“Each of the actors: bankers, politicians, the poor, foreign investors, economists, and central bankers did what they thought was right”

I think Professor Rajan’s book “Fault Lines: How Hidden Fractures Still Threaten The World Economy” is one of the most thoughtful and logical accounts of the true root-causes of the recent financial and economic crisis. (Professor Rajan is the former Chief Economist of the International Monetary Fund and in 2003 was the inaugural winner of the Fischer Black Prize given by the American Financial Association to the best financial economist under forty.) I would strongly encourage you to read this book, as I believe it will change your mind if you are one of those who believe the mainstream media and liberal politicians overly simplistic view that “bankers are to blame” for the unprecedented worldwide financial crisis.

Professor Rajan states it best when he says:

“I do not seek to be an apologist for bankers…..But outrage does not drive good policy. Though it was by no means an innocent victim, the financial sector was at the center of a number of fault lines that affected its behavior. Each of the actors…..bankers, politicians, the poor, foreign investors, economists, and central bankers…..did what they thought was right. Indeed, a very real possibility is that key actors like politicians and bankers were guided unintentionally, by voting patterns and market approval respectively, into the behavior that led inexorably toward the crisis. Yet the absence of villains, and the fact that each of these actors failed to bridge the fault lines makes finding solutions more, rather than less, difficult.”

A common but mistaken view that I have often read in the mainstream press and other accounts of the financial crisis is roughly that: “The unsustainable housing price bubble was caused by U.S. banks and independent mortgage lenders lowering credit standards for mortgage loans”. This is neither economically logical nor factually correct. Professor Rajan makes clear (as have other economic experts) that asset price inflation comes first and credit naturally expands as a result. In other words, credit expansion is a byproduct not the initial cause of asset price inflation. Only in the later stages of an asset bubble does credit expansion reinforce this trend and cause asset prices to rise even higher. The point being, it wasn’t the bankers and mortgage lenders who started the housing bubble, it was central bankers, like our Federal Reserve, manipulating market rates too low for too long (for job-creation reasons), world trade imbalances between countries (that caused huge pools of unquestioning investor funds from developing countries seeking highly-rated debt instruments to flow into the U.S. and other developed countries), and government housing policies (most mention CRA requirements and Fannie and Freddie’s role, some mention the mortgage tax-deduction, few mention FHA’s role in setting lending standards for subprime loans and no one mentions that Congress, during the Clinton administration, passed a law to allow owner-occupants to sell their homes every two years and avoid capital gains of $500,000 each time! In hindsight, I believe, this law encouraged consumers to buy and flip owner-occupied homes and that as soon housing prices began to rise, this group of hidden real estate speculators exploded in size) that started the unsustainable housing bubble in the U.S. and many other developed countries. The expansion of private sector mortgage lending and the deterioration in lending standards (just as the fervor to buy homes by many individual Americans) were a symptom of these central bank/government actions and world trade/financial imbalances.

Another common misperception by the mainstream press and public is that this financial crisis was strictly centered in housing and mortgage lending in the United States. Not true. The U.S. mortgage market pre-crisis just happened to be the largest debt market in the world (larger even than the U.S. Treasury market) and homes were the largest asset that individual Americans owned, so it became the key (and almost only) focal point of the crisis; but before and during the crisis (and even today in countries like China and Canada) major bubbles and busts occurred in housing markets around the world, as well as many other types of asset classes (commercial real estate, private equity leveraged-buyouts, publicly-traded equities, bonds, commodities, etc.), and these asset price increases logically led to the deterioration in all types of lending standards and banking crises occurred, as a result, all over the world. The point being, U.S. mortgage lenders were not the only or even the primary cause of the worldwide financial crisis. Their activities were a logical byproduct of central bank/government actions and world trade/financial imbalances. Professor Rajan points this out:

“In addition, the promise (by the Federal Reserve) that liquidity would be plentiful over the foreseeable future meant that bankers were willing to make longer-term illiquid, and hence risky, loans. But with firms unwilling to invest, banks went looking for deals that would create demand for loans. One option was for private equity investors to acquire firms, relying on banks to finance the deals. Banks, in turn, packaged the loans they made……creating collateralized loan obligations (CLOs)….and sold debt securities against them, thus obtaining the funds to make yet more loans. The result was that larger and larger leveraged acquisitions were proposed to satisfy the seemingly insatiable investor hunger for debt claims. As the rush to lend increased, lending standards declined rapidly: the classic signs of the frenzy were ‘covenant-lite’ loans, bereft of the traditional covenants banks put in to trigger repayment if the borrower’s condition deteriorated, and pay-in-kind bonds, schemes by which borrowers who could not pay interest simply issued more bonds. As I argued earlier, the recent crisis was not caused only by lending to the poor!” (related to home lending, Prof. Rajan means primarily CRA through subprime, the GSEs, and FHA, when he says “poor”).

