Southern New Hampshire Real Estate and Short Sales: "The Big Short" Falls Short 2 - Was The Fed Complicit?

"The Big Short" Falls Short 2 - Was The Fed Complicit?

 "The Big Short" does a great job of advancing the generally accepted story that toxic "sub-prime" mortgages were the main factor that led to the Great Recession of 2008.  

Although it is ostensibly just a story about a bunch of guys who were smart enough to make a fortune shorting the market, there is no question The Big Short is a morality play and blame is being squarely placed.  In this case the blame is being placed on Wall Street and the sale of subprime mortgages.  (As an aside, the Big Short does a really poor job of explaining the difference between the origination of mortgages and the ultimate trading of the securities that result from pooling those mortgages, leading some viewers to believe that Wall Street traders were out in force convincing Mr. & Mrs. Main Street to take on loans they couldn't afford...but that's a whole other issue.)

This desire to find one entity that we can place the blame on is a natural function of human nature.  If we can identify the evil, we can crush it and we'll be safe.  The problem lies in oversimplification.  If we oversimplify and misunderstand the causes of a situation, the steps we take to prevent a reoccurence will be profoundly skewed and may well place us in an even worse situation going forward.

Mind you, there is plenty of blame to be placed for the greed and stupidity that showed itself on Wall Street and within the banking industry in the years leading up to the beginning of the real estate bubble collapse in 2006 (I mean, really, just for believing that the Gaussian Copula Function could pop out a simple number that would accurately assess risk correlation, they should all be slapped) but there is nary a mention of the Federal Reserve Monetary Policies and Government Mandates that played into that.

This desire to place the blame solely on Wall Street and the banks is eerily similar to the 1930s when both the government and the public blamed the "evil money changers" for the Wall Street Crash and ensuing depression.  Today, however, it is widely understood by economists (including Ben Bernanke) that the major reason for both The Crash and The Great Depression was the Federal Reserve policies and their actions, or inactions, as the case may be.

What?  The Fed caused the Great Depression?  How could that be? 

Well, here's the Reader's Digest Condensed version:

After a series of bank crashes culminating in the Panic of 1907, people started wondering why we (The United States) kept having these problems that countries like Great Britain and Germany did not.  The answer was they had a Central Bank.  So, not to be outdone by Europe, we created the Federal Reserve System which consisted of 12 Regional Banks and one Board of Governors in Washington, a "decentralized central bank". It opened for business in late 1914 charged with the responsibility of insuring the safety and soundness of our financial system through the control of the money supply.  They would also be responsible for setting interest rates and regulating banks.  Great idea.

However, it did not take the Fed long to begin experimenting with "steering" the economy by Federal Reserve Steering Economyattempting to stimulate activity through lowering rates and thus "Monetary Policy" was born. 

Unfortunately, like a jalopy full of ossified jellybeans and their jazz babies on the way  home from a juice joint, they quickly lost control and, inadvertently, caused a stock market boom that had speculators borrowing more money than the entire amount in circulation.  Not good. 

In 1928 they realized what was going on, became alarmed and slammed on the brakes...too hard...and sent their passengers right through the windshield.  Also not good.

Initially, the New York Federal Reserve bank acted appropriately by providing liquidity and they prevented a panic.  However, the Federal Reserve Board of Governors in Washington was fearful that this would lead to a reignition of speculation so they stopped the easing and, in true 1920's fashion, climbed up onto a flagpole and sat there.   Really not good.

Banks began to fail because they, literally, had no money as the Fed continued their flagpole sitting and watched from on high while the monetary system collapsed thereby turning what would have been a recession into the Great Depression.  Really, really bad.

Clearly, they did not understand the depth of the problem or even what the problem was and after a certain point, they were powerless to change the course of events.

The Great Depression would not be the last time that the Fed misdiagnosed a problem and adopted policies that did more harm than good.  The Great Inflation comes to mind.  I won't bore you with the details of that fiasco except to say that the Fed was more afraid of unemployment (a fear leftover from The Great Depression) than inflation and their simple formula indicated that low interest rates (which can, and in this case did, lead to inflation) would prevent the unemployment rate from rising.

Unfortunately, the simple formula was wrong and inflation and unemployment both rose, the cost of living nearly doubled and the value of the dollar plummetted to less than half. 

Have I ever mentioned that over simplification will bite you in the butt every time?

