Of course, it’s always easier to be stupid if others are acting that way, too. That’s what Scottish essayist Charles Mackay long ago called “the mad-ness of crowds.” Individuals, Mackay wrote in 1841, “go mad in herds, while they only recover their senses slowly, and one by one.” That assessment could well describe modern bubbles, including the most recent one in real estate, whose pop we are now experiencing.
But crowds are not always mad. Collectively, we decide the rational price for everything from food to shares of stock. And in the long term after all variables are taken in, the prices are rational. That’s why another student of crowds, pioneer value investor Benjamin Graham, describes the stock market as a “voting machine” in the short run but a “weighing machine” in the long run. More recently, journalist James Surowiecki in his book The Wisdom of Crowds, written partly as a rejoinder to Mackay, notes how large groups have accurately guessed everything from the weight of an ox to the outcome of close elections.
Whether crowds are mad or wise depends on whether diverse voices are included and effective feedback mechanisms exist for those voices to be heard
This is where public policy comes in. The government can distort a crowd’s voice by providing incentives for one type of behavior and disincentives for another. Economist Brian Wesbury has said that nearly all bubbles—periods with wildly inflated prices followed by great falls—have “policy mistakes” as an underlying cause.
POLICY BLUNDERS
The main policy mistake we hear about in this case is the supposed lax regulation. The financial institutions making bad loans and buying and selling bad mortgage securities were doing so as a result of unfettered markets, so the argument goes. But active individual investors who follow the market regularly know this is far from the whole story.
The past few years have hardly been an era of deregulation with the advent of the Sarbanes-Oxley accounting mandates. As I have written previously in SFO (“The Downside of Sarbox: Bad News for Stock Investors,” April 2007), this law rushed through Congress in 2002 in response to the Enron and WorldCom scandals, cost billions of dollars in compliance and contained “many mandates that unduly restrict legitimate entrepreneurs … making it more difficult” for smaller firms “to raise money in America’s public capital markets.” This in turn, I wrote, “rob[bed] investors of their rights to place their money in stocks that carry risk but also have potential for great returns.”
And it turned out, while Sarbox mandates were requiring much documentation of matters of trivial importance to shareholders—in some cases auditors were looking at matters such as office keys and employees’ computer passwords—real business risks were being overlooked. A recent Financial Times article notes that as a result of Sarbox, boards such as that of the failed Bear Stearns were more concerned with compliance risks and liability than on the soundness of their overall business strategies. This is a typical effect of regulations that lack focus and are counterproductive, and is what we want to avoid for regulation in response to this crisis.
Moreover, many types of government intervention actually contributed to this very problem. For decades, the government has promulgated subsidies and regulations tilting financial markets to favor housing over other sectors. And regulations distorted information about risk through protecting a credit rating agency duopoly and imposing pro-cyclical mark-to-market accounting rules that exaggerated both the gains and losses in asset prices during booms and busts.
Some type of new regulatory framework is inevitable, but if we are to avoid a Sarbanes-Oxley type overkill—this time likely in the area of futures and options as well as stocks, and one that again would probably limit the ability of active individual investors to chart their financial futures as they see fit—we need to have a thorough understanding of the existing policy factors that led to this crisis. Three stand out.
1. PROMOTING HOME-OWNERSHIP
Both Republicans and Democrats treated home-ownership as sacrosanct, and wrote laws and policies accordingly. Through the decades but accelerating in the past few years, they aggressively created subsides and mandates that added greatly to the bubble.
We can start with the Federal Housing Administration, created during the New Deal to insure mortgages for lower- and middle-income borrowers. Under the FHA, banks make mortgages to borrowers for homes under a certain value, borrowers pay insurance premiums and the government picks up the tab if the borrower defaults. When it was created in 1934, the FHA required a down payment of 20 percent to help ensure that borrowers were responsible, even if they did not have perfect credit histories.
But by the 1990s, the required down payment was whittled to just 3 percent of a home’s value. And in the late ’90s, Andrew Cuomo, the Clinton Administration’s then-Secretary of Housing and Urban Development, which oversees the FHA, pushed through a loophole that made the down payment for many FHA borrowers effectively zero. Under this policy, home sellers could set up foundations to provide borrowers with down payment assistance. The FHA did not count assistance from these foundations as a seller inducement—as many non-FHA lenders do—so seller-funded charities would contribute virtually unlimited amounts to borrowers to cover down payments, closing costs and even FHA borrower insurance premiums.
