Market Failure, Mortgage Style

In our prior post, I alluded to the failure of markets and mortgage origination. This requires additional discussion.

When discussing free markets versus regulation, one of the basic tenets of laissez-faire economics is that human beings are rational, self-interested actors. This turns out to be a faulty premise. Humans can be illogical, irrational, and overly focused on the short term to the detriment of long-term performance results.

Case in point: Mortgage brokers and underwriters reckless lending to unqualified borrowers during the 2001- 06 housing boom. The immediate gains in compensation for all parties involved seemed to totally overwhelm the longer-term concerns of ensuring loans get repaid.

The repayment of principle should be the single most important concern to any firm that lends money. Once that became secondary, we were set up for our market failure.

Under normal circumstances, the fear of losses and eventual business failure operates within the marketplace to prevent businesses from doing anything too stupid. Lenders should have been self-interested enough to not recklessly lend money to people who couldn’t repay it. However, that seems to not applied this time around. According to the Mortgage Lender implode-o-meter, 262 major US lending operations have gone belly up since late 2006.

The normal operations of the marketplace simply failed to work. Where markets fail to prevent recklessness, irresponsibility and behaviors that inflicts significant damage on the broader economy, some form of limited government preventative regulation is called for.

A great nation, even a mostly capatilistic one (with quadrennial socialism) such as ours is not obligated to allow these failures to cause unfettered and ongoing economic ruin. The alternative is what we have today: An environment where anything goes, no referees are on the field, and the current housing and credit crisis was allowed to develop the unfettered.

There is a balance between free-market competition, and limited government regulation where absolutely required. The Greenspan Fed ‘s ideological preference for the former, has led to a situation we are where we are all but guaranteed the latter.

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  1. Donny commented on Jun 11

    Where are all those bottom calling, perma bulls now? They actually floated the idea that the Bear Stearns debacle was the end of this mess.

    Buckle up fu**ers, we’re headed to new lows!

  2. Phil commented on Jun 11

    I partially disagree. Fed manipulated low interest rate and too much artificially created liquidity was a major cause of all the speculative, malinvenstments in real estate. We have too much Gov’t regulation to say we operate a free market.

  3. Zachary A. commented on Jun 11

    Without getting into the “regulate or not-to-regulate” argument, I wonder how much political and social backlash would have come if regulators had stepped in and stopped lenders from lending to unqualified borrowers. Would it be similar to class warfare rhetoric we hear now that the borrowers are getting foreclosed on? I can’t help but think a few social activists would have tried and throw in a race angle as well if the government prevented these loans from being made.

    I do not doubt that Greenspan’s ideology was main reason behind the lack of regulation; however, I can’t help but think regulators didn’t want to be perceived in some villainous way for not allowing lenders to bend practical lending standards in order to get low income and/or minorities into homes.

    Wouldn’t that perception, in some way, encourage lax regulation?

  4. karen commented on Jun 11

    B of A’s Lewis is calling for a Q3 peak in the credit crisis. Anyone remember his last call for a peak? TIA

  5. Matt commented on Jun 11

    I think your description of the market not working is, in fact, demonstrating that the market does work. Reckless lenders are now reaping the rewards of their actions. A functioning market does not require that no one fail, only that those who take on additional risk in search of outsized rewards be fully liable should those bets not pay off as expected.

    And don’t get me started on how government regulation contributed to this mess by mandating the need to lend to borrowers who previously would not have qualified for a loan. :)


    BR: That’s the point — the Invisible hand should have prevented these companies from making absurd loans that was against their long term self interest in the first place.

    Sure, a few 100 firms are now gone — that was inevitable.

    Traditional Free Market Theory suggests that they should not have done so — and now the global economy is digesting trillions in losses.

  6. Rex commented on Jun 11

    On the contrary, almost all the people involved in the mortgage disaster were acting rationally in their own self-interest. As individuals, they maximized their own welfare (at least they thought so at the time), but not necessarily the long-term welfare of the company they worked for. The interests of the workers and the company did not align.
    The same thing happened at a larger scale. Moody’s was paid to rate securities, not to make sure the securities were sound.
    This is a major failure of the incentives in the financial firms: People are paid to make the deal, not to make deals that make sense.

  7. Jack Stevison commented on Jun 11

    “one of the basic tenants of laissez-faire economics is that human beings are rational, self-interested actors. This turns out to be a faulty premise.”

    i call your false with another false. the tenant that you reference regards the individual, but your argument is against that of the group.

  8. General Specific commented on Jun 11

    Two thoughts:

    1. I think anarchical libertarians play a self-defeating game in not realizing that lack of some regulation can increase the probability of very bad regulation when crisis comes. Minimal good government will serve us all better than no government followed by the reaction to crisis that follows–particularly if the libertarians work hard to make government incompetent by repeatedly drowning it in the bathroom.

