Posts Tagged ‘financial reform’


Former Fed Chair Alan Greenspan in today’s Financial Times:

The financial system on which Dodd-Frank is being imposed is far more complex than the lawmakers, and even most regulators, apparently contemplate. We will almost certainly end up with a number of regulatory inconsistencies whose consequences cannot be readily anticipated. Early returns on the restructuring do not bode well.

Greenspan goes on to note: “The act may create the largest regulatory-induced market distortion since America’s ill-fated imposition of wage and price controls in 1971.”

For those who have watched the financial reforms, this judgment (and much of the Greenspan’s comments) comes as no surprise.

Far more surprising:

Bill Murray has been cast to play FDR (brilliant choice)

Christine O’Donnell has a book contract (insert punch line here)

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The Treasury has been spinning TARP as a victory in the months leading up to midterm elections. I have a lot of respect for Elizabeth Warren (former Chair of the Congressional Oversight Panel for TARP, currently helping in the early work for the Consumer Finance Protection Agency she promoted) and the work she has done on bankruptcy.

As John Maggs reports in Politico, it appears that Elizabeth Warren is not too cheery on TARP’s performance.

Money quote:

“The rescue of AIG continues to have a poisonous effect on the marketplace,” said one critic recently. “By providing a complete rescue that called for no shared sacrifice on the part of AIG and its creditors, the government fundamentally changed the rules of the game on Wall Street. As long as the biggest companies in America believe that you and I will bail them out, the worst effects of the AIG rescue will linger.”

The critic was not a Republican politician or some conservative think tank. It was Elizabeth Warren, President Barack Obama’s choice to set up a new agency that will protect consumers from financial system abuses, and her blunt assessment is shared, to some extent, by critics on the left and the right.

Of course, Warren is correct, particularly in her observation: “The greatest consequence of TARP may be that the government has lost some of its ability to respond to future crises.”

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When Reform Isn’t Reform

In the months leading up to the passage of the financial reform legislation, Congress decided to segregate the issues of financial regulation and the government sponsored enterprises (GSEs) that were central to the collapse. Now that Dodd-Frank is in the bank, Congress and the White House are turning to Freddie and Fannie, the two GSEs that have already  sopped up $150 billion in taxpayer money. Will this process lead to meaningful reforms?  An article by Binyamin Appelbaum in yesterday’s NYT does not give me much hope.

The financial crisis came in the aftermath of the collapse in the real estate bubble. The bubble was created, in part, by government efforts to promote high levels of home ownership, particularly among low income citizens. This was justified in the 1990s through evidence suggesting racial discrimination in credit markets; during the Bush presidency it was promoted as part of the effort to create the so-called “ownership society.”

The Federal Housing Enterprises Financial Safety and Soundness Act of 1992 mandated that the Department of Housing and Urban Development set quantitative targets for GSE purchases of mortgages serving a low and moderate-income clientele.  Between 1993 and 2007, the target increased from 30 percent to 55 percent.  Even if we stipulate arguendo that the goal of extending home ownership to low income borrowers was laudable, it was nonetheless the case that this population—and the speculators that moved in to take advantage of liberalized underwriting standards—were highly vulnerable to economic fluctuations.

Let me be clear: I am not claiming that the housing policy of the Clinton and Bush administrations and Congress was the sole source of the financial crisis. But without the bubble it created (facilitated by a number of other factors, including the Taxpayer Relief Act of 1997, the Fed’s policies, and private sector chicanery), the crisis would not have occurred.  Clinton, Bush, and congressional majorities of both parties embraced a set of social goals and decided to use the GSEs as the instruments of choice in realizing these goals.

The NYT article contains some quotes that should disturb anyone hoping for genuine reform.  Appelbaum reports:

Mr. Geithner said continued government support was important “to make sure that Americans can borrow at reasonable interest rates to buy a house even in a downturn.”

While a range of options are on the table, Appelbaum notes:

The choice will reflect in large part a judgment about how hard the government should try to increase homeownership. Broader guarantees create greater risks for taxpayers, but also lower interest rates, bringing ownership within reach for more families. Shaun Donovan, the housing secretary and a host of the conference with Mr. Geithner, said that the administration remained committed to “broad access to homeownership, including options for those families who have historically been shut out of these markets.”

The conclusion: clear evidence that efforts to use the GSEs to engineer a predefined level of home ownership has had no discernable impact on policymakers’ desire to continue using the GSEs for this purpose.

I can imagine a principled argument from the Right that the level of home ownership is an emergent property of incomes and preferences. Rather than trying to achieve some politically-defined level of ownership, we should create the preconditions for growth and make certain that lenders bear the risk for the loans they make, even if this results in more stringent underwriting standards.

I can imagine a principled argument from the Left that the real problem has been the nation’s failure to invest in public housing for low-income households. Under the sway of neoliberalism, Democrats and Republicans alike gravitated toward “third way” solutions that effectively allowed them to move their responsibility to the poor off budget.

What I cannot imagine is a principled argument for a continuation of the status quo.

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Freddie and Fannie are in the news again.

Freddie is currently seeking an additional $1.8 billion in funding (to be added to the $160 billion that has already been spent on the two government sponsored enterprises or GSEs). This recent news has led me to pose an account of how a standard political choice story of political exchange evolved into one of state vampirism. Let us review some of the facts.

The financial collapse revealed the weakness of many institutions, much to the surprise of regulators. No one in government fully appreciated the fragility of AIG or Lehman, for example.  But the same cannot be said of the GSEs. A partial accounting of the warning signs:

  • When accounting scandals led to the collapse of Enron in 2001 and WorldCom a year later, attention turned to the misapplication of accounting standards in other large firms. In January of 2003, Freddie Mac admitted that it had engaged in creative accounting to “smooth out” its earnings growth and mask underlying volatility.
  • That same year, the IMF  identified a host of problems at the GSEs including the “systemic risks inherent in the agencies’ large mortgage portfolios and their hedging operations” and the “lack of transparency.”
  • In 2004, the OMB warned: “The GSEs are highly leveraged, holding much less capital in relation to their assets than similarly sized financial institutions….a misjudgment or unexpected economic event could quickly deplete this capital, potentially making it difficult for a GSE to meet its debt obligations. Given the very large size of each enterprise, even a small mistake by a GSE could have consequences throughout the economy.”
  • Congress held hearings over the course of the next several years to consider strengthening the oversight of the GSEs  and limiting the size of their portfolios. Greenspan—usually skeptical of regulation—testified that the GSEs should be forced to reduce their trillion dollar portfolios to $100 or $200 billion, a position echoed by Treasury officials. Although proposals to create a new agency to oversee the GSEs were introduced in both chambers, Republicans and Democrats blocked reforms—refusing to place restrictions on the size of their portfolios, preventing the regulator from considering systemic risk, or tying passage to the creation of an affordable housing fund to make grants to advocacy groups.

