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09/21/2008

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Jonathan Goodall

"The difference is how recently Bernanke and especially Paulson were appointed, how heavily they are relying on financial experts from the private sector rather than on civil servants, and how small a role the politicians in Congress and the White House have played in shaping the response to the crisis."

How can we still call these Wall Street financiers "experts", and why should we rely on them, when these are the same who believed they could limit risk?

My personal takeaway from this debacle is this: I don't want to hear talk of "free markets" again. "Freer markets", maybe. But it is hard not to take away from these last two weeks the idea that the perils of capitalism fall only to those who live outside the zip codes of Manhattan, while the benefits are mainly bestowed upon those same zip codes.

Jonathan Goodall
Fordham Law '08

Peter Pearson

Didn't the collapse of Fannie Mae and Freddie Mac contribute heavily to this crisis? And weren't Fannie and Freddie political creations, whose mischief over many years was protected by politicians who happened to be getting contributions from them? Wouldn't this mortgage crisis have unfolded much differently if Fannie and Freddie had been subject to the same accounting and transparency rules as private companies, and if there had been no game of peek-a-boo over whether taxpayers were responsible for Fannie's and Freddie's debts? Laying all blame on free markets seems extreme.

Jason Smee

I agree with Becker that it's a moral hazard issue, but I think wiping out equity holders (and maybe debt as well) is the best possible scenario (I owned LEH so I have an incentive to the contrary). John McCain is right in his outlook (but wrong in his solution) that wall street compensation is way out of whack (not necessarily too high but uncorrelated w/ performance) and was treated as a giant casino. Incentives were completely misaligned and to a degree equity holders were more like debt holders as employees controlled a disproportionate amount of the upside. The answer to this is not in the form of more regulation however, but via the market. With the major losses experienced by equity holders, a well functioning free market will have the remaining (and future) equity holders saying that enough with high levels of comp and reforms are necessary to tie comp w/ performance. And if not, at least there's a precedent to see their values next time history repeats itself. Then again, maybe I have too "Chicago" of an outlook on markets.

Jason Smee
Chicago GSB '07

Redmund Sum

I agree with Judge Posner that the highly complex derivative products that has led to extreme leveraging and increasing lack of transparency and flexibility, is the main culprit of this financial crisis. As are to blame the casino mentality at Wall Street, and out-of-this-world executive compensation, etc, etc. But I do think that Congress's brow-beating of the mortgage industry into sub-prime lending, and for several years, cheer-led the "increased home-ownership," was the original sin. Even today, some in Congress continue to argue that the Government should fail out "struggling homeowners who are about to lose their homes." It is gut-wrenching to lose one's home. But we are not, at least I am not, sympathetic to seeing an expensive BMW being reprocessed, should we be sympathetic by opening our wallet to those who became home-owners by taking out a NINJA loan? (NINJA = No Income, No Job or Asset)

This crisis may not be the direct result of "failure" of the government, but government's failure in monitoring the two Freddie's, while some prominent names (Dodd and Obama among them) got big money contributions from these two institutions is troubling. The problem is that we don't call this "failure", we call this "business as usual."

robert

"To a great extent, they are not responses by government."
Judge Posner, wasn't the federal Community Reinvestment Act the trigger for what happened here? And isn't the taxpayer money (supposedly as high a 1 trillion dollars) being pledged to bail out these businesses about as governmental a response as one could imagine?

Thomason

What of this 'war' and the diversion of capital to that; what about the federal deficit and the political expedient of 'tax cuts' that contributed to that??? To absolve the current administration and its 'economic policies,' and simplistically to foist all the blame on those who endeavored to capitalize on created opportunities, is too forgiving.

Gary Beale

I'm having a hard time believing, with all that concentration of IQ and experience on Wall Street, that executives didn't understand the "complex financial instruments" they were using to control risk. It does seem plausible though that many of them didn't want to understand those instruments.

