Reason vs. Ritholtz, EFSF Buys Its Own Bonds (No Joke), and Paul Blacked Out Last Night

Last week, Barry Ritholtz, who runs the blog The Big Picture, had a column in the Washington Post titled "What Caused the Financial Crisis? The Big Lie Goes Viral" which is critical of what he sees as the conventional explanation for the financial crisis.  His rational is as follows:

What caused the crisis? Look:●Fed Chair Alan Greenspan dropped rates to 1 percent — levels not seen for half a century — and kept them there for an unprecedentedly long period. This caused a spiral in anything priced in dollars (i.e., oil, gold) or credit (i.e., housing) or liquidity driven (i.e., stocks).

●Low rates meant asset managers could no longer get decent yields from municipal bonds or Treasurys. Instead, they turned to high-yield mortgage-backed securities. Nearly all of them failed to do adequate due diligence before buying them, did not understand these instruments or the risk involved. They violated one of the most important rules of investing: Know what you own.

●Fund managers made this error because they relied on the credit ratings agencies — Moody’s, S&P and Fitch. They had placed an AAA rating on these junk securities, claiming they were as safe as U.S. Treasurys.

• Derivatives had become a uniquely unregulated financial instrument. They are exempt from all oversight, counter-party disclosure, exchange listing requirements, state insurance supervision and, most important, reserve requirements. This allowed AIG to write $3 trillion in derivatives while reserving precisely zero dollars against future claims.

• The Securities and Exchange Commission changed the leverage rules for just five Wall Street banks in 2004. The “Bear Stearns exemption” replaced the 1977 net capitalization rule’s 12-to-1 leverage limit. In its place, it allowed unlimited leverage for Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers and Bear Stearns. These banks ramped leverage to 20-, 30-, even 40-to-1. Extreme leverage leaves very little room for error.

•Wall Street’s compensation system was skewed toward short-term performance. It gives traders lots of upside and none of the downside. This creates incentives to take excessive risks.

• The demand for higher-yielding paper led Wall Street to begin bundling mortgages. The highest yielding were subprime mortgages. This market was dominated by non-bank originators exempt from most regulations. The Fed could have supervised them, but Greenspan did not.

• These mortgage originators’ lend-to-sell-to-securitizers model had them holding mortgages for a very short period. This allowed them to get creative with underwriting standards, abdicating traditional lending metrics such as income, credit rating, debt-service history and loan-to-value.

• “Innovative” mortgage products were developed to reach more subprime borrowers. These include 2/28 adjustable-rate mortgages, interest-only loans, piggy-bank mortgages (simultaneous underlying mortgage and home-equity lines) and the notorious negative amortization loans (borrower’s indebtedness goes up each month). These mortgages defaulted in vastly disproportionate numbers to traditional 30-year fixed mortgages.

●To keep up with these newfangled originators, traditional banks developed automated underwriting systems. The software was gamed by employees paid on loan volume, not quality.

●Glass-Steagall legislation, which kept Wall Street and Main Street banks walled off from each other, was repealed in 1998. This allowed FDIC-insured banks, whose deposits were guaranteed by the government, to engage in highly risky business. It also allowed the banks to bulk up, becoming bigger, more complex and unwieldy.

●Many states had anti-predatory lending laws on their books (along with lower defaults and foreclosure rates). In 2004, the Office of the Comptroller of the Currency federally preempted state laws regulating mortgage credit and national banks. Following this change, national lenders sold increasingly risky loan products in those states. Shortly after, their default and foreclosure rates skyrocketed.

Now in addition to making my way through Mises' absolutely wonderful Human Action, I have been going back and forth reading Ritholtz's Bailout Nation for a few months (admittedly pathetic because of its short length) and I can say from the portions I have read, it is a phenomenal account of the bailouts and policies that lead to the financial crisis.

With that being said, the idea that Ritholtz is some kind of libertarian (The Big Picture was ranked as the 5th most visited libertarian site by DBKP Report) is absurd. As evidenced by the above list and within Bailout Nation, Ritholtz sees a legitimate role for government regulation within the banking sector.  His views in short are while the Fed provided the incentive for investment in riskier ventures, Wall Street ultimately ate the low hanging fruit. 

