I emphatically disavow the extreme partisan narratives for this crisis. To blame the Community Reinvestment Act for what happened is wrong, To blame financial deregulation for what happened is wrong. The narrative I present following this executive summary describes a combination of government failure and market failure.
I blame excessive securitization, induced by regulatory anomalies, particularly with regard to capital requirements. These anomalies were responsible for the unwarranted expansion of Fannie Mae and Freddie Mac as well as for bank participation in the phenomenon of private securitization of subprime mortgages.
I also blame mortgages with low down payments. Such mortgages encourage speculation and destabilize the mortgage market. With borrowers’ equity consisting almost entirely of house price appreciation, in a rising market nearly anyone can buy a home; but when 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 mortgage securities and credit default swaps, that overloaded the mental circuits of industry executives and regulators.
Mortgage securitization is not inherently efficient. It owes its growth to anomalies in accounting and regulatory treatment.
When a bank originates a low-risk mortgage, why would the bank pay Freddie Mac a fee to guarantee that mortgage against default? Freddie Mac has no intrinsic comparative advantage in bearing the credit risk. However, in practice, the bank is able to reduce its capital requirements by exchanging its loans for securities. For bearing the exact same credit risk, Freddie Mac will be allowed by its regulator to hold less capital than the bank. With securitization, the credit risk goes to where the capital regulation is softest. If there were no regulatory differential, the bank might keep the loan in order to avoid the unnecessary transaction costs of securitizing it.
The regulatory anomaly is even more striking with high-risk loans. If a bank originates a high-risk loan, you would think that there is no way to avoid high capital requirements. However, it turns out that when the loan has been laundered by Wall Street, it can come back into the banking system in the form of a AA-rated security tranche. Most of the true risk is still there, but that risk is now hidden from capital requirements.
Letter-of-law Regulation is thwarted by financial innovation.
The unwarranted growth of mortgage securitization illustrates a problem known as regulatory arbitrage. Financial innovation interacts badly with what I call letter-of-the-law regulation. With letter-of-the-law regulation, we give financial institutions specific requirements, such as the precise asset weights used in risk-based capital for banks under the Basel agreement. We tell executives that as long as their institutions meet those requirements, they are fine. The problem is that with rapid financial innovation, firms are able to stay within the letter of the law while at the same time subverting the purposes of regulation and violating their responsibility to maintain safety and soundness.
I am not a lawyer, so I do not know if there is any plausible alternative to letter-of-the-law regulation. However, I wish that somehow the executives of financial institutions that rely on explicit or implicit government guarantees could be made to comply with the spirit of regulation. I wish that they took some sort of oath to protect taxpayers from risks, and I wish that violation of that oath carried with it serious penalties, including prison.
Suits vs. Geeks
In my opinion, the innovations in mortgage finance over the past twenty years have gone beyond the ability of industry executives and regulators to manage. Financial engineers and key decision-makers were not on the same page concerning the new financial instruments. This suits vs. geeks divide meant that executives were making decisions based on a distorted assessment of the risks involved.
Even now, Paul Volcker, Eugene Ludwig, Ben Bernanke, Henry Paulson, and other important public figures view the crisis through lenses that are very different from mine. To me, this is not a re-run of the bank failures of 1932, nor is it a rerun of the savings-and-loan crisis of 1980. There is a new transmission mechanism at work, particularly in the form of credit default swaps.
After the executive summary, I offer a history of mortgage securitization and the financial crisis. The implications of this history for policy are the following:
- Mortgages with low down payments are conducive to speculation in housing. This is risky for individual homeowners and destabilizing for the market as a whole. The goal of broadening home ownership should be addressed in ways that do not encourage speculative purchases.
- Securitization is not necessary for mortgage lending. On a level regulatory playing field, traditional mortgage lending by depository institutions probably would prevail over securitized lending. The mortgage market can function without Freddie Mac and Fannie Mae.
- Bank capital requirements for sound mortgages are overly onerous. Reducing capital requirements for loans with reasonable down payments would help lower mortgage interest rates.
- There were specific mistakes made in the management and regulation of Freddie Mac and Fannie Mae. When, as at Freddie Mac, the chief risk officer warns that your mortgage lending policies are ill-advised, I can think of more appropriate responses than firing the chief risk officer. Also, the regulation of Freddie Mac and Fannie Mae appears to me to have been emasculated, in large part due to the combination of heavy-handed lobbying by the two firms and Congressional meddling with the regulatory process. Certainly, performance could improve with better leadership and better regulation. However, the easiest way to prevent future problems at Freddie Mac and Fannie Mae would be to let the mortgage lending function revert to depository institutions.
- The credit default swap is not a transaction that should be encouraged.
- Financial innovation in general does not blend well with letter-of-the-law regulation. If financial executives cannot be punished for violating the spirit of regulations, then regulators will need to take a wary view of financial innovation. It can be difficult to distinguish innovations that provide genuine efficiency from those that serve mainly to facilitate regulatory arbitrage.
- Policymakers appear to me to be relying too heavily on vague analogies with past crises in designing their response to the current situation. A policy that relies on rescues and bailouts strikes me as counterproductive. Such actions serve to speed up a de-leveraging process that needs to slow down, and they slow down a process of closing failed institutions that needs to speed up.