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MoralHazardduringtheFinancialCrisisof2008andFutureImplicationsfortheUnitedStates

DylanMichaelRudolph

MichaelMunger,FacultyAdvisor

HonorsThesissubmittedinpartialfulfillmentoftherequirementsforGraduationwithDistinctioninPoliticalScienceintheTrinityCollegeofArts&SciencesatDukeUniversity

DukeUniversity

Durham,NorthCarolina

2020

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TableofContentsAbstract (3)Introduction (4) CentralArgument (6)OverviewofMoralHazard (9)Subsidies (13) Subsidy#1:FannieMae&FreddyMac (14) Subsidy#2:DiscountWindowLending (16) Subsidy#3:CentralBankBailouts (18) Subsidy#4:FederalDepositInsurance (20) Subsidy#5:InsuredFraudulentCharges (23)CaseStudy:WashingtonMutual (24)CompoundingEffects:DerivativesandCDOs (30)AnAlternativetoIncreasedRegulation (34)FutureImplications (36)WorksCited (39)

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Abstract

TheFinancialCrisisof2008islargelyunderstoodtobeastoryofbadactors,incentivized

byachainofdumpingoffdebtinvestmentrisktoanotherparty.Thisphenomenonwasseen

fromthehighestlevel,particularlywithWallStreetbanks,totheindividualmortgagelender

andallpartiesinbetween.ThispaperexplainsthattheCrisiswasindeedcausedbywhatwillbe

discussedas‘moralhazard,’butrefutesthecommonnotionthatmoralhazardwassystematic

tothefreefinancialmarket.Specifically,thispapercontendsthatgovernmentsubsidiesdid

moretopropupmoralhazardandallowfinancialinstitutionstotakeadvantageofalackof

institutionalriskthanhadtheseinstitutionsbeenleftalonealtogether.Throughanexamination

offivegovernmentsubsidiesaswellasacasestudyontheformerfinancialinstitution

WashingtonMutual,thispaperaffirmsthehypothesis,andpositsthatlessgovernment

intervention,althoughnotcompleteremoval,inregulatingfinancialinstitutionswilldobetter

tocreatelesssystematicpressuretocreatemoralhazardthanmoreintervention.

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Introduction

Economistshavelongstudiedthecausesandeffectsoftheinfamous2008Financial

CrisiswhichleadtoarecessionbothwithintheUnitedStatesandabroad.Anofficial

commissionlaunchedbytheU.S.federalgovernmenttoinvestigatethecausesofthecrisis

itselfyieldedconflictingexplanationsobviouslytiedtopartyaffiliationanddidnotproduceany

cleareconomicorpoliticalconsensus.StudyingtheCrisisisnotonlyenlighteningbutcrucialto

understand,asanuancedandholisticcomprehensionofitscausesandeffectscanhelpto

preventfuturecrises.TheCommission’sconclusionstatesthat“Ifwedonotlearnfromhistory,

weareunlikelytofullyrecoverfromit.SomeonWallStreetandinWashingtonwithastakein

thestatusquomaybetemptedtowipefrommemorytheeventsofthiscrisis,ortosuggest

thatnoonecouldhaveforeseenorpreventedthem…Itisanattempttorecordhistory,not

rewriteit,norallowittoberewritten.”1Preventingacrisisofthismagnitudefromhappening

againisandhasbeenatthetopofmindofourgovernmentforoveradecade.Withapotential

recessionloomingonthehorizonoverthenextyearortwo,studyingtheCrisisisnow,more

thanever,paramounttoeconomicdecision-making.

Further,itisusefultodistinguishthetruecausesofthecrisisfromlessimportantones,

anddiscoverwhatwastruly“unavoidable,”ifanything.Economists,politicians,andacademics

alikehavestruggledtodeterminewhetherthecrisis,fueledbymoralhazard,wasaresultof

governmentormarketfailure.Distinguishingbetweenthesetwopotentialcausesisalsoofthe

utmostimportancefortheFederalGovernment.EventheCommissionrecognizes“theFederal

Reserve’spivotalfailuretostemtheflowoftoxicmortgages,whichitcouldhavedoneby

1http://fcic-static.law.stanford.edu/cdn_media/fcic-reports/fcic_final_report_conclusions.pdf

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settingprudentmortgage-lendingstandards.”Aconclusionsupportingtheargumentthat

governmentfailurewasthecauseofthecrisis,ratherthanmarketfailure,wouldleadustoa

narrativethatthecrisiswasavoidabletosomeextent,andcanbeavoidedinthefutureif

necessaryprecautionsaretaken.

Itiswellknownthatfinancialcrisesleadtocontagionsthatcanaffectentireregions,

countries,andeventheworldinthecaseofthe2008Crisis.Preventingfuturecrisesisnotonly

beneficialforourselvesandourownbusinesses,buttheentireglobalmacroeconomy.Given

therapidincreaseinfinancializationinthelastfewdecades,macroeconomictrendsareyielding

resultsthataredrasticallycompounded.Forexample,theissuanceandsignificantriseinsales

ofOTC(“over-the-counter”)derivativesinformslikesyntheticcollateralizeddebtobligations

(“CDOs”)amplifiedthecrisis.Hadlargefinancialinstitutionsnotinventedthesecomplex

financialinstrumentsthatdependedonthestabilityofthehousingmarketandtheunderlying

mortgages,billionsofdollarswouldnothavebeenexposedtorisk.Understandingthecausesof

thecrisiswillhelpsignaltofinancialinstitutionsthekindsofinstrumentstheyshould,andmore

importantlyshouldnotbecreating.OneofthemaingripesexpressedbytheOccupyWallStreet

movementwasthefactthatlargeinvestmentbanksweresellingderivativessocomplexthat

eventhebankersthemselvesdidnotunderstandwhattheyweremarketingandsellingto

clients.Whilefuturerecessionsmaybeunavoidable,giventhenaturalexpansionand

contractionofglobalcapitalmarkets,wecanundoubtedlytakestepstoreducethe

magnificationofsuchphenomena.Assuch,thispiecewillbringtolightchannelsbywhichwe

canbraceforeconomiccontraction,andputourselvesinapositiontosurviveandemergefrom

thenextdownturn.

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CentralArgument

ThispaperwilldemonstratethatchiefamongthecausesoftheCrisiswas‘moral

hazard,’ortheideathatagentsbecomemuchmorecomfortablewithriskwhentheyarenot

theonesbearinganydownsidecost.Moralhazardplaysanimportantroleinallaspectsofour

lives,broadlyrangingfromthingsliketheftinsurancetotenureatuniversities.However,inthis

casemoralhazardwasextreme,aslendersdidnothavetoearnthisreductionofriskbysome

formofmeritorfee(i.e.payingforinsuranceorworkingmanyyearstobegrantedtenure).The

HousingandCommunityDevelopmentActof1992wasanattempttoprovideaffordable

housingtolow-incomefamiliesandindividualsacrosstheU.S.,allowingalltopursuethe

AmericanDreamofbeingahomeowner,regardlessofincome.Hadthegovernmentnotbacked

these‘subprime’loans,lenderswouldhavenoreasonwhatsoevertoissuetheseloans.

Unfortunately,noonethoughtthiswouldlaterbackfirewhenindividualspurchasedmultiple

homeswithmultiplesubprimemortgages,compoundingtheissueandcausingthehousing

bubbletocrash.

