Democrats to blame for financial crisis?

The view from Fox News:

Buffett warned Congress of "biggest financial meltdown"

Buffett urged Congress to pass the Troubled Asset Relief Program:

Legendary investor Warren Buffett warned Congressional leaders Saturday night of "the biggest financial meltdown in American history" if they did not act to secure the financial system.

Buffett, by telephone, was consulted by lawmakers who were in marathon talks on Capitol Hill to forge a deal on the administration's $700 billion economic bailout plan, according to two sources.

One lawmaker in the negotiations said that the participants called Warren Buffett to get his help in gauging potential market reaction. ...

Earlier in the week, Buffett also warned that the financial crisis is "everybody's problem," not just Wall Street's. The potential collapse of financial institutions would cause industry to grind to a halt, he told CNBC Wednesday, and could have "gummed up the economy."

Paul Krugman critiques the draft version of TARP

Krugman's critique:

So there’s a draft version of the bailout out there. Pretty much as expected. Section 113, MINIMIZATION OF LONG-TERM COSTS AND MAXIMIZATION OF BENEFITS FOR TAXPAYERS, is where the rubber meets the road — it’s where the plan says something about how the deals will be done.

As I read it, Treasury can
(1) conduct reverse auctions and suchlike
(2) buy directly — but only if it gets equity warrants or, in companies that don’t issue stock, senior debt

My view is that (1) will be ineffective but also not a bad deal for taxpayers — firms that can afford to will dump their toxic waste at low prices, the way some already have on the private market, and taxpayers may end up making money in the end. Firms in big trouble will probably stay away from the auctions. The plan’s real traction, if any, is in (2), which is a backdoor way to provide troubled firms with equity — and the bill seems to say that taxpayers have to own this equity, although I wish it was clearer how much equity will be judged sufficient.

Not a good plan. But sufficiently not-awful, I think, to be above the line; and hopefully the whole thing can be fixed next year.

Add: House staff tells me that there are significant changes from this draft. More info when I get it.

Mankiw: Obama Distorting History

Harvard economist (and Republican) Greg Mankiw is very critical of one of Obama's answers during the debate:

In the debate last night, Barack Obama asked a good question about the present financial crisis but then gave an answer that is, at best, incomplete:

The question, I think, that we have to ask ourselves is, how did we get into this situation in the first place? Two years ago, I warned that, because of the subprime lending mess, because of the lax regulation, that we were potentially going to have a problem and tried to stop some of the abuses in mortgages that were taking place at the time....we're also going to have to look at, how is it that we shredded so many regulations? We did not set up a 21st-century regulatory framework to deal with these problems. And that in part has to do with an economic philosophy that says that regulation is always bad.

The main problem, we are led to believe, was a Republican ideology of unfettered capitalism that led to insufficient government involvement in the financial system.

Senator Obama might want to read this NY Times article from 1999:

In a move that could help increase home ownership rates among minorities and low-income consumers, the Fannie Mae Corporation is easing the credit requirements on loans that it will purchase from banks and other lenders....Fannie Mae, the nation's biggest underwriter of home mortgages, has been under increasing pressure from the Clinton Administration to expand mortgage loans among low and moderate income people.

I am not suggesting that the entire crisis should be put in the lap of the Clinton team. There is plenty of blame to go around. Indeed, the problem goes back at least as far as the Johnson administration, which helped set up a housing finance system that was always fundamentally flawed.

If Senator Obama really wants to transcend partisan politics, as he would sometimes have us believe, he might want to give a slightly more balanced view of the history of how this all started. He also might want to take note that the Bush administration warned about some of these problems five years ago and had its reform efforts stymied by prominent members of Senator Obama's own party.

An Analysis of the Financial Crisis

University of Chicago economist Robert Shimer analyzes the financial crisis:

Let me explain what I think is happening in credit markets. This is my assessment, formed through numerous discussions with colleagues.... As everyone now knows, financial institutions hold significant assets that are backed by mortgage payments. Two years ago, many of those mortgage-backed securities (MBS) were rated AAA, very likely to yield a steady stream of payments with minimal risk of default. This made the assets liquid. If a financial institution needed cash, it could quickly sell these securities at a fair market price, the present value of the stream of payments. A buyer did not have to worry about the exact composition of the assets it purchased, because the stream of payments was safe.

When house prices started to decline, this had a bigger impact on some MBS than others, depending on the exact composition of mortgages that backed the security. Although MBS are complex financial instruments, their owners had a strong incentive to estimate how much those securities are worth. This is the crux of the problem. Now anyone who considers purchasing a MBS fears Akerlof's classic lemons problem. A buyer hopes that the seller is selling the security because it needs cash, but the buyer worries that the seller may simply be trying to unload its worst-performing assets. This asymmetric information ... makes the market illiquid. To buy a MBS in the current environment, you first need an independent assessment of the value of the security, which is time-consuming and costly. Put differently, the market price of MBS reflects buyers' belief that most securities that are offered for sale are low quality. This low price has been called the fire-sale price. The true value of the average MBS may in fact be much higher. This is the hold-to-maturity price.