In every company there is a never ending tug of war between the risk (and short term profit) seekers, and the conservative safety advocates. This tug of war takes the form of epic political battles between the two factions, with the risk takers arguing that there is too much money on the table to not take the risk, and the safety faction arguing that the risk is too high. Careers, and tremendous compensation rates are on the line. It is typical to use every available piece of evidence to win your point, including complex financial instruments that may or may not accomplish what they purport to do. These instruments offered plausible deniability (at the least).

Seems to me that highly leveraged speculation is the root cause problem here. What with human nature, there does not appear to be any way to do that without tremendous risks being taken, high IQ or no.

Tom Grey

Those Big Brain rocket scientists deserve to have their prior bonuses retaxed in a "windfall incompetence" tax of 90% on $2 million or more over the last 5 years.

This would be a good time for the Chinese, and even the Russians, to start buying cheap US assets with their (soon to be less valuable) USD.

Wes

Posner: [Capitalism] will survive because there is no alternative that hasn't been thoroughly discredited. The Soviet, Maoist, "corporatist" (fascist Italy), Cuban, Venezuelan, etc. alternatives are unappealing, to say the least.How about Scandinavian (or European or Canadian or New Zealand) socialism?As a scientist, the more I hear Republicans talk about how funding for basic science research should be left to the free market (in order to free up more money for military conquest), the more I am inclined to look outside the USA for jobs.Posner: Compensation schemes that tie executive compensation to the stock prices of the executives' companies but cushion them against a decline in those prices (as when executives are offered generous severance pay or stock options are repriced following the fall of the stock price) further encouraged risk taking.Not only that but it calls into question the Republican notion that the free market alone can be trusted to pay people according to their contribution to the economy. If these CEO's had been compensated according to their contribution to the economy then they would have had billions taken away from them.In particular, CEO performance and compensation in this mess calls into question the "divine right of kings" model of corporation governance. It provides a powerful argument that corporations would be better off with a carefully crafted system of governance rather than blind faith that the guy at the top knows best.

Shame On Posner

"To a great extent they are not responses by government, really, but by the private sector."

Wow. And by exactly which means does the private sector extract fund directly from me, the taxpayer, to cover their losses?

Hmmmm, could it be by means of GOVERNMENT action?! Specifically, taxation? And don't forget the printing of more fiat money to inflate the money supply.

To pretend that "federal guarantees", making me as a taxpayer personally liable for ANY debt that I didn't create myself, did not create this financial debacle, is the worst kind of intellectual collusion. For shame.

Redmund Sum

Is Judge P auditioning for John Paul Stevens's job?

Brian Davis

I doubt it but if there's any appellate judge who deserves to be "kicked upstairs" he's certainly one. In fact, that 7th Circuit is replete with 'em.

Tim Lai

The object of the battle between the market vs. government is the systems - the incentives they create, and not what pedigree the person in charge has; whether they are recently from the private sector is by no means relevant. Many government officials make wise decision in their private affairs. I am puzzled by how Posner distinguishes between markets and governments.

It's surely the individuals who've decided to take these highly uncertain and murky risk for fear of missing the boat, but the question is what can the government do to help make the incentives align. They reap the full gains by risking, but bears a risk that is very difficult to ascertain. The ambiguity discounts the fear. So this person will irrationally prefers more risk. There are many ways the government can step in to help, but further rewarding these irrational behavior with bailouts is certainly not the way. The next episode will only get more and more severe, as the correct expectations for yet more bailouts develop. The bullet has got to be bitten.

fedgovernor

Interesting post. I disagree with the conclusions.

Government is most to blame for this crisis, because it is government's job to outlaw thievery and then police the market.

Let me explain: One way to rob a bank is to steal the owners' capital. A sly bank manager could do that by boosting supposed "profits." A sly bank manager would then get outsized bonuses on those supposed profits.

This is the reason why you don't want banks owning securities that aren't highly transparent. Because if you do this, then the bank's managers will try to arbitrarily inflate the value of those securities in order to be rewarded in their compensation systems.

