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GOP Primer on the Financial Crisis Inquiry Commission's report

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The GOP members of the Financial Crisis Inquiry Commission released their own "opinion" report on the larger Commission report issued this week. It is not a terribly bad summary of everything that went into the housing bubble and mortgage derivatives crisis.

The title of the Primer and GOP Commissioners:


Vice Chairman Bill Thomas
Commissioner Keith Hennessey
Commissioner Douglas Holtz-Eakin
Commissioner Peter J. Wallison

Delivered as required by P.L. 111-21: The Fraud Enforcement and Recovery Act of 2009
The report primer mainly consists of a summary of the crisis, not unlike the hundreds of financial articles that have already been published. One must wonder how much the government spent on writing a report that could have easily been a college class assignment?

The primer does not place any blame on any particular persons, positions or entities. Was there any crime involved in the financial crisis? One could argue that knowingly and intentionally selling a bad product would constitute fraud (especially when it is repackaged and sold as high-quality and low risk). With that in mind, the GOP Commissioner's primer did discuss the financial industry that was involved in selling the bad product. It's probably the most positive spin that could be reasonably created, or perhaps the best that money and influence could buy. Needless to say, it stops just a little short of saying that the financial firms were "doing God's work".

How did important financial firms become exposed to the mortgage market?

The primary role that financial firms played in mortgage lending was that of financial intermediary, providing a link between those who wished to invest in mortgages and those who wanted to take out a mortgage to buy a home. This is the value of a robust financial system—it allows investors to make investments wherever they choose and borrowers to borrow at the lowest cost. Without this web of mortgage originators, depository institutions, broker-dealers, money funds, insurance companies, hedge funds, and the GSEs, it would have been incredibly hard for a retiree in California to lend his savings to a homebuyer in Miami, much less a diversified group of homebuyers across the country. But with financial firms acting as intermediaries, getting exposure to the U.S. mortgage market was made incredibly easy.

The process by which financial firms acted as intermediaries is known as securitization. Rather than holding a loan to maturity, the loan originator would sell the loan as part of a pool of loans into the secondary market for mortgages. These loan pools would be purchased, turned into MBS, and sold to investors. The system had worked this way for decades, and worked well.

(Emphasis added)
There was no mention of the moral hazard involved when an industry takes on high risks (such as sub-prime mortgages) and then immediately passes that risk on to unsuspecting customers. Almost humorously, the primer does mention that the large and noble financial companies regrettably carried some risk in the short time that they held the bad debt in their "pipeline". For some reason, the image of a sewer pipe comes to mind, with it's contents briefly in their hands before they pass it on to those foolish enough to purchase the "product".

The Commission found three primary ways that the risk of the mortgage market found its way onto the balance sheets of these financial firms: pipeline risk, super-senior risk, and reputational risk.
Pipeline risk: Firms involved in the structuring of mortgage-backed products had to hold the underlying loans or MBS on their balance sheets while these structured products were in the process of being created. Although the underlying loans or MBS were acquired with the intention of pooling and selling them, the market for mortgage-backed structured products collapsed quickly. Not all of the accumulated loans and MBS could be sold for a profit, or sold at all.
The issue of moral hazard is finally raised in regard to the "too big to fail" syndrome. Additionally, this section hints at one of the greatest threats experienced during the crisis, one that has remained relatively obscure. That threat was the loss of net asset value in supposedly safe money market instruments, otherwise known as "breaking the buck". Considering the amount of money and total confidence given to money market instruments, losses in this area may have created a run on the "banks" (or money market mutual funds) of epic proportions, most likely dwarfing the bank runs of the Great Depression.

This is the moral hazard problem caused by “too big to fail.” If the government is expected to be unwilling to let a firm fail, debtholders will continue to lend money to that firm regardless of the underlying strength of the firm’s balance sheet. This perception was an important source of stability in financial markets during the summer of 2008. After Bear was rescued, Lehman had been perceived as “too big to fail” by the markets, and when it failed, debtholders of other financial firms fled to safer investments.

Think about the state of the world in September 2008 from the perspective of a short-term lender. Your deposits and investments in short-term debt are based on the expectation that these are very safe and liquid. However, with the financial system in crisis, uncertainty abounds, and liquidity is paramount. What if one of your lenders refuses to lend you money or calls in your loan? The rational response is to hoard cash, or at least to move your investments away from counterparties that might be at risk of failure.

With everybody hoarding cash, and nobody lending, financial intermediation operated with escalating friction, and the panic spread rapidly. The first firms to experience problems after Lehman Brothers were the money market mutual funds and the two remaining investment banks, Morgan Stanley and Goldman Sachs. The runs then spread to Washington Mutual, Wachovia, and Citigroup.

(Emphasis added)
We know that the government solution was to prop up the largest players in the financial and insurance industry, and to take on much of the bad debt. Was that the best solution? Perhaps the free market could have played a larger role. Was the U.S. Treasury Department's temporary guarantee program for money market funds enough to prevent a panic? As is the case today, banks and credit unions fail all the time. There is no panic. Individual account holder's assets are transferred to a new institution, and made available in short order. Instead of rewarding the "too big too fail" entities, let the market decide if they should fail. Panic would likely be avoided among money market mutual fund holders. Would stock holders in some financial corporations suffer loses? Yes, but one could argue that they suffered massive losses anyway, and that is the role of the stock market; investors share in profits, and they also share in loses. There is no guarantee, and no one believes that there is a guarantee when purchasing stocks.

Of course extending more government guarantees is far from perfect, but it would have prevented a panic in money markets, and still have allowed the free market to play a larger role. The perfect solution is to remove the government from the business of moral hazard altogether, and especially from bailing out businesses that are "too big to fail". It is not the originally intended, Constitutional role of the US Government, and it should not be the role now. Government involvement in backing the business world will always result in taxpayers paying for heavy losses. Privatizing gains and socializing losses is not capitalism or a free market at all, it's more akin to the economic practices of Mussolini's Italy, and it's theft from the taxpayers on a grand scale.