Typically the AAA-rated tranche of MBSs held rights to about 75 percent of the principal and interest payments due in from the mortgages. That means that if in such a pool at least 75 percent of the homeowners made their mortgage payments, all the AAA MBS holders would get paid. Because the holders of the AAA-rated MBSs get paid first, they bear less risk; accordingly, they are paid a lower interest rate on the money they have invested. The AA-rated tranche of MBSs typically held rights to the next 10 to 15 percent of the principal and interest payments. Because they bear more risk—they don’t get paid anything until the holders of all the AAA-rated MBSs have been paid—they receive a higher interest rate on the money they have invested, and so on.
Even subprime MBSs can deserve AAA ratings (as not very risky) because even in a pool of subprime mortgages, some proportion of the homeowners will make all their mortgage payments. The AAA-rated tranche of a pool of subprime mortgages can therefore deserve its AAA rating as long as the tranche is narrow enough. The key is for the rating agency to make a sound judgment about how many mortgages in a given pool are likely to have their payments made on time. For example, if the rating agency judges that in a certain pool of subprime mortgages, at least 70 percent are all but certain to stay current on their payments, the agency might give a AAA rating to 70 percent of the MBSs based on that pool. If it then turns out that no more than 30 percent of the mortgages in that pool fall behind and go into foreclosure, the holders of the AAA MBSs will still get paid everything they expected. If, however, 31 percent or more of those mortgages fall behind on their payments, there will not be enough income to pay all the holders of the AAA tranche, and we could say the rating agency made a mistake.
As things turned out, the rating agencies did make a lot of bad judgments and made the AAA tranches of many mortgage pools too wide.
In discussion of the FDIC, I call payments from banks to the FDIC not “premiums” but “fees,” because to call them “premiums” seems to distort the usual meaning of the word. For most banks these payments are not voluntary purchases of insurance, but a tax. According to the Congressional Quarterly, “FDIC coverage is mandatory for all federally chartered banks and all state banks that are members of the Federal Reserve System, but voluntary for other state banks.” Congressional Quarterly Weekly Report: Volume 43 (1985), p. 1715. Accessed June 17, 2012, at http://books.google.com/books?id=pqhEAQAAIAAJ&q=%22fdic+coverage+is+mandatory%22&dq=%22fdic+coverage+is+mandatory%22&hl=en&sa=X&ei=XkXeT6WXIKfH6gGKrfypCw&ved=0CEUQ6AEwAQ.
The explanation of how federal deposit insurance grew out of small banks’ desire to avoid competition with large banks on the dimension of riskiness comes from the EconTalk podcast of October 26, 2009, with Charles Calomiris on the Financial Crisis (http://www.econtalk.org/archives/2009/10/calomiris_on_th.html). The relevant portion begins at 17:31 into the conversation.
The shortage of money in the bank panics of 1893 and 1907 was alleviated by the ingenuity of bank clearinghouses, individual banks, and even certain large companies that issued money substitutes. Some of these were certainly illegal, but allowed to circulate by the authorities, who saw that they were filling an urgent need. When the banking panics passed, these money substitutes were just taken out of circulation by those who had issued them. For a fascinating account, see Steven Horwitz’s chapter, “Regulatory Chaos and Spontaneous Order Under the National Banking System” in his 1992 book Monetary Evolution, Free Banking, and Economic Order (Westview Press).
The quotation from George Selgin contrasting the banking experience of the United States and Canada comes from his “Legal Restrictions, Financial Weakening, and The Lender of Last Resort,” in Bank Deregulation and Monetary Order (Routledge, 1996), p. 209.
Franklin Roosevelt’s opposition to government-provided deposit insurance is clear from a 1932 letter he wrote to the New York Sun, in which he said that deposit insurance “would lead to laxity in bank management and carelessness on the part of both banker and depositor. I believe that it would be an impossible drain on the Federal Treasury to make good any such guarantee. For a number of reasons of sound government finance, such plan would be quite dangerous.” More discussion and a link to the original letter are available at http://cafehayek.com/2008/12/franklin-fannie.html.
The article referred to by Clifford F. Thies and Daniel A. Gerlowski is “Deposit Insurance: A History of Failure,” in the Cato Journal Vol. 8, No. 3 (Winter, 1989), p. 680. This article tells brief and darkly entertaining stories of the failures of the various funds. It is available at http://www.cato.org/pubs/journal/cj8n3/cj8n3-8.pdf.
The quotation from George Selgin about private, competitive deposit insurance comes from The Theory of Free Banking, page 135, available online at the Liberty Fund’s Online Library of Liberty at http://files.libertyfund.org/files/2307/Selgin_1544_Bk.pdf. FDIC no longer assesses banks on their total deposits, but on their assets. See below.
Catherine England provides an interesting discussion of the problems with government-provided deposit insurance and the expected advantages of privately-provided deposit insurance in “Private Deposit Insurance: Stabilizing the Banking System,” Cato Institute Policy Analysis No. 54, available at http://www.cato.org/pubs/pas/pa054.pdf. She also presents an interesting proposal for making the transition from the former to the latter.
For information on the FDIC’s assessment base, see the press release at http://www.fdic.gov/news/news/press/2011/pr11028.html. It states that a final rule issued Feb. 7, 2011, changes “the assessment base from adjusted domestic deposits to average consolidated total assets minus average tangible equity.”
For an interesting discussion of a specific proposal for a system of cross-guarantees and predictable resistance to it by special interests, see John Allison’s The Financial Crisis and the Free Market Cure (McGraw Hill, 2013), pp. 48-49. The system was designed by Bert Ely; see his “Financial Innovation and Deposit Insurance: The 100% Cross-Guarantee Concept,” Cato Journal (Winter, 1994), pp. 413-445, available at http://www.cato.org/sites/cato.org/files/serials/files/cato-journal/1994/1/cj13n3-6.pdf.
