Friday, December 17, 2010

Triggers & Bullets

Paul Krugman has an op-ed in the New York Times today and, while I have no bones to pick with it and it makes valid points about the duplicity of the conservative gameplaying on financial regulation, he leaves intact by implication what I believe to be a common oversimplification of the financial collapse. He implies throughout that the sudden fall of major financial houses was caused by “the housing bubble” specifically; by too many houses being sold and by housing prices becoming artificially inflated. His quest for regulation implies otherwise, but he never actually says so.

When someone commits homicide with a gun, he pulls a trigger, but it is not the trigger which causes the victim’s death. The agent of death is the bullet, explosive propellant and cartridge, activated by the mechanism of the gun and set in motion by pulling the trigger. If the gun is not loaded, then pulling the trigger is a completely harmless act.

The defaulted mortgages constituted the trigger event of what led to the collapse, but the explosive and bullet that caused the havoc were the machinations of financial institutions, the games they had been playing with those mortgages. Had they not been doing those things, the defaulted mortgages would have caused much less harm. Homeowners defaulting on mortgages pulled the trigger, but it was financial institutions who loaded the gun by repackaging and reselling those mortgages in “creative” ways.

Each time a mortgage was repackaged or resold, its nominal value was increased to cover the risk of that resale and, of course, to pay the fees of the seller. In addition, new financial instruments could be created, and were, on that mortgage which had no formal tie to that mortgage at all. By the time a mortgage was resold a few times, and with related instruments counted, that mortgage might be worth several times its original value. Well, it would be priced at that level, it would not have gained in actual worth.

So default by a homeowner now no longer meant that a $150,000 loan went sour, most of which could be recovered by sale of the underlying property, it now meant as much as $500,000 in loss, virtually all of it unrecoverable, because of “creative paper” which had been written around the mortgage. (The numbers here are for relative purpose only.)

If mere overvaluing of the underlying properties were the problem, then significant amounts of default could still be recovered, meaning losses but not collapse. In any case the financial collapse was a sudden event that suggests a “house of cards” falling down. It says that defaults triggered concern, causing the intricacies of the “creative paper” to be looked at and found to be bogus.

The excessive lending certainly was problematic. It increased the size of the housing bubble and made the size of the collapse bigger. It was in response to interest rates kept low by the government and the “creative papering” of the financial sector, and without either one of those in place it would not have happened. It was reactive, not causative.

Financial houses such as Goldman Sachs, AIG and other “too big to fail” institutions were involved only to the extent that they were the “creative paperers” and, as such, are escaping blame by conservatives because they did not make the loans that are failing. That is exactly backwards. They created the whole structure upon which all of the fraud was based. Notably, not holding mortgages but holding the “creative paper,” they suffered the collapse or risk of collapse.

Freddie Mac and Fannie Mae are targets for conservatives who want to avoid regulation, and that too is backward. All they have ever held was mortgages, the trigger and not the killer in this debacle, and even those they got into relatively late in the game. Notably, holding only mortgages, they have suffered heavy loss but have not been threatened with collapse.

Anyway, I’m with Paul Krugman on this; we need to do a better job on regulation than it appears we are doing.

1 comment:

  1. Nice post and explaination. Agreed with the need for better regulation [and oversight].