What Caused the Financial Crisis presents the most comprehensive account I have seen of the regulations that, when considered as a whole, have incentivized unprecedented self-delusion and risk-taking in the subprime mortgage market. To put it in a manner that financial advisors will understand, the book shows that the policies and regulations greatly increased the Sharpe ratio of the financial industry – they increased the return for taking risk.
The book is a collection of essays on the financial crisis edited by Jeffrey Friedman, a visiting scholar in the Department of Government at the University of Texas at Austin. It is a republication of the June 2009 issue of Critical Review, a scholarly journal Friedman edits. Most of it is not particularly easy reading; but thankfully it’s not in the impenetrable prose and dense mathematics you see in many scholarly economics journals these days. Because so many of its essayists are economists – 17 of 20 have economics PhDs – and because readers would be largely economists too, the book at times reads like a private post-mortem among players who lost a game.
Many books have been written about the financial crisis since 2008. This book, with a 2011 publication date, is only one of the most recent, and yet its editor boasts that it is “the first collection of scholarly essays devoted entirely to the question of what caused the financial crisis of 2008.” This smacked of academic arrogance to me – as if no previous work had been scholarly?
Nevertheless, I’m inclined to agree – in a specific, limited way – with its editor’s assessment that this volume “brings us much closer to a comprehensive answer” to its central question.
Don’t expect to find in this book reconstructed boardroom palaver or office, restaurant, phone or email chats between CEOs or between CEOs and their top executives. It’s not “The Big Short;” its not that kind of book at all. And Friedman made a point of steering his authors away from anything approaching policy advocacy – its intent is retrospective. But none of this means that the book steers clear of controversy, dissent and criticism – far from it, as we’ll soon see.
The fluid dynamics interpretation of history
The style guidelines do somehow result, however, in many of the essays taking a peculiar view of the interpretation of history. Let’s call it the “fluid dynamics” approach.
In fluid dynamics one specifies the containers, conduits, sources and receptacles. Then based on these, and the influxes, and the physical nature of the fluid or gas, one can calculate the pressures and flows.
The fluid is, in short, expected to obey aggregate physical laws, even though each individual molecule may be going this way or that at any moment. For example one can predict the pressure exerted in aggregate on a containing vessel, even though almost half the molecules in the vicinity of the containing walls are not exerting any pressure on it at all.
For many of the essayists in “What Caused the Financial Crisis”, regulations and government policy –motivated by economic theory or politics – constitute the containing structure, while all other economic actors (for example bankers, and even ratings agencies) are the fluid. The fluid only does what it must do given its containers and conduits. Hence, if something goes wrong, it is by implication the fault of the containing structures.
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.
Note that ratings were crucial to both these operations – the banks could only reduce required capital if the securities received high ratings from those ratings agencies that held a U.S. government-conferred designation as Nationally Recognized Statistical Rating Organizations (NRSROs); basically, Moody’s, S&P and Fitch.
This put overwhelming pressure on ratings agencies to produce AAA ratings to feed ballooning demand for asset-backed securities, whose quality was actually declining fast as the best pickings were snapped up. The ratings agencies complied, using ratings models that claimed support from economic theory.
Two of the essayists, Friedman and American Enterprise Institute Fellow Peter Wallison, argue that the ratings agencies didn’t produce more-accurate ratings because they had been granted an oligopoly and were thus shielded from market competition by the government NRSRO designation; Posner debunks this however with a nice bon mot, “But what would have been the market for such wet-blanket raters?” The raters were competing in a market not to produce accurate ratings, but ratings favorable to the issuers; if investors wanted more accurate ratings, they could have paid independent advisors for them.
The economists dunnit
As you may have noticed, the foregoing does not make accusations against bankers, or even ratings agencies. (Only one author, Nobelist economist Joseph Stiglitz, points fingers, but he spreads the blame widely.) It’s all about the structure of the containment vehicles and conduits – that is, the regulations and government policies. The bankers and raters will follow the laws governing them, just as the laws of fluid dynamics govern fluids, which then do what the containment structures make them do.
