A Perfect Storm of Ignorance
by Jeffrey Friedman
Jeffrey Friedman is the editor of Critical Review and of Causes of the
Financial Crisis, forthcoming from the University of Pennsylvania Press.
You are familiar by now with the role of the Federal Reserve in stimulating
the housing boom; the role of Fannie Mae and Freddie Mac in encouraging
low-equity mortgages; and the role of the Community Reinvestment Act in
mandating loans to "subprime" borrowers, meaning those who were poor credit
risks. So you may think that the government caused the financial crisis. But
you don't know the half of it. And neither does the government.
A full understanding of the crisis has to explain not just the housing and
subprime bubbles, but why, when they popped, it should have had such
disastrous worldwide effects on the financial system. The problem was that
commercial banks had made a huge overinvestment in mortgage-backed bonds
sold by investment banks such as Lehman Brothers.
Commercial banks are familiar to everyone with a checking or savings
account. They accept our deposits, against which they issue commercial loans
and mortgages. In 1933, the United States created the FDIC to insure
commercial banks' depositors. The aim was to discourage bank runs by
depositors who worried that if their bank had made too many risky loans,
their accounts, too, might be at risk.
The question of whether deposit insurance was necessary is worth asking, and
I will ask it later on. But for now, the key fact is that once deposit
insurance took effect, the FDIC feared that it had created what economists
call a "moral hazard": bankers, now insulated from bank runs, might be
encouraged to make riskier loans than before. The moral-hazard theory took
hold not only in the United States but in all of the countries in which
deposit insurance was instituted. And both here and abroad, the regulators'
solution to this (real or imagined) problem was to institute bank-capital
regulations. According to an array of scholars from around the world — Viral
Acharya, Juliusz Jablecki, Wladimir Kraus, Mateusz Machaj, and Matthew
Richardson — these regulations helped turn an American housing crisis into
the world's worst recession in 70 years.
WHAT REALLY WENT WRONG
The moral-hazard theory held that since the FDIC would now pick up the
pieces if anything went wrong, bankers left to their own devices would make
clearly risky loans and investments. The regulators' solution, across the
entire developed world, was to require banks to hold a minimum capital
cushion against a commercial bank's assets (loans and investments), but the
precise level of the capital reserve, and other details, varied from country
to country.
In 1988, financial regulators from the G-10 agreed on the Basel (I) Accords.
Basel I was an attempt to standardize the world's bank-capital regulations,
and it succeeded, spreading far beyond the G-10 countries. It differentiated
among the risks presented by different types of assets. For instance, a
commercial bank did not have to devote any capital to its holdings of
government bonds, cash, or gold — the safest assets, in the regulators'
judgment. But it had to allot 4 percent capital to each mortgage that it
issued, and 8 percent to commercial loans and corporate bonds.
Each country implemented Basel I on its own schedule and with its own
quirks. The United States implemented it in 1991, with several different
capital cushions; a 10 percent cushion was required for "well-capitalized"
commercial banks, a designation that carries privileges that most banks
want. Ten years later, however, came what proved in retrospect to be the
pivotal event. The FDIC, the Fed, the Comptroller of the Currency, and the
Office of Thrift Supervision issued an amendment to Basel I, the Recourse
Rule, that extended the accord's risk differentiations to asset-backed
securities (ABS): bonds backed by credit card debt, or car loans — or
mortgages — required a mere 2 percent capital cushion, as long as these
bonds were rated AA or AAA or were issued by a government-sponsored
enterprise (GSE), such as Fannie or Freddie. Thus, where a well-capitalized
commercial bank needed to devote $10 of capital to $100 worth of commercial
loans or corporate bonds, or $5 to $100 worth of mortgages, it needed to
spend only $2 of capital on a mortgage-backed security (MBS) worth $100. A
bank interested in reducing its capital cushion — also known as "leveraging
up" — would gain a 60 percent benefit from trading its mortgages for MBSs
and an 80 percent benefit for trading its commercial loans and corporate
securities for MBSs.
