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Towards a unified-field theory of the financial crisis

050405_einstein_tongue.widec.jpgCommenter Yahnik pleads:

First I read David Frum's article where he states that the crisis was because of major consumer debt and China and it's wheeling and dealing with it's currency. Then, I hear on TV that it's because of bets made by the major financial institutions and now you write that the major cause was bank runs in the shadow banking industry. Which is it? Can somebody tell me the core issue behind this latest crisis?!?

All of these explanations are part of the same story.

1) Developing countries like China have massive trade surpluses and they park their capital in the United States, because we're a safe place to put your money (Frum, or more to the point, Martin Wolf and This American Life).

2) All this money speeds the rise of a massive institutional banking sector, which needs a lot more collateral than currently exists in order to guarantee the loans that different institutions are making to one another. That drives the desperate desire to package every mortgage in the country into a massive security that can be used as collateral (Gorton's point, and the one you read in my earlier post).

3) And, finally, these securities blow up, showing that all these banks made obviously terrible bets when they invested in them.

Basically, the question here is when do you start your story: With the rush of easy money that inflated the bubble? The reason the money spurred demand for mortgage-backed securities? Or the investors that didn't realize there was a bubble?

But where you start your story matters for what you learned from it. You could take the economic crisis as a reason to rebalance global trade, strengthen the institutional banking market so that it uses safer collateral and is less vulnerable to runs, or pass regulations making it easier for regulators to see when major banks and investors are making bad decisions and need to shed some risk or be broken up. We're really only doing the last of these.

By Ezra Klein  |  April 26, 2010; 5:20 PM ET
Categories:  Financial Regulation  
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IMO, the Chinese excess savings argument is a narrative being peddled by Greenspan to divert attention from the fact that the Fed ran an excessively easy monetary policy in the mid-late 90s, which started around the Mexican Peso crisis, included the Asian crisis, Long Term Capital Management, and finally Y2K. By the late 90s, it was clear we were in an equity bubble and there were imbalances in the economy that needed to be corrected. If Greenspan had allowed any of these crises to be the catalyst for a much-needed recession, the tech bubble would have been burst with less damage to the economy and the housing bubble would never have started.

The other reason why the housing bubble inflated was Fannie Mae's American Dream Commitment which lasted from early 2000 to 2006. It was a politically-driven $2 trillion commitment to boost lending to historically underserved demographics, led by Franklin Raines. With their partners in Countrywide, Doral, and others, Fannie agreed to buy subprime loans their partners originated. The ADC pretty much correlates with when the US residential market went vertical. The completion of the ADC pretty much correlates with the crash.

While Wall Street was packaging these mortgages into more and more exotic derivatives, the simple fact is if we did not have a residential real estate bubble in the US, we would not be having this conversation.

Posted by: sold2u | April 26, 2010 5:53 PM | Report abuse

Great explanation Ezra! Now it makes sense to me when I'm listening to several debates and I keep hearing or reading that "the bill is not doing enough". I guess now for me, I need to think about if where the WH and Congress is starting is a good place to start. At least for my own opinion...thanks!

Posted by: yahnik | April 26, 2010 5:54 PM | Report abuse

the tragic irony is that so much of this financial calamity could have been avoided if the money had simply been given to me.

Posted by: bdballard | April 26, 2010 6:06 PM | Report abuse

The fact that "we're really only doing the last of these" is troubling in that the one we're doing is "making it easier for regulators to see when major banks and investors are making bad decisions".

Putting glasses on a drunk driver doesn't necessarily improve his ability to steer but guardrails on the sides of the roads and bumpers on automobiles might lessen the damage done. It may be that statutory hard-limits, not subject to regulatory interpretation, are necessary: if nothing more, the changing of such statutory limits draws public attention to a Congressional spectacle, which should be an alert to a potential problem. At that point, then, it becomes a citizen responsibility. Conversely, the presence of regulators with broad powers seems to be most useful to indemnify the citizens and their elected officials who decided to ignore a potential problem.

Posted by: rmgregory | April 26, 2010 6:09 PM | Report abuse

Wall Street is a casino...innovation in finance is a Ponzi scheme. Real reform is outlawing all this betting, plain and simple. That is the progressive stance, what is the conservative?

