Saturday, February 07, 2009

Pace Andrew Sullivan

One of uniform features of blogs by conservatives is that comments are not allowed. You have to write to the author, and you never know whether they've read it, or simply discarded it into the bit bucket. Andrew Sullivan, at the Atlantic, often admired by leftie types, is no exception. His quote of Will Wilkinson, Cato Institute flack, therefore led to this response:

Will Wilkinson:

Government-subsidized borrowing gave us the housing bubble, precipitated financial Armageddon, helped prompt recession and mass unemployment. But, as the infomercials say, that's not all! By zealously pushing home-ownership, federal housing policy has pinned to the map many now-jobless Americans who otherwise would have moved to find new work.

I'm reading James Grant's book "Mr Market Miscalculates : The Bubble Years and Beyond". Grant is the editor of Grant's Interest Rate Observer. (

The book consists of essays written from 1999 to May 2008. Many essays touch on the residential mortgage and derived markets.

Grant writes about the "too-big-to-fail" syndrome, which he believes led investors to take greater risks than they would have otherwise, and the low interest rates promoted by the Federal Reserve; but nowhere does he write about government-subsidized lending as having contributed to this mess. (Where he stands philosophically - e.g., he writes that Glass-Steagal 1933 was misguided, and was happy at its demise).

Here is a quote from June 15, 2007, commenting on a speech by Kevin Warsh, a Federal Reserve Governor:

"Reading between Warsh's lines, it's apparent that the Federal Reserve carries a torch for the Efficient Markets Hypothesis. Are investors invariably cool and calculating? Are markets frictionless? Is information universally disseminated to all the lucid participants? Do they act on it? If you answer "yes" to these questions, you, too, may find the board of Governors of the Federal Reserve System a collegial place to work.

I will meet Warsh halfway. I will concede that markets are just as efficient as the people who operate in them. How efficient is that? Let us turn to mortgage finance to find out. Here is a living laboratory in complexity gone wrong. During the long upswing, lenders were happy to credit a highly counterintuitive proposition. They accepted that a clump of low-rated mortgages could be transformed into a highly rated security. Only very smart people could dream up such a wonderful idea. And only educated people could accept it (they are taught to respect great minds, no matter what cockamamie conclusion those minds arrive at). What was the source of this alchemy? The reordering of cash flows to assure continuous payments to the holders of the senior claims. Risk of nonpayment, such as it was, was borne by the holders of the mezzanine and equity tranches. They bore it willingly. The ratings agencies lent their imprimatur to the assumptions and calculations on which the projections were based.

Investors bought with confidence. It reassured them to know that the ratings agencies deployed default probability generator models featuring a Monte Carlo multi-step default probability apparatus -- whatever that was. Besides, the mortgage scientists and ratings agency quants believed that diversification was their shield and armor. A given residential mortgage-backed security would contain mortgages from every region of the country. The diversity of collateral delivered low correlation in credit performance; they could hardly all default at once. As for house prices, the mortgage scientists observed that they almost invariably went up. And all agreed that home ownership was an unalloyed social benefit.

And if the lenders, borrowers, ratings agency analysts, investment bankers, appraisers, etc., hadn't been human, the story might have a happy ending. But it won't, because people in markets neglected to judge the effects of their actions on others. Uniquely uninhibited underwriting practices pushed up house prices and thereby coaxed more borrowers to employ greater leverage. Not wanting to be left behind, lenders completed with one another to offer the easiest terms. Loans tumbled out of the origination mills into the securitization factories, emerging as ABS or CDOs, investment-grade for the most part and thereby suitable for widows, orphans and foreign central banks. Thankfully, too, there were hedge funds and proprietary trading desks to absorb the residual credit risk of the lower-rated tranches. Warsh paid tribute to these social benefactors in his talk the other day: "By serving as willing counterparties in a variety of contracts, these institutions, in my view, are serving as a critical linchpin in the development of more complete markets."

Interjection - where is the government subsidized-lending in the cycle described here? This is entirely a creation of the private sector.
A little later, Grant states:

"My bet is that, come the next bear market in credit, correlations will prove to be shockingly high across the full spectrum of debt instruments. It will turn out that everything ws correlated to credit itself -- to the ability to borrow on terms over which posterity will shake its head, muttering, "What were they thinking?"

I know you're a conservative, and thus by habit must blame the government. But you also strive to see what's under your nose, and surely that trumps your ideology.

Grant has an essay from Nov 4, 2005, "In Kansas We Busted" which describes what happened in the Great Plains segment of the real estate market of 1886. "...the lesson of the Great Plains levitation is that, in order to create a really big asset-price bubble, a central bank is neither necessary nor sufficient. A critical mass of human beings is all that's required".

PS: A consistent theme in Grant's writing is that investors see what they want to see, which is not necessarily consistent with reality. The nature of large masses of people is, on occasion, to create bubbles. In this case, the housing bubble was contributed to by "lenders, borrowers, ratings agency analysts, investment bankers, appraisers, etc." and the effects of their actions on each other. It had nothing to do with government-subsidized lending.