Roubini Misses the Boat on Regulation - Mish's blog

Summary:
Mike Shedlock argues that the cause of the financial crisis is not lack of regulation, as argued by by Roubini et al., but government intervention in free markets and fractional reserve banking. Government promoted an ownership society mentality and established HUD, FHA, Fannie, Freddie, and hundreds of affordable housing programs. But government promotion of housing put an artificial bid on housing that a free market never would have, raising the price of housing. In addition, the simple reason Moody's, Fitch, and the S&P do such a miserably poor job is government sponsorship. If Moody's, Fitch, and the S&P had to survive based on how good their ratings were instead of a model where the SEC says they have to rate everything, the problem with rating agencies would be cleared up overnight. The Fed is part of the problem too. The creation of the Fed was a blatant intrusion on the free market in the first place, but the Greenspan Fed's allowance of sweeps was economically equivalent to reducing the reserve-requirement ratio to zero for banks with sweep programs. Ultimately, the problems can be blamed on fractional reserve lending and the ability to create money (credit really) at will by borrowing it into existence. (Published: 10/09/08)

Notes:

• Roubini correct about US becoming United Socialist State Republic of America
• but: wrong about what went wrong and who is to blame
• e.g. the "fanatically and ideologically zealot free-market laissez-fair administration"
• e.g. "ideologue regulators who literally held a chain saw at a public event to smash unnecessary regulations"
• true cause: government meddling in the free markets
  
• there does not need to be regulation of Fannie Mae or Freddie Mac because neither should have existed in the first place
• it was government meddling in the free markets that created Fannie and Freddie
• government meddling in the free market will always blow up
• no matter how many government regulators one threw at Fannie or Freddie, both were going to blow up sooner or later
• ownership society mentality
• the HUD, FHA, Fannie, Freddie, and hundreds of affordable housing programs all came out of "ownership society" type thinking
• sponsorship of such entities creates a problem that regulators can never get right
• the bureaucratic mission inevitably takes on a life of its own
• government promotion of housing put an artificial bid on housing that a free market never would have
• that artificial bid had the exact opposite effect of what was intended
• every government sponsored affordable housing program raised the price of housing
• regulation could not fix that basic flaw and eventually the model blew up with ever increasing efforts to keep the ponzi scheme operative
• Ponzi schemes always blow up as soon as but not before the pool of greater fools runs out
• solution to all the above problems is simple
• eliminate government sponsorship of housing
• i.e. abolish the FHA, the HUD, Fannie Mae, Freddie Mac, Ginnie Mae, and every silly program on the books to create affordable housing
• government sponsorship of rating agencies
• many blame lack of regulation for the incredible fiasco at the rating agencies
• the simple reason Moody's, Fitch, and the S&P do such a miserably poor job is government sponsorship
• solution is easy: End government (SEC) sponsorship of the big three
• far past Time To Break Up The Credit Rating Cartel
• if Moody's, Fitch, and the S&P had to survive based on how good their ratings were instead of a model where the SEC says they have to rate everything, the problem with rating agencies would be cleared up overnight
• no amount of regulation can possibly cure flaws that arise out of government sponsorship
• Fed is the problem
• creation of the Fed was a blatant intrusion on the free market
• Greenspan Fed, ever wanting to "help" banks make more profits, instituted a policy of sweeps
• note on sweeps
• retail deposit sweep programs increase bank earnings by reducing the amount of noninterest bearing deposits that banks hold at Federal Reserve banks
• a bank's transaction deposits beyond approximately the first $50 million are subject to a 10 percent reserve requirement ratio, which is satisfied by holding vault cash or noninterest-bearing deposits at Federal Reserve banks
• in contrast, savings deposits are subject to a zero percent ratio.
• retail deposit sweep programs take advantage of this difference by "sweeping" transaction deposits into savings deposits
• that is, relabeling transaction deposits as savings deposits for reserve-requirement purposes.
• this is economically equivalent to reducing the reserve-requirement ratio to zero for banks with sweep programs
• effectively, the end of binding statutory reserve requirements
  
• every penny has been swept out and lent out (10 times over) thanks to the Greenspan Fed and fractional reserve lending
• what cannot be paid back will be defaulted on
• securitization problems
• in a free market with a sound currency, the originate to securitize model, aided and abetted by the rating agencies, would never have occurred in the first place
• None of the problems can be blamed on "free-market laissez-faire policies"
• every one of them can be blamed on fractional reserve lending and the ability to create money (credit really) at will by borrowing it into existence

Expand notes

Summary only...

