We never learn

Back in the early 1990s lots of liberals I knew argued that the S&L fiasco showed the need for “re-regulation.”  And so we re-regulated banking.  I argued that the fix would not work, as it didn’t address the core issue—moral hazard.  I suggested that Fannie and Freddie were time bombs waiting to go off.

You’ll have to take my word for all that.  But not for my 2009 prediction that Obama’s policy of pumping up FHA was another time bomb waiting to go off.  His solution to the financial crisis caused by reckless sub-prime lending was to try to use government levers to inflate another sub-prime bubble.  The bubble has not arrived yet, but three years later even the New York Times is worried about FHA:

DO we have another Fannie or Freddie on our hands — another mortgage giant headed for a rescue?

Like Fannie Mae and Freddie Mac before it, the Federal Housing Administration is suffering in a mortgage hell of its own making. F.H.A. officials say they won’t need taxpayers’ help, but we’ve heard that kind of line before.

The F.H.A. backs $1.1 trillion of American mortgages and, by the look of things, it’s in deep trouble. Last year, its mortgage insurance fund was valued at $1.2 billion. Today that fund is valued at negative $13.48 billion.

Granted, that figure, reported by F.H.A.’s auditor, doesn’t represent actual losses. It’s an estimate of the difference between future mortgage insurance premiums that the F.H.A. will collect and the expected losses on the mortgages that the agency is obligated to cover over time, combined with the agency’s existing capital resources.

But the upshot is this: If the F.H.A. were to stop insuring new home loans today, it wouldn’t have the money it needs to cover its expected losses in the coming years.


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31 Responses to “We never learn”

  1. Gravatar of StatsGuy StatsGuy
    11. December 2012 at 09:04

    (sorry, can’t help myself)

    So here is my prediction:

    FHA is not in trouble, and will not need anything close to the Federal subsidies required for AIG and F&F. So there, we have both predictions in print. Let’s be clear on a few things:

    1) Most losses on current loans were older, and many are for defaults still in progress from 2008 and earlier mortgages. These were not only extended to individuals with lower quality scores, but also on houses that were sold at bubble prices

    2) It’s a federal agency, not a for-profit with federal backing, that is encouraged to profit while exposing others to risks

    3) Without another round of excess Fed stupidity, we’re unlikely to see a housing crash replay. Again, new loans were not sold at bubble prices (so lower loss risk), and something approximating a poor man’s NGDP target may be in place, which should prevent asset price collapses of 2008/9 magnitude.

    4) Did you note that the Federal government just turned a profit on AIG?

    5) I’m surprised you point to the late 1990s as an era of reregulation, since most point to it as the pinnacle of financial deregulation. Let’s go back to 1999, shall we?

    http://www.wsws.org/articles/1999/nov1999/bank-n01.shtml

    Reregulation? No. Corruption, influence peddling, and deregulation with massive risk subsidies? Yes.

    6) The change in nominal valuation for FHA assets over the last year represents a 1.4% swing in asset prices, and projects forward based on recent costs (which reflect a 3-4 year lag effect) due to accounting protocols… However, recent costs are almost certainly in excess of future costs. Even so, this would normally be well within a 15:1 capital asset buffer (about 7% of assets). The FHA is allowed to run without a capital buffer because it’s essentially backed by congress. In other words, it sounds like a lot, but simply isn’t.

    IMO, of so many govt programs to pick on, why the FHA? Indeed, Freddie, Fannie, and Sallie are FAR MORE EVIL. They essentially extracted private-level returns for govt-backed risk, and in the case of student loans private vendors cut deals with colleges to market loans at far above the resale value (given federal risk backing). Those “privatized” entities, or the subcontracting relationship, was far more corrupt than the FHA.

    It’s like the prison privatization argument, which was supposed to fix all prison evils. Private prisons, however, are far from the panacea we were promised… Privatization does not fix corrupt government and oversight failure. The privatization of Russia was one of the greatest experiments in history, and proved this conclusively.

    In 3 or 4 years, let’s look back at FHA and we can revisit this – may you be healthy and happy until then.

