Posts Tagged ‘markets’

More on how we got here

Wednesday, October 8th, 2008

Now that we have explained the bailout, how did we get here ? Milton Friedman might have said this.

This is an elegant piece on the moral hazard problem and where it came from. Richard Epstein points out how social engineering led us here.

Disasters like this latest financial meltdown don’t just happen. Mistakes this huge require an impoverished political philosophy to grease the skids. Fannie and Freddie didn’t design their horrific lending policies by chance. No, behind this lending fiasco lay the strong collective preference for the “patterned principles” of justice that Robert Nozick attacked so powerfully in his 1974 masterpiece, Anarchy, State, and Utopia.

I have ordered the Nozick book as it looks like that rare philosophy work that I can get through.

Anyway,

The key function of the legal system is to minimize the transactional barriers and increase the velocity of voluntary exchanges, all of which generate mutual gains for the parties. So long as one is sure that the given distribution of resources is obtained by legal moves from the original position, don’t worry about the relative positions of one person vis-à-vis the others. Don’t, in other words, use state coercion to create a distinctive pattern of rights deemed ever so desirable in the eye of some political beholder.

This is what we call the “market” and that market is the enemy of Barack Obama and his allies. They are concerned with ends, as well as means, and will tilt the scale to attain those ends. Was the market at fault? Russell Roberts says partly but not totally.

Many believe that wild greed and market failure led us into this sorry mess. According to that narrative, investors in search of higher yields bought novel securities that bundled loans made to high-risk borrowers. Banks issued these loans because they could sell them to hungry investors. It was a giant Ponzi scheme that only worked as long as housing prices were on the rise. But housing prices were the result of a speculative mania. Once the bubble burst, too many borrowers had negative equity, and the system collapsed.

Part of this story is true

But that is not the whole story.

Beginning in 1992, Congress pushed Fannie Mae and Freddie Mac to increase their purchases of mortgages going to low and moderate income borrowers. For 1996, the Department of Housing and Urban Development (HUD) gave Fannie and Freddie an explicit target — 42% of their mortgage financing had to go to borrowers with income below the median in their area. The target increased to 50% in 2000 and 52% in 2005.

For 1996, HUD required that 12% of all mortgage purchases by Fannie and Freddie be “special affordable” loans, typically to borrowers with income less than 60% of their area’s median income. That number was increased to 20% in 2000 and 22% in 2005. The 2008 goal was to be 28%. Between 2000 and 2005, Fannie and Freddie met those goals every year, funding hundreds of billions of dollars worth of loans, many of them subprime and adjustable-rate loans, and made to borrowers who bought houses with less than 10% down.

This was a Ponzi scheme alright but who was Ponzi ?

The Community Reinvestment Act (CRA) did the same thing with traditional banks. It encouraged banks to serve two masters — their bottom line and the so-called common good. First passed in 1977, the CRA was “strengthened” in 1995, causing an increase of 80% in the number of bank loans going to low- and moderate-income families.

Fannie and Freddie were part of the CRA story, too. In 1997, Bear Stearns did the first securitization of CRA loans, a $384 million offering guaranteed by Freddie Mac. Over the next 10 months, Bear Stearns issued $1.9 billion of CRA mortgages backed by Fannie or Freddie. Between 2000 and 2002 Fannie Mae securitized $394 billion in CRA loans with $20 billion going to securitized mortgages.

This money is all lost and will have to be repaid by taxpayers. Here is more about the CRA effect with examples.

Did the Bush Administration play a role in the fiasco ?

The Fed did its part, too. In 2003, the federal-funds rate hit 40-year lows of 1.25%. That pushed the rates on adjustable loans to historic lows as well, helping to fuel the housing boom.

The Taxpayer Relief Act of 1997 [which raised the capital gains exemption on houses-Ed]and low interest rates — along with the regulatory push for more low-income homeowners — dramatically increased the demand for housing. Between 1997 and 2005, the average price of a house in the U.S. more than doubled. It wasn’t simply a speculative bubble. Much of the rise in housing prices was the result of public policies that increased the demand for housing. Without the surge in housing prices, the subprime market would have never taken off.

I have a theory that the 9/11 attacks contributed to this bubble. There is also a theory that the Panic of 1907 was caused by the 1906 San Francisco Earthquake because of the enormous insurance losses. Most of the worst property damage in San Francisco was caused by fire producing a gigantic insurance loss since fire was covered when earthquake was usually not. The 9/11 attacks caused an enormous capital loss, both due to the property damage in New York and by the effect on airlines and oil prices that followed. The Bush Administration fought deflation with low interest rates and by telling people to “shop” as a contribution to national security. This has been widely quoted and attacked but it is misunderstood, like most of Bush’s policies. He has been almost criminally inept in explaining them.

