Wednesday, July 6, 2011

Today's links

1--Reckless Endangerment of the Truth, Mark Thoma, Economist's View

Excerpt: The dispute over the cause of the financial crisis breaks down along standard ideological lines. Democrats generally argue that the crisis can be traced to misplaced faith in the ability of markets to self-regulate. According to this view, economists, regulators, and politicians on both sides of the aisle came to believe that large, economy wrecking financial meltdowns were a thing of the past. This misplaced faith in markets led to deregulation of the financial sector, less enthusiastic enforcement of the rules that remained on the books, and government inattention to important market failures in the financial industry.

The second explanation, one pushed by free market advocates, is that government involvement in housing markets to encourage home ownership caused the financial market problems. In this story of the crisis, the Community Reinvestment Act, Fannie and Freddie, Democrats promoting home ownership, and the middle and low income households that received home loans they couldn’t afford are cast as the villains. Had government stepped out of the way and pursued laissez-faire policies, the crisis would not have happened.

However, the evidence does not support the second explanation. First, with respect to the CRA, the main culprits in the crisis were private sector financial institutions that were not subject to the requirements of the CRA. In the story being pushed by free market advocates, the CRA forced banks to make loans to unqualified, low-income households. When those loans blew up, it caused the financial crisis. But the largest players in the subprime market were private sector firms that were not subject to the CRA’s rules and regulations. For example, “Only one of the top 25 subprime lenders in 2006 was directly subject to the housing law that's being lambasted by conservative critics.” The largest losses had nothing to do with banks covered by the CRA.

Second, even if the banks themselves were subject to the CRA, not all loans that they made were covered by these rules. Even in banks where the CRA applied, most of the problems were in loans that did not fall under the CRA’s jurisdiction.

Third, the CRA has been in existence since 1977. If the CRA was responsible, why didn’t the crisis occur sooner? The timing simply doesn’t match up...

Thus, the evidence against the claim that the CRA was an important factor in the financial crisis is quite strong and, turning next to Fannie and Freddie, the evidence here is also compelling. First, during the important years in the build up to the crisis, from 2002 until late in 2006, Fannie and Freddie were losing subprime market share to private sector firms. For example, as noted by McClatchy News, “More than 84 percent of the subprime mortgages in 2006 were issued by private lending institutions,” and “Private firms made nearly 83 percent of the subprime loans to low- and moderate-income borrowers that year.” The loss of market share ended in late 2006, but by then the crisis was already set in motion.

Second, one of the reasons that Fannie and Freddie lost market share is that they faced more restrictions on their activities than firms in the unregulated shadow banking sector. Fannie and Freddie eventually found ways around these restrictions as they moved aggressively to prevent further loss of market share in late 2006, but prior to that time the restrictions were effective. If firms in the shadow banking sector had been subject to similar rules and regulations, and had the rules and regulations been enforced aggressively, things might have turned out very differently.

Third, the targets for home ownership that supposedly led to Fannie and Freddie’s aggressive entry into subprime markets were set in 1992. If these targets were the problem, why didn’t the crisis occur sooner?

Fourth, if Fannie and Freddie had never existed, securitization would have likely happened anyway. As Barry Ritholtz notes, “securitized credit card receivables, auto loans, small biz loans, etc. took place without GSEs. I assume there would likely have been a private sector version for conforming loans, the way there was a private sector securitizing response to the demand for non-conforming (sub-prime) loans.”

The bottom line is that the case that the CRA, Fannie, and Freddie – and by implication Democrats supporting these institutions – were key players in the crisis is at odds with the evidence. Don’t get me wrong, there are lots for reasons to be concerned about Fannie and Freddie, and I'm not trying to defend them or their choices, but the idea that support of these institutions caused the financial crisis is wrong.

2--Obama’s Original Sin, Frank Rich, New York Magazine

Excerpt: The president’s failure to demand a reckoning from the moneyed interests who brought the economy down has cursed his first term, and could prevent a second....

What haunts the Obama administration is what still haunts the country: the stunning lack of accountability for the greed and misdeeds that brought America to its gravest financial crisis since the Great Depression. There has been no legal, moral, or financial reckoning for the most powerful wrongdoers. Nor have there been meaningful reforms that might prevent a repeat catastrophe. Time may heal most wounds, but not these. Chronic unemployment remains a constant, painful reminder of the havoc inflicted on the bust’s innocent victims. As the ghost of Hamlet’s father might have it, America will be stalked by its foul and unresolved crimes until they “are burnt and purged away.”

