Noah Dove - Oct. 7th 2008

The following conversation began on the 30th of September, 2008

Noah says...


The above link is to a republican hatchet job against Obama, but it actually contains some very useful information in the beginning.

The argument basically goes like this:

In the 70's Carter pushed through the "community reinvestment" bill to help low-income families buy houses (aka "affordable housing"). For over a decade, it barely managed to do anything. Then, in the 90's Clinton came by and re-invigorated it. The new version of the bill authorized the creation of "sub-prime mortgages" (whereby loans were given out with interest rates below their primary interest rates. In short, giving risky people loans, without doing anything to back themselves up against the risk). Moreover, any mortgage-issuing company that refused to issue sub-prime mortgages could now be sued. Indeed, there were a number of lawsuits against mortgage giants (by order of law) claiming that the companies were doing what they usually do, denying poor people loans, and thus discriminating against poor people.

Of course, the idea of lending below the actuarial tables creates this "risk gap" in which the mortgage companies themselves started assuming the risk that they were prohibited by law to pass on to the risky debtor. In order to compensate for this extra, artificially-generated risk, the government did what the government is very good at doing: financially backing them up. In brief, companies like Freddie and Fannie were forced to take on risky loans, but the risk was eliminated by a promise from the federal govermnent to cover the difference. When mortgage companies then turned around and sold the loans (a very common thing to do), they advertized them as being very low risk, due to the government backing (thus obscuring the fact that they were actually very high risk). For about a decade, these "toxic loans" that were required by the government in the name of giving poor people houses, leeched into the entire American financial system, also creeping a substantial amount into foreign investment firms as well.

This bad situation needn't have exploded into full-fledged crisis, but circumstances just happened to line up to make it one. The ease of being able to get a home dumped millions of new home buyers onto the market, which caused an absolute explosion in house prices. In a way, this actually propped up the above corrupt system. Other than the guarantee of being bailed out by the government if things went bad, the idea was that if the mortgage went into forclosure, the lender would be fine, because they would be able to sieze the house, and use it as a liquefiable asset to counter their losses.

Then, of course, gas prices doubled, food prices tripled, and the interest rate, in the name of countering inflation, rose to it's highest level ever. This hurt poor people disproportionately to rich people, which meant that suddenly, a lot of people were now unable to afford their "affordable housing". While they may or may not have been able to pay off their loan before, it now became impossible, and the forclosure rate began to soar. All of the sudden, all of these people who artificially showed up on the demand side to make prices skyrocket, suddenly left in a hurry, causing housing prices to plunge down towards their actual level (the bubble burst, so to speak). This meant that the banks and mortgage companies lost big, and they weren't able to recoup their losses with assets (the forclosed properties), because house prices had suddenly halved.

This left banks and mortage companies with a LOT of red ink. Normally, they would have been fine, given that riskier ventures would have higher interest rates, and they'd be able to use their own liquid assets (collected in the form of higher interest from homeowners) to cover the gap, but due to the necessity of issuing sub-prime loans, they couldn't fall back on that either. This meant that companies' liquidity instantly evaporated, and, due to not having any actual cash on hand, they had to do "write downs" (a.k.a. mini-bankruptcies). This very reasonably scared the living skivvies off of people who had invested in morgage companies, who started the equivalent of a bank run on them. With no liquidity to begin with, and panicky investors demanding their investments (in the form of liquid assets), the mortgage companies were doomed.

As a last ditch effort, companies like Freddie and Fannie ran back to the government. After all, the feds had promised to back them up if the risky loans went bad. In the end, the government was obliged to keep its word, resulting in the complete takeover of one mortgage giant after another.

But, of course, the chaos didn't end there. Because real estate has been seen as a generally safe bet, a lot of investment companies invested in mortgage companies. They also bought debt from said companies that was advertised as "safe". Well, the safety that the government promised mortgage companies, needless to say, didn't translate to who the mortgage companies sold the loans to. As such, investment companies took a bath when the loans went bad, and were completely destroyed when the mortgage companies went under.

This leaves the government with a new situation. Either it can let the investment companies fail, which would destroy the middle class (who, for years have been pumping money into retirement funds like 401k's) and eradicate almost all pensions, or on the other hand, they can step in with billions and billions of dollars to save the companies who were hurt by things that were backed up at the end of the line by the government.

