Tag: financial crisis

Fixing Fannie Is Essential

This past week witnessed continued debate in congressional committees over changes to our financial regulatory system.  Perhaps catching the most attention was Fed Chairman Ben Bernanke’s appearance before House Financial Services. 

Sadly missing from all the noise this week was any discussion over reforming those entities at the center of the housing bubble and mortgage meltdown:  Fannie Mae and Freddie Mac.

While many, including Bernanke, have identified the “global savings glut” as a prime force behind the historically low interest rates that drove the housing bubble, often missed in this analysis is the critical role played by Fannie and Freddie as channels of that savings glut.  After all, the Chinese Central Bank was not plowing its reserves into Countrywide stock; it was putting hundreds of billions of its dollar reserves into Fannie and Freddie debt.  Fannie and Freddie were the vehicle that carried excess world savings into the United States.

Had this massive flow of global capital been invested in productive activities, or even just prime mortgages, it is unlikely tha we would have seen such a large housing bubble.  Instead, what did Fannie and Freddie do with its Chinese funds?  It invested those funds in the subprime mortgage market.  At the height of the bubble, Fannie and Freddie purchased over 40 percent of private-label subprime mortgage-backed securities.  Fannie and Freddie also used those funds to lower the underwriting standards of the “prime” whole mortgages it purchased, turning much of the Alt-A and subprime market into what looked to the world like prime mortgages.

Given the massive leverage (at one point Freddie was leveraged 200 to 1) and shoddy credit quality of mortgages on their books, why were the Chinese and other investors so willing to trust their money to Fannie and Freddie?  Because they were continually told by U.S. officials that their losses would be covered.  At the end of the day, Fannie and Freddie were not bailed out in order to save our housing market; they were bailed out in order to protect the Chinese Central Bank from taking any losses on its Fannie/Freddie investments.  Adding insult to injury is the fact that the Chinese accumulated these large dollar holdings in order to suppress the value of their currency, enabling Chinese products to be more competitive with American-made products.

While foreign investors have been willing to put considerable money into Wall Street, without the implied guarantees of Fannie and Freddie, trillions of dollars of global capital flows would not have been funneled into the U.S. subprime mortgage market.  As Washington seems intent on continuing to mortgage America’s future to the Chinese, that at minimum it seems that fixing Fannie and Freddie might help insure that something more productive is done with that borrowing.

Monday Links

  • Burnt rubber: Obama’s decision to slap a 35 percent tariff on Chinese tires whiffs of senseless protectionism.

If I Only Had a Crisis

Bloomberg News points out that President Obama needs a health-care crisis in order to impose a health-care “solution”:

President Barack Obama returns to Washington next week in search of one thing that can revive his health-care overhaul: a sense of crisis….

“At the moment, except for the people without insurance, we’re not in a health-care crisis,” said Stephen Wayne, a professor of government at Georgetown University in Washington. “You do need a crisis to generate movement in Congress and to help build a consensus.”

This administration has used Naomi Klein’s book The Shock Doctrine as a manual. Klein said in an interview that

The Shock Doctrine is a political strategy that the Republican right has been perfecting over the past 35 years to use for various different kinds of shocks. They could be wars, natural disasters, economic crises, anything that sends a society into a state of shock to push through what economists call ‘economic shock therapy’ – rapid-fire, pro-corporate policies that they couldn’t get through if people weren’t in a state of fear and panic.

Whether or not that’s true about the “right-wing” policies that she purported to analyze, the Obama admininstration has taken it to heart. Rahm Emanuel said, “You never want a serious crisis to go to waste.  And this crisis provides the opportunity for us to do things that you could not do before” such as taking control of the financial, energy, information and healthcare industries. Vice President Joe Biden, Secretary of State Hillary Clinton, and the president himself all echoed Emanuel’s exultation about the opportunities presented by crisis.

The financial crisis turned out to be shocking enough to let the federal government extend the power of the Federal Reserve, nationalize two automobile companies, spend $700 billion on corporate bailouts and another $787 billion on pork and “stimulus,” and inject a trillion dollars of inflationary credit into the economy. But now people are balking at further expansions of government, and the administration is longing for just a little more crisis to serve as a further opportunity.

Wednesday Links

  • Cato senior fellow Tom Palmer filing a lawsuit to legally carry firearms in Washington D.C.
  • Podcast: How some on the right-wing are doing everything they can to defend torture. Let’s just call them “enhanced justification techniques.”

Tuesday Links

  • Paul Krugman claims a victory for Big Government, which he says “saved” the economy from an economic depression. Alan Reynolds debunks his claim and shows why bigger government  produces only bigger and longer recessions.
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The Pay Czar at Work

Mark Calabria notes how the form of salary scheme at financial institutions played no apparent role in sparking the financial crisis.  But that hasn’t stopped the federal pay czar from boasting about his power, even to regulate compensation set before he took office.

Reports the Martha’s Vineyard Times:

Speaking to a packed house in West Tisbury Sunday night, Kenneth Feinberg rejected the title of “compensation czar,” but he also said said his broad and “binding” authority over executive compensation includes not only the ability to trim 2009 compensation for some top executives but to change pay plans for second tier executives as well.

In addition, Mr. Feinberg said he has the authority to “claw back” money already paid to executives in the seven companies whose pay plans he will review.

And, he said that if companies had signed valid contractual pay agreements before February 11 this year, the legislation creating his “special master” office allowed him to ask that those contracts be renegotiated. If such a request were not honored, Mr. Feinberg explained that he could adjust pay in subsequent years to recapture overpayments that were legally beyond his reach in 2009.

This isn’t the first time that federal money has come with onerous conditions, of course.  But it provides yet another illustration of the perniciousness of today’s bail-out economy.

Did Bank CEO Compensation Cause the Financial Crisis?

Earlier this summer, the House of Representatives approved legislation intended to, as Rep. Frank, put it, “rein in compensation practices that encourage excessive risk-taking at the expense of companies, shareholders, employees, and ultimately the American taxpayer.”

While there are real and legitimate concerns over CEOs using bailout funds to reward themselves and give their employees bonuses, Washington has operated on the premise that excessive risk-taking by bank CEOs, due to mis-aligned incentives, caused, or at least contributed to, the financial crisis.  But does this assertion stand up to close examination, or are we just seeing Congress trying to re-direct the public anger over bailouts away from itself and toward corporations?

As it turns out, a recent research paper by Professors Fahlenbrach (Ecole Polytechnique Federale de Lausanne) and Rene M. Stulz (Ohio State) conclude that “There is no evidence that banks with CEOs whose incentives were better aligned with the interests of their shareholders performed better during the crisis and some evidence that these banks actually performed worse…”

Professors Fahlenbrach and Stulz also find that “banks where CEOs had better incentives in terms of the dollar value of their stake in their bank performed significantly worse than banks where CEOs had poorer incentives.  Stock options had no adverse impact on bank performance during the crisis.”  While clearly many of the bank CEOs made bad bets that cost themselves and their shareholders, the data suggests that CEOs took these bets because they believed they would be profitable for the shareholders.

Of course what might be ex ante profitable for CEOs and bank shareholders might come at the expense of taxpayers.  The solution then is not to further align bank CEOs with the shareholders, since both appear all too happy to gamble at the public expense, but to limit the ability of government to bailout these banks when their bets don’t pay off.