After the 1929 crash, and thanks in part to the legendary Ferdinand Pecora’s fierce thirties Senate hearings, America gained a Securities and Exchange Commission, the Public Utility Holding Company Act, and the Glass-Steagall Act to forestall a rerun. After the savings-and-loan debacle of the eighties, some 800 miscreants went to jail. But those who ran the central financial institutions of our fiasco escaped culpability (as did most of the institutions). As the indefatigable Matt Taibbi has tabulated, law enforcement on Obama’s watch rounded up 393,000 illegal immigrants last year and zero bankers. The Justice Department’s bally­hooed Operation Broken Trust has broken still more trust by chasing mainly low-echelon, one-off Madoff wannabes. You almost have to feel sorry for the era’s designated Goldman scapegoat, 32-year-old flunky “Fabulous Fab” Fabrice Tourre, who may yet take the fall for everyone else. It’s as if the Watergate investigation were halted after the cops nabbed the nudniks who did the break-in.

Even now, on the heels of Bank of America’s reluctant $8.5 billion settlement with investors who held its mortgage-backed securities, the Obama administration may be handing it and its peers new get-out-of-jail-free cards. With the Department of Justice’s blessing, the Iowa attorney general, Tom Miller, is pushing the 49 other states to sign on to a national financial settlement ending their investigations of the biggest mortgage lenders. What some call a settlement others may find a cover-up. Time reported in April that the lawyer negotiating with Miller for Moynihan’s Bank of America just happened to be a contributor to his 2010 Iowa reelection campaign. If the deal is struck, any truly aggressive state attorneys general, like Eric Schneiderman of New York, will be shut down before they can dig into the full and still mostly uninvestigated daisy chain of get-rich-quick rackets practiced by banks as they repackaged junk mortgages into junk securities.

3--Consumers Weighed Down by Concerns About Jobs, Income, Wall Street Journal

Excerpt: Forget Prozac. Only jobs and bigger paychecks will cure these blues.

The Conference Board said Tuesday its confidence index fell to 58.5 in June, the lowest reading since November 2010. Assessments of both present economy and the future fell. The big trigger for the blues: Increased worries about jobs and future paychecks.

The report showed a deteriorating view of the labor markets both now and six months down the road. And the percentage of consumers who think their income will decrease six months from now rose to 16.5%, the highest rate since August 2010.

These doubts about the future are likely to translate into weaker spending if better data don’t change consumer attitudes. “Given the combination of uneasiness about the economic outlook and future earnings, consumers are likely to continue weighing their spending decisions quite carefully,” said Lynn Franco, director of the board’s Consumer Research Center.

Bear in mind that real consumer spending in the second quarter is on track to increase by the slowest rate since possibly the fourth quarter of 2009. Continued shopping caution will be a problem for second-half growth.

Of course, it’s not just jobs weighing down consumers — although labor prospects are always paramount. The squeeze on budgets and shrinking wealth are also preventing consumers from believing their economic situation is getting better even though the U.S. recovery is now two years old.

According to the S&P/Case-Shiller report released Tuesday, the April composite index of home prices in 20 major cities has plunged 32.8% from its mid-2006 peak. That means homeowners in general are one-third poorer than they were five years ago.

Add to that the 2.6% or so drop in equity prices so far this quarter as the Greek drama and global economic slowdown weigh on market sentiment. Expect more financial disappointment when investors open their second-quarter retirement-fund and portfolio statements in coming weeks.

4--Liquidity trapped, Paul Krugman, New York Times

Excerpt: those of us who worried about the liquidity trap (see the macro readings off to the side for background) made two big predictions that ran very counter to the kind of stuff you were hearing on CNBC and reading in the Wall Street Journal. We said that even if the Fed printed lots of money (not really, of course; we’re talking mainly about bank reserves), it would not be wildly inflationary. And we also said that even very large government deficits would not cause soaring interest rates as long as the economy stayed depressed.

These predictions were right; at most you can quibble over why we have low inflation but not deflation. (Someone is bound to insist in comments that the Austrians were even righter; so, how’s that hyperinflation by 2010 thing going?)

Yet our political discourse, and even much of what economists are saying, is proceeding as if the inflation and crowding-out types had been vindicated rather than utterly refuted by events.

Never mind my hurt ego; think about the policy disaster.

5--Danger in Debt Ceiling Deal?, zero hedge

Excerpt: Bill Schneider, a professor of public policy at George Mason University, wrote an excellent opinion piece for Politico which reflects my thinking, The danger in the debt ceiling deal:

The danger in the debt limit negotiations is not that the two sides will not make a deal. It’s that they will. Specifically, that they will reach the kind of agreement Republicans are demanding — which would cut more than $1 trillion in government borrowing over the next 10 years.

Any deal of that magnitude would have a devastating effect on the nation’s economic recovery. And make the deficit situation worse. Economic activity would slow and government revenues fall even further.

