Tuesday, September 23, 2008

Forced Clarifications

Due to happenstance, I managed to speak to Charles today about my last blog post. He said I was wrong about my assertion that deregulation was to blame for the latest stock market hiccup. And I should stress that as far as the stock market is concerned it is just a hiccup because the total market drop, though severe, is not as bad as "real" crashes that occurred in 1929 and 1987. The drop was about 4.4% of the market, which is nothing compared to the low twenty-some percent from '87 and I have no idea, but I'm sure it was pretty bad in 1929. I'm not going to look up the exact percentages. I'm sure we can agree there is a huge difference percentage wise from those two events as compared to recent events.

Charles claimed that the current situation is due to the banks being forced by the government to lend money to poor people who would not ordinarily qualify for mortgage loans. As a result, it was governmental interference which caused the problem and the government should have stayed out of it. I told him I would look into it because I had never heard anything about it. He called me a liar (without actually using those words) in regards to my promise to look into it.

Anyway, this post is my response to his criticisms. First, I should remind people that I am neither a Democrat, nor a Republican as I feel both organizations are two halves of the same coin. So I don't blame one side or the other for deregulation. It has primarily occurred under Republican Presidencies, but this is due to the fact that the deregulation process has dominated the political scene over the last 28 years and Republicans have controlled the Oval office 20 of the last 28 years. Deregulation is, however, a cornerstone to conservative thinking, but both democrats and Republicans vote the nonsense through. This is why they are two halves of the same coin. (It's a matter of looking at actions and ignoring their words.)

Second, Charles also has an unfortunate habit of doing what most people do (even myself) of oversimplifying and blaming one or two key points for a problem. In reality, problems, especially economic ones, have much more complicated causes. Many factors contributed to the recent hiccup. I know, everyone's thinking, "Gosh golly Patrick, you're trying to blame deregulation, a single issue, as the cause." Admittedly, it looks that way, but deregulation is a rather broad excuse. If anything, people should say I am not being specific enough when I point to it as a cause.

Now, as for Charles's criticisms, I couldn't find any info directly relating to government agencies forcing lending institutions to make loans to low income individuals, but that doesn't mean it's not out there. It probably is, alas, the internet is a big cesspool of information and if you don't get your search criteria just right, you may not find the information you're looking for, or it may not land in the first three pages of search results. Who really goes any further?

So for the sake of this discussion, I'll assume Charles is correct and there were governmental influences in lending to low income crowd. It would not surprise me since the government made a big push to encourage people to keep spending after 9-11, despite all the accounting scandals that were going on at the time and getting pushed to page 12 because of the terrorist attack. Incredibly bad advice in my opinion. Telling people to go out, spend money, and pretend the economy is okay to show those dang terrorists that they can't beat our way of life, when at that very moment our economy was in a pretty serious down swing. Only a politician (or Texan?) could come up with bullshit like that, but I digress.

Naturally, forced lending to the poor are not the only influences on banking procedures. Here is a good article from the Motley Fool (an investment advisor website) entitled, "The Financial Crash in Plain English", by Cliff D'Arcy.

I'll summarize the article: The low interest rates gave banks the prime opportunity to take more risks in their lending practices and they gave out loans to higher risk people (Note it says nothing about being forced to do so by the government). Banks then took these loans and created bonds and other derivative instruments (a security that "derives" its value from another source) and sold them off to other banks and insurers after giving them a stamp of approval as a highly rated security.

The article doesn't mention derivative securities, as they are a bit of a mystery that neither Charles nor I fully understand. The article does mention the banks waving a magic wand to create them. When I get to my argument, we'll see why they're a deregulation problem.

The article also fails to mention the rise in the interest rates and only mentions a decrease in housing values. This is a serious omission in my opinion because these low interest mortgages weren't fixed rate mortgages. They were variable rate mortgages and when the interest rates went up, so many people that were "on the bubble" had been given loans they could no longer afford. Couple that with the drop in house prices that the article does mention and you have people defaulting on loans for property that is not worth the amount of the loan or at least not the proper "industry standard" in terms of the percentage of the loan.

Eventually, investors realize they have been duped. The shitload of bad loans winds up hampering the lending ability of many institutions and a credit crunch starts beginning last fall (about a year ago) and is evidenced by a decrease in loans being made between banks. In short, they don't trust the solvency of each other. Over the last year, housing prices have slipped further and more loans have been going bad. The article actually goes through and lists all the companies that started failing because of this decline starting with a UK company last September, through Fannie Mae, et al this spring, and on up to the present. (Basically, this shows the problem is not restricted to just the U.S. and gives me further cause to doubt Charles's claims that government involvement caused all this.)

After that, the article goes on to speak to the investor and what all this means to them. Knock yourself out. It's not germane to this discussion.

Okay, so far we have Charles's hypothesis that is not terribly supported by a professional , but as I also pointed out, Mr. D'Arcy picks his battles in over simplification and doesn't get into other details I felt were important, so I still can't disregard Charles's claims altogether, but I don't think I can agree that government regulation caused the problem. It's clear greed had much more to do with it. What a surprise!

