Arnold Kling  

Hearing Post

My Planned Oral Remarks... An AP Stats Lecture...

After the hearing on Freddie and Fannie, my wife said, "You know, after I was finished with jury duty, I was feeling pretty patriotic. I wasn't feeling patriotic after this."

C-span took this photo.

The hearing covers two c-span videos, and I only appear on part of the second one. Most of the time was taken by the panel that included the former CEO's. The first video, which includes only them, is here.

The second panel is where I appear. My panel starts about 2/3 of the way through here. [UPDATE: a commenter found a file with just my panel here. For me, the flash video works poorly.]

Not surprisingly, there was a lot of posturing going on. My wife got tired of hearing Congressmen probe into the the salaries received by the former CEO's.

The chutzpah award goes to former Fannie Mae CEO Franklin Raines, who complained that regulators did not do enough to stop Freddie and Fannie from buying high-risk mortgages. I don't know where to begin on that one. I would say it's like a teenager who insists that you let him go to a party, then after he gets drunk and gets put in jail complains that you needed to give him more supervision. But it's even worse than that, considering all the lobbying Fannie did under Raines with the main purpose of emasculating regulation.

Richard Syron and Donald Mudd, the CEO's at Freddie and Fannie, respectively, when they dove into subprime, performed poorly at the hearing, in my opinion. During our panel, Ed Pinto, who now does consulting in the mortgage industry, completely devastated their attempts to claim that they mostly stayed out of subprime. [UPDATE: The New York Times agrees with me that Pinto was the star.]

I can imagine a consensus emerging to take Freddie Mac and Fannie Mae back under the government and use them to try to modify troubled loans. That would be the worst possible outcome. I spoke out against loan modifications, but I'm sure that I am a voice in the wilderness. The more we try to do loan mods, the longer the crisis will last and the more it will cost taxpayers. Other than that, they are a wonderful idea.

The room was basically empty when my panel spoke. The press had gone. All but three of the Congressmen had gone. My wife and daughter stayed, and I felt sorry for them, considering that the CEO panel ran at least two hours longer than expected, with few good questions asked and zero good answers given.

I'm glad they invited me, and I'm glad that I went. My father would have been proud. But it's hard not to come away thinking that I have more influence blogging.

Comments and Sharing

COMMENTS (22 to date)
burger flipper writes:

You acquitted yourself well.

I missed seeing the suits but did enjoy the geeks, though I did lament (as someone mentioned in the comments to your last post) the use of suits v geeks. Framing like like, and the simple analogies you have a flair with, really stick in the mind.

Glad you didn't mention the one-time wealth grab, though I'm sure they'll think of it on their own eventually.

R. Pointer writes:

I just read Liar's Poker where the process of stamping mortgages and tranching was described in 1989. This has been going on since, but only now they are blowing up. Why? What changed?

It has to be one thing. As Dr. Kling points out, no down payments on loans increased the danger.

This is the only thing that I can figure caused it. Maybe the increase in US government debt to massive levels slowly decreased the amount of credit available to lenders and thereby cut the cord on a ponzi scheme, but that is not so clear.

Way to hit'em Dr. Kling.

Keep up the good work. It is ashamed that all the TV's play is the stupid back and forth between the parents and their misbehaving teenagers.

Mr. Econotarian writes:

In a time of rising housing prices, you can foreclose on a loan but still come out ahead.

In a time of falling housing prices, you foreclose and lose a lot of money.

It isn't that foreclosures are so high right now (they are high, but they've been this high before), but with lowered house prices the holders of the mortgage are taking a bath.

Greg Ransom writes:

"I fear ten years from now the fire will still be raging."

Good metaphor. Good picture.

Well said.

Unit writes:


would you be offended if I said your presentation was "Grenspanesque". It's meant as a compliment....

John Thacker writes:

It has to be one thing.

Nah, it can be a lot of things. Remember that some places in the country, even rapidly expanding places like TX and NC, have largely missed out on this. There's a bunch of different causes and things to investigate. For example, one might want to separate two things:

1) Why a housing bubble, and then the pop?
2) Why did the falling prices cause such a financial crisis?

As Mr. Econotarian says, rising home prices can obscure the problem. But bubbles eventually end.

