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The market buggeration: part one - Wemyss's Appalling Hobby:
From the Party Guilty of Committing 'Gate of Ivory, Gate of Horn'
wemyss
wemyss
The market buggeration: part one


 

Cost.  Transactions costs.  Rent-seeking.  Regulatory capture.  The invisible hand and the visible boot.

 

Coase.  Tullock.  Buchanan.  Friedman.  Von Hayek.  Von Mises.  Virginia, Chicago, and Austria.

 

CDOs.  Securitisation.  Demutualisation.  The CRA, Glass-Steagall, Gramm-Leach-Bliley.

 

If these terms, names, and concepts leave you stymied, you are not alone.  Equally bewildered are, inter alia, Messrs Bush, Paulson, Darling, Brown, Obama, and, to a lesser extent, McCain – and all but everyone at Bradford & Bingley.

 

At the moment, we all of us stand rather near to the edge of a precipice.  There is much clamour as various interests debate how we may best go on past, away from, or safely over it.  It seems to me that it would behove us first to look back at how, precisely, we managed to stroll blithely to the edge.

 

There are numerous factors that contributed to the present trifling difficulty (as Supermac should doubtless have put it with his accustomed languor).  Let us first examine the American element in the crisis.

 

With all due respect to Robert Kuttner, whose talents as a partisan polemicist he rather too often allows to overcome his sense as an economist, the problem simply does not arise from the enactment of the Gramm-Leach-Bliley Act in 1999 and its effective repeal of the (second) Glass-Steagall Act (properly, the Banking Act of 1933).

 

Or, rather, to be precise, the problem simply does not arise simply and solely from the enactment of the Gramm-Leach-Bliley Act 1999 and its effective repeal of the Glass-Steagall Act 1933.  Nor, to be sure, is it primarily – it is, rather, only secondarily, although hugely significantly – the result of the Community Reinvestment Act as such.

 

The American factor is a major element in the current credit and liquidity crisis.  The subprime mortgage factor is the major element in the American portion of that crisis.

 

This is not the doing of the invisible hand of the Smithian marketplace, but, rather, of the visible boot of the State’s interference in the market, to use Gordon Tullock’s apt formulation.

 

Let us consider what a rational market does.  One need not be a daily Coase reader to understand that firms and exchanges exist, in place of barter and immediate transaction, because of transactional costs.  If there exists a system for the purchase and sale of collateralised debt obligations, particularly, in our instance, mortgage-backed securities and similar SFCDOs (structured finance CDOs), then the rational response of the markets is to create pools, tranches, of CDOs, that spread the risk that any one collateralised debt will be impaired.  In the case of your actual MBS, risks include not only (1) rates of interest and the time value of money and (2) default on the underlying obligation, but also (3) the possibility of pre-payment.  It is obviously more rational and less risky to own one one-thousandth of a thousand mortgages than it is to own one mortgage in a thousand, for, due to the operations of Sod’s law, yours will inevitably be the one mortgage in a thousand that goes for a Burton.

 

The problem is simply that even the most rational market response may fail to effect its goals in an irrational market.  And government interference in the United States economy has created a systemically irrational market.

 

The abiding problem with Fannie Mae and Freddie Mac is not that they were privatised and then wanted to be bailed-out; it is rather that they were never properly privatised at all.  They were, during the period of their paper privatisation, quangos and nothing more. 

 

Most unfortunately, they were also – in no small part due to their wink-and-nod semi-official status – the dominant players in the mortgage market, on which they exercised a hugely deformative effect.

 

The market was deformed in several ways.

 

Firstly, the quango character of its major players allowed them to provide the worst of both worlds: they spoke and acted with much of the authority of actual Treasury agencies, yet, as ostensibly private entities, were positioned to give out vast campaign contributions, not to say bribes, to their alleged regulators.  Many of these were and are very prominent Democrats.  One of these was and is Mr Obama.  (SEE COMMENTS)

 

On one level, this is a rational response to regulation and oversight in a democracy with free-ish markets.  On another, of course, it is an extreme form of regulatory capture: the capture, that is, of the regulator by the regulated.  The more common forms of regulatory capture of course also ensued: the market became so complex that only the regulated, not the regulators, had any idea of how it worked and how to explain it.

 

And you thought New Labour were corrupt.  (Well, they are, but….)

 

The market was further deformed by another rational response to the State-imposed irrationality of the market: the creation of a largely private and comparatively deregulated side-market in SFCDOs.  The securitisation and sale of risk involved pricing problems that were distorted by government and quango participation in the market; indeed, it is not too much to say that effectively no-one could, by September of this year, accurately value a tranche of SFCDOs.

 

As Adam Smith noted, whenever three men of the same trade meet for luncheon, they are likely to hatch a conspiracy in restraint of trade.