  2. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    11. December 2012 at 09:24

    Actually, FHA was always part of the problem, and now that Fannie and Freddie have been curtailed, the FHA is THE GAME. As Wallison and Pinto pointed out back in 2010;

    http://www.american.com/archive/2010/november/how-the-government-is-creating-another-housing-bubble

    ———–quote———–
    While everyone has been watching Fannie and Freddie, the administration has quietly shifted most federal high-risk mortgage initiatives to FHA, the government’s original subprime lender. Along with two other federal agencies, FHA now accounts for about 60 percent of all U.S. home purchase mortgage originations. This amounts to more than $1 trillion and is rising rapidly. The administration justifies this policy by saying it is necessary to support the mortgage market, yet borrowers are once again receiving high-risk loans.

    The goal of Congress and regulators should be to foster the residential mortgage market’s return to the standards that used to prevail in 1990, before the affordable housing requirements were imposed on Fannie and Freddie. At that time, mortgages required 10 to 20 percent down payments, and were only made to borrowers with good credit and relatively low debt-to-income ratios. When loans of this kind were the standard in the residential mortgage market, we did not have financial crises brought on by the collapse of a housing bubble.

    The Dodd-Frank Act, however, exempts FHA and other government agencies from appropriate standards on mortgage quality. This will give low-quality mortgages a direct route into the market once again; it will be like putting Fannie and Freddie back in the same business, but with an explicit government guarantee.

    For example, thanks to expanded government lending, 60 percent of home purchase loans now have down payments of less than 5 percent, compared to 40 percent at the height of the bubble, and the FHA projects that it will increase its insured loans total to $1.34 trillion by 2013. Indeed, the FHA just announced its intention to push almost half of its home purchase volume into subprime territory by 2014-2017, essentially a guarantee to put taxpayers at risk again.
    ————–endquote————

  3. Gravatar of Major_Freedom Major_Freedom
    11. December 2012 at 09:28

    It should be kept in mind that another vital ingredient to the mortgage fiasco is artificially low interest rates from the Federal Reserve System, without which it would not be possible, or at least would not be as intense.

    How many have learned that lesson?

  4. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    11. December 2012 at 09:35

    Why pick on FHA? Oh, let’s hear again from Pinto and Wallison (January 2012);

    http://www.aei.org/outlook/economics/financial-services/housing-finance/bet-the-house-why-the-fha-is-going-for-broke/

    ————-quote————–
    Under the accounting system approved by Congress for the FHA, the agency’s capital is the amount left over when the present value of its future insurance obligations is subtracted from its current net assets and a projection of future income over the next thirty years. This means that the FHA can include in its capital the net earnings it anticipates thirty years into the future. This practice bears a remarkable resemblance to Enron’s infamous use of assumptions about the future to bring fictitious future profits into the current year’s earnings. In other words, the FHA can be insolvent today—unable to cover even its expected losses on current delinquent loans—yet still show a positive capital account.

    Further, because it is relatively easy for the FHA to adopt assumptions or projections that keep its economic value in positive territory, this system also calls into question the usefulness of economic value or capital ratio as a measure of the insurance fund’s financial health. For example, the FHA can reduce its expected losses simply by making an optimistic projection for the future growth of housing prices. If prices rise in the future, losses will be lower; if they rise slowly or fall, losses will be greater.

    The FHA appears to be following this strategy. Despite the current conditions in the housing market—with a large overhang of unsold homes, falling prices, and millions of mortgages in default and not yet foreclosed—the FHA has estimated that housing prices will rise by an average of 4 percent per year over the next nine years.
    ————endquote————

    So, Stats Guy’s ‘It’s a federal agency, not a for-profit with federal backing, that is encouraged to profit while exposing others to risks’, looks pretty silly.