Astute readers will smell a connection between the Recourse Rule and the
financial crisis. By 2008 approximately 81 percent of all the rated MBSs
held by American commercial banks were rated AAA, and 93 percent of all the
MBSs that the banks held were either triple-A rated or were issued by a GSE,
thus complying with the Recourse Rule. (Figures for the proportion of
double-A bonds are not yet available.) According to the scholars I mentioned
earlier, the lesson is clear: the commercial banks loaded up on MBSs because
of the extremely favorable treatment that they received under the Recourse
Rule, as long as they were issued by a GSE or were rated AA or AAA.
When subprime mortgages began to default in the summer of 2007, however,
those high ratings were cast into doubt. A year later, the doubts turned
into a panic. Federally mandated mark-to-market accounting — the requirement
that assets be valued at the price for which they could be sold right now —
translated temporary market sentiment into actual numbers on a bank's
balance sheet, so when the market for MBSs dried up, Lehman Brothers went
bankrupt — on paper. Mark-to-market accounting applied to commercial banks
too. And it was the commercial banks' worry about their own and their
counterparties' solvency, due to their MBS holdings, that caused the lending
freeze and, thus, the Great Recession.
What about the rest of the world? The Recourse Rule did not apply to
countries other than the United States, but Basel I included provisions for
even more profitable forms of "capital arbitrage" through off-balance-sheet
entities such as structured investment vehicles, which were heavily used in
Europe. Then, in 2006, Basel II began to be implemented outside the United
States. It took the Recourse Rule's approach, encouraging foreign banks to
stock up on GSE-issued or highly rated MBSs.
THE PERFECT STORM?
Given the large number of contributory factors — the Fed's low interest
rates, the Community Reinvestment Act, Fannie and Freddie's actions, Basel
I, the Recourse Rule, and Basel II — it has been said that the financial
crisis was a perfect storm of regulatory error. But the factors I have just
named do not even begin to complete the list. First, Peter Wallison has
noted the prevalence of "no-recourse" laws in many states, which relieved
mortgagors of financial liability if they simply walked away from a house on
which they defaulted. This reassured people in financial straits that they
could take on a possibly unaffordable mortgage with virtually no risk.
Second, Richard Rahn has pointed out that the tax code discourages
partnerships in banking (and other industries). Partnerships encourage
prudence because each partner has a lot at stake if the firm goes under.
Rahn's point has wider implications, for scholars such as Amar Bhidé and
Jonathan Macey have underscored aspects of tax and securities law that
encourage publicly held corporations such as commercial banks — as opposed
to partnerships or other privately held companies — to encourage their
employees to generate the short-term profits adored by equities investors.
One way to generate short-term profits is to buy into an asset bubble.
Third, the Basel Accords treat monies set aside against unexpected loan
losses as part of banks' "Tier 2" capital, which is capped in relation to
"Tier 1" capital — equity capital raised by selling shares of stock. But
Bert Ely has shown in the Cato Journal that the tax code makes equity
capital unnecessarily expensive. Thus banks are doubly discouraged from
maintaining the capital cushion that the Basel Accords are trying to make
them maintain. This litany is not exhaustive. It is meant
only to convey the welter of regulations that have grown up across different
parts of the economy in such immense profusion that nobody can possibly
predict how they will interact with each other. We are, all of us, ignorant
of the vast bulk of what the government is doing for us, and what those
actions might be doing to us. That is the best explanation for how this
perfect regulatory storm happened, and for why it might well happen again.
