Sunday, November 7, 2010

'Inside Job', Outside Job and Resource Constraints: an Anatomy of the Subprime Crisis

Inside Job

The movie ‘’Inside Job’ brilliantly conveys the lethal cocktail of financial leverage and risk unleashed by the repeal of the Glass- Steagall bank regulations; the ubiquity of perverse incentives created by the securitization of mortgage loans – on mortgage originators and ratings agencies; and the error of assuming relationships observed in a different environment – of housing market stability – would continue to hold when underwriting practices radically loosened. It contains a scathing indictment of the economics profession; not just the inability of its models to warn of the crisis, but the pervasive conflict of interest induced by the massive subsidization of the profession by Wall Street and the astonishing absence of any professional ethics regarding disclosure of financial conflicts of interest in research on financial markets. The economics profession comes off rather less well, but substantially similar, to the ‘Madam’ who runs a prostitution ring servicing mortgage traders.

And then there is the revolving door between Wall Street and the US Treasury. Film-maker Charles Ferguson wants to convey the pornographic nature of the ‘capture’ of our government by banking interests. The common thread is Larry Summers –an architect of the Glass Steagall repeal under President Clinton and the guiding force behind the Obama Administration's economic policy. As Willem Buiter comments in the movie “when Obama hired Larry Summers, I knew it would be more of the same” (strange case, Buiter, the ‘Maverecon’ who has now become Citicorp’s Chief Economist).

Mr. Ferguson has stated in an interview that his aim is to agitate the American people to take back their government from the Wall Street crowd who have rigged a zero – sum game in their favor. With the newly elected Republican House leadership aiming to repeal those few aspects of the Dodd-Frank reform that do constrain banking excess, good luck to him.

Outside Job

And yet, Mr. Ferguson’s documentary captures, as it were, only the half of it. It is true the ‘bad –boys’ of Wall Street set up a machine to manufacture leverage and obfuscate risk. But three things had to happen, beyond the citadel of Wall Street, for the machine to cause our economy to go haywire.

First, willing homebuyers had to be found to fill the Subprime pipeline. That was easy enough, as plenty of people were willing to take a punt on a home move-up that they might walk away from in the event everything collapsed. Moreover, an offer to place marginal credits on the ladder of the American Dream of home ownership appeared a noble endeavor at the time. “Inside Job” does touch on this.

Second, institutional investors had to be induced to buy the Subprime CDO’s. They are a savvy crowd. How did they call it so terribly wrong? In part, because they made the same intellectual error as the economists –assuming that past housing default data was indicative of future events. They were also given the assurances of high ratings and risk insurance from AIG and the Monolines, who were considered very solvent at the time. Finally, they were in ‘search for yield’ in a very low interest rate environment. Pension funds and Insurance companies, who invested to meet actuarially fixed future obligations needed to boost returns to be able to meet those obligations, so they became willing participants. But this does beg the question; why were interest rates so low?

Third, there had to be a huge expansion in home building, to manufacture the Subprime collateral; and there was. At it peak, in 2006, there were over 3 million homes built in the US, compared to an average of 1 million – 1.5 million in the prior decade. As I wrote in a previous post, “The housing bubble involved both a massive price increase and a massive expansion of housing production. During the boom years, from 2000 – 2007, the Case Shiller HPI more than doubled; a rate very much higher than the prior trend in home price increase, resulting in a significant rise in the home price/median income ratio. During that period annual new home construction also more than doubled, a rate that dramatically exceeded the growth in household formations. Residential investment grew from under 7% of GDP to over 10% of GDP in the decade ending in 2007”. But, with US savings low and US consumers increasing expenditure, this required a massive inflow of offshore capital to finance investment and (its mirror image) a massive trade deficit to provide consumer goods - in a situation where the sum of US investment and consumption exceeded GDP. This, as we know, was provided by China.

Asian Mercantilism – a Non –Market Factor

So, it was integral to the Subprime process that a wave of Asian savings was injected into the US capital markets, keeping rates low and providing the capital for the home building binge.

In the absence of the massive trade deficit, as I have pointed out ( here, here and here), the process would have been cut short at a much earlier stage. In that case, the increased demand for housing investment would have competed with other forms of investment and driven up interest rates, thus reducing the attractiveness of investing in CDO’s, driving up home mortgage interest rates and damping home prices.

In addition, the increased (perceived) wealth induced by the home price windfall, drove an increase in consumption, which, absent a trade deficit, would have nudged up the price of consumer goods, causing an increased demand for production of consumer goods and a further spike in interest rates.

The Trade Imbalance – Coup de Grace

In other words, the US had to transcend its resource constraint - to consume and invest beyond its means – in order for the Subprime phenomenon to really take off. In the absence of a trade deficit, and its accompanying capital account surplus, a market interest rate rise would have choked off the boom at a much earlier stage, as domestic consumers and producers competed for finite resources.

1 comment:

  1. Great piece, but with one error. There weren't "plenty of people were willing to take a punt on a home move-up that they might walk away from in the event everything collapsed". The vast majority of the people who "filled the Subprime pipeline" didn't understand what they were buying. A combination of high-pressure sales tactics, misrepresentation, biased financial "advice and sometimes outright fraud on the part of originators resulted in people buying homes they could not afford -- and could not understand that they could not afford.

    It's nice to spread the blame evenly across all participants, but that simply doesn't fit the facts. The working family who took out teaser-rate-led subprime mortgage had no idea "the whole thing could collapse". And, they aren't "walking away": they have no place to go and can't afford another place to live. This is the human tragedy in this story, which apparently is of less interest than the financial one.