Fault Lines

Investment Manager's Letter December 2010

“It is very difficult to reach any other conclusion than that this was a market driven largely by government, or government-influenced, money.”

The “Financial Times’” Prize for the best business book of 2010 was awarded to Raghuram Rajan for “Fault Lines” this is an important book and it adds a good deal to our understanding of the causes of the “Great Recession”. Raghuram Rajan is a professor of Finance at the University of Chicago Booth School, and a former chief economist at the International Monetary Fund. Instead of marching out the usual suspects of greedy bankers and Wall Street Traders, Professor Rajan looks beyond these miscreants and finds a lot of political maneuvering – some well-intentioned and some just foolish. As for blame and solutions the Professor says:

“Put differently, solutions are fairly easy if we think the bankers violated traffic signals: we should hand them stiff tickets or put them in jail. But what if we built an elaborate set of traffic signals that pointed them in the wrong direction? We could argue that they should have used their moral compass, and some did; ... (but), solutions are much more difficult if it turns out that the signals are broken, at least from the perspective of our collective societal interests.”

Federal Housing Enterprise Safety and Soundness Act

In 1992, the U.S. Congress passed the “Federal Housing Enterprise Safety and Soundness Act” the purpose of this rather dubiously named piece of legislation was to promote homeownership for low-income and minority groups. The act instructed the Department of Housing and Urban Development (HUD) to develop affordable-housing goals for the agencies and to monitor progress toward these goals. This is a fine and noble goal for congressional activity, but as is often the case, noble causes can have unintended consequences that come back to bite you in the ass.

By way of increasing the Safety and Soundness of our economy the act allowed Freddie and Fanny to hold less capital than other regulated financial institutions and that the budget of their new regulator, an office within HUD-which itself had no experience in financial-services was subject to congressional appropriation.

”This meant that if the regulator actually started constraining the behavior of the agencies, the agencies' friends in Congress could cut the regulator's budget. The combination of an activist Congress, government – supported private firms hungry for profits, and a weak and pliant regulator proved disastrous.”

The agencies found the high rates available on low-income lending particularly attractive and, under the Clinton administration, HUD steadily increased the amount of funding it required the agencies to allocate to low-income housing. After being set initially at 42 percent of assets in 1995 it was increased this 50% in 2000 (the last year of the Clinton administration). A change in the party in power did not improve the trend as the Bush administration raised the requirement to 54% of their assets in 2004.

In addition, in 2004, Fannie and Freddie were moved to more aggressively expand their subprime exposure as pressure from accounting scandals exposed during that year in these agencies made them much more susceptible to Congress's demands for more low-income lending. Fannie Mae began to classify a loan as subprime only if the originating mortgage company itself specialized in the subprime business. Thus many risky loans to low-credit-quality borrowers were not properly classified.

After the loans are appropriately classified, subprime and Alt-A loans by the mortgage giants and the FHA and other government programs which amounted to $85 billion in 1997, had skyrocketed to $2.7 trillion by June of 2008. This amounted to 59 percent of total loans to these categories, meaning that taxpayers were on the hook for the majority of the liar loans’, the covenant light loans, the CDOs squared and anything else that Wall Street and Mortgage brokers could dream up.

The “Greenspan Put”

At the same time that congress was committing this legislative malfeasance, the Federal Reserve Board was doing everything they could to make the problem worse. It was not just that Greenspan left rates too low for too long after the recession in 2001. The FED began building its moral hazard back in the early nineties with the 1994 soft landing, the bail out of Long Term Capital Management in 1998 and, in general, by giving the impression that there were institutions that were “too big to fail“. This was the "Greenspan Put" which encouraged Richard Fuld at Lehman to keep piling on risk because he thought that if something bad happened the FED would be there to bail him out, and which encouraged other the big bankers to “keep on dancing.”

There is no question that there was a lot of bad behavior on Wall Street, and sure it would be nice to stage a few public hangings, but I’m not sure bad behavior is a hanging offense. Even if it were, it would not help to solve the basic problem which was an idiotic monetary policy and a broken political system. As Professor Rajan points out above, if the crash were a simple problem of banker behavior, the solution would be easy; the real problem is deeply embedded in our political system, so the solutions are likely to be “much more difficult”.

In the seventies (the last prolonged period of economic difficulty that we experienced in this country), the problem was inflation, and it took a number of years to find a way to deal with it. Today the real problem is a monetary policy that is trying to solve problems (unemployment) that monetary policy has no business trying to solve, and with a government that has no respect for taxpayer’s money.

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