Morespecifically,thispaperwilladvancetheideathatgovernmentsubsidiesand

guaranteestofinancialpartiesencouragedrecklessfinancialpractices,anddidsomorethan

increasinggovernmentregulationwouldhavedone.Thisresultedinknowledgethatstillshapes

thewayourgovernmentactstodayandexamineitsimplicationsonourdemocraticsystem.To

preventfuturecrises,governmentsoughttoconsiderloweringtheamountofsubsidiesthey

issue,thusdecreasingmoralhazard,insteadofincreasingregulationasamoreefficient

solution.Thisplan,however,doescomewithpotentialcoststhatcannotbeneglected.Forone,

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alackofincreasedregulationputsfaithinthefactthatthefreemarketwilloperateasitis

supposedto.Withheightenedregulation,wecanincreasethelikelihoodthatnothingofthis

magnitudewillhappenagain,butwehavetotrustthatwithoutsubsidiesandguarantees,there

willnotbeincentivestoissuesimilarloans.Moreover,increasingregulationwouldincrease

domesticstatecapacity,whichhasitsownbenefitsanddrawbacks.

Thereareseveralgovernmentsubsidiesthispaperwillexamineandattempttoprove

empiricallythatdecreasingwilldomoretopreventcrisisthanincreasingregulation.These

subsidiesincludedepositinsurance,discount-windowlending,andbailouts.Thepaperwill

examinetherelationshipbetweenriskandreturnofalender’sportfoliotoprovethat

governmentsubsidiesdistortnormalloancapitalmarkets,increasingabnormallyhighissuances

ofloans,makingpreviouslyefficientportfoliosinefficient.Thepaperwillaccomplishthisby

investigatingthespecifictermsofthesemortgagesandwhetherornotborrowerswererational

actors(orrationalenough)intheseinstances.Itisclearthatpredatorylendingplayedalarge

partinthecollapseofthehousingmarketbutwasthispredatorylendingcausedby

governmentsubsidiesmorethanalackofregulation?FirmslikeCountrywideandWashington

Mutualbecamefamousfortheroletheirpredatorylendingpracticesplayedinproppingupthe

financialcrisis.Anexaminationoftheloanstheyissuedandthespecifictermsofthoseloans,

bothbeforeandaftertheissuanceofspecificsubsidies,willbringtolightthestrengthoftheir

overallcreditportfolios.

Thisaforementionedexaminationwillallowfortheutilizationtheefficientfrontier

economicmodel,whichmeasurestherelationshipofrisktoreturninaninvestor’sportfolio.

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Theunderlyingassumptionisthattheefficientfrontiercurveshiftswhenanoutsideagent(i.e.

FannieMae)isintroduced.

2TheEfficientFrontierModel

Theefficientfrontiercurveshiftsupandtotheleftwiththeintroductionofanoutsideagent

thatmitigatesriskinsomeregard.Inthiscase,governmentsubsidiesguaranteeingthe

insuranceofsubprimeloanstolendersdoindeedmovethiscurve.Asaresult,previously

existingportfoliosbecomelessefficientandhavetoberestructuredinordertobecomeas

efficientastheywerebefore.Inpractice,thisplayedoutwherelendersmaximizedonlythe

numberofsubprimeloanstheyissuedsincetheywereallguaranteedtobepaidbackbythe

2https://ift.world/concept1/concept-65-minimum-variance-efficient-frontiers/

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government.Itwasinefficientnottochargeoutrageousinterestratesandcollectasmany

paymentsaspossible,notcaringwhatsoeverabouttheborrower’sriskofdefault.

Basedonthepaper’sfindings,afinalrecommendationwillbemadeforthefuture

actionsofgovernmentsontheirtreatmentoffinancialagentslikelenders.Thepaperwill

suggestthatitisbetterforgovernmentstonotmakeguaranteeswhatsoeveronloansthey

issue,whilearguingthatsome,butnottotalregulationisbest.Thisexaminationwilloccur

whilekeepinginmindthepotentialtradeoffstoanincreaseingovernmentregulation,suchas

havingtotrustinthefaithofefficientfreemarkets,ratherthanguaranteeingamitigationof

riskwithincreasedregulation.However,theconclusionwillshowthatdecreasingsubsidiesare

stillamoreeffectivemeansofpreventingcrisisthanincreasedregulationintermsofoverallnet

benefits.Withouttheseguarantees,lenders(investorsintheefficientfrontiermodel)will

naturallyarriveattheiroptimalloanportfolio,andtheloancapitalmarketswillnotbe

distorted,exposingtheU.S.tofuturecrisis.Thismodelisthebesttoolforanalyzingthevarious

situationsofinstitutionallendersinthelead-uptotheCrisis,astheselendersare,afterall,

investorsinandofthemselveswhocareaboutmaximizingtheirownreturngiventheircapital

allocations.

OverviewofMoralHazard

Itiswithoutadoubtthatmoralhazardplayedasignificantroleinproppingupthe

financialcrisis.WhiletheextenttowhichmoralhazardcausedtheCrisishasbeendebated,the

evidencepointstoitbeingtheprincipalcauseofthecrisisaltogether.TheEconomicTimes

definesmoralhazardas“asituationinwhichonepartygetsinvolvedinariskyeventknowing

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thatitisprotectedagainsttheriskandotherpartywillincurthecost.Itariseswhenboththe

partieshaveincompleteinformationabouteachother.”3Moralhazard“occurswhenthe

borrowerknowsthatsomeoneelsewillpayforthemistakehemakes.Thisinturngiveshimthe

incentivetoactinariskierway.”InthecaseoftheFinancialCrisis,institutionallenderswere

incentivizedtotakeonmoreriskwiththeknowledgethattheirloanswouldbeinsuredbythe

U.S.government.Itwasultimatelythisincentivethatcausedthehousingmarkettocrashin

dramaticfashion.

Theterm“moralhazard”originatedduringthelatenineteenthcentury,whereitwas

usedprimarilybyEnglishinsurancecompanies.Thisphenomenonisnamedassuchduetoits

originalusetocharacterizeinsurancefraudorimmoralbehavioronthepartofaninsured

party.4Itwasnotuntilthe1960sthateconomistsadoptedthistermforitscurrentuse.While

moralhazardhasbeenobservedthroughouteconomicandfinanciallife,mortgage

securitizationisaparticularlystrongexample.Thisisbecausemortgagesecuritization,orthe

practiceofbundlingthousandsofmortgagestogetherandsellingthemasatradeableproduct

thatyieldscashflowsfromtheunderlyingmortgages,allowstheoriginatorstopassontherisk

tootherpartiesandnotkeepthesecuritiesontheirbalancesheet.Inasense,lenderswere

extraordinarilyincentivizedtoinvestinincreasinglyriskyloans,astheycouldbothsellthesein

bundlestoinvestors,aswellashadtheknowledgethattheywereinsuredbytheU.S.

government.Belowisanillustrationoftheeffectmoralhazardhasonthedemandfor

3https://economictimes.indiatimes.com/definition/moral-hazard4Dembe,AllardE.andBoden,LeslieI.(2000)."MoralHazard:AQuestionofMorality?"Archived2016-05-13attheWaybackMachineNewSolutions200010(3).257–79

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healthcare,somethingthatcanbeextrapolatedtoalldemandonceriskhasbeenassumedby

anoutsideagent:

TheEffectofMoralHazardonDemandforHealthcare5

Weclearlyfindthatwithoutanyformofinsurance(moralhazard),thedemandforhealthcare

goesdown.Ifpeoplewereuninsuredtheysimplywouldnotbeabletoaffordessentialcare,

andamorallyhazardousagent(healthinsurancefirms)stepintofillthatdemandvoid.

5https://www.researchgate.net/figure/New-Analysis-of-Moral-Hazard_fig1_5984419

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Moralhazardhasbeenofparticularinteresttoeconomistsandpoliticalscientistsinits

practicalapplicationsinrecentdecades.Theseacademicstendtoarguethattheinefficiency

thatariseswithmoralhazardisduetoinformationasymmetry.IntheInsuranceindustry,for

example,companiesareunabletoobservetheeverydaybehavioroftheirclients,andassuch,

areunabletodenycoveragetoindividualswhotakeriskstheyareunawareof.Inthecaseof

theFinancialCrisis,thefederalgovernmentwascompletelyunawareoftheriskypractices

institutionallenderswouldengageiniftheypromisedtoinsurethesubprimeloanstheyissued.

