BUBBLE TROUBLE

1. BUBBLE TROUBLE Myths and Realities of the Failure of CRapitalism that Caused the Great Recession Gene Epstein gene.epstein@gmail.com Junto, July 7 2012

2. Dan O’Connor • Donate • Volunteer • Tues. June 26

3. BUBBLE TROUBLE Myths and Realities of the Failure of CRapitalism that Caused the Great Recession Gene Epstein gene.epstein@gmail.com Junto, July 7 2012

4. “Great Recession of 2008-09” • --The longest and deepest contraction of the U.S. economy since the Great Depression of the 1930s. • --Rate of unemployment nearly doubled to more than 10%.

5. “Capitalism” • A private enterprise system of profit and loss. • --Profits encourage risk-taking. • --Losses encourage prudence.

6. CRAPITALISM • Contraction of “crony capitalism.” • An economic system in which losses are absorbed by the government. • Thus, without losses encouraging prudence, profits encourage far more risk-taking than is normal in a capitalist system.

7. Crapitalism • Two key examples (key players in our drama): • --Federal National Mortgage Association (“Fannie Mae”) • --Federal Home Loan Mortgage Corporation (“Freddie Mac”) • “Government-sponsored enterprises”-GSE’s

8. Note: Home prices deflated by Consumer Price Index; 1890-1952 year end, 1953-2011 quarterly. Source: Shiller’s Irrational Exuberance

9. Source: Shiller’s Irrational Exuberance, Haver Analytics Note: Data from Q1 1965- Q4 2011; Shiller Historical Housing – Left Scale; Homeownership Rate – Right Scale

10. Krugman on the Fed …[M]acroeconomists were divided in their views. But the main division was between those who insisted that free-market economies never go astray and those who believed that economies may stray now and then but that any major deviations from the path of prosperity could and would be corrected by the all-powerful Fed. Neither side was prepared to cope with an economy that went off the rails despite the Fed’s best efforts [italics added] --”How Did Economists Get It So Wrong?” New York Times Magazine, Sept 6, 2007

11. “To fight this recession the Fed needs more than a snapback; it needs soaring household spending to offset moribund business investment. And to do that, as Paul McCulley of Pimco put it, Alan Greenspan needs to create a housing bubble to replace the Nasdaq bubble.” –Paul Krugman, Aug. 2, 2002

12. “In July 2001, Paul McCulley, an economist at Pimco, the giant bond fund, predicted that the Federal Reserve would simply replace one bubble with another. ‘There is room,’ he wrote, ‘for the Fed to create a bubble in housing prices, if necessary, to sustain American hedonism. And I think the Fed has the will to do so, even though political correctness would demand that Mr. Greenspan deny any such thing.’“—Paul Krugman, May 27, 2005

13. “As Mr. McCulley predicted, interest rate cuts led to soaring home prices, which led in turn not just to a construction boom but to high consumer spending, because homeowners used mortgage refinancing to go deeper into debt. All of this created jobs to make up for those lost when the stock bubble burst.” -- Paul Krugman, May 27, 2005

14. “But although the housing boom has lasted longer than anyone could have imagined, the economy would still be in big trouble if it came to an end. That is, if the hectic pace of home construction were to cool, and consumers were to stop borrowing against their houses, the economy would slow down sharply. If housing prices actually started falling, we'd be looking at a very nasty scene, in which both construction and consumer spending would plunge, pushing the economy right back into recession.” -- Paul Krugman, May 27, 2005

15. Krugman Recants “The reality of the financial crisis was that deregulation — which was part of a broader rightward shift in policies that played a large role in creating rapid growth in income inequality — led to an economic catastrophe of the kind that just didn’t happen during the 50 years or so when we had effective bank regulation.----Krugman, “Financial Big Lies,” Nov. 7 2011

16. Deregulation • …meant three main things since mid-1980s • Elimination of Regulation Q • Elimination of restrictions on branch banking • Partial elimination of Glass-Steagall restriction on commercial banks affiliating with investment banks

17. ●Partial repeal of Glass-Steagall to blame? ”Glass-Steagall legislation, which kept Wall Street and Main Street banks walled off from each other, was repealed in 1998. This allowed FDIC-insured banks, whose deposits were guaranteed by the government, to engage in highly risky business. It also allowed the banks to bulk up, becoming bigger, more complex and unwieldy.”—Barry Ritholtz, “What Cause the Financial Crisis?” Washington Post, Nov. 5 2011

18. Partial repeal of Glass-Steagall to blame? “Gramm-Leach-Bliley isn’t entirely blameless. For one thing, the mergers it encouraged left banks with more capital to invest; some of the capital ended up in that deluded subprime mortgage market.”—N.Y. Times, David Leonhardt, Sept. 26, 2008

19. Three Main Factors 1. Enabling factor: central bank’s negative interest-rate policy, 2002-05 2. Propelling factor: U.S. government’s housing policy beginning in 1992 3. Precipitating factor: replacement of mortgage bankers with casino capitalists

20. 1. Enabling Factor central bank’s negative interest-rate policy, 2002-05

21. 2. Propelling factor U.S. government’s housing policy beginning in 1992

22. Oct. 1992 Title XIII Housing and Community Development Act • “The purpose of the [affordable housing] goals is to facilitate the development in both Fannie Mae and Freddie Mac of an ongoing business effort that will be fully integrated in their products, cultures, and day-to-day operations to service the mortgage financing needs of low-and-moderate-income persons, racial minorities, and inner-city residents.”—from Senate Committee report on the legislation.

