A Blast from Reason’s Past….?

It’s official. My head officially hurts.

Multiple responses to multiple people below:

@james-hanley

Zic, you’ve made that point repeatedly, but repetition doesn’t make it true. Coyote blog recently had a good post on this…

I’ve read articles about Basel II’s standards as a cause of the crisis but I have four concerns about that argument. The first is that no matter what anyone says, it all starts and ends with Greenspan’s manipulation of interest rates circa 2003-2004. Whatever capital standards were in place, yields on fixed income instruments plummeted to a point where fixed income investors had to go elsewhere (and with subprime/CDOs). The second concern is that the damage was so widespread I’m not sure how significant this is to begin with. The third concern is regarding capital, the problem wasn’t with the regulations per se but the fact that the Wall Street firms were using very short-term and volatile sources of funding to originate and sell long(er)-term securities thereby creating a substantial duration mismatch and exposed themselves to liquidity problems. The fourth concern is that even if Basel II provided the incentive on the demand side of the equation, that alone should not excuse the myriad of problems that are well-documented on the supply side of the equation. Basel II should not justify the bad behavior of mortgage brokers that were generating fraudulent loans. Basel II notwithstanding, the real problem is that a supply of toxic loans made it into the capital markets. This is what concerns me the most.

@zic

There were all sorts of other problems, and they all matter. But banks could not have capitalized to cover the synthetic derivative losses and they were not actually dependent on the underlying securities; just as you can make a bet on a horse and not own part of the horse at the track.

Yes, AIG did overtextend itself, but overall, the CDS markets functioned relatively well throughout the crisis. The CDS markets were a far better indicator of signalling which companies were in trouble than the traditional way of ratings agencies downgrades and when all the Lehman CDS positions were settled post-crisis, the market did not go into a tail spin.

@mike-schilling

The usual (entirely false) claim is that the collapse was caused by the CRA, which forced banks to make bad loans to poor and/or dark-skinned people.

Oh nice. Someone has read my post on the subject!!! Five years later and I still refer to it.

@james-hanley

Banks traditionally did not give the types of subprime loans–particularly the ARMS, which were the bulk of the bad mortgages–but they were pressured by the federal government to give them, and the mortgage originators had the assurance that they would be bought (both by investment banks and by Fannie/Freddie, although to be fair, the latter two were actually a bit slow to get into the game, although they did end up getting in in a very very big way).

This was my take in 2009 and I stand by it.

https://ordinary-times.com/blog/2009/06/30/theyre-coming-to-get-you-barbara

I would argue that even if Fannie was buying CRA-loans, they had done it long before they went all-in on subprime in 2005 and were buying loans underwritten to GSE standards. Fannie is a whole other story because circa 2005, an argument can be made that its foray into subprime had nothing to do with politics and everything to do with market share and profits.

@zic

Government and markets can each be both good and bad actors; they can constrain and limit or empower.

I’ve always held that view. Am I not allowed to given my libertarian streak?

First, I really dislike the term ‘mortgage backed,’ because it presumes there were actual mortgages as the basis for synthetic derivatives, and this is not the case.

There were mortgage-backed securities. You couldn’t have created synthetic securities without having an actual portfolio to track. This sounds a bit apples and oranges to me. Yes, investors were over-invested in MBS as well as CDOs and other synthetic derivatives.

The derivatives were based on bets of portfolios of mortgages, and they were originally designed as hedges.

The credit default swaps yes but they were added to CDOs as ways to over-collateralized and “over insure” the cash flow streams. We saw how well that worked out.

They were also derivatives of derivatives of derivatives. It was insane.

As to why the market attracted the investments it did — there were no restraints on it. It was unregulated. I keep repeating this, too, but read about Brooksley Born. If Greenspan and Summers had listened to her in the mid-to-late 1980?s, this would not have happened.

That aspect of it would have been significantly lessened. I believe the time frame was the late-90s since reforming the derivatives markets became an issue after the near failure of Long Term Capital Management.

i think individual banks could have failed without the kind of economic free-fall we would have seen had AIG failed

I strongly disagree. Lehman’s failure triggered the run on money market funds. Had that been allowed to continue, the blood would have spilled over on to Main Street and it would not have been pretty.

From an investment banking perspective, the bit problem was that far too many of the synthetic-derivative bets were based on stock margins;

And “market” valuations based on the opinion of the seller of those securities who would force margin calls and record the gains as profits. Yes, it was that bad.