Posted by: johnnyspazm | April 26, 2010 6:19 PM | Report abuse

On a related note, what about the criticism from Republicans about Fannie Mae/Freddie Mac? Why aren't we tackling that in the comprehensive fin reg bill? Didn't they play a large role in the crisis, too? Where do they fit in?

Posted by: madjoy | April 26, 2010 6:59 PM | Report abuse

Despite the constant repeating of the right wing trope, Fannie and Freddie didn't originate subprime loans and were a very minor player in the subprime crisis. Irresponsible mortgage brokers and lenders like countrywide and WaMu originated the toxic subprime loans that were then dumped on fannie and freddie.

Posted by: srw3 | April 26, 2010 7:24 PM | Report abuse

sold2u makes good points about the influence of easy money from Greenspan on the housing bubble, but it contrtibuted in another way as well. Low rates for money market deposits and Treasuries created an apetite on the part of institutional investors for instruments with higher yields. Mortgage-backed securities and later credit default swaps were sold to them as a way to get higher yields, as were soime of the othe Wall Street scams like auction-rate securities funds which were supposed to be liquid but froze solid when the crisis came, putting some number of people in a real bind because they coiuldn't get at their money. Several brokerages have been sued over these.

Fannie and Freddie get a lot of flak from GOPers who don't want to talk about mortgage frauds and Wall Street scams. They weren't inherently bad, but they ran up horrendous amounts of leverage, woorse even than the investment banks, and so went bad. GNMA and FHA seem to be ok but the privatized ones went bad. BGut Fannie and Freddie were playing into the huge apetite for mortgager-backed securities, whose origins Ezra has explained.

Another problem is that middle-class people were encouraged to go into debt to increase or maintain their standard of living when wages became stagnant. Again, this is the effect of the top 1% taking an outsized share of the pie and constructing scams to do the other 99% out of even that which they had.

Posted by: Mimikatz | April 26, 2010 7:28 PM | Report abuse

I don't understand the link between (1) and (2). If (1) has cash that it is using to buy stuff here, why all the massive intra-institutional lending in order to take the money from (1)? And if so, wouldn't (1) be the ones stuck when they bought stuff that didn't actually have value?

My impression is more prosaic: after years of using houses as ATMs to finance (instead of earn) the American Dream, eventually the US consumer reached a new "set point" where people were maxed out on the new, cheap loans -- they just couldn't borrow more. So the mortgage industry needed to find more customers to keep things rolling. Enter subprimes.

Posted by: willNeuhauser | April 26, 2010 7:33 PM | Report abuse

madjoy wrote:

On a related note, what about the criticism from Republicans about Fannie Mae/Freddie Mac? Why aren't we tackling that in the comprehensive fin reg bill? Didn't they play a large role in the crisis, too? Where do they fit in?

ask and you shall receive:

Fannie Mae press release from 2001. long article. highlights:

Fannie Mae Chairman and CEO, Franklin D. Raines said today that the company financed over $190 billion of home mortgages through its lender partners for nearly 2 million U.S. families most in need during 2000, the first year of the company's "American Dream Commitment" to increase homeownership rates and serve 18 million targeted American families by the end of the decade.

"Fannie Mae and its affordable housing partners did not skip a beat as we completed our Trillion Dollar Commitment last spring and began making significant progress on our redoubled, $2 trillion American Dream Commitment," said Raines. "We are confident that we will meet our ambitious goals, but as in a marathon, the miles ahead will be harder. To all those with a stake in closing the homeownership gaps that still exist, Fannie Mae is asking for your help in breaking the barriers between underserved families and mainstream mortgage finance."

"In 2000, Fannie Mae launched several new mortgage products, processes and partnerships to help the mortgage finance system deliver low-cost mortgage credit, on flexible terms, to people and places outside the mainstream," Raines reported. "We are widening the mainstream - lifting more boats - with very low down payment loans, special community lending products for financial institutions, targeted investments in urban renewal plans, cooperative arrangements with faith-based organizations and other affinity groups, and accelerating our investment in affordable rental housing."

The National Minority Homeownership Initiative

Fannie Mae has challenged the public and private sectors to join in setting a national goal of creating five million new minority homeowners by 2010. Through the American Dream Commitment's National Minority Homeownership Initiative, Fannie Mae has committed to contribute at least $420 billion in mortgage investments to serve more than three million minority households over the decade.