I think it is appropriate to note, that I detected a slight bias in some of Professor Rajan’s statements and conclusions and I believe that bias might emanate from his educational and professional background. He is an academic and professional economist (who I don’t believe has ever worked in the private, “for-profit” financial sector) and those who lead The Federal Reserve Bank are also academic and professional economists. Read Chapter Five “From Bubble to Bubble” for yourself. I give Professor Rajan credit for clearly laying out the facts and describing the Fed’s major policy mistakes, but I believe he fails to condemn them in the same way he does the “amoral” (his word not mine) private, for-profit financial sector, because in his heart and mind he is one of them and could see himself or anyone being under similar pressures and making similar mistakes. Take a look at this excerpt from Chapter 5:

“The danger is that monetary economists will try to wish away links between monetary policy, risk taking, and asset-price bubbles. Bernanke came close to doing so in his 2010 speech to the American Economic Association, where he argued that it was not the Fed’s defective monetary policy….which he considered entirely appropriate, given the Fed’s views on inflation…..but its inadequate supervision that helped trigger the crisis. He concluded: ‘Although the most rapid prices increases occurred when short-term interest rates were at their lowest levels, the magnitude of the house price gains seem too large to be readily explained by the stance of monetary policy alone. Moreover, cross-country evidence shows no significant relationship between monetary policy and the pace of house price increases.’”

“Of course, no one claims that the Fed alone was responsible for the housing debacle. Government policies favoring lowincome housing, as well as private-sector mistakes, contributed significantly. But to suggest that it had no role is disingenuous. Indeed, a detailed study published in the Federal Reserve Bank of St. Louis Review in 2008 presents evidence that ‘monetary policy has significant effects on housing investment and house prices and that easy monetary policy designed to stave off the perceived risks of deflation in 2002-2004 had contributed to a boom in the housing market in 2004 and 2005.’”

I looked it up, disingenuous means “not candid or sincere” and its synonyms are “false” and “devious”. In my opinion, Prof. Rajan, as a professional courtesy, underplays the fact he believes, “Bernanke made a false statement in 2010 when he denied that monetary policy had any role in housing debacle”. Doesn’t that false statement, by a top economic official of the government, cause us to continue to misunderstand the true root causes of the financial crisis (and therefore not take the correct steps to prevent a future one)? It wouldn’t be the first time. Ben Bernanke himself admitted in 2002, during a speech he gave at Milton Friedman’s 90th birthday celebration, that the Federal Reserve’s monetary actions did in fact cause the Great Depression (70 years after the fact and nearly 40 years after Milton and Anna Schwarz blamed the Fed in “A Monetary History of the United States”): “What I take from their work is the idea that monetary forces, particularly if unleashed in a destabilizing direction, can be extremely powerful…..Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna: Regarding the Great Depression. You’re right, we did it. We’re sorry. But thanks to you, we won’t do it again.” Isn’t being “disingenuous” about the Fed’s role in causing the most recent financial crisis, a lot worse than being a member of the “amoral” private, for-profit financial sector? Is it going to take the Fed another 70 years to admit their major role in causing the 2008 financial crisis?

As Prof. Rajan states (about the Fed’s pre-crisis, low-rate monetary policies):

“Low short-term interest rates pushed investors to take more risk, for a number of reasons. Some institutions, like insurance companies and pension funds, had contracted long-term liabilities. At the low interest rates available for safe assets, they had no hope of meeting those liabilities. Rather than falling short for sure, they preferred to move into longer-term riskier bonds, such as mortgage-backed securities, that paid higher interest rates. In addition, as long-term interest rates fell and the value of stocks, bonds, and housing rose, households felt wealthier and may have felt the confidence to take more risks.”

