Today we see how utterly mistaken was the Milton Friedman notion that a market system can regulate itself. We see how silly the Ronald Reagan slogan was that government is the problem, not the solution . . . I wish Friedman were still alive so he could witness how his extremism led to the defeat of his own ideas.
-- Economist Paul Samuelson (January 2009)
The people on Wall Street still don't get it. They're still puzzled--why is it that people are mad at the banks? Well, let's see. You know, you guys are drawing down 10, 20 million dollar bonuses after America went through the worst economic year that it's gone through in decades, and you guys caused the problem.
-- President Barack Obama (December 2009)
The banking crisis that began in August 2007 shocked markets and precipitated the Great Recession. To fully explain the banking crisis, one must account for its timing, severity, and global impact. One must also confront a startling historical contrast. If we define "banking crisis" to mean bank failures and system losses exceeding 1 percent of a country's gross domestic product (GDP), we find that in the period 1875-1913, a period of marked expansion in international trade and capital flows comparable to the last three decades, there were only four banking crises worldwide.1 By contrast, in the period 1978-2009, a period of much more extensive bank regulation, central bank intervention, government protection of depositors and other bank creditors, and government control of mortgage markets, about 140 banking crises occurred worldwide. Of these, 20 were more severe than any crisis from the earlier period of 1875-1913, in terms of total bank losses as a percent of GDP.
Leading financial economists such as Charles Calomiris have argued that a necessary condition for a banking crisis is government policy that distorts the micro-incentives of banks. Likewise, University of Chicago scholar Richard Posner has argued the banks that got into trouble during the recent crisis were simply taking "risks that seemed appropriate in the environment in which they found themselves."2
But then why didn't a banking crisis erupt sooner--say, in the recession years of 1990-1991 or 2001-2002? What changed in recent years that led to business risk-taking capable of wrecking the U.S. housing market and the U.S. banking system and other banking systems throughout the world? Further, why were prudent credit practices reasonably maintained in credit card and commercial mortgage securitization in recent years, but wholly abandoned in residential mortgage securitization?
Some economists have criticized securitization as an inherently flawed business model, particularly since the process of securitization involves a "long chain" of players with "information asymmetries." The buyer of the mortgage or security typically knows less than the seller. But many of the financial institutions involved in subprime securitization (e.g., Citigroup) held portions of their own securitizations, and they have for decades been securitizing credit card loans without major debacles. Calomiris has observed that even during the subprime boom, banks aggregating credit card loans for securitization and investors in securitizations closely examined the identity of originators, their historical performance, the composition of portfolios, and changes in composition over time.3
In contrast, from 2003 until the middle of 2007, the demand for subprime loans and securities proved extremely insensitive to changes in borrower quality and loan structure. There was dramatic new entry into subprime mortgage origination in 2004-2006 as many "fly-by-night" originators offered newer, riskier mortgage products to new customers and homeowners. Yet these new entrants were able to raise funds for origination on terms comparable to those governing originators with longer track records and who were continuing to originate more proven, lower-risk products.
Likewise, since the early 1990s, commercial property mortgages have been securitized just like home mortgages. Throughout most of the residential housing boom from 2000-2006, there was also a boom in commercial real estate values (see chart below). The two real estate bubbles are not directly comparable, because the residential housing downturn was associated with immediate erosion in property market fundamentals and spikes in mortgage default rates. In contrast, the initial decline in commercial property values--which occurred some 18 months after the housing peak--was mostly due to increased risk aversion in the capital markets. Commercial property fundamentals stayed strong in most markets and commercial mortgage default rates remained at historic lows until well after the onset of the recession. The housing bust, the banking crisis, and the recession brought down commercial real estate--not the other way around.
Yet from 2002-2007, the intensely competitive commercial mortgage-backed securities (CMBS) business became dysfunctional at times and lenders frequently complained of "too much money chasing too few good deals." Declining long-term Treasury rates and falling debt and equity risk premia during this period drove up commercial property values, which in turn led to commercial properties being more highly leveraged (as measured by loan amount per square foot or loan amount to original cost). Yet despite some erosion in commercial mortgage underwriting (e.g., the percent of interest-only CMBS loans increased from 6 percent in 2002 to 59 percent in 20074), lender due diligence remained high and disciplined. Also, the 80 percent loan-to-appraised value and 1.20 property cash-flow-to-debt-service ratio, both long-established industry standards, were rarely violated.
