Chairman Frank, Ranking Member Bachus, and CommitteeMembers:
Let me begin by expressing my thanks for the opportunity topresent my views on the matter before this committee.
The question I will address in my testimony is whether Congressshould adopt Title XII of the proposed Resolution Authority forLarge, Interconnected Financial Companies Act of 2009. This Actwould grant the Federal Deposit Insurance Corporation (FDIC) powersfor resolving insolvent non-bank financial institutions similar tothose the FDIC currently possesses for resolving banks. My answerto the question is an emphatic and unequivocal "No." Let meexplain.
The fundamental problem that resolution systems attempt toaddress is that when a financial or other institution fails, thevalue of the claims on that institution's assets exceed the valueof the assets themselves. Thus, someone must decide who gets what,and it is impossible - by virtue of the assumption that we aredealing with a failed institution - to make everyone whole. Thesize of the pie owned by the failing institution has shrunk, sothose who were expecting a slice of that pie face, collectively,the necessity of going somewhat or substantially hungry. Theresolution authority decides who gets moderately well-fed and whostarves, but the unchangeable reality is that someone goeswanting.
It is in society's broad interests to have clear, simple, andenforceable procedures for resolving failed institutions,principally to insure that investors are willing to commit theirfunds in the first place. If the rules about resolution werearbitrary or ever-changing, investors would be loath to invest, andeconomic investment, productivity, and growth would be greatlyreduced. A well-functioning resolution process is part of a goodsystem for defining and enforcing property rights, which economistsbroadly agree is essential to a smoothly functioning, capitalistsystem.
The crucial thing to remember here is that someone has to lose.Just as importantly, it is actually valuable to society as a whole,although not to the directly harmed parties, that those whoinvested in the failed institutions suffer economic losses. Thisprocess releases resources to better uses, it provides signals tothe economy about what are good and bad investments, and it rewardsthose who made smart economic decisions rather than less adeptones. When an economic activity has not turned out well, denyingthis simple reality makes matters worse.
The flip side of the fact that standard resolution systems, likebankruptcy, impose an institution's losses on that institution'sstakeholders, is the fact that a standard resolution authority -such as a federal court - puts none of its own resources into thefailed institution, nor does it ever own the failed institution'sassets, or make it loans, or anything like that. The resolutionauthority is resolving claims and dividing the pie; it is notadding more pie that it has taken from somewhere else.
Under the powers that would be granted to the FDIC under thebill being considered, however, the FDIC would have the power tomake loans to the failed institution, to purchase its debtobligations and other assets, to assume or guarantee thisinstitution's obligations, to acquire equity interests, to takeliens, and so on. This means the FDIC would be putting its own -that is to say, the taxpayers's - skin in the game, a radicaldeparture from standard bankruptcy, and an approach that mimicsclosely the actions the U.S. Treasury took under TARP. Thus, thisbill institutionalizes TARP for bank holding companies.
A crucial implication of this departure from standard bankruptcyis that taxpayer funds foot the bill for the loans, assetpurchases, guarantees, and other kinds of financial support thatFDIC would provide to prevent failing institutions from goingunder. These infusions of taxpayer funds come with littlemeaningful accountability; it will be impossible to know that theyhave been paid back, and often that will not occur. The proposednew authority for FDIC also generates the impression that societycan avoid the losses that failures imply, but that is false: theproposed FDIC actions would merely shift those losses to taxpayers.The new approach is institutionalized bailouts, plain andsimple.
Thus, under the expansion of FDIC resolution authority to covernon-bank financial institutions, bank holding companies wouldforever more regard themselves as explicitly, not just implicitly,backstopped by the full faith and credit of the U.S. Treasury. Thatis moral hazard in the extreme, and it will be disastrous forkeeping a lid on inappropriate risk-taking by theseinstitutions.
Now, a possible response to my concerns might be that the FDICis already the resolution authority for banks, which makes sensegiven its role in insuring deposits, so extending this authority toinclude bank holding companies might seem to be a logical step. Inparticular, many have argued that under current law, the FDIC doesnot have the authority to resolve the banks owned by bank holdingcompanies, which leaves it in limbo with respect to insureddeposits at those institutions.
This legal grey area is a potential concern, but the rightresponse is to modify that aspect - and only that aspect - ofexisting FDIC authority, not to grant it the vastly expanded powersunder the proposed bill.