    2. Responding to Phil’s comment above: True enough. Cheap money can exacerbate or even cause a market failure–one can say it is the failure because it isn’t the market in operation. But I think many will rightly argue that cheap money was not THE problem–e.g. if money is cheap and tall buildings are produced by builders–and then they fall down–we don’t blame the cheap money. We blame the poor building standards, the lack of building regulation.

  9. TDL commented on Jun 11

    I take issue with the assumption that free marketers all believe that “human beings are rational, self-interested actors.” Self-interested? Yes. Rational? Highly unlikely (at least not at all times.) The Austrian school of economics, as well as many in the Public Choice school, do not subscribe to this view point. I wish I were more eloquent on the matter, but unfortunately I am not.

    Not all free marketers subscribe to the purely rational, EMH nonsense.

    As already commented, the Fed’s implicit put created a massive moral hazard. Simply, the banking industry, the Fed, & the this administration were attempting to avoid losses. By doing so these three groups (as well as real estate “investors”) allowed for more risk to be accumulated since they were intent on socializing the costs if anything ever happened.
    Not all free marketers subscribe to the purely rational, EMH nonsense.


  10. Estragon commented on Jun 11

    It’s easy to call for more regulation. What’s hard is to design (and apply) regulation that actually solves the problem without creating others.

    The root cause of the mortgage mess wasn’t so much a market failure, but rather a working market in a peculiar state. The normal state of markets is for an increase in price to reduce demand and increase supply. For a time, we saw the housing market enter a bubble state, which I define as being one in which increases in price increase demand significantly faster than supply can be increased.

    These markets do eventually return to a normal state, though often with significant dislocation.

    Returning to the subject of regulation, exactly how would regulation recognize and deal effectively with this root cause of the problem?

  11. Jim Haygood commented on Jun 11

    “One of the basic tenants of laissez-faire economics is that human beings are rational, self-interested actors. This turns out to be a faulty premise. Humans can be illogical, irrational, and overly focused on the short term.” — Barry R.

    TRUE. Profoundly true. But the rational actor is not merely a proposition of “laissez-faire economics” — it is the core proposition of the Efficient Market Hypothesis (EMH) and much of classical economics. And because this proposition does not account for bias, delusion, irrational exuberance, and herd behavior, it means that most of the underpinnings of economics and capital market theory are just flat wrong.

    And that in turn helps explain why not one economist in a hundred has ever successfully predicted a recession. And why central banks can never add value in attempting to ‘manage’
    the economy.

    Economics is not a science. It’s a degraded form of witchcraft, whose incantations and spells aren’t even effective. Ben — GET A BROOM!

  12. michael schumacher commented on Jun 11


    Q2 peak….was done in late Jan. early Feb. from what I recall. Can’t find the original link though…

    Funny how they keep calling it peaked before the election… one dare make a public call for 2009


  13. Tom C commented on Jun 11

    The fed sets the rates, the treasury prints the fiat currency and ‘regulated’ banks create more credit. It’s a top down deal, Barry. Hardly a characteristic of ‘laissez-faire’. Add the political interests into the mix, i.e. encouraging bankers to make loans based on skin color or ethnicity rather than the ability to handle the obligation, and we get to where we are. Of course, people are not always ‘rational’. Greed and envy are irrational but very human responses to all kinds of situations. If people were rational demogogues would never get a vote. Peace, love and happiness, man, yeah, that’s the ticket!

  14. Roman commented on Jun 11

    “When discussing free markets versus regulation, one of the basic tenants of laissez-faire economics is that human beings are rational, self-interested actors. This turns out to be a faulty premise.”

    I don’t really believe that free market capitalism requires everyone to be rational. If that was true, capitalism would NEVER work in any situation. Free markets work because those that are irrational are eventually punished. However, when you setup a system where the actors know that worse comes to worse a bailout is coming then there is no incentive to be cautious or averse to risk.

    So, I agree with the previous posters. Its not the fault of free markets that has been shown by this crisis, its the fault of government intervention that has been demonstrated.

  15. jombi commented on Jun 11

    I 100% agree with you Barry.

    To your quote “Humans can be illogical, irrational, and overly focused on the short term to the detriment of long-term performance results.”

    To your quote I match one from Benoit Mandelbrot “If reward and risk make a ratio, the standard arithmetic must be wrong. The denominator, risk, is bigger than generally acknowledged; and so the outcome is bound to disapoint”

    This is all human nature playing out. It shocks me that some of the biggest wizards on wallstreet don’t understand this. Or maybe it is their job to pretend like they don’t.. Afterall, this is how they make money….

