Not What They Had in Mind: A History of Policies that Produced the Financial Crisis of 2008
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Last annotated on May 30, 2016
The severity of the current crisis raises many questions about its root causes. Any attempt to understand these root causes, however, requires the placement of policies and regulations in the appropriate context.Read more at location 23
bad bets, excessive leverage, domino effects, and 21st-century bank runs.Read more at location 25
housing policy, capital regulations for banks, industry structure and competition, autonomous financial innovation, and monetary policy—Read more at location 26
the paper concludes that bank capital regulations were the most important causal factor in the crisisRead more at location 28
policy “solutions” to previous financial and economic crises sowed the seeds for this current crisis.Read more at location 29
Without this evolutionary history, there will be no meaningful lessons for today's policy makers.Read more at location 31
the actions of policy makers and regulators contribute to financial fragility,Read more at location 32
“Those who cannot remember the past are condemned to repeat it.” —George SantayanaRead more at location 38
those who only remember the headlines of 2008 will fail to heed Santayana's warning.Read more at location 45
For the roots of the crisis go back many decades, and if we are to avoid repetition, we have to fully understand the contextRead more at location 46
As this paper will illustrate, the seeds for much of the current crisis were sown in the policy “solutions” to previous financial and economic crises.Read more at location 47
illusions that key participants held during the years that preceded the meltdown.Read more at location 51
Financial executives had excessive confidence in mathematical models of risk,Read more at location 52
the fact that regulators themselves encouraged the reliance on agency ratings, particularly for compliance with bank capital requirements.Read more at location 55
impetus to use agency ratings dates back to the 1930s, was reinforced in the 1970s, and was significantly enhanced as recently as January 1, 2002.Read more at location 56
Regulators, too, placed too much confidence in financial engineering. Regulators, too, thought that the dispersal of risk into the “shadow banking system” helped make the core financial system safer. Regulators, too, thought that securitization was a superior form of mortgage finance.Read more at location 60
policy areas: housing policy; capital regulation for banks; industry structure and competition; autonomous financial innovation (not driven by capital regulation); and monetary policy.Read more at location 68
2. A FRAMEWORK FOR UNDERSTANDING THE FINANCIAL CRISISRead more at location 73
four components: bad bets; excessive leverage; domino effects; and 21st-century bank runs.Read more at location 74
Bad bets were the investment decisions that individuals and firms made that they later came to regret.Read more at location 78
housing bubble. When consumers in 2005 through 2007 purchased houses primarily on the expectation that prices would rise, those investments turned out to be bad bets.Read more at location 79
One way to estimate the significance of bad bets is to estimate the loss in the value of owner-occupied housing. The peak value was roughly $22 trillion, and if house prices declined by 25 percent, this is roughly a $5 trillion loss.Read more at location 83
Banks and other financial institutions took on significant risks without commensurate capital reserves.Read more at location 87
Domino effects are the connections in the financial system that made it difficult to confine the crisis to only those firms that had made bad bets.Read more at location 94
professionals had been aware for months that Lehman was in difficulty, and keeping a large position in Lehman debt can be viewed as making a bet that the government would treat Lehman as “too big to fail.”Read more at location 99
Another domino effect potentially comes from sales of hard-to-value assets.Read more at location 101
In a traditional bank run, depositors who wait to withdraw their money from an uninsured bank might find that the bank is out of funds by the time they reach the teller. That creates an incentive for a depositor to run to the bank so as to be the first in line—hence a bank run. By 21st-century bank runs, I mean the financial stress created by situations in which the first creditor that attempts to liquidate its claim has an advantage over creditors that wait.Read more at location 110
Without the bad bets, financial institutions would not have come under stress. Without the excess leverage, the bad bets would not have caused a financial crisis.5 Without the potential domino effects and the 21st-century bank runs, policy makers in 2008 would have been less frustratedRead more at location 142
The ideal objective might be to prevent domino effects and bank runs without forcing taxpayers to absorb losses from bad bets.Read more at location 148
As a result of the bailouts and other policies, we presumably did not observe the worst of what might have happened had the domino effects and bank runs been allowed to play out. It is impossible to know exactly how serious the consequences would have been had those phenomena proceeded unchecked.Read more at location 151