The GSEs avoided the kinds of regulations that, if introduced early enough, might have limited the extent of the crisis.

Making Sense of Nonsense

The above pattern might not seem to make sense until once considers it through the lens of public choice.   The GSEs, although private in the pre-crash days, benefitted dramatically from the implied backing of the US government. They were able to attract capital more cheaply because investors believed that their debt was as good as T-bills.

The GSEs preserved their status by funneling large amounts of money into politics. As Open Secrets noted in a brief 2008 piece on Freddie, Fannie, and political giving:

Fifteen of the 25 lawmakers who have received the most from the two companies combined since the 1990 election sit on either the House Financial Services Committee; the Senate Banking, Housing & Urban Affairs Committee; or the Senate Finance Committee. The others have seats on the powerful Appropriations or Ways & Means committees, are members of the congressional leadership or have run for president.

During the 1989-2008 period, Open Secrets reported that “Current members of Congress have received [as of 2008] a total of $4.8 million from Fannie Mae and Freddie Mac, with Democrats collecting 57 percent of that.” Top recipients of GSE largess for the period 1989-2008:

  1. Christopher Dodd (D-CT)
  2. John Kerry (D-MA)
  3. Barack Obama (D-IL)
  4. Hilary Clinton (D-NY)
  5. Paul Kanjorski (D-PA)

Obama’s performance is pretty amazing given his short tenure in the Senate. In case your are wondering, the top 25 also included Barney Frank (D-MA), Rahm Emaunuel (D-IL), Nancy Pelosi (D-CA), and Steny Hoyer (D-MD) were also in the top 25. And even if the top of this list was full of Democrats, Republicans were recipients of GSE funds as well, claiming a majority in 2006.

So, we have profit-maximizing firms (in this case the GSEs) investing in vote-maximizing politicians (see above) and receiving special regulatory treatment. The costs were borne by consumers and taxpayers. Many members of Congress undoubtedly thought they were doing good while doing well. By requiring via statute that the GSEs make 55 percent of their mortgage purchases from low and moderate income borrowers, they were furthering pressing social goals and contributing to the creation of an ownership society.

From Political Exchange to Political Vampirism

As we know, in 2007-2008, many of the misguided policies interacted to produce a daunting financial crisis and the largest issuance of debt relative to GDP since World War II.  Freddie and Fannie, carrying large portfolios that had been politically insulated by Congress, all but collapsed, forcing a government bailout that has cost, to date, $160 billion.

In 2010, Congress passed the financial reform legislation (formally, the Dodd-Frank Wall Street Reform and Consumer Protection Act).  As noted in a previous posting, Dodd-Frank was expansive enough to cover everything from conflict metals to the racial composition of financial institutions. What was left out? The provisions of the act did NOT cover the GSEs.

One reason for leaving the GSEs alone may have been their continued utility as instruments of social policy.  As Zachary Goldfarb notes in today’s WaPo:

Since then [the collapse], they have been run by government overseers who have told the companies to help carry out the Obama administration’s housing policy. They have focused on continuing to guarantee mortgages to keep interest rates low and on reworking unaffordable home loans so borrowers can avoid foreclosure. The federal government has pledged to keep the companies solvent.

One might be surprised that the administration is using the GSEs to promote the same kind of credit policies that contributed to the housing bubble—on second thought, who would be surprised, since the clownish and melodramatic explanations of the collapse are the ones that have prevailed politically.

Some things did change with the collapse of the GSEs. When the government stepped in with a bailout, new bans were placed on campaign donations. Amazingly enough, Congress believed that once it owned an entity, it might be somewhat unseemly for it to extract donations from it.  Some predicted that after decades of Freddie and Fannie dominance of housing policy, this would have some profound implications. As the WaPo noted on August 7: “now Fannie Mae and Freddie Mac, titans of the mortgage finance industry, are wards of the state, bailed out by Washington to the tune of $160 billion and banned from political activity.”

But even if political donations are temporarily off the table, there are other ways to extract blood from Freddie and Fannie.  From today’s WaPo:

The firms are also paying steep dividends to the government in return for the aid. The dividend rate, 10 percent, is far more than the companies would pay to raise money in the capital markets. After the latest round of assistance, Freddie will be required to pay $6.4 billion in annual dividends to the government. “This dividend amount exceeds the company’s annual historical earnings in most periods,” Freddie said in a statement. “Freddie Mac expects to request additional draws under the Purchase Agreement in future periods.”

So let us review the key facts: Initially, Congress provides the GSEs with an implicit guarantee in exchange for a steady flow of donations and lax oversight. That equilibrium proved quite stable for decades and delivered the goods for legislators regardless of their political stripe. However, exogenous and endogenous shocks punctuated this equilibrium and gave rise to the political vampirism witnessed today. The GSEs are given a lease on life, but a life that might feel more like a slow death as its resources are being drained away.

How are things working out? In Goldfarb’s words: “Now, it is government decisions that are driving a good bit of the companies’ losses.”  How great are these losses? Since the collapse, Freddie has received over $60 billion from the public coffers, and now it is approaching Congress for an additional  $1.8 billion in government aid.  The combined GSE bailout has cost a mere $160 billion, as if anyone other than bondholders are counting.

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As commentators begin to read the Dodd-Frank Wall Street Reform and Consumer Protection Act, they are discovering some hidden gems. The most recent discoveries:

Diversifying the Portfolio (via Carrie Budoff Brown at Politico):

Congress gives the federal government authority to terminate contracts with any financial firm that fails to ensure the “fair inclusion” of women and minorities, forcing every kind of company from a Wall Street giant to a mom-and-pop law office to account for the composition of its work force.