So who is to blame for the mess? Steered away from blaming others by journal style guidelines, several of the economists place the blame squarely in the only place they are allowed – on themselves.
Two articles advance this nostra culpa, one by MIT economist Daren Acemoglu, and a yet stronger one by a group of David Colander, a Distinguished Professor of economics at Middlebury College, and six other economists.
One notion that Acemoglu says was held by economists (and many others) is a notion that I have tried to debunk numerous times. Acemoglu himself says that “It is also one that I strongly believed in.” This now-refuted idea is that “we could trust the long-lived large firms – the Bear Stearnses, the Merrill Lynches, the Lehman Brothers of the world – to monitor themselves, because they had accumulated sufficient ‘reputation capital’ that they would not want to waste it.” In other words, we could trust their brand. “We should not have put our faith in individuals monitoring others simply because they were part of larger organizations,” Acemoglu added.
I believe this should have been obvious, particularly to an economist. I’ll come back to this, but first let’s go on to the more sweeping indictment in the essay by Colander et al, titled “The Financial Crisis and the Systemic Failure of the Economics Profession.”
I find this article deeply satisfying because what it says is precisely what I thought when I first went to an economics conference many years ago. At the time, I was a newly minted Ph.D. in mathematics who happened to have joined a brokerage firm, knowing exactly zero about economics.
I told my mathematician friends after: “These people ought to decide whether they want to be pure mathematicians, in which case they will have to do a lot better mathematics, or whether on the other hand they want to apply mathematics to solve real-world problems, in which case their sloppy mathematics and absurdly unrealistic assumptions will never work.”
In fact, I really think that almost anybody who is not indoctrinated in the economics profession would think there’s something fundamentally strange about the ill-constructed castles in the air that it builds to try to apply to real-world situations. I can’t reconstruct here all of the points that the coauthors make in their paper – which I recommend to anyone with half an interest, as I recommend the entire book – but I can tell you that it validates all of my first doubts about the profession as a naïve outsider.
The paper’s bottom line is that “Economists, like all scientists, have an ethical responsibility to communicate the limitations of their models and the potential misuse of their research. Currently, there is no ethical code for professional economic scientists. There should be one.”
Evidently the authors feel that economists have allowed their theoretical models to be used without communicating their limitations, at least without communicating them forcefully enough. It takes two to do this particular tango, and one could also indict those who apply the implications of the models without taking seriously enough the caveats issued by the model-makers.
The externality of the individual employee
Surprisingly, no one in this book makes what will be my final observation, and even the astute Posner, while closing in on it, doesn’t touch this point.
In economics – especially in a field I have recently taught, environmental economics – there’s a standard terminology, “externality,” or external costs, to refer to a cost imposed on a third party or parties by a transaction between two consenting parties. For example air or water pollution is an externality. It is generally recognized that to “internalize” that cost, in other words to factor it into the parties’ cost-benefit analysis, there needs to be governmental intervention in the form of regulation.
Posner absolves the banking community of responsibility for preventing systemic risk, saying that “The responsibility for preventing external costs … is the government’s.”
He should have taken this one step deeper by mentioning that within a firm, the responsibility for preventing firm risk is not the individual employee’s; it’s the firm’s. Risks that individual employees and divisions took had externalities for the wider organization, but firms were too often delinquent in addressing this problem.
Recall Acemoglu’s point that economists believed that firms would protect their brand, even if individual employees didn’t. It also comes down to the question of how employees are compensated, which before and during the crisis – and still now – provides an incentive to take risks that endanger both the firm and the entire financial system.
But besides the danger to financial firms and the financial system, there is an even broader societal issue. One of the worst features of the financial industry, as it is still set up, is that it causes large amounts of money to flow from the relatively poor masses, to an extremely rich few, getting little value in return. This occurs because so many industry providers methodically and expertly mislead buyers as to how much they pay and what they get for it. It’s a relatively recent and malignant development, one for which you can’t blame only misregulation. Something will have to be done about it, sooner or later.
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