The regulatory response was focused on loss of confidence. The Federal Reserve and the Treasury placed more importance on loss of confidence than on bad decisions.Read more at location 157
In general, if you ask the CEO of a failed business what caused the failure, the CEO will cite loss of confidence rather than bad decisions.Read more at location 161
The founder of a startup that burned through all of its cash will argue that he was making great progress until his investors lost their nerve.Read more at location 163
The evidence for bad decisions includes the large number of mortgage defaults and the large number of downgrades of mortgage securities. It also includes the fact that private hedge funds did not see much opportunity in picking up distressed assets.Read more at location 167
If loss of confidence was the primary problem, then the government's investments in banks ought to earn profits for the taxpayers.Read more at location 171
As stated earlier, the five policy areas are housing policy, capital regulation for banks, competitive boundaries in financial intermediation, response to financial innovation, and monetary policy. Below is a matrix that includes my weights on the importance of each of these factors relative to the column heading.Read more at location 176
As this matrix conveys, capital regulations were the most important causal factor in the crisis. Capital regulations encouraged banks and other financial institutions to make bad bets, to finance those bets with excessive leverage, and to set up financial structures that were subject to domino effectsRead more at location 182
Bad bets were caused primarily by capital regulations and by housing policy. As will be explained below, capital regulations distorted mortgage finance away from traditional lending and toward securitization.Read more at location 184
Another contributor to bad bets was housing policy. Housing policy consistently encouraged more home ownership and subsidized mortgage indebtedness.Read more at location 187
bubbles took place at around the same time in many other countries, including the United Kingdom and Spain.Read more at location 190
Thus, policy alone is not entirely responsible for the bad bets.Read more at location 191
Excess leverage should be blamed largely on the perverse nature of capital regulations. These regulations, which were supposed to constrain leverage, instead were implemented in ways that encouraged risk-taking.Read more at location 193
AIG Insurance, as a major seller of credit default swaps, was effectively writing insurance without being required to set aside either loss reserves or capital. Thus, every major financial institution was given the green light to pile on mortgage credit risk with very little capital.Read more at location 197
Regulators understood most of the reasons for the increase in leverage, but they did fail to appreciate some innovations. For example, it is unlikely that the Office of Thrift Supervision, which had nominal oversight of the AIG Insurance unit that sold credit default swaps, understood the nature of the leverage in AIG's positions. Thus, I give a low but non-zero weight to autonomous innovation in creating excess leverage.Read more at location 200
there are those who place a higher weight than I do on the monetary policy of the Federal Reserve. The argument is that the Fed kept short-term interest rates too low for too long,Read more at location 203
Financial engineers created collateralized debt obligations (CDOs), credit default swaps (CDSs), and other esoteric products largely to exploit opportunities for regulatory capital arbitrage.Read more at location 209
these financial instruments increased the financial interdependence and vulnerability to runs of the financial system.Read more at location 211
For domino effects and bank runs, intuition may suggest that a large role was played by changes to industry structure due to mergers, acquisitions, and the erosion of boundaries between investment banking and commercial banking. The Obama Administration's white paper7 is among many analyses that stress the significance of the growth of the “shadow bankingRead more at location 212
However, much of what is now called “shadow banking” emerged in response to capital regulations.Read more at location 217
consider an alternate history where institutions had to maintain a strict, Glass-Steagall separation of commercial from investment banking, yet continued to operate under capital regulations that blessed securitization, off-balance-sheet financing, and other complex transactions. In that case, I believe that the crisis would have unfolded pretty much as it did.Read more at location 221
CDOs, CDSs on mortgage securities, and SIVs are examples of innovations that took advantage of regulatory capital arbitrage. On the other hand, mortgage credit scoring is an example of what I call an autonomous innovation, meaning an innovation that was created for reasons other than regulatory capital arbitrage.Read more at location 224
4. PAST CRISES MAKE BAD POLICY: HOUSING POLICY AND CAPITAL REGULATIONRead more at location 229
housing policy and bank regulatory policy evolved out of previous crises.Read more at location 230
