Mencius Moldbug tries to provide a Misesian explanation of the bank crisis — Misesian as in Ludwig von Mises — but a commenter named Michael S. gives a much more thorough explanation of what happened — although not a Misesian one:
I can assure you that banks pay a great deal of attention to the duration both of loans and of deposits and apply sophisticated methods of analysis to balance them. A failure to do so is not the reason for the current financial crisis. There are a great many commercial banks that have not been directly affected by it, and are indirectly affected only because of the financial stresses placed on their customers arising from sources outside the commercial banking system.The collapse began in the secondary mortgage market, which was for all practical purposes created by Fannie Mae. Fannie Mae (the Federal National Mortgage Association) was created in 1938 as one of FDR’s New Deal Agencies. In 1968, during the Johnson administration, it was spun off the Federal government as a “GSE” (government sponsored enterprise) in order to get its debt off the Federal balance sheet. Shortly thereafter, Freddie Mac (the Federal Home Loan Mortgage Corporation) was created by Congress to compete with Fannie Mae, so that Fannie would not have an effective monopoly. Between them, Fannie Mae and Freddie Mac hold or have guaranteed over 50% of the residential mortgages in the United States.
Many of these mortgages were and are badly undercollateralized and were made to borrowers of doubtful creditworthiness. The GSEs accepted loans of up to 97% of appraised value. Loan originators made their money from origination fees and had little incentive to underwrite their mortgages soundly since they stood to lose nothing if the loans went bad. Furthermore, appraisers learned that they had to be generous in their appraisals in order to do business with the store-front mortgage brokers. An appraiser we use at my bank told us that he could not get work from such operations because his appraisals were too cautious. Thus, not only were the loans undercollateralized at 97% of appraised value, but the appraised values were unrealistically high.
Fannie Mae and Freddie Mac did not operate under the same rules regarding their lending practices and capital-to-assets ratios as do commercial banks. In addition, under HUD supervision, the GSEs were told how to allocate loans. In 1992, Congress pushed them to increase their purchases of mortgages going to low-income borrowers. For 1996 they were given an explicit target — 42% of their loans had to go to borrowers with incomes below the median in their geographic area. In 2000 this target was increased to 50% and in 2005 to 52%. But politically mandated credit allocation did not stop there. For 1996, HUD specified that 12% of the GSEs’ mortgage purchases be ‘special affordable’ loans to borrowers having incomes less than 60% of the median in their areas. This target was increased to 20% in 2000, to 22% in 2005, and to 28% in 2008.
Fannie and Freddie obtained the funds for these loans not by soliciting deposits from the public, as commercial banks do, but by selling bonds, backed by the mortgages they bought — mortgages we now know, and which we should have known all along, were largely unsound. Why didn’t we? First, because a buyer of such investment securities does not and cannot examine each of the mortgages by which they were backed with the same level of scrutiny that he might investigate an individual borrower applying to him for a loan. He instead relies on bond rating agencies like Moody or Standard & Poor to evaluate the obligation. He further looks to bond insurance companies for guarantees of payment. Second, the bond buyer, like the rating agency and the insurance company acting as guarantor, assumes that- whether or not it be explicitly provided by contract — that a GSE has the implicit backing of the U.S. government. As we now know the U.S. government has been called upon in that role, and has accepted it.
The Federal Reserve’s manipulation of interest rates brought about the first wave of defaults, as customers who had borrowed on 5-year adjustable-rate mortgages with balloon payments at the end of their term found they had to re-finance their remaining balances at rates 2–3 percentage points higher than they had paid for their first 5 years. It may not seem like a great rise in rates, but when applied to a mortgage on a 25- or 30-year amortization schedule, such an adustment can nearly double the monthly payment. Since it is not the price of the house but the monthly payment that really dictates whether a buyer can afford it, many of these houses went on the market when their owners could no longer meet their monthly payments. As more houses came on the market than had willing buyers, the prices at which they could clear the market fell. Now many of them were worth less than the outstanding mortgages on them, which had been made at excessive loan-to-value ratios to begin with. The result was a cascading fall in the price of housing, akin to the fall in the price of stocks in 1929, when people who had bought them on margin could not meet their margin calls. In both cases, the bubble was inflated by easy money and excessive leverage, and punctured by a reversal of the easy-money policy. As housing prices fell, mortgages began to go into default; as mortgages began to go into default, mortgage-backed securities began to fall in value.
Investment banks were affected more profoundly by the collapse in the secondary mortgage maket than were commercial banks, because investment banks were more highly leveraged. Those commercial banks that were affected were, not so much because they had bad loans on their books, as because they owned securities that had fallen so badly in value that when marked-to-market they devastated their balance sheets. Bad investments or loans are charged first to loan-loss reserves, then to current earnings, and finally to stockholders’ equity. It does not take many such charge-offs to burn through most or all of a bank’s capital, leaving nothing to support its deposits.
What is most sad and perplexing about this situation is that politicians — not least of them Barack Obama — have presented it to the public as the result of ‘deregulation,’ and the public has largely swallowed their explanation. Yet it is hard to see how bank deregulation, properly so called, has anything to do with it. The principal bank deregulation that has taken place in the past fifteen years was the relaxation of restrictions on interstate branching in 1993 or ’94, and the Gramm-Leach-Bliley act of 1999, which eliminated some of the barriers set up by the Glass-Steagall act between investment and commercial banking. As an owner of an independent community bank neither of these actions was particularly favorable to me, yet I can’t find particular fault with their effects under present circumstances. Interstate branching has probably strengthened commercial banking more than it has weakened it; the soundness of Wells Fargo and U.S. Bancorporation provide examples. Gramm-Leach-Bliley has permitted J.P. Morgan Chase to acquire Bear Stearns, and Bank of America to acquire Merrill Lynch. These former investment banks will now be subject to the stricter reserve requirements of their acquirers, which is all to the good.
The collapse of housing and the secondary mortgage market stemmed not from ‘deregulation’ but from the political allocation of credit through Fannie Mae and Freddie Mac. Now, under the Paulson plan, which has forced the country’s largest banks to accept senior capital investment from the Federal government (and all of the conditions attached to it) whether they want or need it or not, we shall see more, rather than less, politicized allocation of credit.
Alexander Hamilton’s project of a national Bank of the United States horrified Thomas Jefferson and his followers, because they foresaw that political allocation of credit would lead to favoritism, consolidation, monopoly, special privilege, jobbery, patronage, and theft by taxation. The First and Second Banks — the latter killed by Andrew Jackson — did not last long enough to yield the expected results, but in Fannie Mae and Freddie Mac we have seen the fulfillment of these predictions. Yet do you suppose that the voters of Connecticut will ever call Christopher Dodd to account, or those of Massachusetts do likewise of Barney Frank? I don’t. Like beaten dogs they will return to slobber and fawn over the hands that abused them. The worst irony is that these people claim to represent the party of Jefferson and Jackson, while exemplifying everything those historical figures feared and detested.