 

The real knock-on effect however is directly attributable to the visible jackboot of the State stomping upon the Invisible Hand of the Market.  Doubtless the quangos Freddie and Fannie (stop giggling, Americans don’t understand what that word means in the Queen’s English, although they’re beginning to do) should have bought in to the MBS market in any event.  That they did so to the dangerous extent that they did do is the fault of the State.

 

One of the most dangerous, damnable, and, at the end of the day, damaging (and self-damaging) temptations in any market is that of rent-seeking.  ‘Rent’ in this context is defined as Smith and Ricardo defined it: as seeking something for nothing.  The most efficient people in the world at the ‘redistribution of wealth’ are not totalitarians nor yet gangsters, but, rather, lobbyists.  And this is of course ever more the case as markets are increasingly regulated: when the State through its regulators determines buying and selling, the primary commodities that end by being bought and sold are the regulators and the State.  The Congress – particularly its senior Democrats such as Senator Dodd – becomes, simply, the Friends of Angelo.  When this sort of out and out corruption is coupled with the over-investment of such quangos as Fannie and Freddie in SFCDOs, the breaking-loose of all Hell becomes imminent.

 

Why, it will be asked, even given the temptations of rent-seeking and regulatory capture, did the freer corners of the market as well as Fannie and Freddie become so heavily over-invested in instruments the risks of which they could not quantify and the value of which they could not determine?

 

There are several reasons, most of them poor.  The first is rational enough: markets are not prescriptive.  Like water, a market seeks its own level.  Given a deformed market with systemic irrationality imposed upon it by State action, market actors will nevertheless seek to make money.  And so they ought: for all the thoughtless babble about ‘corporate citizenship’ and ‘moral hazard’ (it exists in its strict sense, in instances of risk insulation – something very much a part of the Freddie and Fannie problem – and informational asymmetry, but one needn’t overrate it), the actual duty and responsibility – indeed, the fiduciary responsibility – of any corporate entity is to its shareholders.

 

The poorer excuses are more alarming.  Partly due to the corruption of certain members whose political base is on the Left and partly as a result of well-intentioned legislation and federal law enforcement directed against redlining, the Carter-era Community Reinvestment Act was revamped in the Clinton presidency in such a way as to mandate the over-creation of subprime mortgages and their introduction in far too great numbers into the market.  Politicians beholden to such groups as Acorn brought home the pork; and the unintended consequences, we now see.  To this was added the complication of ill-defined notions of what precisely constituted a subprime mortgage.  It is a commonplace to observe that, in seeking to warn young people against the use of dangerous drugs, the inclusion in that category of alcohol and tobacco serves only to ‘define deviancy down’: it actually makes it less likely that dangerous drugs are regarded as such.  In much the same way, the inclusion of perfectly credit-worthy ‘Alt-A’ mortgages in the ‘subprime’ pool muddled valuation and pricing and masked the growing problem. 

 

If you have ever wondered ‘but what does a “community activist” or “community organiser” do?’, you now have an answer, and a dusty one it is.

 

Truly private entities are subject to internal oversight by directors and rebellious shareholders, by prosecutors and civil litigants; quangos such as Freddie and Fannie are ‘answerable’ only to politicians whom they can compromise with hard cash or ideological professions of faith.  It was thus in the interest of the quangocrats to embrace the mandated creation of subprime mortgages, and to lobby for more.  Well, they got what they asked for.

 

Now, here is where moral hazard analysis has its place. As quangos, Freddie and Fannie believed themselves to be and were believed by the market to be ‘too big to fail’, even more than was so for a Bear Sterns or a Lehman Brothers or Mr Angelo Mozilo’s friendly Countrywide.  The sole justification for the proposed ‘bailout’ now being debated is that the Treasury is too big to fail, and can alone and uniquely hold the bad assets and those that are currently undervalued by mere association long enough to recoup them by sale to the market when things are better.  This is not necessarily true: corporate and personal tax cuts, capital gains tax cuts, and other measures could as easily be employed to restore liquidity without such intervention, whilst allowing the guilty to suffer.  But it is all too often the perception that matters: note for example that uncertainty paralyses markets quite as much as, say, the certainty that a bailout has been voted down, and notice as well the positive sign of the market coming to its own aid – you mayn’t have noticed – when, the bailout having been voted down, oil prices dropped.

 

The fact remains, even so, that none of the legislation that is now being blamed in some quarters for the disaster – not even the CRA – was a necessary, sufficient, or producing cause of the crisis.  Each act was undertaken in good faith.  Even their combined effects and the combined effects of their unintended consequences would not have produced the current meltdown.

 

No: it was corruption and collusion – in large measure the collusion between Fannie and Freddie on the one hand and certain private firms, notably Angelo’s friendly Countrywide; and the corruption of such persons as Senators Dodd and Conrad, Secretary Shalala and Ambassador Holbrooke, and Messrs Raines and Johnson – that felled the system.  And for all this there is one reason, one indispensable cause: the deformation of the markets, through State action and ideologically-driven policy and through overregulation in some areas coupled with lack of meaningful regulation in others.

