the origins of the sub-prime crisis in various species of criminal fraud, committed by borrowers, lenders or both

TO BE NOTED: From

True Confessions of the Crisis: Up-Close and Top-Down

We are a very long way from having a broadly agreed-upon story of the crisis that quietly commenced on the afternoon of June 20, 2007. That was when two Bear Stearns real estate hedge funds began to come apart, ushering in a long period of nervous waiting for fear eventually to subside (it didn’t) or panic to break out (it did). Nevertheless, a couple of unusually interesting accounts have appeared recently, one by the New York Times reporter who was covering the Federal Reserve Board, the other by a Bush appointee who, conceivably, might have defused the crisis altogether had he been heeded.

“Why did you do it?” That’s Alan Greenspan, interrupting, on the first page of Busted: Life Inside the Great Mortgage Meltdown – shocked, appalled, perplexed and finally curt – as Times reporter Edmund L. Andrews mentions, in the course of interviewing the Fed chairman in December 2007, that he thinks he’s about to lose his own family’s home to foreclosure. “I felt like a teenager who had just told his father that he had crashed the family car.”

Greenspan had been expounding on the origins of the sub-prime crisis in various species of criminal fraud, committed by borrowers, lenders or both. It wasn’t his job to police the riff-raff, the great central banker explained. Perhaps the reporter should interview the director of consumer affairs? Or the general counsel? “Deceptive and unfair practices sound very unfair until you try to define them.”

He was stopped short, though, when Andrews volunteered, “Let me tell you about my own personal experience with these mortgages.” If anybody should have avoided catastrophe, it was the 52-year-old newsman. He’d been a Times reporter for sixteen years; since 1999, he had covered the Fed. Yet in December 2007 he was squarely behind the eight-ball. He had bought a house with one of those no-documentation mortgages; he had diminished his nominal equity by borrowing cash against the house to pay down credit card bills.

But Andrews didn’t feel as though he had committed fraud, or that he had he been defrauded in turn. He had been aided at every step by loan officers, underwriters, banks, Wall Street firms, and rating agencies – a long chain of promoters that now seemed to stretch up all the way up to the revered policymaker with whom he was sitting. Blaming the borrowers, or the faceless bureaucrats of the consumer affairs division, suddenly seemed beside the point.

It was a cathartic moment. Was his interviewer the first person Greenspan had known personally to have been caught in the mortgage meltdown? He certainly wasn’t the last. The Fed chairman ended his own discomfiture that day with a broad grin and a joke. If the reporter had been sufficiently anxious to have avoided default to this point, probably the lenders’ models had been correct after all: “I bet they’ve made money on you already.” But for Andrews, the discomfiture was just beginning.

The result is Busted, a fascinating meditation on the experience of the crisis from the point of view of those facing foreclosure. Why Andrews found himself in dire straits was easy enough to explain. His marriage had come apart, he had fallen in love with a long-ago friend in similar straits (an Argentino mother of four, no less, living in Los Angeles, whom he had first met in high school in the days when his CIA father was stationed in Buenos Aires). Together they had bought a home – for $460,000, with 10 percent down with an adjustable rate mortgage – in a good school district in suburban Maryland in which to finish raising the children of their recombinant marriage.

There are other stories of sub-prime borrowers in the book as well, of upwardly-mobile Hispanics and African-Americans lured to disaster in developers’ tracts in suburban Virginia and southern California. Mostly, though, Busted is a thorough account of the mechanics of one couple’s humiliation and impending ruination at the hands of various representatives of the mortgage-lending industry, rendered as absorbing as any soap opera by Andrews’ unflinching attention to the intimate details of his married life.

There is no happy ending, at least not yet. “As I write in February 2009, I am four months past due on my mortgage and bracing for foreclosure proceedings to begin,” the book concludes. Thus while Andrews’ account of his ordeal does plenty here to whet one’s appetite for the details of foreclosure relief, which may or may not appear in tomorrow’s newspapers, the greater value of this acute personalization of a very complicated story awaits repurposing in a different medium.

Busted would make a dandy movie – one in which Andrews gets to keep his house.

At the opposite end of the spectrum is Getting Off Track: How Government Actions and Interventions Caused, Prolonged, and Worsened the Financial Crisis, by John B. Taylor, of Stanford University. No one needs to turn this compact little book into a film. Its basic argument is summarized in a chart of the federal funds rate since 2000 that The Economist ran in its issue of October 18, 2007 (slide six in this Taylor presentation). The lower line shows the monetary policy that Alan Greenspan pursued since 9/11. The upper line shows the target that was suggested by the eponymous “Taylor Rule.”