  5. Gravatar of Major_Freedom Major_Freedom
    11. December 2012 at 09:36

    “Mr. Speaker, I rise to introduce the Free Housing Market Enhancement Act. This legislation restores a free market in housing by repealing special privileges for housing-related government sponsored enterprises (GSEs). These entities are the Federal National Mortgage Association (Fannie), the Federal Home Loan Mortgage Corporation (Freddie), and the National Home Loan Bank Board (HLBB). According to the Congressional Budget Office, the housing-related GSEs received $13.6 billion worth of indirect federal subsidies in fiscal year 2000 alone.

    “One of the major government privileges granted these GSEs is a line of credit to the United States Treasury. According to some estimates, the line of credit may be worth over $2 billion. This explicit promise by the Treasury to bail out these GSEs in times of economic difficulty helps them attract investors who are willing to settle for lower yields than they would demand in the absence of the subsidy. Thus, the line of credit distorts the allocation of capital. More importantly, the line of credit is a promise on behalf of the government to engage in a massive unconstitutional and immoral income transfer from working Americans to holders of GSE debt.

    “The Free Housing Market Enhancement Act also repeals the explicit grant of legal authority given to the Federal Reserve to purchase the debt of housing-related GSEs. GSEs are the only institutions besides the United States Treasury granted explicit statutory authority to monetize their debt through the Federal Reserve. This provision gives the GSEs a source of liquidity unavailable to their competitors.

    “Ironically, by transferring the risk of a widespread mortgage default, the government increases the likelihood of a painful crash in the housing market. This is because the special privileges of Fannie, Freddie, and HLBB have distorted the housing market by allowing them to attract capital they could not attract under pure market conditions. As a result, capital is diverted from its most productive use into housing. This reduces the efficacy of the entire market and thus reduces the standard of living of all Americans.

    “However, despite the long-term damage to the economy inflicted by the government’s interference in the housing market, the government’s policies of diverting capital to other uses creates a short-term boom in housing. Like all artificially-created bubbles, the boom in housing prices cannot last forever. When housing prices fall, homeowners will experience difficulty as their equity is wiped out. Furthermore, the holders of the mortgage debt will also have a loss. These losses will be greater than they would have otherwise been had government policy not actively encouraged over-investment in housing.” – Ron Paul, July 2002.

  6. Gravatar of StatsGuy StatsGuy
    11. December 2012 at 10:09

    @ Patrick

    The point on the federal agency vs. risk-subsidized private entity is that the latter have every incentive to stretch legal limits on loan quality in order to maximize extended loans (since losses are covered). This is very similar to the problem of Cost-Plus pricing regulation in the utility industry (if you pay someone on volume instead of quality, they will generate volume without quality).

    Federal agencies also have perverse incentives (to please Congressmen for example), but not as perverse. Loan quality in the last 3 years is not nearly as problematic, so while asset growth rates may not equal 4% per annum (or they may…), default rates will not remain at this elevated level.

    In 4-5 years, if I’m wrong, I’ll come back here an apologize. Will you?

  7. Gravatar of acarraro acarraro
    11. December 2012 at 10:25

    Considering that the US government spends 110$ billion a year in housing subsidies through the mortgage interest deduction, 13$ billion over how many years doesn’t sound like a big number to me…

  8. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    11. December 2012 at 10:43

    ‘…risk-subsidized private entity…have every incentive to stretch legal limits on loan quality in order to maximize extended loans….’

    Except that they didn’t do that until 1992 when congress mandated that they relax their underwriting standards. A ‘sub-prime loan’ used to be one the FMs wouldn’t buy, after 92 they were forced to increase their portfolios of such.

    Which they hid from their stockholders as long as possible, until the housing bubble burst and it all became apparent. FHA is similarly hiding its true financial condition, thanks to exemptions from normal accounting standards. Apply private sector accounting to it, and it’s insolvent now.

  9. Gravatar of JimP JimP
    11. December 2012 at 12:33

    The full Monty – and full credit to Scott

    http://www.telegraph.co.uk/finance/economics/9738459/Mark-Carney-suggests-abandoning-inflation-target.html

    Mr Carney, the current Bank of Canada governor who takes over from Sir Mervyn King next June, said central bankers should consider committing to low interest rates until inflation and unemployment met “precise numerical thresholds”, or even changing “the policy framework itself” to stimulate a desperately weak economy.

