ON THE INGREDIENTS OF A BUBBLE

POINTING FINGERS

Watching the Vice-Presidential debate between Senator Biden and Governor Palin last night, I was hoping against hope that when the inevitable question of blame came up for the current financial crisis, one or both candidates would say something like "we all have played a part in this crisis, and that there's plenty of blame to go around."*

Of course, that was naive, and politicians being politicians, in the midst of a bitterly-fought election, here's what they actually said from the transcript, courtesy of CNN.  Here's how the moderator, Gwen Ifill posed the question:

"Who do you think was at fault? I start with you, Gov. Palin. Was it the greedy lenders? Was it the risky home-buyers who shouldn't have been buying a home in the first place? And what should you be doing about it?"

To which Governor Palin replied:

"PALIN: Darn right it was the predator lenders, who tried to talk Americans into thinking that it was smart to buy a $300,000 house if we could only afford a $100,000 house. There was deception there, and there was greed and there is corruption on Wall Street. And we need to stop that.

Again, John McCain and I, that commitment that we have made, and we're going to follow through on that, getting rid of that corruption."

Senator Biden gave the following answer:

"BIDEN: Well Gwen, two years ago Barack Obama warned about the sub prime mortgage crisis. John McCain said shortly after that in December he was surprised there was a sub prime mortgage problem. John McCain while Barack Obama was warning about what we had to do was literally giving an interview to The Wall Street Journal saying that I'm always for cutting regulations.

We let Wall Street run wild. John McCain and he's a good man, but John McCain thought the answer is that tried and true Republican response, deregulate, deregulate."

Neither candidate apportioned any part of the blame to consumers or government at every level, the two parties who eagerly participated in every stage of the sub-prime boom and bust.

Luckily, the Wall Street Journal sets the record straight in an article today, titled "How Government stoked the mania".  Here're the choice bits:

"Many believe that wild greed and market failure led us into this sorry mess. According to that narrative, investors in search of higher yields bought novel securities that bundled loans made to high-risk borrowers. Banks issued these loans because they could sell them to hungry investors.

It was a giant Ponzi scheme that only worked as long as housing prices were on the rise. But housing prices were the result of a speculative mania. Once the bubble burst, too many borrowers had negative equity, and the system collapsed.

"What's missing is the role politicians and policy makers played in creating artificially high housing prices, and artificially reducing the danger of extremely risky assets.

Beginning in 1992, Congress pushed Fannie Mae and Freddie Mac to increase their purchases of mortgages going to low and moderate income borrowers. For 1996, the Department of Housing and Urban Development (HUD) gave Fannie and Freddie an explicit target -- 42% of their mortgage financing had to go to borrowers with income below the median in their area. The target increased to 50% in 2000 and 52% in 2005.

For 1996, HUD required that 12% of all mortgage purchases by Fannie and Freddie be "special affordable" loans, typically to borrowers with income less than 60% of their area's median income. That number was increased to 20% in 2000 and 22% in 2005. The 2008 goal was to be 28%. Between 2000 and 2005, Fannie and Freddie met those goals every year, funding hundreds of billions of dollars worth of loans, many of them subprime and adjustable-rate loans, and made to borrowers who bought houses with less than 10% down."

Forget for a moment that these actions happened under the watch of both Democratic and Republican Presidents, and Congress that was at different points controlled by either party.  All politicians regardless of party, sought this free political lunch, as the WSJ piece makes clear:

"Congress designed Fannie and Freddie to serve both their investors and the political class. Demanding that Fannie and Freddie do more to increase home ownership among poor people allowed Congress and the White House to subsidize low-income housing outside of the budget, at least in the short run. It was a political free lunch."

The piece goes on to provide a lot more detail on the role that government played in all this, and is very much worth reading.

The purpose here is not to lay this at the doorstep of the government, but to highlight that a bubble typically has all constituents participating in earnest to make it a bubble.  And we owe it to ourselves to recognize that basic fact in any post-mortem analysis for lessons learned.

* Image source.

Comments

[Alex Tolley]

Let me fdisagree with teh WSJ. Firstly, there is ample evidence that Fannie and Freddie were not to blame. The WSJ has consistently wanted to remove these agencies from government and privatize them.

As to who was to blame?
Firstly the Greenspan Fed with its policy of very low interest rates and refusal to prick asset bubbles.
Secondly there was lots of predatory lending, so that is also a factor.
Thirdly, let's not forget all those realtors who wanted to get in on the game, egging on consumers to buy houses and driving up prices.
Finally, yes, the stupidity of the people to buy houses at ridiculous prices. However, I blame them least because when prices are rising steeply, there is a fear that they will be forever priced out of a market, especially as landlords keep raising rents in the the face of stagnant wages.

So far no-one has pointed the blame at realtors, no doubt the very same 'soccer moms' that Palin glorifies.

But let's be very clear here. The game was very much perpetrated by those who took transaction fees - realtors, retail banks, loan packagers, wall street banks. All of them stood to make money doing transactions, none of them were putting their own assets at risk in the bubble conditions. Thus they had every incentive to egg on the punters.

Obviously the country (the world?) will shake it's collective head in disbelief at it's own gullibility, but let's not try to deflect the blame from the primary movers.