Tim Cavanaugh of Reason took Ritholtz to task for his views:

Since Ritholtz doesn’t even bother to put a number on his explanations, I’m not going to bother replying to all of them. But here’s some history on Greenspan (who Ritholtz, possibly using the conspiracy theorist’s observation that the central bank is theoretically not an official government entity, seems to classify as a private sector player). Here’s a search for suspects in the real estate bubble – including the government-sponsored enterprises Fannie Mae and Freddie Mac, who repeatedly lied about the amount of garbage debt on their books. Here’s a little something on the failure of government policies supporting loan modification to do anything other than stretch out pain. Here’s something on the anti-deflationary madness that spurred many of the policies Ritholtz laments. Here’s something on Bear Stearns. The fingerprints of HUD, FHA, Treasury, the Fed, the GSEs, and both 21st-century presidential administrations are all over this stuff.

Ritholtz has since replied:

Indeed, beyond the Post column, I have pointed a finger at Washington DC repeatedly. From the very early stages of the collapse, I have stated DC was a significant contributor. Indeed, early in the crisis, I described the government as “Uncle Sam the enabler.” (A Memo Found in the Street, Barron’s September 29 2008).

In the Big Picture blog, I made a list of the top blamees (Who is to Blame, 1-25, June 2009) It is dominated by government players, including the Fed, Congress, SEC, various Senators and Presidents, two FOMC chairs, the OCC, OTS, Treasury Secretaries, as well as private bankers and organizations.

And in Bailout Nation, I clearly detail how Congress did the bidding of Wall Street to allow special exemptions, waivers, and new legislation that contributed to the credit crisis, housing boom and bust, and Great Recession.

From my reading of Bailout Nation, Ritholtz is telling the truth as he does place blame on Washington for contributing to the crisis.  While he does a great job documenting the asinine interest rate policies of the Fed by Alan Greenspan, many times he pines over the great opportunity President Obama had in reforming the banking sector after the almost-collapse.  Despite the 115 regulatory bodies tasked with monitoring the financial sector in the U.S., it just wasn't enough as angelic bureaucrats serving in the public interest were corrupted by the satin-like Wall Streeters and their deep pockets.  Ritholtz, despite his great accomplishment of outlining the pattern of government bailouts in the past four decades, still places his faith in an institution composed of fallible men wielding coercive power.

Yes, Wall Street overleveraged and gorged itself on obscene amounts of risky assets.  And yes, the Federal Reserve and Congress's historic record of bailing out big business and preventing market corrections incentivized such behavior.  Ritholtz acknowledges all this.  But his overall belief that the government can be entrusted to fix this overtly rotten financial system by grasping on to more control is naive.  The banks should have failed and the Fed should be abolished to welcome the return of market-based money.  Ritholtz agrees with the first but not the second.  Because of that, he isn't willing to face the direct cause of the business cycle one on one.  For the author of the great Bailout Nation to not recognize that central banking in itself is the ultimate corporate bailout is disappointing.

Speaking of corporate bailouts, it looks like the European Financial Stability Facility has gone, in Zerohedge's words, "full retard."  From The Telegraph:

The European Financial Stability Facility (EFSF) last week announced it had successfully sold a €3bn 10-year bond in support of Ireland.

However, The Sunday Telegraph can reveal that target was only met after the EFSF resorted to buying up several hundred million euros worth of the bonds.

...and the charade continues.  For a great interpretation of the Euro crisis, see the following drawing made by an 11 year old (ht Mish):

 
So apparently Ron Paul received only 89 seconds of speaking time at last night's foreign policy debate.  I guess not being a murderous loon is frowned upon in a forum for rage-filled screams of "nuke Iran."  Here the seconds are in all their glory:

I was streaming the debate live last night while at a Starbucks.  I lost connection about an hour in.  I was afraid I would miss something good, it looks like I worried for nothing.

Update- Jonathan Catalan gives a great speech at the Ludwig von Mises Institute of Canada which critiques monetary equilibrium theory (ht Dan Kuehn):

Monetary Policy and the Great Recession from Mises Institute of Canada on Vimeo.
I really enjoy his point that an increase in savings acting like "passive countercyclical" policy to counteract credit contraction.  Though it wasn't the subject of his speech, I didn't catch exactly how a free banking environment presuming fractional reserve banking would differ very much from a 100% reserve banking environment.  The benefits he described seem to fall in line with 100% reserve requirement unless I missed something.

Update 2- EFSF denies:

(Reuters) - The euro zone's bailout fund said on Sunday that it did not buy its own bonds last week, denying a British newspaper report that it spent more than 100 million euros ($137 million) to cover a shortfall of demand.

Like Trichet said, in the case of disasters, you need to lie.