If the securities are sufficiently un-transparent, then the owners will not be able to detect this subterfuge until it is too late.

That's where we are today.

The banks owners were told by the bank's managers that the securities they were purchasing were of a certain quality, when in reality, the securities being purchased by the bank management were highly volatile.

Their value could change dramatically from one quarter to the next based merely on market forces beyond the control of the bank managers or bank owners. But, the owners could not detect this. The securities being purchased by the bank managers were sufficiently complex enough to prevent the banks' owners from detecting the fraud being perpetuated upon them by the bank managers.

The bank managers were robbing the bank from the inside, by cooking the books and reporting profits that were, in part, based on the alleged value of the securities the managers were purchasing with the owners' capital.

So ... how do you prevent this. Well, one way is to outlaw the owning of securities by banks. As any student of history will tell you, that's precisely what the government did following the events that created the Great Depression.

For almost 60 years, commercial banks couldn't own securities. This protected the capital from theft by the bank managers ... the inside job.

The repeal of this law was signed by Bill Clinton in 1999. And here we are just 8 years later and everybody is wondering what happened to the capital.

Well, the bank managers stole it. That's what happened to it.

David Heigham

Judge Posner,

You may find it worth refelcting on the fact that the financial crisis managers at the European central bank, in Britain and in Japan have a far lower percentage of people formed in the private finacial sector. All three seem to have shown slower reactions than their US equivalents, but less proclivity to panic, more emphasis on the long term health of the system, and less generosity to the owners and managers of private finance.

The capacity to figure out what is happening rapidly in a crisis is valuable, and the US system is good at that. But the virtues of the other approach may be even more valuable in the longer run.

Michael McCartney

I believe the government had a very large role in this latest crisis. First, Fannie and Freddie, with their implicit and now explicit backing of the Federal Government, created dislocations in the mortgage/housing market, which resulted in a very large misallocation of capital. Further, the SEC, through the NRSO, sanctioned only 3 rating agencies, thereby limiting the marketplace of ratings. Further, after such sanctioning, the SEC allowed the agencies to be paid by the issuers they were rating, which contributed to the excess of AAA mis-priced paper, resulting in way too much liquidity chasing hard assets. In addition, the Fed has a role of overseeing the commercial banking system, which it has failed miserably. These 3 things alone created dislocations in the market, thereby not allowing the market to work properly and improperly incentivizing the private sector to take advantage of dislocations, resulting in the present crisis. There are other mistakes that the government has made. The private sector is not blameless, but they respond to incentives. Let's make sure proper governmental incentives are in place and that the market is allowed to work.

Tom Grey

The gov't also allowed Fannie Mae to claim, quietly to investors, that it was gov't backed, while claiming publicly to Congress, that it wasn't.

This FRAUD was explicitly allowed by Barney Frank and other Fannie supporters & enablers.

Plus, Fannie's irresponsible, non-checking of mortgages (like liar loans) was crowding out the responsible lenders. Fannie Mae and all its associated problems ARE gov't created -- and the willingness to accept, without evidence, a person's word that he can make mortgage payments is the sloppy kind of gov't action one expects in a paper-pushing bureacracy which only rewards approvals.

Gary Beale

Referring to the previous post... Let me see if I've got this straight: The government creates Fannie and Freddie, then privatizes them, and provides pretty loose regulation. Then the private sector owners and managers of F&F play fast and loose with risk as they make themselves dump truck loads of money. Now the dump truck has tipped over, and the Fed has to clean up the mess because it is blocking the road. BUT, this is the governments fault? That's like claiming the police are the cause of crime. The legislature, under intense lobbying and pressure from conservatives backs off on regulation, the private sector goes wild with leveraged speculation and other greed driven behavior, and it is the government's fault? I'm not seeing this logic.

Jim Wells

I wish I could get away with just repeating the old phrase offered by that movie…”I’m mad as hell and I’m not going to take it any more” and then do something or make something happen.

