Post-Meltdown After-Action Report: The Housing Market, the Tasks of the Fed and the Treasury, and Economists' Reputational Bets

Paul Krugman comments on Dean Baker's ire:

The few, the proud, the ignored: Dean Baker is mad at Robert Rubin for suggesting that "few, if any" people saw the financial meltdown coming.

I'd say that there are two levels to this. First, a lot of people -- including Dean, me, Calculated Risk, and others -- saw that there was a huge housing bubble. It remains amazing that so many alleged experts failed to see the obvious.

What's going on now, however, is beyond that: the "financial accelerator," with deleveraging causing a credit crunch that forces further deleveraging, and now threatens to produce a sort of pancake collapse of the whole system, was not, I think, so widely foreseen. Certainly Nouriel Roubini was on the right track; I can claim to have described something quite a lot like what's now happening, though I covered myself by making it a slightly jokey scenario rather than a straight prediction. But in Rubin's defense, I don't think many people saw how much the system itself would break down.

In the larger sense, though, Dean is right. Even now, those who saw the risks are somewhat marginalized in public discussion, while those who airily dismissed all the warnings are still treated as men of good judgment.

I would prefer to make some finer distinctions. During much of the 2000s, the housing boom was generated by six factors:

1. Interest rates artificially pushed down by the Federal Reserve to try to rotate from high-tech to construction as a leading sector, and so avoid a recession.
2. Closely related, interest rates artificially pushed down by the Federal Reserve to try to stem incipient deflation, and so avoid a depression.
3. Lower spreads than in the past on long-term mortgages out of confidence that the Fed does have and will keep inflation licked.
4. The filling-up of America so that you can no longer build a detached single-family house within half-an-hour's driving time of the interesting places people want to be, and the consequent rise both in current location premia and expected future location premia.
5. Interest rates artificially pushed down by foreigners seeking political risk insurance--both private (i.e., get your money into a Citigroup account certain to be safe) and public (i.e., keeping the renminbi low and U.S. imports high in order to avoid unemployment in the streets of Shanghai.
6. A speculative housing bubble leading to a crash.

Of these six factors, (1) through (4) seemed at the time and still seem to me perfectly appropriate at the time--we should have had house price rises and a housing construction boom in the 2000s; it was macroeconomically appropriate for us to do so. (5) and (6) were much more worrisome, and many people (including me) did worry about them at the time. But what we worriers mostly worried about was (5), "global imbalances". It seemed to be the dog, and (6) seemed to be the tail--we could see how a collapse of the dollar driven by the end of what is called the Bretton Woods II configuration of the global economy could bring about a housing crash and a large-scale financial crisis. The chain of events that has actually taken place--a housing crash and a large-scale financial crisis without a dollar collapse--seemed to me ex ante and still seems to me a low-probability leaf on the outcomes tree. As I asked last August, "who had imagined that the people most naked to subprime mortgage risk were the analytically and quantitatively-sophisticated hedge funds of America?"

I also think that Paul gets the emphasis wrong when he writes:

What's going on now, however, is... the "financial accelerator," with deleveraging causing a credit crunch that forces further deleveraging, and now threatens to produce a sort of pancake collapse.... Certainly Nouriel Roubini was on the right track.... But in Rubin's defense, I don't think many people saw how much the system itself would break down...

I would say that many people expected some degree of deleveraging and a flight to safety, but did not regard it as a significant problem: the Federal Reserve exists to supply safe assets to the financial system whenever it does get panicked, and the only danger seemed to be if markets concluded that the dollar was no longer safe and so were demanding assets the Federal Reserve could not supply. The reason that East Asian central banks could not handle 1997-98--indeed, the reason that the Austrian and British central banks could not handle 1931--was that their currencies were no longer regarded as safe. This hasn't happened.

Yet we are still in significant trouble. Why? Especially "why" because nothing terribly bad has happened to the real economy: unemployment has not risen much, production and incomes have not fallen, wildfires have not annihilated all the houses of California's Riverside County driving their inhabitants into Bushvilles in the arroyos of the California desert--normally we would require that something bad have happened to the real economy before the financial side is in such a state.

We are in such a state because:

• Quantitatively- and analytically-sophisticated Wall Street teams greatly overestimated their capability to assess and manage risk.
• Institutions greatly overestimated the extent to which the QaASWSTs were assessing risk as opposed to simply writing out-of-the-money puts they could not value and claiming they had lots of alpha.
• Investors greatly overestimated the extent to which institutions understood what their teams were doing.

And now we have something significantly worse than a financial-accelerator-deleveraging creating a credit crunch. What such an episode would look like was well-analyzed by Paul Krugman last Monday with this graph:

On which Paul commented:

[A] lot of securities are held by market players who have leveraged themselves up. When prices fall beyond a certain point, they get calls from Mr. Margin, and have to sell off some of their holdings to meet those calls. The result can be a stretch of the demand curve that’s sloped the “wrong way”: falling prices actually reduce demand.... In this case, there are two [stable] equilibria, H and L.... And this introduces the possibility of self-fulfilling panic: if something spooks the market, you can get a “systemic margin call” that causes the whole financial market to go to L, and causes a big, unnecessary price decline.... Fed policy seems to be based on the view that if only they can restore confidence — with extra liquidity to the banks, Fed fund rate cuts, whatever — they can get us out of L and back to H. That’s the LTCM model: Rubin and Greenspan met a crisis with a rate cut and a show of confidence, and the whole thing went away...

I would add that Greenspan and Rubin did a third thing in the 1998 LTCM crisis: rate cuts, yes; shows of confidence, yes; but also following the Bagehot rule of lending freely on collateral that would be thought good in normal times in order to (a) provide the market with the liquid, safe assets it is suddenly demanding, and (b) provide those who want to make large bets that the economy will in fact make its way back to the good "H" equilibrium with the resources they need to make such bets.

Deleveraging and the financial accelerator are things the Federal Reserve can deal with through its normal (or at least its not too abnormal) tools and procedures. That, indeed, was Greenspan's bet over 2003-2006: confident that the Fed did have the tools to deal with a credit crunch should it come, the Greenspan Fed thought that it was better to keep the economy near full employment via a housing boom than to diminish the risk of a future bubble collapse and credit crunch by destroying the jobs of millions of Americans.