@james-hanley

The issue is not that zic claims there was insufficient regulation. The issue is that she keeps implying that bad regulation played no role, that the sole regulatory problem was lack of regulation. Those aren’t the same thing. More importantly, she refuses to actually address the substance of what Coyote Blog said.

I think I addressed the Coyote Blog above and I’m more inclined to believe that poor or poorly-enforced regulations bear more of the responsibility here. Mortgage-backed securities are sold in a regulated environment so even if the loans themselves were originated in a lightly-regulated/poorly-regulated environment, the hope is that the checks that were in place pursuant to securities laws would have identified issues and prevented otherwise toxic instruments from going out to market. It didn’t happen that way.

Institutional investors are very “check the box” type people. They aren’t risk takers. They make their investments pursuant to the conservative requirements of the various funds. One thing they do and have done for years is rely on the ratings agency credit ratings, and for good reason – for most kinds of securities like railroad bonds, they know how to rate them.

Not at all. The point is that it made the accounting of those investments very favorable, by allowing the full book value of the investments to be counted toward the firm’s assessed capital sufficiency.

I agree but my problem is that these securities should have never gotten to them in the first place and this is a whole separate issue.

Do you think that if the accounting rules for MBSes and government securities had been the same as for other investments that businesses would have been just as inclined to invest in them?

Yes, but I also believe that had more been taken with respect to the originate-to-securitize end of the mortgage business, even with the incentive, the product the investors would have bought would not have blown up in their faces.

@clawback

Not in any meaningful sense, no. They had a wide variety of investments X to choose from, most of them genuinely safe. The existence of some other discouraged investments in class Y cannot meaningfully be said to “incentivize” them to invest in the riskiest ones from X. Just pick the safe ones from X.

I disagree. It most certainly would and James did not differentiate the risk characteristics of X and Y like you did. I think this skews your answer a bit.

If investment banks had been required to properly value synthetic derivatives, it is unlikely the real-estate bubble would have happened;

The bubble was in full swing long before the explosion of synthetic derivatives. Synthetic derivatives became more favorable after investors couldn’t get their hands on enough mortgages, which was what was happening after most creditworthy and non-creditworthy applicants were spoken for.

With mortgage-backed derivatives, there was no piece of the actual mortgage at the back of the financial instrument; there was a rated security value of a separate transaction — clumps of mortgages.

The pool of mortgages is the collateral. The cash flows generated from each of the mortgages get passed through to the investors based on their tranches and total positions. I don’t understand why you’re attempting to make this distinction.

@mike-schilling

Cite? Because those two, which were the first big ones to fail, didn’t get bailed out, and I honestly don’t recall anyone suggesting at the time that they should. If they were expecting bailouts and the government showed unusual courage in denying them, you’d think that would have made the news.

The bailout talk didn’t start until it became clear that the rot was endemic and the risk of not having bailouts was complete financial havoc, i.e. something resembling the Great Depression. I would certainly prefer a system in which financial power was far less concentrated, so that a relatively small, homogenous group didn’t hold the rest of us hostage, but so long as we insist that inequality isn’t a problem and antitrust legislation is pointless, we lack even the tools to discuss possible solutions for that.

There was plenty of reason for Lehman to believe that it would receive a bailout. The first was that Greenspan had already built a reputation for intervening into volatile markets both in 1987 (Black Monday) and 1998 when he orchestrated a Wall Street-led bailout of Long Term Capital Management, a hedge fund that was believed to have posed a systemic threat if the fund failed and had to be unwound (it had total derivatives exposure in excess of $1 trillion – not bad for $3.5 billion of equity).

While Bear was not bailed out the way the later firms would be via TARP, Greenspan did orchestrate a soft landing through the arranged acquisition by JP Morgan (and taking $29 billion of toxic assets for itself). The reason was systemic risk. Bear held huge derivatives positions with various counterparties and forcing those counter parties to go into the market to cover themselves could have caused all sorts of hell.

If I recall, a lot of people said letting Lehman fail was a mistake and it was. It should have been bailed out the way Bear was, orderly liquidation with the assurance that counter parties would be covered. Punish the firm but keep the systemic issues to a minimum.

I can’t picture management saying to themselves “It’s OK for us to be reckless, because we’ll get bailed out and the shareholders will only lose about 90% of their equity.”

I can picture them saying “It’s OK to be reckless because we’re too big to fail and while your stock price may temporarily suffer during the downturn, the government will give us money, we’ll pay it back and in a few years our share price will return and we’ll be back to seven-figure bonuses.”

That’s what happened, right?Report