Pksimon2007
Member
- May 2, 2015
- 427
- 30
- 16
Many claim the Fed and the GSEs were responsible for the 2008 crisis via low interest rates and moral hazard.
Nothing could be more wrong. It was not a mortgage crisis, and not caused by either the Fed or the GSEs.
Prior to 2000, the majority of securitization was done by the GSEs. This began to change around 2001.
In the early 2000s, GSE securitization of mortgages dropped to less than half of the market, then dropped to about 1/3 by the mid-2000s.
I mentioned earlier that the driver behind the mortgage boom was not interest rates set by the Fed (although Greenspan had dropped the fed funds rate in 2000 in part to encourage home sales, he began raising them again, yet mortgage rates continued to fall), but by demand for the securities pumped out at the other end of the securitization process. In other words, interest rates and/or federal guarantees were not driving the market. It was the other way round: the market for derivative products was driving interest rates down in order to keep a flow of mortgages coming, and the GSEs were being driven out of the mortgage market.
Throughout the 2000s, mortgage originations and securitization migrated away from commercial banks to investment banks, which developed vertically integrated conduits designed with only one purpose in mind: to produce high-grade tranched securities to feed what was, at the time, a limitless worldwide demand for them (these things weren't just punted around Wall Street, they were being sold to investors worldwide). The US trade deficit was so high that foreign banks couldn't buy enough Treasuries with the dollars they had acquired in foreign trade, and were looking for some sort of similar, high-grade securities as substitutes. Wall Street stood ready to provide that: collateralized mortgage obligations. The problem was getting enough mortgages to develop the liquid markets they needed, and to make those markets deep enough to satisfy foreign banks as to their suitability vis a vis Treasuries.
Deregulation had allowed investment banks into the banking business in a big way, but without the restrictions placed on the banks, and their underwriting and purchase standards were not hampered in any of the ways the GSEs were.
Merrill Lynch, Goldman Sachs, Lehman Brothers, Bear Stearns, all of the big investment banks, bought independent originators in order to integrate their mortgage mills without having to deal with the GSEs or federal regulators - the GSEs were competition, making money securitizing mortgages. This was a profit center which investment banks did not want to cede to them. They weren't thinking about federal guarantees in case things went wrong, they were thinking about profits now.
This is where subprime and Alt-A originations found their home. There simply weren't enough qualified buyers out there to feed the hungry maw of the mortgage securitization and derivative mill, so underwriting standards had to be lowered, and homeowners had to be encouraged to refinance early and often - refinancing not only provided grist for the mill (while only affecting the junk tranches of existing issues of CDOs) - it allowed bad underwriting to be covered through the new issue of loans before an existing loan had to be written off for nonperformance. This worked as long as demand for housing remained high enough to keep home prices rising (it was the increase in a homeowner's equity that allowed them to refinance out of one nonperforming loan into another that was just as unlikely to perform). In order to make this happen, they had to ignore the fed funds rate and make mortgage loans at rates that would keep housing demand high. This, again, explains the proliferation of nontraditional loans, which kept interest rates low for a time but recaptured money from the borrower later.
This is not a story of moral hazard caused by federal guarantees. It is not a story of the Fed keeping interest rates low, or lending too freely to banks (these investment houses couldn't get loans from the Fed, they were relying on commercial paper for short-term financing, creating a bubble in that market as well). The credit expansion, the moral hazard, and the outright fraud were all products of a market that was not being manipulated, but was doing its own manipulation.
The subtext to this is that the individuals - the traders, managers, and CEOs who were doing this did not own the companies they were running. They were perversely incentivized to take HUGE risks on behalf of their companies for personal gain. By showing profits in the short term they kept stockholders satisfied - stockholders who had no hope of understanding the products these firms were selling. The idea that moral hazard was created by federal guarantees depends on the thesis that those who were making the risk decisions would be bailed out if their companies failed. But the fact was that those who were making those decisions were employees who received their compensation in the short term, and didn't care about bailouts. As employees, the problem of ultimate company failure wasn't one that particularly worried them.
