On July 3, 1863, the Army of Northern Virginia was defeated at Gettysburg by the Army of the Potomac. As was fitting for a conflict in which each side simultaneously advocated the right of the minority to be free from the majority and the majority’s right to dominate the minority, the South attacked from the north and the North attacked from the south. Defeat crushed the Army of Northern Virginia’s offensive capability, ended any hope of European intervention, and gave Lincoln the confidence to refuse to meet Confederate Vice President Alexander Stephens, who had proposed a conversation about prisoner exchange that would likely have touched on ending the conflict. In every meaningful sense, it was the day the Confederacy lost its chance at independence.
General George Meade was nervous about his victory. He had been in command for all of eight days. Robert E. Lee moved to a defensive formation, anticipating a final attack. The attack never came; Meade knew General Hooker’s forces were shredded at Chancellorsville with similar numerical advantage and didn’t want to press his luck. He let Lee’s army ford the Potomac and escape back to Virginia. For that – and for getting into a fight with a newspaper reporter – the story went out that Meade lost the battle. He was replaced by Grant at the end of the year. It’s not about what happened, it’s about what people think happened. Call it the Liberty Valence Hypothesis.
We are already seeing this sort of revisionist history in the financial crisis.
The first, and arguably most important, revision comes from the banks themselves. It has been easy, because the country can be divided into two groups: people who don’t understand the first thing about finance, and people who draw their income in finance. Very few of the people with any sense of what happened have any interest in criticizing the industry, any more than commodity farmers who understand the USDA’s insanity feel any need to complain about it.
You may have heard some of the following:
- We (Goldman, JPMorgan, certain regional banks) never wanted the TARP money, we were forced to take it;
- Everything would have been fine if Lehman had been bailed out;
- AIG did not affect us;
- There was/is no law that would support nationalization/receivership;
- Mark to market was a bad idea.
The upshot of all of these arguments is meant to be that the firms that have repaid the TARP money should be free to go about their business as before. September was just a weird, fluke event, like Ross Perot’s candidacy or the time an entire season of Dallas turned out to be just a dream:
Bullshit. In the 48 hours after Lehman’s failure on September 15 every investment bank stood at death’s door. There was absolutely no reason for the government to intervene at Lehman; the company had no FDIC-insured depositors (after all, it wasn’t a bank) and every one of its creditors took the risk that the company could fail. When AIG then stood at the precipice and the Reserve Fund broke the buck, Goldman and Morgan Stanley (Merrill had already agreed to the BAC deal) were next to die. LIBOR hit 6.5%, and it was abundantly clear that without government intervention, it was only a matter of time before the investment banks lost the ability to roll their debt. As it happened, the government (a) intervened at AIG, directing billions of dollars to counterparties and halting CDS blowups; (b) allowed Goldman and Morgan to convert to bank holding companies effective 9/22/08, despite the fact that each was undercapitalized to be a bank. You will note that the first private intervention in scale – Berkshire’s $5bn investment in Goldman convertible preferred paying a 10% dividend – happened on September 23, after the government had done the dirty work.
I don’t think the government should have intervened at all, except by seizing the retail and custodial operations of AIG. That’s a minority view; I accept it. But even within the frame of government intervention, the government struck an astonishingly terrible deal for itself. Why leave any equity behind at these companies (or at least, why leave anything other than 20% to avoid consolidation)? Why not state publicly that you will intervene – if and when the debt holders agree to a cram-down of, say, fifty cents on the dollar? Just announce that you are waiting at the bankruptcy court to backstop the business a minute after they file…still drives me crazy.
So rest assured, any argument you hear from a finance company that they should be free to do business as usual is full of shit. Business as ususal is what got us into this mess. Goldman has massive trading profits…which is nice, considering we the taxpayer have both explicitly underwritten their debt and effectively underwritten their equity, so perhaps we should have a say in what happens.
The countervailing trend is a narrative of victimization. The poor deluded soul who took out a mortgage he could never repay for some massive Inland Empire house and is now being foreclosed is somehow a victim of the nasty mortgage broker who never told him that the negative amortization loan was going to blow up in his face if he couldn’t refinance.
This is the Daily Kos thesis, and it’s something that seems to underpin Elizabeth Warren’s post here:
If the status quo is about choice, then explain why half of those with subprime mortgages chose high-risk, high-cost loans when they qualified for prime mortgages.
Elizabeth is brilliant and a voice in the wilderness trying to simplify the legalese that buries consumer credit, but on this one I have to believe she is intentionally closing her eyes. People took out exotic mortgages for the simple reason that exotic mortgages let them buy bigger houses than they otherwise could. It’s the same reason leveraged buyouts use junk bonds.
Perhaps Elizabeth’s argument is that people did not understand the difference between the instrument they purchased and a traditional 80/20 fixed-payment mortgage. That might be true on some level; I am sure many people do not understand the intricacies of any mortgage. There is no requirement that a mortgage applicant demonstrate the ability to calculate a payment schedule on his own or describe in his own words the circumstances under which the particular structure will be disadvantageous. But that’s a bit like saying that many people who drive cars do not have a detailed understanding of how cars work, or in many cases even an in-depth awareness of traffic laws (quick – what is the maximum gross vehicle weight allowed for your category of driver’s license?). They know the basics – that a car is a machine to get from here to there. The overwhelming majority of people who took out mortgages did so understanding the required payment schedule for their type of mortgage and the total amount of principal they subscribed.