John Thacker writes:

For an answer to the "why a housing bubble?" question, you could do a lot worse than reading Ed Glaeser's new book on housing policy. (Free! On-line!)

Mr. Econotarian writes:

By the way, I actually watched your testimony, and you were great! Good job for "throwing darts at both camps" and suggesting government should not use a bail-out to confuse the housing market for 10 years in a zombie-mortgage situation.

Dan in EuroLand writes:

John Thacker,

Thanks for the Glaeser link.


Good job at the hearing. If you can post the video via the website directly that would be tight. Cspan can be a pain to deal with. Most of us are uninterested in Waxman and his comrades congratulating each other, and want to get right to your analysis/testimony.

Ed Hanson writes:

Dr Kling, let me add one more, "you were great." Unlike how it it said to come to most, your 15 minutes of fame resulted after years of work and study, analysis and testing hypothesis, and finally days or weeks of preparing a written testimony in concise language. I hope your 15 minutes will just be the start.

Your ad hoc addition to your prepared opening statement needs to be highlighted in large bold letters.

A terrific panel. But only you spoke as an economist. I hope you can find a Congressman who can understand the language, because your ideas, especially, your last comments, should be taken seriously. It won't be of course, politics will trump economics, but hopefully the economic truth you spoke will sway the political solution toward the better.

Those who are foreclosed on, do not become homeless, they become renters. And renters who will use less of their current income providing shelter.

Please keep us informed of any follow up from the committee members to your testimony. I do not often contact my Representative or Senators very often. But I will now, suggesting that they consult with you to understand the mortgage crisis. Perhaps if other readers of EconLog do the same, a few of our elected leaders will call you. It can only help.

Brad Hutchings writes:

The thing I found most striking from Raines and Syron was that both said that their respective companies got dragged into sub prime loans because that's where the market went and their charter was to keep things affordable where the market was. These two clearly never made a connection between the bottomless money pit backing their move into riskier loans and the rise in housing prices as buyers competed to and beyond the limits of their cash flow to purchase homes. Midstream, shouldn't either of these guys have noticed that things were getting less affordable if that was their mission?

Steve C. writes:

I've been involved in mortgage finance for a bit over 30 years and I've seen every type of fraud and deceit practiced. The most common and widely reported frauds have been blamed on deceptive mortgage brokers duping unsophisticated borrowers or real estate "flippers" scamming lenders with "straw buyer" deals.

However, they are all the equivalent of street muggers compared to the fraud and deceit that was practiced by the executives of the GSEs in concert with their friends in Congress. Can you spell RICO?

How can anyone not call this a Ponzi scheme?

In the end, the "success" in last 15 years in the mortgage industry was completely contingent upon the value of residential real estate appreciating.

I know no one who believed the upward spiral would continue, yet almost no one did anything to, in effect say "the king is wearing no clothes!"

Dan Weber writes:

How do I play the video from yesterday? I see ways to stream the channel live, but not a link for yesterday's coverage.

Or is it on YouTube by now? That would be so much easier.

The Snob writes:

@R. Pointer

I have been asking the same question ("Why now?").

The best picture I've gotten so far is that, like a plane crash, we need to look at this as a chain of less-critical errors, which, occurring in the right configuration, caused a divergent event.

1. Securitization is a "refining" process whereby large pools of not-so-good debt are turned into smaller pools of very good debt.

2. The ratings on pools of debt are dependent on models which extrapolated from historical trends, and appear to have continued to do so long after the applicability of those historical trends should have been questioned.

3. The refiners of debt had no trouble selling the "investment-grade" securities, but appear to have miscalculated the flows and got stuck holding onto a lot of the 'tailings' left over from that process. Given the inaccuracy of the risk models to begin with, they may have assumed this was marginally safe given the profits generated from the other activities.

4. The buyers of debt trusted the ratings agencies, and the regulators of institutions did so as well in a sense by favoring securitized debt over bank's own mortgages.

5. The unraveling of the dot-com boom in 2000-2002 left a lot of money looking for places to go other than equities. Real estate looked pleasingly old-fashioned by comparison.

