Burning Down The House: What Caused Our Economic Crisis?

http://www.youtube.com/watch?v=H5tZc8oH–o

Markets do suffer from hysteria from time to time. They are not always rational, and do not always price securities at the appropriate values.

From the President’s speech:

Second, as markets have lost confidence in mortgage-backed securities, their prices have dropped sharply. Yet the value of many of these assets will likely be higher than their current price, because the vast majority of Americans will ultimately pay off their mortgages. The government is the one institution with the patience and resources to buy these assets at their current low prices and hold them until markets return to normal. And when that happens, money will flow back to the Treasury as these assets are sold. And we expect that much, if not all, of the tax dollars we invest will be paid back.

Seems, contrary to your assertion, that we are able to “price securities at the appropriate values” just fine. Which leads us back to my question: Why aren’t there more individual investors making a move if we are going to make massive profits off of this? You think that government is calm and rational and that thousands of investors in the private sector are the ones who are panicked? I call shenanigans on that.

Isn’t the purpose of the bailout to have the gov’t offer to buy the bad MBS’s at good prices so they have reasonable market value again? If so, wouldn’t my proposal have the same results?

In short, yes, Paulson and Bernanke do have a better handle on the value of these assets than the market does at this point. This paper does have value, and it is not worthless as you incorrect espouse. We know it is not likely to be worth the bank’s valuation, but it does have value. Right now, the market price is ZERO, because nobody will buy it. Not all of those loans will foreclose under normal economic conditions. If your suggestion is adopted, and mass unemployment does occur, then it will be worthless, but it does have a value at this point in time.

Rooting for a credit calamity based on a belief that markets are always rational is extremely irresponsible. Yes, it is a mess. Yes, many institutions and regulations need to be changed, updated, and possible enhanced or deleted. That is a discussion for another day. This day, and the next day, and Monday for sure, we need functional credit markets that are stable. Democratic add-ons are equally irresponsible. However, despite the fact that this plan is not perfect is not a reason to reject it. It is the best, and only actionable plan for today and tomorrow, literally.

The panic you refer to is caused by banks and investment firms trying to hide their loses. If they were open about their assets. People would not fear so much. The reason they are not open about the value of their assets is because they would be out of business. Thus the short sellers and gloom/doom crowd are correct.

Bear Stearns wasn’t a good deal for JP. JP wanted a 30 billion taxpayer guarantee before they would touch it. That tells you what Bear’s real situation was. It says that reality is the dramatically correcting market. Not the over-hyped, panic stricken market that you and others say it is. Thousands cannot be wrong. A few government flunkies can be wrong and often are.

The market isn’t working correctly. What should be the invisible hand at work, guided by everyone’s rational self-interest has given way to fear and panic. Thus, the government needs to step in.

This has been going on for quite a while, I think “panic” would have worn off by now.

Could it be that private investors aren’t stepping in until they know what the government is going to do?

Overall they shopped around for the ratings, and used various derivative tricks and security insurance to convince investors that these were safe, and to be fair to them they were safe as long as either the causes for default on individual mortgages were independent of each other or home prices were increasing.

What killed investors was the fact that the popping of the home price bubble itself caused many defaults as highly leveraged buyers were found themselves with major negative equity and started walking away. Essentially, the ratings agencies grossly underestimated the effect of a large rare event on the market, and we’re all paying the price.

If the root of this problem is that the MBS’s are undervalued because there’s so much risk of default, why doesn’t the government consider reducing that risk, rather than simply transferring it to the taxpayers?

Specifically, what would be the drawbacks of having the federal government offer loans to homeowners with at-risk mortgages to prevent them from being foreclosed?

I think it could work like this: The gov’t would pass a law making a fraudulent mortgage application a felony, punishable by at least several years of prison time. You default, the gov’t looks at your records and if they determine you lied about ability to pay, or signed paperwork overstating the value of the home so you could avoid the down payment, you go to prison. If they determine the bank had something to do with the fraud, their loan officers may go to prison too.

