In this second of two posts on John Bougearel’s guest post at Naked Capitalism, Sherry Jarrell provides an economist’s response.
Response to “2010: Foreseeable and Unforeseeable Risks …”
In this wide-ranging and comprehensive piece, John Bougearel warns of the repercussions on the world economy of the steps taken to remedy the financial crisis. He warns of the impact of the Federal Reserve absorbing the toxic assets and shaky collateral on its balance sheet, and of the unsustainability of Social Security and Medicare in an aging demographic. On these basic facts, I agree.
One of the most difficult things for any writer to do when talking about economics and finance is to establish cause and effect. In trying to analyze past policy decisions and recommend future actions, however, it is absolutely imperative to distinguish cause and effect. In my view, Mr. Bougearel’s overview is either silent on this issue or implicitly assigns blame to the markets, when it belongs squarely on the doorstep of misguided government regulations.
What are “toxic” assets? What does “shaky collateral” mean? What these concepts have in common is mispricing. The value of any asset, whether it’s a bond, a share of stock, or a collateralized debt obligation, is driven by the present market value of the risk-adjusted forecast cash flows of that asset. The borrower and lender agree on terms and a price that fairly compensates the lender and is reasonable to the borrower, given their expectations about the cash flows and risks at the time. Some features – like collateral, the backing of the government, or an enforceable contract — mitigate the risk of default, and thus reduce the explicit costs of borrowing.
Government mandates that require lending that would otherwise not occur in a competitive marketplace – perhaps five percent of the total mortgage activity — effectively caused the underpricing of these loans. The interest rates charged on these loans failed to adequately compensate for the actual risk of default. And the pooling and reselling of these loans by Fannie Mae and other government-sponsored-entities did not magically fix the underlying mispricing.
We all know that there began a period several years ago in the U.S. when mortgage lending began to change. No longer did you need to put money down; no longer did you need to have good credit. You could borrow more than 100% of the purchase price of the house, and get an equity line-of-credit to boot. This “new world” of mortgage lending was the direct result of government mandates that micromanaged the bankers’ business decisions. The mandates led to a pocket of subprime loans that would otherwise never have seen the light of day, and those risky loans infected the entire financial system with the help of Fannie Mae and other GSEs.
Financial innovation was not the cause of the financial crisis. Government meddling in private industry was the cause. Sadly, government meddling creates the problems that then begets further meddling to try to fix the problems, which only exacerbate the problems. It is a vicious cycle which will end only when someone has the political will to say enough. And, like John Bougearel so aptly warns us, we are in a bit of mess now, and the temptation will be to call for more government intervention, not less.
Learning from Dogs 