    Leverage is used to ensure the over profit from a particular investment. An investment is something in which a person puts money in for the eventual profit in the future. A short term investment is what was made of housing once you tuned the profit curve to a much more shorter window. This was magnified by leverage. The tuning was a function of ‘greed’ <- a natural human phenomenon. Who gave access to credit? Who gave access to excessive leverage? Often times it is observed that non-intelligent agents aren't rational during non-norm conditions... They appeal to their more primitive natures most easily... Non-norm condition was presented : Free money/credit... They acted irrationally as expected. To suggest that those of intelligence unknowingly presented these perfect conditions for disaster for their short term profit is unthinkable. I look around America and I see a very disorderly distribution of money, success, and a whacked pyramid of desires. Everyone wants to be a $$$ man because we have built a society/culture that only cares/values $$$$.... > Create a Goal/Level of attainment (Sky high) : Be ultra rich .. Live lavishly
    > Create a system which rewards bad behavior/any means necessary philosophy to obtain said goal.

    And you most certainly will get a disaster. I have grown up some 18 years of my life observing such a thing called ‘Business’ from my father who worked at Citigroup. Needless to say I went the totally opposite route and pursued engineering. For in that 18 years of my life, I saw the most worst characteristics of human beings on display in the name of business and money.

    It is even shocking now that your average engineer/physicists/scientist have given way to their passion/desires to pursue business/$$$ whether it be as quants/wannabe MBAs, etc….

    You want the system to right itself? Redistribute wealth to the innovators of a society. The people who go to work everyday to make it better and create something of substance or the people who work to sustain it. Stop a system by which people who serve no immediate purpose and only serve to rape/pillage the underpinnings of people’s hard work make the most amount of money. Get some substance and fundamental purpose back into society. What exactly/How exactly do you think people make money by figgeting around numbers all day (and lots of it)? By indirectly taking it from people who go to work each day who mine the resources and produce the products that make a fiat currency worth something.

    What has happened and what will continue to happen until this changes is high inflation and misery. You can’t expect and less from an economy in which you have 40% of the people going to work each day ‘working’ and 60% of the other people sitting around profiting from it. It’s economics/human nature/fundamental law 101.

    Regardless of my words which my fellow money making friends say are worthless unless I make money <- funny that.... I have yet to be wrong on many of my predictions since I started back in 06'.... and that will be the case because I understand the fundamentals and I understand that timing wise we have evaded them for far to long and that they are coming back. No intervention or scheme will stop them and it most assuredly will be an ugly battle that will be lost. Regardless of what I have to say and whether I continue to be right/wrong, understand that there is a fundamental operation of things and, if you evade that fundamental operation, you might get away for some time. However, you better feel rest assured that some day you will have to return. How painful that return is will be the delta between where you are at and where the fundamentals are at and the acceleration towards that fundamental level will be exponentially tied to the amount of time you avoided it. A wonderful depiction of life is found in the fibonacci spiral... It wonderfully depicts our short term thinking, our sentiment of feeling we know it all at times when we know hardly anything, the universe, software development, exponential progression, ... soo many things. The beauty of knowledge and wisdom is that it is only parted on those few who seek it for its on sake and not for its wisdom. Wallstreet has some wonderful tricks and formulae. However, they will never have the real goodies and those are the 'fundamentals'. Why you ask? Well, their fundamental nature contradicts them =P. - Good Day all

  16. brasil commented on Jun 11

    Here in Miami anyway…much of what occurred was outright fraud and illegal in many many areas…combined with competely idiotic underwriting by lenders reaching for yield and fees ect …would be better if they followed existing regulations and standard investment practices…how can anyone justify better than 30 times leverage as way of life…the rating agencies and the I banks are the most culpable imo..because they manipulated the system and should have known better …does anyone think the collection of knuckleheads in our congreess and or the rest of our govt is any match for the private sector brainpower..?

  17. Jim Haygood commented on Jun 11

    “basic tenants” should be “basic tenets,” a near-homophone.

    No, I am not gay bashing. LOL.


    BR: Fun with VR — I’ll fix above

  18. Justin commented on Jun 11

    Like other commenters, I disagree that actors here were doing anything but acting in their own self-interest and further, that regulation would have prevented this catastrophe. But just to sum up the big points of how regulation / fiat got us to this point:

    – fiat currency / easy credit = divorcing scarcity from money leads to creating too much money, mispriced assets, malinvestment
    – fiat legal structures = principle/agent problems. Securitization of assets where ownership is entirely muddled. Actors behave in their own self-interest, which can be completely at odds with the interests of the principle
    – stupid tax incentives = enabling folks to pay more for houses thanks to tax deductions. Incentivizing people to trade up on their houses b/c of tax-free capital gains.
    – GSEs — a dumping ground for loans (further layers to principle/agent problem)

    I’m sure there are more minutiae to the above examples (and a few more broad examples to boot). But it seems obvious that the biggest drivers for the bust here are founded on fiat/government-intervention as used by self-interested actors.

    We haven’t had a free market for a long time.

  19. dwkunkel commented on Jun 11

    Markets eventually punish stupidity, but those affected rarely have the patience to wait that long. This impatience spawns calls for regulation.