Maintaining Transparency (via Ed Morrissey at HotAir):

Under a little-noticed provision of the recently passed financial-reform legislation, the Securities and Exchange Commission no longer has to comply with virtually all requests for information releases from the public, including those filed under the Freedom of Information Act.

Controlling the Market in “Conflict metals” (via Michael Tennant at NewAmerican):

it includes language compelling American-listed “companies to certify whether their products contain minerals from rebel-controlled mines in Congo and surrounding countries.”

Since gold is on this list of “conflict metals,” conspiracy theories are beginning to blossom.

What readers will NOT find: reforms of Freddie Mac and Fannie Mae, the two government sponsored enterprises that were embroiled in the financial meltdown (see Colin Barr, Fortune). Not to worry…hearings are scheduled.


Congress, in its infinite wisdom, is prepared to provide  the Financial Crisis Inquiry Commission an additional $1.8 million to continue its work. Daniel Indiviglio (the Atlantic) wonders why, given that Congress leapfrogged the commission:

At a time when both sides of the aisle are worried about excessive government spending on waste, it’s hard to justify providing more funding to a commission whose purpose has become questionable, at best.

Michael Smallberg and Rick D’Amato (the Project on Government Oversight) are concerned about the burdens that the new rules and mandated studies will place on regulators:

we’re concerned that Congress may be burdening regulators and watchdogs with unnecessary studies, rather than putting hard-and-fast rules in place. Many of these studies will simply provide another avenue for the financial services industry to exert its influence on the process, and in the meantime, the studies could impose a significant burden on regulators and watchdogs that are already short on funding, staff, and resources.

Of course, one man’s burden is another’s opportunity. The new regulations this should provide a great source of employment opportunities, thereby contributing to the ongoing success of Recovery Summer. As Julie Steinberg notes:

With the passing of the financial reform bill, the SEC, CFTC and FDIC are all on the hiring warpath. The new CFPB and the beefed-up OCC are also expected to join hiring fray once they figure out staffing needs. The creation of at least 1,343 jobs across two of the agencies has already been announced (SEC and CFTC), and more hiring announcements are expected to follow.

Undoubtedly, there will be thousands of more jobs to come. Ms. Steinberg provides useful information on how to snag a job as a regulator.  What is unclear is whether currently unemployed Census workers will have a suitable skill set. If they do, the last month of Recovery Summer may fulfill the administration’s promises.

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Even though the President should have been able to claim some political credit for the financial regulation legislation (regardless of its ultimately efficacy), defeat was once again snatched from the jaws of victory. The  White House became embroiled in the USDA’s firing of Shirley Sherrod, losing control of the news cycle. As WaPo noted:

Remember that old adage that the secretary of agriculture is meant to be seen but not heard? (You know that one, right?).Tom Vilsack broke that rule this week with his dismissal of, doubling down on dismissal of, apology to and attempted rehiring of (it reads like the 12 stages of grief) a midlevel Department of Agriculture employee named Shirley Sherrod.

Ah the drama! This is precisely the kind of story the media likes—oh those “teachable moments”–and so much time to reflect on “what has happened to the news,” the evils of Glenn Beck, the possibilities for a national dialog on race…..zzzzzz.

Administration embarrassment and amateurishness aside, the story drew attention away from FinReg, one of the two key achievements of the Obama administration thus far. The news cycle on July 21st focused on FinReg. The next day, Vilsack’s firing of Sherrod  and the ongoing saga quickly displaced it (as seen by these story counts from Google).

As the White House is finding it difficult to extract much in the way of political gold out of FinReg, we are beginning to witness the slow drip of “unintended consequences” stories.  Daniel Indiviglio  (the Atlantic) provides one example with rating agency liability:

Only a few days old, the financial reform bill is already making trouble for the markets. One new provision holds credit rating agencies liable for their ratings. Scared about future lawsuits, the agencies have forbidden issuers from putting their ratings in official bond offering documents this week, which shut down the asset-backed securities market.

At 2,315 pages—likely all of which have never been read by a single human being—we can assume that the unintended consequences will continue for some time to come.

Have  a great weekend!

Stories: financial regulation

Stories: Sherrod firing

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The President is scheduled to sign the 2,315 page Dodd-Frank Wall Street Reform and Consumer Protection Act at the Ronald Reagan building today, July 21, 2010.

His prepared remarks read:

These reforms represent the strongest consumer financial protections in history. And these protections will be enforced by a new consumer watchdog with just one job: looking out for people – not big banks, not lenders, not investment houses – in the financial system. Now, that’s not just good for consumers; that’s good for the economy.

In case you find the full legislation to be too demanding, the White House blog has presented what it refers to as “the online attention-deficit version.” I am always pleased to see elected officials raising the level of policy discourse.

Of course, the 2,315 pages is only the beginning. As MarketWatch reports:

The Securities and Exchange Commission is expected to begin shortly an “extremely labor intensive” and “logistically challenging” effort to write a large number of regulations based on sweeping bank-reform legislation on the verge of approval, agency chairwoman Mary Schapiro said Tuesday in prepared remarks at a hearing on Capitol Hill.

Meanwhile…the Financial Crisis Inquiry Commission continues its investigation, hoping to provide its final report to Congress on December 15, 2010 (as mandated by the Fraud Enforcement and Recovery Act of 2009).

Given that the basic regulatory architecture will have been put into place and agencies will be embroiled in rulemaking, one can predict that the final report  will have minimal impact. Thankfully, understanding the core causes of the financial crisis is immaterial to designing a solution.

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I have been working through the stack of books I have accumulated in the wake of the global financial crisis.

One of the best, completed on a rather long set of plane rides (thank you Delta for serial delays) was Carmen M. Reinhart and Kenneth S. Rogoff, This Time Is Different: Eight Centuries of Financial Folly (Princeton University Press, 2009).

