bank of New York today released data showing that roughly 73% of U.S. counties had year-over-year increases in their mortgage delinquency rates in the first quarter (the latest period with full data available). A slightly smaller share of counties — about 71% — had higher delinquency rates for credit cards issued by banks than a year earlier. ... Delinquency rates for mortgages and credit cards are likely to continue rising into next year. ...

    Posted by on Tuesday, October 21, 2008 at 03:06 PM in Economics, Financial System, Housing, Market Failure | Permalink  TrackBack (0)  Comments (50)


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