  20. cinefoz commented on Jun 11

    BR offered:

    Humans can be illogical, irrational, and overly focused on the short term to the detriment of long-term performance results.

    observation: Absolutely, but it is also human nature to have a protective instinct that makes sure that someone else is left holding the bag. People don’t rob banks with guns because they know they won’t get away with it. This is evidence of logical, rational, thinking behavior. Rules always have loopholes and knowing where to find them and how to exploit them is a valuable skill that only looks like slackerism to the naive.

    People will always accept free money whenever it can be found. GS and others are exploiting loopholes in the oil markets and we are all paying for their cleverness. Of course, having an Executive Branch in Washington that thinks this type of predator behavior is evidence of a normal functioning market doesn’t help the rest of us.

    Regarding credit markets, being able to stick someone else with a bag that holds a stinking carcass is normal, rational behavior. Having the environment that allows this behavior is evidence of government failure. It is a proper function of government to make laws and offer police protection so that slackers, slide by artists, and criminals can’t legally crap on the rest of the population and will think twice before trying.

    What you describe is actually the highest level of supply side, trickle down economics in action, according to some who would otherwise be regarded as idiots, criminals, or parasites if there weren’t so many of them.

  21. jombi commented on Jun 11

    I will add a couple more insights on to my previous post.
    Thinking of our planet, an atom, the universe, orbits, fibonnaci sequence, chaos, fractals, flowers/seeds… What’s the commonality? The purpose/substance/order being at the center with wild orbiting nothingness at the fringes. Evolutionary nothingness/chaos from subsequent iterations of a fundamental basic unit. The seed of the fractal. Look at markets. Look out the expansion of markets… And the subsequent parallels to some of these things. LOL, there is beauty in the design.

  22. John commented on Jun 11

    BR: please, most human beings are not the perfectly rational creatures of economic theory. They are stupid, greedy, selfish, gullible, emotional and a host of other adjectives. And contrary to the assertion by Mr dwkunkel markets often don’t punish stupidity and greed as we know from the myriad cases of O’Neil, Prince, Mozilo et al. Whether we like it or not regulation is required for the public good. It may be an imperfect mechanism but do we really want to leave the efficient and honest operation operation of our financial institutions in the hands of the endless procession of individuals we’ve seen fired and/or indicted over the past seven years. I actually think the greed and irresponsibility of these people when 80% of Americans have seen their situation worsen is going to lead to a massive backlash starting in November.

  23. wunsacon commented on Jun 11

    DOH! No sooner do I post a comment to the WashPost article than another article comes along….

  24. wunsacon commented on Jun 11

    Looks like I was cribbing your first paragraph, Barry. But, I swear I didn’t!

  25. BR549 commented on Jun 11

    Although people make irrational decisions, they are predictable. Flood the economy with money and you will get the same result every time. Take the money away and you have to have consolidation because there is no longer enough money to support all the players.The strong, smart or lucky survive. Politicians had no interest in stopping the boom in their states or counties because they would get booted out.
    I say it was all orchestrated to give the central bankers more control of more money . When congress rebuffs Henry and the gang , another shoe will drop and we will be convinced it is in every one’s best interest to have people we never elected control our financial situation.

  26. cas127 commented on Jun 11

    Wow…a lot of comments so far…in case it hasn’t been mentioned, a crucial factor in the housing fiasco was the fact that “risk origination” (if you will) essentially became decoupled from “risk ownership”.

    Mortgage brokers originating loans held few to none for any substantial period of time – unlike the mortgage-originating banks of yore.

    Instead, originated loans were largely sold off to investment banks who in turn would package them into residential mortgage backed securities (RMBS) whose cash-flows were designated (via the RMBS’ legal documents) into different “tranches” with different risk-return characteristics.

    The RMBS were then sold off to buy-side institutions around the world (most notably, hedge funds, who rose to prominence during the same period that RMBS did – a too-little-remarked-upon fact).

    These hedge funds in turn relied (excessively as it turned out) upon the rating agencies’ appraisal of the RMBS and the “reputation” of the investment bankers pitching the deal.

    And, not to forget, the institutional buy-side had its own “risk-decoupling” issues – the vast bulk of the money in institutional investors is not their own.

    Bottom line, once risk-origination and risk-holding become divorced via excessive “specialization”, then intelligence and prudence get disintermediated as well…

  27. cinefoz commented on Jun 11

    Bottom line, once risk-origination and risk-holding become divorced via excessive “specialization”, then intelligence and prudence get disintermediated as well…

    Posted by: cas127 | Jun 11, 2008 11:38:54 AM


    Or, as Bart Simpson would say, “Not My Fault”.

  28. Helter commented on Jun 11

    The loans were not irrational from the perspective of the mortgage companies since their salaries derive from the fees they generated and are paid on an annual basis. Since many decision makers expect to switch employers to improve their careers, the decisions they make now to improve short term returns have little impact on them personally down the road. This has been true in the financial services industry for a long time.

    The investors decided to ignore risk in lending the cash, but what else is new?