There is much to their analysis. It is heavily data driven and provides a great overview of existing scholarly research.   I don’t intend to present an overall summary or critique here.  But here is a sobering passage from page 224, where they note that “financial crisis are protracted affairs. More often than not, the aftermath of several financial crises share three characteristics:

  • First. Asset market collapses are deep and prolonged.  Declines in real housing prices average 35 percent stretched out over six years, whereas equity price collapses average 56 percent over a downturn of about three and a half years.
  • Second, the aftermath of banking crises is associated with profound declines in output and employment.  The unemployment rate rises an average of 7 percentage points during the down phases of the cycle, which lasts on average more than four years.  Output falls (from peak to trough) more than 9 percent on average…
  • Third…the value of government debt tends to explode; it rose an average of 86 percent (in real terms, relative to precrisis debt) in the major post-World War II episodes. …the biggest driver of debt increases is the inevitable collapse in tax revenues that governments suffer in the wake of deep and prolonged output contractions.”

The “Second Great Contraction” (the authors’ term for the current crisis) may be more significant than other postwar contractions because “the global nature of the recent crisis has made it far more difficult, and contentious, for individual countries to grow their way out through higher exports or to smooth the consumption effects through foreign borrowing.” (239)

My take: All of this suggests that we have a long way to go before we can celebrate “Recovery Summer”  and job growth. To the extent that  economic chaos carries political ramifications, we may be in for a prolonged period of instability in electoral politics the impacts of which may not be limited to one or another of the two parties. Indeed, as I read the current polls, there is grave dissatisfaction with both parties.  Even if there is growing skepticism regarding Obamanomics,  the Democratic majorities in the House and Senate, the direction the nation is heading, etc., the news for Republicans is no better (perhaps a product of the dearth of ideas, perhaps a decision to draw a line in the sand over the extension of unemployment benefits).

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Regulation Redux

Financial reform continues to make its way through the legislative sausage maker as conferees desperately seek to meet the administration’s July 4th deadline. As noted in earlier postings, the body created by Congress to investigate the causes of the crisis as a means of informing the legislative process continues to hold hearings in hopes of reporting to Congress in December…some five months from now. If one believed that major regulatory change should be informed by reasoned analysis, this disjunction might prove to be a source of concern.


  • The conference committee was reconvened to kill the $20 billion tax on big banks, tapping TARP instead. Passage remains in doubt.
  • WaPo editorial decries a little noticed provision in the financial reform legislation: “the permanent increase in the size of bank accounts eligible for federal deposit insurance from $100,000 to $250,000–retroactive to Jan. 1, 2008. It’s a bailout for a relative handful of well-off customers that may also increase risks in the U.S. banking system.” In some 2,000 pages, one can only wonder how many more surprises are awaiting discovery (assuming anyone bothers to read the 2,000 pages).
  • David Weidner (Market Watch) provides useful discussion of 10 missteps of financial reform (the list could be extended, as he well admits).
  • The Left is getting restless and may not prove willing to support the legislation in its current form, as Miles Mogulescu suggests at the Huffington Post.

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Recovery Summer

The Recovery Summer is well underway.

  • Vice President Biden sought to rally the troops in the Milwaukee stop of his Recovery Summer tour by noting: “there’s no possibility to restore 8 million jobs lost in the Great Recession.”
  • Today, a  sharp drop in the Conference Board’s Consumer Confidence Index have sent markets into a triple-digit loss.
  • Paul Krugman (New York Times) opines “We are now, I fear, in the early stages of a third depression. It will probably look more like the Long Depression [following the Panic of 1873] than the much more severe Great Depression.”
  • The National Journal reports that in public opinion, “the cement is hardening.” Based on its Congressional Connection poll, “the sputtering economy, the unchecked oil spill in the Gulf of Mexico, two wars and a rough-and-tumble campaign season continue to take a toll on the public’s confidence in the government.”


  • As Congress pushes forward with the most significant financial reforms since the Great Depression, Dan Alamariu at Foreign Policy predicts “The reforms currently debated in Congress represent only the opening salvo of a larger reform process that will take years to complete and whose outcome will be both unexpected and more stringent on financials than the currently debated legislation.”
  • The White House continues to push ahead with discussions on climate change policy with a meeting scheduled for today. The Hill reports: “Tuesday’s meeting with Obama may lay the groundwork for Reid to craft a legislative strategy for trying to get 60 votes this year on an energy and climate plan.”

Although Krugman draws analogies between 2010 and 1933, things feel a bit more like 1937.

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This today from the WSJ:

Federal Deposit Insurance Corp. Chairman Sheila Bair said bank regulators would have the tools they need to banish “too big to fail” institutions from the financial landscape once a Wall Street overhaul bill becomes law.

…Ms. Bair said that new powers allowing regulators to seize and liquidate failing institutions would act like a threat hovering over the financial industry, deterring firms from growing too large or reckless.

This is a kind of a nuclear bomb that you hope you never have to use,” Ms. Bair said. “The fact that it’s there, I think, is going to be important. And if we have to use it, we will.”

So I now have this mental image of a nuclear bomb “hovering” over Wall Street waiting for some bureaucrat to hit the ignition.  Like we don’t have enough to be worried about with this bill already!


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Damian Paletta (WSJ) has a summary of the conference committee’s final agreement on the new financial regulations.

There is nothing all that surprising here: expansion of regulation (with a few politically expedient exemptions and some revenue sweeteners).

Rep. Jeb Hensarling (R., Texas) is quoted in the above story as saying: “My guess is there are three unintended consequences on every page of this bill.”  My guess is that the good congressman is understating things. But even if he isn’t, at almost 2,000 pages—pages that, if experience proves true, have never been read—that is a lot of unintended consequences.

Let us recall that in May 2009, Congress passed legislation to create a  Financial Crisis Inquiry Commission “to examine the causes, domestic and global, of the current financial and economic crisis in the United States.” The commission was given broad investigative powers and is still holding hearings (indeed, it is scheduled to hold hearings next week on the role of derivatives in the financial crisis, where it will question witnesses from American International Group, Inc., Goldman Sachs Group, Inc., the U.S. Commodity Futures Trading Commission, the Office of Thrift Supervision, and the New York State Insurance Department).

Congress directed the commission to submit its report and specific findings on December 15, 2010. Presumably, this report could prove useful in making sense of the financial crisis and designing a new regulatory architecture. That is, it could prove useful if one believed that Congress and the administration were intent on good policy rather than good politics. But as is so often the case, politically established timetables trump careful deliberation.