    His words were directed at the Bank of Canada but will be seen as a hint that he will push for radical action in the UK, where the economy has been stagnant for two years. On his appointment, he said that he would be going “where the challenges are greatest”.

    Addressing the Chartered Financial Analyst Society in Toronto, Mr Carney said that in major slumps: “To achieve a better path for the economy over time, a central bank may need to commit credibly to maintaining highly accommodative policy even after the economy and, potentially, inflation picks up.
    “To ‘tie its hands’, a central bank could publicly announce precise numerical thresholds for inflation and unemployment that must be met before reducing stimulus.”

    He added: “If yet further stimulus were required, the policy framework itself would likely have to be changed. For example, adopting a nominal GDP level target could in many respects be more powerful than employing thresholds under flexible inflation targeting.”

  10. Gravatar of JimP JimP
    11. December 2012 at 12:49

    And full credit to the blogging community that has arisen around this blog.

    This has shown the real power of the net and of good ideas. This blog has actually made a decisive difference in the debate and and in cb policies. That is a big deal indeed.

  11. Gravatar of Dtoh Dtoh
    11. December 2012 at 13:12

    Scott,

    Totally agree. Don’t think we will ever get rid of TBTF so I would advocate an explicit TBTF guarantee and that the Fed regulate minimum and maximum asset to equity ratios by asset class.

    As an aside, the government made money on the S&L bailout.

    Also Salie Mae is the agency that is most distorting the economy these days.

  12. Gravatar of anon anon
    11. December 2012 at 13:13

    JimP, it is unfortunate that this is being framed as “abandoning inflation targets”, which will spook many policy-makers. We should make the case that nominal income level targeting is a superior alternative to inflation targeting that largely achieves the same goals.

  13. Gravatar of Sumner Believes in Government-Created Bubbles and Ticking Time Bombs Sumner Believes in Government-Created Bubbles and Ticking Time Bombs
    11. December 2012 at 13:35

    [...] especially his incredulous responses to Austrian critics of the Fed, should be puzzled by his latest post in which Scott writes: Back in the early 1990s lots of liberals I knew argued that the S&L [...]

  14. Gravatar of Sumner Believes in Government-Created Bubbles and Ticking Time Bombs – Unofficial Network Sumner Believes in Government-Created Bubbles and Ticking Time Bombs - Unofficial Network
    11. December 2012 at 13:57

    [...] especially his incredulous responses to Austrian critics of the Fed, should be puzzled by his latest post in which Scott writes: Back in the early 1990s lots of liberals I knew argued that the S&L [...]

  15. Gravatar of StatsGuy StatsGuy
    11. December 2012 at 15:26

    @Patrick

    “Except that they didn’t do that until 1992 when congress mandated that they relax their underwriting standards.”

    We had this discussion already.

    http://www.themoneyillusion.com/?p=12378

    The 1992 mandate was not enforced – as came out in the SEC hearings, F&F outstanding loans to lower quality borrowers did not materialize in real volume until the early 2000s, when aggressive competition from private actors (e.g. Countrywide) was taking their market share. F&F acted at the direction of aggressive management which was trying to achieve high bonuses (which were paid on volume of asset acquisition, not long term profitability).

    In addition to the timing (8-10 year lag from mandate to action), one other factor suggests it wasn’t the legal rule but rather perverse incentives – many many many loans were made that had even LOWER requirements than allowed by law (so called liar loans). If F&F were actively resisting a legal action that they believed was harming them, they would have resisted implementation (which they did through the 1990s), and we should see no very lax loans and fewer-than-mandated loans to lower credit borrowers than the laws mandated.

    The 1992 legal changes were an excuse made by TBTF execs to blame their behavior on people trying to help minorities. Government is by no means innocent, but Fannie and Freddie were not the victims they want you to believe they are – they were collusive perpetrators.

  16. Gravatar of SG SG
    11. December 2012 at 17:53

    @ MF

    Why are you calling interest rates “artificially low”?