By steering banks' leverage into mortgage-backed securities, Basel I, the
Recourse Rule, and Basel II encouraged banks to overinvest in housing at a
time when an unprecedented nationwide housing bubble was getting underway,
due in part to the Recourse Rule itself — which took effect on January 1,
2002: not coincidentally, just at the start of the housing boom. The Rule
created a huge artificial demand for mortgage-backed bonds, each of which
required thousands of mortgages as collateral. Commercial banks duly met
this demand by lowering their lending standards. When many of the same banks
traded their mortgages for mortgage-backed bonds to gain "capital relief,"
they thought they were offloading the riskiest mortgages by buying only
triple-A-rated slices of the resulting mortgage pools. The bankers appear to
have been ignorant of yet another obscure regulation: a 1975 amendment to
the SEC's Net Capital Rule, which turned the three existing rating
companies — S&P, Moody's, and Fitch — into a legally protected oligopoly.
The bankers' ignorance is suggested by e-mails unearthed during the recent
trial of Ralph Cioffi and Matthew Tannin, who ran the two Bear Stearns hedge
funds that invested heavily in highly rated subprime mortgage-backed bonds.
The e-mails show that Tannin was a true believer in the soundness of those
ratings; he and his partner were exonerated by the jury on the grounds that
the two men were as surprised by the catastrophe as everyone else was. Like
everyone else, they trusted S&P, Moody's, and Fitch. But as we would expect
of corporations shielded from market competition, these three "rating
agencies" had gotten sloppy. Moody's did not update its model of the
residential mortgage market after 2002, when the boom was barely underway.
And Moody's model, like those of its "competitors," determined how large
they could make the AA and AAA slices of mortgage-backed securities.
THE REGULATORS' IGNORANCE OF THE REGULATIONS
The regulators seem to have been as ignorant of the implications of the
relevant regulations as the bankers were. The SEC trusted the three rating
agencies to continue their reliable performance even after its own 1975
ruling protected them from the market competition that had made their
ratings reliable. Nearly everyone, from Alan Greenspan and Ben Bernanke on
down, seemed to be ignorant of the various regulations that were pumping up
house prices and pushing down lending standards. And the FDIC, the Fed, the
Comptroller of the Currency, and the Office of Thrift Supervision, in
promulgating one of those regulations, trusted the three rating companies
when they decided that these companies' AA and AAA ratings would be the
basis of the immense capital relief that the Recourse Rule conferred on
investment-bank-issued mortgage-backed securities. Did the four regulatory
bodies that issued the Recourse Rule know that the rating agencies on which
they were placing such heavy reliance were an SEC-created oligopoly, with
all that this implies? If you read the Recourse Rule, you will find that the
answer is no. Like the Bank for International Settlements (BIS), which later
studied whether to extend this American innovation to the rest of the world
in the form of Basel II (which it did, in 2006), the Recourse Rule wrongly
says that the rating agencies are subject to "market discipline."
Those who play the blame game can find plenty of targets here: the bankers
and the regulators were equally clueless. But should anyone be blamed for
not recognizing the implications of regulations that they don't even know
exist?
Omniscience cannot be expected of human beings. One really would have had to
be a god to master the millions of pages in the Federal Register — not to
mention the pages of the Register's state, local, and now international
counterparts — so one could pick out the specific group of regulations,
issued in different fields over the course of decades, that would end up
conspiring to create the greatest banking crisis since the Great Depression.
This storm may have been perfect, therefore, but it may not prove to be
rare. New regulations are bound to interact unexpectedly with old ones if
the regulators, being human, are ignorant of the old ones and of their
effects.
This is already happening. The SEC's response to the crisis has not been to
repeal its 1975 regulation, but to promise closer regulation of the rating
agencies. And instead of repealing Basel I or Basel II, the BIS is busily
working on Basel III, which will even more finely tune capital requirements
and, of course, increase capital cushions. Yet despite the barriers to
equity capital and loan-loss reserves created by the conjunction of the IRS
and the Basel Accords, the aggregate capital cushion of all American banks
at the start of 2008 stood at 13 percent — one-third higher than the
American minimum, which in turn was one-fifth higher than the Basel minimum.
