Friday, March 28, 2008

What caused the financial crisis?

We are being told, of course, that it was all of those greedy banks lending to people who couldn't afford the mortgage repayments.

Well, up to a point, Lord Copper.

Via Samizdata, here is an article that echoes something that I saw a couple of months before Christmas; the basic summary is: oh look, the politicians fucked up yet again by passing legislation that created perverse incentives and other unintended consequences.

Well, who would'a fucking thunk it, eh?

Here is the article, reproduced in full.
[Samizdata's Dale Amon:] I received and read a copy of this article from DC Downsizers early this month but have only today been given a go ahead for republication. I think you will find it an interesting and refreshing account of just who is responsible for the whole subprime mortgage problem.

You can watch hours and hours of news, or read columns of print in most newspapers, and come away no wiser about the causes and prospects for the current financial turmoil.

Most journalists and TV talking heads do not really understand the subject, and those that do speak and write using so much jargon that the average person must feel he or she is trying to follow a conversation in ancient Hebrew.

We are going to try to cut through the jargon, and explain the situation as best we can, in plain English. If you find our explanation of value, please forward it to others.

The current housing crisis, and all that flows from it, comes from two main sources, both deriving from Washington.

First, Congress passed something called the "Community Reinvestment Act" in 1977, resulting in the creation of bureaucratic regulations designed to encourage, or even compel, financial institutions to make loans to people with lower incomes. These regulations were then amended in 1995 and 2005 to create different rules for institutions of different sizes, so that various kinds of institutions would be better able to meet the government's goals for fostering home ownership in lower income communities.

Second, the Federal Reserve starting making loans available to the banking system at extremely low interest rates.

Third, steps one and two combined to make cheap housing loans available to people who could not have afforded or qualified for them before. This caused an increased demand for housing that sent home prices spiraling upward.

Fourth, mortgage lenders managed the risk involved in making these loans by selling their mortgages to other companies, which in turn thought that they were managing their own risk because they had a wide variety of mortgages, from many different types of borrowers, in their portfolio.

Fifth, these decisions about how to manage the increased risk created by the "Community Reinvestment Act" were all in error, because the Fed's policy of easy money had falsely inflated the value of ALL homes. This meant that good mortgages could not be used to manage the risk involved in questionable mortgages, because the value of ALL homes was falsely inflated.

Sixth, as with all inflationary booms, increases in home prices finally absorbed the increased purchasing power provided by the Fed, leading to a slow-down in home purchases. When this moment arrived everyone realized that the homes they had purchased weren't really worth what they had paid for them. The defaults and foreclosures then began, along with the collapse of the financial institutions that owned these unsound mortgages.

Now, the complicated, multi-part scenario described above has been simplified in popular reporting to just two words: sub-prime loans. These two words, combined with the idea that lenders took advantage of poor unsuspecting customers, are supposed to explain everything. But this explanation is both simple and simply insufficient.

A study by the Mortgage Bankers Association tells the true story. In the third quarter of last year fixed rate mortgages accounted for 45% of foreclosures, while sub-prime ARMs accounted for only 43%. (See Cato)

It's not hard to understand why. Who wants to be on the hook for a mortgage that is tens or hundreds of thousands of dollars higher than the property is really worth? Rather than bear this burden, many borrowers are choosing to default, and walk away from their properties. This is especially happening with speculators who bought houses in order to "flip" them. To cope with these foreclosures . . .

Banks have offered their bad mortgages as collateral to borrow money from the Federal Reserve. The money the Fed lends through this process is created out of thin air. This has two shocking consequences. First, the Fed is coming to effectively own an increasing portion of America's stock of housing, and two, these Federal Reserve loans are inflating the money supply, causing prices to rise all through the economy.

As the Fed creates more and more new dollars, the value of all the previously existing dollars declines. This forces people to seek ways to protect their accumulated wealth against the devaluing effects of monetary inflation. Thus . . .