    If you believe that the government monopoly on currency is illegal, then the interest rates are always “artificial.” Who’s to say whether they are too low or too high?

    And if you’re saying that interest rates are too low, Scott and the other market monetarists agree with you. MM’s want the Fed increase to inflation expectations, which would increase interest rates. It’s nice to see that you and Scott do indeed have some areas of agreement!

  17. Gravatar of SG SG
    11. December 2012 at 17:53

    oops, I said “illegal” but i meant “wrongful”

  18. Gravatar of Morgan Warstler Morgan Warstler
    11. December 2012 at 17:56

    There are three things driving housing prices up right now:

    1. FHA
    2. MBS backed purchasing by Fed
    3. SFH are a new asset class, everyone bidding is paying cash. Blackstone, Colony, Silver Bay – everyone. MOST are becoming operators, very few are looking to flip.

    note: I’m not counting mortgage deduction

    The thing is #3 alone is enough to clear the market. We don’t NEED #1 or #2.

    Home prices will not plummet, but they will not increase, and new builds will likely continue on pace.

    Multi-family is still gong strong.

    And while it would be healthy for US to get rid of mortgage interest deduction…

    We don’t have to do that seize this opportunity to make the US population far more mobile.

    Seeing home ownership drop to 60% would be healthy, so the quicker, the Fed gets out of the way on #2, and FHA gets out of way on #1 and lets the investors become landlords…

    The better off we will be in the next couple decades.

  19. Gravatar of Suvy Suvy
    11. December 2012 at 18:45

    The problem in with the financial sector as a whole are the incentives. All of the incentives are geared toward short term profits: that’s how everyone in the sector gets paid. They get bonuses but have no downside. They can take huge risk to make short term profits and get more bonuses, but they don’t have any punishment if the huge risk they take causes their firm to blow up. Instead, we(the taxpayers) bail out their poor decision making. There needs to be some sort of skin in the game. There also needs to be stricter limits on leverage for both institutions and households.

    Fixing all of those things doesn’t require more rules and regulations; it requires better rules and regulation. It requires overhauling the current system and replacing it with a simpler system where everyone has skin in the game.

  20. Gravatar of Benjamin Cole Benjamin Cole
    11. December 2012 at 18:53

    I can’t say I am scared of a $13 billion loss. The “b’s” and and “t’s”– are they mixed up in the NYT article?

    $13 billion is just 1/7th of just the annual R&D budget of the Pentagon, now running at $90 billion a year. And that $13 billion is a one-time loss. Not a $90 billion loss every year (macroeconomically speaking).

    That said, I regard fiscal and most credit stimulus policies as giving amphetamines to a patient, while the Fed is asphyxiating the same.

  21. Gravatar of ssumner ssumner
    11. December 2012 at 18:57

    Statsguy, You are preaching to the converted on many of those issues. I’ve also argued AIG is not the real problem. Indeed TARP in general is not likely to cost money, except the auto bailouts. I agree that the GSEs are far more evil than FHA.

    Yes there was “regulation” after the S&L fiasco, just as there was “reregulation’ under Obama. In other words lots of smoke and mirrors to make gullible anti-market liberals feel good, while doing nothing to disturb the special interest groups that both the Dems and the GOP are in bed with. Neither reregulation program did much good.

    Patrick, I’m no expert in this area. I will say that the recent study that Cowen linked to supports your CRA argument, which everyone mocked at the time.

    acarraro, Because they are already wasting $110 billion, what’s the harm of wasting another $13 billion? Is that your argument?

    JimP, Very interesting. Thanks.

    Dtoh, I’m pretty sure the government did not make money on the S&L bailout–can anyone confirm?

  22. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    11. December 2012 at 19:37

    Stats Guy, None so blind as….

  23. Gravatar of acarraro acarraro
    12. December 2012 at 02:39

    My argument is that it’s 13 billion over many years. Those losses should be amortized other the life of the program. So probably 2 orders of magnitude smaller than the mortgage deduction. Given that housing subsidies are generally regressive, cutting the most progressive part of it wouldn’t be my first priority.