Moreover,thegovernmentcouldnothavepredictedtheinstrumentsWallStreetwould

develop,suchasCollateralizedDebtObligations(“CDOs”)thatwouldrapidlyexacerbatethe

financialcrisisuponthedemiseofthehousingmarket.Whileitiseasytoblamebanksand

otherinstitutionallendersforunethicalandpredatorypractices,itshouldcomeasnosurprise

thatcrisisensued.Withtheintroductionofthisgovernmentsubsidy(theguaranteeofinsured

loans),lendershadtore-optimizetheirownloanportfolios.Additionally,thiswastheonlyway

forlow-incomeorhighriskindividualstoobtainthenecessaryleverageforamortgageoftheir

own.

Moralhazardwasnotafactorinthemortgagelendingmarketbeforetheintroduction

ofsuchasubsidybyFannieMaeandFreddyMac.Lendershadtoconsideraclient’s

creditworthinesswithextremecareanddeliberationbeforedecidingwhetherornottoissue

suchaloan.Anydownsideriskwastobeassumedbythelenderthemselvesand,assuch,the

subprimemortgagemarketneverbecamepopularuntilthelead-uptothecrisis.Itwas

preciselythisgovernment-createdformofmoralhazardthatleadtoaseriesofevents,

ultimatelyresultinginaglobalrecession.Government-createdmoralhazardwastheprimary

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culpritproppinguptheCrisis,andanexaminationofthespecificsubsidiesgrantedbythe

governmentwilldisplaywhichofthese,ifany,needtobereducedmorethanregulationneeds

tobeincreased.

Subsidies

Perhapstheprimaryreasonfortheexistenceofgovernmentsubsidiesandguarantees

infavoroffinancialinstitutionsinthelead-uptothecrisiswasthecentralbeliefthatthese

firmswere“toobigtofail.”Whileitisimportanttomakesureourfinancialinstitutionsare

strongandcanmaintainandstabilizeflowsofcapitalacrosstheglobe,itcanbeverydangerous

toviewtheseinstitutionsastooimportantorcentralthatwecannotallowthemtogo

bankrupt.Ina2010speech,then-USFederalReservechairmanBenBernankefamously

remarkedthat“ifafirmispubliclyperceivedastoobig,orinterconnected,orsystematically

criticalfortheauthoritiestopermititsfailure,itscreditorsandcounterpartieshaveless

incentivetoevaluatethequalityofthefirm’sbusinessmodel,itsmanagement,anditsrisk-

takingbehavior.Asaresult,suchfirmsfacelimitedmarketdiscipline,allowingthemtoobtain

fundingonbettertermsthanthequalityorriskinessoftheirbusinesswouldmeritandgiving

themincentivestotakeonexcessiverisks.”6Theobviousproblemwithfirmsthatareso

massiveandcentraltoeconomiesistheriskofcontagionwhenanyofthesefirmsexperiences

downturn.Moreover,80-90%ofthemoneysupplyintheU.S.(definedasM-1)iscomposedof

bankcheckingdeposits.Ifthegovernmentweretoremovesubsidiesissuedtothesefirms,they

6BenS.Bernanke,SpeechattheIndependentCommunityBankersofAmericaNationalConvention:PreservingaCentralRoleforCommunityBanking(March20,2010).

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wouldnotbeincentivizedtotakeonmoreriskthantheyshould.Thisnotonlydrastically

decreasesthechancethattheonefirmisexposedtopotentiallosses,butalsodecreasesthe

riskofthecompoundingeffectsofthoselossesonthemarketasawhole.Further,itis

importanttodiscernwhichsubsidiescontributemostsignificantlytothearisingofmoralhazard

andwhatactions(orrather,inactions)futuregovernmentscantaketomitigatethechanceof

contagion.

Subsidy#1:TheformationofFannieMaeandFreddyMacasGSEs

Throughoutthemajorityofthetwentiethcentury,mortgagelendingtookplace

primarilyatbanks,thrifts,andcreditunions.Themostcommonmortgagewasafixed-rate

mortgage,oronethatoffersthesameinterestratefromthedayitisissued.Theinstitutions

thatoriginatedtheloanstendedtokeepthemortgagesontheirownbooks,notsecuritizing

andsellingthem,andboreallthedownsiderisk.WhileFannieMaewasoriginallycreatedin

1938aspartofthegovernment,itbecameprivatizedasagovernment-sponsoredenterprise

(“GSE”)in1968,withFreddieMacfollowingtwoyearslater.Almostimmediatelythereafter,a

secondarymortgagemarkethadbeencreated,allowinglenderstosecuritizeandsellawayany

risktheyhadbeentakingon.Sellingthesemortgagesgavethelendersadditionalcapitalwith

whichtheycouldcreateevenmoremortgages,creatingacycleoforiginating,bundling,selling,

andoriginatingmoremortgages.

Initially,“FannieMaeandFreddieMachadapositiveinfluenceonthemortgagemarket

byincreasinghomeownershipratesintheUnitedStates.However,allowingFannieMaeand

FreddieMactofunctionasimpliedgovernment-backedmonopolieshadunintended

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consequences.”7Astimewenton,theseconsequencesgrewever-largerandtheharmscreated

bythisgovernmentsubsidydrasticallyoutweighedthebenefits.Oneoftheprimarybenefitsof

obtainingGSEstatus,andthemostimportantinthecaseoftheCrisis,istheSecretaryofthe

Treasury’sauthorizationtopurchaseupto$2.25billionofsecuritiesfromeachcompanyto

supporttheirliquidity.Thus,thegovernmentitselfhadupto$4.5billionofexposuretorisk,all

investedinkeepingthetwoGSEsasliquidaspossible.

Webegintoseeachainofdumping-offrisktothenextparty,whichallcamebacktothe

government.Bycontinuingtosellriskierandriskierassetstothenextparty,noindividual

institutionbelievedtheywereatriskbyinvestinginthesemortgages,ortheMortgage-Backed

Securitiesthatwerecreatedwiththem.“Thefactthatthemarketbelievedinthisimplicit

guaranteeallowedFannieMaeandFreddieMactoborrowmoneyinthebondmarketatlower

yieldsthanotherfinancialinstitutions.TheyieldsonFannieMaeandFreddieMac’scorporate

debt,knownasagencydebt,washistoricallyabout35basispointshigherthanU.S.Treasury

bonds.”8While35bps(0.35%)maynotseemlikeasignificantspread,whentherearetrillions

ofdollarsatstakeanyseeminglynominalincreaseinabpsspreadbecomessignificant.Herewe

seeanamassingofprivateprofitsthroughpublicrisk.WhileFannieMaeandFreddieMacwere

incrediblyprofitableforovertwodecades,theimplicitguaranteeofthegovernmentdidnot

actuallybenefithomeowners.Thissubsidysimplycreatedmoralhazardwhichhelped

contributetotheCrisis.

7https://www.investopedia.com/articles/economics/08/fannie-mae-freddie-mac-credit-crisis.asp8Ibid

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Subsidy#2:DiscountWindowLending

ThediscountwindowisanadventofUSmonetarypolicythatallowsbankstolendfrom

acentralbanktomeetliquidityshortagesthatarecausedbysomesortofdisruption.This

differsfromthe“LIBOR”ratewhichissimplytherateatwhichcommercialbankslendfromone

another.Bankstendtopreferborrowingfromotherbanksgivenacheaperrateandalackof

obligatorycollateral.Assuch,duringtimesofeconomicdistress,discountwindowlending

spikeswhenallbanksarefacingliquidityshortages.Thediscountwindowhasbeeninexistence

sincetheestablishmentoftheFederalReservein1913andwastheFed’sprimarytoolduring

itsinception.

