Saturday, January 24, 2009

Financial Crisis Stories

My stepfather sent along a video from Fox News last year that "shows Bush and McCain warning the Democrats of financial mess."

I'd rate it somewhere between a 1 and 2 on the 1-10 truthiness scale (where 10 is 100% true).

The most-likely-to-be-true explanation for the financial crisis I've seen is from Arnold Kling. He's an economist who used to work for Freddie Mac. He thinks that the regulators screwed up the banking system with some bone-headed regulations-- it goes something like this:

Banks are required to keep a certain percentage of the money they get in safe investments ("capital reserves"). The rest they can lend out.

For example: Say you deposit $100 in the bank. They invest $10 of that in a Treasury Bond, and lend out the other $90 to your neighbor who wants to buy a hot dog stand.

Banks want to lend out as much as they can, but they also want to make as much money as they can on their capital reserves.

So Wall Street creates some new-fangled financial doo-hickeys that are supposed to be really safe. For example, they take a bunch of crappy mortgages, put them in a blender, package up the "cream" that rises to the top, get it rated as "AAA", and sell it to the banks. Oh, and they package up the gunk at the bottom of the blender along with an insurance policy (a "credit default swap") that's supposed to insure against catastrophic losses and sells THAT to investors.

And the regulators go along with it. They write rules that encourage the banks to park their money in very profitable AAA-rated mortgage-backed securities, rather than investing in traditional 20% down, 30-year mortgages.

For example, you put $100 in the bank, and the regulations allow them to:
a) Keep $15 in reserves, invested in traditional mortgages paying 6% interest, and lend $85 to the hot dog cart guy (at, say 10% interest).
b) Keep $10 in reserves, invested in AAA-rated mortgage backed securities that pay 6% interest and lend $90 to the hot dog cart guy.
c) Keep $9 in reserves, invested in Treasury Bonds paying 2% interest, and lend $91 to the hot dog guy.
(dollar figures Not To Scale-- I have no idea what the actual requirements and interest rates are)

Choice (b) is a better deal, so banks were buying up a ton of these mortgage-backed securities, and everybody was making lots of money. Fannie Mae and Freddie Mac got into the game kinda late, but did make the crisis worse by funding a lot of crappy mortgages and reselling them.

Well, it turns out the Wall Street Wizards were wrong about the risks. You can't actually take a bunch of crappy mortgages and make them safe-- it just looks like you can when housing prices are rising everywhere. The vicious circle that inflated the housing bubble went something like this:

Banks see they can make more money holding mortgage securities, SO
Mortgage brokers sell more and more mortgages with lower and lower requirements, SO
People buy more and more houses, SO
Housing prices rise, SO
Nobody defaults on their mortgage, making the crappy mortgages look safe.
So the regulators and investors and banks and homeowners are happy. And the cycle starts again...

Until the bubble pops. Then it all comes crashing down.

I think this story is probably 80% true. There are some mysteries (like why are Ireland and Spain having very similar housing crises? Are their banking regulations similar, or did their banks invest in US mortgages?), but it seems to me it explains what happened without relying on any conspiracy theories involving evil bankers or deregulation or deadbeat homeowners or Barney Frank.


thanbo said...

which also explains why the credit has dried up - the banks don't want to lend, since lending has become a bad risk for them.

it's what lets banks create $1000 of loans from $100 of deposits.

the reserve ratio has gone up & down, but i don't know what it is today, or, say, a year ago when the market started to tank.

this shows required reserves being lowered throughout most of the bush years, pretty dramatically, and only raised, if by smaller amounts, in the past few months.

but part of it was also putting the smaller and smaller reserves into riskier and riskier investments.

it's big, it's complicated, it came from 20-30 years of changing bank regulation, i don't think there's one factor that explains it, nor do i think it was the work of one administration that brought it it.

i've been reading harold feld '89's blogs and he believes the primary culprit was increasing reliance on the free market which, according to "chicago school" economists such as the friedmans, would regulate itself. that turned out not to be true. a return to the less-regulated financial markets of the pre-new-deal era, meant a return to the boom-and-bust cycle that gave us panics in 1857, 1873, 1891, 1907, etc. so now we have a panic.

Gavin Andresen said...

I don't think the reserve requirements have changed at all during this crisis-- what HAS changed is the bankers realized that the Wall Street Wizards (and the rating agencies and regulators who went along) were wrong-- that the AAA-rated mortgage securities that they're holding aren't safe.

The Economist magazine has several very good articles dissecting the financial crisis this week, and I agree with their assessment: regulation did not keep up with the changes in finance.