This technicality aside, then, the right alternative toexpanding FDIC authority - that is, to the bailout approach - isgood old-fashioned bankruptcy. It has become "accepted wisdom" thatbankruptcies by financial institutions cause great harm, and it isasserted in particular that letting Lehman Brothers fail lastSeptember was the crucial misstep that caused the financial crisis.In fact, nothing could be further from the truth.
As I explain in more detail in my written testimony - a paperrecently published in the Cato Journal - the ultimatecauses of the financial crisis were two misguided federal policies,namely, the enormous subsidies and pressures provided for mortgagelending to non-credit-worthy borrowers, and the implicit guaranteesprovided by both Federal Reserve actions and the U.S. history ofprotecting financial institution creditors. These forces generatedan enormous misallocation of investment capital away from plant andequipment toward housing, created a housing price bubble, andestablished a setting where numerous financial institutions wereinevitably going to fail because their main assets - the onesbacked by housing - were highly overvalued relative to economicfundamentals. Lehman's failure was one part of the adjustment thissituation implied, and a necessary part. If anything, too fewfinancial institutions have failed or shrunk, since the massiveinterventions in credit and housing markets that have occurred overthe past year have artificially propped up housing prices, delayingmore inevitable adjustments.
Thus the better way to resolve non-bank financial institutionsis bankruptcy, not bailout. This is not to say that existingbankruptcy law is perfect; one can imagine ways it might be fasterand more transparent, which would probably be beneficial. Norshould one assume that, had bankruptcy been allowed to operatefully in the Fall of 2008, the economy would have escaped withoutsome degree of panic and recession. A significant economicdownturn, in particular, was both inevitable and necessary giventhe fundamental misallocation of capital that had occurred in theyears preceding the panic. But nothing in historical data or recentexperience suggests these bankruptcies would have caused anythingworse than what we have experienced, and broader bankruptcy wouldhave meant that in future both banks and non-banks would recognizethat the losses from excessive risk-taking must be borne by thosewho take these risks.
In light of these assessments, I urge the members of thiscommittee to vote against this bill, since it codifies an approachto resolution that is fundamentally misguided. We need to learnfrom our mistakes and trust bankruptcies, not bailout, goingforward, as we should have done in the recent past.
Thank you for your time and attention.
Bailout or Bankruptcy?
A Libertarian Perspective on the Financial Crisis
From Cato Journal, Vol. 29, No. 1 (Winter 2009).
by Jeffrey A. Miron
At the end of September 2007, the U.S. economy had experienced24 consecutive quarters of positive GDP growth, at an averageannual rate of 2.73 percent. The S&P 500 Index stood at roughly1,500, having rebounded over 600 points from its low point in 2003.Unemployment was below 5 percent, and inflation was low andstable.
Roughly 12 months later, in September 2008, U.S. TreasurySecretary Henry Paulson announced a major new intervention in theU.S. economy. Under the bailout plan, as explained at the time, theTreasury proposed holding reverse auctions in which it would buythe troubled assets of domestic financial institutions.1 Further, as the plandeveloped, Treasury proposed using taxpayer funds to purchaseequity positions in the country's largest banks. These policiesaimed to stabilize financial markets, avoid bank failures, andprevent a credit freeze (see Paulson 2008).
In the weeks and months after Paulson announced the bailout,enormous changes occurred in the U.S. economy and in the globalfinancial system. Stock prices fell sharply, housing pricescontinued the decline they had begun in late 2006, and the realeconomy contracted markedly. The House of Representatives initiallyvoted down the bailout bill, but Congress approved an expandedversion less than a week later. The Federal Reserve and othercentral banks pursued a range of rescue efforts, including interestrate cuts, expansions of deposit insurance, and the purchase ofequity positions in banks.
In this article, I provide a preliminary assessment of thecauses of the financial crisis and of the most dramatic aspect ofthe government's response-the Treasury bailout of Wall Streetbanks. My overall conclusion is that, instead of bailing out banks,U.S. policymakers should have allowed the standard process ofbankruptcy to operate.2 This approach would not have avoidedall costs of the crisis, but it would plausibly have moderatedthose costs relative to a bailout. Even more, the bankruptcyapproach would have reduced rather than enhanced the likelihood offuture crises. Going forward, U.S. policymakers should abandon thegoal of expanded homeownership. Redistribution, if desirable,should take the form of cash transfers rather than interventions inthe mortgage market. Even more, the U.S. should stop bailing outprivate risk takers to avoid creating moral hazards.
The article proceeds as follows. First, I characterize thebehavior of the U.S. economy over the past several years. Next, Iconsider which government polices, private actions, and outsideevents were responsible for the crisis. Finally, I examine thebailout plan that the U.S. Treasury adopted in response to thecrisis.