Senator Dodd is quoted in the above story as saying: “This is about as important as it gets, because it deals with every single aspect of our lives.” Indeed, one measure of its importance is that Congress decided to act before it had allowed the experts it appointed to do the heavy intellectual work to complete their mission.

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This week, House and Senate conferees are working out the details in what will likely be the most significant financial regulatory reform in some time. Should the new Consumer Financial Protection Bureau be housed in the Fed? Should the Volcker rule be universally applied? Should banks really be required to spin off their derivative activities? These are important issues and, in some cases, reform may be justified regardless of whether it actually addresses the causes of the financial collapse.

But what if the House and Senate have simply failed to understand the underlying problem? What if they have allowed politically-defined timetables to force premature closure, resulting in regulatory changes that will not have the intended impact?

A piece by Binyamin Appelbaum and Sewell Chan  published in the New York Times on May 2, entitled “Senate Financial Bill Misguided, Some Academics Say,” should have attracted more attention than it did.

The lead paragraph: “As Democrats close in on their goal of overhauling the nation’s financial regulations, several prominent experts say that the legislation does not even address the right problems, leaving the financial system vulnerable to another major crisis.” The piece continues: “A diverse group of critics… say the legislation focuses on the precipitators of the recent crisis, like abusive mortgage lending, rather than the mechanisms by which the crisis spread.”

Some attention is given to Gary Gorton ( I have discussed his book, Slapped by the Invisible Hand, in a previous posting). In a presentation to the U.S. Financial Crisis Inquiry Commission, Gorton summarized his argument as follows (his entire testimony can be downloaded here, along with additional testimony):

  • As traditional banking became unprofitable in the 1980s, due to competition from, most importantly, money market mutual funds and junk bonds, securitization developed. Regulation Q that limited the interest rate on bank deposits was lifted, as well. Bank funding became much more expensive. Banks could no longer afford to hold passive cash flows on their balance sheets. Securitization is an efficient, cheaper, way to fund the traditional banking system. Securitization became sizable.
  • The amount of money under management by institutional investors has grown enormously. These investors and non‐financial firms have a need for a short‐term, safe, interest‐earning, transaction account like demand deposits: repo [repurchase agreements]. Repo also grew enormously, and came to use securitization as an important source of collateral.
  • Repo is money. It was counted in M3 by the Federal Reserve System, until M3 was discontinued in 2006. But, like other privately‐created bank money, it is vulnerable to a shock, which may cause depositors to rationally withdraw en masse, an event which the banking system – in this case the shadow banking system—cannot withstand alone. Forced by the withdrawals to sell assets, bond prices plummeted and firms failed or were bailed out with government money.
  • In a bank panic, banks are forced to sell assets, which causes prices to go down, reflecting the large amounts being dumped on the market. Fire sales cause losses. The fundamentals of subprime were not bad enough by themselves to have created trillions in losses globally. The mechanism of the panic triggers the fire sales. As a matter of policy, such firm failures should not be caused by fire sales.
  • The crisis was not a one‐time, unique, event. The problem is structural. The explanation for the crisis lies in the structure of private transaction securities that are created by banks. This structure, while very important for the economy, is subject to periodic panics if there are shocks that cause concerns about counterparty default. There have been banking panics throughout U.S. history, with private bank notes, with demand deposits, and now with repo. The economy needs banks and banking. But bank liabilities have a vulnerability.

Returning to the New York Times piece, the authors write: “Gorton…said the financial system would remain vulnerable to panics because the legislation would not improve the reliability of the markets where lenders get money, by issuing short-term debt called commercial paper or loans called repurchase agreements or ‘repos.’ … ‘It is unfortunate if we end up repeating history,’ Professor Gorton said. ‘It’s basically tragic that we can’t understand the importance of this issue.’

I find Gorton’s case compelling, although there are additional dimensions to the collapse that need to be explored. Moreover, there are the larger public choice problems and the difficulties inherent in engaging in social engineering via the political manipulation of credit markets).

The New York Times piece, which I strongly recommend to readers interested in understanding the debates, ends on a sober note: “critics point to the words of Nicholas F. Brady, a former Treasury secretary who led the bipartisan investigation into the 1987 stock market crash: ‘You can’t fix what you can’t explain.’”

Does anyone believe that the hard intellectual work of understanding the financial collapse has been completed (note: The Financial Crisis Inquiry Commission created by Congress, is not even scheduled to report its findings until December 2010) Does anyone believe that what we have learned thus far has informed the legislative debates?

By now it has become axiomatic that we should never let a good crisis go to waste. But what if moving rapidly to capitalize on the current crisis does nothing to prevent (or even worse, increases the likelihood of) a future crisis?

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This week should be remarkably interesting for those following the financial reform legislation.  Among the big issues on the table include the so-called derivatives “push out” (forcing banks to spin off their derivative trading activities) and the “Volcker rule” that would prohibit proprietary trading at banks. Silla Brush (the Hill) has a quick summary of the work that remains to be done and how the interests are lining up.

Shock of the day: Banking Lobbyists are Making a Run at Reform Measures. Eric Dash and Nelson Schwartz (New York Times) report that “the banking industry is mounting an 11th-hour end run.” Primary focus: the Volcker rule. There are several alternatives being floated and Dash and Schwartz nicely delineate them.

Are these provisions going to survive? Hillary Canada (WSJ) provides one indicator: Citigroup is planning to raise more than $3 billion for private equity and hedge funds via Citi Capital Advisors, its alternatives arm. And as the Times reports, JP Morgan Chase is moving ahead with talks to acquire a Brazilian alternative investment fund manager, Gávea Investimentos. Is this irrational exuberance or a rational calculation that past investments in Congress will yield the projected returns?

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During and after the financial panic of 2008, we were exposed to a host of economists trying to explain the market meltdown, what should be done about it, and how we might avoid repeating it. Some of the leading lights in the discipline weighed in on the market problems. Now we have a reform proposal working through Congress that my fellow Pileus bloggers have written intelligently about (see here, here, and here).

Opinions are wide-ranging. I might share some of my own soon. But what unites all the various economists is a complete and utter cluelessness on the most important variable in the economic meltdown: fear.

Stock markets have been falling and have been highly volatile recently, apparently over the debt crisis in Europe (though I have to say that most media explanations for why markets move the way they do in a given day are complete gibberish). I would not be surprised to see the market slide even further, erasing most or all of the big gains of the past year.