In the end, the problem was fueled by millions of regular people wisely putting billions of dollars into "safe" retirement plans, which funneled into companies who wisely included a healthy amount of "safe" real estate investment, which funneled money into mortgage companies which took heavy stock in very risky mortgages that were branded as "safe" by the government, when they really weren't. This leaves us in a situation where the helpful, law-abiding engine of America's financial system is now being smeared as being part of "wall street greed" and "reckless anti-regulatory fiscal policy" on the side of the government, when really neither of these groups are to blame (at least, not as much as they ARE getting blamed).

In the end, the only companies now standing are the banks, mortgage companies and investment firms who were willing to criminally discriminate against the poor by refusing to offer them "affordable housing". Maybe their attitude should have been more pervasive in the first place.

Matt replies...

I think you may have missed a key part of the freddie mac & fannie may history. In particular, they were not pushed into taking these toxic loans, rather, they had been begging the government to be able to create these assets for years. It was thought that most sub-prime loans would still pay out, and with the capital these companies would be investing, the theoretical return was significant. I don't think the blame lies with Carter, nor with Clinton. Rather, the blame lies with those companies that the government is now considering bailing out.

It's very interesting that we arrive at very different ways of interpreting the crisis, all based on what the intent of legislature from the 70s/90s was about. I suppose this, in many ways, is why the discussion of politics is so acidic nowadays: republicans defending the corporation and bashing the government, while the democrats do the opposite. Of course, I don't mean to say that they are both right in general, because on any particular issue clearly one side or the other can be demonstrated to be right.

To most economists (who tend to be democratic nowadays), this is a story of the greed of these mortgage lenders, rather than some arbitrary government decision with no clear purpose.

I think the best summary of the whole story is This American Life's coverage: http://www.thisamericanlife.org/Radio_Episode.aspx?episode=355.

Noah replies...

So that was a neat story (I wouldn't expect any less of this american life). It was interesting the perspectives that they got, but it seemed like they came frustratingly short of actually explained why things happened the way they did. They did a good job showing how just a little bit of malfeasance at every step in the chain implied a whole lot of collective malfeasance in the end, but it did leave me wondering:

1.) Why on earth did everybody invest in mortgage backed securities? Yes, they made a brief mention of S&P's rating snafu, but am I really supposed to believe that NOBODY actually checked into ANYTHING? I mean, they make such a compelling case for why everybody's policies were so completely retarded, but they didn't explain why people across the world shoveled tens of TRILLIONS of dollars into it without ever checking to see if something might be up. I mean, it makes sense if the idea of the government backing the security is true, as it would be easy for companies like fannie mae to claim that they were AAA-class investments, as, in fact, a AAA-ranked organization was behind it all. Otherwise, it seems hihgly dubious to me that over 5 years and tens of trillions of dollars, it took the most massive financial collapse in the world's history for everyone to realise the emperor had no clothes.

2.) I also think that they were too harsh on investors. The fact that people had lots of money and they wanted to invest it into a sure thing like real estate is hardly massive greed. Yes, there is malfeasance in that this demand caused them to be less scrutinizing on where their investment was going, and it furthermore caused companies to relax their standards (the sole cause for this I would be reluctant to blame on a single group of people as this program does), even to rediculous amounts, but greed doesn't seem to be the driving factor so much as security was. People had money that was NOT inflation resistent, and they wanted to put it into something that was secure (like AAA-rated, for example), and preform with a slight profit, so much at least to counter inflation. Now, of course, they have gone way too far in the other direction, being willing to take money at a loss (government insured treasury bonds) just so that they wouldn't potentially lose more. Not only is this bad for average people (credit crunch), but it will wind up being bad for themselves as well, as gross global wealth is eaten away by inflation.

3.) There must be something else to account for the lack of resistance to the purchase by banks of bad loans. The way they set it up, it came across as mass hysteria that just nobody could resist (if only someone would have stepped in and saved them from themselves). The problem is that in as much as investors of any type are profit-minded, they are even more risk-averse, precisely due to things like the current financial mess. The way it comes across here, everyone who had any money all the sudden simultaneously got a case of the stupids, which I find hard to believe. While greed and hysteria are, indeed, strong forces, I'm unwilling to make the leap of faith to say that Warren Buffet was the ONLY person who put security above the possibility of mass profits.

