Some of the most dangerous thinking in public policy happens when the ends are used to justify the means.  Our constitution was designed to move slowly; separation of powers was meant to constrain ‘easy’ changes.  Many social activists lament this.

Bill Clinton had the noble goal to increase home ownership for the poorer Americans.  In retrospect we can ask if there was even a problem there, but that is secondary.  In order to promote this goal he created a model where the regulators teamed up with the regulated to accomplish his goal.  Fannie Mae became adept at lobbying Congress and eviscerating regulators.  Prudent lending standards were compromised, and this carried forward into the corporate world.

A lot of homeowners, not to mention the taxpayers, were put at risk, but as long as the noble goal was being achieved few cared.  And those that did sound alarms were politically muted.

But even after the disaster unfolded little has been done to fix the system to prevent a repeat.  The collapse was a result of greed and good intentions.  Those who made fortunes in the mortgage bubble were revered because the noble goal was being achieved.  Now they are demonized.

When times are good we believe we can accomplish anything and that we can suspend the very principles that lead us to the prosperity we seek to exploit.  This is the root cause of economic cycles.  Those who preach prudence during these times are marginalized.  Worse they are criticized as being racist or otherwise insensitive to the needs of others.

Economic greed is a fact of life that competition often cures.  Political greed is also a fact of life.  Elected officials are able to make promises without paying for it; and often their reckless policies are not recognized until they are out of office and their million dollar memoires have already gone to paperback.

Many social activists secretly wish for a benevolent dictator to accomplish their objectives without the obstruction of a constitution or traditional principles.  But the problem is that when the dictator is no longer benevolent, he is still a dictator.  The benevolent dictator is the ultimate application of the ends justifying the means.

We have found other means, whether it is judicial activism, unbridled regulation, or unwarranted executive power.  The ultimate results remain the same.

The outcome of the 2008 election centered around the financial collapse that hit just months before the vote.  Even the most committed capitalists were taken by surprise at what seemed like a significant failure of capitalism.  Outrage was magnified as taxpayer dollars were used to bail out Wall Street millionaires.  In the months before the election we had little insight as to what caused this catastrophe.

Three years later we have collected insights from several good books on the subject.  With the clarity of hindsight we see that there was much more than Wall Street greed involved.  This is not to excuse the behavior of the self proclaimed financial masters of the universe who created self acknowledged crappy products as long as they could find suckers somewhere on the planet to buy their crap.  Their hubris rationalized absurd leverage because they bought into the “this time it’s different” mindset that seems to accompany every financial collapse.  They replaced an old school philosophical understanding of risk with a delusional mathematical certainty based on mathematical models that had soon to be realized severe limitations when applied to human action.   It is amazing what people will believe when they get paid outrageous sums.

But this was not enough to explain what happened.  As Thomas Sowell noted, blaming this collapse on greed is like blaming an airplane crash on gravity.  Greed has always been with us; why would it show so strongly at this time?

This excess was fed by the very institutions that claim to protect us.  Rating agencies gave higher ratings than merited because of implied government guarantees. Worldwide investors poured money into this market because because of the high scores from the ratings agencies.  But the center of the implosion was the housing market and this bust was the direct effect of Federal housing policies and the two Macs; Freddie and Fannie.  Wall Street served the political aims of a government that thought everyone should own a home, regardless of whether they could afford it.  To facilitate this objective Freddie and Fannie threw prudent lending out the window.

At The American Peter J. Wallison and Edward Pinto write Why the Left Is Losing the Argument over the Financial Crisis, 12/27/11.

Excerpts:

To the extent that we have had any success in challenging the conventional narrative about the causes of the crisis, it is because fair-minded people are persuaded by facts, not invective. Our argument is and has been that the financial crisis would not have occurred but for government housing policy implemented principally through Fannie and Freddie and the Department of Housing and Urban Development (HUD). Although there were a number of such policies, the most important were the affordable housing requirements first imposed on Fannie and Freddie in 1992 and expanded and tightened by HUD through 2007.