Now I'll get into my deregulation argument as the primary cause. A tedious task no doubt, but when I get into these types of discussions I am forced to actually look up the names of these things, so I guess this is good practice at reinvigorating my knowledge base. Start with this article, The Long Demise of Glass-Steagall. It's not so much an article as it is a timeline of the primary regulations set into place after the Great Depression to aid in avoiding another Great Depression. The law was called the Glass-Steagall Act. I'll use highlights from this to prove my point. I could use more resources, but I'm already getting sick of writing this, no doubt you are getting sick of reading.

We start in 1933 with this act, according to the article, the legislation sought "to limit the conflicts of interest created when commercial banks are permitted to underwrite stocks or bonds." This legislation forced "banks to choose between being a simple lender or an underwriter (brokerage)." An underwriter is a company that assesses risk on investments. Hopefully, you can already see where I'm going with this based on my earlier comment.

The law is actually strengthened in 1956, not much happens in the '60s and 70's, but banks and brokerage firms begin their lobbying attempts to get Congress to relax the law. That appears to not have worked out so well, so in 1986 & 87, the Fed steps in and "reinterprets" some key passages that allow banks to start acting as brokerages, but limits them to 5% income on such matters. (The first signs of deregulation!)

The law is loosened to a 10% limit in 1990.

In '91 and again in '95 legislation is nearly passed to repeal Glass-Stegall altogether.

In '96 & '97 the Fed raises the underwriting limit to 25% of the institutions income. (According to the article this renders the Glass-Steagall Act obsolete as "Virtually any bank holding company wanting to engage in securities business would be able to stay under the 25 percent limit on revenue." I don't personally know enough about financial markets to make this assessment. I'll leave that determination up to the reader. I can say that that is, obviously, a rather significant percentage of a company's income. Certainly enough to get banks interested in the practice.)

In 1999: "After 12 attempts in 25 years, Congress finally repeals Glass-Steagall, rewarding financial companies for more than 20 years and $300 million worth of lobbying efforts. Supporters hail the change as the long-overdue demise of a Depression-era relic." (A law signed by Clinton! And nobody believes me when I call him a snake. But again, deregulation is not a Democrat versus Republican issue.)

The timeline stops there, but let's recap with what was said above.

Banks started bundling their bad loans together into bonds and other magical derivative instruments. They then used their underwriting priveledges to over assess their value and pawned them off onto other institutions. A priveledge obtained through the deregulation of the laws put in place just after the first great stock market crash of 1929. Laws that were made to prevent this very circumstance.

Thus, we had the laws in place to keep this EXACT thing from happening and they were deregulated out of existence throughout the '80s and '90s. So how exactly is the current problem not due to deregulation? Given these facts, there is no way anyone can claim deregulation is not to blame.


charles said...

Pat: I don’t think I implied you were a liar. I think that you are simply either misinformed or naive. (Hehehehe I always wanted to say that to someone as smart as you).

When you tell the financial institutions how they are going to deregulate, how they are going to operate, and encouraging them to operate in a certain way through incentives and penalties, then it certainly isn’t deregulation, is it? Its still a planned government controlled and highly regulated process.

Doing away with some outdated regulations isn’t “deregulation.” Creating organizations like FANY MAE to “buy” mortgages so that the banks can lower their underwriting standards isn’t deregulation. Nor is raising the FDIC amounts to $100,000 per account so that banks don’t have to worry about making risky loans. Nor is it deregulation when you force banks to participate in “community development” funding projects or forcing them to stop “red lining” practices.

The base root of the problem is actually our tax code. If I had more time I would tell you why.

Doc Brown said...

When I said you implied I was a liar, I was referring to your comments about me not responding to your criticisms. You implied that I would not.

As for your criticisms here, you are now wasting my time. You seem to be portraying yourself as not understanding the difference between "deregulated" and "unregulated". Deregulation refers to the systematic reduction or simplification of regulations under the guise of encouraging more efficient operation of a market. Deregulation is not the complete removal of regulations. Last week was the result of macroscopic changes in the banking industry throughout the '90s. If the banks were completely unregulated, Lord knows how bad things would be now.

Furthermore, saying that regulated deregulation on the banks is regulating the banks is nothing more than semantics and double-speak. Trying to back up your argument through the use of microscopic regulations designed to spur growth in underfunded areas does not disprove the argument I gave in the main entry. Besides, the banking industry has far too much money (Hell, in a way, they have ALL of it!) to lobby with, if those regulations you refer to were so detrimental to the industry, they would have been able to buy their way out of them.

Until you can find some evidence to disprove the very simple argument I made, you have demonstrated nothing. Here is a link to the fallacy you are employing:


charles said...

Good Morning Pat:

Community Reinvestment Act

Instead of wasting your valuable Pat Cave time explaining it to you in the simplied language necessary to explain simple concepts to the overly intelegent (read book smart) I am going to suggest you watch the following. It has a good sound track.