The problem now, however, is deeper than simply "financial accelerator and credit crunch." As Paul was diagnosing it only last Monday, we now seem to be in a situation in which supply and demand for mortgage-backed securities looks like this:

As Paul wrote last Monday:

[A] series of rate cuts and other stuff just hasn’t done the trick — which suggests that maybe there isn’t a high-price equilibrium out there at all. Maybe the underlying losses in housing and elsewhere are sufficiently large... [that] the Fed can’t rescue the financial markets. All it — and the feds in general — can do is to try to limit the effects of financial crisis on the rest of the economy...

That appears to be our problem right now.

But I would like to amend Paul Krugman's analysis by referring to the analysis of Alan Blinder down the hall from Paul in the Princeton Economics Department (actually, I think Paul Krugman's office is at the WooWoo). Alan looks back at the Depression-era Home Owner's Loan Corporation. If the U.S. government has a vehicle to buy up (at a discount from face value) and then manage home loans that look shaky, and if it can set the price of such loans, it might be able to do so in a way that not only rescues the financial system but makes money for the taxpayer. Suppose that the Feds set a price P at which they will buy up shaky loans like so:

and then buy up those loans offered at that price, taking them out of the market and thus out of private sector supply:

And then push the economy back to the good equilibrium, making money for the Treasury in the process:

If I were working for the Treasury right now, I would be saying: make this happen on Monday. There isn't time to set up a new bureaucrtacy--a HOLC, which is what Alan Blinder wanted to do as of three weeks ago. So use an existing bureaucracy: Fannie Mae. If I were Treasury Secretary Hank Paulson, I would spend the weekend building a legislative vehicle to introduce Monday morning on an emergency basis to give Fannie Mae the resources and the mission to undertake this mortgage rescue operation, and I think Fannie Mae is the right institution for the task: why does it have its government-sponsored status and guarantee if not to be used for purposes like these at times like these?

And if I were Ben Bernanke and Tim Geithner, I would be spending this weekend thinking about how to first thing Monday morning punish bear speculators on Bear Stearns, Lehman, and others by pushing their CDS spreads back to more normal levels. It seems to me that people on Wall Street need to be taught that betting that the Fed will not intervene to stabilize or that its interventions to stabilize will be unsuccessful is an unhealthy thing to do.

---

Global Imbalances:

Bretton Woods II:

Comments

[jerry]

I take Rubin's comments as an attempt to provide cover to everyone that did get it wrong. We wouldn't want to have our friends lose their jobs now....

It's similar to the "everyone got Iraq wrong!" Everyone except the dirty fucking hippies that is, and I have to include Paul Krugman in that latter category (and myself for allowing PK to convince me.)

By saying everyone was wrong, you don't have to make the impolitic remark that some people were very wrong, or worse, I was wrong. It's the modern equivalent of "Mistakes were made."

Somewhat related:

http://www.npr.org/templates/story/story.php?storyId=88276487

If you listened to NPR this morning, Jon Kyl, Rethuglitard-AZ made just that argument again, included the sentiment that McCain has been right on the surge (ignoring Petraeus' comments last week),

"Kyl says the current debate in the presidential contest over authorizing the war is a distraction from the U.S. military success in Iraq. "It's a false political game that these folks are playing to turn attention away from the fact that it turns out that our effort in Iraq is working," he says."

and then put a capstone on his remarks by claiming that the current state of our armed forces is due to ....

...

...

...

THE CLENIS!!!!!

[Tracy Lightcap]

Paul Davidson has been saying we need to re-up the HOLC and the RTC to deal with this since February. I'm not sure that Fannie is the answer; indeed, that would be akin to putting the fox to guard the hens. We already have a good historical record on how to handle this problem. All we need to do is pick it up, read it, then go and do likewise.

Problem = Dear Leader won't let any solution with a snowball's chance of actually working get any oxygen. We have a big problem alright.

[Cal]

Stephen Roach at Morgan Stanley has been warning about the problems with a serial asset-bubble economy for years.

[maynardGkeynes]

"And if I were Ben Bernanke and Tim Geithner, I would be spending this weekend thinking about how to first thing Monday morning punish bear speculators on Bear Stearns, Lehman, and others..."

If I were them, I would be thinking about (1) abolishing the FED (2) selling the T-Bills in their 401Ks and (3) buying yuan.

[zanon]

I find it hard to understand your logic, Brad.

Firstly, I'm not sure that the "filling up of America" argument fits at all with reality. Prices doubled or tripled between '98-'08, and there have been *no* dramatic increases in population, settlement patterns, or demographics to suggest anything was being "filled in". The Bay Area still has not recovered population since the height of the internet bubble, and it is a *less* interesting place to be in '08 than '96, yet prices have tripled.

Secondly, you say that the dollar has not collapsed. I'd agree, but it *has* softened, and may soften further. What does dollar/yen have to trade at before we can say the collapse has come? 70? 60?

Home prices have to fall to once again be inline with incomes. Why should the tax payer get stuck with the bill of trying to keep prices artificially propped up? Do you agree prices need to fall? If so, how would you let this happen? Just through inflation (which seems to be the current strategy)?

-zanon

[Ponzi Q. Globalization]

" During much of the 2000s, the housing boom was generated by six factors:"

Let's not forget the seventh factor: swindlers making craploads handing out loans to anyone with a pulse because of the securitization grift.

"Especially "why" because nothing terribly bad has happened to the real economy"

Perhaps nothing bad happened to the real economy because there is no real economy. The good times we've been having is a unsustainable debt-driven inflated-asset-price dream.

[Blissex]

The curves above simply CANNOT HAPPEN, because neoclassical Economics, which underpins the professorships of Brad DeLong and Greg Mankiw, and the central truthiness that income depends solely and always on productivity (Mozilo is a *very* productive person like O'Neill and the others) depends critically on curves like that never ever happening. If the curves above simply CANNOT HAPPEN, then all that is needed is to let the markets find a clearing price (which is GUARANTEED by mathematics to be unique and optimal) and do nothing. Laissez faire, laissez enricher! :-)

[Ponzi Q. Globalization]

Oops! I forgot the last two paragraphs...

