Following the news about the credit crisis has been frustrating for a “free marketeer,” particularly one who worked in the mortgage industry for seven years. The realities of the situation are very different than the myths our political leaders and the media have been repeating:
Myth Number One: We are facing the “worst economic crisis since the Great Depression.”
Reality: We are facing a credit crisis, which could become an economic crisis if the government continues to mismanage it. If things go badly, it could end up as the worst economic crisis since the Great Depression. But we aren’t there yet. In August of 1979, the unemployment rate was about the same as today’s (6.0 vs. 6.1 percent), but the inflation rate was 11.8 percent compared to today’s 5.4 percent. The loss of confidence was reflected in President Jimmy Carter’s infamous “malaise” speech and a prime rate that approached 20 percent.
But in one very important sense, we were better off in the fall of 1979 than we are today. In August of 1979, Paul Volcker became Chairman of the Federal Reserve Board. He understood the cause of the problems facing the economy: an easy money policy that had debased the value of the dollar over the previous decade. He also understood the Fed’s role in solving the problem: to stop creating so many dollars. The treatment was painful – in 1982 unemployment reached 10.8 percent – but the patient was cured. Unfortunately, there is no sign of similar leadership on the horizon today.
Myth Number Two: We are facing a “liquidity” crisis.
Reality: We hear a lot of talk about the fact that there is no “liquid” market for mortgage-related assets, but that is not the problem. Most of these assets were designed to meet the needs of specific investors, not to be widely traded. The current crisis is a credit crisis, and the primary cause was monetary policy that provided too much liquidity to the economy over the last seven years.
In 2001, many economists were worried that our economy was becoming deflationary. The stock market declined after the dot.com bubble burst, consumer prices were stable overall (actually falling for many items), and long-term interest rates fell below short-term rates. The shock of 9/11 reinforced the concern about deflation. Since deflation is as bad – or worse – for an economy than inflation, the Fed responded by reducing interest rates to the lowest level in four decades, and kept them there for the following three years. The result was a credit bubble – the one that is currently unwinding. Compounding the error, the Fed chose to respond to the early stages of the current crisis by slashing interest rates below the inflation rate again. Today, there is no shortage of liquidity in the system – rates on short-term U.S. government obligations were close to zero last week. But because we are still unwinding the inflated asset prices of recent years, lenders are afraid to rely on the balance sheets of potential borrowers who are carrying these assets. That is the problem that needs to be addressed to re-establish confidence in the credit markets.
Myth Number Three: The mortgage-related assets being held by many banks and investors are “toxic” because of their complexity and opacity.
Reality: Mortgage-backed securities and related assets, though complex, are “toxic” to the banks and investors that hold them primarily because they are overvalued and/or financed with short-term debt. The extent to which real estate prices inflated during the credit bubble is not hard to measure. From before 1980 until 2001, home prices had a consistent relationship with income. Beginning in 2002, when the Fed cut rates below the rate of inflation, that relationship vanished. Home prices rose approximately 35 percent above where they would have been had the historical relationship with income been maintained.
The best prediction of where home prices will stabilize is at the level where the historical relationship with income will be restored. So, to calculate a fair value of mortgage-related securities, you need to model the securities based on home prices returning to their historical relationship to income, making related assumptions about defaults, foreclosure losses, refinances, and write-downs to avoid foreclosure. In most cases, that price will be lower than the current book value of those assets, rendering some holders insolvent and others undercapitalized. In addition, some holders (particularly the traditional investment banks, which have now all been bought by or converted into commercial banks) funded these assets with short-term debt. My formula will not give you a current “market” price – nobody is going to take on the risks of these assets right now unless they can buy at a substantial discount. So when the debt comes due, lenders (who frequently loaned the money at rates reflecting low risk) are reluctant to extend the maturity because they know those assets cannot be sold in a pinch to pay them off. This mismatch between the maturities of assets and liabilities will render additional holders insolvent.
Myth Number Four: The current crisis is a market failure.
Reality: Although the workings of the markets (and political system) have created the current atmosphere of crisis, the root causes of the housing bubble were government policies. The first, discussed above, is the “easy money” policy followed by the Federal Reserve since 9/11. That policy translated directly into inflated real estate prices by a simple mechanism: When interest rates are low, the same monthly payment will service a larger debt, thus enabling buyers to pay more for homes.
The second is the policy of promoting home ownership, particularly as it manifested itself in the operations of Fannie Mae and Freddie Mac. Fannie and Freddie were (until a few weeks ago) hybrid entities; private for-profits companies that paid dividends to shareholders (and generous compensation to executives) but served the “public purpose” of promoting homeownership. Because Fannie and Freddie were chartered by the federal government for a public purpose, the companies were widely considered (correctly, as things turned out) to have the backing of the federal government, and thus very low borrowing costs. Fannie and Freddie were able to make large profits through arbitrage, borrowing at low rates and using the money to buy mortgage-backed securities bearing higher rates, including securities backed by subprime mortgages that were not eligible for purchase or securitization by Fannie and Freddie. Fannie and Freddie became the largest buyers of mortgage-backed securities, thus reinforcing the artificial inflation of home prices generated by loose monetary policy. These two policy errors set the table; the mortgage industry and Wall Street were only too happy to gorge themselves at the feast.