Thesimplefactthatcommercialbankshaveacentralbanktobackthemincasethey

needimmediateliquidityincentivizesbankstomakeriskierbets.Thisgoesfarbeyondmortgage

loans.Whenassessinganybusiness’creditworthiness,banksdonothavetoworryextensively

aboutdownside-caseoutcomes,astheyhavetheknowledgethattheywillbeabletoacquire

liquidassets(i.e.cash)fromtheFederalReserve.Thisisaverygeneralsubsidythatencourages

allsortsofriskypractices.However,ifdiscountwindowlendingdidnotexist,bankswouldbe

moreresponsibleforself-regulation,andwouldalsonotengageinsuchriskypractices.

Althoughthisseemssomewhatcounterintuitive,giventhefactthatwetendtothinkincreased

regulationleadstolessrisk,ithasbeenproventhatanoversteppingbythegovernment,inthe

formofthisissuedsubsidy,leadstolessstabilityinthemarketsovertime.

Thereareseveralrateschargedtoinstitutionsincludingtheprimarycreditrate(byfar

themostcommon),thesecondaryrate(lessstableinstitutions),andseasonalcreditrate.Both

primaryandsecondarycredittendtobeofferedonasecured,overnightbasis,whileseasonal

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creditisextendeduptoninemonths.Theprimaryrateis100basispoints(“bps”)abovethe

federalfundstarget,andthesecondaryis50bpsabove.Again,wefindsomethingseemingly

counterintuitive.Thelesscreditworthyinstitutionischargedalowerrate.Thisisbecausethe

subsidyexiststoassiststrugglingbanksthatareindireneedofliquidity.However,weseethis

unfortunatelybackfire,aslessstablebanksthatarealreadyengaginginrelativelyriskypractices

areawarethattheirinterestratewillbenominallylowerthantheprimaryrate,andthus

continuetoengageinriskierpracticesthanotherinstitutions.Discountwindowlendingthus

provesitselftobethemostdamagingsubsidyandonethatisdeemednecessarybecauseofthe

existenceoffinancialinstitutionsthataresystematicallyimportant.However,weretherenever

anysuchinstitutionor“toobigtofail”backdrop,therewouldbenoneedforthesubsidy.

Thetwoaforementionedgovernmentsubsidieshaveshownthemselvestodomore

harmthangoodintimesofdistress.Whilethecreationofthesesubsidieswereperhapsdone

withnobleintentions,governmentinvolvementinfinancialregulationhasproventobe

ineffectiveanddamagingtoAmericansinthelongrun.Thegovernmenthasfailedtoconsider

inthepastthatitisnotanincreaseinregulation,butadecreaseinsubsidiesthatwillleadto

moreeconomicstability,growth,andefficientmarkets.Hadthesesubsidiesneverbeenin

place,thesefinancialinstitutionswouldhavebeenresponsibleforself-regulation,andwould

nothaveengagedintheriskypracticestheydidwiththesesubsidiesinplace.Bankslike

WashingtonMutualandCountrywidewouldhaveneverfailed,andperhapstherecessioncould

havebeenpreventedaltogether.Self-regulationisnotalwaysabadthing,especiallywhenthe

alternativehasproventobesodamaging.

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Subsidy#3:CentralBankBailouts

Theissueofwhetherornottobail-outtheselarge,globalbankswasacornerstoneof

theOccupyWallStreetmovementduringtheheightoftheCrisis.Manyindividualsacrossthe

countryfeltthattheirtaxpayerdollarsshouldnotbespentonrescuingfirmsthattimeandtime

againexhibitedunhingedandriskybehavior.Aswenowknowafteraninitialfailed

congressionalvote,theU.S.governmentoverwhelminglydecidedthatthesystematically-

importantfinancialinstitutions’(“SIFIs”)collectivefailurecouldcauseashocksoseverethatthe

worldmayneverrecover.Whileitiswidelyviewedthattherightdecisionwasmade,itis

importanttopositwhetheritwasrighttoevenofferbailoutstobanksthatcouldfailbeforethe

Crisiseveroccurred,againincreasingmoralhazard.ItisinthiscapacitythattheFederalReserve

isconsidereda“lenderoflastresort,”anideainitiallysuggestedbyWalterBagehot.InMunger

andSalsman’sIs“TooBigtoFail”TooBig?,itisnotedthatBagehot“arguedthatmanyfinancial

crisesaremerelyproblemsofilliquiditynotinsolvency.Insuchasituation,contagioncanbe

contained,andevencuredbymakingsureacentralbankdoesthreecrucialthings:

1. Lendasmuchmoneyasnecessarydirectlytotroubled(temporarilyilliquid)banks

2. Atapenaltyrate(farabovethemarketinterestrate)

3. Andonlyagainstgoodcollateral,asofferedbyatechnicallysolventbank”9

Unfortunately,wediscoverthatthese“rules”arenotactuallyusefulwhenitcomestocrafting

legitimatepolicy.Atruelenderof“lastresort”willhavetoviolateboththesecondandthird

rulesbynature.However,itisprimarilythethirdrulethatallowsustodistinguishbetween

insolvencyandilliquiditywhenitcomestobanks.Failingbanksthatlackgoodcollateral(likely

9Munger&Salsman,Is“TooBigToFail”ReallyTooBig?

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mostfailingbanks)arepotentiallymorecontagiousthanthosewithgoodcollateraltoborrow

against.However,ifweassumeitisthejoboftheFederalReservetopreventcontagion,it

wouldbeimpossibletoadheretothethirdrule.Therealitythatmustbeunderstoodisthat

failingbanksaresimplygoingtobelackinggoodcollateral.Illiquidityandinsolvencyare

undoubtedlycorrelated.Oncethecentralbankagreesthatitmustbail-outinsolventbanks,it

becomes“nolongeramerelenderoflastresort,butalsoaninsureroflastresort—abackstop

forbankbondholdersandstockholders…Such‘loans’cannotberepaid,atleastnotatpenalty

rates,becausetheloanwasmadetorestorethevalueofthefirm(itssolvency,ornetasset

value),nottoprovidetheliquidityitneedstooperate.”10Withthisunderstandingitis

abundantlyclearthatbailoutsdonotfunctionastheyareintendedto.

Bailoutsnotonlyfailtosolveissuesofmarketfailure,butactuallypropthemup,as

banksbecomeincentivizednottoremainliquid.ThenewBaselIIIliquidityandminimumcapital

requirementsimposedonSIFIsfollowingtheCrisis11,onlyrestrictedbanks’abilitytooperate

morethanifthegovernmenthadneverintendedtobailoutthebanksupontheirfailurefrom

thestart.Imposingliquidityrequirementsdoesindeedputthesebanksatalowerriskoffailure,

butalsoinhibitstheirabilitytofunctionastheywish.Inanaturalmarketcharacterizedbyboth

lessregulationandfewersubsidies,bankscanbothoperatetotheirfullcapacitywhilestill

hedgingagainstriskwiththeknowledgethattheywillnotbesavedbytheFederalReserve.

