Edward Conard

I don't give up on many books, but "Unintended Consequences" was one of those which I didn't finish. Books about the Economy are always a challenge for me, typically technical, dry, and uninspiring. But I continue to try them, hoping for enlightenment. I found this book something of a challenge, requiring much more effort than I had available, and my mind continually drifted as I moved through the chapters. As a result, I gave up and moved on to my next book. Other readers, more interested or trained in the subject, will most likely succeed better than I, but this just didn't work for me.… (mer)

An interesting little book, with favorable cover blurbs by Steven Levitt of Freakonomics fame, Glenn Hubbard of Columbia University, and Bill Bain of Bain & Company. Conard himself was formerly a partner at Bain Capital. Mitt Romney gets mentioned once, in the acknowledgements, for inspiring the author to be community-minded.

Conard seems to know an awful lot about how finance works in this country. I've studied a fair amount of popular economics, but this is a couple levels above Thomas Sowell. It is easy to get lost in the discussions of tranches, credit default swaps, capital reserves, and so on. In fact, the first half of the book gets a bit tedious, being concerned with pointing out what the U.S. system does right, debunking some myths about what went wrong during the Financial Crisis, but mostly just educating the reader.

Then, towards the end of the second of the three sections ("What Went Wrong"), Conard delivers the carefully prepared K.O. Rather abruptly, in the space of a couple of pages, the read goes from somewhat tedious to stunning and infuriating.

I really need to not read books like this. I know damn well Conard will be ignored along with his diagnosis and recommendations for a cure. Our civilization is too far gone to be fixed at this point. But I digress.

According to Conard, who throws an awful lot of data at you to support his thesis, but without swamping you with tables and graphs: the U.S. was doing pretty darn well before the Crisis, and a lot of it was because we were making risky investments. Conard is convinced that the only game in town worth playing is innovation, and the price of innovation is risking capital. More specifically, risking equity: Conard doesn't particularly mind that lots of furriners are buying our debt, because that means our own money is buying equity. He insists that the financial crisis was not the fault of bankers. It was not the fault of the trade deficit. It was not due to faulty incentives (no one lost more in personal fortunes that the bankers most centrally involved.) It was not the fault of predatory lending (when almost all the risk is shifted from borrowers to lenders, that's not predatory lending.) He makes an awfully good case.

Conard attributes the Crisis to a situation in which risk-averse foreign capital was being borrowed on a short-term basis to fund long-term subprime mortgages. More on the mortgages later, but it wasn't the mortgages, of themselves, that were the disaster. Only a fifth of the losses in the Crisis were due to defaults. No, the problem was that investors knew very well they were making risky investments, and when home prices dropped 30% on homes with little or no equity -- well beyond the 20% reserve that always seemed reasonable until now -- they got spooked (this was all short-loan risk-averse capital, after all) and there was a classic panicked run on the banks. Conard makes as good a case as I expect to see that the bailout was exactly the appropriate thing to do to damp the panic. You may have heard the Obama administration crowing that the government is now selling all the troubled assets it purchased at a profit; Conard points out that this is exactly what you expect following a government bailout to damp an irrational panic, and even the Obama administration couldn't mess this up. (That last part was my conclusion; Conard is remarkably restrained in his political comments, though it's obvious he doesn't think much of the Obama administration, even if he is no Tea Party type.)

About those mortgages. Under tremendous political pressure, arising from a Boston Reserve Bank report in 1992 claiming widespread mortgage discrimination, banks started handing out mortages to folks who would normally never qualify and who made little or no down payment. The equity reserve, if I understand correctly, was supplied instead by high-risk long-term loans while the rest was funded by short-term risk-averse capital -- the notorious triple-A tranches. As near as I understood what Conard was saying, the risky tranches would take it in the shorts if the mortgages defaulted with a loss, but the triple-A tranches were expected to be quite safe. Especially when no one really expected that with home prices growing so fast.

Why were they growing so fast?

"The logic behind Clinton's home-ownership strategy was simple: the government would use Fannie and Freddie to "prime" the mortgage market by creating an artifiical demand for risky subprime mortgages with greatly reduced down payments and credit standards. By creating a growing demand for risky subprime mortgages, momentum investors would chase rising market prices. This in turn would amplify the available private-sector funding for subprime mortgages. The resulting feedback loop would become self-reinforcing, to the benefit of subprime borrowers. Only the government is large enough to create momentum investing in a market as large as the morgage market."

