Friday, December 5, 2008

In addressing the financial crisis, we need to focus on, well, the markets...

I am very pleased to see that Cato Unbound will have essays and a follow-up discussion regarding the financial crisis (h/t - Cato-at-Liberty). I've actually wanted to blog about this for quite some time (given that I'm in the thick of it), but I've been very busy with other personal matters and haven't had the time or the energy to see this through.

With this forthcoming discussion, I will probably use this as an opportunity not only to resume some sort of semi-regular blogging but also address an issue that I have followed since rising default rates in subprime mortgages started doing damage to the fixed-income markets. Professionally, I work in the commercial real estate business in an investment sales/capital markets capacity. Prior to my current gig, I spent three years on Wall Street. While I didn't have direct exposure to what was going on in the residential markets, some of the root causes contributing the massive increases in securitization activity over a 4-5 year period ending in 2007 parallel, albeit inperfectly, similar activity in the residential sector.

The opening essay was written by Lawrence H. White's. To summarize:

The housing boom and the aftermath of its bust arose from market distortions created by the Federal Reserve, the government backing of Fannie Mae and Freddie Mac, the Department of Housing and Urban Development, and other federal interventions. We are experiencing the unfortunate results of perverse government policies, compounded in some degree by private mistakes.

Setting aside the fact that the Community Reinvestment Act as as cause to the subprime crisis (which White's essay covers) is a virtual nonstarter (see Aaron Pressman's article which demonstrates that most subprime lending occurred outside of financial institutions subject to the CRA) and the fact that I believe that most of the blame here should lie with the Federal Reserve, if we are going to mention a crisis "compounded in some degree by private mistakes", let us not write off what "in some degree" really is because in my opinion, it's a pretty damn big degree. If we are going to talk about what went on the markets, then it is imperative to at the very least pay attention to what was actually going on in the markets and make a brutally honest assessment about what happened, no matter where those conclusions take us.

I want to focus on the actions of private actors. For this, I'll post two quotes. The first is from Arnold Kling's systemic risk primer:

There is systemic financial risk when contingency plans that are developed individually are collectively incompatible.

For example, imagine that we have banks without deposit insurance. My contingency plan, in case I suspect that my bank is in trouble, is to run down to the bank and withdraw my money before they run out. My bank's contingency plan, in case it experiences an unusual rush of withdrawals, is to go to other banks that have plenty of cash on hand and borrow from them on a short-term basis.

My individual plan looks fine. My bank's plan looks fine. But if every depositor and every bank has the same plan, you can see how it could fall apart. A rumor starts at a couple of banks that they are in trouble, everybody tries to pull funds out at once, rumors spread to other banks, and pretty soon the whole system collapses. Note, for future reference, that the risks of this are reduced to the extent that banks have capital and reserves to protect against short-term losses.

My second one is from a Paul Krugman column:

As the economist Irving Fisher observed way back in 1933, when highly indebted individuals and businesses get into financial trouble, they usually sell assets and use the proceeds to pay down their debt. What Fisher pointed out, however, was that such selloffs are self-defeating when everyone does it: if everyone tries to sell assets at the same time, the resulting plunge in market prices undermines debtors’ financial positions faster than debt can be paid off. So deflation in asset prices can turn into a vicious circle. And one consequence of what he called a “stampede to liquidate” is a severe economic slump.

Both quotes are on the money, and in a bad market, there is a herd mentality amongst investors. No one wants to be the first one in and, more importantly, no one wants to be the last one out. In a very short period of time, we went from a market where there was unprecedented demand for fixed income paper backed by mortgages of all shapes, types and sizes to a market where just about everyone (from investors to the banks trying to unload inventory) was trying to sell securities to raise cash to cover losses, margin calls. This death spiral has been occuring for the last year or so (until recently, its impact was seen mostly in the bond markets).

The direct cause of the financial crisis is, in my view, unprecedented (and undetected) increases in systemic risk caused primarily by market participants acting in a collective manner. Public policy may have created an incentive system which set the wheels in motion but to leave the argument at that would be an analytical travesty. I'll mention what I two primary "private actor" causes.:

1. Origination by All Means Necessary. Personally, I found William Black's lead essay interesting with respect to the discussion on mortgage fraud. Fraud, no matter who caused it, did play a role in origination volume but it is important not to exclude the erosion of underwriting standards. In commercial real estate, borrowers were able to secure higher loan-to-value proceeds. The majority of loans were becoming interest-only. Also, lenders were becoming more aggressive in funding interest reserves and underwriting to future cash flow levels with respect to current cash flow levels on the basis that property values would keep rising. The stories about residential lending, especially with respect to subprime lending are so well known that it is probably not worth documenting everything but the fact that people were able to secure so-called NINJA loans speaks volumes.

Given unprecedented investor demand for higher yielding fixed income products, the proliferation of collateralized debt obligations (the really, really, really toxic stuff), the willingness of ratings agencies to put investment grade ratings on securities that had no business being rated as such and, broadly speaking, the whole originate-to-securitize business model, gasoline was being thrown on a fire.

All this being said, despite the damage and the "woulda coulda shoulda" arguments about regulating the industry, I think the market itself has wiped out many of the problems that may require remedy. This is not to say that I wouldn't consider looking at, for example, more oversight in the mortgage brokerage business or consider regulations that would require conduit lenders to keep a piece of deals they originate. The market for so-called "toxic mortgages" is dead, and when it comes back, private investors will buy this paper at prices that reflect the appropriate level of risk (a price that will be too costly for new loan origination). .

2. High Levels of Leverage. In a strong market, people tend to forget about the downside risk of leverage, and if given the ability to leverage themselves to the hilt in order to maximize returns, it will be done. As much as I would like to leave capital structure decisions in the hands of individuals or companies, the herd mentality amongst investors in the market is such that when the market goes bad, investors will rush to the exits. The problem isn't individuals taking on high levels of leverage. The problem occurs, as Krugman and Kling mention, when individuals act in the same way at the same time. This is exactly what has happened in our current situation and the impact on the financial markets has been devastating. Unlike 1998 with Long Term Capital Management, this fire spread to the whole economy.

This is not meant to be all inclusive. Reasonable minds can disagree about the causes of this crisis.

While I do not doubt that public policy decisions to some degree put us on this path (especially the Fed's interest rate policy circa 2003-2004), when the rules governing the financial markets are rewritten, I have a hard time envisioning public policy makers focusing as much energy on previous public policy decisions as they will on the mortgage brokerage business, credit derivatives, the securitization business, leverage levels, rules governing residential mortgages and increasing transparency in the markets so participants can accurately price risk.

We will have nothing to add to this debate if we continue to treat the actions of private individuals within the financial markets (behaving collectively or otherwise) as some sort of secondary concern or an unintended consequence of public policy. Part of this process, as painful as it could be for some, will be to acknowledge that in some areas (leverage and the mortgage industry in general), a lack of regulation made things worse (far worse, in my opinion, than the Community Reinvestment Act).

I may be an advocate of free markets and would certainly prefer less regulation to more regulation, I also believe systemic risk to be the sort of negative externality that needs to be contained. With the damage already done, it is imperative that we look forward and determine the proper balance between fostering innovation, growth and wealth creation and keeping the sort of excesses that can threaten the stability of the markets in check. Any other strategy is pointless.