Incentive Matters: Systemic Risk in the Financial Crisis

May/​June 2012 • Policy Report

The conventional narrative surrounding the subprime lending debacle rests upon the fundamentals of mass psychology: both borrower and lender behavior was irrational, the wisdom goes, which in aggregate caused the catastrophe to spread globally. But in “What Made the Financial Crisis Systemic?” (Policy Analysis no. 693), economists Patric H. Hendershott and Kevin Villani dispute this explanation. “Virtually all of the behavior that created the subprime lending debacle,” they write, “can be explained by incentive distortions.” The authors begin by tracing the “unique historical evolution of public intervention” in U.S. markets, beginning with the early origins of federal regulation, the development of government‐​sponsored enterprise (GSEs), and “the subsequent expansion of U.S. secondary markets in housing finance.” They show how “moral hazard created by the SEC and deposit insurance further undermined mortgage market discipline in the 1990s.” Hendershott and Villani go on to describe the origins and development of the subprime lending bubble, noting in particular how mission regulation “ended up competing with and ultimately undermining prudential regulation.” The authors conclude by offering the policy implications of their argument and the resulting recommendations, zeroing in on the more general problem that “federal regulators did not understand and mitigate systemic risk.” In the end, “it wasn’t the lack of regulatory authority, but rather its pervasiveness and widespread failure, that not only allowed but caused the subprime lending debacle.”

Funding Erosion in Pension Plans
“Pension and health care benefits provided to state and local government employees are considerably broader in coverage and more generous compared with those for private sector employees,” Cato senior fellow Jagadeesh Gokhale writes. In “State and Local Pension Plans: Funding Status, Asset Management, and a Look Ahead,” Gokhale offers a detailed description of the recent funding erosion that has occurred in these plans over the last decade. Controlling for the declines in pension plan asset values during the latest recession, he asks whether blame for this funding condition belongs to insufficient contributions — on the part of either employers or employees. He finds that some of the blame can be assigned to inadequate contributions overall. “The results suggest that pension authorities in small‐​government states exhibit greater fiscal responsibility in funding employee pensions and the generally well‐​off states with fewer federal dollars in total state spending make more timely and adequate contributions,” he writes. Gokhale notes furthermore that pension plans are operated by government entities that are unlikely to be shut down — and as such argues that it is worth examining how their funding conditions would change if future benefits are taken into account. While he finds that total state and local liabilities would be much larger, only some states would continue to struggle to improve their poor funding conditions, while others would likely improve over time. In the end Gokhale concludes that a significant portion of the deterioration happened in states with initially well‐​funded plans. “Much of the blame for this must be placed on the illogical accounting standards set by the Governmental Accounting Standards Board,” he writes.

Social Security: Privatize It
The recent volatility of capital markets has reinforced the widespread argument that private investment in personal retirement accounts is unacceptably risky. “I’d have thought, after being reminded how quickly the stock market can tumble … that no one would want to place bets with Social Security on Wall Street,” President Obama has said. But in “Still a Better Deal: Private Investment vs. Social Security” (Policy Analysis no. 692), senior fellow Michael Tanner provides substantial evidence that, in the long term, private capital investments are “a remarkably safe bet.” After running through several different hypothetical investment scenarios, Tanner finds that — in each instance — a worker would have received higher monthly benefits from private investment.

“In fact, even in the worst‐​case scenario, a low‐​wage worker who invests entirely in bonds, the worker does no worse than under Social Security,” he writes. Ultimately, the debate comes down to a question of risk. By its nature, Tanner notes, private capital investment will always contain a degree of uncertainty. Yet the current system is facing a $21 trillion shortfall in the future. As such, allowing workers to invest in a system of personal accounts involves “exchanging the political risks of an underfunded Social Security system for the market risks of private investment.” Tanner concludes that the choice is clear. According to the numbers, “the vast majority of younger workers would be better off switching to such a system.”

Mortgage Finance and the FHA
The government‐​sponsored enterprises Fannie Mae and Freddie Mac — along with many private subprime lenders — played the starring roles in the recent mortgage meltdown. But there were a number of supporting parts as well. In “Fixing Mortgage Finance: What to Do with the Federal Housing Administration?” (Briefing Paper no. 123), Mark Calabria, director of financial regulation studies at the Cato Institute, focuses on the most prominent. The Federal Housing Administration (FHA) — an agency tasked with insuring lenders against the risk of borrower default — was “one of the largest sources of credit for subprime borrowers.” Calabria delves into the history of the FHA, “which has been one of an almost constant reduction in standards, usually as an excuse to ‘restart’ the housing market.” The recent bust, he notes, has been similarly characterized by “governmental attempts to restart the bubble by transferring massive amounts of risk to the taxpayer” — and doing so at a great cost. The main problem with the FHA is that small changes in its portfolio can result in significant losses, potentially costing taxpayers more than the bank bailouts of the Troubled Asset Relief Program. Calabria therefore advocates a step toward sounder footing. The FHA should be scaled back immediately, he writes — with an emphasis on improving its credit quality — as a preliminary step toward terminating the agency in full. “Only then can we hope to avoid leaving the taxpayer holding the bag when the next bubble inevitably bursts,” he concludes.

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