Bailout Nation (40 page)

This was not the only time Mr. Market has managed to get things precisely wrong. There are far too many examples to enumerate here.

I
n the final analysis, allowing markets to set policy is inherently
anti-democratic.
Free people are entitled to elect a representative government, which then enacts legislation on their behalf. Those elected representatives go to Washington, D.C., to do the people's will. If it is the people's will to prevent testosterone-addled traders from saddling the taxpayers with trillions in losses, that is their choice.

Americans have long recognized the advantages of economic freedom. We want the markets to be relatively free to operate. However, we do not want to allow the worst of human behaviors to have free rein. Complaints about regulating markets are actually objections to proscribing the worst behaviors of the people who operate in those markets. We want markets to operate intelligently, but not run roughshod over us. Blame the radical free-market extremists who insist on replacing representative government with the so-called wisdom of markets. This has proven to be misguided.

What the actual result of market-based decision making does is to eliminate those pesky human voters from exercising their will through a representative government. Ultimately, the free-market zealots are not only antiregulation, they are antidemocracy and antirepresentative government. Taken to illogical extremes, they would create a market-based dictatorship.

One part bad philosophy, one part mob rule. That pretty much sums up the financial markets, circa 2008-2009.

—Charles Darwin

 

 

O
ne of the oddest things to come out of the 2008 U.S. presidential campaign was a series of accusations seeking to throw off blame for the current economic crisis. It wasn't radical deregulation, the Federal Reserve, or so-called ninja loans that were at fault, politicos claimed. Instead, they shifted blame to decades-old government policy.

Some of the arguments had merit—at least as policy criticisms. However, none of them made the leap to correctly identifying the proximate causes of the present crisis. Here we'll look at the targets of five such arguments: the mortgage interest deduction, naked shorting, the Community Reinvestment Act (CRA), securitization, and last, Fannie Mae and Freddie Mac.

The Sixteenth Amendment to the U.S. Constitution was made in 1913, effectively reinstating an overturned 1894 tax law and making income tax legal. Ever since, all forms of interest—including mortgage interest—have been deductible.

Indeed, the tax code provides a fairly generous benefit for being a mortgage-paying homeowner: The full interest deduction reduces your taxable income. Hence, if a renter and a homeowner are making similar monthly payments, the renter's after-tax costs are as much as 35 percent higher.
¹

Several commentators have criticized this, and some, such as Harvard economics professor Edward L. Glaeser, claim it to be a major factor in the housing collapse.
²
Glaeser recently wrote:

While the professor's basic premise is intriguing, his conclusions are suspect. Yes, we do encourage people to become homeowners by subsidizing interest payments. But is it worth it? Do we get the maximum benefit out of this subsidy? That is a worthy discussion for another time.

But the leverage side of the argument remains dubious. It was only recently that so many home buyers engaged in reckless, highly leveraged purchases. Since the interest deduction came into effect a century ago, most homeowners have used it responsibly.

It is a huge leap to get from that history to placing blame on the interest deduction as the root cause of the current maelstrom. When something has existed for almost 100 years without incident, we are better served looking for more recent, intervening factors that are probable causes. For housing, ultralow rates and the abdication of lending standards were those factors.

A recurrent theme in 2008 was the role of naked shorting in the fall of Bear Stearns, Lehman Brothers, and others. This is yet another case of misplaced blame.

To legitimately short a stock, one must first borrow the shares, then sell them. Upon covering the short (“buying in the shares”), the borrowed stock can be returned. Naked shorting is where this borrowing never takes place.

“Going naked” has been a dirty secret among Wall Street firms for years, and for good reason: It is very profitable. Not only does a commission get transacted that might otherwise not, but there is an even juicier vig on the trade. Whenever a short sale is made, the transaction takes place in a margin account. The broker-dealer gets to charge an annual margin fee of 9 percent or more.

There is a delicious irony to bank CEOs complaining about naked shorting destroying their firms when they had spent decades profiting from it.

While it may be an illegal and abusive practice, it had little to do with the fall of Bear or Lehman. These firms had by their own volition leapt off the roof of the Empire State Building; naked shorts were the people who threw stones at the bodies as they fell. More likely causes of death were the excess leverage, the undercapitalization, the lack of risk controls, the bad mortgage-related investments, oh, and a general insolvency—not naked short selling.

