Arnold Kling  

Recommended Reading on the Financial Crisis

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Just for fun, Felix Salmon's take on Citicorp management. I would make a similar criticism of the Freddie Mac CEO during the 2003-2008 period. But from the larger systemic perspective, is bad management really an exogenous variable? Or is it inevitable in a bubble that bad managers will find their way to firms and, more importantly, that in a bubble bad managers will be given much more leeway to do dangerous things?

Also, recommended by Greg Mankiw are two valuable papers, one by Baily, Litan, and Johnson and the other by Hall and Woodward. The latter ask why the problems of asymmetric information and principal-agent problems were so fatal in this instance.


If capitalism could not solve this general type of problem, capitalism would not be viable. While there does appear to be irresponsibility at nearly all levels of the subprime mess, similar chains of responsibility in the prime mortgage market were present since the creation of Ginnie Mae in 1968, and have operated successfully. The subprime failure is unique.

All products involve chains of responsibility. A supplier of crankshafts to Toyota cannot provide shoddy goods just because a failed crankshaft becomes Toyota's problem, And Toyota cannot ignore the problem because it falls on the owner of a Toyota.

I think that the way that capitalism wants to solve the problem of mortgage securitization is to stop doing it. My conjecture is that if there were a level regulatory playing field, then old-fashioned mortgage lending would win and securitization would lose.


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COMMENTS (15 to date)
Mary Saunders writes:

This just seems so obvious. I can't understand why not one Congressperson seems to get this.

If absentee landlords are still considered to be sub-optimum in the rental market, how are absentee mortgage-holders substantively better?

Fannie and Freddie were out of scale and out of place. They cannot possibly deal responsibly with the inventory on their plates.

Taking care of these properties is going to fall on local governments, who aren't prepared either.

The unemployed who are now getting hung-up on by overwhelmed employment offices might as well just go to their local libraries and church basements and start making plans on their own about how to take care of abandoned properties.

They can design the Requests for Proposals (RFP's), then design the proposals themselves, and then ask the local governments to sign off, or not, on the model of South American workers taking over abandoned factories.

The last public meeting I tried to go to had a locked door, and I could not get in. I could see the people inside. Maybe they could not see me. Gloria Steinem as said women over 50 are invisible.

The hobbit wanted the ring of invisibility. I'm not sure I do on a cold and rainy night.

I worked for a Holocaust survivor many years ago. She said when the Russians invaded her homeland, they took the biggest houses and had dances there. She was a child, and she used to sneak off to watch the grown-ups dance through the windows.

I hope we don't have to go through a Weimar or Argentinian inflation on our way to such a thing.

Portland people are uncommonly blessed. Libertarians on the right/left and anarchists on the right/left have seen this coming for such a long time. Preparations have been made.

Mercutio.Mont writes:

"I think that the way that capitalism wants to solve the problem of mortgage securitization is to stop doing it."

Unfortunately, people have this wacky belief that high land prices are good. Strange, since they don't seem to enjoy paying lots of money for gasoline, food, or televisions. And as long as people want high land prices, politicians would commit suicide to cut policies - such as securitization subsidies - which keep land prices high.

I have a further question: Why doesn't the "mania" explanation get much traction?

Gary Rogers writes:

"Or is it inevitable in a bubble that bad managers will find their way to firms and, more importantly, that in a bubble bad managers will be given much more leeway to do dangerous things?"

I think you may be onto something with these statements and would really like to hear more details, but they make more leaps than my mind can follow. Why would bubbles make bad managers find their way to any particular type of firm? Why would bubbles give managers more leeway to do dangerous things?

My personal opinion is that years of stimulative measures created both bubbles and bad managers. Low interest rates reduce savings while making leveraged deals more profitable. At the same time we had tax deductions for home mortgages, low down payment loans for low income home buyers and a plethora of other stimulative measures. As savings dwindled, leveraged deals became easier to make and economic bubbles formed and burst. Each bursting bubble created more economic stimulus which brought us to our current situation.

Our situation is not new, though. It is not the derivitives or the CDOs or even bad managers that did this. It is the fact that we have spent ourselves into insolvency at almost every level of our economy. It is a problem that has been seen over and over throughout history and it cannot be solved with more economic stimulation.

Here is what I think is critical:

We need to recognize what the problem is so we do not make it worse.

We get rid of managers that risked too much through too much leverage by allowing companies to fail.

We do not add to the problem by introducing stimulus packages that borrow more money.

We come to grips with federal debt.

Larentino writes:

I have proceeded up to the page 6 reading "Like other successful central banks, the Fed has dedicated its interest-rate policy to the single objective of stabilizing inflation at a low positive level, a policy that has the healthy side effect of calling for stimulus in recessions and moderation in booms."

and then page 7,
"Had the Fed pursued a high-interest policy in the late 1990s to cool off the stock market, deflation would certainly have occurred, creating a intractable problem."

and I gave up further reading. Why the deflation on the earth would be the "intractable problem" if it is a consequence of growing productivity? If productivity rises,then one would expect prices exactly to fall (many individual prices have fallen indeed dramatically during the previous decade). The same old puzzle of the mainstream economics: it is good and well for individual prices to fall as a consequence of technological and managerial innovations and productivity growth, but somehow, miraculously, it becomes "intractable problem" when those individual price decreases translate into falling general level of ALL prices. Then we suddenly need central bank to stop this "intractable problem", by pumping money into the system. That is rubbish.

michael svehla writes:

"...........creation of Ginnie Mae in 1968, and have operated successfully. The subprime failure is unique."

