Fannie Mae and the Housing Crisis: Two Links

In connection with the previous post, the New York Review of Books published an interesting review of Reckless Endangerment by Gretchen Morgenson and Joshua Rosner. The book puts much of the blame for the financial crisis on Fannie Mae. Among other criticisms, the review, by Jeff Madrick and Frank Partnoy addresses the data used by Wallison and Pinto, on which the authors of Reckless Endangerment apparently relied.

My review of Reckless Endangerment can be found here.

Unconvincing Analyses of the Causes of the Financial Crisis: Frontline and AEI

This past week I have encountered two unconvincing analyses about the causes of the U.S. housing crash and the financial crisis of 2008.  One is the contained in the first part of the PBS Frontline documentary, Money, Power and Wall Street, and the other is an American Enterprise Institute (“AEI”) paper by Peter Wallison and Edward Pinto, “Free Fall: How Government Policies Brought Down the Housing Market.”

The Frontline documentary appears to argue that it was derivatives and their lack of regulation which caused the crisis.  The documentary’s argument is a little bit confused, since it jumps from edited interview to edited interview, some of which appear to be placed somewhat out of context.  Also, the documentary does not take note of the regulatory differences between credit default swaps (“CDS”), and securities backed by actual mortgage loans or synthetic collateralized debt obligations (“CDOs”), whose payment streams included flows from CDS.  

A bigger flaw than confusion over what is an “unregulated” derivative as opposed to a security is the documentary’s lack of analysis as to what caused the housing bubble, at least in the first two parts that have aired (the last two parts air tomorrow).  It does not make a convincing case that it was all due to derivatives or securitization.

As far as regulation is concerned, the problem was not solely, or even primarily, that CDS were unregulated instruments; after all, the major players were subject to regulation.  There was a failure by the regulators to use their existing authority; the documentary could have usefully explored why that was.  Also, it could have explored the role of monetary policy, the activities of mortgage brokers and lenders, the flawed ratings of the less, but plenty, risky tranches of CDOs, and the desire of many homeowners to borrow against the appreciated value of their homes in order to finance their desired consumption.  Beyond that, the documentary could have addressed the housing bubble in European countries and the reasons for the buildup of exposures of many banks to AIG in connection with CDS.  Even more ambitiously, the documentary could have compared the U.S. banking system and mortgage practices with those of Canada, whose major banks fared better during the financial crisis than U.S. banks.

In other words, what Wall Street did with CDS and securities backed by mortgages, along with some of the unseemly practices that have been documented with respect to synthetic CDOs, were part of what fueled the financial crisis, but they are not the whole story.  If one’s analysis is limited to what Frontline has presented so far about the crisis, then one may be led to expect that more stringent regulation on OTC derivatives is all that is needed to prevent another crisis from occurring.

The AEI paper, on the other hand, ignores derivatives and CDOs and firmly puts the blame for the housing boom and bust on government policy.  In particular, Wallison and Pinto’s culprits are Fannie Mae and Freddie Mac, government mandated affordable housing goals, and the 30-year mortgage and the tax deductibility of mortgage interest payments.  The data that Wallison and Pinto use to attempt to demonstrate that Fannie Mae and Freddie Mac’s participation in risky mortgages have been subject to serious criticism.  Also, many dispute that government mandates, such as the Community Reinvestment Act, had much to do with the financial crisis.  As far as 30-year mortgages are concerned, those have been around in the U.S. for a long time without causing the housing boom of the magnitude we saw in the last decade. 

Fannie Mae and Freddie Mac did play a role in the financial crisis, but Wallison and Pinto are not convincing that they are the main culprits.  Again, how can you ignore monetary policy, the lack of regulatory action in the face of an obvious real estate bubble and lowering of credit standards, and the frenzied activity of Wall Street firms in mortgage related products?  This is not to say that government subsidies to the housing sector are not something that should be looked at.  Indeed they should, but the political difficulty of reducing the credit and tax preferences to housing are politically difficult to change.  For example, the deductibility of interest on home mortgages was something that the Tax Reform Act of 1986 did not change while it eliminated the deductibility of interest for consumer and student loans.  Everyone knew that this would create an incentive for individuals to take out loans backed by their primary residence.

As with much of what has been written about the financial crisis, these two recent analyses take a myopic view of what happened.  In truth, the financial crisis was over determined; it is easy to point to various failures as the cause.  There will be debate about the root causes, and the definitive analysis accepted by most people will be elusive.  But it is disheartening to see two flawed analyses, which many people will take seriously, even if some of the issues raised are legitimate.      

Oil Prices and Politics

Republicans have tried to place the blame for high gasoline prices on the Obama Administration.  There should be more drilling, they say, the Keystone Pipeline should be approved, and the Arctic National Wildlife Refuge should be opened up to the oil companies.  Never mind that none of this would impact the oil market in the short run and that the long run effects for the global market are either modest or nil.

Feeling the heat, the Administration responded with an initiative of its own.  If oil prices are too high, maybe the markets are being manipulated.  The New York Times reported on the President’s remarks on April 17 as follows:  “With his re-election prospects influenced by the price of gasoline, President Obama on Tuesday demanded more ‘cops on the beat’ to crack down on oil market manipulation, calling on Congress to bolster federal supervision of oil markets and to increase penalties for subverting markets.”