Back when my firm initiated a short in Lehman Brothers in June 2008, the stock was over $30. It was an easy borrow. There was no need to short naked; we simply called the stock loan desk and got an authorization number. My biggest regret about Lehman Brothers—aside from all the unfortunate souls who lost their jobs when the company imploded—was that I didn't think of buying put options, an even bigger, more leveraged bet against the company.

And no, option trading didn't kill the company, either.

—FDIC Chairman Sheila Bair
⁴

 

As housing and credit collapsed into the heart of the 2008 presidential campaign, a mad dash began. Politicos sought to duck responsibility for what occurred, with each side trying to lay the blame at the feet of the opposing party. Of all the flailing criticism and finger-pointing after the collapse, blaming the Community Reinvestment Act (CRA) was probably the oddest:

The purpose of the CRA was to encourage banks to lend money back to their own business customers and depositors. The CRA followed other legislation such as the Fair Housing Act of 1968, the Equal Credit Opportunity Act of 1974, and the Home Mortgage Disclosure Act of 1975. CRA compliance is part of the standard bank review by regulators—Federal Reserve, Federal Deposit Insurance Corporation (FDIC), and Office of the Comptroller of the Currency (OCC)—and includes a very soft rating system, not a hard quota. This modest legislation was designed to help overcome redlining. That was an illegal bank practice of literally encircling a neighborhood on a map with a red marker and not making any loans to residents within that red line, regardless of income or creditworthiness.

The CRA told banks that if they opened branches in Harlem, they could not suck up all the local businesses' and residents' cash deposits, then turn around and lend the funds only to Tribeca condo buyers. Banks were under no obligation to open Harlem branches, but if they did, they were required to at least try to lend the locals back some of their own money. There were no quotas, minimums, or mandates—just a good-faith attempt to make loans.

Those who insist the CRA was to blame for the current crisis have a hard time explaining some obvious logical flaws.

Why was there no credit or housing meltdown from 1977 to 2005? Why did dozens of other countries, from the United Kingdom to much of Europe to New Zealand and Australia—none of which are covered by American laws such as the CRA—have a remarkably similar housing boom and bust to the U.S. one? The pundits fail to address these questions. It's as if this legislation somehow manages to transcend both time and space.

It's even more dramatic when you see where the foreclosure crisis is concentrated in the United States. California leads the nation in defaults, delinquencies, and foreclosures, followed by southern Florida, Arizona, and the Las Vegas area. As of December 2008, year over year, California's foreclosure activity was up 51 percent. The foreclosures are concentrated primarily in bedroom communities in the suburbs of cities like San Diego and Los Angeles. These are not, as you would imagine, CRA regions.

Florida is in some ways worse: At the end of 2008, its foreclosure activity was up 68 percent from the year before. Blame the enormous overbuilding of condos for the real estate debacle. As Dan Gross pointed out in
Newsweek
, these weren't inner-city loans to minorities; they were the products of, for example, “WCI Communities, builder of highly amenitized condos in Florida (no subprime purchasers welcome there).
...
Very few of the tens of thousands of now-surplus condominiums in Miami were conceived to be marketed to subprime borrowers, or minorities—unless you count rich Venezuelans and Colombians as minorities.”
⁶

Oh, and WCI Communities filed for bankruptcy in August 2008.

There are additional errors with the “blame CRA” argument. The CRA applies to depository banks. But the financial institutions that made a headlong dive into the subprime market weren't regulated banks; they were the innovative new mortgage originators. Companies like Argent and American Home Mortgage and their ilk were not required to comply with the CRA. And these firms worked closely with Bear Stearns and Lehman Brothers to securitize their subprime mortgages. Neither Bear nor Lehman was covered by the auspices of the CRA.
⁷

Of course the CRA did not force mortgage companies to offer loans to people with bad credit or whose incomes would not support the payments. And the no-money-down, no-income-check features were also innovations independent of the CRA. Throwing underwriting standards out the window was the creation of the mortgage originators alone. And as far as I can tell, nothing in the CRA forced the credit rating agencies to slap AAA high-grade ratings on subprime debt that went into default in record numbers.
⁸

Numerous studies have found the CRA blameless in the current mess. Fed Governor Randall S. Kroszner
⁹
and Federal Deposit Insurance Corporation Chair Sheila Bair
¹⁰
each, in unrelated speeches, drew the same conclusion.

Since the Bear Stearns collapse in March 2008, there has been a veritable parade of bankers, mortgage originators, lenders, fund managers, and investment bank CEOs all testifying before Congress. Curiously, not one blamed the CRA:

Consider this Federal Reserve Board data, as compiled by the McClatchy Company: