The Great Recession - Immediate Causes

To the degree you can use an organizing principle, here is my elevator story on what happened to cause the Great Recession. 

1.      FFDERAL GUARANTEE:  The root cause, and by far and away the main cause, is the sub-prime mortgage issue.  Ironically Fannie and Freddie were depression era government guaranteed corporations set up to encourage broad home ownership.  The (not just implied, but now actual) government guarantee of Fannie and Freddie was equivalent to putting up a sign over their door saying "steal here", you can’t lose.

2.      FAILURE OF REGULATION:  Barney Frank, George Bush - the whole policital class - used the government guarantee to corrupt Fannie and Freddie by weakening their ability to enforce normal lending practices but instead they provided loans to the politician's constituencies. To their discredit, the financial institutions (Goldman and Lehman et al and sub-prime mortgage borrowers getting houses they in no way “deserved”), did steal - and over-fed at the trough.  Letting them over feed, Barney says, was a failure of regulation.  Indeed, it was that too.  However there aren't many whole governments in the world large enough to regulate what Freddie and Fannie came to be, particularly with Barney getting legislation passed PRECLUDING careful lending and regulation by calling it discriminatory.  Well, yes, being discriminating is discriminatory.

3.      WALL STREET GREED - OVER LEVERAGING:  The implied guarantee had a second order effect also.  It encouraged the investment banks to over leverage.  For every one dollar in mortgage assets as collateral (because the mortgage "would never fail") they themselves borrowed thirty dollars.  Wrong, and the Bushies relaxed the regulation on leverage allowing just four select investment banks to go above the 12.5/1 ratio that had been in force, including Paulson’s firm, Goldman Sachs.

4.      FAILURE OF THE RATING AGENCIES;  The investment banks then took the underlying mortgages and mixed triple AAA rated mortgages with less well rated mortgages (sub-prime) and sold them as a package.  And, low and behold, the rating agencies rated the bundled mortgages as triple AAA!  So the investment banks mixed in more and more sub-prime mortgages, effectively buying sub prime mortgages for cheap but getting to sell them for the same price as triple AAA mortgages - very profitable.  The rating agencies were in no position (staffing and resources) to have any idea how to rate these complex packages of mortgages, but, maybe because they were paid to rate financial instruments, and NOT paid to NOT rate them, they didn't admit to the instruments being unratable. 

I personally don't feel the solution is for the government to buy sub prime mortgages from financial institutions.  It is buying a pig in a poke - the opaqueness of the instruments is the core of the problem in the first place so there is no efficient market to price the asset.  No one yet knows what are in those packages of mortgages.  The intervention point, it seems to me, is at the company level.  Warren Buffett can answer pretty clearly what he gets for his $5 billion investment in Goldman Sachs.  What does the US tax payer get for $700 billion?  Warren gets 10% of Goldman in Preferred Shares paying a 10% dividend.  Doing the numbers, the US taxpayers should get at least fourteen Goldman Sachs (more, given that few of the remaining companies are worth what Goldman is).  If the taxpayer were to say we will buy the next fourteen Goldman Sach, first come first serve, and the rest of you are on your own, it would be interesting to see what happens.  More importantly than the infusion of capital, perhaps, is that the government would then own institutions which know the underlying assets and have the people and systems to manage those assets.  Just buying bad loans means the government, not having any people or systems to handle the assets, will hire – you guessed it – Goldman Sachs to manage and sell those assets and even be a customer for those assets at cents on the dollar!  One could be cynical.”

I think the government should consider taking over the rating function from Standard and Poors and Moodys, which acted so badly.  The government role would be to act as the referee, and that could be an appropriate role.  After all, the government is better reffing than playing, and given that the tax payers are de facto guaranteeing the facilities, why not have the government say up front what they will back and what they won’t?”

Written in 2009