Taylor proposed his algebraic formulation to guide monetary policy in 1992. It is one of a whole family of target mechanisms developed in the 1980s and ’90s designed to bolster central banks’ credibility as they sought to control inflation – policies considered, until recently, to have worked quite well. His rule took an extremely simple form, making it something on whose exercise presumably all market participants could agree: the federal funds rate should be one and a half times the inflation rate, plus one half the GDP gap (the distance between current output and the level of its normal trend), plus one. The central bank thus would tighten as inflation accelerated, and ease when unemployment loomed. Had the rule been followed, Taylor argues, there would have been no boom, no bust. “The Great Moderation” of cyclical swings would have continued.

Why the departure? Alan Greenspan had plenty of reasons for the considerable monetary easing that followed the 9/11 bombings. No one wanted the US to fall into a prolonged recession, much less a Japanese-style deflation; George W. Bush was planning to go to war in Iraq. Though it would be clear only in retrospect, the economy already had been shrinking since March 2001; monetary easing ended the shallow recession in November, after only eight months. If the Fed had tightened instead, the accompanying political heat would have required all the president’s attention.

So instead the Fed explained that interest rates would remain low “for a considerable period of time,” and that when they eventually began to rise, it would be “at a measured pace” – which, as the chart shows, is exactly the path that interest rates ultimately took. Before long, a new reason for the easy money was discerned. There was a “global savings glut,” originating mainly in China. The central bankers were powerless to control the boom.

The problem with such a “counterfactual” exercise is that Taylor was there in Washington all along – in the administration, in fact, as Under Secretary of the Treasury for International Affairs from 2001-05. It was a big job, overseeing all the elements of the US “war on terror” that involved international finance. Later he wrote a book about it: Global Financial Warriors: the Untold Story of International Finance in the Post 9/11 World appeared in 2007.

But even though Taylor had loyally remained silent on the administration’s monetary policy throughout, when the time came to replace Alan Greenspan in January 2006, he had been nowhere on George W. Bush’s list. Not until the summer of 2007 did Taylor finally air his dissent, at the Jackson Hole conference of central bankers and economists staged annually in August by the Federal Reserve Bank of Kansas City. That tells you something about how dominant was the consensus that Alan Greenspan had been doing the right thing.

That meeting took place barely three months before reporter Andrews contributed his own more personal critique, confessing his embarrassment to the Fed chairman. It was just about the time that market participants all around the world were waking up to the gravity of the situation, and dramatically revising their estimates of Greenspan’s reputation. It will be years before a consensus evolves about the US government’s role in causing and prolonging the crisis. Both of these confessions, different as they are, will turn out to have been important contributors to the process. "

either agents made implausible assessments of future risk/return tradeoffs, or were engaged in "looting" the system by exploiting implicit guarantees

The Spigot Theory is attacked by Menzie Chinn on Econbrowser:

"A New Meme: Blame It on Beijing (and Seoul, and Riyadh...)

Perhaps I'm overstating it, but I think this is the abridged version of the Bush Administration's perspective on how we got into the financial mess we find ourselves in. You might ask why I focus on the ideas of the outgoing government. Well, it's because I'm confident that this will be a thesis pushed by some commentators eager to absolve previous policymakers of blame( I AGREE. IT'S AN ATTEMPT TO SHIFT BLAME. ) [1]. And indeed (as Mish points out), this view has apparently adherents in high places.

But let me let the the Economic Report of the President [large pdf] (Chapter 2) speak for itself:

• The roots of the current global financial crisis began in the late 1990s. A rapid increase in saving by developing countries (sometimes called the "global saving glut") resulted in a large influx of capital to the United States and other industrialized countries, driving down the return on safe assets. The relatively low yield on safe assets likely encouraged( THAT'S ALL IT WAS ) investors to look for higher yields from riskier assets, whose yields also went down. What turned out to be an underpricing of risk across a number of markets (housing, commercial real estate, and leveraged buyouts, among others) in the United States and abroad, and an uncertainty about how this risk was distributed throughout the global financial system, set the stage for subsequent financial distress.
• The influx of inexpensive capital helped finance a housing boom. House prices appreciated rapidly earlier in this decade, and building increased to well-above historic levels. Eventually, house prices began to decline with this glut in housing supply.
• Considerable innovations in housing finance—the growth of subprime mortgages and the expansion of the market for assets backed by mortgages—helped fuel the housing boom. Those innovations were often beneficial, helping to make home ownership more affordable and accessible, but excesses set the stage for later losses.
• The declining value of mortgage-related assets has had a disproportionate effect on the financial sector because a large fraction of mortgage-related assets are held by banks, investment banks, and other highly levered financial institutions. The combination of leverage (the use of borrowed funds) and, in particular, a reliance on short-term funding made these institutions (both in the United States and abroad) vulnerable to large mortgage losses.
• Vulnerable institutions failed, and others nearly failed. The remaining institutions pulled back from extending credit to each other( A CALLING RUN ), and interbank lending rates increased to unprecedented levels. The effects of the crisis were most visible in the financial sector, but the impact and consequences of the crisis are being felt by households, businesses, and governments throughout the world.
• ...

