The Cause of the Financial Crisis (dart)

[_TAK]

Low interest rates causing inflation is basic.

And yet we have maintained until recently..low inflation and relatively low interest rates. I am not arguing that Monetary Policy does not require interest rate flux, but minimally - which is back to my point I do not see low interest rates over the last 15 years as a leading factor in this crisis.



by the way,
Paul Samuelson is Keynesian , I do not believe he espouses a Monetary Policy which we have been on for the last 20 years and last advised Jimmy Carter.. (possibly Clinton to some small extent..)

[_Analytics]

Low interest rates causing inflation is basic.

And yet we have maintained until recently..low inflation and relatively low interest rates. I am not arguing that Monetary Policy does not require interest rate flux, but minimally - which is back to my point I do not see low interest rates over the last 15 years as a leading factor in this crisis.

Of course you are entitled to your opinion, but I’ll just make three quick points.

1- I'd suggest that it is pretty clear that low interest rates have in fact contributed to the inflation in housing prices, and that housing inflation is a fundamental part of what is going on.

2- For every borrower there needs to be a saver. The interest rate needs to be at a level that is fair to the borrower and to the saver. If the federal government manipulates interest rates so that the savers can’t get a half-decent return on a simple bond, then if they don’t simply spend rather than save (leading to inflation), they’ll look for creative ways to get a higher yield, contributing to the current mess.

3- With the trade deficit, budget deficit, and “giant sucking noise” of high-paying jobs going to Asia, it’s hard to argue that the U.S. economy has recently been in a state of equilibrium. I suspect that the reason low interest rates haven’t caused more inflation has to do with other factors temporarily offsetting it; I would wager that the eventual correction will still come home to roost.

by the way,
Paul Samuelson is Keynesian , I do not believe he espouses a Monetary Policy which we have been on for the last 20 years and last advised Jimmy Carter.. (possibly Clinton to some small extent..)

True enough. I was looking for a Paul Samuelson quote because you asked where who knows took Econ 101. Hopefully the fact that the Samuelson citation provides a concise Greenspan quote will convince you that the point is valid outside of a models with Keynesian biases.

[_Analytics]

Of course not. But would i like to live in an economy where 0% rates are the norm? Hell no.

Well good news you never will .. that's why your counter argument fails.

You missed his point. This was in response to you saying, "If you think a 10% mortgage is better for the economy than a 5% (which was rare except for a teaser rate..) then by that logic a 15% rate would be better."

That was an idiotic argument that also fails.

[_TAK]

That was an idiotic argument that also fails.

So why is the ecomomy better off with a 10% mortgages as opposed to say my 5 7/8s?

[_Analytics]

That was an idiotic argument that also fails.

So why is the ecomomy better off with a 10% mortgages as opposed to say my 5 7/8s?

Because rates that are too low encourage borrowing, discourage savings and cause inflation. Just because I believe that interest rates can be too low in no way implies that I think when it comes to interest rates, the higher the better!

[_Who Knows]

That was an idiotic argument that also fails.

So why is the ecomomy better off with a 10% mortgages as opposed to say my 5 7/8s?

It's all a big balancing act - trying to find the 'happy medium'. Rates should be at a level that allows controlled, sustainable growth, while avoiding recessions and hyperinflation.

[_antishock8]

http://www.cnn.com/2008/POLITICS/09/29/ ... pstoryview

The current mess would never have occurred in the absence of ill-conceived federal policies. The federal government chartered Fannie Mae in 1938 and Freddie Mac in 1970; these two mortgage lending institutions are at the center of the crisis. The government implicitly promised these institutions that it would make good on their debts, so Fannie and Freddie took on huge amounts of excessive risk.

Worse, beginning in 1977 and even more in the 1990s and the early part of this century, Congress pushed mortgage lenders and Fannie/Freddie to expand subprime lending. The industry was happy to oblige, given the implicit promise of federal backing, and subprime lending soared.

[Anonymous]

Analytics,

I think you made some fair points. I wish you would get a little more pointed regarding who created the policy that forced or induced institutions into lending to unqualified buyers. I also would like you to lay out a timeline of warnings by various institutional voices, such as the Federal Reserve Chairman, who did what, and who blatatanly ignored or killed any bills brought to Congress and why.

I think that would give a clearer picture to the framework you've provided.

-AS8

Here is the timeline as I see it. I'm not aware of anybody warning that escalating home prices and investment banks and their "private label" CMOs were going to bring down the economy. If you know of any, I'd like to hear about it.

Timeline
1970: GNMA (Ginnie Mae) issues world’s first pass-through security.