At any rate, after Paul Volcker stepped in as Chairman of the Fed and got that mess under control, we had a period of time known, affectionately, as The Great Moderation.  It was "Morning In America" again.

Enter, "The Maestro", Alan Greenspan.  Interestingly enough, one of the reasons Greenspan was appointed was that he was known to be a disciple of Ayn Rand and a "free market" guy.  Boy, did he change his tune once he took over as Chairman of the Fed in 1987. 

The Maestro Alan GreenspanGreenspan became a regular cheerleader for the financial markets and would aggressively intervene at the first sign of trouble.  The problem is these interventions dramatically expanded the Fed's mission to include intervening in the stock market as well as the "real" economy.  This aggressive intervention became known as the "Greenspan Put" and contributed to the overarching belief that any amount of risk could be taken because if things got out of hand, the Fed would come to the rescue.  

For instance, in the time leading up to the Dot-Com bubble bursting, Greenspan espoused the belief that a bubble was impossible to spot until it burst and, so, all the Fed could, and should, do is pick up the pieces.  He also espoused the belief that a bubble bursting need not be catastrophic to the economy.

When the Dot-Com bubble did burst, Greenspan responded with a series of interest rate cuts and a crisis and full blown recession was averted.  This seemed to lend creedence to Greenspan's theory about bubbles and led many people, who were not already on board, to jump on the bandwagon.  After all, on the surface, it seemed to work.

It would appear that all of these psuedo successful interventions contributed to a misplaced sense of safety by everyone - investors, regulators, members of Congress. 

Greenspan had it all under control. 

I use the term psuedo-successful because although crisis was averted, the underlying economy was ailing; there was no employment growth, goods prices were low and stock prices were still shaky.

Following the September 11, 2001 attacks, the Fed upped their attempts to jumpstart the economy and made  a rapid series of rate cuts, dropping the rate all the way down to 1.00%.  There is a question here as to whether the underlying purpose of The Fed was to promote growth at any cost...keeping the economy looking good even if it had to be propped up by spending and debt.

A falling stock market, investors leery of said stock market, and government policy that pushed lax underwriting standards caused all eyes to turn to housing/mortgages as the economic savior.

WH-A-A-T-T?  Government policy PUSHED lax underwriting standards?  Can't be...

Let's look back at the Clinton Administration retooling of the Community Reinvestment Act.  Originally a somewhat vague mandate which encouraged Regulators to look at whether an insured bank was making efforts to meet the needs of the "entire" community, it was changed drastically in 1995.  Banks now had to show that they made a requisite number of loans to the targeted LMI borrowers (low to moderate income).  It also mandated the use of "innovative and flexible" programs to meet that quota.  The stick that the CRA carried was the ability to block mergers or the opening of additional branches if quotas were not met.

Being the curious sort that I am, I took a look at how trying to meet these quotas might look in 2000Rising House Prices Easy Money as all of this was starting to unfold.  I picked on Worcester, MA as my model.  In 2000 the median income in Worcester (according to DataPlace) was $35,623.  According to the CRA definition, low income is defined as 50% or less of the median income or, in this case, $17811.50 a year or $1484.30 per month.  Using standard, responsible lending criteria, 28% of gross monthly income or $415.60 should be used to calculate the maximum mortgage amount.  Using that figure and the Bankrate reported interest rate for a 30 year fixed rate mortgage in June of 2000,  the maximum mortgage amount would be $55,319.91.  The median home price in Worcester in 2000 was $140,000. 

Do you see a problem here?

During the same period much was made of an Urban Institute report that found that local and regional lenders were lending to LMI borrowers much more frequently than the GSEs (Fannie Mae and Freddie Mac).  This may well have been due to the club the CRA was wielding (just guessing).  The GSEs had already had an "affordable housing mission" added to their charters by Congress and were ultimately required to show that 55% of their mortgages were LMI loans and, within that, 25% had to be to low and very low income borrowers.  The GSEs then went down the same road, non-existent underwriting standards - low doc and no doc loans.

Do not misunderstand me!  I am not trying to pin this on low income borrowers. (More on this in Part 3)

WHAT I AM SAYING is that well meaning programs (that were unfunded, by the way), combined with CHEAP MONEY FROM THE FED, contributed greatly to the opening up of a Pandora's Box of unintended consequences.   Or, perhaps, they were intended all along...