I begin by examining the recent behavior of the U.S. economy.This sets the stage for interpretation of both the financial crisisand the bailout.
Figure 1 shows thelevel of real GDP over the past five years.3 GDP increased consistently and stronglyuntil the end of 2006, and then again during the middle of 2007.GDP fell in the final quarter of 2007, rose modestly during thefirst half of 2008, and then declined again in the third quarter of2008. Thus, GDP grew on average over the first three quarters of2008, but at a rate considerably below the post-war average (1.05percent vs. 3.27 percent at an annual rate).
Figures 2-4 presentdata on industrial production, real retail sales, and employment.For industrial production, growth was robust for several years butflattened in the second half of 2007 and turned negative by thesecond quarter of 2008. A similar pattern holds for retail sales,except that the flattening occurred in the final quarter of 2007and negative growth began in December 2007. For employment, theflattening also occurred in the final quarter of 2007 and negativegrowth began in December 2007.
The overall picture is thus consistent across indicators. Asignificant slowdown in the U.S. economy began in the final quarterof 2007 and accelerated during early 2008. This performance isconsistent with the determination by the National Bureau ofEconomic Research's Business Cycle Dating Committee that arecession began in December 2007 (seewww.nber.org/cycles/dec2008.html).
Figure 5 shows theCase-Shiller Housing Price Index, adjusted for inflation, for theperiod 1987-2008. Housing prices increased enormously over1997-2005, especially in 2004 and 2005. The increase was large,roughly 80-90 percent in real terms. From the end of 2005, housingprices declined slowly through early 2007 and then at anaccelerating pace from that point. Despite these declines, housingstill appeared to be overvalued in late 2008 and needed to fallanother 20-30 percent to reach the pre-2001 level.
Figure 6 shows theU.S. homeownership rate for the past four decades. Afterfluctuating in the 63-66 percent range for about three decades,homeownership began increasing in the mid 1990s and climbed tounprecedented values in the subsequent decade. Beginning in 2005the rate stabilized and declined slightly, but in 2008 it was stillwell above the level observed for most of the sample.
Figure 7 displaysresidential investment in the United States over the past severaldecades. Housing construction fluctuated substantially butdisplayed an overall upward trend through the early 1990s. Fromthat point the trend accelerated and continued for over a decadebefore beginning a marked decline starting in early 2006. Evenafter the substantial decline, however, housing investment in late2008 was about where one would have predicted based on the trendline through the mid-1990s.
For 10-12 years, therefore, the U.S. economy invested in housingat a rate above that suggested by historical trends. This boomcoincided with a substantial increase in homeownership. These factssuggest that the United States overinvested in housing during thisperiod. Housing prices rose substantially over the same period. Thefact that housing quantity and price increased together suggeststhat higher demand for housing was a major determinant of thehousing boom.
Figure 8 shows thereal value of the S&P 500 stock price index over the past 150years. This value soared during the 1990s to a level above thatimplied by historical rates of return, and growth after 9/11 andthe 2001 recession was robust. Even after the large declines in thefall of 2008, therefore, the market was not obviously below areasonable estimate of its long-term trend. Standard predictors ofstock prices, such as the price-earnings ratio, tell the samestory.4
Figure 9 shows theeffective federal funds rate, a standard measure of the stance ofmonetary policy. The low rate from the early 2000s through much of2004 was plausibly one factor in the housing and stock marketbooms. Inflation was low and stable during this period, averaging2-3 percent for the most part, so the real interest rate wasnegative. This implies that the demand for stocks and housingshould have expanded, driving up their prices. The substantialincrease in interest rates from mid-2004 through mid-2006 isplausibly one factor that slowed the economy starting in2007.5
To summarize, the U.S. economy had overinvested in housing as ofearly 2006, and housing and stock prices were high relative tohistorical norms. Thus, the economy was misaligned, and a majoradjustment-such as a recession-was plausibly necessary to correctthe misallocation. The subsequent declines in housing and stockprices (along with the increase in oil prices) reduced theeconomy's real wealth, providing one impetus for a slowdown.Monetary policy stimulated during much of the boom and contractedin advance of the slowdown.6
What Caused the Economic Events of the Past FiveYears?