I don't think this is a true statement. This Ginnie Mae construct may have been a final point of divergence, where the financial interests cut all moral and ethical ties with the general society, but I think the divergence began far earlier.
Capitalism has never worked, it is just a bunch of experiments looking to escape regulators.

Larentino writes:

"Capitalism has never worked, it is just a bunch of experiments looking to escape regulators."

Didn't you see little contradiction here: if capitalism always had to undertake experiments to "escape regulators" then capitalism had never been allowed to work in the first place? How do you knew it never worked when it never existed free of regulations/regulators?

RobbL writes:

Larentino sez;

"...How do you knew it never worked when it never existed free of regulations/regulators?"

Perhaps you are unfamiliar with the past? Capitalism did have a period of no regulation. Try reading "The way we live now" by Trollop. The reason we have regulations is that we have seen what capitalists do when there is no regulations.

The last line of defense of any defective system on the right or left is to claim that it hasn't been tried.

BB Smith writes:

Michael Lewis points out in his Portfolio.com article, The End, that investment banks created the Black Box of their own destruction by going public. They spread the risk of their investments far beyond the small group of owners who once took personal responsibility for their investments. The rest is history

tom writes:

Arnold, what is the way around your new/old system of 80/20, 30-yr fixeds? How do low-income low-savings people buy homes?

I think you there are good answers to that question, but you need to be pushing them publicly, not leaving them as implicit consequences of your plan:

1. home-ownership levels will and should fall by 10% or more. Renting is honorable and sustainable and more stable than the type of fake 'ownership' that comes with low down payments. Much of the case for home-ownership has been wildly overstated because it was premised on the type of borrowers who bought homes in the past (people who put down 10 or 20%), not 'buyers' who stepped in more recently as renters with equity-upside options.

2. Governments would have to directly guarantee or issue the debt for non-qualified borrowers and keep it on its books.

3. Uninsured/un-government-guaranteed lenders could re-start the subprime market as they wish, with it being clear that they are not getting any government help.

To really sell your 'neuter the guaranteed banks' idea you must say what will happen to the riskier deals. You would have had to do that under George 'House Party!' Bush, and you will have to do it even more under a Democratic administration.

Now is the time to make the case that home ownership doesn't mean anything in itself; that rising home ownership levels were an effect of stability more than a cause of it.

RWard writes:

"Why would bubbles make bad managers find their way to any particular type of firm? Why would bubbles give managers more leeway to do dangerous things?"

Can't speak for Arnold, but his thoughts sound rational to me.

My reasoning goes as follows: firm in a bubble area are going to be expanding quickly (or, as in the dot com boom, created quickly), so there's an increased demand for workers and managers at all levels. Given the short time-frames, there isn't enough time for labor supply to adjust, so the increased demand means that lower quality applicants (at all levels) are accepted. Since it's easier for a low-quality manager to get a job/higher pay at a firm related to the current bubble, they'll gravitate there. Moreover, even a low-quality manager can appear productive when the field they're in is expanding faster than their incompetence is causing problems...

At the same time, the firm in question is likely to be expanding rapidly thanks to the bubble. In turn, the corporate governance is unlikely to be able to keep pace with the rate of expansion. This open more possibilities for the managers at various levels to... work creatively, shall we say? In addition, a bubble is going to encourage risk-taking in any case, since the rewards are high and the risks are obscured (or completely forgotten, depending on the length of the bubble).

Everything combined would work out pretty much like Arnold suggests.

Larry writes:

Isn't another critical exogenous variable the explosive growth of return-chasing savings worldwide in the past decade, especially from Asia and the Middle East? Wasn't that the fuel for this whole affair?

Alex writes:

"My conjecture is that if there were a level regulatory playing field, then old-fashioned mortgage lending would win and securitization would lose"

Arnold,

Do you feel the same about CMBS vs on-balance sheet commercial mortgage lending?

Bill Stepp writes:

The Toyota analogy is wrong. To make it correct, there would have to be a criminal who was intervening to make the crankshafts defective. The ultimate fault is with him, and Toyota can bring an action against him and be compensated. The role of the criminal in the financial scenario is played by the Fed. Greenspan has done more damage to the world economy than anyone except 43, although he may well have earned the top spot when the dust finally settles, accounts are cleared, and the taxpayers are through being robbed.

Larentino writes:

RobbL,
yes, financial free capitalism has been tried, but incontinently - not in America, but in Hong Kong, Singapore, Cayman Islands, Virgin Islands e.g, or even better in Scotland's and Sweden's experiment with free banking. Even Canada today has less regulations in financial sector than USA. Even XIX century US banking and financial system was far from free, with many regulations concerning branching (one of the key factors for banking sector collapse during Great Depression. No single bank collapsed in Canada in great Depression). Nothing to say about orgy of government meddling in XX century. To say that free capitalism has been tried in America and failed so we know need government help is completely contrary to historical evidence.

Lorentino writes:

sorry, typo - not "incontinently", but "inconveniently".

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