When you say you want government out of the markets, it is exactly this sort of result that you are begging for.
Nothing could be more wrong. It was not a mortgage crisis, and not caused by either the Fed or the GSEs.
Prior to 2000, the majority of securitization was done by the GSEs. This began to change around 2001.
In the early 2000s, GSE securitization of mortgages dropped to less than half of the market, then dropped to about 1/3 by the mid-2000s.
I mentioned earlier that the driver behind the mortgage boom was not interest rates set by the Fed (although Greenspan had dropped the fed funds rate in 2000 in part to encourage home sales, he began raising them again, yet mortgage rates continued to fall), but by demand for the securities pumped out at the other end of the securitization process. In other words, interest rates and/or federal guarantees were not driving the market. It was the other way round: the market for derivative products was driving interest rates down in order to keep a flow of mortgages coming, and the GSEs were being driven out of the mortgage market.
Throughout the 2000s, mortgage originations and securitization migrated away from commercial banks to investment banks, which developed vertically integrated conduits designed with only one purpose in mind: to produce high-grade tranched securities to feed what was, at the time, a limitless worldwide demand for them (these things weren't just punted around Wall Street, they were being sold to investors worldwide). The US trade deficit was so high that foreign banks couldn't buy enough Treasuries with the dollars they had acquired in foreign trade, and were looking for some sort of similar, high-grade securities as substitutes. Wall Street stood ready to provide that: collateralized mortgage obligations. The problem was getting enough mortgages to develop the liquid markets they needed, and to make those markets deep enough to satisfy foreign banks as to their suitability vis a vis Treasuries.
Deregulation had allowed investment banks into the banking business in a big way, but without the restrictions placed on the banks, and their underwriting and purchase standards were not hampered in any of the ways the GSEs were.
Merrill Lynch, Goldman Sachs, Lehman Brothers, Bear Stearns, all of the big investment banks, bought independent originators in order to integrate their mortgage mills without having to deal with the GSEs or federal regulators - the GSEs were competition, making money securitizing mortgages. This was a profit center which investment banks did not want to cede to them. They weren't thinking about federal guarantees in case things went wrong, they were thinking about profits now.
This is where subprime and Alt-A originations found their home. There simply weren't enough qualified buyers out there to feed the hungry maw of the mortgage securitization and derivative mill, so underwriting standards had to be lowered, and homeowners had to be encouraged to refinance early and often - refinancing not only provided grist for the mill (while only affecting the junk tranches of existing issues of CDOs) - it allowed bad underwriting to be covered through the new issue of loans before an existing loan had to be written off for nonperformance. This worked as long as demand for housing remained high enough to keep home prices rising (it was the increase in a homeowner's equity that allowed them to refinance out of one nonperforming loan into another that was just as unlikely to perform). In order to make this happen, they had to ignore the fed funds rate and make mortgage loans at rates that would keep housing demand high. This, again, explains the proliferation of nontraditional loans, which kept interest rates low for a time but recaptured money from the borrower later.
This is not a story of moral hazard caused by federal guarantees. It is not a story of the Fed keeping interest rates low, or lending too freely to banks (these investment houses couldn't get loans from the Fed, they were relying on commercial paper for short-term financing, creating a bubble in that market as well). The credit expansion, the moral hazard, and the outright fraud were all products of a market that was not being manipulated, but was doing its own manipulation.
The subtext to this is that the individuals - the traders, managers, and CEOs who were doing this did not own the companies they were running. They were perversely incentivized to take HUGE risks on behalf of their companies for personal gain. By showing profits in the short term they kept stockholders satisfied - stockholders who had no hope of understanding the products these firms were selling. The idea that moral hazard was created by federal guarantees depends on the thesis that those who were making the risk decisions would be bailed out if their companies failed. But the fact was that those who were making those decisions were employees who received their compensation in the short term, and didn't care about bailouts. As employees, the problem of ultimate company failure wasn't one that particularly worried them.
When you say you want government out of the markets, it is exactly this sort of result that you are begging for.