The adverse selection problem then aggregates from individual securities to financial service institutions. Because of losses on their real estate investments, these firms are undercapitalized, some more so than others. Investors rightly fear that any firm that would like to issue new equity or debt is currently overvalued. Thus firms that attempt to recapitalize push down their market price. Likewise banks fear that any bank that wants to borrow from them is on the verge of bankruptcy and they refuse to lend. This is the same lemons problem, just at a larger scale. No firm that is tainted by mortgage holdings, even those that are fundamentally sound, can raise new capital.

With a theory of the problem, we can now ask whether the Paulson plan would solve it. My understanding is that the $700 billion would be used in a series of reverse auctions. In such an auction, the government would announce its intent to use some amount of money to purchase a particular class of security. Financial institutions would then compete by offering the most securities at the lowest price. I think we can agree that it is implausible that the government would be better than other buyers at determining the current value of the stream of payments from those securities. This gives financial institutions a strong incentive to sell the government their lowest quality securities at the highest possible price. Indeed, the government seems to want sellers to unload their worst assets so as to improve their balance sheet, so there really is no conflict of interest here.

This program does not solve the lemons problem. The government purchases a lot of lemons at an inflated price. This improves the balance sheet of the firms that can sell their worst securities. It also improves the balance sheet of firms that own better securities because the market price of those securities will increase. ... But this is fundamentally no different than giving taxpayers' money to owners, managers, and debt-holders of firms that made the worst decisions.

Stiglitz: Who is to Blame for the Financial Crisis?

Nobel Laureate Joseph Stiglitz lays out the blame:

Many seem taken aback by the depth and severity of the current financial turmoil. I was among several economists who saw it coming and warned about the risks.

There is ample blame to be shared; but the purpose of parsing out blame is to figure out how to make a recurrence less likely. ...

One can say the Fed failed twice, both as a regulator and in the conduct of monetary policy. Its flood of liquidity (money made available to borrow at low interest rates) and lax regulations led to a housing bubble. When the bubble broke, the excessively leveraged loans made on the basis of overvalued assets went sour.

For all the new-fangled financial instruments, this was just another one of those financial crises based on excess leverage, or borrowing, and a pyramid scheme.

The new "innovations" simply hid the extent of systemic leverage and made the risks less transparent; it is these innovations that have made this collapse so much more dramatic than earlier financial crises. But one needs to push further: Why did the Fed fail?

First, key regulators like Alan Greenspan didn't really believe in regulation; when the excesses of the financial system were noted, they called for self-regulation — an oxymoron.

Second, the macro-economy was in bad shape with the collapse of the tech bubble. The tax cut of 2001 was not designed to stimulate the economy but to give a largesse to the wealthy — the group that had been doing so well over the last quarter-century.

The coup d'grace was the Iraq War, which contributed to soaring oil prices. Money that used to be spent on American goods now got diverted abroad. The Fed took seriously its responsibility to keep the economy going.

It did this by replacing the tech bubble with a new bubble, a housing bubble. Household savings plummeted to zero, to the lowest level since the Great Depression. It managed to sustain the economy, but the way it did it was shortsighted: America was living on borrowed money and borrowed time.

Finally, at the center of blame must be the financial institutions themselves. They — and even more their executives — had incentives that were not well aligned with the needs of our economy and our society.

They were amply rewarded, presumably for managing risk and allocating capital, which was supposed to improve the efficiency of the economy so much that it justified their generous compensation. But they misallocated capital; they mismanaged risk — they created risk.

They did what their incentive structures were designed to do: focusing on short-term profits and encouraging excessive risk-taking.

Bill Clinton is Right about Glass-Steagall

Recently, a lot of Democrats and left-leaning journalists have been blaming the 1999 repeal of the Glass-Steagall Act for today's financial problems. I believe they are wrong. Their reasoning is based on the post hoc ergo propter hoc ("after the fact, therefore because of the fact") fallacy. They reason that since Glass-Steagall was repealed in 1999 and we have a credit crisis today, the repeal of Glass-Steagall caused the credit crisis.

The truth is that there were far more bank failures a decade prior to the the repeal of the Glass-Steagall Act than there are today, even though today's financial crisis is much worse.

Instead, today's financial crisis is due to the decline of a housing bubble. The housing bubble was caused by unreasonably low Fed interest rates, a savings glut overseas, and the get-rich-quick mentality of home buyers.

While many Democrats and journalists are wrong about the repeal of Glass-Steagall, Bill Clinton is right:

One policy Clinton said he doesn't regret is his repeal of the Glass-Steagall Act in 1999, which, for the first time since the Depression, allowed commercial banks to engage in investment banking activities. Clinton said the commercial banks were an important moderating force on the risk-taking of the big investment firms that collapsed this week. "In the case of the current crisis, I believe the bill I signed allowed Bank of America to take over Merrill Lynch," he said.

