Idiot’s guide to the financial crisis


US low-income (“subprime”) housing policy. The US federal government decides, rightly in my view, to have private housing for the poor. 

  • The market”. However, “the housing problem” exists because “the market” doesn’t spontaneously provide “toxic mortgages”.
  • Government vs the market. So the government decides to induce the market to do the opposite of what it does when free, in other words, finance toxic mortgages.
  • Government Sponsored Enterprises (GSEs). How does it get the market to do this? It creates GSEs (Freddie Mac, Fannie Mae, et al) to buy toxic mortgages from the banks, thus miraculously converting high-risk loans into zero-risk loans.
  • Bank bonanza. US banks are thrilled – they laugh all the way to the bank.
  • Success! The US government gets intoxicated by its success as banks, realtors and developers respond enthusiastically by granting around 100 million tax-funded mortgages. The stratagem is such a roaring success that the GSEs run out of money.
  • Money, money, money. The GSEs, in need of much more money, “securitise” (instructive word) the mortgages it buys into “derivatives” and vend them internationally. It uses the proceeds to fund more subprime mortgages creating an inevitable bubble.
  • Bubble trouble. Bubbles being what they are, exponential resources are necessary to prevent / delay the inevitable burst. No problem, the Fed fuels the fire by lowering interest rates and increasing the money supply.
  • Government “backing”. “The market” would never buy trillions of dollars of toxic mortgages – except when encouraged to do so by government “backing”.
  • Market frenzy. Now that’s really fun, the market is ecstatic, hedge funds, banks, institutions, governments, trusts and the rich embark on a derivative feeding frenzy.
  • Market magic. At last “the market” does what markets do; it trusted the government and geared and leveraged “government-backed” insecure securities to a point where underlying security was a fraction of debt.
  • Losses are normal. Normally that would be fine because mortgage debt defaults would have creditors losing slowly over long periods. Subprime debt can be “rescheduled” if security is insufficient to cover outstanding balances.
  • Government accomplishment. Meanwhile the US government is very happy, boasting about the magnificent success of its unique low-income housing policy.
  • Market correction thwarted. Whilst the government celebrated its triumph over the market, the market did another thing markets do and worked out that the flow of funds was insufficient to sustain the bubble, which resulted in typical and desirable “market corrections”. However, the Fed assured doubters it could and would provide sufficient funds, thereby reversing and delaying corrections ... and the bubble grew.
  • Potential crisis ignored. A growing number of astute analysts, cautious investors and free market advocates tried raising the alarm, but were ridiculed or ignored.
  • Implicit” backing solution. Daunted by the looming enormity of the problem and the staggering success of its “secondary mortgage market”, the US government changed from “formally backed” to “implicitly backed” toxic mortgages.
  • Market triumph over government failure. Eventually the market did what markets do, it reasserted itself over government failure, burst the bubble and set about a massive, painful and protracted “correction”.
  • Fighting the good fight. Well, it didn’t quite triumph over government failure, because the government hadn’t given up yet. It had lots more fight left, in fact trillions more taxpayer dollars and the muscle with which to satisfy its “borrowing requirement”.
  • Hi-tech orgy on steroids. Governments have now embarked on a modern hi-tech New Deal-on-steroids orgy of borrowing, taxing, printing and spending, euphemistically called “stimulus packages” and “bailouts”.
  • Iatrogenic treatment killing patient. The response to the “crisis” is iatrogenic. That’s a word everyone should know and use often. It’s the term for treatment that’s worse for the patient than the disease.
  • Imperfect market. There were concatenatious market-driven factors exacerbating the “subprime crisis”, together constituting a “perfect storm”, but they, unlike the government-created subprime phenomenon, are neither necessary nor sufficient conditions for a “global meltdown”.
  • Anti-market fundamentalists. Anti-market fundamentalists are searching for any possible explanation, such as “Wall Street greed”, “deregulation” and the supposedly “unregulated market” – everything other than the obvious. As Bertrand Russell said, people often stumble upon the truth, but they soon pick themselves up and press on.
  • The “unregulated market”. Far from being “unregulated”, financial markets are the most regulated of all markets – so we have government failure, not market failure.
  • Turning a process into a crisis. A neglected aspect is why the spontaneous market correction should be a crisis rather than a process. After all, underlying security often falls below the value of outstanding balances. That’s normal, predictable and factored as an inherent risk into all secured credit, the predicted impact being no more than a need to reschedule the debt or cut losses and foreclose. Such losses occur and are realised appropriately over time, a full generation with subprime mortgages, as and when there are actual foreclosures. For the most part, debtors keep paying and nominal losses occur where they don’t. Falling house and land values are commonplace, usually geographically confined, no surprises, no need to panic.
  • GAAP, government “protection”. However, to “protect” us from another Enron (where assets were over-valued ... fraudulently), more government failure triumphed over market preference when new accounting standards were imposed under IFRS, specifically GAAP (Generally Accepted Accounting Practice). It should, of course, have been called Generally Imposed Accounting Practice.
  • Old-fashioned free market accounting. Accountants and managers used to value assets by whatever convention they preferred, explain themselves, and left “the market” to make what it wished of their logic. If they lied, the time-honoured market solution to Enron-type fraud was common law prosecution. But bureaucrats and politicians always know better, so, to stop over-valuation, they mandated under-valuation. If companies couldn’t “mark to market” (assign a prevailing market price) they had to “mark down” (to below real values, perhaps to zero).
  • Basel II, more government “protection”. To “protect” us from “bank failures”, Basel II forced banks to provide credit only to companies with minimum GAAP assets. Combine these anti-market interventions, and we have (a) companies being forced to say they’re insolvent when everyone knows they aren’t – when their toxic mortgages marked to maturity are worth perhaps 10% or 20% less – and (b) banks being forbidden from relying on perfectly valuable assets. So, unlike anything that would happen in a free market, solvent companies were declared insolvent and banks wanting to finance them weren’t allowed to.
  • Simple versus simplistic. Of course the truth is more complicated, it always is. However, the inescapable basics are surprisingly simple, a confluence of anti-market interventions:
  • Create GSEs to deluge the market with toxic subprime mortgages.
  • Sell them into a massive government-backed secondary mortgage market.
  • Delay market correction of the inevitable bubble by flooding the market with easy money.
  • Force holders of toxic derivatives and banks to under-value assets.
  • Destroy inter-institution credit by outlawing bank autonomy.

    Author: Leon Louw is the Executive Director of the Free Market Foundation. This article may be republished without prior consent but with acknowledgement to the author. The views expressed in the article are the author’s and may not be shared by the members of the Foundation.

    FMF Feature Article / 28 July 2009
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