George Selgin’s observation on the discipline exerted through clearinghouses is from his “Bank-Lending Manias in Theory and History,” page 266, in Bank Deregulation and Monetary Order (Routledge, 1996).
Notes to Part III “Conclusion”
How might we make the transition from central banking with fiat money to free banking and free-market money? While there are many proposals, the reader would do well to begin with George Selgin’s “A Practical Proposal for Reform” on pp. 168-172 of his The Theory of Free Banking. Lawrence H. White discusses “Making the Transition to a New Gold Standard” in the Cato Journal, Vol. 32, No. 2 (Spring/Summer, 2012), available at http://www.cato.org/sites/cato.org/files/serials/files/cato-journal/2012/7/v32n2-14.pdf.
For a useful discussion of “the leading criticisms of the gold standard,” see Lawrence H. White’s Cato Briefing Paper #100 (February, 2008), “Is the Gold Standard Still the Gold Standard Among Monetary Systems?” at http://www.cato.org/publications/briefing-paper/is-gold-standard-still-gold-standard-among-monetary-systems.
Notes to Chapter 13 “Hope for the Future”
For information about Children’s Scholarship Fund Baltimore, see http://www.csfbaltimore.org/. For information about Children’s Scholarship Fund nationally, visit http://www.scholarshipfund.org.
Those interested in the benefits of ending government intervention in education should read Sheldon Richman’s fine book, Separating School and State, published by the Future of Freedom Foundation in 1994.
For a short video presentation by Peje Emilsson, the founder of Kunskapsskolan, see http://www.youtube.com/watch?v=X_6MLZonT3U. A promotional video for the Manhattan school is at http://www.youtube.com/watch?v=_weyT_NyV6U. Kunskapsskolan’s website is at http://www.kunskapsskolan.com/.
Information about the origins of Khan Academy is taken from the Wired magazine article of July, 2011, “How Khan Academy Is Changing the Rules
of Education,” at http://www.wired.com/magazine/2011/07/ff_khan/all/1. The quotations from Khan Academy are from the academy’s website at http://www.khanacademy.org/about.
Per pupil expenditures in public elementary and secondary schools in the U.S. have increased around 24 percent in the last ten years, 41 percent in the last twenty, and nearly doubled in the last thirty. See the National Center for Education Statistics Fast Facts, http://nces.ed.gov/fastfacts/display.asp?id=66.
The article about Kelley Williams-Bolar is “The Latest Crime Wave: Sending Your Child to a Better School,” by Micheal Flaherty, on the Wall Street Journal opinion page October 1, 2011, available at http://www.cato.org/sites/cato.org/files/serials/files/cato-journal/1994/1/cj13n3-6.pdf. Flaherty writes, “Only in a world where irony is dead could people not marvel at concerned parents being prosecuted for stealing a free public education for their children.”
I arrive at the average spending per child in the Baltimore City Public Schools using figures from the system’s FY 2013 Adopted Operating Budget (http://www.baltimorecityschools.org/cms/lib/MD01001351/Centricity/domain/1/pdf/2012_13BudgetBookFINAL.pdf). Total expenditure of $1,302,266,468, given on p. 11, divided by total enrollment of 84,212, given on p. 4, yields $15,464 per student.
The Cato Institute study quoted from is Adam Schaeffer’s “They Spend WHAT? The Real Cost of Public Schools,” Cato Institute Policy Analysis, No. 662 (March 10, 2010), available at http://www.cato.org/publications/policy-analysis/they-spend-what-real-cost-public-schools.
Links to academic papers James Tooley and his colleagues have published on private schooling in poor nations, along with photographs and links to news reports and several inspiring videos, including two BBC broadcasts, are available at the website of Tooley’s E.G. West Centre at Newcastle University, http://research.ncl.ac.uk/egwest/.
About the Author
Howard Baetjer Jr. is a Lecturer in the Department of Economics at Towson University in Baltimore, Maryland, where he has taught since 1996. He teaches courses in microeconomics, comparative economic systems, and money and banking. Dr. Baetjer is also a regular faculty member at summer seminars offered by the Institute for Humane Studies.
Dr. Baetjer earned a B.A. in psychology from Princeton in 1974, an M.Litt. in English literature from the University of Edinburgh in 1980, an M.A. in political science from Boston College in 1984, and a Ph.D. in economics from George Mason University in 1993. His dissertation was published as Software as Capital: an Economic Perspective on Software Engineering by IEEE Computer Society in 1998.
He is a founding trustee of Children’s Scholarship Fund Baltimore, which, since 1999, has provided partial scholarships to more than 6000 low-income Baltimore children, to help them attend private and parochial schools their parents choose.
You can visit Dr. Baetjer’s website at http://www.freeourmarkets.com/.
Table of Contents
Acknowledgements
Introduction
Part I. Principles of Spontaneous Economic Order
1. Prices Communicate Knowledge
2. Profit and Loss Guide Innovation
3. Free Market Incentives Foster Service To Others
Part I. Conclusion
Part II. Regulation by Market Forces Outperforms Government Regulation
4.Ownership Matters
5. Government Regulation Gets Captured by Special Interests
6. Market Forces Regulate
7. Special Interests versus Democracy
Part II. Conclusion
Part III. The Housing Boom and Financial Crisis
8. Mortgage-Making In A Free Market
9. Boom, Bust, And Turmoil
10. Why Housing Boomed
11. Why the Boom Got So Big
12. Why the Housing Boom Led to a Financial Crisis
Part III. Conclusion
13. Hope for the Future
Appendix A
Appendix B
Notes
About the Author
Free Our Markets Page 38