An extreme variant of Professor Warren’s position seems to be Richard Serlin’s argument that individual leverage should be regulated to avoid bidding wars on houses. I have a bit of a debate with him in the comments here, but figure if I have a blog of my own, might as well take this to the home court:
Legal mortgage interest rate limits could simply be made low enough that the median family would not be able to get a large enough mortgage to buy a home that would consume more than 25% of its income in monthly payments. With all other families limited in the same way, a family would still be able to buy a home in just as good a suburb. They would not be outbid, because competing families would face the same constraint. It would be like placing a severe arms limitation on all sides of a mutually self-destructive arms race…
With all families limited – essentially by law through mortgage interest rate ceilings – to spending, say, half as much on housing, no family would lose its relative position. No family would end up in a lower ranked community, but the typical family would be far more financially secure. This is just as with countries in an arms race. They would all be far better off if they were all limited to spending half as much on arms. No country would lose its relative position. All would be just as militarily secure, but they would have far more money to spend on their economic security and quality of life.
Apparently, it’s not possible for a family to value housing at more than 25% of their income…
The argument that anyone outside of a bidder has an claim on someone’s bid seems a bit strange to me. Suppose two of us are bidding on a Picasso. I value the Picasso at $100,000, because I am a jackass. If no one else shows up to bid, I might get it for $20,000, which is terrific for me – I get a huge consumer surplus. If you show up to bid – perhaps because you are interested, or perhaps because you are a shill – and the price creeps up toward $100,000, I lose surplus. Suppose the bidding goes to $100,001, and you end up with the Picasso. I may be upset, since I am a grouchy person looking for others to blame, but what right do I have to be ticked off? You wanted to pay more than I did. Good for you; it’s yours.
Now suppose that your net worth is $100,002. You put virtually everything you have into this painting. You can’t even afford the cab ride home (no, I will not give you a lift). It’s a wild, reckless bet on the appreciation of the artwork and your enjoyment of it. If we faced the same cap on “percentage of net worth allocated to Picassos”, I would be driving home with the painting. But you wanted it more.
Now for housing. I don’t do debt. Wouldn’t it be great if everyone were forced by law to behave the same way? Suppose mortgages were banned. Hell, suppose the whole country behaved like a New York coop, and required not only full cash payment for the dwelling but also a minimum net worth multiple of the dwelling price. That would be fantastic. For me.
You see, in this alternate universe not only do I get to live at my risk tolerance, I get to force everyone else to live at my risk tolerance. I get to have a house that reflects my percentile rank in the country’s net worth distribution. And everyone else is required by law to value his house at the same level that I value mine (no more than 100% of liquid net worth).
In fact, I’d like to extend this to all walks of life. I don’t like to spend much on clothing, so no one should be able to spend a larger percentage of his income on clothing than I spend on clothing. This way I can be exceptionally well-dressed and thrifty, because I start with more money than the average American.
Is the crazy getting through to you? If someone wants to ascribe 75% of his income to mortgage debt service, it’s his affair, not mine. He wants the house more than I do; he is willing to constrain his life and his future more than I am. If I don’t like the price of houses in a market, I don’t have to buy one. There is no obligation that I match the more aggressive bidder. The crazy bubble psychology that took place in chunks of the country was that someone had to get into the real estate market. It was never true. There is and always was the option to get a house that reflected a lower percentile of the housing stock than your income or net worth stood in the population distribution. Warren Buffett does not have one of the ten nicest houses in America.
Financial deregulation brought with it a host of confusing legalese, and I hope that Professor Warren is able to tear through the thicket. You shouldn’t need a law degree or years in finance to understand consumer credit contracts. The petty-ante stuff of credit card companies – rotating mailing addresses so bill payments get lost, double-cycle billing, moving interest charges into fees, etc – should be stopped.
That still leaves us with the issue of how we got here and what we should do in the brave new world. The housing bubble has one group to blame: people who bought houses. It’s not about the banks who lent the money – they were stupid enough to fund the individuals’ bad decisions, and a just government would let them fail for their trouble. It’s not about the brokers or the appraisers or the realtors or the rest of the fluffers who told people what they wanted to hear. It is about people who decided that buying House A for $B was a good idea, and then discovered that it was not a good idea, or took on a negative amortization loan and found themselves owing 135% of the principal on a house that is worth 60% of their basis.
An individual who decides that he does not want to spend more than 25% of his income on housing will succeed in doing just that. If enough people decide for purely selfish reasons that this is the amount of risk they want, that will be the personal leverage level in the market. If people decide that exotic mortgages are too exotic for them, they can move to one they like (by the way, 80/20 fixed payment is no more or less arbitrary than any other payment structure; it is more aggressive than 70/30 and less aggressive than 90/10, and the only thing that makes it “prime” is Fannie/Freddie saying so).