As well, the idea that this was a bunch of greedy companies begging the government to let it do really risky things in a short-sighted pursuit of profits doesn't seem like an accurate description. Of course they were looking for monstrous profits (they're corporations after all), but remember as well, that they are risk averse. Big corporations with lots of money want to make low-risk profit (as even the radio program notes), because a vast majority of investors want to invest in things that are safe (most people don't invest in junk bonds for this reason), because they are ultimately responsible for not only their own rediculously inflated wages, but as well are responsible for said wages of the boards, and the wealth of the shareholders, who hired them (who are mostly middle class people investing in secure things for things like college for kids, and retirement). Plus, banks and real estate have a strong reputation for being safe investments for a reason, and it would take something truly titanic (like what we're in now) to change that: something that the greed of a few important CEO's doesn't seem to account for. I mean, we're talking about a system of terrible coincidences, rather than obvious and wholistic fraud, like ENRON.

Something seems to me to be more peculiar in all of this. So the way that a crediting company offsets its risk is by offering riskier clients loans at (much) higher rates. The really curious part of it all, then, is why were banks and mortgage companies taking on risky loans with LOW interest? The idea, apparently is that since they are mortgage-backed securities, there is assets (with the mortgages having adjustable rates as a release valve just in case). Investing in assets isn't exactly the highest-risk thing, I mean, when the chips are down, look at how many people are investing in oil, gold, and other asset-driven investment opportunities. As such, from the outset, it looked like mortage companies were going about coming up with a system that generated assets (giving out lots of loans to that people could buy and build houses), which they would then invest in, in a pretty secure way. None of this cries horrible corporate greed or a fundamental failure of regulation (although in some cases, the actual predetory lending practices at the very bottom rungs are), but rather a master plan that was too clever by half. Now that the first cog has fallen out of the machine, it's all crumbling apart.

It seems to me to be an unfortunate set happenstance where the perfect storm hit the free market, and it simply couldn't cope, due mostly to bad systems of its own design. It does make me wonder, though, what the future will hold, as the idea of nationalized housing strikes me as a very bad thing, and the idea of fierce new regulations seems like all it will do is worsen the credit problem and also make the average person even LESS able to buy a home, especially if they are in lower income ranges. While a hair of the dog solution also doesn't necessarily seem ideal, I'm sure it's going to take a lot of bickering and arguing to come up with the right long-term strategy once the immediate problem is addressed.

Matt replies...

For the middle-left leftist view, I present this (but don't agree with it as completely as the author does).


Noah replies...

So, I went and read the entire article, and I'm really surprised you call that the "middle" left. It seemed to be nothing more than a wholesale assault against the intellectual framework of capitalism, while branding republicans, corporations, and people who extend credit as the most evil and oppressive force on earth (with the ultimate conclusion of "fight the man, and be a hippie"). Do you get further to the left than this?

I had a bit of a hard time following his arguments due to the over-the top left-wing rhetoric that he used before each of them, but the one useful tidbit I was able to glean was the idea of a credit glut. While I highly doubt that the bush tax "cuts" (read, decreased increase) suddenly glutted a few rich people with so much cash that they suddenly got a hard-on for exploiting people with it (as the author flatly states), it did leave me to wonder, where did all of this credit come from? Or to put it otherwise, where did all of this extra investable money coming from?

One of the first things I looked up was the invention of the 401k. Authorized in 1980, it basically allowed people to take income and put it in a special account, and then not have to pay income tax on it (in some cases at all, in some cases not until far, far into the future). Obviously, this would be an appealing option to people, especially if your company matches your contributions up to a certain amount (so, twice as much money is up for investment than before). While there were only 17,000 companies that offered them in 1984, the number rose to 438,000 by 2003. Let's say that 10 million people (assuming only 1 in 30 save for retirement) contribute only $5000 per year to their 401k's (an # of people and amount which I believe will yield a lower than average amount), and assume that since corporations get tax write-offs for doing it, they match it, it means that you now have $100,000,000,000 (a hundred billion) EVERY YEAR that requires a home. Compare that to the $58 billion of tax savings the the bush tax cuts enabled (and assume that 100% of the tax cuts went straight into the stock market, rather than buying mansions, or whatever).

Then, of course, you have to add on IRA's (similar to a 401k, except that you can't put as much into it), pensions, and raw gross domestic product increases (+30 billion dollars, after you screen out inflation), and foreign investment (which rose over 200 Billion dollars in the past two years (in ADDITION to the obscene number it was already at), thanks in part to the weak dollar). It seems to me that given the expanding wedge of the US economy over the last decade, it would make sense that there's a lot more cash around, needing to be invested.

