Friday, August 20, 2010

The Economy: what happened, what's happening, and what will happen (Part 1)

I was going to comment on some current economic trends and make some predictions, but I ended up writing a whole lot of shit so I decided to break it down into a few parts and maybe make it more organized in the process.  Before I get into the current shit that's happening, I'll give my take on what happened in order to get to this point.  I can't take credit for much of the information here since I read it (basically stole it) from other sources.  But I think it gives a pretty good rundown on the 4 main events that led to the housing boom and bust.

EVENT 1: In 1977, Congress passed the Community Reinvestment Act (CRA).  This was passed because Congress didn't think banks were giving enough loans to poor people and minorities.  The act stated that banks have "an affirmative obligation" to meet the credit needs of the communities in which they are chartered.  That turned out to be too vague or something, and Congress wasn't seeing loans go to people that they wanted loans to go to (they assumed that was up to them for some reason), so in 1989 congress amended the Home Mortgage Disclosure Act.  The amendment required banks to collect racial data on mortgage applications.  Turns out that minorities were denied home loans at a higher rate than whites.  Was this because banks love white people and hate brown people?  No, minorities were turned down at a higher rate because they had weaker finances on average.  But a Boston Federal Reserve study alleged that there was systemic discrimination.  A University of Texas economics professor looked at the study and found it to be tremendously flawed.  He showed that the data it used contained thousands of egregious typos, like loans with negative interest rates, and he found no evidence of discrimination on any basis other than creditworthiness.  Think about it, if these banks are run by the greedy corporate type who is only interested in making a buck, then wouldn't they want to give out loans to people who pose a reasonable risk, regardless of race, in order to make money off the interest?  If they're only interested in making money, that means denying loans to high risk people, and giving loans to low risk people.  The relationship between race and loan approval was a blatantly spurious one while the relationship between risk and loan approval was real*.  It just so happens that minoriteis tend to be higher risk.  They were discriminating based on risk, not skin color.  It turns out that banks don't "hate brown people and love white people", banks "love making low risk loans and hate making high risk loans" (At least they used to.  More on that below).  But that Boston Federal Reserve study became the standard on which government policy was based.


In 1995 the Clinton administration issued regulations that tracked loans by neighborhoods, income groups and race in order to rate the performance of banks.  Regulators used the ratings to determine whether the government would approve bank mergers, acquisitions and new branches.  The regulations also encouraged community groups like ACORN and the Neighborhood Assistance Corporations of America to file petitions with regulators, or threaten to file petitions with regulators, that would slow or even prevent banks from conducting their business by challenging how banks were making loans.  This created a huge leverage over the banks and some groups were able to effectively extort banks to make huge piles of money available to the groups.  Money these groups, along with the banks, used to make loans.  Banks and community groups issued loans to low-income people who often had bad credit or insufficient income.  These loans, which became known as "subprime" loans, made available 100% financing, didn't always require the use of credit scores, and were even made without documenting income.  But damnit, minorities and low-income folks were getting extra money for some reason!  The government insisted that banks, particularly those that wanted to expand, quit using their traditional loan-approval standards (Low risk people get loans, high risk people don't). CRA-elligible loans have been valued at $4.5 trillion

EVENT 2: In 1992 the Department of Housing and Urban Development pressured two government-charted corporations, known as Fannie Mae and Freddie Mac, to purchase (or "securitize") large bundles of these loans for the conflicting purposes of diversifying the risk and making even more money available to banks to make further risky loans (risky loans to some, fair and equal loans for everyone -- regardless of merit -- to others).  Congress, in their divine wisdom, also passed the Federal Housing Enterprises Financial Safety and Soundness Act.  This act mandated that these companies buy 45% of all loans from people of low and moderate incomes.  What did this do?  First, it created more incentives for banks to make risky loans since Fannie and Freddie would buy them.  Second, it created a secondary market for these loans where they could be bought and sold.  And then in 1995 the Treasury Department established the Community Development Financial Institutions Fund, which provided banks with tax dollars to encourage even more risky loans.


