Long or Short Capital

Barney Frank is in full regulator, politician-in-need-of-something-to-yell-about mode. Unfortunately, I must note that Mr. Frank is among our most financially-savvy elected officials (gulp) as well as one of the leading advocates of Zimbabwenomics. In this interview with the Economist, he discusses his misguided rationale for dealing with the current financial mess and, as any good politician should, proposes to 1) increase government regulation and 2) increase taxes.

1)

“[Hedge funds and unregulated pools of capital] caused the problem by making a wide ranges of loans that shouldn’t have been made. Now some of the borrowers shouldn’t have borrowed… but there was no regulation to prevent abuse.”

“If only [banks and credit unions] were the originators, there would be no subprime crisis and no recession today.”

Now every major US bank I can think of – Citigroup, BofA, Wells Fargo, etc. — has written down billions in losses from the sub-prime, Alt A, sub-crap, and moderate-crap mortgages they held. Additionally, they are still trying to unload the billions of remaining debt still on their books from their loans to the only group more levered than sub-prime borrowers: private equity firms. These banks were regulated but they still participated, enabled, benefited from, and ultimately suffered as a result of the sub-prime fiasco. Why? Because the problems that the financial system has suffered over the last 18 months are the result of an expansionary credit cycle. Credit begat credit until temporarily insane lenders gave cash to un-worthy borrowers. Sub-prime were the symptom of this craze rather than the cause and while regulation may have been able to stem some of the more egregious abuses, an expansionary credit cycle will find a way to wreck damage.

Here’s Warren Buffet on the subject:

There are significant limits to what regulation can accomplish. As a dramatic illustration, take two of the biggest accounting disasters in the past ten years: Freddie Mac and Fannie Mae. We’re talking billions and billions of dollars of misstatements at both places.

Now, these are two incredibly important institutions. I mean, they accounted for over 40% of the mortgage flow a few years back. Right now I think they’re up to 70%. They’re quasi-governmental in nature. So the government has set up an organization called OFHEO. I’m not sure what all the letters stand for. But if you go to OFHEO’s website, you’ll find that its purpose was to just watch over these two companies. OFHEO had 200 employees. Their job was simply to look at two companies and say, “Are these guys behaving like they’re supposed to?” And of course what happened were two of the greatest accounting misstatements in history while these 200 people had their jobs. It’s incredible. I mean, two for two!

It’s very, very, very hard to regulate people.

LoS prediction: Frank and his legislative cohort will find a way to prevent any of the abuses of this cycle from recurring. Say good-bye to pick-n-pay, Freedom, and pay option loans. However, this regulation will do nothing to prevent the excesses of the next expansionary credit cycle, scheduled to start in 2012 which may include Magic Loans, Money Tree Triple-Reverse Amortizing ARMs (if it works in old-time college football, it can work in loans), Collateralized Magic Loan Obligations, Ultra-SIVs and our favorite, Chocolate Covered Mortgages, which will not not only be affordable but delicious.

2)

“First, try to pay as little as possible [to bail people out].”
“I’m willing to give [homeowners who can’t afford their houses] some help. Not direct taxpayer assistance but some other type…”

“They didn’t bail out Bear Stearns. [The Fed] bailed out the people who did deals with Bear Stearns.”

Now for the classic politician’s sleight of hand. When people won’t tolerate direct transfers of wealth, make the transfers indirect. The First Law of Bailouts is that Someone Must Pay. So when Barney says that he’s willing to give homeowners who speculated on housing (and lost) “some help” but that won’t involve direct taxpayer assistance, he’s not quite lying. Instead of giving these people straight cash, he will find some other ways to transfer taxpayer dollars to these people (voters).
Similarly, it’s true that the Fed didn’t bail out Bear Stearns. After all the company was sold to JP Morgan and the employees lost most of their equity. However, he failed to mention that the Fed DID bail out the Bear Stearn’s bondholders [see John Hussman’s insightful analysis] who did nothing to deserve the preferential treatment.

Recommendation: Stop voting for politicians who cannot think more than 2 steps ahead of themselves. Stop voting for politicians who have never heard of the 2nd (forget about the 3rd) order effects.