"Especially "why" because nothing terribly bad has happened to the real economy"

Perhaps nothing bad happened to the real economy because there is no real economy. The good times we've been having is a unsustainable debt-driven inflated-asset-price dream.

What happened is that the dream economy ended when we woke up to the reality that assets prices can't keep rising beyond the ability of people to pay for them forever.

The waking world will be much harsher for America than the dream world. But let's look at the possible bright side of this nasty wake up call. Perhaps we'll get some progressive legislation that causes the creation of good jobs for enough Americans that the need for social control via mass incarceration is ended. Perhaps we'll stop trying to dominate the other 95% of humanity, losing our democracy and freedoms in the process. Perhaps we'll realize that, even with technological advancement, the current economic models drive us to eat the world faster than the world can regrow. Perhaps some of us (me included) we'll lose some weight ;-)

[Barkley Rosser]

Blissex,

I am presuming that you are being satirical, given your use of the term "truthiness"? If not, I shall simply note that your remarks about mathematics insuring that such curves cannot exist are, well, wrong.

Brad,

I tend to agree that Fannie Mae might be the best way to go to get a handle on the housing mortgage part of this mess.

What I find a bit odd is your hope that there will be a run on the dollar. Really? Is not the current decline of the dollar itself feeding the problem in a nasty positive feedback loop sort of way? Dollar down, oil up, financial markets more discombobulated. Indeed, your discussion of worrying about global imbalances implied that a run on the dollar is the sign of that crisis. And, also, in the short run, the J-curve means that a crashing dollar does not resolve but worsens the current account problem (although the gradual decline that has been going on has helped the non-oil parts of the account).

[anon]

your plan to have fannie and freddie help with the clean up is interesting. it could gain traction were it not for the wingnuts over at NEC, OFHEO, AEI and the Financial Services Roundtable (Lockhart, DeMarco, Canfield, Wallison, etc). they would rather risk the collapse of the financial system than sanction any initiatives that would strengthen the GSE's.

and let's also not forget that the longer this problem festers, the bigger the economic problems the democrats will have to deal with when they take over in 2009. this has undoubtedly played a part in the administrations' laissez-faire response to the crisis so far. (that and the fact that the DNC has received more $25,000 pledges from CT and NY alone than the RNC has received from the ENTIRE COUNTRY.)

i have dealt with all of the key players in the ongoing debate. there is a real sense of crisis and desire to arrive at joint solutions everywhere except the White House. they continue to view this in partisan terms. it's depressing.

[matt wilbert]

Why bother proppnng up Bear Stearns? This is not top-tier institution. If we have to prop them up, we might as well nationalize every financial institution now, because they are all too big to fail.

I have no problem with the government encouraging some kind of merger, but the current owners need to be wiped out, and I don't think it would be bad if the bondholders got a pretty good haircut as well.

[Emma Anne]

Ponzi: --" During much of the 2000s, the housing boom was generated by six factors:"

Let's not forget the seventh factor: swindlers making craploads handing out loans to anyone with a pulse because of the securitization grift.--

Agreed. The securitization racket ought to be on the list and pretty high up.

[howard]

prof, as an economic historian, surely you recall that in the '60s, the thinking was that all the economy needed was "fine tuning."

we all know how well that worked out.

so i don't know why your #3 would ever be accepted by anyone: the idea that we have something as complex as the modern global economy understood and solved to the point that inflation will permanently stay licked does not strike me as a product of deep ratiocination, and as we also know, hope is not a plan.

[capitalistimperialistpig]

I've got to go with Ponzi and Emma Anne. Some clearly failed to assess risk, but I doubt that it was those who put the financial instruments together. Ponzi schemes happen not because their creators can't guess how they end, but because they hope to make a bundle first.

The question in my mind is whether the supposed regulators were just dumb or were they in on the profits?

[esb]

Bradford, my good man ...

What you are actually recommending is an office (or a set of offices, hell, a series of floors or buildings) within the federal government which attmepts to "set" the prices of debt instruments, residential properties, derivatives (including but not limited to CDS), equity instruments of investment banks, equity instruments of banks (but here presumably only of a certain size) among other things too numerous to mention.

Why not just go "all the way" and include food items, energy items, metals (prescious and base) and agricultural items. And do not forget to include agricultural properties and even medical services.

Or is it that you want your price control program to only address prices when they fall, the inversion of the Nixon plan?

The Nixon plan was absolute unadulterated fantasy, and your breathtaking inverted plan is, well, I will leave the adjectives (and the adverbs) to others.

[easaba]

Hum,

seems like 6) is very under explained, that there was there a bubble via speculation. Was it only speculation? A relevant fact, it seems that during the bubble in the 9 counties that make up the SF Bay Area, around 50% of all mortgages were non-traditional, ALT-A etc etc. These loans alone seem to be sufficient to make a bubble. How? If the buyer is only concerned two items ,cash flow, and a presumption that housing only appreciates, then these two states lead the buyer to purchase more house than they can afford using previous prudent mortgage standards. Furthermore people who wanted to use the old standard found themselves competing with the ALT-A buyer. The traditional buyers have two options, buy a lesser house then they could have, or get a ALT-A loan.

This I think is a better explanation for the housing bubble than speculation alone.

[knzn]

I'll go more or less along with Ponzi, Emma Anne, and capitalistimperialistpig. Securitization was a huge part of it. Certainly there was fraud, but I would say that an even bigger issue (and largely what enabled the fraud) was a gargantuan error on the part of the bond rating firms (and a gargantuan error on the part of investors in taking the ratings at face value). It's abundantly clear now that they gave investment grade (even AAA) ratings to a lot of stuff that was total garbage and that a little careful thought would have shown to be total garbage.

[stig]

Back in '99 when they were popping the champaign corks at the death of Glass-Steagall...they knew.

http://www.businessweek.com/bwdaily/dnflash/oct1999/nf91029b.htm

"The implications of the new law are enormous. For instance, like other deregulated businesses, a merger frenzy of potentially unprecedented scale and scope is likely to be unleashed in the financial-services industry. Regulators rightly worry that these new behemoths will be considered too big to fail, encouraging their managements to throw the dice by lending recklessly throughout the global economy. These companies would profit handsomely if the gambles pay off, and taxpayers pick up the tab if they don't -- shades of the 1980s savings-and-loan crisis."

According to the article this didn't matter because...consumer bank fees were going to drop.