All told, after adding the SEC’s new data to our original estimates, there were approximately 28 million subprime and Alt-A loans outstanding on June 30, 2008, before the financial crisis, with a value of approximately $4.8 trillion. This was half of all mortgages in the United States. Of these loans, over 74 percent were on the books of U.S. government agencies and firms subject to government housing finance policies. This shows where the demand for these low quality loans came from. Fannie and Freddie were themselves exposed to more than 13 million subprime or Alt-A loans, or 65 percent of the government total.

HKO further comment:

We are only now beginning to see Washington take responsibility for their role in this crisis.  Any effort, law, or regulation that seeks to either solve this problem or prevent such a crisis from being repeated, that does not acknowledge and address this important factor is doomed to fail.

One of the rules of the Dodd Frank Financial Reform bill was the cutting of the bank fees charged for debit cards.  I have read much about the financial collapse of 2008 and I do not recall any analyst who thought that high debit card fees had a significant role to play.

I did find many that found that imprudent lending practices initiated by Fannie Mae had a role, but that agency was left untouched in Dodd Frank.

The debit card fee cut was supposed to reduce the fees businesses were charged and thus put more money in the pockets of businesses and consumers. Of course the reduction in fees the bank collected would have a negative effect on bank earnings, which would more than offset the stimulative effect of lower fees.  Shortly after the passage of Dodd Frank Bank of America laid off 30,000 employees.

In order to recoup the lost revenue banks are raising other fees.  Free checking for small accounts is becoming a thing of the past and fees are now being charged to debit card users to make up for the lower transaction fees they are allowed to charge merchants.

But at least the businesses will benefit from the lower fees, right?

Wrong.

Many of the consumers who resist the new monthly fees will switch to credit cards which charge higher transaction  fees to the merchants (but lower or no fees to the consumers) and are not subject to Dodd Frank restrictions.   How will this affect my company?

Let’s assume a transaction of $100, a common size transaction at my company.  If a customer used a debit card they used to charge a flat fee of forty four cents to the merchant. Under Dodd Frank the bank can now only charge me twenty one cents.  But since the consumers can now avoid the new monthly fees by using credit cards instead of debit cards I now pay a fee of 2% or two dollars on that same transaction. (Merchants with smaller average transactions will pay a higher percentage for credit cards.)  Instead of cutting my transaction fees in half they have quadrupled my transaction costs.

Thank you Dodd Frank, you damn idiots.

What this rule has done is to give credit cards a competitive edge.  Visa and Mastercard will make more money, consumers will not.  Since the fees for credit cards are higher this may actually increase income for financial institutions that move more business away from debit cards to credit cards.  To the extent that consumers will just use cash more,  the merchants will save money and the financial company will lose fee income.  Banks will modify their products to make credit cards more like debit cards by using prepaid features.  Your spending on the credit card can be limited to the amount you have deposited in another account.

Businesses and consumers will adapt to the new law, but for the relative few that will reap some benefit many more will experience higher fees and greater inconvenience.

If you have the cue ball and just one other ball on the pool table lined up for shot in the corner pocket, AND you are a reasonable competent pool player then you can determine with some degree of accuracy and consistency that you will have a high degree of probability of sinking that shot.  If the shot is not lined up perfectly and you must hits the ball at some angle or if you must bank the shot off the side bumpers, then the possibility of missing the shot escalates.

Now add another ball between you and the target ball, and the risk of missing the shot escalates enormously especially if the second ball is off center. By the time you add several balls to the table the likelihood of making the shot drops to near zero. The analogy is that the more variables you add to a system the less you are able to predict with any certainty.

You can predict with great certainty that you will miss the shot when several balls or variables are added to the scenario because the uncertainties and variables are very visible.  If there were several balls on the table and they were invisible, then you would look at the table and discern that you had a much greater chance of making the shot that you would actually have.

In retrospect the collapse of the financial system showed plenty of visible signs of impending doom.  There were several prominent analyst who warned us. One of them was Nassim Nicholas Taleb, author of The Black Swan (the pool table analogy is partially from that book).