Additionally,theAmericantaxpayerwouldnothavetoworryaboutthepracticesofthese

banksastheirtaxeswouldnolongerbefundingthispreexistingsafetynet.Thisscenario

10Ibid,44211https://www.bis.org/bcbs/basel3.htm

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logicallyseemstobeawin-winforallpartiesinvolved,butwillonlyworkifthegovernment

acceptsthefactthatbailouts,andtheexpectationthereof,domoreharmthangoodinthelong

run.Currentlythereare29GlobalSystemicallyImportantBanks(G-SIBs).Thesheerquantityof

G-SIBsthatexistwarrantadiscussionsurroundingtheirpracticesandtheextenttowhich

governmentsshouldinvolvethemselvesintheirpractices,particularlyintheUnitedStates

wherethereareeight(BankofAmerica,BankofNewYorkMellon,Citigroup,GoldmanSachs,JP

MorganChase,MorganStanley,StateStreet,andWellsFargo).12

Subsidy#4:FederalDepositInsurance

TheFederalDepositInsuranceCorporation(FDIC)wasinitiallyestablishedasaresponse

totheGreatDepressionintheUnitedStates.TheBankingActof1935madetheFDICa

permanentgovernmentagency,aftertwoyearsofbeingatemporaryagency,andprovideda

maintaineddepositinsurancelevelof$5,000peraccount.FollowingtheglobalCrisisin2008,

thelimitwasraisedto$250,000.TheFDICisalsotheorganizationresponsibleforreceiving

insolventbanksandsellingthemquicklytoanotherfinancialinstitution.Therehasbeenaclear

historicaltrendwhereweobservethefederalgovernmentgrantingtheFDICmorepowerand

controloverbanks,especiallyfollowingtimesofeconomicdownturn.This“concentrationof

powerintheFDICistraditionallyjustifiedbytwoarguments:(i)FDICcontrolspeedsthe

dispositionofthebank’sassetswhichmaintainstheliquidityofdepositsandencouragesfaith

inthebankingsystem,and(ii)theFDIC’sroleasthelargestcreditorgivesitanincentiveto

12https://www.fsb.org/wp-content/uploads/2015-update-of-list-of-global-systemically-important-banks-G-SIBs.pdf

21

maximizerecovery.”13Whiletheseargumentsappeartobesomewhatsalientuponaninitial

glance,onemustaskthequestionastowhatacounterfactualwouldlooklikehaddeposit

insuranceneverexisted.Perhapsdepositinsuranceencouragesfaithinthebankingsystem,but

ifdepositors’assetswerenotinsured,bankswouldbeincentivizedtodowhatevertheycould

toprotectthesedeposits.Abusinesslikeanyother,bankswillobviouslydowhatevertheycan

tokeeptheircustomershappyandmaintainaconsistentstreamofdeposits.Inafractional

reservebankingsystemliketheonewehavetoday,banksdonotkeepalloftheirdeposited

assetsascash.14Thislowerlevelofliquidityisofsignificantconcernwhenabankfails.Without

depositinsurance,bankswouldbeincentivizedtokeepasmuchliquidityastheyneedtoin

ordertopreventacollapseintheeventofabankrun,aswasthecaseduringtheGreat

Depression.

Additionally,theviewthattheFDICdeservestheamountpoweritcurrentlyenjoysis

notonethatisubiquitouslyheld.RichardHynesandStevenWalt,professorsattheUniversity

ofVirginiaSchoolofLaw,positthatthetwojustificationsoughtnottobeconsidered.They

arguethat“thefirstargumentfailsbecauseitconflatestheneedforatimelysatisfactionofthe

claimsofinsureddepositorsbytheFDICwiththeneedtoquicklydisposeofthefailedbank’s

assets.Asstated,thesecondargumentfailstojustifyFDICcontrolasthelargestcreditorcan

takeself-interestedactionsharmfultootherclaimants…Adetailedsurveyofthecapital

structureoffailedbanksrevealsthattheFDICisusuallytheonlymajorcreditorandthatthe

13https://scholarlycommons.law.wlu.edu/cgi/viewcontent.cgi?article=1023&context=wlulr14https://onlinelibrary.wiley.com/doi/full/10.1111/ajes.12023

22

valueoftheFDIC’sclaimnearlyalwaysexceedsthevalueofafailedbank’sassets.”15

Furthermore,theauthorsputforthfourlimitsontheargumentinfavorofFDICcontrol:

(i) Capitalstructureisendogenous—theabsenceofclaimsjuniortotheFDICmay

reflectthelackofvoicegiventotheseclaimantsinabankresolutionprocess

(ii) AgencycostsinternaltotheFDICmaypreventtheFDICfrommaximizingthe

recoveryfromthefailedbank’sassets

(iii) TheFDICmaynotbetheresidualclaimantofextremelylargebankswith

complexliabilitystructures

(iv) Debtconversionschemeswhichallowforautomaticfinancialrestructuringofa

failedbankmayrenderbankresolutionprocedureslessnecessary16

ItisabundantlyclearthattheamountofpowergrantedtotheFDIC,andfranklythe

organizationitself,havedrawbacksthatdoindeedperpetuatemoralhazard.Moreover,asof

June30,2019,therewere5,303FDICinsuredinstitutions.17Assuch,therewerealsoover5,300

institutionssusceptibletomoralhazardbecauseofdepositinsurance.Perhapsconsumers

oughttothinkmoredeeplyaboutwhytheFDICenhancestheirfaithinthebankingsystem.Itis

worthaskingthequestionofwhetherdepositinsuranceactuallydoesmoreharmthangoodby

wayofcreatingmoralhazardforboththemostimportantfinancialinstitutionsintheworldand

reallyanybankinsuredbytheFDIC,especiallyinafractionalreservebankingsystem.

Subsidy#5:InsuredFraudulentCharges

15Ibid,98516Ibid,98617https://www.fdic.gov/bank/statistical/stats/2019jun/industry.pdf

23

Whilewetendtobelievethatbanksareliableforcreditordebitcardfraud,asthe

cardholderisinsuredbylawintheseinstances,itisnotalwaysthatsimple.Letustakethe

exampleoftheinfamousTargetdatabreachthatoccurredin2013.Unfortunately“Usingthe

credentialstoexploitweaknessesinTarget’ssystem,theattackersgainedaccesstoacustomer

servicedatabase,installedmalwareonthesystemandcapturedfullnames,phonenumbers,

emailaddresses,paymentcardnumbers,creditcardverificationcodes,andothersensitive

data.”18Asaresult,Targetwasheldresponsibleandwasorderedtopayan$18.5million

multistatesettlement,whichwasatthetimethelargesteverfordatabreach.Initially,banks

thatwerepartneredwithTargetfortheircardswereresponsibleforreimbursingtheir

customers.ThesebanksthenturnedtoTargetandviaaseriesoflawsuitsdemandedtheybe

paidback,asthiswasnottheirfault.ThebiggestloserinthesituationendedupbeingTarget,

whobothhadtopaytheaforementionedsettlement,aswellasincurthemillionsofdollarsin

lossesresultingfromtheinitialfraud.WhileTargetdidhavetobeararatherunfortunateloss,

thistypeofoccurrencecanbeextremeforsmallbusinessownerswhocannotaffordsuchahit.

Althoughinthepreviouscasethepartnerbanksweresuccessfulintheirlegalpursuit,

theyarealsoableto“purchaseinsurancetoprotectagainstlosses”19fromthegovernmentasa

secondlineofdefenseagainstfraudulence.Althoughbanksdohavetodealwithtemporary

lossesintheeventoffraud,theyalmostalwayspursuelegalactionagainstthebusinesswho

wastheinitialvictim.Whiletheydo,onoccasionlosetheselawsuits,theytypicallypurchase

fraudinsurancefromthegovernmentsotheyarenotdirectlyliableforsuchfraud.Assuch,

18https://www.usatoday.com/story/money/2017/05/23/target-pay-185m-2013-data-breach-affected-consumers/102063932/19https://www.businessinsider.com/heres-what-happens-when-your-bank-fails-2015-7

24

bankshavenoproblemissuinglinesofcreditforeventssuchasoverdraftastheyknowthat

evenintheeventoffraud,theycaneitherpurchasesomeformofinsurancefromthe

governmentthemselvesorcomeafterthebusinessthattheyfeelisresponsibletopaythem

back.Banksarenotincentivizedtocompletelyputanendtofraud,asinmanycases,theyare

nottheultimateloserandinfactrecoupalltheirinitiallosses.Thefactthatthegovernment

allowsthepurchaseofsuchinsurancecompletelydisputesthenotionthatbanksarenoble

saviorsthatalwayslookoutfortheft.Whilethissubsidyisnotquiteaspotentastheothers,it

nonethelessdoesnothingtodiscouragemoralhazard.