Yippie!

[Blissex]

«Back in '99 when they were popping the champaign corks at the death of Glass-Steagall...they knew.» Thanks to "stig" for this delightful quote; that was the reason why it was repealed I guess, bankers are not fools. «I am presuming that you are being satirical, given your use of the term "truthiness"? If not, I shall simply note that your remarks about mathematics insuring that such curves cannot exist are, well, wrong.» You don't have faith in the mathematical truthiness of Arrow-Debreu and convexity? You must be a Communist terrorist! (yes, I am being sarcastic, but the greatest faith in Arrow-Debreu and convexity leads indeed to riches and a chance at becoming a presidential advisor :->).

[bigTom]

I'm amazed to find myself in TOTAL agreement with Ponzi. I would like to add causes 7 & 8 to your list:
(7) Look the other way (cause it makes our party look good in the short term) regulators, who just let all the dodgy loan practices go on.
(8) The widespread perception among a large segment of the public, that price of real estate didn't matter. The only price figure of merit was the monthly payment. And for ARMs, and other sorts of loans that defered the actual high costs until later, the only thing that mattered was the initial monthly payment.

Of course we had whole armies of people whose well paying job was to encourage (7) and (8). For a non numerically literate public they were pursuasive. Again it should have been the job of government regulators to stop this sort of nonsense. But I guess they were too busy rereading AynRand to bother.

[tellitlikeitis]

"punish bear speculators on Bear Stearns, Lehman, and others by pushing their CDS spreads back to more normal levels". I truly must give you credit for one of the most creatively spun ways of saying "bail out my wall street buddies"

[kdp]

The assumption here is that the lower stability point L is invalid due to an "unnecessary price decline", as Krugman called it. Unfortunately, I think that the market is being perfectly rational here with it's expectations for the future housing market.

The HOLC idea won't fix anything. If the HOLC buys the mortgages at a price that is higher than its true value, then the government is saddled with a lot of bad debt that it will have to resell at a loss. Should the government not want to do this, it can inflate it's way out. In fact, the HOLC will probably end up causing inflation as it buys up the bad loans, since the loans have to be bought with dollars financed by debt.

So the HOLC will add inflation. Given the current commodity inflation we're seeing, this just adds to the inflationary pressure. Higher inflation means higher interest rates will be needed, which will once again put strain on the financial system. If the financial system is having problems at the current interest rates of 1.3% for 3 month notes and 3.44% for 10 yr notes, how would it handle a potential doubling or tripling of those rates?

The only time the HOLC works as desired would be when we are close to a bottom and the market continues to remain illiquid. However, trying to use the HOLC to force a market bottom won't work as I see it.

[Barkley Rosser]

I do not think one can view the use of unusual subprime mortgage instruments as separate from the speculation. Historically speculative bubbles have often been further fueled by unusual financing that could only be maintained as long as the bubble continued. That was the deal with all these no-interest and negative amortization mortgages. They worked fine as long as housing prices kept rising rapidly. Once that stopped and they started falling, the unsustainability of these forms of housing finance became manifest.

[christofay]

Rubin's latest remarks, ass covering

[Peter Principle]

Not to go all structuralist here, but I think Brad is ignoring the role of financial deregulation and "innovation" in all of this -- i.e. the creation of what Bill Goss likes to call the "shadow banking system."

I would go further and argue that what Wall Street has created (with the applause of the politicians, the regulators and, by and large, the financial academics) is a new monetary regime, in which what we persist in calling money is increasingly indistinguishable from credit -- or, to put it another way, in which the velocity of money has become almost infinitely more important than the money supply itself, both narrow (Fed reserve and currency) and broad (M1, M2, etc.)

This, too, was predicted some years back by an ex-New York Times reporter named Joel Kurtzman, who wrote a book called "The Death of Money." Kurtzman argued that a velocity-based monetary system would be inherently unstable, fostering both the creation and implosion of asset bubbles on a massive scale. In this he clearly has been proven prescient.

What Kurtzman didn't point out is that we have been here before -- the state banks of the 19th century were also essentially unregulated and capable (during boom times) of almost infinite leveraging of the stock of "hard" money (gold), leading to a pattern of increasingly destructive financial panics that eventually gave us reserve requirements, deposit insurance, regultory oversight and the creation of the Fed -- all the various safeguards that have turned bank credit into "hard" money (i.e. a reasonably reliable fixed store of value.)

Now financial "innovation" has leveraged the supply of bank credit the way the old wildcat banks leveraged the supply of specie, with even more spectacularly unstable results.

Ultimately, this system is going to have to be dragged kicking and screaming under tighter regulatory control. But, given the power of the vested interests involved, and the influence of their regulatory and academic cheerleaders, this almost certainly won't happen until after we've suffered through an enormous financial train wreck.

[Dan]

Interesting. That said, if they did this and your analysis is incorrect (or, in other words, demand curves slope down, which isn't an unreasonable assumption), then taxpayers will have just spend trillions of dollars to bail out speculators to little effect... I already suspect the $200B we just risked was a bad idea.

[Robert Waldmann]

I think your effort to distinguish your story about the cause of the meltdown from Krugman's is QaASWSTry worthy of a Jesuit.

[Robert Waldmann]

I think your effort to distinguish your story about the cause of the meltdown from Krugman's is QaASWSTry worthy of a Jesuit.

[David Pearson]

Prof. De Long, I must say I find your "punish the bears comment" amusing.

I (an individual investor) have been "betting that the Fed will not intervene to stabilize..." for three years now, ever since the homebuilders' parabolic rise cracked in the summer of '05.

At each step of this short-selling journey, I was warned by everyone that it did not pay to bet against the Fed. And yet, imagine! It has been a profitable enterprise after all. Could it be that the Fed was actually powerless to reverse the course of inflated financial markets once they set down the path of delevering?

So here we are, at one of the final junctures, and again, I hear the warning: "betting against the Fed is unhealthy."

To which I say, "someone please warn the Fed that the belief that intervention always works is unhealthy, not just for them, but for the whole economy."

[Edward Vielmetti]

On liquidity and who knew this problem was going to happen beforehand, read Markus Brunnemeier at Princeton:

http://www.princeton.edu/~markus/

esp. his slides here

http://www.princeton.edu/~markus/research/papers/liquidity_crunch_2007_8_slides.pdf

paper "coming soon".