 

The solution follows so soon as we grasp the cause: greater market transparency; a consequent reduction in the motives for, and the possibilities of, rent-seeking and regulatory capture; the elimination of earmarks and pork (you see, I do read the American newspapers); ethics reform in Congress; the elimination of quango domination of the market, quangos being peculiarly tempted towards rent-seeking and regulatory capture and peculiarly liable to political pressure (such as the pressure to make unwarranted loans); rationalised regulation in a rational market; tax cutting; and the rejection of lobbyists and special interests tied to the expansion of subprime lending (such as Acorn).  The political moral, you may draw for yourself.

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Comments
blamebrampton From: blamebrampton Date: September 30th, 2008 02:52 pm (UTC) (Link)
You and I have opposing underlying ideologies on this, which is fine. You have well-constructed reasons for yours, as I do mine. But I must take issue with a paragraph which I believe to be disingenuous:

Firstly, the quango character of its major players allowed them to provide the worst of both worlds: they spoke and acted with much of the authority of actual Treasury agencies, yet, as ostensibly private entities, were positioned to give out vast campaign contributions, not to say bribes, to their alleged regulators. Many of these were and are very prominent Democrats. One of these was and is Mr Obama.



The sums donated are on record and Obama has received $126,349 in contributions from both FMs in total since his election to the Senate in 2004. By comparison John McCain has received, in this election cycle alone, $298,413 from Merrill Lynch, $269,251 from Citigroup Inc, $233,272 from Morgan Stanley, $208,395 from Goldman Sachs and $179,975 from JPMorgan Chase & Co.

One could infer that this meant McCain was deep in the pockets of the banks too, but on closer inspection, it is not that simple, as four of these top-five McCain supporters appear on Obama's top-10 supporters list, and for larger sums. They, like all large companies in the US, are hedging their bets as they have always done.

I agree that in a perfect world, none of this would happen, but to tar Obama as a corrupt puppet is not a fair or just statement when he is more accurately represented as simply an American politician functioning in a deeply disturbing system.
wemyss From: wemyss Date: September 30th, 2008 03:21 pm (UTC) (Link)

Perhaps I was unclear.

1. The contributions made to both candidates from private entities are different in kind, not in degree only, from those made by the quangos, precisely because the latter ARE quangos.
2. It is - I won't say disingenuous; I will say it is mistaken - to confine an analysis of contributions to the period since Mr Obama's US Senate election. Mr Obama received anomalously large contributions from regulated entities and quangos when still only a local politician.
3. I failed to note that the context: one in which Mr Obama has in the past actually represented Acorn in litigation expressly designed to loosen restrictions and facilitate subprime lending to self-evidently uncreditworthy borrowers, and in which Messrs Raines and Johnson are amongst his primary supporters: makes his situation even more deeply suspect than would be the case for anyone else in that position (and, no, I am not spinning any wild theories that this an Alinskian-Gramscian plot, nor am I even referring to the fact that the man is, after all, a Chicago machine politician; the position at issue is his reliance on certain vectors of campaign financing support, particularly FROM QUANGOS, which is eo ipso worrisome for the reason I stated, i.e., that quangos simply as such are 'peculiarly tempted towards rent-seeking and regulatory capture and peculiarly liable to political pressure'.)

My apologies for having failed to be clear or, w/r/t my third point, comprehensive. Thank you for pushing me to a better and fuller statement of the concern.
shezan From: shezan Date: September 30th, 2008 10:04 pm (UTC) (Link)
Community Reinvestment Act

But will the voters see it?
wemyss From: wemyss Date: September 30th, 2008 10:32 pm (UTC) (Link)

That's your job.

Or Kristol's. Isn't it?
shezan From: shezan Date: September 30th, 2008 11:26 pm (UTC) (Link)

Re: That's your job.

Workin' at it....
woman_ironing From: woman_ironing Date: October 1st, 2008 09:39 am (UTC) (Link)

Mind yer backs!

People have been talking about breakdown in trust, but now I see that trust has nothing to do with it, because there is none. As you say, the market finds its own level, which is to say it does whatever it can get away with, and makes whatever profit is there to be made. The Fannie and Freddie that you've described show that there is no division between the the market and the government. The power of directors and rebellious shareholders never came into play: they were making a profit, they were happy. Some of them won't be happy now, so perhaps litigation will follow. A bit late, though. The election will certainly follow, but who are the people going to vote for? Whoever they vote for, the market gets in!
wemyss From: wemyss Date: October 5th, 2008 09:32 am (UTC) (Link)

Well, yes. However...

... one must always remember that 'the market' is - like soylent green - the people.
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