In answer to the questions posed above about what specific factors explain the: causes and timing of the banking crisis and the extraordinary departure from historically sound underwriting and securitization standards for residential mortgages, we identify a potent mix of six major government policies that together rewarded short-sighted collective risk-taking and penalized long-term business leadership:
1. Bank misregulation, in particular the international Basel capital rules, including a U.S. adaptation to them--the 2001 Recourse Rule--and the outsourcing of risk assessment by regulators to government-sanctioned rating agencies incentivized (not merely "allowed") the creation and highly-leveraged systemic accumulation of the highest yielding AAA- and AA-rated securities among banks globally. The demand for these securities was met mainly through the increased securitization of U.S. subprime and Alt-A mortgages, an artificially large portion of which carried credit ratings of AAA or AA. The charts below display the typical tranche shares for subprime and Alt-A mortgage-backed securities (MBSs) in 2006, and show that 85.9 percent of subprime MBS tranches, and 95.3 percent of Alt-A tranches, were rated either AAA or AA.
2. Continually increasing leverage--driven largely by Fannie Mae and Freddie Mac credit policies and the political obsession with taking credit for increased homeownership--into the U.S. mortgage system. Reduced down payments and loosened underwriting standards were a matter of government policy throughout the housing boom. The two nearby charts illustrate the leverage trends from 2001 to 2007--residential mortgage debt as a share of GDP rose from less than 50 percent in 2001 to almost 75 percent by 2007 (top chart); and the percent of residential real estate sales volume with loan-to-value ratios of 97 percent or higher (down payments of 3 percent or less) increased from about 10 percent in 2001 to almost 40 percent by 2007 (bottom chart). Taken together, these graphs show that housing leverage was increasing to historically unprecedented levels by 2007 at the same time that the quality of housing debt was deteriorating considerably due to an erosion of sound underwriting standards and lower down payments, as discussed above.
Creditors with the lowest cost of capital generally drive underwriting and leverage standards within the segment in which they compete. In the residential mortgage market, with government entities historically being the low-cost providers of capital and the dominant purchasers and guarantors of loans and securities, it is reasonable to hold government accountable for system-wide leverage.
Economist Eugene White has noted that the U.S. housing boom and bust in the 1920s was similar in magnitude to the recent one.5 With essentially no government intervention in the mortgage market in the 1920s, system-wide leverage expanded during the boom, but generally only up to the 80 percent loan-to-value level. Also, there were no special incentives provided to the banking sector for a concentrated build-up of balance sheet exposure to high-risk mortgages. Therefore, when real estate prices crashed in 1926, it was not enough to cause a banking crisis and, in fact, bank suspensions nationally were lower in 1927 and 1928 than in 1926. Further, bank losses in the late 1920s were concentrated in agricultural areas unaffected by the boom in residential real estate.
3. The enlargement of the riskier subprime and Alt-A mortgage markets by Fannie and Freddie through the abandonment of proven credit standards (e.g., dropping proof of income requirements) during the 2004-2007 period, and their combined accumulation of a $1.6 trillion portfolio of these loans to meet the affordable housing goals Congress mandated. As of mid-2008, government entities had purchased, guaranteed, or compelled the origination of 19 million of the 27 million total U.S. subprime and Alt-A mortgages outstanding.6
4. The FDIC, Federal Reserve, Treasury Department, and Congress undertook explicit or implicit creditor bailouts for large financial institutions starting in the 1980s (First Pennsylvania, Continental Illinois, the thrift industry, the Farm Credit System, etc.) and continuing to 2008 (Bear Stearns). These regulatory decisions led to an absence of creditor discipline of financial institution leverage and risk-taking (especially at Fannie and Freddie) and the "too big to fail" expectation of a government bailout.
Creditors--not shareholders--normally control business risk-taking. They do this by: 1) reducing leverage; 2) demanding higher interest rates; 3) declining to finance risky projects; 4) requiring more collateral; 5) imposing restrictive terms and loan covenants; and 6) moving deposits to safer alternatives (in the case of bank depositors, who are creditors of banks). Without excessive government protection of creditors, there is little doubt we would have seen creditors act to reduce risk in the U.S. financial system, particularly with respect to Fannie and Freddie.