[knzn]

What is missing is the recognition that the QaASWSTs were largely responsible for the boom in the first place. The relatively narrow spreads for low quality mortgages and the ability to originate so many at such narrow spreads, with so few questions asked, were the result of QaASWSTs' overconfidence in their (and one another's) rather naive (as it turned out) risk management techniques, and the demand for housing was facilitated by the availability of mortgages.

[David Levine]

You do not mention one cause of the bubble that seems important: a cascade of bad incentives that meant lots of (often prosperous) people made money lending money to (often not prosperous) people who could not repay the loans. That is, there were a lot of subprime loans with two or more of the following:
* adjustable mortgages with unsustainably low teaser rates,
* systematic encouragement for misrepresenting income and assets, including the now-infamous NINJA ("no-income-no-job-no-assets") loans, and
* loans-to-value ratios of 95% up to 103%, and so forth.

It was obvious to many in the mid-1990s that those loans would not be repaid. Personally, I missed that default could be delayed by rolling over loans -- as long as real estate prices kept rising. (Note the familiar positive feedback bubbles depend on.)

I know why loan brokers liked these loans, along with all the financial engineers who made money on transactions slicing a dicing their cashflows into complex derivatives. It is shocking that so many sophisticated investors looked at the short-term track record of the comlex financial instruments based on these unsustainable cashflows and then bought them. Not a good episode of financial capitalism.

[curmudgeonly troll]

I would argue the two equilibria correspond to a shift in the demand curve between different market regimes, and government can't shift the market back to the old regime.

At the high equilibrium, markets assume low volatility, low inflation, rising asset prices. This attracts a lot of leveraged players and mean reversion strategies that create the low volatility and rising prices that the markets expect, attract even more money to those strategies, and create a virtuous cycle of low volatility and rising prices.

However, while the strategies work in the short run, they don't properly account for shocks that are inevitable in the long run.

When the shock comes, everyone realizes that the assumptions are wrong and they have to delever. The virtuous cycle runs in reverse, as leveraged players and strategies exit the market, leading to higher volatility and declines in markets.

Government intervention can't really shift the private demand curve back once everyone realizes the old assumptions are wrong. Maybe you can cushion the fall and prevent an overshoot, but all the kings' horses and all the kings' men can't put Humpty Dumpty back together again.

[Michael]

Does anyone actually think that some tinkering with short-term interest rates will cause house prices to suddenly start going up again? It would actually take more than that. Unless prices rise 25% in California, there are still years of buyers who are underwater. Unless prices continue to go up at a rapid rate for years, the selling price isn't justified by the appreciation. That's not going to happen.

It's also a mystery to me how bailing out banks is supposed to help. They all have piles of bad mortgages worth billions (hundreds of billions, in Fannie's case.) Even if they don't have to recognize these bad debts, they certainly can't invest or lend money like they did before. The only thing that would cure the "credit crisis" would be if the government made loans on the scale that the whole industry was doing during the bubble. Even the feds don't have that kind of money.

[a]

C'mon, If LTCM hadn't been bailed out and had just been left to fail, we wouldn't have been in the mess that we are in now. All along the way, the Fed with the Greenspan put and economics advisors safely in their ivory towers have always taken the short-term view to risk: let's paper over this immediate problem and let's worry about the future when it gets there. When there's a recession, let's lower interest rates to keep consumption up, even though Americans have over-consumed for the past forty years. Mexico's in trouble, let's bail it out. The problem is the market is not static, but it learns and adapts. Things turned out okay in the past, with x amount of risk, because the Fed bailed us out, so now we can take on 2 * x or 3 * x, until eventually even the Fed is not able to achieve the bail out. The Fed thinks of itself as the bank in a casino, but at some point even the bank cannot meet the payout and has to fold.

Krugman is trying to take credit for sort of seeing the current mess; I don't think so. He's part of the problem, and economics will be in for yet another Keynesian moment, when current occupants of the tower of economics ideology will be gradually thrown out and replaced (and yes cursed by future generations).

[Dean Baker]

The big unknown in Brad's story is at what price we have the government institution buy up the mortgages.To my mind, Bard has a very weak story for explaining the run-up in house prices in this period. Why didn't it show up in rents, if it is due to fundamentals? If the government buys up houses or guarantees mortgages at bubble inflated prices, it will be a huge handout to the banks, a big cost to the government, no favor to the homeowners (who will never get any equity) and will prolong the adjustment process.

The honest version of the Blinder proposal is to allow the government to buy up or guarantee mortgages at 14.5 times the appraised rental value. This can provide a bottom to the market at a price that we can be reasonably sure is not inflated by irrational exuberance.

btw, we MUST get combating asset bubble on the Fed's job description. It is far more important than anything else they have done in the last quarter century.

[Bravo]

Dean Baker's post has a slight literary weakness: he uses the word "story" twice in two sentence. I propose replacing the first one with "proposal."

Substantively he hits the nail on the head. Selling mortgages at that price would be a big loss for that institutions that hold them, who are (at least some) of the ones who should take the hit. It would put a floor under the damage and thus thaw frozen credit markets. The only drawback I see is that some affluent speculator mortgagees would be bailed out; far better them than billionaires, banks, and non-bank financial institutions.

The major implementation problem is The Decider and his fellow ideologues in Congress. We're doomed.

[a]

Dean: 14.5 times rental value? Ouch. I think that would bankrupt Fannie and Freddie (not that I'm against that, but just saying).

[Bobby]

In my mind it looks like the the Fed and Paulson have lost the initiative. They're rocked back on their feet, stuck in a cycle of reacting to events. Why isn't there a plan like Brad suggests (or anything else)? Because too many people at Treasury and the NY Fed are getting 2 hours of sleep this weekend working on making sure Bear Sterns doesn't detonate Monday morning. Meanwhile, I don't think enough time and effort is being spent on getting out ahead of the crisis.

[Charles]

Why buy the mortages, when one can simply pay the cost of the reset for five years? That's a much more cost-effective strategy that keeps people in their homes.

No, no, I guess we can't help ordinary people, since that would create a moral hazard. The only ones who are immune to moral hazard are financial institutions and investors.

