May 24, 2011
A thoroughgoing analysis of regulatory failure
Let’s recount a few of the many regulatory and policy pressures. One covered in the volume is America’s idealization of home ownership and the government’s policy of promoting a “nation of homeowners.” In his Afterword, written specifically for the book version of these essays, Richard Posner – a U.S. Court of Appeals judge and a prolific and highly regarded writer – points out that “an economic advantage of a nation of renters is that relocation to a different city or state to pursue new job opportunities is easier when one rents rather than owns one’s home.” Nevertheless, we have idealized home ownership, and governments have done all they can to help people pursue that ideal, including:
- Making interest on home loans tax-deductible
- Requiring that borrowers be allowed to refinance without penalty
- Making home loans non-recourse to the borrowers in several states including California – borrowers can walk away from a mortgage and the lender has recourse only to the property
- Exempting housing assets up to $500,000 from capital gains tax in the 1997 Taxpayer Relief Act
- Implicitly backing government-sponsored mortgage lenders Fannie Mae and Freddie Mac
On top of that, the unusually low interest rates set by the U.S. Federal Reserve in the years 2002-2005 created an incentive to borrow. In one essay, Stanford economist John Taylor claims that regression analysis shows that the subprime boom-bust wouldn’t have happened if monetary policy had followed the oft-applied “Taylor Rule” for determining how the Fed should set the interest rate (named after Taylor himself). I’m skeptical of the ability of regression to prove anything in economics, especially when the data are as limited as Taylor’s, but it may be suggestive.
In addition, Posner points out something I haven’t heard mentioned before: when the Fed finally began pushing rates back up in 2004, “Greenspan promised, in effect, that if high rates had a negative impact on the economy he would lower them. This was taken as a commitment that if housing prices began to tumble, the Fed would cushion the fall by pushing interest rates back down again” [emphasis added]. While this is speculation on Posner’s part, he’s probably right that the financial industry read it that way.
The Basel rules and the ratings agencies
Now we come to the real hard evidence. Here it starts to get complicated; this is also where the book really shines. Nowhere else have I seen so clearly explained how a combination of the Basel rules and the government-endorsed special position of the ratings agencies incentivized the creation and sale of securitized, tranched mortgage instruments – and their mis-rating.
The Basel rules are the bank-capital regulations recommended by the Bank for International Settlements (BIS) Basel Committee on Banking Supervision.
The Basel rules as applied by the United States required a bank to hold 5% capital in reserve for a portfolio of mortgages. But for a portfolio of AAA or AA rated securities the bank needed to hold only 2% in capital. In addition, for commitments less than a year in duration, a bank needed to hold no capital. Therefore banks did one or both of two things:
- Sell their mortgages to a securitizer, then buy back mortgages in the form of AAA or AA tranches of mortgage-backed securities or CDOs. (Half or more of the securitized obligations, as several of the articles point out, were purchased by banks themselves.)
- Sell the securitized loans to an off-balance-sheet conduit, such as a structured investment vehicle (SIV), and back them with annual rolling bank guarantees so the conduit can issue short-term asset-backed commercial paper. In this way, neither bank nor conduit need hold reserve capital, and the risky assets are off the bank’s balance sheet.
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