Thought provoking post. Very interesting items and have enjoyed immensely. Please visit my site also….

An Open Letter to my Friends on the Left
by Steven Horwitz
Department of Economics
St. Lawrence University

One of the biggest confusions in the current mess is the claim that it is the result of greed. The problem with that explanation is that greed is always a feature of human interaction. It always has been. Why, all of a sudden, has greed produced so much harm? And why only in one sector of the economy? After all, isn’t there plenty of greed elsewhere? Firms are indeed profit seekers. And they will seek after profit where the institutional incentives are such that profit is available. In a free market, firms profit by providing the goods that consumers want at prices they are willing to pay. (My friends, don’t stop reading there even if you disagree – now you know how I feel when you claim this mess is a failure of free markets – at least finish this paragraph.) However, regulations and policies and even the rhetoric of powerful political actors can change the incentives to profit. Regulations can make it harder for firms to minimize their risk by requiring that they make loans to marginal borrowers. Government institutions can encourage banks to take on extra risk by offering an implicit government guarantee if those risks fail. Policies can direct self-interest into activities that only serve corporate profits, not the public.

http://myslu.stlawu.edu/~shorwitz/open_letter.htm

Uncovering the roots of the disastrous home mortgage bubble that popped last year will keep economic historians busy for decades. Yet, one factor has so far been largely overlooked: the bipartisan social engineering crusade to drive up the rate of homeownership by handing out more mortgages to minorities.

More than a negligible amount of the blame for the mortgage meltdown can be traced back to multiculturalism: government-mandated affirmative-action lending, demographic change, illegal immigration, and the mind-numbing effects of political correctness.

The chickens have finally come home to roost.

About half of all mortgages for blacks and Hispanics are subprime, versus roughly one-sixth for whites. Not surprisingly, the biggest home price collapses have occurred in heavily Hispanic cities such as Las Vegas, Miami, Phoenix, and Los Angeles.

The mortgage bubble was essentially a bet on the purportedly increased creditworthiness of the bottom half of the American population. After three decades of the home ownership rate stalling at around 64 percent, a series of federal initiatives to increase minority and low-income ownership helped push the rate up to just below 70 percent.

Now here’s a big picture look, demonstrating what all conservatives now realize about Bush, that “compassionate” conservative is not a synonym for “fiscal” conservative.

http://www.takimag.com/site/article/the_diversity_recession_or_how_affirmative_action_helped_cause_the_housing/

When Palin invoked the populist notion that we weren’t going to let Wall St. greed get us in this situation again, my immediate reaction was why didn’t she lay it at the feet of the Democrats. But I think her approach is the only one that will resonate with the voters. There is enough failure across the board that the argument just turns into a food fight.
All of these initiatives including the Mark to Market rules have a place and a reason, but what we need is the ability to adapt to changing conditions. Computer modelling that would trigger various restraints. Imagine what it would take to program that.
Markets that would self-correct are being juiced by government intervention to the point they no longer act rationally, IMHO.
The trick will be coming up with rules that allow the markets to act naturally. Democrats are likely to give us more Sarbannes-Oxley bills!

3. Once the music stopped, these banks and brokers got caught holding loads of this AAA rated paper, leading to $130 billion — and counting — in write downs.

4. The banks then saw their credit ratings get downgraded by the same companies that rated the original crappy paper AAA.

I forgot to mention that this “crappy paper” was forced to be immediately declared at a loss, due to “mark to market” rules. Yep, a Clinton Presidency initiative! Mark to Market was instituted by Clinton in the early 1990′s I believe.

Clinton did that, and Enron, by the way, immediately began making use of it, with their own highly aggressive energy-derivatives trading games. Eventually forcing California into rolling brownouts while their young-ish traders giggled in real time about it, over their phones, shocked that via their trades they could actually FORCE this to happen!

If mark to market hadn’t been in effect during 2006-2008, the losses would not have had to be immediately declared, since the prior loss declarations were on a traditional, long-time standard depreciation schedule, to smooth out market bumps.

Good luck explaining all this in campaign commercials, eh!?!?!

Hi Brian,
Thanks for the info in the posts! I’ve been reading the posts from everyone (thank you all!) and this helps a great deal.

I found a small summary on what the rating agencies did with the Fannie Mae subprime mortgages and other instruments:

1. Moodys (and S&P and Fitch’s) labelled a bunch of horrific junk — RMBS, CDOs, CDS, and other stuff — high quality AAA.

4. The banks then saw their credit ratings get downgraded by the same companies that rated the original crappy paper AAA.