  29. cinefoz commented on Jun 11

    Or, to put it another way … you have a President who is similar in may ways to Homer Simpson, a VP who resembles Mr. Burns, with Smithers playing the role of Larry Kudlow and others who live in the apologist and professional flack group.

    This is our government.

  30. HCF commented on Jun 11

    The principle market failure at the present is the inability of regulators to allow for any sizable failure. Essentially EVERYTHING is too big to fail, so we as a society have underwritten insurance policies not based on risk, but solely on size. So what if BSC fails? Maybe it would have cascaded to cause LEH to fail, maybe MER, maybe C, etc. But it would not take down the system (and if it did, then that means our system itself is a failure). What we may get out of this is a Japanese style “Night of the Living Dead” where we as taxpayers subsidize firms that made bad, risky, excessively leveraged bets. Let creative destruction occur!

  31. Estragon commented on Jun 11


    I think you’re on the right track. The problem isn’t that the market fails, it’s that it works.

    I’m no apologist for the current (or any) government, but a thoughtful reading of Paulson’s reform outline suggests moves in the right direction. In particular, he notes the need for principles based authority to monitor and respond to increased brittleness in the overall financial system, rather than knee-jerk rules intended to deal with component symptoms in response to a crisis.

    Sadly, it doesn’t look like it will go anywhere.

  32. DownSouth commented on Jun 11

    ☺☺”Economics is not a science. It’s a degraded form of witchcraft, whose incantations and spells aren’t even effective. Ben — GET A BROOM!”–Posted by: Jim Haygood | Jun 11, 2008 11:00:33 AM

    I agree.

    My theory is that classical liberal economics was the Enlightenment’s answer to Christianity, that is it is a philisophical framework used to justify stealing other people’s property.

    How this worked in Christianity became known as “the cross and the sword” and is best set out by the 16th-century Spanish humanist and translator of Aristotle, Juan Gines de Sepulveda, who argued:

    “It is with perfect right that the Spanish dominate these barbarians of the New World…who are so inferior to the Spanish in prudence, intelligence, virtue, and humanity, as children are to adults, or women to men, that I am tempted to say that there is between us both as much difference as between…monkeys and men.”

    “…nothing more healthy could have occurred to these barbarians than to be subjected to the empire of those (Spaniards) whose prudence, virtue, and relgion shall convert the barbarians, who hardly deserve the name of human beings, into civilized men, as far as they can become so.”

    Sepulveda concluded:

    “As the Indians were presocial, they could legitimately be conquered by ‘civil men’ from Europe, and all their goods could be put to civilized use.”

    For more information one can also read the Requerimiento…..

    Naked Capitalism has had several posts on heterodox economic theory, the latest being……

    Referring to the linked Scientific American article, it is all too clear that three of the underlying “scientific assumptions” that underpin classical liberal economic theory, as blatantly nonsensical as they now appear, were crafted for no other reason than to offer a “rational” justification for paying low prices for Natural Resources:

    “Natural resources exist in a domain that is separate and distinct from a closed market system, and the economic value of these resources can be determined only by the dynamics that operate within this system.”

    “The external resources of nature are largely inexhaustible, and those that are not can be replaced by other resources or by technologies that minimize the use of the exhaustible resources or that rely on other resources.”


    “There are no biophysical limits to the growth of market systems.”

    In the third world, liberal economic theory has consistently been backed up, just like Christianity, with force–gunboat diplomacy. I suppose the modern combination could be called the “galvonometer and the sword.”

  33. Vermont Trader commented on Jun 11

    Comment volume seems to have ramped up the last few days… How’s that proprietary indicator looking BR?

  34. colder commented on Jun 11

    BR stated: “The repayment of principle should be the single most important concern to any firm that lends money. Once that became secondary, we were set up for our market failure.”

    Amen to that!

    Digging a little deeper, we see this behavior in more than just the mortgage market. The U.S. government seems to think they can behave similarly. That’s a dangerous prospect indeed. What about U.S. debt, Medicare, or Social Security? Heaven forbid if these issues come to a head anywhere close to simultaneously! I may be wrong, but I fear the failure of any of these may make the current credit-crunch look like childs-play on the international play-ground.

  35. Tom C commented on Jun 11

    You’re confusing mercantilism with capitalism.Mercantilism has it’s roots in old-fashioned imperialism or the zero-sum thinking behind the belief that one nation can only prosper at the expense of another. Kind of like modern leftism.

  36. zell commented on Jun 11

    Tramps and thieves. That’s our gov’t and financial sector. It’s not the invisible hand that has been operative but sleight of hand! Our recent bubbles have been promoted with malice and forethought.

  37. MRegan commented on Jun 11

    In reply to DownSouth’s post, I have to say that I am particularly grateful for it. Extremely erudite. I haven’t seen any references to Sepulveda in a looooong time and making mention of the Requerimiento was a true flourish. Me quito el sombrero.