Democrats and Republicans are arguing over the correct balance between spending cuts and tax increases. Republicans insist that all the savings come from spending cuts. Democrats are willing to accept some cuts but insist that the deal be “balanced” with new tax revenues.

What they are both missing is that the exact mix doesn’t matter. What matters is how much money is taken out of the economy at a time when economic growth is desperately needed. Economic growth is necessary for any deficit-reduction plan to succeed.

Ronald Reagan knew that. Reagan said in his 1985 State of the Union speech, “The best way to reduce deficits is through economic growth.” That is because big spending cuts and tax increases are politically impossible.

On the other hand, growth will not be sufficient. The debt problem has become so large that we can’t grow our way out of it without further sacrifice. Some spending cuts and tax increases will be necessary. But growth will have to be a major part of the solution, just as it was in the late 1990s.

6--China Raises Rates to Counter Fastest Inflation Since 2008, Bloomberg

Excerpt: China raised benchmark interest rates for the third time this year, adding to efforts to cool the world’s fastest-growing economy after inflation accelerated to the quickest pace since 2008.
The one-year lending rate will increase to 6.56 percent from 6.31 percent tomorrow, the People’s Bank of China said on its website. The one-year deposit rate rises to 3.5 percent from 3.25 percent.

Stocks fell and oil and copper extended losses on concern that a slowdown in China will add to headwinds for the global economy. JPMorgan Chase & Co., HSBC Holdings Plc and Bank of America Merrill Lynch said the increase may be the last this year as analysts forecast that inflation will moderate after probably exceeding 6 percent last month.

The government’s appetite for tightening may “wane in response to evidence that the economy is slowing,” said Mark Williams, a London-based economist with Capital Economics Ltd. Inflation “is now widely expected to decline in the second half of the year,” he said.

7--Bad Loans Threaten Chinese Banks, VOA News

Excerpt: Moody's Investor Services, one of the world's top credit rating agencies, says China's banks could be in more trouble than first thought due to bad loans.
Moody's said Tuesday that China's auditor likely underestimated the amount of loans made to local governments by $540 billion.

The additional loans have likely exposed China's loans to increased risk, said Moody's, and that 8 to 12 percent of all the loans made by Chinese banks could go unpaid. Moody's had earlier estimated only 5 to 8 percent of the loans would be classified as "non-performing."

Report author Yvonne Zhang also expressed concerns about the Chinese auditing agency's failure to include the $540 billion of loans in its report last week. She said that may mean many of the newly discovered loans are poorly documented and that the borrowers are at even greater risk of defaulting.

China's banks responded to government calls to increase lending when the global financial crisis struck in order to help boost the economy. Many banks lent vast of amounts of money to local governments for infrastructure projects.

8--No normal party, Economist

Excerpt: ... Democrats have signed on to trillions in spending cuts. They appear to be offering to accept closed loopholes and eliminated tax expenditures, as opposed to rate increases, as the revenue side of the deal. And we learned yesterday that Democratic leaders are apparently willing to put tens of billions in cuts to Medicare and Medicaid, on top of reduced spending growth rates already offered, on the table.

The Republican response? Leaders are now considering adding to their demands and making a vote on a balanced budget amendment to the constitution part of the final deal. But at this point, Democratic leaders can have little confidence that additional concessions will bring them any closer to a deal. The parties aren't moving toward each other; Democrats are following Republicans to the right, and closer to the cliff's edge.

It is becoming ever more difficult to write about this ongoing negotiation (if you can call it that). Journalists can't see the actual discussions between the two parties and grab at whatever leaks come their way to try and construct a narrative. The economists have mostly concluded that a default would be disastrous, and are keeping themselves busy watching financial markets, looking for any sign that they're becoming worried. It's difficult to know what to look for, however; how would you hedge against default of the world's bedrock, risk-free asset?

In all probability, America won't default; it's still difficult to imagine that it cold come to that. The bigger danger, I think, is that the Republican strategy will either lead Democrats to accept short-term cuts large enough to endanger recovery or will result in a short period of "prioritisation", in which spending is suddenly and dramatically cut back to prevent a default once the money runs out (on or about August 2nd). America may make it through this episode with its credit rating intact and still sustain significant economic damage.

9--Market Share of Mortgage Debt Outstanding, David Beckworth

Excerpt: Mark Thoma is frustrated to see some commentators once again push the view that Fannie and Freddie caused the economic crisis. When this issue arose back in late 2008, Richard Green's figure on the share of mortgage debt outstanding held by type of institution settled the debate for me. That figure showed the GSE's share declined during the housing boom while the asset-back security issuers' share increased. Here is an updated and slightly modified version of that figure: (Chart)

The data is unambiguous here: Fannie and Freddie were not the immediate cause of the housing boom. They may be guilty of a number of things, but directly causing the housing boom is not one of them.

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