Fortunately or unfortunately as the case may be I’m just your average John Q. Public and I have no individual leverage or power that can effect any change or action with this present crisis in the investment world. I am angry though, so very angry as I listen to the bliviots discuss what has happened here with our money. You can tell as they present a great deal of smoke in their discourse that they really have no clue or shorthand method to explain what just got done to us by Wall Street, the moneyed people, our betters... and the politicians. They are qualified however to talk about it since they are more than fifty miles from home and always have their briefcase with them. That’s a requirement to be a TV expert.

It isn’t my intent to get into discussing naked short selling, CDO’s, derivatives or any mystical ethereal forms of investment activity that has taken place but let me tell you one Joe Six-pack story that is pretty simple and deals with something we all understand and recognize… real estate.
This happened to me and it’s a small part of what has occurred and what, we…the public, are going to be paying for.
About ten years ago, after selling our business my wife and I began buying and selling houses. We had been doing this in a very general way throughout our married life and realized that we were good at it. Our shared philosophy being that we always tried to leave any place where we stayed, better than when we found it. Thus over our 37 years of marriage we had improved a number of different pieces of real estate. Some owned and some rented.

We learned that every day at the court house there were properties offered for sale at a foreclosure auction. This was over ten years ago and everybody wasn’t aware that there were significant sales taking place everyday, least of all us. It took a few months to get a feel for how these occurred, what the rules were and how the game is played but after those few months we felt ready.

A foreclosure auction here in Tampa used to have maybe 15 to 30 people in attendance. The number increased as the TV real estate guru’s became more prevalent to the point where there were crowds of people, shoulder to shoulder bidding on these homes. I understand they had to move the location because of the crowds.
We discontinued our activity about five years ago but when we started ten years ago, we had from one to thirty properties to bid on each day, five days a week.
There were always a lot of homes on the foreclosure list which became available from the County Clerk and several services did the necessary background research and put this information into a notebook form, for a price. Things you needed to know like second mortgages, taxes, liens and things of that nature are available at various places, not generally reported as part of the foreclosure paperwork but generally all were included and reported as part of the purchased notebook service.

We and most of the people buying these homes were bidding on them after a simple drive-by inspection. Each Sunday we would make a list of the homes that we might be interested in, after reviewing the book we had purchased of upcoming foreclosures. We would then drive around and look at them. Noting whether they were still occupied, external condition of the property and if vacant we’d look in the windows. We would establish a price that we felt the area and house could support for a final sale after we had rehabilitated it. These houses had no guarantee that anything worked. We received no assurances that the house was anything other than a shell. A foreclosure does provide you with a clear title however. We would then determine an offer value generally between 50% and 70% of what we felt we could sell the property for. We did this each week and bought about four homes a year.

If you were successful in your bid the county required a 3% deposit on the spot. $100,000 house required $3,000 in cash or a cashiers check and you had until 4:00 pm to get the rest of your money together. If it was a $100,000 house you had to come up with a total of $100,000 plus Documentary Stamps of a few hundred dollars. No bank was available to help you take that flyer, this was all private money.

So if we found a house that had what we felt was a final value of $150,000 our bid would be somewhere in the area of $75,000 to $105,000. We would generally have a top price that we wouldn’t go past and only violated that a few times, heat of the battle and all that so to speak.

We were always looking for houses that had some equity in them. That is the bank/mortgage holder was owed less than what we wanted to pay for the house. The bank/mortgage holder generally would be represented at the sale and bid the amount that was owed. So a house that we felt had a sale value of $150,000 after rehab and was one that we would be willing to pay up to 70% needed to come to foreclosure at a price of less than $105,000. Ten years ago there were generally a few properties each day that that met our criterion and some 10 to 15 a week.

About five years ago we noticed things changing. When a property came in that had some equity in it that we felt we could bid on, the bank indicated its intent to pay up to eighty or ninety percent. A word here about “intent to pay”.