Greenspan: Housing Stabilization Key to Crisis End - WSJ

Summary:
Greenspan: A necessary condition for an end to the current global financial crisis is the stabilization of the price of homes in the U.S. Stable home prices will clarify the level of equity in homes, the ultimate collateral support for much of the financial world’s mortgage-backed securities. We won’t really know the market value of the asset side of the banking system’s balance sheet — and hence banks’ capital — until then. Public policy can hasten this process by not prematurely propping up housing starts and by expanding the underlying demand for homes generally. The most effective initiative, though politically difficult, would be a major expansion in quotas for skilled immigrants. Skilled immigrants tend to form new households, by far the most important source of new home demand. (Published: 13/08/08)

Expand notes

Summary only...

Snake Oil and Deflation - RGE Monitor

Summary:
London Banker argues that the core problem leading to the current seizure of the credit markets is the misallocation of credit into unproductive works during the boom years. Markets all over the world carelessly followed the path of under-production, dis-savings and over-consumption as the path to prosperity. No amount of new credit will solve the problem unless the distortions promoting misallocation are redressed through fiscal and regulatory policy changes. Bailouts and recapitalisation of failed policies of the past are only digging a deeper hole, betraying more capital of younger generations into the unproductive works financed by the current generation. Correcting the bias toward betrayal of capital will not be popular or easy. Correcting the bias toward unproductive investments will require a massive change of political structures, financial intermediation channels, savings and consumption habits, and economic incentives. Savings must be encouraged and must be allocated to productive investments that will yield not just future prosperity but social equity to minimise political conflicts. But those who sold us or imposed on us the current set of policies and practices will be re-bottling their snake oil under new labels. (Published: 08/08/08)

Notes:

• “Panics do not destroy capital; they merely reveal the extent to which it has been previously destroyed by its betrayal into hopelessly unproductive works”. - John Stuart Mill
• obvious facts
• borrowing short through commercial paper to lend long on mortgages and credit cards to bad credits with inadequate collateral is not a sound business model
  
• yet somehow the alchemy of securitisation with a sprinkling of AAA pixie dust was widely accepted as turning financial lead into gold
• a house, once built, is not a productive asset as it produces no revenue but instead absorbs a high proportion of its owner’s income on mortgage interest, property taxes, maintenance and utilities
• credit card debt, once consumption goods are purchased, produces no productive income stream for repayment of the debt but instead becomes an obstacle to future consumption as debt service eats up a rising proportion of stagnant wages
• a car that weighs twice as much and uses twice as much fuel is not as productive as a car that is small and fuel efficient, and costing twice as much will harm more productive savings and investment with the excess debt borrowed for its purchase
• the financial sector, as intermediaries between savers and productive ventures requiring capital, should never rise to the point where it alone represents over thirty percent of economic activity
• Nonetheless:
  
• markets all over the world carelessly followed the path of under-production, dis-savings and over-consumption as the path to prosperity,
• in fact: path to a betrayal of capital into hopelessly unproductive works
• core problem leading to the current seizure of the credit markets is the misallocation of credit into unproductive works during the boom years
• no amount of new credit will solve the problem unless the distortions promoting misallocation are redressed through fiscal and regulatory policy changes
• bailouts and recapitalisation of failed policies of the past are only digging a deeper hole, betraying more capital of younger generations into the unproductive works financed by the current generation
• Correcting the bias toward betrayal of capital will not be popular or easy
• correcting the bias toward unproductive investments will require a massive change of political structures, financial intermediation channels, savings and consumption habits, and economic incentives
• challenge virtually every assumption made by at least two generations of American businessmen and consumers and exported globally
• Regulatory policies promoting misallocation of capital
  
• elimination of restrictions on bank dealing and brokerage of securities and derivatives
• self-determined models-based capital adequacy calculation
• ratings-based weightings of capital assets
• accounting reforms that permitted off-balance sheet financings
  
• acceptance of ill-transparent corporate structures
• Savings must be encouraged and must be allocated to productive investments that will yield not just future prosperity but social equity to minimise political conflicts.
  
• Those who sold us or imposed on us the current set of policies and practices will be re-bottling their snake oil under new labels.
  
• We must be wary before buying bulk lots in the tens of billions of dollars worth of the same old snake oil that has sickened our economies and political processes already.
  
• In the US: bailouts of Bear Stearns/JPM and Freddie/Fannie; perpetuates the subsidies to speculation and unproductive housing markets.
  