[piotr]

Yes, I am one of the dense people who wonder: why lower equilibrium curve is "bad"?

[Well, it isn't "bad"--unless you think that an economy with low investment spending and 10% unemployment is "bad" in some sense relative to an economy with higher investment spending and 5% unemployment. Big falls in asset prices generate big falls in investment spending.]

Some politician had fix view on the proper level of taxes: they should be lower. Never mind what is actual current level.

Similarly, there should be some relationship between price of assets and ability of potential buyers to pay (forget willingness). Suppose that we want to open a spiffy high tech outfit, we pay, well, the average for the area, and no potential workers can afford a home in the area where we want to do it. Are there any solutions? Say, try Cleveland, Ann Arbor, Buffalo, whatever.

In some countries the central government actually supports such solutions, so assets of the country are used in a more uniform manner. In USA, the government supported the bubble.

By the way, is the any outrage that junk was passed as AAA bonds?

[Movie Guy]

DeLong - "What's going on now, however, is beyond that: the "financial accelerator," with deleveraging causing a credit crunch that forces further deleveraging, and now threatens to produce a sort of pancake collapse of the whole system, was not, I think, so widely foreseen."

The financial guys saw this coming. I don't have any key brokers, banks, or investment advisors who missed this one. The warnings grew very loud no later than December and January. More to follow...no doubt.

>>>

[shander]

Value guys like Buffett and Munger saw it 5 years ago.

They looked like cranks all along and based upon your proposals they'll still look like cranks because the economy and financial system couldn't survive the unwinding back to an economy with capital markets that looked more like the 70's 80's and early 90's .

What would the financial system look like if interest rates were 4%(risk premium of the past) higher than the growth of M-3?

The whole economy would go under...its all based upon expectations of full employment and the full employment is based upon capital spending leveraged almost 95%(mature properties are lower) based on borrowing at barely over a decent productivity neutral inflation rate or selling new equity(or the expectation thereof for vc guys) at mutiples with no risk premium over those very low rates.

Only another investment based bubble will save us.

Actually the foreign governments could save thier own economies and ours by buying spending their accumulated surpluses on american products and services.

[Outtanames999]

Peter Principle and shander have it right.

Principle:
"Now financial "innovation" has leveraged the supply of bank credit the way the old wildcat banks leveraged the supply of specie, with even more spectacularly unstable results.

"Ultimately, this system is going to have to be dragged kicking and screaming under tighter regulatory control. But, given the power of the vested interests involved, and the influence of their regulatory and academic cheerleaders, this almost certainly won't happen until after we've suffered through an enormous financial train wreck."

He is exactly right. And here's where the regulation should begin: anyone on Wall St. who packaged or sold more than oh, say $1 billion of any exotic mortgage backed derivative (not the initial tranches derived from the actual mortgages, but the follow on derivatives and hedges) goes straight to jail. And the SEC draws up the most byzantine rules around the offering of any novel or nouveau financial product. And anyone who made money on the de-leveraging likewise goes straight to jail. Trust me, it's a fate far better than lynching by a mob of angry investors.

shander:
"Only another investment based bubble will save us."

Ironically, this is the supreme and everlasting truth. Ah, but where is that next bubble going to be?

[sglover]

"The waking world will be much harsher for America than the dream world. But let's look at the possible bright side of this nasty wake up call. Perhaps we'll get some progressive legislation that causes the creation of good jobs for enough Americans that the need for social control via mass incarceration is ended. Perhaps we'll stop trying to dominate the other 95% of humanity, losing our democracy and freedoms in the process. Perhaps we'll realize that, even with technological advancement, the current economic models drive us to eat the world faster than the world can regrow."

I'd like to think so, but my reading of history is that economic and military reversals practically NEVER bring anything but mass psychosis.

About the only bright spot I can see coming out of the developing shitstorm is that people will finally recognize economics as the shamanism that it's always been.

[JasonC]

Triple the price level with house prices static, and all the mortgages are "sound" again. It is everything else that goes nuts. House prices are only crazy if you regard nominal wages paying them as fixed. They are, admittedly, stark raving mad if nominal wages are effectively fixed.

Now, you can delay by parking a portion in federal hands, surely. But the overall mispricing hit will be borne by someone, and there are only two classes big enough - home equity, and nominal debts.

Deflation solutions put all the loss on the first, but have the side effect of smashing lots of existing businesses - bankruptcy is assymmetric that way. Inflation solutions put the loss on the second.

Here is what not to do - stand around dickering over who will take the hit somewhere down the road, instead of assigning it yesterday. That will quadruple the damage. Here is another thing not to do - break the whole economic system by changing all the rules to save past errors. By e.g. outlawing foreclosure (nobody will lend again), or criminalizing the act of talking while doing finance (alleging fraud whenever anything goes sour), or deciding the time to combat a past inflation that already occurred is in the middle of the smash.

Right now this frankly looks like amateur hour, everybody focusing on finance side issues not real allocation issues, and procedural minutae, and reacting to last week's headlines. Make the real allocation, make it brutually with eyes open, but not a fight, a decision. Get it over with. Either double the price level on purpose, or half house prices on purpose. Either will get the markets liquid again. Delay and more credit papering over the problem, or political blame games, will not.

[pt]

JasonC is correct, I believe. Either house prices are allowed to drop dramatically, and people who loaned money to buy them at their former high prices are allowed to lose big, or incomes are doubled through inflation. Wall Street, the Democrats, homeowners... and most other sources of political power want the second solution, so that will probably happen. In effect, the inflation in asset prices in the last 10 years will be passed on to wages and consumer prices.

I just wish that the next time a central banker says that there's no evidence that asset price increases beyond the official target rate of inflation are not a warning sign of future consumer price and wage inflation, someone hits them.

[Stratonovich calculus]

Apropos of Brad's proposal to get back to the "good" equilibrium (via CR via Greg Ip):

Fed Denies Discussions to Buy MBS [tinyurl.com/3agccq]

This would only make sense if, as Dean Baker notes above, the Fed buys this stuff at 14.5 times real rents. Or current valuations of the ABX AAA indices [tinyurl.com/35psag], which is about the same -- a 50 percent haircut.