EVENT 3:  All of this government intervention and social engineering created a financial instrument by-product known as the "derivative", which turned the subprime mortgage market into a ticking time bomb that would magnify the housing bust by orders of magnitude.  A derivative is a contract where one party sells the risk associated with the mortgage to another party in exchange for payments to that company based on the value of the mortgage.  They pretty much let people gamble on whether the mortgages would default or not.  In many cases, investors who did not even make loans would bet on whether the loans would be subject to default.  Although it's not the best example, derivatives can be understood as a form of insurance against risky loans.  Derivatives allowed commercial and investment banks, individual companies, and private investors to further spread, and ultimately multiply, the risk associated with their mortgages.  Some financial institutions like AIG invested heavily in derivatives.


EVENT 4:  The Fed's role in the housing boom and bust cannot be overstated.  The Fed slashed interest rates repeatedly starting in 2001 from 6.5% to 1.0% in 2004.  Naturally, this started to create too much inflation for comfort so Greenspan and Bernanke began to steadily raise interest rates back up to 5.25% in 2006.  This flluctuation in interest rates artificially and inappropriately manipulated the housing market by interfering with normal market conditions and contributed to a destabillization of an economy that was already in a very precarious position.


In 2008 and 2009 the federal government spent tax dollars at an astronomical rate in order to rescue the financial markets from their own mismanagement.  TARP money neared $1 trillion and was originally set up so the government could buy risky or nonperforming loans from financial institutions.  Just weeks later the government began using the money to buy equity positions in financial institutions, probably so they could inject cash directly into these entities. Oh, and $350 billion of the TARP funds cannot be accounted for.


On top of the TARP money, The Federal Reserve also gave $30 billion to Bear Stearns, $150 billion to AIG, $200 billion to Fannie and Freddie, $20 billion to Citigroup, $245 billion to the commercial paper market, and $540 billion for the money markets.  The Bush administration also spent $152 billion on the 2008 stimulus and the Obama administration spent $787 billion on the 2009 stimulus.  Billions were also spent on Cash for Clunkers, the Home Buyer Tax Credit, and a host of other government programs.


And this all started in large part because Congress and the federal government decided to tell banks who they should loan money to.  Numerous laws, regulations, entities and funds were created in order for the government to dictate to banks who should get loans and how they should be managed.  To say that this problem occurred in a bubble of capitalism without regulation and interference from government is utterly ridiculous.**  It's not difficult to see that the problem occurred because of government intervention in the free market, not because they were mysteriously absent.  In fact, the only place government was absent was in controlling the terrible conditions that they created, and that's the unregulated part that got everybody upset.  ""Government didn't regulate derivatives!"  "There wasn't enough oversight!"  That's true, but the fact of the matter is that government created derivatives and then failed to regulate them and government failed to oversee the shitty results of their own shitty policies.  The banks and financial institutions did what they always do, they tried to make money in whatever condition they were place in.  And politicians did what they always do, they (with good intentions) tried to get private businesses to do what they wanted them to do, created a shitty mess in the process, failed to properly deal with the shitty mess they created, and blamed the shitty mess on private businesses who only did what government told them to do.  It's the new circle of life.



I mentioned earlier how much money was thrown at the problem.  In the next post I'll explain why this was a bad idea, why it will not work in the long run, what actually should have been done and what the ultimate results will be.  Yes folks, another random person on the internet knows how to handle the nation's economy!


*A classic example of a spurious relationship is deaths by drowning and ice cream sales.  As ice cream sales go up, so does the number of people who drown to death.  As ice cream sales go down, so does the number of people who drown to death.  Does that mean that ice cream causes people to drown?  Of course not.  And minorities weren't routinely and systematically denied loans simply based on skin color.  In both examples there is a third factor that needs to be considered.  In the ice cream-drowning relationship, the missing factor is, of course, heat.  As it gets warmer, ice cream sales as well as drowning deaths go up for obvious reasons.  In the home loan example, the missing factor is creditworthiness.  As creditworthiness goes up, so does loan approval.  Minorities, on average, were less creditworthy so their loans were denied at a higher rate.

** In 2006 the official compilation of rules issued by the federal government contained 74,737 pages of regulations.  I don't think a couple more was going to solve much.

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