Which Way Is Wise?

If there is one phrase to describe the events in the subprime
meltdown, it is “collective stupidity.” Looking back on the poor
underwriting standards for mortgages, the inflated ratings for loans
that were packaged together and the unknowns about the new financial
instruments that big institutions eagerly gobbled up, it boggles the
mind that so many could have rushed in asking so few questions.

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