While there can be manipulation of particular futures pricing, no one that the Administration could charge with illegal activity can manipulate the global price of oil.  For example, Saudi Arabia can obviously affect the price of oil by its decisions on how much to produce, but charging them with a violation of the Commodity Exchange Act is inconceivable.  (All signs are that Saudi Arabia is trying to be helpful as international economic sanctions on Iran limit the supply of oil entering into the global market from that country.)  

In fact, the Administration gives away that it has no evidence that high gasoline prices are being caused by manipulation.  Both the President’s prepared remarks on this subject and the accompanying fact sheet are carefully worded.  In his prepared remarks, the President says that “none of these steps by themselves will bring gas prices down overnight.  But it will prevent market manipulation and make sure we're looking out for American consumers.”  The fact sheet is also cautious: “At a time when instability in the Middle East is contributing to rising global oil prices that impact consumers at the pump, it is critically important to give American families confidence that illegal manipulation, fraud and market rigging are not contributing to gas price increases.”

In other words, the Administration knows that more policing of the oil market, especially the oil futures and OTC derivative markets, is not going to bring down the price of oil.  The phrasing of the two White House documents is deliberate and most likely the result of negotiations among Administration officials knowledgeable about the oil market and those focused on politics.  The Administration obviously does not want a written record indicating that it said something stupid, but it apparently does not mind how the press covered this initiative in the current political environment.

This is a separate consideration from whether the specific Administration initiatives are a good idea.  For example, an increase in the CFTC’s surveillance and enforcement staff, as the Administration recommends, is probably necessary given the enhanced responsibilities of this agency to monitor the OTC derivatives market.  But does anyone think the current Congress will pass legislation for a six-fold staff increase, as the Administration proposes?   Also, while granting the CFTC enhanced margin authority over exchange-traded oil futures is, in my mind, not objectionable, but it is unlikely to bring down the price of oil and is unlikely to be enacted by Congress unless some severe problem on an exchange and its margin setting procedures emerge. 

One troubling aspect of this is that the CFTC is supposed to be a market neutral regulator, that is, not caring whether prices go up or down.  The futures markets, after all, are a zero sum game.  The total gains and losses due to market price moves cancel each other out.  In fact, the CFTC used to argue that this is a reason that it should not be merged with the SEC, which it implied had a bias in wanting the stock market to go up.  But if the CFTC uses increases in oil prices to argue the urgent need for more authority but is silent when prices decline, it compromises its supposed market neutrality.     

The arguments that the futures markets are keeping the price of oil higher than it should be are weak.  Proponents of more regulation are on better ground when they argue that futures markets may increase price volatility, but this is very difficult to prove.  The direction of causation is notoriously hard to determine.  After all, greater price volatility can spur more activity in futures market because it engenders a greater demand for hedging and makes speculation more interesting.

Unfortunately, increases in oil prices always seem to engender a lot of political rhetoric and uninformed commentary.  Maybe oil prices will ease a bit, and this will calm down, but no one really knows.

Health Care, the Supreme Court, and Baloney

Some of the arguments that were made at the Supreme Court last week were amazing, especially to those who are aware how the Commerce Clause of the Constitution has been interpreted in the past, to say nothing of the broad taxing power granted to the federal government by the 16th Amendment.  For example, Charles Fried, who was President Reagan's solicitor general, argues that the ACA individual mandate is constitutional: “So health care is interstate commerce.  Is this a regulation of it?  Yes.  End of story.”
 
There is a lot more commentary available on the web on the legal arguments to anyone interested.  In this post, I just wanted to share an amusing exchange between Paul Clement and Justice Elena Kagan:

MR. CLEMENT: Well, with respect, Mr. Chief
Justice, I suppose the first thing you have to say is
what market are we talking about? Because the
government -- this statute undeniably operates in the
health insurance market. And the government can't say
that everybody is in that market. The whole problem is
that everybody is not in that market, and they want to
make everybody get into that market.

 JUSTICE KAGAN: Well, doesn't that seem a
little bit, Mr. Clement, cutting the baloney thin?
mean, health insurance exists only for the purpose of
financing health care. The two are inextricably
interlinked. We don't get insurance so that we can
stare at our insurance certificate. We get it so that
we can go and access health care.

A Brief Note on Floating Rate Notes and Money Market Mutual Funds

Potential purchasers of Treasury floating rate notes include money market mutual funds, which have been paying very low yields lately.  There would appear to be two advantages to them:  (1) FRNs would lessen the funds' frequent need to roll over bills or other short-term paper and (2) they might provide a somewhat higher yield than bills.

Money market mutual funds are supposed to be invested in short-term investments with no market risk.  Apparently, FRNs would qualify.  But one of the arguments for Treasury to issue FRNs is that they would serve to lengthen the average maturity of the public debt.  Obviously, there is some tension here between how the money market mutual funds would look at FRNs and how some argue the Treasury should look at them.

If FRNs were to yield the same as, or lower than, Treasury bills, it would be a reasonable option.  But if they yield higher than bills, the case for them is very weak.  Helping out money market mutual funds is not one of the goals of Treasury debt management, and I would think that the current people in charge of Treasury debt management would want to be careful to avoid any perception that this has become a motivating factor.