Contrary to the regulators' assumption that bankers need regulators to
protect them from their own recklessness, the financial crisis was not
caused by too much bank leverage but by the form it took: mortgage-backed
securities. And that was the direct result of the fine tuning done by the
Recourse Rule and Basel II.
HOW DID WE GET INTO THIS MESS?
The financial crisis was a convulsion in the corpulent body of social
democracy. "Social democracy" is the modern mandate that government solve
social problems as they arise. Its body is the mass of laws that grow up
over time — seemingly in inverse proportion to the ability of its brain to
comprehend the causes of the underlying problems.
When voters demand "action," and when legislators and regulators provide it,
they are all naturally proceeding according to some theory of the cause of
the problem they are trying to solve. If their theories are mistaken, the
regulations may produce unintended consequences that, later on, in
principle, could be recognized as mistakes and rectified. In practice,
however, regulations are rarely repealed. Whatever made a mistaken
regulation seem sensible to begin with will probably blind people to its
unintended effects later on. Thus future regulators will tend to assume that
the problem with which they are grappling is a new "excess of capitalism,"
not an unintended consequence of an old mistake in the regulation of
capitalism.
Take bank-capital regulations. The theory was (and remains) that without
them, bankers protected by deposit insurance would make wild, speculative
investments. So deposit insurance begat bank-capital regulations. Initially
these were blunderbuss rules that required banks to spend the same levels of
capital on all their investments and loans, regardless of risk. In 1988 the
Basel Accords took a more discriminating approach, distinguishing among
different categories of asset according to their riskiness — riskiness as
perceived by the regulators. The American regulators decided in 2001 that
mortgage-backed bonds were among the least risky assets, so they required
much lower levels of capital for these securities than for every alternative
investment but Treasury's. And in 2006, Basel II applied that erroneous
judgment to the capital regulations governing most of the rest of the
world's banks. The whole sequence leading to the financial crisis began, in
1933, with deposit insurance. But was deposit insurance really necessary?
The theory behind deposit insurance was (and remains) that banking is
inherently prone to bank runs, which had been common in 19th-century America
and had swept the country at the start of the Depression.
But that theory is wrong, according to such economic historians as Kevin
Dowd, George Selgin, and Kurt Schuler, who argue that bank panics were
almost uniquely American events (there were none in Canada during the
Depression — and Canada didn't have deposit insurance until 1967). According
to these scholars, bank runs were caused by 19th-century regulations that
impeded branch banking and bank "clearinghouses." Thus, deposit insurance,
hence capital minima, hence the Basel rules, might all have been a mistake
founded on the New Deal legislators' and regulators' ignorance of the fact
that panics like the ones that had just gripped America were the unintended
effects of previous regulations.
What I am calling social democracy is, in its form, very different from
socialism. Under social democracy, laws and regulations are issued
piecemeal, as flexible responses to the side effects of progress — social
and economic problems — as they arise, one by one. (Thus the official name:
progressivism.) The case-by-case approach is supposed to be the height of
pragmatism. But in substance, there is a striking similarity between social
democracy and the most utopian socialism. Whether through piecemeal
regulation or central planning, both systems share the conceit that modern
societies are so legible that the causes of their problems yield easily to
inspection. Social democracy rests on the premise that when something goes
wrong, somebody — whether the voter, the legislator, or the specialist
regulator — will know what to do about it. This is less ambitious than the
premise that central planners will know what to do about everything all at
once, but it is no different in principle.
This premise would be questionable enough even if we started with a blank
legal slate. But we don't. And there is no conceivable way that we, the
people — or our agents in government — can know how to solve the problems of
modern societies when our efforts have, in fact, been preceded by
generations of previous efforts that have littered the ground with a tangle
of rules so thick that we can't possibly know what they all say, let alone
how they might interact to create another perfect storm.
This article originally appeared in the January/February 2010 edition of
Cato Policy Report.
http://www.cato.org/pubs/policy_report/v32n1/cpr32n1-1.html 