  38. linda commented on Jun 11

    Regulation, schmegulation.

    Regulation we have. What we needed was oversight and enforcement.

    Every rule in the book was being broken, but everybody was making money so nobody cared. It was so widespread that they’d have to lock up the whole country so instead they locked up nobody, and everybody knew it.

  39. Rational expectations commented on Jun 11

    Irrationality leads to market failure, surely, but the real question is whether some alternative form of agency is more rational. Do you really think government regulators are going to do a better job?

    Part of the problem today is that much of our system is a hybrid. The complexity of partial regulation probably contributes to market failures. Who pumped all that money into the system, consumers? There was nothing particularly irrational about using leverage when none of your own skin was in the game. Similarly, banks got burned but many individuals in the banking system made stacks of money. Perhaps the problem is not with the assumption of individual rationality, but with the assumption that firms are individuals.

  40. DonKei commented on Jun 11

    There was not a failure of free markets, because there wasn’t, and hasn’t been since at least the 1930’s an unfettered “free” market in residential mortgages in the US.

    Fannie, and then Freddie, et al, were long ago created to fund, whether it needed it or not, the residential mortgage markets.

    What really happened was a heavily regulated market was manipulated by its participants as they tried to enrich themselves at the expense of everyone else.

    Fannie and Freddie created the secondary mortgage market. The investment bankers came later, when they say how much fun the twin titans were having.

    Had we not been running huge current account deficits that had to be neutralized with financial surpluses, and had the GSE’s not had the implicit backing of the federal government, Fannie and Freddie, etal would not have been able to sell every piece of crap paper they had to overseas investors that were either too careless or too stupid to understand the risks they were taking.

    This was most decidedly not a failure of too little government, nor was it evidence that humans are irrational.

    Every player in the game was rationalizing his way to riches–none of the folks you listed lost a dime when the loans weren’t paid back.

    The real truth is that the whole mess would not have been conceivable without 1) huge current account deficits, and 2) implicit government guarantees of gse debt; both of which imply a market heavily influenced by government action, only in an inept manner.

  41. DownSouth commented on Jun 11

    ☺☺”Regulation we have. What we needed was oversight and enforcement.”

    “Every rule in the book was being broken, but everybody was making money so nobody cared. It was so widespread that they’d have to lock up the whole country so instead they locked up nobody, and everybody knew it.”–Posted by: linda | Jun 11, 2008 12:35:19 PM

    I suppose I should finish the story about Sepulveda.

    In the end, Carlos V and the other Reyes Catolicos rejected the arguments of Sepulveda. Humanitarian Laws of the Indies were promulgated to protect the Indians, their land and their property.

    However, for the same reasons you describe, the laws became ineffective. As Carlos Fuentes explains in “The Burried Mirror:”

    “No wonder, then, that when new humanitarian laws arrived from Spain, local officials in the New World simply placed them on top ot their heads and solemnly stated, ‘La ley se obedece pero no se cumple,’ that is, ‘The law is formally obeyed, but actually it is disregarded.’ A deep divorce between the legal country, enshrined in royal laws and later in republican constitutions, and the real country, festering behind the legal facade, thus demoralized and disrupted Spanish America from the very start.”

    In other words, Linda, you have hit upon one of the key differences between a great democracy and a Banana Republic.

  42. chubster commented on Jun 11


    This is hardly a free market when there is a monopoly on the issue of currency, among other things. We are suffering from a perverse over-expansion of credit. A truly free market with a hard currency would have held credit expansion in check and limited the consequences of the defaults primarily to the parties offering the credit. Privatization of profit and socialization of risk is the correct description of our situation.

    What people misunderstand is that there is far more economic planning in a free market. The contributions are made by individuals and private businesses who are best qualified to decide appropriate levels of production because they are in intimate contact with their various markets (not large central bodies – hence the invisible hand).

    The answer is not to relinquish further control of one’s life to outside agencies. It is dangerous to blame the free market for the fallout and call for more regulation. This will only lead to greater misallocations of capital and production. However, I concede that this will be the most likely result.

  43. Bill commented on Jun 11

    Congrats to BR, zell, cinefoz and linda –
    Only thing that I see missing is the aiding and abetting from legal counsel that shifted into overdrive after Central Bank of Denver 1994

  44. Sean commented on Jun 11

    Barry, not sure if you have read about the testimony of a hedge fund manager over congress a couple weeks ago, about the oil and commodities bubble? I would like to hear your expert opinion on the physical delivery explanation of it.

    I think he said that it is the ETF, and money from Retirement Funds (eg. CALPERS) that is buying the Oil and all other commodities future contracts (through bankers and therefore they are listed as Commercial instead of speculators). When the time come to deliver oil and wheat to these ETF/Funds, they simply roll over to the next month contract. In other words, they basically just go LONG and never sell.