The “intent to pay” program was one of the first things we learned when going to the court house. There was always someone, never a “bidder”, who kept track of how much the mortgagee was willing to pay to redeem the property. If it was more than anyone was willing to pay then they could bid $100 and avoid the payment for the Document stamps for the full amount. So it worked like this. A property was coming up for bid and there was $65,000 owed on it to ABC bank. ABC bank representative, let the keeper of the “intent to pay sheet” know that they are planning on bidding $95,000 on the property. When the property comes up for bid they bid $100, no one bids against them. They get the property back for $100 and Doc Stamp fee of maybe $1. If a bidder still wants to bid on the property you can bid them up and the winner gets to pay for the house and then pay the Doc Stamps as part of the transaction.

The notice of intent was helpful to the bank, they saved a ton of expenses on Doc Stamps (our tax dollars) and it was helpful to the general public bidding since you weren’t wasting a lot of time and effort in bidding on something that you were never going to get. The loser was/is the county and state government who is providing the foreclosure process and protection at no cost to the banks.

Once the banks raised what they were willing to pay to a level that we felt uncomfortable with, we just sat back and watched for a while. I was sure that at some point their pot would get full and they would have to back off. But I am such a small thinker. That didn’t happen. They just kept on buying.
They drove us and many of the people that we had become acquainted with out of that business. They sold many of those homes to the TV rehabbers or hired the work out themselves at 90% of value. I had no problem with that and have no problem with that; I am a true capitalist pig. If you can make it work better than someone else, more efficiently and make money doing it…more power to you. I’ll watch and try and learn. If you fail however, let’s see, now you’ve stopped me from making a living that way and you’ve failed so badly that you need me to pay for your failure. That pisses me off; can you say that in a missive such as this?

I am told that many of these homes were loss proof (to the individual bank) because there was mortgage insurance involved and I’ve been told that banks consistently packaged these losing mortgages with other mortgages into bundles and were able to sell them for top dollar. I’m really clueless as to what they were doing except that now that they are in trouble we are responsible for bailing them out.
It isn’t just me but a large group of people that for one reason or another had to find another way to make a living and were doing so by cleaning up the trash of people who had problems, had their home foreclosed and had moved on. We actually improved neighborhoods. What we as a group didn’t do was manage to pay off the politicians.

The politicians who went to the likes of Fanny Mae, Freddy Mac and Safe Guard Properties to get the significant contributions to their political campaigns. The politicians... who now must find a way to get the taxpayer to finance the complete bailout without letting anyone see how they took their money first. I cannot believe that these politicos are so shameless as to perform their hearing on TV and

What should we do? I’m firm believer in, if you’re going to bitch, you should at least have the remnants of a solution.
First of all a bailout to the banks where the CEO has been taking a huge salary and huge bonuses and not doing his job are unconscionable!
Second the oversight by congress of Freddy and Fanny has only been effective in fattening the campaign coffers of the politicians on the several congressional committees’. There has been no oversight except to make sure that the CEO’s of these entities got huge bonuses and salaries ($100 Million in one instance) so that they would continue to pass the bucks on to them, the members of congress. So let’s leave them (the Congress) out of it.
Perhaps we should put together a group of knowledgeable citizens who actually have the interests of the country at heart and haven’t had their beak at the public trough all their life. I am so tired of hearing these bastards talk to one another in TV hearings and constantly reassure each other that “our only concern is in the interests of the taxpayer”. Then their next sentence is to outline the people that can fix this are the same ones that created it in the first place. That is such a crock it makes my head hurt.


So let’s find a bi-partisan CEO to head up an agency of other concerned citizens and take this away from these DC bureaucrats.
We are talking about simple real estate transactions here and they are trying to make this as complicated as possible. They want to hire lots of experts and make sure that neither the banks nor the citizens get hurt. Let me give someone a clue, you idiot, someone is going be hurt. The taxpayer is already hurt while the Fed, the Treasury and congress have been having golf outings and big dinners and talking about raising their own net worth, the public is getting killed.