Like I said, Conard is remarkably restrained his political criticisms. But what he just said, when you work through the jargon and polite language, is that the Clinton administration deliberately created the housing bubble for political gain.

It gets worse. When their home prices went up, do you know what all those subprime mortgagees did? They consumed their equity by taking out additional loans. There was no equity in those mortgages even while prices were going up. And then the mortgagees would walk away from the mortgage, having extracted $$thousands in equity, and U.S. mortgage laws meant that there wasn't a thing the banks could do about it. Only in the U.S. are mortgagees so ridiculously protected if they default.

So it was not only a deliberately created housing bubble, but it was a housing bubble deliberately created to transfer vast wealth to Clinton's political base.

Yeah, I know. I'm ranting. Beg pardon.

Conard suggests that we will never get back to a thriving economy unless we resume innovating, and we will never resume innovating until we are willing to risk our capital again. That requires low taxes on high income taxpayers, so there will be appropriate incentives to innovate. It requires sensible regulation, not Dodd-Frank. It requires genuine guarantees of a bailout if there is a run on the financial institutions. Yeah, I know. Conard makes a strong case that investors will not risk their capital again unless such guarantees are in place. No, he is not ignorant about moral hazard; he discusses it at some length. He believes the guarantees should be coupled to a sensible insurance scheme that will slap risky investors with appropriately high premiums. How to price the insurance? Let some small fraction of the insurance -- enough to make a market -- be in private hands, which will set the price appropriately.

Conard does not think much of the welfare state. He argues, convincingly, that the vast bulk of the gains from innovation end up in the hands of ordinary consumers, not the investors. Investors capture only a tiny sliver. A dollar spent on welfare is a dollar not available for investment, and when you work out all the cascade from that dollar (which includes something called buyer's premium that I confess I never quite understood) the dollar in investment does far more for the poor than the dollar in welfare.

Conard obviously does not think much of Obama, though is much more tactful in how he expresses than, say, Glenn Reynolds. Nor does he think much of Krugman. But neither does he think much of the more extreme Tea Party types; he is no libertarian.

Like I said, I probably shouldn't read books like this, because: (1) they remind me that there really are some really competent people out there, one of whom did not get elected last November; (2) but nothing is going to change, due to lousy politics; and (3) the average American voter is completely unqualified to judge who the best people are to run the country.

"Restricting banks from funding their AAA-rated tranches of default-prone subprime loans with hair-triggered short-term debt directly addresses the cause of the Financial Crisis, although not of financial crises more broadly. Unfortunately, proponents of subprime home ownership are determined to do the opposite by successfully deflecting blame for the Crisis to secondary issues. They blame predatory lending when competition between investors shifted risk from home owners to lenders. They blame credit rating agencies for underestimating default risk despite capital buffers the size of conventional 20 percent down payments. They blame incentives that paid 50 percent of banker pay in long-term compensation but make no practical recommendations to change it. They blame laissez-faire regulators despite far-reaching improvements to capital adequacy requirements and their own inability to recognize the risk. They blame credit default swaps, which is no different than blaming the practice of lending. They blame lack of visibility for unnecessarily triggering panic when no amount of data would have allowed investors to predict the size of real estate price declines, withdrawals, or the reliability of government guarantees -- the primary drivers of the panic. They cheered the growth of subprime lending rather than taking steps to restrict it. Despite their own utter cluelessness, they claim bankers and bank regulators should have known better!"

In other words: The stupid, it never stops.

Don't get the wrong impression. I quote that paragraph because it is one of the most heated in the book. This is not a book full of exclamation marks and shouting in ALL CAPS by any means.

This book has got me thinking about the usual conservative assumption that people will always be stupid and venal, so the trick is to set up institutions that neutralize or even harness the stupidity and venality. Conard has me convinced otherwise: Yes, institutions matter, a lot, but competence also matters, perhaps a lot more.

Maybe y'all should avoid this one. I'd hate to lose any of my online friends to a sudden vascular accident precipitated by an attack of high blood pressure.… (mer)