There is greater detail in the section titled: "Origins of the Crisis", subheading "The Global Saving Glut":

...

As this influx of capital became available to fund investments, interest rates fell broadly. The return on safe assets was notably low: the 10-year Treasury rate ranged from only 3.1 percent to 5.3 percent from 2003 to 2007, whereas the average rate over the preceding 40 years was 7.5 percent. While to some extent the low rates reflected relatively benign inflation risk, the rate on risky assets was even lower relative to its historical average: the rate on a 10-year BAA investment-grade (medium-quality) bond ranged from only 5.6 percent to 7.5 percent from 2003 to 2007, whereas the average over the preceding 40 years was 9.3 percent. The net effect was a dramatic narrowing of credit spreads. A credit spread measures the difference between the yield on a risky asset, such as a corporate bond, and the yield on a riskless asset, such as a Treasury bond, with a similar maturity. Risky assets pay a premium for a number of reasons, including liquidity risk (the risk that it will be difficult to sell at an expected price in a timely manner) and default risk (the risk that a borrower will be unable to make timely principal and interest payments).

Thinking in terms of systems of supply and demand is a very useful disciplining device. And here I think resorting to this framework, even allowing for distortions in the markets, can be useful, for it reminds one that the outcome (current account balances or the mirror image, financial account balances, and interest rates) are the equilibrium outcome of supply and demand for saving. (A related, but distinct, perspective is Brad Setser's creditors/debtors story.)

I'll admit that it's plausible to think of an exogenous shift in excess saving (decrease in investment demand in East Asia, increase in corporate and household saving in China, etc.) as resulting in increased US borrowing from abroad. This is indeed a variant of the Bernanke "saving glut" thesis. The Bernanke focus is on the "depth and sophistication" of the US capital markets.

Well, I think this last point leads us to my critique. Was it really sophisticated capital markets in the US, or a mania in which either agents( YES ) made implausible assessments of future risk/return tradeoffs, or were engaged in "looting"( YES ) the system by exploiting implicit guarantees( YES ) and building up contingent liabilities for the taxpayers( YES ), that sucked in capital from the rest of the world.( YOU'VE GOT IT )

Three years ago, I'd surely have a difficult time convincing people that US capital markets weren't completely self-regulating and self-correcting. Maybe it's time to revisit the "saving glut" hypothesis, and say that perhaps capital "sucked" into America, rather than "pushed" into America.

Even if one were to say that the excess saving from East Asia -- and the oil exporters as we enter 2005-08 -- drove( HELPED ) the bubble (and I'm willing to admit that there is something to the argument that global imbalances exacerbated domestic imbalances, especially related to the housing sector), I have two big caveats.

The argument that the saving glut led to low interest rates is not unambiguously accepted. [2], [3], [4], [5] [6] [7]. Consider Wright's work [pdf] on how the conundrum can be explained without resort to a central role for international factors (although he allows for some; see also this post). Also consider the correlation between low interest rates and the US current account. Below is a graph from a post two years ago.

Figure 1: The Net Export to GDP ratio and the ten year constant maturity yield (end of quarter) yield minus the ten year ahead (median) expected CPI inflation rate. Source: FRED II and Philadelphia Fed.

But, thinking again about exogeneity, why were funds flowing to the US. Some of it was low national saving. And why was that saving low? Because we were piling tax cuts upon tax cuts (admittedly I'm sounding like a broken record here: [8] [9]). But then add to this question why did the oil exporters start building up current account surpluses of enormous magnitudes? Because demand for oil rose in China, and the US (some observers conveniently ignore the US and focus on China, but it was adding substantial amounts of incremental demand up to 2005 or so). But some of that Chinese demand for oil was "derived demand", driven by US consumption of Chinese made goods.

So, while I won't say that the idea of saving flows coming from East Asia had some role in the financial crisis we're now undergoing [is completely without content grammar corrected 11:15 Pacific 1/22]], I'd say one has to think about how those flows came about, as much as how big they are. We don't usually think of the rest-of-the-world driving macroeconomic events in the US (here's my take: [10]), and I still don't think it's time to start.

Figure 2: Trade balance to GDP ratio (blue) and trade balance ex. oil imports to GDP ratio (red). NBER defined recessions shaded gray. Sources: BEA/Census trade release for November, Macroeconomic Advisers [xls] (release of 15 January 2009), NBER, and author's calculations.

By the way, I am disagreeing slightly with Brad Setser's take on this subject, although I think it is more a point of emphasis than substance. My reading of his post is that excess saving from East Asia and oil exporters enabled( I AGREE ) (my phrase, not his) the US housing boom, and the search for yield. I think that's somewhat different from the ERP thesis."