Let’s have this agency figure out a way to do this bailout and run it like a business instead of a giveaway. I have an idea that the guys you get to run it aren’t going to require $700B. They will figure out a way to get started for a fraction of that, aren’t going to need all that money at the out set and if they are effective in their business acumen the value of the real estate will provide most of the funds necessary on into the future.

As write I am listening to Dr. Bernanke and Secretary Paulson responding to Senators who are talking about moving everything at fire sale prices. You are actually talking about $700B of real estate. More than likely that has a value of $700B. These guys love to talk about moving things at fire-sale prices because they know that they when that happens, with that kind of value floating around, they will wind up (through there campaign funds) getting a large piece of the action.


In my opinion unless we get the resolution away from these experts and politicians we are going to have a real disaster.

pettibone

I think people who want to blame the government for this problem because of Fannie and Freddie are missing the point. Fannie and Freddie are not governmetn agencies in the normal sense. They are (or were) for-profit operations that acted to maximize their profits with executives who were ocmpensated based on those profits, etc. While it's true that the implicit government backing may have (did) encourage excessive risk-taking, they were hardly alone in that as it was endemic throughout the entire industry.

But all this is past. My question for Professors Posner and Becker is what price should the government pay for the assets of the companies in which it has taken a financial position? My understanding is that if they pay the current market price, that will leave the companies undercapitalized (because the current price is so low), but if they pay a higher price, it will put taxpayers at greater risks since they may be overpaying for the value of the asset.

Is there really a good argument for the government paying an above market price for these assets. If so, how do I get the government to pay me an above market price for my condo in Florida?

pettibone

I think people who want to blame the government for this problem because of Fannie and Freddie are missing the point. Fannie and Freddie are not governmetn agencies in the normal sense. They are (or were) for-profit operations that acted to maximize their profits with executives who were ocmpensated based on those profits, etc. While it's true that the implicit government backing may have (did) encourage excessive risk-taking, they were hardly alone in that as it was endemic throughout the entire industry.

But all this is past. My question for Professors Posner and Becker is what price should the government pay for the assets of the companies in which it has taken a financial position? My understanding is that if they pay the current market price, that will leave the companies undercapitalized (because the current price is so low), but if they pay a higher price, it will put taxpayers at greater risks since they may be overpaying for the value of the asset.

Is there really a good argument for the government paying an above market price for these assets. If so, how do I get the government to pay me an above market price for my condo in Florida?

Andy

Great article. I put down the real cause of the financial crisis to over LEVERAGE just like you alluded to here! As I wrote recently, What really caused the magnitude of the current financial crisis was the amount leverage used in the housing market and mortgage backed securities derived from it. Leverage is a double-edged sword that is a powerful ally during boom times, but can quickly become your worst enemy during the ensuing bust. The collapse or bailout of some of our most highly regarded financial institutions – Fannie Mae, AIG, Lehman Brothers and Merrill Lynch - was squarely due to leverage.

Mike Shapiro

http://www.mikeshapirocartoons.com/~mikeshap/v/Finance/W6586.JPEG.html

Don

To Dr.Becker: America is actually a early stage socialism country.

Capitalism itself is unavoidable process in human being development history, and American hold the highest position in this history stage. The highly advanced capitalism is actually the early stage of socialism, but socialism is based on the advanced material development. Economy is basis, politics is upper architecture. Capitalism is basis, socialism is upper architecture. just like capitalism is upper architecture comparing to feudalism basis. In different history steps, society types have different roles.

Miles Ellison

Privatized profit and socialized risk are hallmarks of fascist economics. Perhaps the 700 billion or so that is being handed out as corporate welfare could be distributed to the taxpayer instead. Or when these reconstituted companies rake in obnoxious profits in the next bubble, they can cut a check (with interest) to the taxpayers whose money bailed them out.

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