    So my question is, who is taking these physcial deliveries? I mean, if I buy 100 barrels of oil for July contract, I would expect physcially 100 barrels would arrive at my dock station. If I roll over the contract, then what happens to the oil producers that suppose to ship me tihs 100 barrels? They got to find a storage tank to store my oil on the sea?

    I understand that now banks are acting as the middle man to do all these fancy swaps and listed as Commercials. But still, who are taking deliveries? Or is it possible that all the contracts “sold” (to these bankers) are actually from some other funds that went short, i.e. they don’t have the real physical stocks to deliver?


  45. shrek commented on Jun 11

    Im with Justin from above. Weve been hiding between credit expansion for a very longtime. A free market wouldnt have allowed credit to expand this because banks would have failed routinely just like everything else. All this greenspan and bernake wizard of oz crap can be chalked up to unlimited credit expansion.

    Dont be surprised when this whole system fails

  46. gina commented on Jun 11

    The joy of Trickle down economics 90% get to drowned in the piss that the 10% created thanks to Reagen, Clinton and the Bush crime families manipulation of government.
    almost time for the torches and pitchforks

  47. Mike M commented on Jun 11

    Enough about free market failure! To call the mortgage markets free is simply wrong.

    1. Foreign governments bought tons of mortgage backed paper.

    2. The paper has an implicit guarantee by a government (GSE).

    3. Credit rating agencies (government sponsored) have no competition and turned junk into AAA paper.

    4. Banks are conditioned to take enormous risks due to a non-free market entity called the Federal Reserve.

    5. Borrowers were given a market signal of high prices mostly due to the Fed’s easy money policies.

    Come on Barry! Dig deeper man! This failure has NOTHING to do with free markets.

    Unfortunately, a lot of smart people like you are calling this a free market failure. Guess what’s next? More government involvement, more capital distortion, lower standard of living. Thanks, buddy!

  48. KnotRP commented on Jun 11

    BR stated: “The repayment of principle should be the single most important concern to any firm that lends money.”

    The repayment of Other People’s principle, on the other hand, can be safely ignored.

    As for “more regulatory power”….regulations are ignored when skimming off OPM.

    They do come in handy for driving up political donations, but is there realy anyone left in the country who thinks it’s going to make a whit of difference?
    Fools and their money are soon parted is a famous
    saying because it’s true.

  49. Eric commented on Jun 11

    I would alter this a bit…Humans can be illogical, irrational, and overly focused on the short term to the detriment of the planet. To my mind, this is where the Ken Fishers of the world show their greatest weakness. They see environmentalists as “nuts” and describe inflationary hawks as “worry warts”. To them it’s simple: “Just let capitalism do it’s thing.” Yeah…too simple. By and large businessman want to make enough money to separate themselves from their neighbors — to make sure their kids don’t have to go to school with the dumb, ugly kids down the street. And if that means ruining the planet in the long-run, they couldn’t care less.

  50. Steve commented on Jun 11

    Why do we always regress to black and white discussions?

    The Fed is the mother of all regulators when it comes to $$. They print money like there is no tomorrow and we wonder why problems arise?

    Simple analogy: I don’t like being over regulated in my choice of automobile and how much I’ll drive it. But that does not mean that I am for absolutely no rules, no lines, no limits. There have to be rules and limits and guess what? There will be a number of people who don’t obey the rules and there will be accidents and deaths. So we try to improve the rules. If we set a speed limit of 25 mph everywhere and forced people to modify their cars such that it was impossible to go faster there would be a lot less death on the highways. But there would still be deaths, and there would be jerks that would break the rules and modify their cars and go faster.

    ‘laissez-faire’ is a straw man argument for fools. But how much closer to total command and control do you want to go Barry?

  51. Northern Observer commented on Jun 11

    Regulation we have. What we needed was oversight and enforcement.
    Every rule in the book was being broken, but everybody was making money so nobody cared. It was so widespread that they’d have to lock up the whole country so instead they locked up nobody, and everybody knew it.
    Posted by: linda | Jun 11, 2008 12:35:19 PM

    This comment goes to the heart of the matter, the free or not free market debate is sterile. The question is, why was there no enforcement? And here you may not have the goods to blame free market ideas but you sure as hell do have the goods to blame free market ideologues who in their misguided way decided that oversight and enforcement was “anti-market” when it was anything but. Minimum standards are part of a functioning free market as is the monitoring and elimination of perverse incentives. This was the role of the agencies, and they failed to fulfill their role due to the ideological personel in charge at the time, from Greenspan down. That is the story, not some oh we weren’t free market enough. That’s right up there with saying that communism has never failed because it’s never really been tried before. Sorry, no mulligans allowed in the real world.

  52. Pat commented on Jun 11

    It seems to me that if mortgage companies couldn’t sell a crappy loan on the secondary market they would be less likely to make the loan in the first place. I.E. They wouldn’t be willing to piss away their own money.

  53. Pat commented on Jun 11

    BTW If you think humans are logical, rational, and focused on the long term I’d be happy to sell you a bridge with a lovely view of Manhattan.

