NOT WHAT THEY HAD IN MIND: A HISTORY OF POLICIES THAT PRODUCED THE FINANCIAL CRISIS OF 2008ARNOLD KLING SEPT ‘09

BRAD

JUNG

ROBERT

SAMANTHA

VARIAN

ARNOLD KLINGPhD Economics from MIT

Affiliated Senior Scholar at Mercatus Center at George Mason University

Worked as Economist for Freddie Mac and Federal Reserve

INTRODUCTION

• Examines the Roots of Financial Crisis

• Policy Considerations

• Alternative Causes of Crisis

FOUR COMPONENTS OF THE FINANCIAL CRISIS

• Bad Bets

• Ex. Subprime Mortgage Loans

• Excessive Leverage

• Domino Effects

• 21st-Century Bank Runs

• Kling emphasizes that the financial crisis required all four elements

CAUSAL RELATIONSHIPS

Policy Area Bad bets Leverage Domino effects Runs

Housing policy High No No No

Capital regulation Very high Very high Very high Very high

Industry structure No Very low Low Low

Innovation Low Low Low Low

Monetary policy Low Low No No

CAPITAL REGULATIONS• Most Important Causal Factor in the crisis

• Capital regulations encouraged bad bets financed using excessive leverage financial structures subject to domino effects and 21st century bank runs

PAST CRISES MAKE BAD POLICY

Housing Policy and Bank Regulatory Policy evolved out of previous crises

•Reshape of Mortgage Market in 1930

• 5 Year Balloon Mortgage 30 Year Fixed Rate Mortgage and creation of FHA, FNMA, and Federal Deposit Insurance

PAST CRISES MAKE BAD POLICY• 2nd Attempt at Reshaping Mortgage Market in 1970s-Late

1980s

• Savings and Loans Holding 30 year mortgages went under (Inflation and Rising Interest Rates)

• Excessive risk-taking due to Federal Deposit Insurance

• Policy makers after S&L Crisis promote

• Securitization of mortgages• Market-Value Accounting• Risk-Based Capital

PAST CRISES MAKE BAD POLICY

Regulator response to S&L Crisis contributed to most recent crisis

•Mortgage securities become “toxic assets”

•Risk-Based Capital and Market-Value Accounting contribute to domino effects:

1. Bank forced to sell mortgage-backed securities

2. Lowers market value of securities

3. Triggered write-downs at other banks due to market-value accounting

4. Put other banks below regulatory minimum for capital

HOUSING POLICY• Government encouraged home ownership

• Mortgage Interest Deduction• Capital Gains Tax Exclusion

• Eased mortgage writing standards

• Stated Income and Stated Asset Loans where income and assets did not have to be documented

• Cheaper

• Reduced documentation becomes a magnet for fraud

• Housing Prices began to fall in 2005

HINDSIGHT IS 20/20

Government could have avoided crisis by:•Forcing banks and mortgage institutions to hold more capital

•Cracking down on loose mortgage standards

• Political landscape during Clinton, Bush administrations made cracking down unlikely

BANK CAPITAL REGULATIONS• Outsourcing credit ratings

• Primary constituents were banks not investors• FED Researcher David Jones (2000)

• Shows support for securitization and off-balance sheet entities to reduce capital requirements

• Sympathetic Jailor• Essentially investors were purchasing assets with

attractive returns in which they thought there was little or no risk, yet these assets were backed by risky long-term mortgages

POSSIBLE BANK CAPITAL SOLUTION

Economists Susan Woodward and Robert Hall propose:

•Require banks to issue subordinated debt

• Gives a better market idea of risk• Investors demand interest rates given their perception of bank

risk

• Cushion for taxpayers• Convert to equity in times of crisis (Contingent Convertibles)

•Kling worries that new regulation will either fail to prevent or perhaps cause future financial crisis

EROSION OF COMPETITIVE BOUNDARIES

•Barriers to Entry

• Glass-Steagall (1933)• Constantly challenged by technology and innovation• Inherently disliked by economists• Kling believes the case to remove these barriers is sound

•Safety and Soundness

• Dilemma• Allow banks to expand into non-bank financial activities• Keep banks separate from certain financial activities

• Shadow Banking System

•Gary Gorton

• Paper written after financial crisis supports barriers to entry

FINANCIAL INNOVATION•Mortgage credit scoring replaces human underwriting in 1990s

• Saved fees• Finer grades of risk put into many risk buckets• Facilitated securitization by providing objective data for risk of

underlying mortgages•Structured Finance

• Credit risk split into three tranches• Senior tranches could obtain AA or AAA ratings

•Credit Default Swaps

• Insurance against default on security• Financial derivative but differ from currency or interest rate risk

(Coin Flip)•Innovations emerged as banks demanded AAA ratings to lower capital requirements

MONETARY POLICY•Kling provides evidence that housing bubble was caused by expansionary policies from ’01-’03

•Monetary policy should stabilize GDP and not financial markets

DOMINO EFFECTS AND BANK RUNS•Minsky and Galbraith suggest instability is a characteristic of financial markets

•Systematic Instability comes from signaling

• Government backing is an extremely valuable signal (FDIC)•Signals have slow upward growth but rapid downward growth

• Bank Runs

Non-financial markets Financial Markets

Short-Term Riskless Assets Long-Term Risky Assets

Long-Term Risky Liabilities Short-Term Riskless Liabilities

AIM FOR EASY TO FIX RATHER THAN HARD TO BREAK

•Encourage financial structures that involve less debt

•Tax policy encouraging Equity Financing

• (Dot Com Bubble)•Weaker correlations between institutions

CONCLUSION•Core of ‘08 crisis consisted of unsound practices in mortgage finance boosted by regulatory developments that:

• Essentially allowed for lower capital requirements• Encouraged securitization• Decreased lending standards• Financial innovations with negative consequences

• Credit Default Swaps

• Low rates contributed to housing boom• Did not enforce competitive boundaries allowing for “too big to

fail” bank size