1971: Freddie Mac begins issuing pass-throughs. The ownership of mortgages begins to seriously shift from savings institutions to the owners of pass-through securities, thus helping savings institutions become safer by making them better able to match the duration of their assets and liabilities.

1981: Fannie Mae begins issuing pass-throughs.

1983: Freddie Mac issues first collateralized-mortgage obligation (CMO). The CMOs are designed to rearrange the cashflows from the underlying pass-throughs to get new duration and pre-payment risk patterns and thus expand the amount of capital available in the mortgage market. The market for CMOs grows rapidly in size and complexity.

[Up to this point, things are going rosy. Fannie Mae and Freddie Mac had strict underwriting requirements—people needed to have good credit, a big down payment (or otherwise a good LTV ratio), and a good payment-to-income ratio. Further, Fannie and Freddie only accepted relatively modest-sized mortgages]

1990: Non-agency mortgage companies and investment banks that have absolutely nothing to do with Fannie Mae and Freddie Mac begin issuing “whole-loan” or “private label” or non-agency CMOs. These CMOs are based upon “non-conforming” mortgages, meaning mortgages that don’t meet the size and underwriting requirements that Fannie Mae and Freddie Mac require, and thus can’t be purchased by them.

Entirely private companies known “rating agencies” (e.g. Moody’s, Standard & Poor’s) begin giving credit ratings to the nonagency CMOs. The issuers of the non-agency CMOs devise “credit enhancements” so that securities based on non-conforming mortgages get AAA ratings. The credit enhancements include things like over-collateralization, tranches with different payment priorities, and credit insurance. The rating agencies give the top tranches their highest ratings (e.g. AAA, Aaa). This is purely their personal opinion of the risk.

1999: The non-agency CMOs steadily grow to $280 billion in outstanding debt.

1999: Under pressure from the Clinton administration, Fannie Mae slightly relaxes the credit requirements for the loans it underwrites. This expands the number of people who qualify for Fannie Mae mortgages. However, the nonagency CMOs market share continues to increase, and the sub-prime piece of Fannie’s book remains a tiny fraction of their book.

2001: 9/11 attacks. Economy goes into recession.

2002: Interest rates drop. House prices go way up. 30-year fixed-rate mortgages under 6.25%, 15-year fixed under 5.5%, ARMs under 4.25%. Everybody refinances their mortgages and take out second mortgages on new equity.

2002: Fannie and Freddie’s market share peeks at 40% of loans outstanding.

2002: Issuers of non agency CMOs get very aggressive with their securities. They offer Alt-A mortgages to people with good credit who can’t verify their income. Sup-prime mortgages to people with poor credit. Mortgages for 125% of the property’s value. Interest-only mortgages. Adjustable rate mortgages. Negative amortization mortgages. Mortgage brokers make a ton of money off of the re-financing boom, and they advertise heavily. Nobody is forcing them to do this, because they immediately make money from closing the deal, and the risk goes straight from the mortgage brokers to the investment bankers to the holders of the CMOs. With low interest rates and increasing home prices, people realize that the way to make money is to borrow as much as possible against their homes. People move into nicer homes or take out home improvement loans. This desire to be long on the housing market drives up the home prices.

2004: New issues of nonagency CMOs is greater than the mortgage-backed securities of Fannie Mae, Freddie Mac, and Ginnie Mae combined. About 75% of the mortgages supporting these nonagency CMOs are ARMs.. There is a tectonic shift in the market away from the GSEs. In order to remain players, the GSEs purchase credit-enhanced, AAA-rated non-agency CMOs for their portfolios.

2005-2006: Issuers of non-agency CMOs continue to gain bigger and bigger shares of the market. House prices continue to go up and people continue to refinance, purchase bigger homes, max out second mortgages, and do whatever it takes to remain as leveraged as possible in the housing market to take advantage of increasing house prices and low interest rates.

2007: Because of their immersion in the highly profitable non-agency CMO business, from September of 1999 to February of 2007 share price of Lehman Brothers increases 1000%. Share price of Fannie Mae stays flat over the same time period.

2007: House prices stop going up. People default on their mortgages. This severely hurts the nonagency CMOs, and the nonagency CMO market dried up.

2007: Moody’s and S&P begin downgrading the nonagency CMOs. AIG begins to get strained on the credit enhancements it sold.

2008: Armageddon.

[_Who Knows]

Great summary Analytics! Well done.

[_Trevor]

Great summary Analytics! Well done.

Clearly, Obama's pals were up to no good. ;-)