Economic Failure Analysis

Last blog post railed against the jump to a quick fix seemingly without the benefit of a comprehensive analysis of this dramatic economic failure. As the economic collapse continues to ripple through the economy like a slow atom bomb, I thought I'd take a crack at seeing if I could pull up some credible sources on the topic. Through the wonders of Google, I found a plethora of credible material which helped me piece together this mess. This material tells the tale of a series of bad regulatory decisions made on gut feels and philosophical guesses as to how a market works. Much like the solutions that are now proposed, the story of the economic crisis is one of blind deregulation dating back to Reagan's "Morning in America."

Don't get me wrong. Regulations should always be questioned, but the elimination of a law should always be done with caution. Removing that law should be well substantiated with facts, data, and analysis. This is because laws rarely ever proceed tragedy; they are a reaction to it. The laws of aviation came after the number of crashes became too high, and the laws of bank came after the crash of our economy. These laws are based on data and experience often written in the blood of their unfortunate predecessors. To think that the economic model which caused the initial economic collapse had changed is to assume that the fundamental principles by which humans operate had changed. This idea is as much a fallacy as the laws of physics changing.

The story, written in quotes, below, is laughable if its effects weren't so devastating. The St. Louis Fed paper tells of the step by step process which brought about the subprime market: the deregulation of restrictions on financial institutions, loosening of restrictions on lending, etc. The process made more credit available to more people and that was thought of as a good thing. However, they also recognize that the most variable form of credit was now going to more people who were more at risk of not paying it back. Gov. Gramlich's speech from 2004 hints softly at the warning signs of this marked in a large number of foreclosures. The mentality at the time was that this is "ok" because more people are in "their own homes." However, unlike loans to a business, where credit can be applied to increase the business's chance of increasing its income, a home loan does not at all increase the payees ability to increase their own income and repay. The logic used to accept the reality staring these legislators and analysts in the face is ludicrous.

The failure of logic didn't stop with the creation of a fragile fiscal apparatus, it spread into higher forms of investment, as described in the Fed Reserve of Dallas's report. This article describes the deregulation of the barriers between investment banks and commercial banks allowing cross-pollination of large financial institutions. The hope was that this would "increase competition, thus generating greater efficiencies and economies of scale and benefiting consumers and the economy." However, the reality is that when the barriers fell the companies started combining and reducing options. It allowed Bear Stearns and other financial heavies to invest in the poorly established subprime market putting at risk enormous sectors of the economy that used to be firewalled by regulations to protect against just such a failure.

Any "recovery plan" that does not undo what these deregulations did will not stop the hemorrhaging. Pouring money into the system will only temporarily fill up the economic tub. The hole at the bottom of the tub needs to be sealed so that it won't become bigger.

The silver lining to this fiasco is that we can confirm that anyone who looks proudly at the economic deregulation of the 80's and 90's should probably be kept out of any further federal decisions before they risk any other critical function of government with their blind incompetence.

The Evolution of the Subprime Mortgage Market, January 2006
From the Federal Reserve Bank of St. Louis

The ability to charge high rates and fees to borrowers was not possible until the Depository Institutions Deregulation and Monetary Control Act (DIDMCA) was adopted in 1980. It preempted state interest rate caps. The Alternative Mortgage Transaction Parity Act (AMTPA) in 1982 permitted the use of variable interest rates and balloon payments.

These laws opened the door for the development of a subprime market, but subprime lending would not become a viable large-scale lending alternative until the Tax Reform Act of 1986 (TRA). The TRA increased the demand for mortgage debt because it prohibited the deduction of interest on consumer loans, yet allowed interest deductions on mortgages for a primary residence as well as one additional home. This made even high-cost mortgage debt cheaper than consumer debt for many homeowners. In environments of low and declining interest rates, such as the late 1990s and early 2000s, cash-out refinancing6 becomes a popular mechanism for homeowners to access the value of their homes. In fact, slightly over one half of subprime loan originations have been for cash-out refinancing.

The growth through the mid-1990s was funded by issuing mortgage-backed securities (MBS, which are sometimes also referred to as private label or as asset-backed securities [ABS]).

Remarks by Governor Edward M. Gramlich At the Financial Services Roundtable Annual Housing Policy Meeting May 5th 2004!

While the basic developments in the subprime mortgage market seem positive, the relatively high delinquency rates in the subprime market do raise issues. Even further social benefits would result if various institutions could agree on and implement changes that would lower foreclosures.

Ownership rates have now risen to more than 68 percent, and foreclosures are relatively high in the subprime market, an important source of new mortgage loans.

"Slow but Steady Progress Toward Financial Deregulation"
Southwest Economy, Issue 1, January/February 2003,
From the Federal Reserve Bank of Dallas

Financial Services Modernization Act of 1999, also known as Gramm–Leach–Bliley, was hailed as a major step toward ending government regulation that was initially imposed following the stock market collapse in the late 1920s and the ensuing Great Depression. Proponents claimed that eliminating the artificial barriers that divided the financial sector into distinct industries would increase competition, thus generating greater efficiencies and economies of scale and benefiting consumers and the economy.