Nothing in traditional finance can say anything useful about fear, nor can the macroeconomists. Perhaps there is something in the “new behavioral finance,” but I’m not aware of anything.  Keynes talked about “animal spirits,” but did not have a systematic theory of fear. To say that people behave irrationally is not a theory. A theory of fear would tell us something about why, when, and how fear develops and how it can be contained or modified. Similarly, we would could use a theory of the exuberance which leads to bubbles in the first place. I don’t think anyone really has a clue.

When the housing bubble burst, a lot of institutions were left holding high number of “toxic assets,” which were mostly mortgage-backed securities. Their price went to essentially zero, even though I cannot conceive of any model that would say a bunch of bad loans should have a zero price (even a really, really bad batch—say one where 50% of the mortgages will default—should still be worth 50 cents on the dollar, shouldn’t it?). Thus, the market went from systematically overvaluing these securities to systematically undervaluing them. What model of investor behavior can explain both phenomena?

Now we have debt problems in a few small European economies. Investors are acting as if the value of that debt is going to zero, though it is hard to imagine a complete collapse of the government that results in any European country simply defaulting on all its debt, though it is possible to think of cases where debt would need to be restructured and bond-holders would lose some value (in fact, the EU should require that to happen, rather than just throwing more money at these irresponsible states). This nervousness, this fear, spills over into other bond markets and into equity markets, which threatens the economic recovery. Systematic fear can be as devastating to an economy as real shocks.

People say that we need to understand the causes of the financial meltdown before proposing solutions. I think there are commonsense reforms that can be made, but these mostly won’t get at the real problem: no one has a clue about how to regulate either exuberance or fear.

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I have a somewhat different take on the financial legislation passed by the Senate than that presented by Jim Otteson, although I agree with his argument. Here is my take:

The New Deal era financial regulations created several separate financial industries, each governed by its own set of regulators and insulated by regulatory barriers to entry. Although this system functioned remarkably well for several decades, the pressures imposed by high inflation and new technologies forced a process of deregulation, which gained steam over the past several decades. In 1999, Congress passed the Gramm-Leach-Bliley Financial Services Modernization Act. It permitted the consolidation of commercial banks, investment banks, securities firms and insurance companies in financial holding companies, thereby eliminating the last vestiges of Glass Steagall. “Functional regulation” continued to exist, even if the functions were consolidated in financial holding companies. Moreover, while the 1999 Act essentially revoked Glass-Steagall, many of the changes had already occurred incrementally. For example, often through mergers and acquisitions, commercial banks had already made forays into investment banking and brokerage activities, creating more diversified financial service companies.

In an ideal world, a new regulatory architecture would acknowledge these changes rather than layering another set of processes and institutions over an already fragmented system.

As we discovered in the last few years, regulators will come to the rescue of large financial firms regardless of which industry or industries they are in.  Under the assumptions:

(1) We cannot return to the tidy world of Glass-Steagall where there are clear regulatory firewalls between financial industries, and

(2) There are few things more dangerous than implicit guarantees

One would have hoped that regulations would have subjected all financial firms, regardless of industry, to a form of insurance comparable to that in place with the Federal Deposit Insurance Corporation. The funds, could be used to rescue failing firms.  More importantly, the system could be used to subject insured firms to higher levels of oversight and there could be a uniform set of procedures in place for liquidating (or “winding down”) failing firms.

The Senate legislation makes motions in this direction (i.e., it expands the reach of the FDIC) but it retains the high fragmented regulatory structure and simply creates new means of coordination (i.e., through the creation of a new Financial Stability Oversight Council).

There are a number of potentially positive features of the legislation.

It makes sense to bring much derivative trading off of “dark markets.” The requirement that banks spin-off their derivative activities is unlikely to survive conference (and may well die at the Obama administration’s request).

Some of the duties assigned to the new Consumer Financial Protection Bureau are necessary. Markets cannot function effectively when there are great information asymmetries and this has been a serious problem  in consumer financial markets (as Elizabeth Warren has documented). However, one can question whether the Senate’s desire to place this new agency within the Fed will survive conference. Moreover, regulators often over-reach. Can we be confident that the new bureau will restrict itself to the functions promoted by Warren?

It is also quite positive that the legislation addresses the conflicts of interest among credit rating agencies (they are compensated by the financial firms whose securities they rate).

But there is also much room for mischief. Banks with more than $250 billion in assets will be subject to higher capital standards. One can imagine that the process of setting these standards will lead to efforts of social engineering (e.g., setting standards to create an “ideal” industrial structure).

Most important: I remain highly skeptical that this legislation is based on a coherent understanding of the causes of the financial collapse. If, as Gary Gorton has argued in his new book, Slapped by the Invisible Hand, the crisis was a panic in the repo market, it is unclear how this legislation will prevent a similar set of events from occurring in the future—or, more to the point, that such events can be prevented.

Of course, financial regulation is only part of the problem. The existing regulatory framework was inadequate. But absent the housing bubble, the collapse would not have occurred. The bubble, in turn, cannot be understood without reference to elected officials leveraging financial markets and using government sponsored enterprises (Fannie and Freddie) to engineer a desired level of home ownership, and  the Fed’s promotion of low interest rates rather than acting under the discipline of the Taylor Rule.

Needless to say, neither of these issues has been addressed by the legislation.

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For many observers, it seems obvious that the roots of the current recession lie in the crisis in the banking sector.  In the Economist’s Voice (a non-technical, yet academic, electronic journal), Robert Barbera attacks University of Chicago Economist Casey Mulligan and other real business cycle theorists for having a framework that cannot either predict or even describe important economic phenomena.

Barbera chides for Mulligan for predicting in the Fall of 2008 that we wouldn’t see large decreases in employment because of the weak linkage between the financial sector and the rest of the economy.  Mulligan argued, and still does, that gyrations in the financial sector are not closely linked to performance of the economy overall.  In other words, the obvious is not obvious.

In a sharp response, Mulligan correctly points out that Barbera’s critiques are not based on any theoretical critique of the large literature on this topic, but merely on Mulligan’s incorrect prediction.  Mulligan acknowledges he was wrong, but points out that that obvious story cannot easily account for two important facts.  First, that even though employment fell sharply, GDP and consumption did not.  Second, the massive infusion into the financial sector did relatively little to increase lending.  [It all seemed to go into the monetary base, which caused know-nothings like Glenn Beck to rant about how this was going to cause rapid inflation and financial catastrophe.]