CaseStudy:WashingtonMutual

WashingtonMutualisperhapsthebiggestnameassociatedwiththe2008Financial

Crisis.Itsfailurewasthelargestinbankinghistory,anditsstoryisonethatwemustdraw

lessonsfromasanationlookingtopreventfuturecrises.Sinceitsinception,Washington

Mutual(“WaMu”)wasamid-sizedthriftthatspecializedinhomemortgages.In2003,however,

itsCEOKerryKillingerclaimedthathewanted“todoforthelendingindustrywhatWal-Mart

andothersdidfortheirindustries,bycateringtomiddleandlowerincomeAmericansand

helpingthelesswelloffbuyhomes.”20ThisishowWaMu’sriskylendingstrategywasborn,and

by2006itshighriskstrategystartedtocomeundone.Thefirmincurredrecordratesofboth

delinquencyanddefault,anditssecuritiessawsignificantratingsdowngrades.By2007,the

bankitselfhadstartedtoloseprofits,frighteningbothinvestorsanddepositorsalike,and

leadingtoaneventualliquiditycrisis.OnSeptember25,2008theOfficeofThriftSupervision

20https://www.hsdl.org/?view&did=7125

25

(OTS)hadnochoicebuttoseizeandsellWaMutothemorestableJPMorganChase,

representinga$1.9billionsale.Althoughthissalewassomewhatcontroversial,withopponents

arguingthatthegovernmentshouldhavesimply“letthebankfail,”theOTSdidnothavea

realisticchoiceinthematter,notwantingtoriskcompletelyexhaustingthe$45billionDeposit

InsuranceFund.

Itiswithoutadoubtthatthebanks’increasingtoleranceforrisk,duetogovernment

guarantees,iswhatbothunderminedthisspecificinstitution,andshockedtheentireglobal

financialsystem.“Itsfixedratemortgageoriginationsfellfrom64%ofitsloanoriginationsin

2003,to25%in2006,whilesubprime,OptionARM,andhomeequityoriginationsjumpedfrom

19%oftheoriginationsto55%.”21Furthermore,WaMu’ssubprimesecuritizations,facilitated

byitssubprimelender,LongBeachMortgageCorporation,grewoversixtimes,increasingto

$29billioninsubprimesecuritizationsin2006and$42.6billioninOptionARMs(Adjustable-

RateMortgages,theflagshipproductofthebank).

NotonlydidWaMushiftitsloanportfoliotoadrasticallyriskierone,butengagedin

clearlyquestionable,ifnotdownrightunethicallendingpracticesthatcompoundedtheeffects

ofitsportfolio.WaMuwouldqualifyhighriskborrowersforloanstheyclearlycouldnotafford

andtermsforinterestratestheydidnotunderstand.ManyoftheseloansoriginatedbyLong

Beachwereshortterm,hybridadjustableratemortgages,referredtoas“2/28,”“3/27,”or

“5/25”loans,allofwhichwere30-yearmortgages.Thesewouldadvertisethelowfixed“teaser

rate,”whichwouldthenchangetoahigherfloatingrateafteracertainnumberofyears(the

numeratorineachoftheaforementionedfractions).LongBeachandWaMuwouldqualify

21Ibid

26

borrowersbasedonwhethertheywereabletoaffordtheteaserrateratherthanthehigher

adjustablerate.Incertaincases,WaMuwouldnotevenverifytheborrower’sincomewhen

issuingthemaloan.Thesearewhatbecameknownas“NINJA”loans(No-Job,No-Income)and

becameapopularproductforlendersthroughoutthecountry.Withtheknowledgethatthese

loanswouldbeinsuredbyFannieMaeandFreddieMac,WaMuandotherswereclearly

incentivizedtoissueasmanyloanswithhighinterestratesastheycould,eventually

recuperatingtheentireprincipalandcollectinginterestuntiltheborrower’sinevitabledefault.

WaMuandothers“designedcompensationincentivesthatrewardedloanpersonnelforissuing

alargevolumeofhighriskloans,valuingspeedandvolumeoverloanquality.”22Thisproblem

plaguedthebankfromtheC-Suiteallthewaythroughindividualloanofficersthatwouldmeet

withthefamiliesthatpurchasedmortgageloans.

Inanadditionalattempttomitigatethebank’sexposuretorisk,WaMuwouldsecuritize

andsellbundlesofthesehigh-riskmortgagestoinvestorsonWallStreet.InJanuary2005,a

proposalpresentedtotheWaMuboardofdirectorsthatbecamethebasisforthebank’shigh-

riskstrategy.Theproposalincludedacalculationthatshowedadramaticimprovementin

profitabilitywiththisnewstrategy,givenboththecollectionofhigherinterestpaymentsand

theabilitytosecuritizeandsellthesebundlesintheformofMortgage-BackedSecurities

(“MBSs”)athigherprices.23ThememorandumtotheBoardnotedthat“Ourprimaryfinancial

22Ibid

23“HigherRiskLendingStrategy‘AssetAllocationInitiative,’”submittedtoWashingtonMutualBoardofDirectorsFinanceCommitteeDiscussion,JPM_WM00302975-93,HearingExhibit4/13-2a.

27

targetsforthenextfiveyearswillbetoachieveanaverageROE[ReturnonEquity]ofatleast

18%,andanaverageEPS[EarningsPerShare]growthofatleast13%.”24Thesehigh-riskMBSs

paidamuchhighercouponthansimilarly-ratedsecurities.Thiswasduetothehigherrisk

associatedwiththeseunderlyingmortgages,butthatriskwasthoughttobediversifiedaway,

asthesebundlesweremixedwithhighly-ratedAAAandAAratedloans.Thegreatfallacy,

however,wasthattheratingsagenciesweremisrepresentingthequalityofthesemortgagesto

appeasetheircustomers(i.e.WaMuandotherlenders).Itisbelievedthat“Thefailureof

ratingsagenciestoproperlypricetheriskysecuritiesattheheartofthefinancialcrisishasbeen

attributedtoconflictofinterest(beingpaidbytheissuersoftheassetstheyarerating)and

shoppingforthebestrating(getmorethanonerating,thenonlymakepublicthehighest

one).”25However,economistsarguethattheseincentiveshavealwaysbeeninplace.Itwas

boththetimingandthecomplexityoftheassetsbeingratedthatcontributedtothe

misrepresentedqualityofMBSs.Supposedly,“Whentheassetsareverysimple,riskassessment

isnotverycomplicatedandthedispersionofratingsacrossagenciesisverylow.Thus,thereis

noincentivetoshoparound.Inaddition…peopleoutsidetheagenciescanindependentlycheck

andverifytheratingseasilysoanymanipulationoftheratingswouldbeeasytodiscover,and

therevelationthattheirratingsareinflatedwoulddamagetheircredibilityandhencetheir

business.”26Thecomplexityofthenewly-formedassetscreatedaproverbialdon’t-ask-don’t-

246/1/2004WashingtonMutualmemorandumfromKerryKillingertotheBoardofDirectors,“StrategicDirection,”JPM_WM05385579at581.

25https://economistsview.typepad.com/economistsview/2009/03/why-did-ratings-agencies-fail.html 26Ibid

28

tellsituationbetweentheratingsagenciesandthebanks.Althoughthebanksweresomewhat

awarethatmanyofthemortgagescomprisingthesecuritieswerenotsound,theywereableto

hidethiswithinthe“diversity”ofthesecurities.Ontheotherhand,theratingsagenciesfelt

comfortablejustifyingtheirmisrepresentationoftheassetqualitybyacceptingdiversification

asanexplanation.Thus,bankswereunawareofthetotalexposuretorisktheytookonby

owningtheseassets,andagencieshadanexcusetokeepthebankshappyandpreservetheir

clientele.ThefollowingchartshowsthetypicalcapitalstructureofaMortgage-BackedSecurity

andtheinvestorswhoownedpartofeachtranche:

29

27Mortgage-BackedSecurityComposition

Onthesurface,theassetappearstobewelldiversifiedtoyieldbothhighcashflowsfromthe

lower-ratedBBandBB+tranchesofdebt,exemplifiedbythehighspreads(relativetoLIBOR).