By 2005, Congress’ Government Accountability Office found that FHA borrowers who received assistance from a seller-funded nonprofit were more than twice as likely to default compared to the agency’s borrowers who received no down-payment assistance. In 2006, delinquency rates on
FHA loans had risen to new records and were higher in some quarters than even subprime delinquencies. But the FHA in the supposedly conservative Bush administration continued the down payment program and even moved aggressively to compete with subprime lenders. In 2005, then-HUD Secretary Alphonso Jackson told the Washington Post, “I am absolutely emphatic about winning back our share of the market.” Thus, the race to the bottom began.
The Community Reinvestment Act was also an instance where good motivations led public policy astray. Enacted in 1977, the law mandates that banks make loans to the entire community it serves, including borrowers of low and moderate incomes. In the mid ’90s, the government began aggressively reviewing a bank’s CRA compliance as a condition of approving mergers or interstate branching. Although it’s true, as the CRA’s supporters argue, that the law did not specifically require banks to make a specific type of bad loan, the hard numerical quotas or goals of lending to low-income borrowers inevitably meant making loans to borrowers with less ability to repay than many banks would have otherwise chosen to do.
Moreover, some bank regulators actually warned that traditional lending standards could be ruled discriminatory. In the early ’90s, the Federal Reserve Bank of Boston wrote a manual for mortgage lenders stating, “Discrimination may be observed when a lender’s underwriting policies contain arbitrary or outdated criteria that effectively disqualify many urban or lower-income minority applicants.” As Stan Liebowitz, a professor of economics at the University of Texas-Dallas Business School, noted recently in the New York Post, “Some of these ‘outdated’ criteria included the size of the mortgage payment relative to income, credit history, savings history and income verification.” In other words, the Boston Fed was discouraging the very criteria that could have prevented many of the bad loans that caused the subprime meltdown.
Then there are the mortgage giants Fannie Mae and Freddie Mac, which had the peculiar designation as government-sponsored enterprises. Although owned by private shareholders since Fannie’s reorganization and Freddie’s creation approximately 40 years ago, they were chartered by Congress and maintained special privileges from the government. They were exempt from state and local taxes and, unlike every other public company, they were exempt from SEC regulation. Also, they each had a $2 billion line of credit with the United States Treasury Department.
Critics, including my boss Competitive Enterprise Institute President Fred Smith, had long warned that this hybrid structure—with “privatization of profits” and “socialization of losses” through implied government guarantees—held dangers. In 2000, Smith testified to the House Financial Service Committee that “no one is quite sure how these entities should be evaluated or held accountable.” On the line of credit with the government, he argued that “as long as the pipeline is there, it is like it is very expandable” and added that “it is only $2 billion today. It could be $200 billion tomorrow.” Eight years later, it turns out he may have underestimated the amount Fannie and Freddie may cost taxpayers after the government took them over.
During the past 15 years, Fannie’s and Freddie’s portfolios were allowed to grow to approximately $6 trillion in mortgages that they bought or securitized. Through their tremendous market power,
Fannie and Freddie became ready buyers for mortgages that may not have been issued in the absence of their existence. By the end of 2007, they had guaranteed or invested in $717 billion of subprime or near-subprime Alt-A mortgages, according to the New York Times. But even aside from that, they had lowered the standards for a prime mortgage. A 2004 article in the Fannie Mae publication “Housing Matters” notes, “Lenders now classify some mortgage products that were traditionally B or C as A- because Fannie Mae and Freddie Mac are willing to purchase these mortgages.”