Policymakers, pundits, and academics have blamed the financialcrisis on various factors, such as excessive risk taking by theprivate sector, inadequate or inappropriate regulation, deficientrating agencies, and so on. My assessment is that all these factorsplayed a role, but the crucial, underlying problem was misguidedfederal policies.7
The first misguided policy was the attempt to increasehomeownership, a goal the federal government has pursued fordecades. A (partial) list of policies designed to increasehomeownership includes the Federal Housing Administration, theFederal Home Loan Banks, Fannie Mae, Freddie Mac, the CommunityReinvestment Act, the deductibility of mortgage interest, thehomestead exclusion in the personal bankruptcy code, thetax-favored treatment of capital gains on housing, the HOPE forHomeowners Act, and, most recently, the Emergency EconomicStabilization Act (the bailout bill).8
Government efforts to increase homeownership are problematic.Private entrepreneurs have adequate incentives to build and sellhouses, just as individuals and families have adequate incentivesto purchase them. Thus, government intervention to expandhomeownership has no justification from an efficiency perspectiveand is instead an indirect method of redistributing income. Ifgovernment redistributes by intervening in the mortgage market,however, it creates the potential for large distortions of privatebehavior.
The U.S. government's pro-housing policies did not havenoticeable negative effects for decades. The reason is likely thatthe interventions mainly substituted for activities the privatesector would have undertaken anyway, such as providing a secondarymarket in mortgages.
Over time, however, these mild interventions began to focus onincreased homeownership for low-income households. In the 1990s,the Department of Housing and Urban Development ramped up pressureon lenders to support affordable housing. In 2003, accountingscandals at Fannie and Freddie allowed key members of Congress topressure these institutions into substantial risky mortgagelending.9 By2003-04, therefore, federal policies were generating strongincentives to extend mortgages to borrowers with poor creditcharacteristics. Financial institutions responded and created hugequantities of assets based on risky mortgage debt.
This expansion of risky credit was especially problematicbecause of the second misguided federal policy, the long-standingpractice of bailing out failures from private risk-taking. Asdocumented by Laeven and Valencia (2008), bailouts have occurredoften and widely, especially in the banking sector. In the contextof the recent financial crisis, a crucial example is the nowinfamous "Greenspan put," the Fed's practice under Greenspan oflowering interest rates in response to financial disruptions in thehope that expanded liquidity would prevent or moderate a crash inasset prices. In the early 2000s, in particular, the Fed appearedto have made a conscious decision not to burst the housing bubbleand instead "fix things" if a crash occurred.
The banking sector's history of receiving bailouts meant thatfinancial markets could reasonably have expected the government tocushion any losses from a crash in risky mortgage debt.10 Since government wasalso exerting pressure to expand this debt, and since it wasprofitable to do so, the financial sector had every reason to playalong.11 It wasinevitable, however, that at some point a crash would ensue. Asexplained in Gorton (2007), the expansion of mortgage credit madesense only so long as housing prices kept increasing, but thiscould not last forever. Once housing prices began to decline, themarket had no option but to suffer the unwinding of the positionsbuilt on untenable assumptions about housing prices.
This interpretation of the financial crisis therefore putsprimary blame on federal policy rather than on Wall Street greed,inadequate regulation, failures of rating agencies, orsecuritization. These other forces played important roles, but itis implausible that any or all would have produced anything likethe recent financial crisis had it not been for the two misguidedfederal polices.12 Wall Street greed, for example, certainlycontributed to the situation if, by greed, one means profit-seekingbehavior. Many on Wall Street knew or suspected that their riskexposure was not sustainable, but their positions were profitableat the time. Further, markets work well when private actors respondto profit opportunities, unless these reflect perverse incentivescreated by government. The way to avoid future crises, therefore,is for governments to abandon policies that generate suchincentives.
Was the Treasury Bailout Good Policy?
The Treasury's bailout plan was an attempt to improve bankbalance sheets and thereby spur bank lending. The justificationoffered was that, as of early September 2008, major banks werefacing imminent failure because their mortgage-backed assets haddeclined rapidly in value.
No one disputes that several banks were in danger of failing,but this does not justify a bailout. Failure is an essential aspectof capitalism. It provides information about good and badinvestments, and it releases resources from bad projects to moreproductive ones. As noted earlier, housing prices and housingconstruction were too high at the end of 2005. This conditionimplied a deterioration in bank balance sheets and a retrenchmentin the banking sector, so some amount of failure was bothinevitable and appropriate.
Thus, an economic case for the bailout needed to show thatfailure by some banks would harm the economy beyond what wasunavoidable due to the fall in housing prices. The usual argumentis that failure by one bank forces other banks to fail, generatinga credit freeze. That outcome is possible, but it does not mean theTreasury's bailout plan was the right policy.
