Opinion: “The Policies that Got Us Into This Mess”

Posted on September 2, 2012 by

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In the context of the upcoming election, I keep hearing about “the policies that got us in this mess.” Let’s be clear about what those policies are, and what “this mess” is.

This mess:

As of September, 2012, we have GDP growth less than or near 2% for most of the last 4 years, unemployment above 8% for most of the last 4 years, depressed housing prices nationwide and millions in foreclosure.

What got us in this mess:

  • It was not tax policy,
  • It was not debt,
  • It was not the lack of (or excess of) government spending.

It was the market crash of 2008-2009 that began under George W Bush’s presidency and continued under Obama’s. That and the related implosion of banks and financial institutions is the primary cause of the present recession from which we have not yet recovered. However, these failures have a common cause with an earlier origin…

What really got us here:

We got here through a complex, interrelated set of government polices, banking policies, and market forces that set the world up for an amazing fall. They are:

  1. US government support for the idea that everyone should own a home: ca 1995, that support took the form of metrics that rewarded mortgage companies for making loans to those who couldn’t really afford them.
  2. Creation of mortgage contracts (like ARMs) with artificially low initial rates that were extremely attractive to people who couldn’t really afford them.
  3. Absence of processes to properly qualify people for mortgages: For instance, it was possible in the mid 2000s to get a loan without any proof of income. Millions of families got ARMs that they should not have and which ultimately failed.
  4. Creation of a huge market for mortgages with mortgage-backed securities (MBSs) that provided a means for the world to fund an incredible housing boom that delivered huge loans to these people who couldn’t afford them.
  5. Bad math:  Without going into too much detail, the creators of MBSs incorrectly estimated the likelihood of mortgage failures and this led to mis-pricing of MBSs (too low) and consequently mortgage interest rates that did not reflect their true risk. If they had gotten this math right, mortgage rates would have been significantly higher, and fewer folks would have qualified for them or asked for them.
  6. Credit default swaps (CDSs): Again, I will skip details, but these instruments let the rest of the world bet on MBSs without even owning them.  There was a primary market in mortgages and now a secondary market in CDSs that was several times larger.
  7. Ratings agencies did not understand the risks of MBSs and gave them top ratings.

Items 1-4 fueled each other in a positive feedback loop that fed an unprecedented building spree, along with loans to millions of families who were doomed to default on their loans.  5, 6 & 7 enabled the entire world to participate in this terrible fantasy.

How the implosion happened:

It  is not complicated. First, in 2007 and 2008 the people whose ARMs shifted to the high rate began to default on their mortgages. This was the trigger that initiated a negative feedback loop that drove us into recession.  MBSs began to fail at unexpected rates and in concert CDSs propagated the losses to others. Stock prices and companies themselves began to falter. Now more people defaulted on their loans. More defaults on led to more MBS failures, and so on.

Whose fault is it?

We made at least two mistakes, the first was the original shift in policy to allow folks who should not have, to get loans they didn’t really qualify for.  This shift began in the 1990s under Clinton and continued in the 2000s under George W Bush. The other, more important mistake was lack of oversight of the MBS and CDS markets.

These two financial instruments “snuck up on us” in the sense that they quickly but quietly became a significant and trusted component of portfolios on Wall Street and world wide. That in itself is not as important as the fact that they were poorly understood.  Neither the issuers, the buyers nor government regulators correctly estimated the risk in these contracts.

It is not clear to me that either party saw these problems coming, or that they could have or would have shifted policies to prevent them.

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Posted in: public policy