  54. chubster commented on Jun 11

    Northern Dude,

    Mulligan? When did we get to hit the ball? What we have now is what always happens when power is centralized.

  55. EricL commented on Jun 11

    I’ve been waiting for this discussion for some time.

    i believe there is a third dimension in this debate between between laissez-faire and regulation. it is about quality/quantity of information. the lenders were only able to make these loans because there was an under(mis)-informed market supplying the funds.

    the structural preventative solution is to have 1000x better information. if the markets were able to drill into the underlying mortgages by teasing apart every layer of cdo traunch, they could (would is a different question) have discovered and quantified the true quality of the assets and arrived at their own pricing models. this could have lead to a dampening of funds much earlier on.

    if we redefine regulation as the information requirements for new products instead of restrictions/rules that prevent or try to guide behavior against otherwise natural tendencies for short term gain, we will have better, more efficient markets.

    we see alot of blame getting spread around between the “greedy” land speculators, the “greedy” under-qualified borrowers, the “greedy” mortgage brokers, the “greedy” banks, and the ‘incompetent” ratings agencies. With the exception of the ratings agencies, all of these parties were behaving rationally to exploit a market supplying funds. The only way to prevent the whole mess is to fix and supplement the ratings agencies by providing the market supplying the funds with far better information and follow ‘buyer beware’ models.

    the problem with the current pendulum back and forth between no-reg/ too much reg, is that we don’t get better markets, we just go boom and bust depending on political climate.

    the laissez-faire crowd fought to the death against FD in the 90s, so the only way for this strategy to get executed is for the pro-regulation crowd to move to the center and get back to progressive support of markets with a rallying vision of striving to achieve the perfect information required for truly efficient markets.

    with technology where it is today, this type of information regulation would not create an ongoing manual labor burden, the entire process could/should be automated.

    securitization had the potential to be one of the greatest and most innovative engines of growth ever. i hope history accurately blames the laissez-faire crowd for setting us back a 100 years from where we could be.

  56. Shane commented on Jun 11

    Governments, regulatory bodies, etc . . . are just entities made up of people. So if the free-market can be “irrational” then reg. bodies can be just as irrational since they are made up of people who have their own interest at hand. It all comes to money and power. Gov. sponsored reg. bodies want just as much money and power as free market bodies. The big difference being in gov. sponsored bodies, they essentially have a violent monopoly (i.e. forced by the law).
    I’d rather trust “profit-making” entities that can go bankrupt and out of business than non “profit-making” entities that for all practical purposes can’t.

    As far as true free-markets not taking care of the environment I call boulder-dash. If enough people in the US see the environment at a threat then all they have to do is stop buying from companies that are “evil” to the environment. So instead of asking for more regulation . . . educate your fellow man and boycott “evil” companies, otherwise your just a liar.

    As far as commodities/oil . . . hmmm oil has increase 75%+ since the Fed started cutting rates in August. Coincidence . . . . I think not.

    If interest rates floated on a free-market we wouldn’t have had 2005 housing bubble and we wouldn’t have 2008+ commodities boom/bubble.

    The only thing government meddling does is cause more government meddling.

  57. Risk Averse Alert commented on Jun 11

    Looking forward to “Market Failure, Commodities Style.”

    Some of the folks commenting here would do their nation some good investigating the history of the American System of Political Economy and such personalities as Alexander Hamilton, Matthew Carey, his son Henry C. Carey, as well as Friedrich List, John Q. Adams, Henry Clay and many others. All these men understood how a European oligarchy propping up the British Empire (with friends in the U.S.) worked such tools as Adam Smith to bring ruin upon our nation.

    Today’s standard bearers of such fanciful philosophies as serve a few at the expense of many [obviously] continue their effort, and bring us to our current state.

    Were only some of us less willingly made useful dupes, we might demand of our elected representatives they drop their subservience to financiers whose latest scheme seeks public-private partnerships and insist upon a reconstitution of the Bank of the United States.

    Why should we allow ourselves to be driven by the terms of some mythical “free market” (THERE IS NO SUCH THING!) when, instead, we could be setting the terms for ourselves and our posterity…

  58. Todd commented on Jun 11

    This is a classic example of the failure of the GOP’s slavish adherence to unfettered free markets at all costs. Any regulation is bad regulation according to Kudlow, Luskin, Kneale, the IBD editorial board etc etc etc.

    Get it through your thick heads : no regulation means greed, fraud, and recklessness run wild. Naturally, as a result we will get the pendulum swinging too far the other way so it’s only a question of time before the catcalls of overregulation a la the criticism of Sarbanes-Oxley. Everyone will blame everyone else.

    Another example of broken government in the USA under Bushco and the Republicans, no longer the greatest country in the world. Sorry, Larry Kudlow. It’s just not, anymore. And don’t call me unpatriotic either. I’m a realist like BR.

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