And of course, all of this wasn't raw speculative trading. While I'm sure that speculative, day-trading, and short-selling went up, I doubt that it did in comparison to the % of the rest of the trading (given that most of the money input was from pensions, retirement plans, and the like). In short, I'd have a really hard time blaming the market system as the cause of these problems, as much as I would point out that they are the ones (at least right now) suffering the most from what's going on right now.

One of the things that I find interesting is that both this article, and the NPR story have the same line of thinking "there was a lot of money around for the investing, ergo banks decided to act like idiots". Of course, the primary focus on why this happened is greed. While I have no doubt that there wasn't excessive competition for real-estate backed secure investments, the simple demand for them does not magically cause people to do whatever it takes, abandoning all personal security, to increase the supply. No, there must have been demand on the other side of the equation to make it happen.

Yes, some people were definitely criminally swindled into buying houses, but how much of the one TRILLION dollars of mortgages written up in the past two years were really due to fraud? Plus, while banks lending out mortgages with too-low of an interest rate is undoubtedly a cause of the crisis, said "sub-prime" (which, unlike what the author says, DOES refer to lending to less trustworthy people) loans only make up 8% of the mortgage market, and that's their total accumulation over the past decade+, not just what was written out in the last year. In short, while some of the mortgages were being pushed, greedily onto "hapless" consumers (who signed the paperwork), a vast majority of mortgages being put out weren't. Plus, if all the losses could be attributable to the % of the % of the loans which were made out of greed, and ALL of them defaulted, we wouldn't be in this mess, as corporations can (usually) take a few percentage points of loss without completely going under and needing the government to bail them out.

In short, while mortgage company greed is undoubtedly a part of what's going on, it must be a small part in a big tapestry of problems, as greed, pure and simple, isn't nearly strong enough to send the entire system into collapse. There is so much going on that squarely blaming big business, in this case, seems little more than short-term ass-covering which has the potential to create bad long-term problems down the road.

Matt replies...

So I'm going to bet that the part that you became inflamed about was somewhere around the 'explanation' of the current credit crisis. Let me explain why what he says is a reasonable explanation:

On the left (if I place myself there), there's a general mistrust of Bush. For many reasons, some of which are documented examples of lying, while others are made up excuses. Whatever the reason for his lying, every single Democrat I have ever met thinks that Bush has harmed the country. Democrats are still waiting to hear the real reason why Iraq was invaded, because the reasons offered at the time turned out to be lies. The only conclusion that seems to make sense is a power trip on the part of the administration. Since Bush & Co was willing to kill many many people for some reason yet to be explained, the Democrats don't put a limit on what his administration is capable of. You may call Rushkoff's theories conspiratory, but I'm confident most Democrats have a similar theory, due purely to the lack of clear information coming out of the Bush government.

Also, it seems you take issue to the supposed 'greed' of the banks and other institutions that contributed to this mess. You don't think that only their want for more money could outweigh their good sense not to take large risks. I think your assumption there about reward vs. risk is sound, and retroactively applying that logic, the banks must have thought these mortgages good investments; otherwise, they wouldn't have invested in them. Whatever thought process that led them to that conclusion could certainly be attacked, but it is clear that everyone thought these were good things. Furthermore, creditors in general do not make the most money when borrowers default, nor when they pay back the loan in full; rather, if the creditors can make the borrower take out such a large loan so that they can meet the minimum payment, then the return on the investment will be the largest. So, while a 'good' creditor might loan you such an amount so that you could afford the loan with 10% of your monthly salary, it would be in his best interest from purely a monetary standpoint to give you a loan that requires 30% of your monthly salary. This extra (false) buying power is, I believe, what Rushkoff is talking about when he writes "there was a surplus of credit in the system."

Your reasoning that the $1 trillion mortgage market cannot consist entirely of fraudulent loans is sound. However, borrowers began to default on loans that weren't sold fraudulently. This, combined with a higher than average fraud rate caused more loans than predicted to go bad, and so caused the many bundles of mortgages that initially looked like profit to become write-downs on the asset books.

Finally, since you claim that big business (whatever that is) is not alone in blame, then I would ask what other entity might also have contributed. I suppose you could accuse those homebuyers who wanted a house and took out a loan that ended up being beyond their means. But I'm sure than when (if) they looked at how much it would cost them, they determined it to be manageable (assuming rational borrowers. Oops. :)). Besides 'big business' you might also choose to blame the government for not stepping in and drafting legislation to prevent this, or for allowing legislation to go through that created this mess. Rushkoff does this, as well as your father (though, for different reasons), but I'm not as inclined to. Rather, I think the governments of the past thirty years (going back to your initial Carter reference) did what they could at the time to appease the most number of people. That includes the big-business lobbyists (who have great control over the current administration) as well as many other special interests. I'm sure the people in the government involved would blame those lobbyists, or perhaps those chartered to cast predictions on the market. I think had 'big business' not been able to offer these loans, then there would not have been been a boom or a bust. But which administration would want to be seen as resisting the free market and its want to increase the number of potential homeowners?

Noah replies...

Firstly, I'll be glad when the anti-presidential paranoia is over. I mean, the high level expressed by so many people seems almost to me like a lot of people feel betrayed, which is very odd as it implies that liberals were holding Bush up to a rediculously high standard. I mean, hasn't anybody learned anything from Clinton? Bush 1? Reagan? Presidents are scoundrels. As well, I might note that liberals are NOT reacting to Bush lying to the American people in the same way that they reacted when Clinton did. It can't just be about war either. I mean, Clinton tried to convince everyone that getting our military bogged down in a long, slow, horrific civil war (the Balkans) was in the national interest. Thus I find it silly that so many people seem to be taking this so very personally.

As for the second paragraph, I think that NPR had it righter than your description of this guy. I would be more likely to see an increase in credit as the result in an increase of money that's willing to be invested / leant out.

As for the next paragraph, I definitely think you're right. There are a lot of people suffering disproportionately to the amount of damage they caused I mean, poor people getting forclosed out of huge houses and banks taking a bath on their risky laons is one thing, but now it's broken out of its box to go all the way to people with good credit wanting to buy a car, and anyone with a pension or a retirement fund beginning to suffer

As far as who I blame, I think that nearly everybody has some amount of blame, and that the real cause that turned it from a potential problem into a real crisis is that EVERYBODY was doing something wrong, and those many hands made a crisis possible. Although I suppose I would give a little bit of extra blame to a couple groups of people. The first would be mortgage companies, specifically the ones like freddie and fannie who made their securities look safer than they really were. The second group I'd say is the government. If it's the government's job to protect people's investments (which I don't think it is), then they never should have authorized sub-prime lending in the first place, NOR should they have focused so hard into creating and promoting the idea that even the poorest of the poor deserve a house. If it ISN'T the job of the government to ensure people's assets, then I still blame the government for, decreasing it's interest rates to the point where capital had to get desperate to find a home, and for then not acting to "bail out" the companies, but in the meantime not doing very small things that would have prevented the large measures we have to do now. And the last group that gets a little extra kick in the pants is the people who bought sub-prime mortgages in the first place. Of course, some of them got conned, yes, but I'm definitely under the impression that most sub-prime buyers were just greedy, thinking they could get a little more than they could afford, and not having the middle-class skepticism of "if it's too good to be true, it is" that would have caused the money to go somewhere else, rather than into their bad loans.

Oh, and as to your point about the government, I'd agree that it wasn't anything nefarious, but rather short-sighted self-interest (other than possibly the ideology of "affordable housing" and even that has the stink of influence). In any case, I don't think that absolves them from a lot of bad moves over a really long period of time.

Matt replies...

Well, excluding your omission of the various conservatives who are also disappointed in Bush, I don't think you can disparage the liberals for holding the presidency to a high standard. I know that you tend to be distrustful of government and critical of its excesses, but there are many people who do expect a lot from the people who hold positions there. Many liberals were shocked to discover that a person of Bush's low intelligence could become president, simply because they had held that position in such high regard. Now, libertarians might expect such behavior of presidents and government, but I assure you that such pessimism is a minority.

As to your point about who to blame, I don't think it's fair to lump all governance into simply "the government." Personally, I do not think that the government should be swayed by business whatsoever, as their first priority is not in line with that of the government's. That said, though, I don't think that had the scenario we are in now, where businesses are failing and people/governments are unable to get necessary credit, been presented to the government at the time of the sub-prime lending legislation, they would not have voted for it. It's reasonable to assume that the evidence presented to them painted a rosy picture, and, given that information, they acted on it in a reasonable way.

It's also interesting the way you talk about the people who sought these sub-prime loans, not because I disagree with you, but because of your validation of the existence of this huge mass of people that I've never met that act in ways in which I wouldn't. I have long suspected their existence (Bush wins... twice! Automatic-gun control laws are shot down to protect personal handgun/rifle use. WTF?), but I suppose that I hadn't thought that anyone else thought this way. But clearly, you and I are not one of these people, but they have been a part of the worse financial meltdown since the Depression. That's strange. Who are these people anyway?