Mulligan does have an alternative account of the current recession.  He thinks it was caused primarily by distortions in the labor market, namely three successive increases in the minimum wage and a mortgage modification program that was associated with an marginal tax rate of over 100%.  He does acknowledge that there might be monetary or capital sector stories that could be explored, but I find the labor market story intriguing.

I’m highly suspicious that the banking sector crisis was completely unrelated to the current recession (and I suspect Mulligan would allow for some role).  But, on the other hand, Mulligan’s argument is based on careful modeling, data analysis, and peer review.  Barbara’s argument is based on huffing and puffing about what is obvious.  Mulligan admits the full story isn’t known, but he is none to kind of the resurgence of Keynesian thinking in the public sector:

Recent events only reinforce the prescription that economic analysis should be rooted in incentives, not voodoo incantations of multipliers and contagion.  But the latter will continue to enjoy prominence in the political marketplace, where there’s nothing like telling taxpayers “Give me your money and, trust me, your gift will make you richer.”

Often when people say something is obvious it means they don’t have a good argument.

Addendum: One of the commentators below references the views of Scott Sumner, who always has intelligent things to say.  In particular, back when Paul Krugman was screeching that we simply HAD to have a giant stimulus because we were in a liquidity trap and therefore out of monetary tools, Sumner wrote a nice little piece in The Economist’s Voice arguing that of course we still had tools.  If you are interested, you can also read my little comment on Sumner and on Brad DeLong’s mischaracterization of our available policy options (DeLong argued that the only way to do deficit spending was to increase spending, neglecting to mention cutting taxes).  It is my simple-minded attempt to be a macroeconomist–something I will avoid in the future, except when blogging!

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The NYT has this story on how manufacturers, auto dealers, and the Chamber of Commerce are lobbying against the proposed derivatives exchanges and new consumer financial protection agency in the financial reform bill. It seems to me that they’re right to be concerned. Industrial firms, apart – apparently – from U.S.-owned automakers, are not treated as being “too big to fail” and do not face moral hazard incentives to invest in risky financial instruments. They’re simply trying to hedge against risk of price rises in their inputs. Cracking down on derivatives generally thus doesn’t make much sense. A properly tailored financial regulation bill would regulate banks and perhaps insurance companies specifically – the companies backed up by Federal Reserve lending, the Treasury’s implicit too big to fail guarantee, and deposit insurance.

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I’m referring here to Paul Krugman’s column today.  The ratings system in the financial sector has been a complete pile of crock.  As Krugman noted, 93% of AAA-rated subprime-rated mortgage securities are now junk. How often should a AAA-security end up as junk?  Clearly there has been huge systemic failure in this area.

I’m a very cautious regulator.   One of the potential justifications for government regulation occurs if quantities and/or prices are not transparent.  Mortgage-backed securities seem to be a clear case of non-transparency.   And this non-transparency was aggravated by the corruption of the ratings’ process.

I don’t know what the best fix is, but I think the good news is that ratings should be an area where government’s role need not be huge or even terribly intrusive, even though it might end up being crucial.  Indeed, a little intervention in the ratings game might have gone a long way to avoiding the systemic failure of this part of the industry.

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Arnold Kling at EconLog echoes my skepticism a few days ago about predatory lending.  This is from his post on the proposed financial reform legislation:

Finally–and this will get me in big trouble–I have to rant about the notion of a consumer financial protection agency. I know that it’s axiomatic that poor people are helpless victims. But in the case of these mortgages, that is a really hard sell. The banks did not take from poor people. They gave to poor people. If you were lucky enough to get one of these exotic mortgages when house prices were still going up, then you got to reap a nice profit on your house. If you were not so lucky, you lost…close to nothing. I’m sorry, but if you borrowed up to 100 percent of the value of the house or more, then all you really lost were your moving expenses.

What about predatory lending? As I understand it, the idea of predatory lending is to saddle the borrower with an expensive mortgage so that you can foreclose on the property and sell it at a profit. How many times did that happen? Have you read of a single instance in the past three years where the bank made a profit on a foreclosure?

I am always ready to feel sorry for poor people because of their poverty. But I cannot feel sorry for somebody who was given a basically free option on a house and the option didn’t happen to come into the money.

Very nicely said.

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President Obama gave a rousing speech today on the proposed financial reforms.

We know that financial regulations can bring far greater stability to the economy. Even Milton Friedman and Anna Jacobson were forced to acknowledge that the FDIC “succeeded in achieving what had been a major objective of banking reform for at least a century, namely, the prevention of banking panics.”

My concerns focus on what was not addressed by the president by seems every bit as important as regulatory reform.  The asset bubble that burst in 2007/08 was itself a product of public policy decisions.  To be more specific:

  • Ongoing regulatory pressure for relaxed underwriting standards as a means of promoting social goals (e.g., higher levels of home ownership, and under Bush, the “ownership society”)
  • The Federal Housing Enterprises Financial Safety and Soundness Act of 1992, which  mandated that HUD set quantitative targets for GSE purchases of mortgages serving a low and moderate-income clientele (the target would ultimately reach 55 percent).
  • The Taxpayer Relief Act of 1997 that exempted the first $500,000 in gains from any home sale (for couples, $250,000 for single filers)
  • Persistent trade deficits that provided funds for reinvestment in mortgage-backed securities combined with Greenspan’s pursuit of historically low interest rates

Voters who can use homes they can’t afford as ATMs to purchase goods they could not otherwise justify may be quite content, even if the policies that make this all possible simultaneously create the preconditions for an asset bubble.

The president, in focusing exclusively on regulatory reform, seems content with changes that will reduce the extent to which, when the next bubble bursts, the collateral damage will not be as great.  It feels like mandating that all cars have better airbags before liquoring up a teenage boy and handing him the car keys. Without the liquor, the need for better airbags might not be as great.

What would be necessary to assure that future elected officials won’t pursue social policy goals (e.g., creating an “ownership society”) that have the unintended consequences witnessed in the past few years?