Myth Number Five: The mortgage market is an example of “unregulated capitalism.”
Reality: The mortgage market is highly regulated. Although mortgage brokers are not regulated in some states, mortgage companies (who actually make the loans) are required to be licensed everywhere. There are extensive regulations about appraisals, disclosure of terms, closing of loans, and the sale and securitization of loans. There are programs that encourage mortgage companies to make and investors to buy loans made to less-than-creditworthy borrowers and there are regulations that require some investors to purchase only “investment grade” securities.
As discussed above, Fannie Mae and Freddie Mac also play a substantial role in the market. In particular, Fannie and Freddie, because of their low cost of funds, make it impossible for private firms to compete with them for the loans they will buy, thus forcing firms to look to the “non-conforming” (i.e., higher risk) market for opportunities. This had the effect of concentrating the risk of default instead of spreading it across the entire market. For politicians looking for an example of “unregulated capitalism” to attack, the mortgage industry is a bad choice.
Myth Number Six: The mortgage boom and bust have been a disaster for homeowners and the economy.
Reality: It’s too soon to tell. From 2001 through 2006, the percentage of American households owning their own homes went from 63 percent to 69 percent. It has fallen since, but not below 63 percent. The homes that were built during the boom still exist; as a result, prices for homebuyers will be lower for at least several years. That is good for families looking to buy a home though bad for families looking to cash out. As with any boom and bust, there will be winners and losers: only time will tell whether the benefit to the economy as a whole will outweigh the cost. But anybody who uses a 3G mobile device knows that the infrastructure built during the dot.com boom did not go to waste.
Myth Number Seven: Government should take action to mitigate the crisis.
Reality: The way to end a financial crisis is to let it run its course, not to try to slow it down. Government actions designed to mitigate financial crises can turn them into economic crises. The best example of this is the Great Depression. Anybody interested in a good, but not technical, book on this topic should read Rethinking the Great Depression by Gene Smiley.
So where do free marketeers go from here? The answer, I believe, is not to lose faith in markets. At the same time, I think we need to recognize that markets are not as “efficient” as many of us had believed – if they were, credit markets would be making distinctions between borrowers exposed to mortgage-related assets and borrowers without mortgage exposure. Those distinctions are not being made today. Based on these premises, I propose the following “free market” solution to the credit crisis.
· No federal purchase of "toxic" assets. No “insurance” program to make well-managed banks pay for the errors of poorly managed ones. No bailout. As discussed above, when Wall Street says "toxic" it means "overvalued." Write the assets down to their true value and they are no longer toxic. But some institutions will be insolvent.
· We have insolvency regimes for ordinary businesses and broker/dealers (bankruptcy), banks (FDIC receivership and liquidation), and insurance companies (state receivership). Use them to establish the losses and move the overvalued assets out of the system.
· In cases where the failure of an institution does pose a systemic risk, create a means for the government to intervene, but only to address the systemic risk, and only on the following terms: Government money is last in and first out.
· Immediate receivership for any institution that has to participate, as was done with Fannie and Freddie. Management should be out, and the receiver should be charged with preventing systemic risk and maximizing the recovery for creditors.
· The receiver should have the power to recapitalize, sell, or liquidate the institution. The proceeds should be distributed to claimants based on their legal priorities (e.g., shareholders get nothing unless creditors are paid in full). As a result of this process, the people and assets currently tied up trying to preserve failing firms will be redeployed to where they can help restore growth.
The events of the last dozen days have demonstrated that our economic and legal system is up to the task of resolving the credit crisis without transferring massive losses to taxpayers. Institutions that were not heavily involved in subprime lending, like Bank of America and JP Morgan, or that wrote down subprime assets aggressively, like Citigroup, are buyers in this market. Citi, JPMorgan, Goldman Sachs, and Morgan Stanley have each raised $9 billion or more in new capital. The FDIC is moving aggressively to clean up the banking system. If we give the system time to work, it will.
This course, unlike the proposed bailout, will end the "crisis" as quickly as possible. Once the credit markets realize that insolvent borrowers have been weeded out, they will return to normal functioning. There will be a recession, but recessions are an inevitable part of the business cycle, and efforts to postpone them always end up making them worse. Once the crisis passes, we can turn to reform.
Tom Kelly is a partner in the Finance and Restructuring Department at Dorsey & Whitney LLP. He is also on the Board of Directors of the Minnesota Free Market Institute.
October 2, 2008