This is basically my view.

"We call this "circling the wagons" because what this argument does is shift the blame."

From Forbes:

"Treasury's Paulson Gets It Wrong
Brian S. Wesbury and Robert Stein 01.06.09, 12:01 AM ET

In a recent interview with the Financial Times, U.S. Treasury Secretary Hank Paulson blamed the credit crisis on global imbalances. Specifically, he repeated a storyline popularized by Alan Greenspan and Ben Bernanke: that a global savings glut (otherwise known as an imbalance) pushed interest rates down around the world and drove( NO ONE HAD TO DO THIS. IT'S A MECHANISTIC EXPLANATION OF HUMAN BEHAVIOR. ) investors toward riskier and more leveraged investment activities( I DON'T CREDIT THIS THEORY AT ALL ).

We call this "circling the wagons" because what this argument does is shift the blame( I AGREE, ONLY I THINK THAT IT SHIFTS THE BLAME AWAY FROM INDIVIDUAL HUMAN DECISIONS. ). It shifts the blame off of the Fed, which pushed interest rates down too far in 2002-2004( I DON'T CREDIT THIS EXPLANATION EITHER, FOR THE SAME REASONS GIVEN ABOVE ABOUT THE GIANT SLOSHING POOL OF MONEY. ). It also lets the Fed off the hook for using the phrase "considerable period" back in 2003 when the federal funds rate was 1%--that was how long it said it wanted to hold interest rates low. That language was designed to lower long-term interest rates by basically double-daring( YOU HAVE TO ACCEPT A DARE? ) hedge funds and investment banks to use massive leverage--borrow short at low rates and buy long at higher rates.

It lets rating agencies, which are sanctioned by the federal government, slide despite their huge mistakes( CRIMES. BUT I AGREE. ). It whitewashes Fannie Mae, Freddie Mac and the politicians who supported their ability to hold mortgage rates down artificially( STILL NO EXCUSE FOR BAD LOANS. ANOTHER MECHANISTIC EXPLANATION. ). It also ignores rules and regulations, such as the Community Reinvestment Act (which forced banks( COME ON ) to make low income loans) and mark-to-market accounting (which artificially( SENSIBLY ) pushed up capital ratios at financial institutions in the early 2000s as the Fed cut interest rates and risk spreads narrowed as leverage increased).

Most important, it fans fears( THEY'RE ALREADY WELL-FANNED ) of global financial markets, free trade and free markets in general. If this argument influences the policy debate, it will lead toward protectionism or devaluation, both of which would harm the U.S. economy.

The Greenspan/Bernanke/Paulson theory suggests that China (in particular), as well as other countries holding massive reserves, created a glut of savings and low interest rates. The way China accumulated these dollars was by running a trade surplus. Never mind that the U.S. was running a deficit exactly equal to the rest of the world's surplus and the last time we looked, exactly equal meant "balanced."( THE SPENDER COUNTRY/SAVER COUNTRY SYMBIOSIS ) Never mind that, because what the Treasury Secretary is supporting is an argument that the trade deficit is a problem. This creates another support for those who want to see a U.S. devaluation or the introduction of more barriers to trade.

Despite the high level of support for this "global imbalances" argument, we remain skeptical. First, the Fed controls short-term interest rates. And when the Fed signals that it will hold rates low for a considerable period (as in 2003), this encourages( AT BEST. IT DOESN"T DETERMINE. ) what Mr. Paulson called the "mis-pricing" of risk.

Second, if China (or other high trade surplus countries) used accumulated dollars to purchase goods and services from the U.S., those dollars would not disappear, they would still be in circulation.

So the idea that somehow there is a glut of money because one country or another is holding a big stash ignores the fact that no matter what that country did with the money it would still exist. If it were spent it would represent sales, profits, incomes and savings for some other entity. For every debit, there must be a credit. For every trade surplus, there must be a deficit. For every so-called imbalance on one side of the ocean, there exists an equal but opposite imbalance on the other side of the ocean. There are no leaks; the world, when it comes to dollars, is a closed system.

While we understand the desire to circle the wagons and shift blame, the idea that a global savings glut destroyed the economy is seriously wanting( I AGREE. NOT USEFUL. ). We hope this is not the only explanation for our current financial crisis that policy-makers employ. The underlying cause of a crisis is important to understand. If policy-makers are mistaken, then policy responses will be flawed.( THIS IS TRUE, BUT THEY ARE ALSO WRONG IN FOLLOWING MECHANISTIC EXPLANATIONS OF THE CRISIS, WHICH ARE ALL OF LITTLE USE. )

Brian S. Wesbury is chief economist, and Robert Stein senior economist, at First Trust Advisors in Lisle, Ill. They write a weekly column for Forbes.com."