I emphatically disavow the extreme partisan narratives for thiscrisis. To blame the Community Reinvestment Act for what happenedis wrong, To blame financial deregulation for what happened iswrong. The narrative I present following this executive summarydescribes a combination of government failure and marketfailure.
I blame excessive securitization, induced by regulatoryanomalies, particularly with regard to capital requirements. Theseanomalies were responsible for the unwarranted expansion of FannieMae and Freddie Mac as well as for bank participation in thephenomenon of private securitization of subprime mortgages.
I also blame mortgages with low down payments. Such mortgagesencourage speculation and destabilize the mortgage market. Withborrowers' equity consisting almost entirely of house priceappreciation, in a rising market nearly anyone can buy a home; butwhen prices stop climbing almost no one can buy a home.
Finally, I blame what I call the "suits vs. geeks" divide.Financial engineers created instruments, including exotic mortgagesecurities and credit default swaps, that overloaded the mentalcircuits of industry executives and regulators.
Mortgage securitization is not inherently efficient. Itowes its growth to anomalies in accounting and regulatorytreatment.
When a bank originates a low-risk mortgage, why would the bankpay Freddie Mac a fee to guarantee that mortgage against default?Freddie Mac has no intrinsic comparative advantage in bearing thecredit risk. However, in practice, the bank is able to reduce itscapital requirements by exchanging its loans for securities. Forbearing the exact same credit risk, Freddie Mac will be allowed byits regulator to hold less capital than the bank. Withsecuritization, the credit risk goes to where the capitalregulation is softest. If there were no regulatory differential,the bank might keep the loan in order to avoid the unnecessarytransaction costs of securitizing it.
The regulatory anomaly is even more striking with high-riskloans. If a bank originates a high-risk loan, you would think thatthere is no way to avoid high capital requirements. However, itturns out that when the loan has been laundered by Wall Street, itcan come back into the banking system in the form of a AA-ratedsecurity tranche. Most of the true risk is still there, but thatrisk is now hidden from capital requirements.
Letter-of-law Regulation is thwarted by financialinnovation.
The unwarranted growth of mortgage securitization illustrates aproblem known as regulatory arbitrage. Financial innovationinteracts badly with what I call letter-of-the-law regulation. Withletter-of-the-law regulation, we give financial institutionsspecific requirements, such as the precise asset weights used inrisk-based capital for banks under the Basel agreement. We tellexecutives that as long as their institutions meet thoserequirements, they are fine. The problem is that with rapidfinancial innovation, firms are able to stay within the letter ofthe law while at the same time subverting the purposes ofregulation and violating their responsibility to maintain safetyand soundness.
I am not a lawyer, so I do not know if there is any plausiblealternative to letter-of-the-law regulation. However, I wish thatsomehow the executives of financial institutions that rely onexplicit or implicit government guarantees could be made to complywith the spirit of regulation. I wish that they took some sort ofoath to protect taxpayers from risks, and I wish that violation ofthat oath carried with it serious penalties, including prison.
Suits vs. Geeks
In my opinion, the innovations in mortgage finance over the pasttwenty years have gone beyond the ability of industry executivesand regulators to manage. Financial engineers and keydecision-makers were not on the same page concerning the newfinancial instruments. This suits vs. geeks divide meant thatexecutives were making decisions based on a distorted assessment ofthe risks involved.
Even now, Paul Volcker, Eugene Ludwig, Ben Bernanke, HenryPaulson, and other important public figures view the crisis throughlenses that are very different from mine. To me, this is not are-run of the bank failures of 1932, nor is it a rerun of thesavings-and-loan crisis of 1980. There is a new transmissionmechanism at work, particularly in the form of credit defaultswaps.
After the executive summary, I offer a history of mortgagesecuritization and the financial crisis. The implications of thishistory for policy are the following:
- Mortgages with low down payments are conducive to speculationin housing. This is risky for individual homeowners anddestabilizing for the market as a whole. The goal of broadeninghome ownership should be addressed in ways that do not encouragespeculative purchases.
- Securitization is not necessary for mortgage lending. On alevel regulatory playing field, traditional mortgage lending bydepository institutions probably would prevail over securitizedlending. The mortgage market can function without Freddie Mac andFannie Mae.
- Bank capital requirements for sound mortgages are overlyonerous. Reducing capital requirements for loans with reasonabledown payments would help lower mortgage interest rates.
- There were specific mistakes made in the management andregulation of Freddie Mac and Fannie Mae. When, as at Freddie Mac,the chief risk officer warns that your mortgage lending policiesare ill-advised, I can think of more appropriate responses thanfiring the chief risk officer. Also, the regulation of Freddie Macand Fannie Mae appears to me to have been emasculated, in largepart due to the combination of heavy-handed lobbying by the twofirms and Congressional meddling with the regulatory process.Certainly, performance could improve with better leadership andbetter regulation. However, the easiest way to prevent futureproblems at Freddie Mac and Fannie Mae would be to let the mortgagelending function revert to depository institutions.
- The credit default swap is not a transaction that should beencouraged.
- Financial innovation in general does not blend well withletter-of-the-law regulation. If financial executives cannot bepunished for violating the spirit of regulations, then regulatorswill need to take a wary view of financial innovation. It can bedifficult to distinguish innovations that provide genuineefficiency from those that serve mainly to facilitate regulatoryarbitrage.
- Policymakers appear to me to be relying too heavily on vagueanalogies with past crises in designing their response to thecurrent situation. A policy that relies on rescues and bailoutsstrikes me as counterproductive. Such actions serve to speed up ade-leveraging process that needs to slow down, and they slow down aprocess of closing failed institutions that needs to speed up.