  24. Gravatar of ssumner ssumner
    12. December 2012 at 05:00

    acarraro, Nor is it my first priority–I do far more criticism of the mortgage interest deduction.

  25. Gravatar of Mike T Mike T
    12. December 2012 at 06:12

    Suvy,

    “The problem in with the financial sector as a whole are the incentives… They get bonuses but have no downside. They can take huge risk to make short term profits and get more bonuses, but they don’t have any punishment if the huge risk they take causes their firm to blow up.”

    >> Right, so shouldn’t the incentive include ensuring those individuals/firms bear the full burden of losses? I’m not sure how much new or smarter regulation we would need other than, more or less, reinstituting capitalism and having government simply enforce contract and bankruptcy laws.

  26. Gravatar of Josiah Josiah
    12. December 2012 at 07:19

    Scott,

    I thought you didn’t believe in bubbles?

  27. Gravatar of Suvy Suvy
    12. December 2012 at 09:26

    Mike T,

    I think you need to have clawback provisions on all of the top level executives that get bonuses. I also think it’s critical to make sure no firm has excessive risk if there’s any chance it gets bailed out. For example, over 900 hedge funds went bust in 2008; does anyone care about that? Of course not, because those hedge funds weren’t bailed out. If there is any firm that is “too big to fail”; they shouldn’t be allowed to have more than a certain leverage ratio(I’d start with something like 5:1 assets to reserves for all large financial institutions).

    Another solution would be to break up the financial sector so that no firm is too big to fail. That would also be a solution I’d be okay with. I’m just not okay with people taking massive risk and us bailing them out if they make an error.

  28. Gravatar of Mike T Mike T
    12. December 2012 at 09:45

    Suvy,

    “I think you need to have clawback provisions on all of the top level executives that get bonuses.”

    >> Yeah, I had thought about that as well and it reminds me of something Jim Grant had brought up when he gave a speech at the NY Fed earlier this year (a great speech to read in its entirety, but below is the relevant passage with respect to compensation clawbacks):

    “Well said, Withers! And what makes a good banker is more than skill. It is also the fear of God, or, more specifically, accountability for the solvency of the institution that he or she owns or manages. To stay out of trouble, the general partners of Brown Brothers Harriman, Wall Street’s oldest surviving general partnership, need no regulatory pep talk. Each partner is liable for the debts of the firm to the full extent of his or her net worth. My colleague Paul Isaac, who is with me today—he doubles as my food and beverage taster— has an intriguing suggestion for instilling the credit culture more deeply in our semi-socialized banking institutions.

    We can’t turn limited liability corporations into general partnerships. Nor could we easily reinstate the so-called double liability law on bank stockholders. But what we could and should do, Paul urges, is to claw back that portion of the compensation paid out by a failed bank in excess of 10 times the average wage in manufacturing for the seven full calendar years before the ruined bank hit the wall. Such a clawback would not be subject to averaging or offset one year to the next. And it would be payable in cash.

    The idea, Paul explains, is twofold. First, to remove the government from the business of determining what is, or is not, risky—really, the government doesn’t know. Second, to increase the personal risk of failure for senior management, but stopping short of the sword of Damocles of unlimited personal liability. If bankers are venal, why not harness that venality in the public interest? For the better part of 100 years, and especially in the past five, we have socialized the risks of high finance. All too often, the bankers who take risks don’t themselves bear them. By all means, let the capitalists keep the upside. But let them bear their full share of the downside.”

  29. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    12. December 2012 at 10:38

    ‘I think you need to have clawback provisions on all of the top level executives that get bonuses.’

    Guess what, they did have such clawbacks in their compensation packages. Fairly stiff ones too.

  30. Gravatar of Doug M Doug M
    12. December 2012 at 10:59

    Government entities are selling insurance, but they do not do the due diligence in their underwriting to charge the correct premium for the insurance that they are providing.

  31. Gravatar of Suvy Suvy
    13. December 2012 at 07:14

    Patrick,

    Is this called having “fairly stiff” clawbacks?
    http://www.youtube.com/watch?v=L_0Y8OCAgk8

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