23. Krugman on inequality • “[T]he right’s answer is to claim not just that the government did it, but that it caused the crisis by its attempts to reduce inequality! It’s kind of a masterstroke, in an evil way.” • --Krugman, “Financial Big Lies,” Nov. 7 2011

24. Bill Clinton, 1994 • In 1994 President Bill Clinton directed HUD to boost the homeownership rate to an “all time high by the end of the century,” and HUD secretary Henry Cisneros set a goal of a 70 percent homeownership rate in the Nation-al Homeownership Strategy of 1995.--”What Made the Financial Crisis Systemic?” Hendershott and Villani, March 6, 2012

25. President Bush, 2002 • “The goal is, everybody who wants to own a home has got a shot at doing so. The problem is we have what we call a homeownership gap in America… And we need to do something about it… We are here in Washington, D.C. to address problems. So I've set this goal for the country. We want 5.5 million more homeowners by 2010… economic security at home is just an important part of -- as homeland security. And owning a home is part of that economic security. It's also a part of making sure that this country fulfills its great hope and vision.”

26. President Bush, 2002, cont. • “And I'm proud to report that Fannie Mae has heard the call and, as I understand, it's about $440 billion over a period of time. They've used their influence to create that much capital available for the type of home buyer we're talking about here. It's in their charter; it now needs to be implemented. Freddie Mac is interested in helping. I appreciate both of those agencies providing the underpinnings of good capital.”

27. Source: Shiller’s Irrational Exuberance, Haver Analytics Note: Data from Q1 1965- Q4 2011; Shiller Historical Housing – Left Scale; Homeownership Rate – Right Scale

28. Source: Inside Mortgage Finance

29. Sources: FHA, Fannie Mae, Freddie Mac

30. Note: Incremental GSE Affordable Annual Housing Volume above 30% Historic Baseline/Annual Total Origination Volume

31. Sources: Inside Mortgage Finance; Incremental Self-Denomination Subprime Annual Volume Percentage (net of Fannie/Freddie PMBS subprime purchases) above 1992 Baseline of 9% of Annual Total Origination Volume

33. Krugman on no-risk Fannie & Freddie • “[Fannie and Freddie] didn’t do any subprime lending, because they can’t . . . by law. • “ . . . So whatever bad incentives the implicit federal guarantee creates have been offset by the fact that Fannie and Freddie were and are tightly regulated with regard to the risks they can take. You could say that the Fannie-Freddie experience shows that regulation works.”—”Fannie, Freddie, and You,” New York Times, July 14, 2008

34. 800-Lb Gorilla • Sept. 2008: Fannie and Freddie’s creditors are bailed out by the federal government • Dec. 2011: the SEC, chaired by the Obama-appointed Mary Schapiro, seeks “disgorgement of ill-gotten gains” from six former Fannie and Freddie executives, based on the allegation that they “caused the federal mortgage firms to materially misstate their holdings of subprime mortgage loans.”

35. 800-Lb Gorilla, cont. • SEC estimate of $ value of high-risk mortgages held by F&F as of June 30 2008: $1.7 trillion • SEC estimate of F&F losses from Jan. 2007 through March 2011: $241.3 billion • Ed Pinto estimate of F&F losses from Jan. 2008 through Dec. 2011: $242 billion

36. Federal vs. private share of high-risk mortgages—June 30, 2008 No of loansUnpaid Princ. • Federal 20.6 million $2.9 trillion • Private 7.8 million $1.9 trillion • TOTAL 28.4 million $4.8 trillion • Source: Edward Pinto

37. “The Fannie and Freddie Hate Storm”--Holman W. Jenkins, Jr. Dec. 28 2011 • “Yes, we had a housing bubble. Yes, we had deterioration in lending standards. Fannie and Freddie had a role in both…. • “But these things did not lead inexorably to the panic of 2008. The housing losses should have been manageable by the financial system. A systemic meltdown came instead because a handful of giant financial institutions in the U.S. and Europe had leveraged up with short-term and even overnight borrowings in order to hold complex mortgage derivatives that suddenly became illiquid and hard to value…. • “The role of Fannie and Freddie in all this? Very little, except that their seizure accelerated the unraveling of equity values across the banking system as investors feared nationalization would be the fate of other large and flailing financial institutions.”

38. Similar fallacy • “There is no evidence that the crisis—as opposed to the housing bubble—was caused by…Fannie and Freddie.” • --Engineering the Financial Crisis, by Jeffrey Friedman and Wladimir Kraus

39. Counter-factuals to Jeffrey Friedman • 1. There could have been many subprime PLMBS, but market panic over them would not have affected banks so severely, if there had not been a burst housing bubble. • 2. There would not have been a housing bubble that blew up and burst with such severity had government agencies not accumulated such a massive position in non-traditional mortgages.

40. Counter-factuals to Jeffrey Friedman • 3. Had the federal government not gotten so aggressively into non-traditional mortgages starting in the 1990s, via the various agencies, the later accumulation of NTM PMBS by banks would not have occurred in such size or so far out the risk-curve. • As Wallison wrote in his review, "Bubbles tend to suppress delinquencies and default, and by the early 2000s, the losses on subprime and other low quality mortgages were substantially lower than past experience would have suggested."

41. Friedman’s shocking response • “I agree with everything you say here…the book was written for course adoption at elite liberal-arts colleges. There has to be a certain amount of conservative-bashing rhetoric in order to get through that door, there to sow radical new thoughts.”