• In the UK: talk of a cut in stamp duty (a transfer tax on house sales)
• Snake oil, unfortunately, wins elections because it appeals to constituencies that are politically important
• as a result, we may be entering a dangerous phase where the democratic structures are biased to economically damaging policies that further harm future growth and prosperity
  
• because investment in unproductive works is so widespread as to form part of the popular culture

Expand notes

Summary only...

Too much risk? - Interfluidity

Summary:
Steve Waldman argues against the conventional wisdom that the financial system took on "too much risk" in recent years. Hundreds of billions of dollars were poured into new suburbs, while very little capital was devoted e.g. to the alternative energy sector. Capital was withdrawn from a variety of industries deemed "uncompetitive", because to gamble on recovery is far too great a risk. Big central banks, whose investment largely drove the credit boom, were (and still are) seeking safety, not risk. The housing boom was born less from inordinate risk-taking than from the unwillingness of investors to take and bear considered risks. Huge institutions are treating the financial system like a bank: depositing trillions in generic "safe" instruments and expecting wealth to somehow appear. A generation of professionals were trained to forget that investing is precisely the art of taking economic risks, then delivering the goods or eating the losses. Investors' childlike demand for safety has made the financial world terribly risky. We must not pretend that risk can be regulated or innovated away. (Published: 07/08/08)

Expand notes

Summary only...

Lessons from a “lost decade” - The Economist

Summary:
Some major differences between the US housing bubble and Japan's bubble in the early 90s are overstated. They were comparably severe, and the Japanese policymakers were not slower than American ones to cut interest rates and loosen fiscal policy after the bubble burst. In a way, the US is even more exposed than Japan was, due to a much lower savings rate among the population (more difficult to prop up consumer spending). There are a number of advantages the US today has over Japan back then. The US regulatory system, financial markets and political structure are more transparent, pressing banks into recognising losses and repairing their balance-sheets quicker. The cost of its housing bust is spread across other countries, with foreigners holding a large slice of American mortgage-backed securities and sovereign-wealth funds have provided new capital for American banks. American exports are booming, thanks in part due to a cheap dollar. (Published: 21/08/08)

Notes:

• Japan's decade of stagnation
• followed property bubble
• burst in early 1990s
• was fueled by cheap money and financial liberalisation
• people assumed property prices could not fall nationally
• when property prices fell borrowers defaulted and banks cut their lending
• result was decade with average growth of <1%

• some difference between US and Japanese situations are overstated
• no major difference in relative size of property bubbles
• America's house prices actually rose more and are likely to fall further
• Japanese home prices have since fallen by just over 40%
• American prices already down by 20%, many economist expect another 10%
• Japan's commercial property boom was smaller than America's
• Japan had stockmarket bubble bursting year earlier than in property
• hurt banks, because they counted part of their equity holdings in other firms as capital
• but its impact on households was modest, because only 30% of the population held shares, compared with over half of Americans.
• Japanese policymakers not slower than American ones to cut interest rates and loosen fiscal policy after the bubble burst
• BoJ began to lower interest rates in July 1991, soon after property prices began to decline.
• discount rate was cut from 6% to 1.75% by the end of 1993
  
• two years after American house prices started to slide, the Fed funds rate has fallen from 5.25% to 2%
  
• Japan gave its economy a big fiscal boost
• the cyclically adjusted budget deficit increased by an annual average of 1.8% of GDP in 1992 and 1993
• similar to America’s budget boost this year
• Japan’s monetary and fiscal stimulus did help to lift the economy
• after a recession in 1993-94, GDP was growing at an annual rate of around 2.5% by 1995
• but: deflation also emerged that year
• pushing up real interest rates and increasing the real burden of debt
• from here on that Japan made its biggest policy mistakes
• in 1997 the government raised its consumption tax to try to slim its budget deficit
• with interest rates close to zero, the BoJ insisted that there was nothing more it could do
• only much later did it start to print lots of money
• America’s inflation rate of above 5% is an advantage
• not only are real interest rates negative
• inflation is also helping to bring the housing market back to fair value with a smaller fall in prices than otherwise

• in a way, America is more exposed than Japan was
• when its bubble burst in 1991, Japan’s households saved 15% of their income
• by 2001 saving had fallen to 5%
• helped to prop up consumer spending
• America’s saving rate of close to zero leaves no such cushion

• monetary and fiscal relief were necessary but not sufficient to revive Japan’s economy
• missing ingredient was a clean-up of the banking system
• on which Japanese firms were more dependent than their American counterparts
• Japanese banks hid their bad loans beneath opaque corporate structures, and curtailed new lending to profitable businesses
• vicious circle developed, whereby banks’ bad loans depressed growth which then created more bad loans.