To see why, note first that allowing banks to fail does not meanthe government plays no role. Federal deposit insurance wouldprevent losses by insured depositors, thus limiting the incentivefor bank runs. Federal courts and regulatory agencies (such as theFDIC) would supervise bankruptcy proceedings for failedinstitutions. Under bankruptcy, moreover, the activities of failingbanks do not necessarily disappear. Some continue duringbankruptcy, and some resume after sale of a failed institution orits assets to a healthier bank. In other cases, merger in advanceof failure avoids bankruptcy entirely. Private shareholders andbondholders take the losses required to make these mergers andsales attractive to the acquiring parties. Taxpayer funds go onlyto insured depositors (see Fama 2009, Zingales 2008).
Consider, therefore, how bailout compares to bankruptcy fromthree perspectives: the impact on the distribution of wealth, theimpact on economic efficiency, and the impact on the length anddepth of the financial crisis.
From a distributional perspective, bailout is unambiguouslyperverse; it transfers resources from the general taxpayer towell-off economic actors who profited from risky investments. Thisis not a criticism of risk-taking; that is appropriate so long asthose benefiting in good times bear the costs in bad times. This isexactly what occurs under the bankruptcy approach.
From an economic efficiency perspective, bailout is againproblematic. Mere consideration of a bailout distracts attentionfrom the fact that government was the single most important causeof the crisis. Relatedly, bailout creates a moral hazard, therebygenerating excessive risk-taking in the future. Bailouts oftenadopt goals that are not economically sensible, such as propping uphousing prices, limiting mortgage defaults, or preventing thefailure of insolvent institutions. More broadly, a bailoutencourages perverse actions by institutions that are eligible forthe money, such as acquiring toxic assets that the Treasury mightbuy or taking huge risks with Treasury capital injections.
The Treasury bailout of 2008 also initiated a governmentownership stake in the financial sector. This means that, goingforward, political forces are likely to influence decisionmaking inthe extension of credit and the allocation of capital. Government,for example, might push banks to aid borrowers with poor credithistories, to subsidize politically connected industries, or tolend in the districts of powerful legislators. Government pressureis difficult for banks to resist, since government can threaten towithdraw its ownership stake or promise further injections wheneverit wants to modify bank behavior. Further, bailing out banks sets aprecedent for bailing out other industries. Thus, the long-runimplications of bailout are unambiguously bad.
Bailout is superior to bankruptcy, therefore, only if allowingbank failures would cause or exacerbate a credit crunch. Neithertheory nor evidence, however, makes a compelling case for such aneffect. As a theoretical matter, failure by a bank means that itcannot extend credit, but this means a profit opportunity existsfor someone else. As an empirical matter, it is difficult toestablish whether panics cause credit freezes or underlying adverseshocks to the economy cause both reduced lending and panics. BenBernanke's famous paper on the Great Depression (Bernanke 1983)suffers exactly this problem; it shows that bank failures andoutput losses are correlated, but it does not pin down thedirection of causation.
This is not to deny that credit freezes occur and cause harm,nor to assert that credit markets would have been healthy under thebankruptcy approach. Rather, the claim is that overinvestment inhousing and the excessive level of housing prices that existed inthe United States meant that an unwinding was necessary to make theeconomy healthy. This restructuring implied reduced residentialinvestment, declines in housing prices, plus shrinkage andconsolidation of the banking sector. All of this would plausiblyhave generated a recession, even without any credit freeze, and therecession-along with increased awareness of the risks of mortgagelending-would have caused lending to contract, again even without acredit crunch. Thus, it is not obvious how much of the creditfreeze was due to bank failures versus negative shocks to theunderlying fundamentals.
In fact, the bailout might have exacerbated the credit crunch.The announcement that the Treasury was considering a bailout likelyscared markets by suggesting the economy was worse than marketsrecognized (see Macey 2008). Likewise, the announcement may haveencouraged a credit freeze because bankers did not want to realizetheir losses or sell their institutions to acquiring firms ifgovernment was going to get them off the hook. The bailoutintroduced uncertainty because no one knew what the bailout meant:how much, what form, for whom, for how long, with whatrestrictions, and so on.13 The bailout also did little to makebank balance sheets transparent, yet the market's inability todetermine who was solvent was plausibly a key reason for thefreeze. Plus, banks can respond to capital injections by payingbonuses to executives and dividends to shareholders, or by hoardingcash; nothing guarantees they will lend out capitalinjections.14
Thus, the bailout had huge potential for counterproductiveimpacts and at best an uncertain prospect of alleviating the creditcrunch or ameliorating the recession. This means that allowingfurther failures would have been a price worth paying. Inparticular, the process of failure and bankruptcy would havecountered the financial sector's temptation to "bank" on governmentlargesse, so the bankruptcy approach would have created betterincentives going forward for private behavior towardrisk.