There’s more to this, because I *do* remember that Fannie Mae executives were able, due to their close (incestuous!) ties with Democrats in Congress, to pressure Moody’s and the other agencies to rate the “Crap” as AAA. That made these high-risk loans able to packaged with other securities and instruments and sold off to investors in the opaque high-rated AAA packages. And resold and resold and resold… always at a profit. But no one knew what they were holding.

That forced upgrading of instruments to the high-grade AAA level is corruption. Are you listening, you vicious ba$tard, Barney Frank??? How about you, Chris Dodd? Had those subprime mortgages been forced to remain at the correct grading level – without Fannie Mae and Democrat corruption – they could NEVER have been eligible to be traded the way they were. This entire crisis does seem to rest almost entirely on the twisted backs of Fannie Mae/Democrats.

I had forgotten all about the Moody’s/rating agencies angles, and yet another connection to Fannie Mae and Our Dear Democrats.

As anybody who’s been paying attention to the situation will know, insurance policies and retirement plans have nothing to do with the bailout. AIG’s insurance and retirement plans are run through AIG subsidiaries, which everyone agrees are well capitalized and which, at least in the case of the insurance operations, are governed by strict regulations that severely limit the risk to people like you and me. Nothing I’ve read in the last couple of days suggests that these were ever in danger, even if AIG went into bankruptcy.

Rather, the reason for the Fed bailout is, quite simply, the massive counterparty risk that an AIG failure would cause. As newspaper graphic designers across the globe are struggling to explain to their readers today, AIG is a huge player in the market for credit default swaps, which means that they effectively sell insurance to corporate bondholders against the possibility that the companies who issued the bonds will default. In other words, CDS help big financial players limit the risk of their fixed-income (i.e. bond) investments.

CDS are not in and of themselves evil or duplicitous instruments; in fact they help shift risk to the people and companies who want to take it on and away from people who do not. But the major problem with CDS is that the market for them is completely opaque and unregulated, thanks in large part to the efforts of one of John McCain’s chief economic advisors, Phil Gramm. (A more minor problem–which reared its head earlier this year–is that CDS contracts don’t require initial ownership of the underlying bonds, thus the instruments can quite easily be used to speculate on a company’s demise.)

The Fed bailed out AIG because the company could not raise the $14.5 billion in collateral it needed to avoid bankruptcy. And unlike the insurance plans or retirement portfolios, the CDS contracts would be at risk in the event of bankruptcy. If all of a sudden a huge swath of CDS contracts were effectively canceled, then you’d have a huge swath of the financial market holding all kinds of risk that it was trying to avoid in the first place. And as soon as that happened, that whole swath would likely start selling off those newly risky investments all at once, causing a huge seize-up in the credit markets. And the credit markets, remember, are how companies get short-, medium-, and long-term loans to fund their daily operations (read: things like payroll for their employees). And so if AIG went under, the negative effects would work their way very quickly from Wall Street down to Main Street.

At least, I think that’s how it all goes. In any case, you can assure yourself that Henry Paulson and Ben Bernanke wouldn’t be doing this if it were at all avoidable. I mean, just think what this means: a Republican administration has effectively nationalized one of the world’s largest insurers. It’s funny how a little financial panic makes socialists of us all.

The company was a big lender of 40-year and 45-year mortgages, which Mr. Dallas says are a better way to put moderate- and low-income families into homes than adjustable-rate loans that start with low introductory rates but reset after a few years to much higher rates.

His passion proved compelling. In 2005, Merrill Lynch bought a 20 percent stake in Ownit, whose majority owner was CIVC Partners, a private equity firm in Chicago.

Merrill, along with JPMorgan Chase, also provided Ownit with billions of dollars in credit lines to make mortgages.

But Mr. Dallas’s relationship with Merrill began to sour in 2006 after the bank announced in September that it was buying First Franklin and as defaults on loans Ownit made that year spiked.

Merrill argued that Ownit was contractually obligated to buy back loans made to borrowers who had missed the first few payments. Mr. Dallas asserted his company would not do so because the borrowers made their payments to Ownit before the loans were sold. He further argued that Ownit was not responsible for missed payments after Merrill bought the loans.

Just to make matters more complicated, the banking rules established in the late 1980′s, set the capital requirements for banks (amount of leverage) which is approximately 12:1. In 2004, the big five Wall Street investment banks went to the SEC and asked that they be given an exemption to increase their leverage, which went up to as high as 40:1.