If Glass-Steagall were still law, a troubled Bear Stearns would not have been allowed to merge with JPMorgan. Also, Goldman Sachs and Morgan Stanley would not have been allowed to become commercial bank holding companies. The repeal of Glass-Steagall has been a savior, not a villain.

Harvard Economist Greg Mankiw Endorses the Bailout

Harvard economist Greg Mankiw reluctantly endorses the bailout:

What is my opinion about all this? I am of two minds about the complex situation we find ourselves in.

On the one hand, I share many of the concerns of the letter signers and other critics of the Treasury plan.

On the other hand, I know Ben Bernanke well. Ben is at least as smart as any of the economists who signed that letter or are complaining on blogs or editorial pages about the proposed policy. Moreover, Ben is far better informed than the critics. The Fed staff includes some of the best policy economists around. In his capacity as Fed chair, Ben understands the situation, as well as the pros, cons, and feasibility of the alternative policy options, better than any professor sitting alone in his office possibly could.

If I were a member of Congress, I would sit down with Ben, privately, to get his candid view. If he thinks this is the right thing to do, I would put my qualms aside and follow his advice.

Krugman: A $700 Billion Slap in the Face

Paul Krugman points out why the Paulson/Bernanke plan is severely flawed. This should have been a full NY Times article, but Krugman made it a blog post instead (probably due to a desire to make it public ASAP).

The initial Treasury stance on the bailout was one of sheer demand for authority: give us total discretion and a blank check, and we’ll fix things. There was no explanation of the theory of the case — of why we should believe the proposed intervention would work. So many of us turned to our own analyses, and concluded that it probably wouldn’t work — unless it amounted to a huge giveaway to the financial industry.

Now, under duress, Ben Bernanke (not Paulson!) has offered an explanation of sorts about the missing theory. And it is, in effect, a metastasized version of the “slap-in-the-face” theory that has failed to resolve the crisis so far.

Before I explain the apparent logic here, let’s talk about how governments normally respond to financial crisis: namely, they rescue the failing financial institutions, taking temporary ownership while keeping them running. If they don’t want to keep the institutions public, they eventually dispose of bad assets and pay off enough debt to make the institutions viable again, then sell them back to the private sector. But the first step is rescue with ownership.

That’s what we did in the S&L crisis; that’s what Sweden did in the early 90s; that’s what was just done with Fannie and Freddie; it’s even what was done just last week with AIG. It’s more or less what would happen with the Dodd plan, which would buy bad debt but get equity warrants that depend on the later losses on that debt.

But now Paulson and Bernanke are proposing, very nearly, to do the opposite: they want to buy bad paper from everyone, not just institutions in trouble, while taking no ownership. In fact, they’ve said that they don’t want equity warrants precisely because they would lead financial institutions that aren’t in trouble to stay away. So we’re talking about a bailout specifically designed to funnel money to those who don’t need it.

It took four days before P&B offered any explanation whatsoever of their logic. But as of now, it seems that the argument runs like this: mortgage-related assets are currently being sold at “fire-sale” prices, which don’t reflect their true, “hold to maturity” value; we’re going to pay true value — and that will make everyone’s balance sheet look better and restore confidence to the markets.

As I said, this is really a giant version of the slap-in-the-face theory: markets are getting hysterical, and the feds can calm them down by buying when everyone else is selling.

So, three points:

1. They’re still offering something for nothing. In major financial crises, the beginning of the end comes when the government accepts that it will have to pay some cost to recapitalize the banks. But in this case they’re still insisting that it’s basically a confidence problem, and it we can wave our magic wand — a $700 billion magic wand, but that’s just to impress people — the whole thing will go away.

2. They’re asserting that Treasury and the Fed know true values better than the market. Just to be fair, it’s possible, maybe even probable, that mortgage-related paper is being sold too cheaply. But how sure are we of that? There are plenty of cash-rich private investors out there; how many of them are buying MBS? And isn’t it bizarre to have officials who miscalled so much — “All the signs I look at,” declared Paulson in April 2007, show “the housing market is at or near a bottom” — confidently declaring that they know better than the market what a broad class of securities is worth?

3. Even if it works, the system will remain badly undercapitalized. Realistic estimates say that there will be $800 billion or more of real, medium-term — not fire-sale — losses on home mortgages. Only around $480 billion have been acknowledged by financial institutions so far. So even if the fire-sale discount is removed, we’ll still have a crippled system. And Paulson is offering nothing to fix that — unless he ends up paying much more than the paper is worth, by any standard.

Meanwhile, Paulson and Bernanke seem to be digging in their heels against equity warrants or anything else that would make this a more standard financial rescue. I say no deal on those terms — and if the lack of a deal puts the financial world under strain, blame Paulson and Bernanke, who have wasted most of a week demanding authority without explanation.

Is More Regulation Really the Answer?

David Brooks points out the flaws of assuming more regulation is the answer to America's financial crisis.