The company also has pledged to lead the market in affordable lending finance to all racial and ethnic groups and is on track to achieve our strongest targeted lending performance ever.

-- Minority Lending. In 2000, Fannie Mae purchased loans totaling

nearly $35 billion of minority lending and served more than

316,000 minority households.

Posted by: sold2u | April 26, 2010 7:50 PM | Report abuse

And just to emphasize it, because it really needs to be emphasized:

"In 2000, Fannie Mae launched several new mortgage products, processes and partnerships to help the mortgage finance system deliver low-cost mortgage credit, on flexible terms, to people and places outside the mainstream," Raines reported. "We are widening the mainstream - lifting more boats - with very low down payment loans, special community lending products for financial institutions, targeted investments in urban renewal plans, cooperative arrangements with faith-based organizations and other affinity groups, and accelerating our investment in affordable rental housing."

Holy Homeownership, Batman! Don't we refer to this as predatory lending?

The fact that the Left refuses to consider the role that social engineering at Fan and Fred at the behest of Washington demonstrates the Left suffers from epistemic closure just like the Right.

Posted by: sold2u | April 26, 2010 8:01 PM | Report abuse

More than anything, I suspect the wrong people learned the wrong lessons from the Ivan Boesky, and Michael Milken debacles in the late 1980s.

I seem to recall that Milken pocketed $1 bill. back in the 1980s and merely had to pay out 50 percent his ill-gotten gains.

Today the criminal is worth $2.1 billion and has bought his way back to semi-respectability.

What kind of lesson does that teach?

e.g. Cheat on your taxes, cheat on your clients, break the law, serve a little time and pay a little public penance and live like a king?

Some of the details are different, but I suspect you'd probably find more similarities. Back then it was Japan, today it's China.

It's probably no accident either that people like AIG's FP head Joseph Cassano cut their teeth at places like Drexel Burnham Lambert in the 1980s.

Posted by: JPRS | April 26, 2010 8:16 PM | Report abuse


The main problem is that the numbers don't add up.

Fannie and Freddie were a major player in subprime up until about 2004. However, during the boom years it was primarily secondary lenders like New Century and Countrywide who dominated the subprime market with funding from investment banks.

On balance Fannie and Freddie held conforming loans too, which helped to keep their quality of the loans on their books from turning completely to zero.

If you were assessing blame, maybe Fannie and Freddie get a nice 5 percent allocation. Changes in net-capital ratios at the major firms and the rise of the shadow banking, derivative market took the core issues to another level entirely.

If this was just a crisis about Freddie and Fannie Mae's subprime holdings you're talking about something that's perhaps a $100 billion crisis. A mini-TARP would have restored financial stability without much difficulty. There wouldn't have been massive economic losses in other parts of the economy.

Posted by: JPRS | April 26, 2010 8:37 PM | Report abuse


A $2 trillion commitment to subprime isn't insignificant. They were a huge part of the investor demand for this paper. I don't think it is a coincidence that the music stopped in the credit markets once Fannie completed its commitment to purchase subprime paper. As usual, the most marginal players (the epitome of dumb money) were dominating the scene at the end of the bubble, as Fan and Fred were backing away.

The thing is, I don't think the real estate bubble began in 2004 - I think it began in the late 90s, when housing appreciation decoupled from its historically strong correlation with income growth. Maybe for the last year of the bubble, Fannie and Fred weren't big players. But they were for the majority of the time.

Of course Fan and Fred aren't the only ones to blame. IMO, Alan Greenspan probably had the most to do with it - by easing every time Wall Street had a hiccup in the late 90s, he created this perception of a Greenspan put, which created the mentality on Wall Street that there was little risk of a liquidity squeeze - in an emergency the Fed would flood the system with easy money and any crisis would be averted.

CDO originators who were compensated on assets under management versus profitability were part of it. Ratings agencies were as well. Wall Street securitized crap mortgages with the rationalization that covariance matrices and an ever-appreciating real estate market would cover up dodgy credit decisions. And Washington, by subsidizing the US residential real estate market six ways to Sunday also deserves some of the blame too.