27https://www.govinfo.gov/content/pkg/GPO-FCIC/pdf/GPO-FCIC.pdf

30

Asitturnsout,mortgagesratedashighlyasAAwouldeventuallyturndelinquentanddefault.

Thediversificationsafetynetdidnotexistwhatsoever.Investorsdidnotknowwhattheywere

purchasing,agenciesweremisrepresentingtheproductsbeingsold,andlenderscontinuedto

investinincreasinglyriskymortgagesandsecuritizingthem.Withthebenefitofhindsightit

seemsasthoughWashingtonMutual’sdownfallwas,attheveryleast,inevitable.

UnfortunatelyforAmericans,whileWaMuwasnot“toobigtofail,”itwasbigenoughthatits

failureimpactedthelivesofmillionsofhouseholds.Onceacriticalmassofindividualsbeganto

defaultontheirmortgages,WaMuandotherlendersbecameunabletorecovertheirlosses,

evenwiththeassistanceofFannieMaeandFreddyMac.Theentirehousingmarket

plummeted,andhomevaluesreachedincrediblelows.Thiswassomethingleadingeconomists,

theAmericangovernment,andevenexpertslikeBenBernankeandTimothyGeithnerthought

impossible.Housinghadbeenanindustrythathadnotonlybeenstable,butwasthoughtto

continuetobegoingup,perhapsforever.Thehousing“bubble”isoneofseveralweturnto

throughouthistorytohelpexplainotherbubblesandmarketcrashes.Oncethehousingmarket

crashed,itwasinevitablethatallofWallStreetwouldfollow,andtheshocksfromthecrash

wouldbefeltthroughouttheentireglobalcapitalmarkets.

CompoundingEffects:DerivativesandCDOs

Thefollowingimages,bothfromtheFinancialCrisisInquiryCommissionReport,reflect

subprimemortgageoriginationsandmortgagedelinquencies,respectively,fromthelate1990s

throughthelate200s.Weseeacleareffectfromonegraphtothenext.TheSubprime

MortgageOriginationsgraphdisplaysastarkincreaseinnumberofsubprimeloansissued

31

beginninginabout2003(whenthegovernmentdecidedtoprovidethesubsidytolendersinan

efforttoincreasenationalhomeownershiprates).Afteraspikein2006at23.5%subprime

shareoftheentiremortgagemarket,thevastmajorityofwhichweresecuritizedandsoldto

WallStreet,thenumberofsubprimemortgageoriginationsfelldrastically.Atthesametime,

therewasadramaticspikeinMortgageDelinquenciesbyLoanTypeacrossalltypesofloans,

butespeciallyinsubprimeadjustableandfixedratemortgages.

28 29

Weobserveaclearcausalrelationshipbetweensubprimeoriginationanddelinquency(and

ultimatelydefault)ofthesemortgages.Tomakemattersworse,theseloansweresecuritized,

bundled,andsoldtoinvestorswhoexpectedthatthecashflowsoftheunderlyingmortgages

wouldproducesignificantreturnstotheinvestors.Itisundoubtablethatderivativesbasedon

thesemortgagesamplifiedtotheimpactofthehousingcrisis,causingaglobalrecession.

TheConclusionsoftheFinancialCrisisInquiryCommissionsnotethattherewerethree

primarywaysinwhichOver-The-Counter(“OTC”)derivatives,orderivativeswhichareprivately

28Ibid,7029Ibid,217

32

negotiatedandtradedwithoutanysortofexchange,contributedtothecrisisinthree

importantways.“First,onetypeofderivative—creditdefaultswaps(CDS)—fueledthe

mortgagesecuritizationpipeline.CDSweresoldtoinvestorstoprotectagainstthedefaultor

declineinvalueofmortgage-relatedsecuritiesbackedbyriskyloans.”30Acreditdefaultswapis

simplyacontractthatoffersinsuranceonabondorloaninthecasethatitfails.AIG,for

example,sold$79billionworthofCDSs.Thesebanksandlendersthoughtthehousingmarket

wouldneverfail,andassuch,werehappytosellasmanyswapsastheypossiblycould,

believingtheywouldsimplycollectinterestpaymentsontheswapsintoeternity.However,

whenthehousingmarketdideventuallycollapse,thesebanksweresoover-exposedontheir

swapsthattheirliquiditywasdrainedunlikeeverbefore.The2015filmTheBigShortdepicts

hedgefundmanagerMichaelBurrygoingfrombanktobankonWallStreetbuyingasmany

creditdefaultswapsashecould,affirminghisbetthatthehousingmarketwouldcollapse.

Whenthesebankshadtopayoutontheirswaplosses,theyhadtobebailedoutbythe

governmentgivenextremeliquidityissuesandBurry,alongsideafewothers,madehundredsof

millionsofdollarsontheirbet.

ThesecondwayderivativescontributedtotheexacerbationoftheCrisiswasthefact

that“CDSwereessentialtothecreationofsyntheticCDOs.ThesesyntheticCDOsweremerely

betsontheperformanceofrealmortgage-relatedsecurities.Theyamplifiedthelossesfromthe

collapseofthehousingbubblebyallowingmultiplebetsonthesamesecuritiesandhelped

spreadthemthroughoutthefinancialsystem.”31Again,weseethebeliefthatthehousing

30ConclusionsofTheFinancialCrisisInquiryCommission,xxiv31Ibid,xxiv

33

marketwouldneverfaildrasticallyamplifyingtheCrisis.AsifCDOswouldnothavedone

enoughdamageontheirown,thecreationofaspeculativetoolallowinginstitutionstobeton

CDOs,whichwerealreadybettingonunderlyingmortgages,wasanincrediblyunfortunate

thing.GoldmanSachsalonecreated,packaged,andsold$73billionworthofsyntheticCDOs

between2004and2007.TheseCDOsreferencedover3,400mortgagesecurities,with610of

thembeingreferencedatleasttwice.Thebetthatthehousingmarketwouldneverfailproved

tobeadisastrousone,andonethatwemustconsiderwhendevelopingnewfinancial

instrumentsinthefuture.

Finally,thefactthatlenders,andAIGinparticular,werenotrequiredtoputaside

capitalreservesforprotectionagainstthesaleofitsderivativeproducts,costthegovernment

dearly.TheInquiryCommissionnotedthat“Thegovernmentultimatelycommittedmorethan

$180billionbecauseofconcernsthatAIG’scollapsewouldtriggercascadinglossesthroughout

theglobalfinancialsystem.Inaddition,theexistenceofmillionsofderivativescontractsofall

typesbetweensystematicallyimportantfinancialinstitutions—unseenandunknowninthe

regulatedmarket—addedtouncertaintyandescalatedpanic.”32Thegovernmentfranklycould

notletAIGfail,astheresultingeffectsonthemarketswouldhavebeenirreversible.AIGwould

havenevercreatedthesederivativetoolsinthefirstplaceifitdidnotthinkthehousingmarket

wouldnotfail.WhileitiseasytoblamealackofregulationinthecaseofAIG(i.e.capital

requirementsforliquiditypurposeswouldhavepreventedthecollapse),itisimportantto

rememberthatifthegovernmenthadnotcreatedtheseguaranteesonloansinthefirstplace,

32Ibid,xxv

34

andbelieveditselfthatthehousingmarketwasstrong,AIGwouldnothavebeendoingwhatit

feltitneededtoinordertomaximizeitsownefficiencyasafinancialinstitution.