This deus ex machina could throw two more twists into the demand curve: as quantity goes down via this specific mechanism (due to removal of assets marked with drastic price reductions), bond traders will also price the mortgages available to them down. Then we have a mirror image of this demand curve reflected about the vertical, reduced supply curve. The equilibrium "H" now becomes unstable, pushing us back down to a much lower "L" equilibrium.

The only thing that would support these "H" equilibria is high confidence.

[halbhh]

The only thing "good" about the higher equilibrium is for wealthy investors and investment banks to have an easier time (instead of a bigger haircut for investors (who are diversified remember) and investment banks mostly going under). It would not be hard at all for Bank of America or Wells Fargo to hire more people and do M&A and such. We don't actually need to have certain "investment" banks around for the economy to function well. We only need to have some large banks, capitalized adequately. There are many ways to re-capitalize survivors. I'd favor letting the US itself become a "Sovereign Wealth Fund" and do the investing, and thus let taxpayer get an actual investment for their contribution.

But the inevitable re-set of apparent wealth back down to nominal values in line with productivity is going to happen in every scenario, including the inflating and the inflate-and-____ scenarios. Further, production of goods and services not needed isn't actually....productive, so to speak. That is, having extra realtors and furniture makers more than demand asks for is destined to be corrected regardless of any factors.

Simply because there is a balance of trade over the very long run. Creditors don't extent credit indefinitely.

The arguments seem to come down to whether it's better to be like Japan (gradual and stagnate decline, with losses hidden from view), or Argentina (more sudden), or inflate, or simply transfer all the losses away from the wealthy investors holding the MBS paper and onto the middle class.

The offered solutions so far all look to transfer the losses onto the middle class (whether via the FED or FHA expansion or inflating). That might be reality (necessary), but I'd say that's not clearly necessary.

So if you are not personally with skin in the game, or relying on client with skin in the game, you have to ask: why not let the bubble collapse more rapidly (richer investors to take more of the total losses instead of the middle class) and plan to either nationalize or take big stakes in remaining survivor banks. Don't imagine we have to have particular Manhattan banks around for the US economy to function. If you can prove we do need them, show why.

[halbhh]

For clarity I should add that I don't see any way to save many jobs at Starbucks, new retail stores, etc that are in excess relative to a balanced (without new credit) buying power *including inflating our way out*. If we inflate, then the initial squeeze on the middle class will eliminate such jobs more drastically even than in other scenarios.

So if you accept that the adjustments (job losses) are inevitable (you may not), then I wonder why not simply do a little of everything. Some inflating, some FHA expansion, some FED hidden transfers (seems will happen regardless), some new aid to families, etc. I dare say this is a likely scenario, and it may be the best scenario.

But if someone can demonstrate a way to make existing jobs pay more quickly other than such things as the coming tax "rebate", for instance, it would be interesting.

I suspect the best solutions not already on the table is to accelerate innovation in the economy as rapidly as possible, so as to innovate our way into greater productivity as rapidly as possible.

[Ponzi Q. Globalization]

Why don't we just give the sharks that run these investment banks 10% of all tax revenue and ask them to stay home? Then having done our duty to our wealthy betters, we can start treating these banks as the utilities they are instead of pretending they are cutting-edge wealth-generating businesses while allowing them to parasitically suck our blood.

[Nick]

Personally, I'd rather the Fed not play the same gambling game as the IB's who did so on the assumption that they would get a bailout when their leveraged bets went bad (which they are getting). The bailout for the Fed is increased national debt and increased taxes, to pay for money which ultimately went to IB executives, traders, hedge fund managers, and everyone else driving the bubble and inevitable crash.

Your model assumes an equilibrium point with speculative valuations, but that's an economic hypothesis without much basis. If the high point truly was an equilibrium point, then by definition minor disturbances (like a 10% decline in housing value) should perturb the situation but it should tend to return back to that point. Instead, what happened was a rapid cascading correction back to the real equilibrium point, where valuations would be normal without speculation and leveraging.

To anon, who suggested the government was not doing more because of partisan politics in the white house:

Another explanation for the executive branch's unwillingness to engage in more bailouts is that they (perhaps unexpectedly) are the only ones who really understand the cause of the current situation (the expectation of a bailout driving risk), and are the only ones doing the right thing to prevent similar situations in the future. In this case, that would be not engaging in bailouts, resisting the pressure to undertake dramatic intervention, and letting the market fix itself. I know it flies in the face of general perception of the liberal media, but Bush is doing the right thing in doing [mostly] nothing. If only they could get the Fed to figure it out too and get on the same page...

[RCH]

"This, too, was predicted some years back by an ex-New York Times reporter named Joel Kurtzman, who wrote a book called "The Death of Money." Kurtzman argued that a velocity-based monetary system would be inherently unstable, fostering both the creation and implosion of asset bubbles on a massive scale. In this he clearly has been proven prescient."

Actually this was suggested much earlier by the communist Rosa Luxemburg. Capitalists were arguing that the credit system as it became larger and moved money faster could avoid the problems Marx saw. Rosa countered that this very speed made the capitalist system even more unstable because the money would be pushed onto consumers to buy the excess capacity from the factories, and then at the first sign of trouble the money would be quickly moved to safe havens causing a sudden collapse.

I'm not a commmunist but this was quite prescient at the time.

[RCH]

Here's another idea, it may not be new though. The Fed uses Fannie Mae perhaps to offer to buy mortgages with negative equity from the banks, but at no more than what the houses are worth now. This would entail having large parts of the real estate market revalued to see what properties are really worth now.
Now there are two kinds of mortgages like this, those that people are walking away from and those that people are still trying to pay off. If people are defaulting or just walking away from their homes then the banks lose nothing by selling the house to Fannie Mae at what they would get at auction if they were lucky. Then Fannie Mae can offer the people still in the house a mortgage that is no larger than the current value of their home. In all these cases then negative equity is removed, and the banks are saved the expense and risk of getting even less money for the house.
Fannie Mae can even offer people a lower mortgage rate to make the payments easier, on the basis that this might stop more people from defaulting and help the market to rebound saving Fannie Mae money in the long run. It could even guarantee people that they could have their home revalued yearly and if there was later more negative equity than the mortgage then their repayments would be reduced to match this.
This helps the banks out by getting them out of their nonperforming loans. It also stimulates the economy by putting money in the hands of those who need it, people who can't pay their mortgages. It largely stops the sales of houses by banks because there is little point in their not just selling the loan to Fannie Mae, they can't get more for the house on the open market. So the number of houses on the market reduces which helps the market to recover. The banks write off the losses they made on those mortgages and can then resume lending on housing because they can always sell the mortgage to Fannie Mae if prices decline more, and make money if prices go up.
Working out the valuations of all these houses also helps to work out what subprime bonds really are worth. Perhaps some of the mortgages in those bonds can also be sold to Fannie Mae at no more than what the house is worth, the rest of the mortgages repackaged into more saleable bonds. If this problem continues, more nonperforming loans are sold to Fannie Mae.
Fannie Mae is unlikely to lose from this because it buys mortgages at the value of the houses at that time. Since people are paying lower repayments they have no fear of higher rates, and will see that this might well cause the market to recover.