Lessons for the Future
In my assessment, the financial crisis yields two main lessons.The first is that redistribution to low-income households should bedirect and on budget, not indirect and off-budget, as in subsidizedmortgage credit. The second lesson is that the moral hazards frombailing out private risk-taking are substantial, even when these donot always appear immediately.
Adjusting policy to incorporate the first lesson is relativelyeasy: it requires elimination of specific, pre-existing policiessuch as Fannie Mae, Freddie Mac, the Federal HousingAdministration, and so on. This might be hard politically, but atleast the target is well defined.
Adjusting policy to avoid the creation of moral hazard isharder. A few specific programs, such as the Pension BenefitGuarantee Corporation, are ripe for elimination from thisperspective, but policymakers have many ways to bail out privaterisk-taking. Even elimination of agencies like the FDIC and theFederal Reserve-setting aside whether this makes senseoverall-would not prevent a determined Treasury from bailing outbanks. Thus, the only real constraint on such flawed governmentpolicy is increased recognition of its long-term costs.
1 I use theterms financial institution and bank interchangeably to includeboth banks and investment banks. The distinction became irrelevanton September 22, 2008, when the last major investment banks(Goldman Sachs and Morgan Stanley) became traditional bankinginstitutions.
2 To simplifythe discussion, I use the term bankruptcy to indicate any officialreorganization or liquidation procedure, meaning both those underthe bankruptcy code and those conducted by regulatory bodies suchas the FDIC. The former applies to nonbanks, the latter tobanks.
3 The data onGDP (GDPC1), industrial production (INDPRO), real retail sales(RRSFS), employment (USPRIV), residential investment (PRFIC1), theCPI (CPIAUCSL), and the federal funds rate (FEDFUNDS) are from theSt. Louis Federal Reserve data bank,http://research.stlouisfed.org/fred2/. The Case-Shiller housingprice data are from Standard and Poor's,http://www2.standardandpoors.com/portal/site/sp/en/us/page.topic/indice… data on homeownership are from the U.S. Census,http://www.census.gov/hhes/www/housing/hvs/historic/index.html. Thedata on stock prices are from Shiller (2000), updated athttp://www.irrationalexuberance.com/.
4 For furtherexamination of this issue, see Cochrane (2008) and Hamilton(2008).
5 An additionalcause of low real interest rates may have been a surge in thedemand for U.S. assets (a savings glut) caused by global financialimbalances. See Caballero, Fahri, and Gourinchas (2008).
6 See Mulliganand Threinen (2008) for a more detailed analysis of the role ofwealth effects in the propogation of the financial crisis.
7 For analysessimilar to that presented here, see Dorn (2008) and Taylor (2009).For alternative views about the causes of the crisis, see Baily,Litan, and Johnson (2008), Brunnermeier (2008) and Hall andWoodward (2008).
8 See Slivinski(2008) for further discussion of the government role in promotinghomeownership.
9 See Roberts(2008), Leibowitz (2008), Wallison and Calomiris (2008), White(2008), and Pinto (2008).
10 Gerardi etal. (2008) find that analysts in the mortgage market realized thata fall in housing prices would mean a drastic fall in the value ofmortgage assets, but assigned only a low probability to thatoutcome. One interpretation is that the analysts (and theiremployers) trusted the Greenspan put to keep prices fromfalling.
11 A mandatethat banks issue risky debt might not generate significant problemsif the risk is appropriately priced (Stock 2008). When governmentmandates that banks issue debt they would not have provided ontheir own, however, a market-clearing price might not exist. Animplicit government guarantee of this debt, moreover, virtuallyensures the risk will be underpriced.
12 SeeKashyap, Rajan, and Stein (2008) or Calomiris (2008) for adiscussion of the regulatory issues and Lucchetti and Ng (2007) fora discussion of the role of ratings agencies.
13 Higgs(1997) provides suggestive evidence that uncertainty created bypolicymakers contributed to the length of the Great Depression.
14 See Bordoand Schwartz (1998, 2000) for evidence on both the tendency forbailouts to exacerbate moral hazard and the ability of bailouts toimprove economic performance.
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