This was before Cox became SEC chairman, but the criticism is he didn’t keep sufficient oversight.

I think you can see that there is plenty of blame to go around. And don’t forget, the securities industry is self-regulated. How do you control greed? It doesn’t matter what rules are imposed, there are people that will circumvent them. We need to be realistic about how much government can protect us from ourselves.
Combining banking and investments may not have been such a good idea, except it freed up capital.

Hope this helps.

Something that is often overlooked in all this is the unrealistic expectations about what constitutes an exceptable house today. I grew up in a 1000 square foot house with three siblings. We live in an 1800 square foot house and had three children. My oldest daughter lives in a 2500 square foot house with one child.
These expectations alone have driven the cost of housing up, and we may need to rethink what is necessary for a fulfilled life, just as we will need to reconsider how big of a car we need to drive.

Some friends from Sweden just stopped buy a couple of days ago. Tore was an exchange student in the 60′s that stayed with my wife’s family. He and his wife flew into San Diego to visit a relative, then drove to Washington to visit friends before flying to visit their son, who is studying forestry in Alberta, Canada.
The had no idea of the distances, and I think it gave them more appreciation of the difficulties we face in terms of mass transit, etc. The rented a Buick LaSabre and liked the car very much. But they did comment that we needed to drive smaller cars, and we needed to live in smaller houses.

Lenders in California say big investment banks encouraged and pushed them to make risky loans. On Wall Street, bank executives say mortgage lenders became sloppy and did not pay enough attention to fraud. Whatever the cause, Ownit provides a vivid example of what went wrong.

William D. Dallas, the founder and chief executive of Ownit, acknowledges loosening lending standards but says he did so reluctantly and under pressure from his investors, particularly Merrill Lynch, which wanted more loans to package into lucrative securities.

He recalls being asked to make more “stated income” loans, in which lenders do not verify the information provided by borrowers and brokers with tax returns, pay stubs or other documentation. The message, he said, was simple: You are leaving money on the table — do more of them.

Mr. Dallas, a trim 51-year-old who has been in the mortgage business for more than 25 years, said he disagreed, but complied.

“If I can sell it at a profit,” he said, “why would I not do it?”

A spokesman for Merrill Lynch denied Mr. Dallas’s assertions, but declined to elaborate.

Mortgage companies like Ownit grew quickly last year by making it easier for home buyers to take out loans without proving their incomes or making down payments.

In retrospect, it was exactly the wrong time to ease credit: interest rates were rising and home prices were cresting after a sharp four-year rally. Many in the industry also suspected that speculation and fraud were rampant in many hot real estate markets on the coasts and in the Southwest.

There is no doubt that the standards in the subprime market deteriorated sharply last year. More than 44 percent of all subprime loans in 2006 were based on limited documents or none at all, up from 38 percent in 2004, according to Lehman Brothers. More than 26 percent of borrowers took out a second mortgage, indicating that they did not have enough savings for a full down payment, up from 14 percent.

But Tom Marano, who heads the mortgage business at Bear Stearns, disputed the contention that Wall Street pressure led to the loosening of credit standards. Investment banks, he said, do not directly make many loans.

“If enough independent companies set standards, that becomes the market,” he said. “Wall Street’s role is largely one where we assess risk, we purchase loans.”

Wall Street, however, is now wading more directly and deeply into the business. Big banks and hedge funds are buying up bankrupt or ailing mortgage companies that did not have enough capital to weather the downturn. These bigger financial players and more diversified lenders like Countrywide Financial may well inherit the subprime business.

Officials at mortgage companies and Wall Street banks acknowledge that it may be too dangerous to allow borrowers with weak credit who are financing 100 percent of a home’s purchase price to borrow without documentation of their income. But they defend the practice as appropriate for buyers with better credit or those making a substantial down payment, arguing that it helps extend homeownership.

The idea that the investment banks didn’t know the quality of the loans they were purchasing is absurb. And if I were a private mortgage broker, and a bank was going to buy my subprime loan why should I care how qualified the homebuyer is.
In this case, Merril Lynch was suing Ownit Mortgage for the bad loans, but why didn’t they check the quality of the loans they were buying from Ownit?

There is plenty of blame for the Wall St. investment banks and private mortgage brokers. What I don’t know is the precentage of subprime loans made because of CRA and brokers just looking to sell loans.