The low interest rates were continued too long and contributed to the bubble. Had Bush and the Fed raised rates two or three years ago, the bubble would have popped with much less damage as the speculation might have stopped before the worst of the excesses had occurred. Here is someone who was warning about this years ago. He got nowhere.

Anyway,

Once Congress set in place a destructive lending policy, we could count on private parties to issue bad loans from which they profited, knowing that dear old Fannie and Freddie would happily pay face value for paper that everyone knew was worth a whole lot less.

But Congress lived in a dream world. It forgot that the quality of the paper would deteriorate as its ambitious social objectives let its underwriting go south. So, too late in the game, we learn from yet another case where Congress should have done good by doing nothing at all. Let people rent or buy in unsubsidized markets and then watch with supreme indifference what residential patterns emerge.

This does not explain how to recover but it does point out how unlikely it is that Congress will be helpful in the next phase of this crisis. Obama, in particular, has all the helpful instincts of Herbert Hoover. He is opposed to free trade. He is an interventionist. And he is stubborn and unwilling to acknowledge that raising taxes is the worst thing a government can do in this situation.

God help us all.

The Changing Face of China

Saturday, May 3rd, 2008

Reader and commenter, Allan, has written a review of a book on China titled, The Changing Face of China: From Mao to Market, by John Gittings. Here is his review of the book:

As one who spends a great deal of a time studyingstock charts and investment reports, I’ve found thatsometimes it pays to back away to get a larger senseof the global backdrop. Which is how I came to pull off the shelf a book titled The Changing Face of China: From Mao to Market by John Gittings. Heavier on the Mao than the Market, the theme of this work is focused on the transition from the peasant-centric world of 1949 to a nation that, by 2004, is as capitalistic as any western economy around. It’s a progression from an agrarian economy woefully inefficient, to a rumbling and awkward giant beset by corruption, pollution, growing discontent of the rural and urban poor, and long unfinished business with Taiwan, along with the Tibet and the Uighur Autonomous Regions.

For those who desire an insider’s view of this transition, Gittings glides in and out the parade of individuals who came to the forefront, often to be crushed by the constantly shifting personal and cultish politics of the Communist Party under Mao. And, although much emphasis is placed on the elites, he does not ignore the peasant classes who evolved into urbanized factory workers, technicians and engineers on one hand, and those who became the left behind illiterate laborers and rural poor on the other.

Gittings himself lived for years in China, having set up the Shanghai bureau of the Guardian while serving as that paper’s editor for China and East Asia from 1983-2003. The author to his credit avoids injecting his personal life experience into the narrative, yet the reader benefits from a modicum of quotes and anecdotes from a spectrum of everyday Chinese that are obviously derived from Gittings’ interviews and personal associations. One comes away from this book realizing that Communist China is not the authoritarian monolith as much as an ever evolving project. Even their classification as communist is blatantly erroneus. Their transition to a market economy is in its early stages despite the already global waves they create in global markets as producers and consumers. Since the last pages of the book toward the end of 2004, there’s been a China stockmarket boom and subsequent halving some would foolishly deem a collapse. There’s been massive foreign capital infusions greatly eclipsing what was once thought to be just as massive only at the beginning of the decade.

And with their country flung open there’s been concomitant strife and discontent skyrocketing along with the widening gap between the haves and the rest. The Chinese are out capitalizing the capitalists in even that regard. A market economy is a competitive beast. The SOE (state owned entreprise) as a production unit has been gutted and rejected, although a number limp along still in order to assure a more peaceful demise of this socialistic device, carrying with them mounds of bad debt that remain on the books of the state banks. And worse, the disassembling of hundreds of smaller, provincial SOE’s created much corruption as managers stripped them of assets and sold off the pieces for personal gain. While at the same time, tossing thousands upon thousands of workers into unemployed status.

Which also exposes a major problem for China going forward, as the Party, having buried the communist central planning model and turned their back on even the SOE’s, now faces a new onslaught of domestic issues from healthcare to education to enviroment, which Gittings enumerates at length in the final chapters. In essence, the Chinese were only trying to catch up with the world by transforming their government and their economy, but found themselves on the verge of overtaking all but the mightiest of the world leaders. Reading this book makes you wonder if they are anywhere near ready for all that entails. They are winging it, in my opinion. And rushing through stages that nations like the US spent decades working out.

Thanks, Allan.