Thursday, September 11, 2008

Failure of the Free Market?

The recent collapse in housing prices, banks, Freddie Mac, Fannie May, IndyMac, etc. has become fodder for the anti-capitalists in this country. They say the failures of these companies is an example of the failure of the free market. These companies represent excess and greed gone amok and that they are hurting society as a whole because of their actions. What these companies have done may actually have been illegal and definitely immoral. However, the root cause of the problem does not lie necessarily with these companies or people. It lies with the incentive system established by the government and the (privately owned) Federal Reserve System.

The US government, under FDR, established the first of the GSEs to promote home ownership. The implicit government guarantee of home mortgages allowed GSEs to buy mortgages cheaply due to their ability to raise capital at lower rates than private individuals or corporations. Over time, this along with the massive money printing by the Fed created an excess of capital seeking to purchase real estate loans by the GSEs. Profit seeking individuals in the form of banks and mortgage brokers saw an opportunity to make a quick buck. Since they made their money originating the loans rather than servicing them, their credit underwriting slipped. These banks and brokers unloaded all of their risk to the GSEs and their implicit government backing. Finally, individual and institutional investors bought the securitized mortgages under the understanding that if things would go wrong the taxpayer would refund them for losses. Then process repeated.

This charade finally reached a tipping point when investors stopped buying MBS' leaving the banks that sold the mortgages retail with their hands dirty. Holding nearly a trillion dollars at face value of mortgages. Now many of these mortgages are trading at less than 22 cents on the dollar (Merril Lynch).

Now we need to understand the fractional reserve system. Banks are required only to have a small fraction of the actual loans made backed by deposits; usually around 8-14%. This leverage means that a 10% drop in the value of assets will lead to bank insolvency and failure. Unfortunately for many banks, real estate mortgages were the primary assets on their books. When some of these mortgages dropped in value by nearly 80% they were stuck with a lurking problem, insolvency.

There are two major ways for a bank to become insolvent. Asset degradation and a run on deposits caused by lack of faith in the financial institution. Bear Stearns was a recipient of the bank run. The rapid withdrawal of deposits caused the reserve ratio to sink below the required rate. IndyMac faced liquidation because of asset devaluation/degradation. Their subprime and Alt-A loans fell so much in value that the FDIC had to come in and insure the deposits.

So the real problem here is not the free market. The free market does not exist today. Government has stuck its hands in everything from restaurant inspections, to bank regulations, oil drilling, antitrust, pharmaceuticals, automotive regulations. All of these things are costs that are passed on to the consumer. Government intrusion into every aspect of your consumption creates incentives and disincentives for companies to act on. If the free market did exist, Fannie Mae and Freddie mac would not own nearly half of the mortgage market and would definitely not be able to leverage itself over 20 times. A bank that failed would be purchased, likely below net asset value, punishing bond and stock holders for making poor investments. Instead what this crisis has demonstrated is that this country has made its push towards socialism or fascism, neither is good for civil liberty. And it has demonstrated that socialism/fascism have failed (like they always do) because when the government creates incentives to act badly (or take on excessive risk - i.e. moral hazard) then people will act badly.

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