Count me with the conservatives (as Prof. Rajan describes them in his Epilogue); I strongly believe that the Federal Reserve Bank’s (“extremely powerful”, Bernanke’s words) politically-motivated and mistaken pre-crisis monetary policies and the strong, “markets are mostly right and efficient” economic culture they fostered throughout the entire financial system (as a result of Greenspan’s market philosophy and his then “infallible” aura as Chairman, and the Fed’s central financial role and then respected status) squelched any appropriate counter-cyclical banking regulation and are the primarily reasons for the 2008 financial crisis (a close second being government housing policies and world trade/financial imbalances, followed by private investors, bankers and consumers who responded to these economic incentives in what they believed at the time was a rational and appropriate way).

Lastly, I don’t think Prof. Rajan’s arguments about the “amoral” private, for-profit financial sector are quite logical? They don’t ring true to me, because they don’t explain the fact that the government-controlled, not-for-profit, FHA insurance fund made the same economic decisions as the private “for-profit” financial sector before the crisis (they were one of the largest subprime lenders in the Country before the crisis, with billions in zero down payment, subprime credit score, high debt-to-income ratio, and no income or asset documention home loans) and FHA was much slower to react during the crisis (than the private sector) to tighten its lending standards and increase its guarantee fees (only recently, around the time they became insolvent did they make significant changes) and today, they are the only subprime and no income or asset documentation (reverse mortgages) home lender in the nation; taking over major mortgage market share from the collapse of the private subprime mortgage market. It was always my view, and I know IndyMac’s management team, board, shareholders and regulators shared this view, that before this crisis, we felt like we were “doing good”. Sure, we were making a profit, but we were also just as importantly helping people buy homes, lower their mortgage payments, pull cash-out out of their home’s equity to make improvements, send their kids to college, buy a car, pay for unexpected medical bills, or start a business. In other words, we thought and felt strongly pre-crisis that we were “doing good” for our customers and also “doing well” for ourselves and our shareholders. I think FHA probably thinks they were (pre-crisis) and are (post-crisis) “doing good” too, despite their present high level of nonperforming loans, foreclosures, insolvent status, and recent negative press; including an LA Times OpEd by a resident fellow of the American Enterprise Institute entitled: “The FHA: A home wrecker”.

I believe that we (all of us) have allowed a double standard to develop in America, where citizens in the private sector are held to a higher standard of conduct and accountability than citizens in the public sector. And I believe it is getting worse over time (as the government expands) and it is eroding our individual rights and liberties and hurting the private sector’s ability and desire to take risks and innovate (succeeding sometimes, but more often failing and then trying again); the keys to a dynamic and vibrant economy. It is my view that Americans operating in the government sector (especially those in power, but even those who are not), must be held to a higher standard of duty and care than American’s operating in the private sector. Yet clearly today it is the opposite. Nearly all of our civil laws and regulations and the entire civil enforcement apparatus of the government is aligned against the private sector and private individuals. Nothing, other than our mostly disinterested and uninformed electorate, holds the government and its key officials to account for their conduct and mistakes. Why is it that because you seek to make your career in the “for- profit” sector (and help create jobs and taxpayers), some people think it is not possible to “do good” at the same time? And if something does go wrong (in an unprecedented financial crisis, say), it’s even worse. Your conduct and motives are immediately called into question and your reputation is unfairly besmirched. And years of your professional life are taken away being investigated by the government and sued (there are even calls in the press and among certain politicians for criminal prosecutions, without any knowledge of specific wrongdoing). However, if you are a government official and you are mistaken or fail, nothing happens. In fact, you get to have the financial reform bill named after you, you get reappointed as Chairman of The Federal Reserve Board, you get reappointed as Chairman of the FDIC (and retire to a D.C. foundation as a banking expert and write a narcissistic book that essentially says “if these boys had only listened to me”), or you retire as the head of OFHEO (Fannie Mae/Freddie Mac’s regulator’s name before it was changed) to a lucrative career with a private equity firm.

I will leave you with the following from Prof. Rajan:

“In structuring reforms, we have to recognize that the only truly safe financial system is a system that does not take risks, that does not finance innovation or growth, that does not help draw people out of poverty, and that gives consumer little choice. It is a system that reinforces the incremental and thus the status quo. In the long run…..settling for the status quo may be the greatest risk of all, for it will make us unable to adapt to meet the coming challenges. We do not want to return to the bad old days and just make banking boring again: it is easy to forget that under a rigidly regulated system, consumer and firms had little choice. We want innovative, dynamic finance, but without excessive risk and the outrageous behavior.”

Excerpts From Fault Line

More Excerpts From Fault Line

Posted on January 29, 2013, in Postings. Bookmark the permalink. Leave a comment.

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