The handicappers used risk models with two large defects.  The models were created in a world where all the pool balls were visible, where the chances of gain and loss were subject to measurement and where the amount that could be lost was somewhat limited even if possibly severe.  Taleb called this world Mediocristan. These models were applied to a world where the pool balls could become invisible, where risks were less subject to being known and measured and where the losses could prove fatal to the system.  It is foolish to decree with some delusional certainty that there is only a one per cent chance of a loss without considering the size of the potential loss.

It was foolish to apply game theory to a world void of the fundamental assumptions of the theory and it was even more foolish to consider risk of loss without considering the amount.

Why do we use such flawed thinking?  We seek the comfort of order where there is none. We are reluctant to admit that we do not know.  The more complicated our systems get (not just financial systems) the more we depend on intellectuals and academics for the answers.  These people do not thrive by focusing on what they do not know.

To use another analogy from Taleb’s book, it is like being lost in the Alps and using a map of the Pyrenees because that is the only map you have, and it is thus better than nothing.  No it isn’t: you are far better to use your own eyes and senses than a flawed model.

Rather than replace one horribly flawed model with another we need to recognize that we are in a game with invisible balls, unknowable risks, and with risks that can kill the host.  Much of the risk can be addressed by eliminating excessive and dangerous debt. More can be done by breaking larger units into smaller units but we must also reduce or eliminate interrelated risks.  We are no better off with smaller units so related than they will all go up and down together.  The last crisis saw unhealthy large institutions tied to every other large institution with activity so interrelated that it behaved like a single diseased entity.

The new Frank Dodd Financial reform addresses none of this. It assumes that we can compensate for the miserable failure of regulations and regulators with more regulators and regulations.  In 2006 Barney Frank angrily denounced those who warned Congress of the looming dangers  in Fannie Mae and Freddie Mac. Fannie and Freddie were exempt from most regulatory oversight from the Treasury, the SEC , and the FDIC; they were regulated by Congress themselves with Frank and Dodd in the most responsible positions as head of the House and Senate Banking Committees.

The monumental failure of Fannie and Freddie was at the center of the financial collapse, yet both are exempt from the financial reform package.

Those who believe that in light of the severity of the collapse that we must do “something” are still lost in the mountains and they are still using the wrong map.

In the Wall Street Journal, Culprits From Beltway Casting- The financial inquiry commission lets a crisis go to waste, (subscription required), takes exception to the partisan conclusion of the commission.   

The Financial Crisis Inquiry Commission reached a conclusion that appeared preordained. It was supported by the Democrats on the commission and rejected by the Republicans. The blame was heavily weighted to greed, derivatives and deregulation.  But greed is nothing new and apparently it isn’t quite clear from the conclusion when greed suddenly became a problem.  And it was not just derivatives, but derivatives tied to the housing and mortgage market. Fixed income derivatives seemed to have no similar problem.  And regulations have been growing, even under Bush.  Losses on mortgages, not tied to derivatives, were also severe.  Maybe it wasn’t de-regulation- but poor or misguided regulations or inattentive regulators.  Or maybe it was the interference of Congressmen with regulators after being plied with campaign contributions from the regulated.

Once again it is demonstrated that in the face of irrefutable evidence it is still possible to reach the wrong conclusion.

Blaming the economic crash on greed is like blaming an airplane crash on gravity.  It is a force to be acknowledged but serves no useful purpose in preventing the next crash.  There were clearly financial instruments allowed that should have been much more clearly regulated. But it is also true that government hubris especially at Fannie Mae and Freddie Mac drew the rules of the game that created this mess.  But the Democrats, almost by straight party line, rejected efforts to tighten controls of Fannie and Freddie, years before the crash.  But long before even the  Republicans and Alan Greenspan thought the risk was worth the potential benefit of expanding home ownership.

This crisis was a toxic mix of destructive government policy and poorly understood and poorly regulated toxic financial instruments.  Housing was the perfect tool because it served the purpose of vote buying government policy.  It was also the most dangerous because of its size and impact on so many people. By contrast Enron and WorldCom were record bankruptcies but posed no systemic risk.

But the problem was less from exotic financial instruments than from the same factor that causes all crashes: too much debt.  The greed of Wall Street villains, which is nothing new, was much less of a cause than the consumers who wanted houses they could not afford, and a government more than willing to accommodate them.