If, instead of defaulting, you apply for the new program, the gov’t loans you enough money to pay down the loan (minus an amount kicked in by the mortgage lender so they can avoid going to prison too) and refinance at payments you can afford.

The loan then gets repaid with a surcharge on your taxes, for which default becomes tax evasion and lands you in prison.

Most people would probably prefer to avoid this, and would work hard to keep up their payments. Those who can’t would have an alternative to defaulting, and a huge incentive to use it – to avoid prison time. This would reduce the default percentage dramatically, leaving the MBS’s valued at much closer to face value again.

Wouldn’t this be likely to cost a lot less than 700 billion, with a lot less interference to the free market?

We cannot stop bubbles and panics, they will happen from time to time. We CAN however look at the wisdom of previous generations who decided that allowing a few corporations to own most of any one industry is fraught with potential for this sort of disaster. Allowing AIG to use leverage to buy up a majority of the nation’s insurance assets was foolish.

IMO all large investment concerns should be broken up and stratification should not be allowed to happen in the future.
The hostility to anti-trust in recent decades is a direct causality of a lot of our problems.

Most of the time you are extremely knowledgeable, and your pieces always well written and contain useful insight. I recognize that you are a nationally known blogger, and a member in good standing with the conservative community and I am neither. This time, however, you are not only wrong, but dead wrong.

Markets do suffer from hysteria from time to time. They are not always rational, and do not always price securities at the appropriate values. At this time, the credit markets are simply not functional due to a hysteria concerning MBS’s and CDS’s (Mortgage Backed Securities and Credit Default Swaps). When major corporations such as McDonald’s and Caterpillar are having a difficult time getting loans as has been widely reported (OK, for McDonald’s it is primarily franchisees), something is clearly not right. This problem MUST be fixed by the opening of the market MONDAY, or this market, retirement funds, University endowments, and your ability to get a loan will go into the toilet. I don’t care how good your credit rating is … there won’t be money for the loan. Theoretically, there probably are better mechanisms to deal with the issue. But any mechanism must be large and immune to market psychology for the turbulent weeks and months to come. Today, the most workable option is to give Ben Bernake and Hank Paulson most of the tools they requested, and yes, sufficient funds, to tackle the problem(s) using their approach. There will be plenty of time later to discuss the best and most pure way of handling this mess. Pure conservative ideology is not the right approach this time, and I think Jim DeMint made a complete idiot of himself on TV yesterday. Democracy usually doesn’t follow the best course of action; the issue at hand is whether the plan is good enough. And yes, I think it is.

Mark Olsen

…. and who now have a primary mortgage that is for more than their property is worth …

… get the difference between their mortgage and their home’s value changed.

Second mortgages, HELOCs, and people who took equity out of their homes when their homes increased dramatically in value must deal with gambling by using secured value to take care of unsecured debt.

So they want to bail-out these people, so they can stay in this homes, and land up in FORECLOSURE a few years down the road rather than now when they STILL won’t be able to afford the home.

So, yet again instead of letting the bubble burst, we are putting patches on the bubble and putting off its complete/final rupture somewhere down the road.

“If the mortgage-backed securities are undervalued and taxpayers are going to make money at the end of any bailout procedure, then it stands to reason that we should have more private investors buying MBSs.”

That’s true, of course. The problem is the markets are acting irrationally. Fear, panic, and uncertainty – a group of less delightful human emotions – have overridden the normal market principles, where everyone acts in their own enlightened self-interest.

It’s irrational of course; there’s potential profit to be made. Aye, there’s the rub.

The market isn’t working correctly. What should be the invisible hand at work, guided by everyone’s rational self-interest has given way to fear and panic. Thus, the government needs to step in.

Hopefully the bailout/recovery/whatever can alleviate the fears and let market forces start acting normal again. I think it’s the best plan because it directly confronts the problem at hand.

As I wrote before I’m just as opposed to government interference in markets as everyone else. Unfortunately, broad, abstract principles don’t always stand in the real world. Thus, when I say I oppose government bailouts what I really mean is I oppose bailouts 96% of the time. It’s not some grand betrayal to our inner-soul. It’s just recognizing realities of the current situation.