Jim's Blog

The subprime crisis was caused by regulation and the expectation that some companies were too big to fail – that if those companies got in trouble, the government would make sure their debtors were paid.

What did regulation tell financiers about subprime loans? It told them they had better make subprime loans, or face a lawsuit by ACORN, a lawsuit in which the regulators made it clear they would be backing ACORN.

Ted Day tells us what regulation said

The Boston Fed, speaking for the entire fed, declared in 1992 “discrimination may be observed when a lender’s underwriting policies contain arbitrary or outdated criteria that effectively disqualify many urban or lower-income minority applicants.”

Some of these “outdated” criteria included the size of the mortgage payment relative to income, credit history, savings history and income verification. Instead, the Boston Fed ruled that participation in a credit-counseling program should be taken as evidence of an applicant’s ability to manage debt.

So yes, starting in 1992, the regulators COMPELLED financiers to make these toxic loans that sunk the world’s financial system.

Indeed, this is natural and predicable, it is inevitable that regulation will always be counterproductive, will always have the opposite effect to that intended, for government regulators have no incentive to be prudent, whereas lenders do have an incentive to be prudent – unless they are lending to a firm that is too big to fail.

If a firm is too big to fail, people will lend it money, knowing the government will ensure they get paid back. So the too big to fail business borrows unreasonably large amounts of money, and lends it in unreasonably risky ventures – if things go well, the too big to fail business pocket the profit, if things go badly, someone else (usually the taxpayer), loses the cash, heads I win, tails someone else loses.

So the government has to regulate too big to fail businesses to restrain them from taking excessive risks – but such regulation is always politically unpopular, for it invariably means that people who “need” credit don’t get loans, and instead loans go to people who don’t need them – that loans go to people with plenty of assets and a history of using money profitably and paying their debts as and when they fall due, which people are seldom popular – goes to wealthy Jews instead of poor blacks, goes to the financially prudent instead of the politically connected, goes to the industrious and thrifty instead of ward heelers who get out the vote. So in practice, regulation aways works the other way around – encouraging or compelling too big to fail businesses to take excessive risks, rather than restraining them from taking excessive risk.

As it did this time.

The more government is involved in business, the bigger the losses are, and because government is more involved in business that it was, the losses were bigger this time.

The bailout will fail.

If the government offers implicit or expicit debt guarantees, if a firm is “too big to fail, then that firm can easily borrow lots of money cheaply, and lend that money to people not so guaranteed at a higher interest rate.

Free Money!

The too big to fail firm is going to take absurd risks that no one would ever take with their own money. And if trouble ensues, then they have less to lose, in proportion as the taxpayer has more to lose, so they will bet even bigger.

To prevent this, the government regulates these “too big to fail” entities, prohibiting them from taking excessive risks.

Regulation failed in three ways:

1. Gaming the rules by financiers: The government felt that judgments of character, competence, and credit worthiness were too subjective, so wanted risk evaluated by the numbers. But you cannot evaluate risk by the numbers! So the numbers were gamed, and loans to reckless people of bad character were rearranged to as to have wonderfully low risk numbers.
2. Political correctness by government: The government and various interest groups noticed that when borrowers were evaluated by credit worthiness, character, and competence in managing money, most people with good scores were white. So they pressured financiers to abandon these criteria, and regulated them to make loans that required them to abandon these criteria – and since the financiers were too big to fail, they were willing to comply.
3. Loss of contact with reality by accountants: Accountants, both by natural inclination, and because they were compelled by Sarbannes Oxley regulation, focused on the numbers, forgetting what the numbers actually stood for. When the unreality of the numbers was revealed, the entire financial sector became paralyzed. They are in the dark, and there is no source of light proposed

The bailout is an effort to keep business as usual going – but business as usual was not working, failed, failed catastrophically. We need a new finance sector, a main street finance sector where local bank branches ledn to to local people on the basis of character and solvency. Most of the wall street finance sector which the bailout is intended to keep alive needs to be shut down, to permanently go out of business, and despite massive cash injections, it simply is not in business right now. It remains paralyzed, despite gigantic handouts of cash, because they are aware that if they were to resume business as usual, they would piss away the new money in the same way they pissed away the old money.

If a company is too big to fail, then people will take risks they would not otherwise take.  “Too big to fail” is an implicit subsidy for taking big risks – which results in people taking big risks. So we have just paid people seven hundred billion dollars for taking stupidly big risks. What do you think is going to happen?

As we have seen, organizations that are too big to fail, fail big.  The US government is the biggest of them all.

For credit to work, people who need credit should not get credit.  You should only be able to get credit if you can prove you do not need it.  The major purpose of the bailout is to ensure that people who need credit will continue to get it.

For capitalism to work, to produce good results, rich people have to be smart.  Therefore stupid and greedy rich people need to be swiftly separated from their money.  As recent events demonstrate, the financial sector is dominated by stupid greedy rich people.  One major purpose and intent of the bailout is to prevent them from becoming stupid greedy poor people.

But if stupid greedy rich people continue to run the financial system, and the financial system continues to make credit available to those that need credit, rather than those that are most likely to be able and willing to pay their just debts as and when those debts fall due, then we are going to have more and bigger financial crises like the one we just had.

“Too big to fail” results in everyone putting their wealth in the hands of organizations that are too big to fail – which as we have seen are generally run by morons, resulting in bigger failures.  Eventually, most wealth will be in the hands of the biggest organization of them all, the US government, which is run by the most stupid morons of them all.  And then that too will fail.  The day will come when you  will get paid in nice crisp dollar bills, but they will not be worth much.  This has been the most expensive financial crisis in history.  If the bailout goes through, expect the ultimate financial crisis, when the US government itself goes broke, around 2020 or so.