Posted by: sold2u | April 26, 2010 9:08 PM | Report abuse


Subprime accounted for less than $200 billion of Fannie and Freddie's $3 trillion plus holdings. The peak year in subprime lending was 2006, at which point Fannie and Freddie accounted for only 16 percent of the market.

The overwhelming majority of subprime loans were originated from 2005 to 3Q2007 (about twice as many as the proceeding period when Fannie and Freddie played a more significant role).

The Dallas Fed has a good early history on the subprime crisis.

Even at the lowest points, Fannie and Freddie weren't underwriting NINJA loans with 107 percent financing. Most of the loans that the GSE's backed were by definition ones that conformed to prime lending standards.

We seem to agree that there were many other factors. Fannie and Freddie's subprime involvement was definitely a contributing factor, but only perhaps in the 5 percent range if we're apportioning responsibility. There were other much more significant factors (e.g. changes to the Net-Capital rule in 2004, certainly the rise of the shadow banking industry post 2000 was a major problem, loose monetary at the policy was a factor -- although it was AWOL in other respects too).

Posted by: JPRS | April 26, 2010 10:06 PM | Report abuse

until you address and SHOOT the bipartisan elephant in the room(US Treasury)the PRIVATE "Federal" Reserve Bank all the elegant and intellectual and econometric "solutions" wont matter and wont stave off the Weimar-like crash/collapse.

Ron Paul and too few others have warned about the unConstitutionality and corruptness of central banking and its fiat currency and have fought the banksters and thier shills in DC and the MSM....time is running out....nuetered bills, insolvency, bankruptcy, bank holidays and chaos is right around the corner.

The solutions of MORE government and MORE redistribution of FRN's are like shoveling sand on the beach....

our freedom and soveriegnty are at stake....

Posted by: ChrisBieber | April 27, 2010 10:20 AM | Report abuse

I'm going to take issue with point 1. Unless I'm mistaken, the Chinese don't have a dollar printing press. Any money they send to us, we originally sent to them. If the availability of funds for lending was soaring, it is because the Fed was creating new money.

On the FNMA/FHLMC issue, I think it's pretty clear that the primary problem with those guys is that everyone (correctly) saw their debt as implicitly guaranteed by the US Gov, and with such cheap funding they got into leverage problems. I agree with JPRS that while they contributed to subprime problems, a lot of the damage was done by private sector lenders.

The GSEs were a net negative, but they weren't nearly the biggest negative. Agree with sold2u that our problem was too much new money created by the Fed, and an institutional structure which channeled that money into the housing sector, with the marginal buyers being worse and worse credit risks.

I will say that from a nudge perspective, the 'getting people to be homeowners at all costs' meme disseminated by government - both from people like Barney Frank and George Bush - probably was a (unquantifiable) net negative.

Posted by: justin84 | April 27, 2010 10:35 AM | Report abuse

Ezra, here's the unifying truth:

“Too Big to Fail” is not the issue ---- “Too Empire for democracy” is the real issue the corporatist media is hiding.

And none of these FTEs (_____ Tools of Empire) from either ‘Vichy’ party or the corporatist media is going to do squat.

The real story is not about the visible "financial crisis" but should really be about the "social democracy crisis" hiding behind the front 'cover' story.

A few decades ago the few leading intellectuals and academic experts
who understood and wrote about endemic cheating, looting, concentration of
non-democratic power, and abuse of that power in our political economy,
like; Noam Chomsky, William Greider, and David Korten were easily
characterized as 'radicals' and could be just as easily censored by the

But today the entire leading group of Nobel laureates in economics; Akerlof,
Stiglitz, Krugman along with probable future Nobels like Simon Johnson and
Robert Shiller, the majority of leading political philosophers like Sheldon
Wolin, former media truth tellers and authors like Christopher Hedges, Ron
Suskind, and Andrew Bacevich are ALL revealing the truth about the cancer
and causation of guileful EMPIRE behind this superficial story of the latest
financial crisis --- and while none can be dismissed as 'radicals', the media
continues to suppress the real story behind the story.

Why do you think the media is acting in such an apparently complicit
way, along with the Empire's TWO-Party 'Vichy' facade of phony democratic government, in suppressing truth about the seminal cause and real scope of this crisis in American social democracy?

Alan MacDonald
Sanford, Maine

Posted by: alanmd | April 27, 2010 12:48 PM | Report abuse

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