Phil Gramm, Paul Volcker on Crisis
Two elder statesmen weigh in on the financial crisis, Phil Gramm, who helped craft the deregulatory Gramm-Leach-Bliley Act of 1999, and Paul Volcker, former Federal Reserve chairman and current Obama economic advisor. Gramm blames Congressional mandates or social engineering for the most part, while Volcker blames financial engineers (an interesting article in Wired magazine also illuminates the role of financial engineers).
Gramm:
The results [of the Community Reinvestment Act]? In 1994, 4.5% of the mortgage market was subprime and 31% of those subprime loans were securitized. By 2006, 20.1% of the entire mortgage market was subprime and 81% of those loans were securitized. The Congressional Budget Office now estimates that GSE losses will cost $240 billion in fiscal year 2009. If this crisis proves nothing else, it proves you cannot help people by lending them more money than they can pay back.
…The principal alternative to the politicization of mortgage lending and bad monetary policy as causes of the financial crisis is deregulation. How deregulation caused the crisis has never been specifically explained. Nevertheless, two laws are most often blamed: the Gramm-Leach-Bliley (GLB) Act of 1999 and the Commodity Futures Modernization Act of 2000.
Volcker:
This phenomenon can be traced back at least five or six years. We had, at that time, a major underlying imbalance in the world economy. The American proclivity to consume was in full force. Our consumption rate was about 5% higher, relative to our GNP or what our production normally is. Our spending – consumption, investment, government — was running about 5% or more above our production, even though we were more or less at full employment.
You had the opposite in China and Asia, generally, where the Chinese were consuming maybe 40% of their GNP – we consumed 70% of our GNP. They had a lot of surplus dollars because they had a lot of exports. Their exports were feeding our consumption and they were financing it very nicely with very cheap money. That was a very convenient but unsustainable situation. The money was so easy, funds were so easily available that there was, in effect, a kind of incentive to finding ways to spend it.
When we finished with the ordinary ways of spending it – with the help of our new profession of financial engineering – we developed ways of making weaker and weaker mortgages. The biggest investment in the economy was residential housing. And we developed a technique of manufacturing class D mortgages but putting them in packages which the financial engineers said were class A.
So there was an enormous incentive to take advantage of this bit of arbitrage – cheap money, poor mortgages but saleable mortgages. A lot of people made money through this process. I won’t go over all the details, but you had then a normal business cycle on top of it. It was a period of enthusiasm. Everybody was feeling exuberant. They wanted to invest and spend.
You had a bubble first in the stock market and then in the housing market. You had a big increase in housing prices in the United States, held up by these new mortgages. It was true in other countries as well, but particularly in the United States. It was all fine for a while, but of course, eventually, the house prices levelled off and began going down. At some point people began getting nervous and the whole process stopped because they realized these mortgages were no good.
You might ask how it went on as long as it did. The grading agencies didn’t do their job and the banks didn’t do their job and the accountants went haywire. I have my own take on this. There were two things that were particularly contributory and very simple. Compensation practices had gotten totally out of hand and spurred financial people to aim for a lot of short-term money without worrying about the eventual consequences. And then there was this obscure financial engineering that none of them understood, but all their mathematical experts were telling them to trust. These two things carried us over the brink.
They both make some good points, and the full articles are worth a read, but they ignore the role that leverage played in destroying financial capital. In our 2008 postmortem, we identified changes to the SEC’s Consolidated Supervised Entity program in 2004 as a primary culprit, as it allowed some large banks to increase their financial leverage substantially, which in turn helped fuel the CDS market and AIG’s massive levering up, among other things. When those measures were reversed, ex-SEC Chairman Christopher Cox stated that it was a gap in regulatory oversight that resulted from Gramm-Leach-Bliley, which raises at least one objection to the defense put forth by Sen. Gramm.
URLs:
http://online.wsj.com/article/SB123509667125829243.html
http://ednews.org/articles/34263/1/VOLCKER-SPEECH-IN-CANADA/Page1.html
http://www.wired.com/techbiz/it/magazine/17-03/wp_quant?currentPage=all
News and Views | art February 24, 2009