The lesson is that financial regulation is not like a math problem, where, once you solve it the problem stays solved.Read more at location 231
This natural process of seeking to maximize profits places any regulatory regime under continual assault, so that over time the regime's ability to prevent crises degrades.Read more at location 235
When the Great Depression hit, the typical mortgage loan was a five-year balloon: The borrower paid interest only for five years, at which point the entire mortgage came due. The borrower either had to obtain a new loan or pay off the existing loan.Read more at location 237
the advent of the thirty-year, fixed-rate mortgage, promoted by new agencies,Read more at location 241
Because the savings and loans associations (S&Ls) were holding thirty-year, fixed-rate mortgages, their assets plummeted in value with rising inflation and interest rates.Read more at location 245
Thus, the combination of thirty-year, fixed-rate mortgages and insured deposits, which were the solutions to the 1930s mortgage crisis, ended up producing the 1970s crisis.Read more at location 247
In the aftermath of the S&L crisis, policy makers drew three conclusions. One was that securitization of mortgages was better than traditional mortgage lending. The thinking was that pension funds, insurance companies, and other institutions with long-term liabilities were better positioned to bear the interest-rate risk associated with thirty-year, fixed-rate mortgagesRead more at location 260
Another lesson of the S&L crisis was that regulators should not rely on book-value accounting.Read more at location 263
A final lesson of the S&L crisis was that capital requirements needed to be formal and based on risk.Read more at location 266
The concept of risk-based capital was embedded in the Basel Accords in 1989,Read more at location 267
Thus, the regulators responded to the S&L crisis by promoting securitization, market-value accounting, and risk-based capital, all of which contributed to or exacerbated the most recent crisis. Mortgage securities became the “toxic assets” at the core of the crisis. Risk-based capital regulations promoted the use and abuse of these instruments. The combination of risk-based capital and market-value accounting served to exacerbate both the boom and the bust.Read more at location 269
When a bank was forced to sell mortgage-backed securities, this lowered the market value of these securities, triggering write-downs at other banks under market-value accounting. This put other banks below the regulatory minimum for capital.Read more at location 274
Instead, it may be more effective to aim for a system that is easy to fix than a system that is hard to break.Read more at location 857
This means trying to encourage financial structures that involve less debt, so that resolution of failures is less complicated. It also means trying to foster a set of small, diverse financial institutions.Read more at location 858
In the United States, tax policies tend to encourage debt financing.Read more at location 860
Another way to make a financial system easy to fix would be to have small institutions with only weakly correlated risks.Read more at location 863
From the standpoint of making the regulatory system harder to break, it may make sense to have a neat regulatory organization chart, without gaps or overlaps. However, such a well-ordered regulatory system might result in a situation where all of the institutions performing a particular function, such as mortgage lending, fail together.Read more at location 866
A number of regulatory developments helped to stimulate the boom in mortgage lending and securitization.Read more at location 878
The Basel Accord on risk-based capital set up crude risk buckets that initially favored Freddie Mac and Fannie Mae, because capital requirements were lower for mortgages securitized by the GSEs than for loans originated and held by banks.Read more at location 879
From the mid-1990s onward, the government pressured mortgage lenders to increase lending to low-income borrowers. Freddie Mac and Fannie Mae lowered credit underwriting standards considerably in response to this pressure, taking on significant subprime mortgage exposure in 2006 and 2007, just as house prices were poised to fall.Read more at location 883
The incentives to hold AAA- and AA-rated assets stimulated various financial innovations that had unfortunate consequences. Among many examples, AIG insurance used credit default swaps on mortgage securities to “rent” its AAA rating to banks.Read more at location 886
Monetary policy that was intended to stabilize inflation and employment kept interest rates low from 2002 through 2004, which contributed to the housing boom.Read more at location 887
Regulators lacked the will and the ability to enforce competitive boundaries in the financial sector. These boundaries eroded over a forty-year period, primarily as a result of innovation but also as a result of regulatory decisions and legislation. Consequently, institutions became large and complex. These “too big to fail” firms posed major challenges to policy makers during the crisis, because they were subject to domino effects and 21st-century bank runs.Read more at location 889
Note: INCORAGGIATO IL TOO BIG TO FAIL