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Now that health care reform has passed, attention will turn to other initiatives. Financial regulation is already moving briskly ahead, although we have to wait and see whether the regulatory changes actually address the problems at the heart of the financial collapse. Call me skeptical.

There are competing ways of understanding the collapse. Let me generate a quick list of interpretations:

1. The problem was the ruthless mortgage brokers who exploited informational asymmetries and naïve borrowers.  Here the crisis was a story of black hats and white hats, your typical melodrama. It demands additional consumer protection efforts similar to those promoted by Elizabeth Warren, chair of the Congressional Oversight Panel for the TARP currently being considered for a Supreme Court vacancy.

2. The problem is one of ideology. As Barney Frank noted in a piece a Financial Times piece entitled “Why America needs a little less laissez-faire,” the collapse was an indictment of “America’s 30-year experiment with radical economic deregulation.”  As Congressman Frank should know, it is easy to overstate the extent of deregulation.  Consider regulatory budgets. In 2008, the last year of the Bush presidency, the combined regulatory budget was $48 billion. To place this number in perspective, inflation-adjusted regulatory budgets grew by 310 percent since 1980, outpacing the growth of GDP. The inflation-adjusted budgets for the regulation of finance and banking grew some 316 percent during this period, 16.7 percent during the Bush presidency.  Yet, there is clear evidence that regulators provided too much discretionary authority with respect to capitalization levels and the management of risk.

3. The problem is one of misguided regulation.  Critics might concede the above point and note that while we continued to invest in regulation, we simply regulated the wrong things. There was no meaningful regulation of credit-default swaps.  And if Gary Gorton is correct, the crisis really stemmed from a bank run in the shadow banking system that was virtually unregulated. (For more on Gorton’s argument, see the Finance Blog).

4. The problems cited above were products of a larger public choice problem. When the real estate industry is contributing some $40 million to members of the two key congressional committees during the 2004-08 election cycles and the securities and investment industry is contributing another $46.7 million, it may be difficult to introduce policies that will suppress the real estate boom and impose greater regulatory oversight.

5. The problem was a classic and tragic example of moral hazard. The so-called government sponsored enterprises (Freddie and Fannie) engaged in reckless behavior on the assumption (correct as it turned out) that the costs they imposed would be socialized. Large financial institutions engaged in excessively risky behavior on the assumption (once again, largely correct) that they would be deemed too big to fail.

6. The problem stemmed from misguided efforts to promote social policy goals through financial markets. Banks were pressured to increase their loans to traditionally underserved populations through a loosening of underwriting standards. The Federal Housing Enterprises Financial Safety and Soundness Act of 1992 mandated that the Department of Housing and Urban Development (HUD) set quantitative targets for GSE purchases of mortgages serving a low and moderate-income clientele.  Between 1993 and 2007, the target increased from 30 percent to 55 percent, creating a large secondary market for subprime mortgages. Clinton was enamored of “third way” solutions and Bush sought to promote an “ownership society,” both of which found an expression in regulatory interventions to increase levels of home ownership.

7. The crisis was a result of excessively low interest rates, a product of our persistent trade and budgetary deficits (and the influx of Chinese dollars) and the Greenspan doctrine. Had we made a decision not to be consumer of last resort to the world, had the Maestro abided by the discipline of the Taylor Rule, the bubble would not have been created (and hence, it would not have collapsed).

Which interpretation is correct? My guess is that some combination of all of the above.   Public policy decisions over a two-decade period created a massive asset bubble and assured that its devastating effects would be maximized when the bubble popped (and all bubbles pop).  Clearly there were tragic examples of exploitation, policymakers wearing ideological blinders (or their financial equivalents, thanks to the constant inflow of campaign finance). There were poorly designed regulations that failed to address the financial services industry as it had evolved in the post 1970s era. There were obvious problems of moral hazard. The Fed held interest rates artificially low with impacts that were magnified by our failure to manage our own fiscal affairs and tame levels of debt-fueled consumption.

Now for the big question: how many of these problems have been addressed by the proposed regulatory changes?

A second question: had these changes been implemented, is there any reason to believe that the financial collapse would have been avoidable.

And a third question: should I take comfort in the fact that I am once again receiving preapproved offers for credit cards and home equity loans that exceed the value of my house?

If so, than I guess the crisis is behind us. Thank goodness.

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Predatory Dating

Now that he has helped plunge the country into a financial abyss through ObamaCare, Paul Krugman of the NY Times has devoted his attention to strangulating financial markets.   On Wednesday he repeated a common theme of the Left—that we need more protection from “predatory lending.”

This idea of predatory lending is sort of weird, isn’t it?  It means that if I apply for a loan that is over my budget, whoever gives it to me is a predator.  What if we extended this idea to other realms of life?

What about predatory dating? Some people mistakenly assume that Tiger Woods is a sexual predator.  But predatory dating would say that women involved were the predators, since they gave him the sexual services he wanted.  He was just unfortunate enough to be victimized over and over again.  In fact, any woman who accepts a date from a man she shouldn’t be with (even if she doesn’t know he is a creep) is a predator.

Then we could have predatory charity. If I give money to a charitable organization that ends up mismanaging its funds and going under, that makes me a predator, since I gave them the money.

Or how about predatory complements?  If I tell a friend that he is actually a better basketball player than he is to make him feel good and he goes out and gets schooled in the local pickup game, then I am predator.

There are lots of ways I’m probably a predatory consumer.  Any time I let someone make me a sales pitch that I turn down, I’m a predator.  Or if someone offers a bid to do home repair work for me and he doesn’t make sufficient profit, I’m a predator.

Dang.   I used to think if someone making $40K a year buys a $300K house that something funny is going on, that the mortgage company must be defrauding its underwriter or that the applicant must be misrepresenting something important.   Didn’t almost all such people taking out these kinds of loans know, deep down, that something was very fishy and that they were in over their heads?  But, no, getting in over your head just makes you a victim.

Now, this is not to say there hasn’t been serious fraud in this industry—by borrowers, lenders, underwriters, and the financial institutions that securitized these bad loans and foisted them on a market where people were too greedy to carefully assess their risk.

Punishing fraud is good.  But is the role of government to protect the greedy from themselves?

I guess I’ll buy that new Porsche after all.   I’m such a victim.

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