[halbhh]

RCH- The Devil in the detail of the various plans to have FHA etc buy risky loans written down to the "current price" of the house is of course what is the...."current price". See? This is the spot where the taxpayer will get robbed most likely. I'd be very surprised to see otherwise. The "current price" will be quite a bit higher than the house could actually be sold for, almost guaranteed, since the markets in question are declining rapidly now. The appraisals will be backward looking, by necessity, and thus will do nicely to accomplish the objective -- sell the taxpayer (via FHA etc) the loan at an old value.

i.e. House with old mortgage of $280,000 will get a haircut and sold to FHA re-fi at $240,000 for instance, but if it was put on the market in reality (no make believe), it might fetch $210,000, $195,000 etc.

It would be a clever slight of hand, seemingly all above-board. But the money guys in the private sector don't make the big bucks for nothing.

-- interesting about Kurtzman

[RCH]

halbhh, the real estate market is generally able to value houses for financing quite well. Normally people can't just pick a price for their homes and get a bank to loan that amount on it. The price has to be justifiable according to the condition of the house and comparable sales in the area. Appraisals are not backward looking, but are about recent sales. Since the system can already do this then it should be able to work out from current sales what houses are worth now. For example, if a bank wants to sell a mortgage to Fannie Mae it needs to have independant valuers determine the value of the house. They can check the history of what this house sold at before, compared to other houses that sold in the area. If it is a 3 bedroom house for example then it is compared with sales of 3 bedroom houses historically, or similar houses such as 4 bedrooms with a price adjustment for the extra bedroom.
There is room for some abuse and fraud, but remember a bank is not usually interested in bribing valuers to give the wrong values of houses. The valuers have their reputation to uphold, which is also built up from valuing houses for other mortgage transactions. If necessary two valuers might value each house, the cose is not high compared to the house value.
If the market is declining then Fannie Mae might offer a further discount on this, e.g. 10% less. However, once the system started working it should reduce the slide in house prices. If people are selling because they can't afford their mortgage or interest rate increases then they are less likely to default. Also the number of houses coming on the market from defaults would decline, mopping up a lot of the inventory for sale.
Banks that lost too much money selling their mortgages like this might be bankrupted, or helped out by the Fed, but the mortgages and houses would be more likely to avoid default. Fannie Mae might even be able to resell the mortgages to another bank fairly quickly at this lower price, if the owners are making their payments.

[halbhh]

RCH--if your "current sales" are within say 30 days, it's not the worst possible case, but....this is only one method loans pushed into FHA by law (Frank's proposal) might have their values above what you could actually manage to sell said house for. The danger is simple enough....unlike a responsible party, the FHA representative isn't playing with their own personal money or the consequence to their own banks, but rather taxpayer money that makes no difference to themselves personally +/- 10% (whew, this is a big case load, I don't care, that appraisal will have to do...etc)

[EorrFU]

There is an underlying assumption that the MBS's have already overshot their true value. Now I agree that 50c on the dollar is below what they are probably worth that gives the Gov't the ability to renegotiate the loans at a better price and eventually make the American taxpayer some money. It would basically bailout those who bought houses they couldn't afford and would create the orderly fall of these industries. How many people would sell their MBS's at 50c on the dollar just to fund their margin calls.

[RCH]

halbhh, I agree there is potential for abuse. This system though needs to be compared with what else is available. The advantages I see are:
1. It uses the current system for valuing houses. While some valuers might engage in fraud they have their reputations and livelihood on the line of found out. A bank has no real way to lean on valuers to engage in fraud for them. Granted some home owners might ask a valuer to make a lower price for them in exchange for a bribe, but this should be rare. Otherwise it would already have happened in valuing houses higher for larger loans.
2. The market gets to find out just what houses are really worth because each is being professionally valued. This is in contrast to no one really knowing what is going on at the moment. If the market is still declining this will show up in houses being valued less and less over time, so the offers for mortgages can reflect this.
3. The market needs to be helped to recover. This system puts more money in the hands of those who really need it, the people who have negative equity and are struggling with their payments or considering walking away from their property. Stopping those defaults is a major way to help the economy rather than just giving money to banks.
4. Keeping people in their homes helps neighbourhoods to hold their values as empty houses leads to vandalism, squatters, and more uncertainty over prices.
5. If Fannie Mae ends up with houses that people default on anyway it could rent them out or resell in the knowledge that they are owed approximately the market value. They would make some money on the interest they charge people who stay in their homes to offset losses.
6. If banks sell their mortgages like this then it ends the uncertainty over whether those banks are still solvent. Other banks can see how much they lost, how much help the Fed will give them and likely banks can resume lending between each other.
7. MBS's can have their true value determined by these valuations and those with negative equity can be liquidated for reasonable prices. Fannie Mae might well buy these bonds on the same basis, what they are worth with the negative equity discounted. That also frees up the market since everyone can then determine just what these bonds are worth now. Since people might lose less money on these bonds there are less margin calls and delevering in the financial market.
8. The banks can also guarantee Fannie Mae that if the values of houses decline further then the banks will pay them the difference. This would protect taxpayer money more, but I think it increases uncertainty on how solvent the banks are. Better to make a fixed price for the mortgages so the banks know how much liquidity they have.
9. What is the alternative but to mail cheques to everyone, bail out people like Bear Sterns, etc. Something has to be done, everyone agrees on that. In this way what is done is based on valuations for each property, rather than guesswork.