6. Real estate was in the midst of a sustained secular increase in value in a number of areas, namely large coastal cities where demand was (and continues) outstripping supply. As these cities are also historic centers of finance and government, I wonder if it led the Masters of the Universe to mis-perceive the broader market as being equally-driven.

7. The Fed's cheap-money pumping injected liquidity into the market at the ideal moment to feed this bubble. At the same time, the powers-that-be were more concerned about a global financial collapse due to 9/11-driven uncertainty than overheating the economy, which traditionally had not led to anything like what we're seeing now.

Without any one of these, it seems to me this might have turned out more like a typical bubble. In isolation all of these things had been around in various ways long before 2005, but the stars had never aligned quite so well to send the system spinning out of control.

Michael writes:

@ Dan:

Dr. T writes:

"Not surprisingly, there was a lot of posturing going on....

The room was basically empty when my panel spoke. The press had gone. All but three of the Congressmen had gone...."

You should have taken my advice and just said no.

John Thacker writes:

Real estate was in the midst of a sustained secular increase in value in a number of areas, namely large coastal cities where demand was (and continues) outstripping supply.

A somewhat bad turn of phrase. Demand does not outstrip supply, exactly, it always intersects. An economist would say rather that supply is inelastic, so the price fluctuates drastically with small changes in demand. Supply doesn't grow much when demand does, so prices increase instead-- only to fall back dramatically whenever demand slackens a bit.

In some areas, like in TX or NC, instead of prices changing so much, supply does. (The cost of construction is close to fixed.)

John Thacker writes:
The ratings on pools of debt are dependent on models which extrapolated from historical trends, and appear to have continued to do so long after the applicability of those historical trends should have been questioned.

Yes, although as Professor Kling has noted, Freddie had very good models... that were then thrown out the window in a rush to follow the risky, growing lending leaders based on the experiences of a short time, instead of the long time series of the original risk models.

Another problem is bad mathematical assumptions of independence, and assuming (based on history) that one area of the country's housing crisis would not affect another's chances of having one much. These assumptions make the mathematics easier, but were wrong.

The Snob writes:

A somewhat bad turn of phrase. Demand does not outstrip supply, exactly, it always intersects.

Guilty as charged, though I think you got the point, which is that the intersection of geography and politics tends to insure that supply is a lot more inelastic in a place like Boston or San Francisco than Atlanta.

Yes, although as Professor Kling has noted, Freddie had very good models... that were then thrown out the window...

Again, the linchpin in all of this is the ability to "upgrade" debt through various secondary structures and thereby sell it to a third party at a premium. The GSEs did this organically through their implied government backing, while I-banks did this through the ratings agencies. The question is whether the rating agencies' ratings were so inaccurate because of malice (cooking the good models to ensure continued business) or incompetence (failure to develop a good model to begin with).

In either case, the market for investment-grade securities is much larger than for lower-grade stuff, which many institutions aren't allowed to even touch. It would be interesting to know in hindsight how much high-grade debt could have been created had appropriate models been used.

Philo writes:

[An aside on deposit insurance:]

“Suppose that the [solvent] bank [that is experiencing a run] has loans that are coming due in three months, but right now it is short of cash. The stern sheriff approach [which Arnold advocates] would be to charge a high fee for bank withdrawals now, with a much lower fee in three months when it expects loan repayments to give it plenty of cash on hand. Customers who participate in the run will be hit with high fees. Customers who wait three months will preserve more of their wealth.” Fine; but the depositors should have known about this policy, and agreed to it, going in; it should not be arbitrarily imposed ex post. A would-be depositor who is not willing to take this risk should make other arrangements, such as depositing T-bills with his broker in an account that carries check-writing privileges.

“When individual depositors rush to take their money out of a bank, the FDIC provides funds to protect the depositors. That policy is based in law as well as a moral concern for the well-being of the uninformed individual depositor. The alternative of forcing depositors to hold tight until the bank's cash position improves seems unreasonable.” It is unreasonable only if the depositors were deceived about the risk, not if they knew about it and voluntarily assumed it.

Amicus writes:

Arnold, you are too hard on yourself.

You did a great job..

It was a breath of fresh air not to hear someone gas bagging left and right to fend off every political attack.

Short, concise (but not too pithy), and easy-to-follow. Bravo.

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