2. CREDIT RATING DUOPOLY
In the movie “Tommy Boy,” the auto parts salesman played by the late comedian Chris Farley tries to convince a skeptical customer to buy his brake pads, even though a rival product has a guarantee on the box. As Farley explains, “The way I see it, Guy puts a fancy guarantee on a box ‘cause he wants you to feel all warm and toasty inside.” But in the end, as Farley puts it, there is no “guarantee fairy” that can ensure that the product the customer bought is not a “guaranteed piece of … ”
During the past year, many banks have woken up to the fact that there is no “guarantee fairy” for financial products either. An “AAA” rating is no substitute for an investor’s own due diligence. The deeper problem, though, is that the ratings of Standard & Poor’s and Moody’s are enshrined in regulations for the capital requirements of banks, broker-dealers and pension funds. These institutions frequently can only buy securities of a certain rating to comply with capital rules. And until very recently, the SEC had only designated S&P and Moody’s as “nationally recognized statistical rating organizations.” So rather than existing as one of many tools to evaluate the creditworthiness of a security, credit ratings today—because they are embedded in regulatory capital requirements—serve as a barrier to independent financial judgment.
Fortunately, Congress did take a step with the Credit Rating Agency Reform Act of 2006 toward more competition among and less forced reliance on the rating firms. But the SEC has just now begun to implement this law. So although it came too late to stem the subprime security crisis, it will likely be a valuable tool in preventing financial blowups in the future.
3. MARK TO MARKET OR MARK TO PANIC
Despite the existence of foolish lending practices and perverse policy incentive, by itself the sheer number of mortgage delinquencies and foreclosures does not justify a crisis of this magnitude. In the Mortgage Bankers Association’s latest National Delinquency Survey, the mortgage delinquency rate is just 6.4 percent—historically high, but not anywhere close to the mortgage default rate of more than 40 percent in the depths of the Great Depression.
Among the crucial factors that helped make this crisis a world financial “contagion” were new accounting rules going into effect in the U.S. and Europe just as foreclosures were spiking and real estate values were dropping.
In the past few years, the mark-to-market method became part of the official U.S. Generally Accepted Accounting Principles (GAAP), and began to be required by the Securities and Exchange Commission, bank regulatory agencies, credit rating agencies and in the Basel II international framework for measuring bank solvency. In a classic example of fighting the last war, this accounting change came after the collapse of U.S. savings and loans in the 1980s and the Japanese banking crisis of the ’90s.
Accounting standards bodies argued that traditional or “historical cost” accounting, in which loans are booked at cost and not marked up or down unless they are sold or in default, allowed financial institutions to “hide” bad assets on their books. And the solution they proposed was to book financial instruments based on the value they would trade at if they had to be sold today.
But economists are now recognizing that this type of accounting has a significant “feedback effect.” It is pro-cyclical and can inflate gains or losses during a boom or bust. In the case of Enron, as readers may remember, it allowed the firm to mark up its books during a booming energy market even though no cash was coming in for the energy derivatives. In the case of the real estate bust, in a type of reverse Enron, it is forcing banks to take billions in “unrealized” losses—even if the loans on their books are still performing and they have no plans to sell them—if another bank sells similar loans at firesale prices. But these paper losses nonetheless affect a bank’s capital as measured by regulatory agencies such as the Federal Deposit Insurance Corporation.
As a result, mark-to-market accounting has a cascading effect in which banks rush to sell loans and drive down values even further. This leads to even less of a market in which to measure a “market price.”
As Yale economist and finance professor Gary Gorton wrote in a paper presented this summer at the Federal Reserve Bank’s annual Jackson Hole Symposium, “With no liquidity and no market prices, the accounting practice of ‘marking-to-market’ became highly problematic and resulted in massive write-downs based on fire-sale prices and estimates.” So “partly as a result of GAAP capital declines, banks are selling … billions of dollars of assets—to ‘clean up their balance sheets,’” Gorton notes, creating a “downward spiral of prices, marking down—selling—marking down again.”
SOLUTIONS
There are many constructive solutions being discussed. Among them, the creation of new trading exchanges for instruments such as credit default swaps, in which more liquid market prices can provide more transparency. One move that also should be considered, given the problems in the debt market, is easing rules that discourage use of the equity market for growing businesses, such as Sarbanes-Oxley. But before we move forward, we must know why we have been where we have been and how public policy with the best of motivations contributed to this systemic risk.
John Berlau is director of the Center for Entrepreneurship at the Competitive Enterprise Institute in Washington, D.C., and blogs at OpenMarket.org. Fred Smith, president and founder of CEI, contributed to this article.
Author(s) of the Piece: John Berlau
Date of Publication: December 2008
Original text can be viewed here: http://www.sfomag.com/article.aspx?ID=1267&issueID=c