AnAlternativetoIncreasedRegulation:RevisitingtheEfficientFrontier

Itisclearthatincreasedregulationofinstitutionallendersandsecuritizingagentsinthe

leaduptotheCrisiswouldhavehelpedpreventsuchadisaster.Thispaperhasalsoshownthat

hadthegovernmentnotissuedthesubsidiestheydidtolenders,theextremeresultsofthe

Crisiscouldhavealsobeenprevented.Thequestionnowremainsastowhichsolutionisbest.

TheEfficientFrontierModelexplainsthatinvestors(inthiscase,lenders)attempttooptimize

giventheconstraintsthatexistontheirportfolios.Whileweknowthatsubsidiesthatcreated

moralhazardshiftedthecurveupandtotheleft,causinglenderstoredesigntheirportfolio

composition,increasedregulationwouldalsoshiftthecurve,butdownandtotheright.Not

onlydoesthismeanthatlendershavetore-optimizetheirportfolios,buttheyareunableto

issuethesamenumberofloanstheyotherwisecouldhavewithouttheintroductionofan

outsideagent.Thiswouldresultnotonlyinlessprofitforbanksandotherlendersbutlower

homeownershiprates.ItisimportantthatlowincomeAmericanshavesomesortofvehicleto

investin(typicallyahome)tohelpthemescapepovertytrapsthatconsistentlyoppressthem.

Theoptimalsolutionendsupbeingamorehands-offapproachfromthegovernmentinthe

affairsofinstitutionallenders,especiallythosethatissuemortgagesandsecuritizethose

mortgages.Thiswaylenderswillarriveatanaturaloptimalportfoliothatallowsforincreased

homeownershipwithoutthenegativeside-effects.Whilesomeregulationisalwaysnecessary

35

topreventabuseslikepredatorylending,governmentsoughttobecarefulaboutissuing

subsidiesthatdomoreharmthangoodtoourfinancialsystem.

Economists,politicians,andacademicsalikehaveconsistentlyattributedthecauses

financialcrisistothisaforementionedlackofregulation.WhenthetimecametobailtheWall

Streetbanksout,themediabroadlyportrayedtheUStaxpayerasthemajorloserfollowingthe

FinancialCrisis.Americansfeltthattheyweretheonespayingfortheexcessivegreedand

sometimesillegalpracticesoffinanceprofessionals.However,thisstoryisoftentold

incorrectly.ItwasnotthegreedofWallStreet,butthesheerlackofforesightfromthe

government,whendecidingtoissueparticularlydangeroussubsidies,thatwastheoriginal

partyatfault.Inthissense,wecantracetheexacerbationoftheCrisisallthewaybacktothe

HousingandCommunityDevelopmentActof1992.Whilethegovernmenthadnoble

intentions,wantingeverycitizentobeabletolivetheAmericanDreamofowningtheirown

home,theydidnotcorrectlypredictthecascadeofmistakesthatwouldfollow.Itisforthis

reasonthatwecanconcludethegovernmentoughttosimplyinvolveitselflesswhenitcomes

totheregulationoffinancialinstitutions.Pastattemptstoimprovetheeconomyhavebeen

largely“hitormiss,”butthemistakesmadeintheleadupto2007aresimplyunforgivable.Itis

theprofessionalsthathaveworkedintheindustrytheirwholelivesthatunderstanditbestand

willnaturallyregulatethemselvesifgivenmorefreedom.Thiswouldcreatetheperfectbalance

ofcompetition,ahighceilingforsuccess,andself-regulationthatwouldproducenet-benefits

forallofsociety.

Indeed,marketfailureisaveryrealphenomenonthatrequiresgovernment

interventiontosolve.However,the2007FinancialCrisiswasnottheresultofmarketfailure,

36

butratherashowcaseexampleofclear-cutgovernmentfailure.Therewillprobablyalwaysbe

debatesurroundingtheroleofgovernmentinthefinancialindustrybutitisnevertheless

importanttoacknowledgebothsides.Take,forexample,theVolckerRule,which“bansbanks

frommosttradingorspeculatingunlesstheyaredoingsooncustomers’behalf.Proponentssay

theruleisdesignedtoreininrecklessrisk-takingattaxpayer-insuredbanks,butconservative

criticscomplainthatitisundulyburdensometocomplywith,anddeprivesbanksoflegitimate

moneymakingopportunities.Theyalsosayithasharmedliquidity—theabilitytoeasilybuyor

sell—incertainfinancialmarkets.”33Whilemanybelievethatlessissuanceofsubsidieswilldo

moretodiscouragemoralhazardthanincreasingregulation,thereisabsolutelynodoubtthat

lesssubsidieswouldleadtomoreefficiencyforfinancialinstitutions.Withtheabilitytoact

almostfreely,firmsarenotdeprivedofmoneymakingopportunities,noraretheyincentivized

toactirrationallyortakeontoomuchrisk.Thus,decreasingtheamountofsubsidieswould

havebeenfarmoreefficient,forallpartiesinvolvedintheleaduptotheCrisis,thanincreasing

regulation.

FutureImplications

Whenthinkingaboutthefutureoftheglobalfinancialsystem,bothintheU.S.and

abroad,itwouldbeidealforgovernmentstosimplynotinterferewiththepracticesof

mortgagelendersforthebenefitofallparties.Whilethisisnotnecessarilytheprevailing

viewpointheldbyeconomicandpoliticalhistorians,itisundoubtedlyonethatneedstobe

33https://www.marketwatch.com/story/financial-regulation-reign-in-the-banks-or-let-the-market-work-2017-05-22

37

consideredbygovernmentswhenthinkingaboutwhatliesahead.Withtalksofanimpending

recessionandtherecentinversionoftheyieldcurve,34itbecomesallthemoreimportantwe

considertheagentspropagatingmoralhazardinoureconomytoday.Whileitistruethatmoral

hazardisanaturalphenomenonthataffectsusallwhenwenolongerhavetobearthe

downsidecostassociatedwithrisk,therearecertainlyactionswecantaketopreventputting

ourselvesinsuchaposition.

Theaforementionedbeingconsidered,theFederalReservestillplaysacriticalrolein

controllingthepaceofoureconomyandmakingsurethingsstayincheck.Shouldtherebea

recession,itwillbeparamountthattheFedraiseinterestratesattherighttime(followingsaid

recession)tostimulateborrowingandspendingintheeconomy,andbeforetheeconomygets

tooaccelerated,raisethoseratesbacktotheirpreviouslevel.Thegovernmentdoesandshould

playaroleinsettingtheboundsthatafreemarketshouldoperatein.Weneedtocorrect

marketfailure,makesureactorsplayfairlybytheruleswevoteon,andcontrolrates,

somethingonlyaccomplishedbythegovernment.Beyondthat,however,wemustrealizethe

benefitsoffreemarketsandfinancialself-regulation.Thereoughttobenaturalwinnersand

losers,andnaturalconsequencesfortheactionsofindividualsandfirms.Creatingharmful

financialproductslikethesyntheticCDOonamarketthatmayormaynotbeabubbleoughtto

havedireconsequences.However,itisunlikelythesewouldeverbecreatedwereitnotforthe

governmentinterveningintheaffairsoffinancialinstitutionsinthefirstplace.Weneedto

allowfirmstooptimizeundernaturalconstraintsofthemarket,ratherthanforcethemintoa

34https://www.washingtonpost.com/business/2019/08/14/recession-watch-what-is-an-inverted-yield-curve-why-does-it-matter/

38

setofcircumstancestheywillonlytrytocircumvent,harmingeveryoneintheprocess.While

thisisnotalwaysaneasydiscussiontohave,thereisatrueoptimalsolutiontotheproblemof

thecreationofmoralhazardinthefinancialmarkets.

39

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