Once the GSEs changed their model and began purchasing sub-prime loans it created competition with the Investment and Commercial Banks which ramped up demand for these loans which in turn upped the value of them which then reduced the risk premium (which had been a deterrent to originating these types of loans even after they came into existence) so more and more of these loans were originated and offered to everyone because how could lenders offer these type of  loans (no hassle/no doc) to the sub-prime market and not to the prime market. 

When you combine the lax underwriting standards encouraged by government mandates with the accomodative monetary policy of the Fed (read really cheap money) and the dramatically increased leverage this allowed,  along with the false sense of safety engendered by the Fed's past success in averting crises and add to it the financial innovations that appeared to protect lenders (mortgage backed securities, credit default swaps and, let us not forget the Gaussian Copula Function) and top it off with the national belief that homeowners would never default in great enough numbers to do meaningful harm you can begin to see how and why things went the way they did.

Businesses follow the incentive structure set up by the Fed's monetary policy and government mandates particularly when there is money to be made.

As I indicated in the beginning of this post,  if we oversimplify and, therefore, misunderstand the causes of a situation, the steps we take to prevent a reoccurence will be profoundly skewed and may well place us in an even worse situation going forward.

But, perhaps, I'm oversimplifying.

Next up:  Did Fed missteps, after the housing bubble began to deflate in 2006, turn a slowdown into the Great Recession?  Was the subprime crisis really a subprime event? (Gasp!)  Is "The Big Short" accurate when it indicates that the regulatory environment has not changed since then.  Stay tuned for Part 3.

I know you can't wait.  Try to contain yourself.

 

 

 

 

 

Comment balloon 7 commentsJoy Baker • February 02 2016 11:26AM

Comments

I live just 40 miles from Stockton, California, which was one of the epicenters to the housing meltdown.  What I know is there was a heavy amount of new home construction going on there, leading up to the crash.  Subprime lending was a major part of the activity going on.  You only had to be breathing to get a loan.  And the qualifying payment for the first year, would escallate quickly in the second year.  That's when folks began having major issues with meeting payments.  Marry that situation with the fact that banks were packaging up mortgages and selling them on the secondary market.  At first, there would be a few toxic loans tossed into the packages, but that quickly escallated as more and more mortgages became toxic.  Ultimately these packages moved on to Toxic Default Swaps, a recipe for disaster.  I see a whole lot of activity leading up to the meltdown, that contributed to a perfect storm that left little avenue of escape.

Posted by Myrl Jeffcoat, Greater Sacramento Real Estate Agent (GreatWest Realty) over 2 years ago

Thank you for taking the time to read and comment on this post, Myrl.  It must have been quite an experience living and working that close to the epicenter.  Obviously, we were impacted here in New Hampshire but we did not have the wholesale abandonment of subdivisions like you did.  Of course, a big subdivision here is 50 houses. 

There is no doubt there was plenty of skullduggery going on and there were plenty of people who were complicit. 

A perfect storm is a good descriptor.

Posted by Joy Baker, So NH RE & Short Sale Specialist (RE/MAX Insight) over 2 years ago

Joy, my reaction to this is Holy Crap.  I look forward to seeing the movie when it is available to rent.

Posted by Kathleen Daniels, San Jose Homes for Sale-Probate & Trust Specialist (KD Realty - 408.972.1822) over 2 years ago

FEATURED IN CRAP-TACULAR

 

MR. CRAPPY KNOWS ALL TO WELL ABOUT THE  CRAPPY MORTAGE CRISIS

 

Posted by Kathleen Daniels, San Jose Homes for Sale-Probate & Trust Specialist (KD Realty - 408.972.1822) over 2 years ago

Holy Crap is right, Kathleen Daniels!  Thanks for the feature!

Posted by Joy Baker, So NH RE & Short Sale Specialist (RE/MAX Insight) over 2 years ago

Joy, I know many had a lot to say about this movie, and still have not seen it, and so important in our field!  

Posted by Joan Cox, Denver Real Estate - Selling One Home at a Time (Metro Brokers - House to Home, Inc. - Denver Real Estate - 720-231-6373) over 2 years ago

I think that the Fed was complicit, as were thousands of others involved in making sure that this house of cards grew and grew with a certain outcome that could only end in a crash.

Posted by Bob Crane, Forestland Experts! 715-204-9671 (Woodland Management Service / Woodland Real Estate, Keller Williams fox cities) almost 2 years ago

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