• America's regulatory system, financial markets and political structure will not let it procrastinate for so long
• has a more transparent regulatory structure which presses banks into recognising losses and repairing their balance-sheets
• even if regulators were slow to recognise that the banks were shifting risky securitised assets off their balance-sheets in the first place
• over the past year, American banks have been quicker than those in Japan in the 1990s to disclose and write off losses and raise new capital
• in Japan it took a long while before the political will was there to use taxpayers’ money to plug the banking system
• big test for America’s Treasury will be how quickly it recognises the need to nationalise Fannie Mae and Freddie Mac, the teetering mortgage giants

• Americ's advantage over Japan
• America is spreading the costs of its housing bust across other countries
• foreigners hold a large slice of American mortgage-backed securities
• sovereign-wealth funds have provided new capital for American banks
• America’s booming exports have helped to support its economy
• thanks to the cheap dollar
  
• in contrast, the yen’s sharp appreciation after Japan’s bubble burst hurt exports at the same time as domestic demand was being squeezed

Expand notes

Summary only...

Finding the Mess Behind the Mess - The New York Times

Summary:
According to Tyler Cowen, the US is unlikely to experience a lost decade as Japan did in the 1990s, but there will still be a long and protracted process of recovery. Number of problems in the real economy are underlying the financial crisis, and will remain once the financial crisis clears up. Problems faced by the US economy: lack of personal savings (people have for years treated rising asset prices as substitute for personal saving); credit crisis stopping banks from investing our savings and making loans; lower consumer spending, need to produce for export; still excess of homes in the market; energy prices. Further fiscal stimulus and excessive banking regulation will make things worse. Solving these problems will be like untangling a bunch wires: need to carefully pull the right wires, in the right sequence. (Published: 23/08/08)

Notes:

• Japanese recession in 1990s
• set off by bursting real estate bubble
• took economy more than a decade to resume steady, noticeable growth
• unlikely to happen in the US
• but will still see protracted process of recovery
  
• may take longer than the usually year or two to climb out of recession
• usually a crisis in the real economy behind every financial crisis
• based in some underlying structural deficiency
• even if financial crisis is bottoming out, sooner or later the real crisis must be faced
• problems in the US economy
  
• fundamental problem in the US economy:
• for years people treated rising asset prices as a substitute for personal savings
• as long as your home's value rose every year, you didn't have to set aside so much from your paycheck
• if your stocks went up, so much the better
• asset prices haven't been rising much lately
• many people will need more savings for their retirement or possible emergencies
• second problem
• US economy enduring a credit crisis
• many banks trying to raise more capital and make fewer loans
• savings are good for the economy when they lead to investment, but there is no guarantee that financial institutions will be allocating capital efficiently
• third problem
• lower consumer spending
  
• will require the US economy to make some shifts
• may mean fewer Starbucks and fewer new homes, but more tractor production for export to foreign markets
• shifting some consumption to investment probably beneficial to the economy in the long run
• in the short term, may mean job losses and costly readjustments
• fourth problem
• still excess homes on the market
• housing prices need to fall further
• such price declines make banks less solvent and thus worsen the credit crisis
• politicians would like to moderate this fall in prices, prolonging the adjustment process
• fifth problem
• energy prices
• high prices will encourage conservation and cleaner energy alternatives
• but: voters want low gasoline prices and winter heating bills
• politicians see lower energy prices as a way to help the economy in the short run, and as a way to win votes
• evolution of energy prices may not follow any kind of desirable logic
• danger that the Fed will view high energy prices as a sign of permanent inflation and tighten the money supply growth prematurely

• what should policy makers do?
• counterproductive path: further fiscal stimulus in form of tax rebates
  
• can raise consumer spending and bolster economy in the short run
• works only by pushing consumers to spend rather than to save
• merely postpones the needed adjustments by providing a grab bag of goodies at exactly the wrong time
• another danger: excessive bank regulation
• regulatory structure for financial institutions has failed in the current crisis,
• change is in order
• but shouldn't reform in a way that will discourage bank lending and weaken the tie between savings and investment
• banks already allergic to very risky mortgages
• we shouldn't overreact by punishing them for past mistakes
• regulatory reform needs to be forward-looking rather than focused on penance
  
• recipe for success likely requires, in ht right combinations and in the right sequences
  
• smooth adjustment into new growth sectors
• more savings from disposable income
• cleaning up the housing mess
• well-functioning energy markets
• more effective financial intermediation
• but: neither the government or the Fed can control this process
• Fed can add regulatory and monetary clarity, but there isn't any magical bullet

• Japanese failed to break out of their recession quickly because they didn't promptly close down or clean up their bank problems
• so far, Fed and other regulators show no signs of making this mistake
• but: not enough to guarantee a successful transition
• American economy will be tested for its deftness
• test will be difficult because there isn't a single enemy to focus on
• undoing a bunch of tangled wires
• if you don't pull on the right wires in the right order, the mess becomes worse
• if you pull too hard, the whole thing can break
• but if your first pulls are good ones, the untangling becomes easier with each move
• like our economy's situation today
• if we expect too much too quickly, we'll make matters worse
• but: there's a way out of the mess, and it lies in our hands

Expand notes

Summary only...

Treasury's mortgage rescue plan - Peston's Picks

Summary:
Robert Peston on Sir James Crosby's assessment of the outlook for mortgage finance. Darling worried by risk that the chronic shortage of mortgage finance could lead house prices to fall much further and faster than would be warranted on the basis of notional economic fundamentals. Discusses the importance of MBS to mortgage lending and the UK economy. Consequences of the credit crunch: demand for MBS dried up; no cash for mortgage lending; only five or six banks still able to lend; lending more expensive; lending only to the most reliable borrowers; rising number of defaults; exacerbating house price fall and weakening consumer demand. Crosby's likely to recommend action. Either Bank of England becomes the market-maker of last resort for mortgage-backed bonds; or government guarantees, on commercial terms, billions of pounds of better quality tranches of new mortgage-backed securities (i.e. taxpayers underwriting a huge slug of the mortgage market). Significant risks to the health of the economy from doing nothing. (Published: 29/07/08)

Notes:

• Sir James Crosby, FSA
• assessment of the outlook for mortgage finance
• forecasting that a chronic shortage of mortgage finance for homebuyers and homeowners will continue throughout this year, 2009 and 2010
• importance of mortgage-backed securities (MBS)
  
• finance from the sale of MBS was equal to two-thirds of all net new mortgage lending in the UK by 2006
• total stock of UK MBS was a staggering £257bn out of total residential mortgages of £1200bn by end 2007
• equivalent to around a fifth of the value of the British economy
• consequences of the credit crunch (almost exactly one year ago)
• demand for MBS completely dried up
• still almost impossible for any bank to issue mortgage-backed securities
• no cash to meet even the current reduced demand for mortgages from homeowners who need to refinance their debts and from prospective homebuyers
• leading banks are expecting the net increase in mortgage lending to fall to £60bn in 2008, from £110bn last year and a similar amount in 2006
• drop of 45%
• shrinkage that reflects a collapse in mortgage approvals for house purchase
• banks also struggling both to raise other forms of wholesale funding and to extend the maturity of their existing debts
• squeeze on the money they have available for new mortgages is exacerbated by their obligation to repay around half of their existing mortgage-backed borrowings over the coming three years
• likely to be a rise in the number of mortgage holders who can't pay their debts
• mortgage finance is now only available to those with utterly reliable earnings and deposits equivalent to at least 25% of the value of what they want to borrow
• what little lending there is is now dominated by the UK's biggest five or six banks
• small banks and building societies making almost no new loans
• many mortgage intermediaries expected to disappear
• shortage of mortgage finance likely to exacerbate the fall in house prices and the weakness of consumer spending
• recommendations
• government needs to attempt to re-open the market for mortgage-backed securities
• to prevent the banks becoming so strapped for cash that the housing market would go from decline to meltdown
• two possibilities
• Bank of England becomes the market-maker of last resort for mortgage-backed bonds
• Bank agrees to lend to almost any financial or investment institution against the security of mortgage-backed bonds bought by the relevant institution
• Bank would be guaranteeing that if the market for such bonds were shut, it would make sure that the bonds did not become totally illiquid
• government guarantees, on commercial terms, billions of pounds of better quality tranches of new mortgage-backed securities
• i.e. taxpayer would be providing a promise that it would pick up the tab in the event that the value of of those securities was impaired by a huge rise in repayment difficulties or defaults by mortgage borrowers
• i.e. taxpayers underwriting a huge slug of the mortgage market
• other possibility: government should not intervene, on the basis that such intervention may create more difficulties than it would solve
• but: would be significant risks to the health of the economy from doing nothing
• Darling deeply troubled by the risk that the chronic shortage of mortgage finance could lead house prices to fall much further and faster than would be warranted on the basis of notional economic fundamentals
• wants to prevent house prices overshooting on the way down, just as they overshot on the way up, and thereby wreaking massive damage to the economy

Expand notes

Summary only...