A Map Of Our Current Crisis

A map of our current crisis:

A) The rise in home prices:

Randal O'Toole on Cato:

"The credit crisis has led to numerous calls for bigger government. Yet the truth is that big government not only let the crisis happen, it caused it.

This truth is obscured by most accounts of the crisis. “I have a four-step view of the financial crisis,” says Paul Krugman. “1. The bursting of the housing bubble.”

William Kristol agrees. His account of the crisis begins, “A huge speculative housing bubble has collapsed.” “The root of the problem lies in this housing correction,” said Secretary of the Treasury Henry Paulson."

So it all started with the bubble. But what caused the bubble? The answer is clear: excessive land-use regulation. Yet while many talk about re-regulating banks and other financial firms, hardly anyone is talking about deregulating land."

B) The amount of money looking for investments:

This American Life Episode Transcript
Program #355
The Giant Pool of Money

"Alex Blumberg: The thing that got me interested in all this was something called a
NINA loan. Back when the housing crisis was still a housing bubble. A guy on the
phone told me that a NINA loan stands for No Income, No Asset, as in, someone will
lend you a bunch of money without first checking if you have any income or any
assets. And it was an official, loan product. Like, you could walk into a mortgage
broker’s office and they would say, well, we can give you a 30 year fixed rate, or we
could put you in a NINA. He said there were lots of loans like this, where the bank
didn’t actually check your income, which I found confusing. It turns out even the
people who got them found them confusing."

And:

"The real roots of the crisis lie in a flawed response to China. Starting in the 1990s, the flood of cheap products from China kept global inflation low, allowing central banks to operate relatively loose monetary policies. But the flip side of China's export surplus was that China had a capital surplus, too. Chinese savings sloshed into asset markets 'round the world, driving up the price of everything from Florida condos to Latin American stocks.

That gave central bankers a choice: Should they carry on targeting regular consumer inflation, which Chinese exports had pushed down, or should they restrain asset inflation, which Chinese savings had pushed upward? Alan Greenspan's Fed chose to stand aside as asset prices rose; it preferred to deal with bubbles after they popped by cutting interest rates rather than by preventing those bubbles from inflating. After the dot-com bubble, this clean-up-later policy worked fine. With the real estate bubble, it has proved disastrous."

C) Who said these investments were good:

"An Expert-Induced Bubble

The nasty role of ratings agencies in the busted housing market

David M. Levy and Sandra J. Peart | September 30, 2008

"Those who made the ratings became like expert witnesses in court, seeing things the way their clients, the firms holding the securities and offering them for sale to you and me, wanted things to be seen. The problem was that shoppers, like a jury, did not have the ability to average out different pieces of testimony to help remove the bias. As long as experts were trusted and the market didn't know the difference between unbiased and biased estimates, the trick worked marvelously. The collapse followed suddenly as we have all come to understand that the ratings were miserably biased."

And:

"When, in 2006, the roof began to fall in, Wall Street was in a quandary. It held outsize volumes of triple-A-rated mortgage-backed securities (MBSs). That they were not, in fact, triple-A, had become painfully obvious. Curious analysts consulted the financial statements of the top mortgage dealers, including Bear Stearns, Goldman Sachs, Lehman Brothers, Merrill Lynch and Morgan Stanley, for clarification.

Readers, however, found no clarification and no foreshadowing of the troubles to come. Neither in Bear's year-end 2006 report (10K, in Securities and Exchange Commission jargon) nor in its March 31, 2007, quarterly filing was there a meaningful word of warning about the sagging prices of the MBSs that did so much to pull Bear down. Those seeking to learn Merrill's exposure to the mortgage contraptions called collateralized debt obligations, or CDOs, were similarly stymied. Although Merrill was to write off $23 billion worth of CDOs in 2007, the phrase "collateralized debt obligation" did not appear once in its 2006 10K.

Because there was often no market for these idiosyncratic securities, Wall Street did not have to value them at market prices. Rather, it marked them "to model." That is, it assigned them prices at which they would trade, according to one mathematical construct or another, if they could trade. Of course, these mathematical constructs tended to cast things in a cheerful, management-approved way. Only later did a telltale plunge in the value of traded mortgage indices open the eyes of the market to the full extent of the troubles.

Prices can be unwelcome pieces of information."

D) Who insured the investments as good:

"Credit Default Swaps: Yes, You Have to Think About Them

Brian Doherty | October 3, 2008, 7:16pm

"If my theory is correct, then the credit default swap protection is somewhat of a delusion....It is too late to undo the delusion. In the aggregate, markets under-estimated the risk of the bonds they were buying. The risk premium needs to adjust upward. That upward adjustment is not a credit squeeze--it's a return to reality" Arnold Kling

And:

"Before your eyes glaze over, Michael Greenberger, a law professor at the University of Maryland and a former director of trading and markets for the Commodities Futures Trading Commission, says they are much simpler than they sound. "A credit default swap is a contract between two people, one of whom is giving insurance to the other that he will be paid in the event that a financial institution, or a financial instrument, fails," he explains.

"It is an insurance contract, but they've been very careful not to call it that because if it were insurance, it would be regulated. So they use a magic substitute word called a 'swap,' which by virtue of federal law is deregulated," Greenberger adds.

"So anybody who was nervous about buying these mortgage-backed securities, these CDOs, they would be sold a credit default swap as sort of an insurance policy?" Kroft asks.

"A credit default swap was available to them, marketed to them as a risk-saving device for buying a risky financial instrument," Greenberger says.

But he says there was a big problem. "The problem was that if it were insurance, or called what it really is, the person who sold the policy would have to have capital reserves to be able to pay in the case the insurance was called upon or triggered. But because it was a swap, and not insurance, there was no requirement that adequate capital reserves be put to the side."

"Now, who was selling these credit default swaps?" Kroft asks.

"Bear Sterns was selling them, Lehman Brothers was selling them, AIG was selling them. You know, the names we hear that are in trouble, Citigroup was selling them," Greenberger says."

E) Why accounting problems contributed:

"Prophets of Accountancy: Tyler Cowen: Marginal Revolution

"Here is Franklin Allen and Elena Carletti, circa 2006:

When liquidity plays an important role as in times of financial crisis, asset prices in some markets may reflect the amount of liquidity available in the market rather than the future earning power of the asset. Mark-to-market accounting is not a desirable way to assess the solvency of a financial institution in such circumstances. We show that a shock in the insurance sector can cause the current value of banks’ assets to be less than the current value of their liabilities so the banks are insolvent. In contrast, if historic cost accounting is used, banks are allowed to continue and can meet all their future liabilities. Mark-to-market accounting can thus lead to contagion where none would occur with historic cost accounting."