People buy other currencies, causing the exchange value of the dollar to fall They buy gold, pushing the price up above $1,000 an ounce And they buy oil futures, driving up those prices too

But it gets worse . . .

Monetary inflation is making foreign investors reluctant to buy U.S. Treasury bonds. Who wants to hold bonds denominated in dollars when the Federal Reserve is reducing the value of the dollar?

The "London Telegraph" reports that foreign participation at a recent auction of U.S. Treasury bonds fell from 25% to less than 6%. (See Telegraph)

Sadly, there is every reason to expect this phenomenon to continue. This will leave the Federal government with only two options for funding its ever growing deficits. The government must either pay much more interest on its bonds, to compensate lenders for the monetary inflation, or it must sell its bonds to the Federal Reserve System, which will buy the bonds with yet more money created out of thin air, adding still more fuel to the inflationary fire.

The more the Federal government has to pay in interest, the larger the deficits will grow, or, the more it borrows from the Federal Reserve, the more it will have to pay in interest to private lenders. It's a vicious bind.

There is one thing the Federal government could do immediately to lessen this bind. It could cut spending to balance its budget, thereby reducing inflationary pressures. Please use our "Unfunded Liabilities" campaign to ask Congress to do exactly that.

Use your personal comments to tell Congress that you know foreign participation in U.S. bond auctions is declining. Tell them you do not want them to sell their bonds to the Federal Reserve, thereby driving up the money supply. CONGRESS MUST BALANCE THE BUDGET NOW. You can send your message here, at DownsizeDC.org.

Then, do one thing more. Send Congress a second message asking them to pass Ron Paul's "Honest Money" bills. Use your personal comments to tell Congress that you're aware that the current crisis was caused by a combination of the "Community Reinvestment Act" and the Federal Reserve's easy credit policy. Tell them you want Ron Paul's "Honest Money" bills to curb the ability of the Fed to inflate the money supply. You can send that message here, at DownsizeDC.org.

No, markets are not absolutely perfect; however, one can pretty much guarantee that when there is a truly colossal fuck-up, it is always a bunch of who are politicians, ultimately, behind it.

9 comments:

mitch said...

why do i smell the fingers of the goblin king here?

Robert said...

DK -

That analysis is right enough as far as it goes, but it leaves out the role of the Boston Fed. The result is still the same - that it's the fault of the regulators - but only more so.

Anonymous said...

The financial crisis here has not simply been imported from america. The British government and the Bank of England have affectively done the same thing. Brown boasts of creating liquidity, i.e. creating new money and inflation which is the source of our economic ills.

Anonymous said...

If you reread the piece, you might find that the Fed is largely responsible, not the politicos.

The Fed is a privately owned set of institutions.

Sorry to ruin a good slagging off of politicians (who normally deserve it).

Anonymous said...

> What caused the financial crisis?

The Jews. Obviously.

Mark Wadsworth said...

Credit bubble = asset price bubble = credit bubble and so on ad infinitum.

They are the same thing.

If there is more money sloshing around but the economy is not growing, then you get inflation. Inflation in most goods didn't happen because of China etc so all the extra 'money' went into property.

This is all just human nature, it happens every 18 years in the property market (see Fred Harrison). Which is why he (and I) support Land Value Taxation to keep land/property prices low and stable.

The only arguments that land value taxers have are a) whether it should be a % of annual rental values or capital market values, and
b) what taxes should be scrapped in exchange.

Bishop Brennan said...

Mitch - given what the Goblin King gets up to, if you've been smelling his fingers, I suggest you get yourself down to the nearest A&E asap!

Anonymous said...

if everyone knows what is causing/has caused the crisis...why is there a crisis?

I blame bill gates.

Richard said...

Yup.

Basically the US government regulation meant that the banks had to lend to one broke no-job no-hoper for each 4 real commercial loans.

So each duff mortgage allowed them to write 4 real ones.

This worked ... for a while ......