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Tuesday, October 7, 2008

The Financial Crisis? Who's Responsible? Beware of Simpleminded Uni-Causal Claims

Today's Initial Topic

It's set out clearly in the subject-title for the current buggy commentary, and you'll find it posted at Carpe Diem, where prof bug agrees in part with Prof. Mark Perry's liberrtarian views about the culpability of certain government policies --- above all, in this case, the enthusiasm of both the Clinton and Bush-W administrations to expand house-purchases to millions of Americans . . . with, in the upshot, Fannie Mae and Freddie Mac buying and selling a large number of house-mortgages whose credit-standards had been lowered by these two private, but government-backed, agencies in the mid-1990s Clinton era.

What Freddie and Fannie Do

These shaky mortgages were set up and financed originally by banks and other mortgage-dealing financial enterprises, especially once they became aware of the relaxed lending standards and new credit-lines to the US Treasury that the two agencies had.  Called sub-prime mortgages because Fannie Mae and Freddie Mac would buy or insure the mortgages from the banks and other mortgage-dealers that were written as a contract with the original house-buyer at about 1/4%  to 1/2% lower than prevailing rates.  These sub-prime loans were aimed at low-income families who otherwise wouldn't be able to afford a house.  The relaxed credit standards were further expanded to reduce or even ignore the need for any downpayment. 

You'll sometimes see the term --- until recently! --- GSE, or government-sponsored enterprises, applied to Fannie Mae and Freddie Mac. 

They don't themselves originate mortgages, remember. 

Instead, they buy and insure them from the original banks and other lenders of long-term house-loans.  Some of these mortgages they hold themselves, deriving money-income from the fees they charge the banks and mortgage-dealing lenders.  Lots of them, though, Fannie Mae and Freddie Mac "securitize": they bundle them together in MBS or mortgage-backed securities and sell them to other financial enterprises: investment banks, other commercial banks (which have investment affiliates under law since 1999), hedge-funds, sovereign (government-owned foreign) funds, mutual funds, credit agencies, insurance firms like AIG, and "virtual" banks . . . the latter not having any more of a brick-and-concrete location than Amazon does. 

In This Way, House Mortgages Here and Abroad Entered the Derivative Secondary Financial Markets

Of course, the two agencies ---- remember, ostensibly private but backed by the US Treasury and susceptible to political pressures (in this case, to extend "risky" housing mortgages to low-income families without the necessary credit-standards, income, or down-payments that most housing mortgages required --- these two agencies weren't the only buyers and sellers of mortgages in the derivative secondary markets, let alone the only ones creating new and large repackaged mortgages.

To clarify quickly, about a half of the $12 trillion worth of housing mortgages active in the US today are owned or guaranteed by the two agencies.  The remainder is in the hands of totally non-governmental agencies . . . at any rate in this country (some may be owned by sovereign foreign-government funds, most likely the Chinese and Arab-oil rich countries governments.  And of course similar mortgage-extension was going on in the EU and elsewhere during the last decade, a large but unknown percentage of which ended up as CDO's too: collateralized debt obligations, with the housing (Mortgage Backed Securities) the biggest chunk world-wide, with the sub-primes and other risky house-mortgages slapped together and sold and resold and credit-swapped in the process in long-reaching, non-transparent, non-regulated, non-accountable global chains of creditors and insurers linked together in opaque ways. 

Still, Fannie Mae and Freddie Mac --- essentially bankrupt in terms of liquidity --- have recently been put under government conservatorship and will play a big role in the new government rescue package.  (They may soon have to take over another 25% of the housing mortgage-market --- hence a total of 75% of the $12 trillion mortgage-based total --- if the economy enters a serious recession.)

The Wider Issue at Carpe Diem.

A libertarian, Prof Perry --- who believes free markets would work with near-perfection if governments didn't muck things up (the core-belief of all libertarian economics) --- stops with government and government policies as the only culpable causal agent of the global financial crisis . . . now risking, on top of everything else, a huge confidence-crisis that is choking up credit lending even between banks, let alone between banks and businesses and households. 

The buggy prof, no libertarian --- he has always supported deregulation in industry and non-financial markets, but always been suspicious of extending it to financial institutions because of what he learned early on about the financial system in the 1930s Great Depression.  More general, prof bug not only noted the role of market-oriented institutions --- poor credit-analysis, a failure to manage risk properly (all investments are risky and volatile to one degree or another), a desire to make a quick buck, a shaky belief the risks could be managed or passed down the line to unknown other financial agents in repackaged deals, extremely high leverage, and so on --- but insisted as a general methodological matter that few complex events or behavior, even by individuals, can be reduced to just one cause.  Social scientists, not just economists, are always trained to look for multiple causes, sort through them with the evidence, and weight them in terms of significance.  If possible, statistical models do this.  If the behavior or events can't be easily modeled statistically, good case-studies --- using a cross-comparative or historical perspective (or both, along with whatever quantitative data can be pinned down and analyzed) --- are needed.

Enough Said:

Click here for the original Perry comments and the bugged-out reply.