5. The increase in FDIC deposit insurance from $40,000 to $100,000 per account in 1980 combined with the unchecked expansion of coverage up to $50 million under the Certificate of Deposit Account Registry Service beginning in 2003. These regulatory errors of commission and omission reduced the incentives of business, institutional, and high net-worth depositors to monitor and discipline excessive bank leverage and risk-taking. When federal deposit insurance legislation was first enacted in 1933, policy makers understood that it contributed to moral hazard, tempting bankers to take short-sighted risks. Accordingly, the initial coverage was limited to $2,500 per account (about $42,000 in today's dollars), resulting in a large portion of bank liabilities without a government guarantee. Today, virtually no depositor has any "skin in the game" and, according to one estimate (Walter and Weinberg 20027), more than 60 percent of all U.S. financial institution liabilities, including all those of the 21 largest bank holding companies, were either explicitly or implicitly guaranteed. There were therefore almost no incentives in recent years to monitor the excessive risk-taking by banks that contributed to the housing bubble and financial crisis.
6. Artificially low and sometimes negative real federal funds rates from 2001 to 2005--a result of expansionary Fed monetary policy--fueled the subprime and Alt-A mortgage boom and widened the asset-liability maturity gap for banks (see chart below). Most subprime and Alt-A mortgages carried low initial rates made possible by low federal funds rates, which spurred borrower demand for these mortgages. In the context of federal funds rates falling faster than long-term rates in the 2002-2005 period, low federal funds rates --widened the duration gap inherent in borrowing short and lending long, making the rollover or refinancing of short-term instruments all the more precarious when the value and liquidity of the subprime and Alt-A mortgage securities this paper was financing became doubtful and the wholesale funding markets started to deleverage. In particular, many large investment banks reached for more firm leverage during the housing bubble and roughly doubled the proportion of total assets financed by overnight repos.
Underlying all these six government policies is the underappreciated problem of government failure, a problem rooted in the absence of incentives to reconcile a policy's social costs and benefits with the costs and benefits to the policy makers. Therefore, the banking crisis should be understood more fundamentally as a government failure than as a market or business failure.
Government failure does not explain every aspect of the banking crisis and ensuing recession. It does not explain, for instance, why JPMorgan Chase, operating under the same regulatory regime and economic incentives as Citigroup, largely exited the residential MBS business as Citigroup and other large banks were ramping up. The crisis certainly could not have occurred without certain private firms (e.g., Citigroup, UBS, Merrill Lynch) engaging in excessive corporate short-termism (or perhaps "greed") along the same lines as Fannie and Freddie. But greed is a timeless and universal component of human nature, and it influences the public sphere at least as much as the private sector. As such, greed has little relevance in explaining the timing and crucial facts of the recent crisis--such as why credit standards and due diligence practices in housing finance deteriorated so much more dramatically than in any other credit segment. The argument we advance is that the interaction of these six government policies explains timing, severity, global impact, and other important features of the banking crisis better than any faulty business practices unrelated to the perverse incentive effects of these government policies.
What is remarkable is that policy experts and politicians sympathetic to the views Paul Samuelson and President Obama have expressed--those who would have us believe that a combination of market defects, business greed, and under-regulation provide the better fundamental understanding of the crisis--rarely, if ever, argue along that line. They call our attention to business deficiencies such as "predatory lending" and incentive-based compensation practices based strictly upon annual performance. They are right to do so. But they do not provide a direct counter argument to the one we make. They do not tell us why the crisis reflects a failure of unfettered capitalism more fundamentally than a failure of government policies.
For example, in his book Freefall, Joseph Stiglitz tells us that "blame for the crisis must lie centrally with the financial markets" and that "the financial crisis showed that financial markets do not automatically work well, and that markets are not self-correcting."8 Yet nowhere in the book's 361 pages does Stiglitz directly counter our argument analytically--only rhetorically and briefly, at that. In fact, while Stiglitz points fingers in every direction, what he seems to find most culpable is the cronyism inherent in the government's "too big to fail" bailout policies, which he refers to as "ersatz capitalism." The net effect of the Stiglitz book is to support our argument.
This issue--the relative contribution of government policies versus independent financial market practices to the financial crisis--is all-important. It is the "elephant in the room" of every current and future discussion of financial reform and the role of government in the economy generally.
A more accurate interpretation of the financial crisis as predominantly a government failure could pave the way for real financial reforms that would contribute to both future financial stability and productivity. These reforms would include: 1) the gradual reduction of government intervention in mortgage markets through legislation such as the GSE Bailout Elimination and Taxpayer Protection Act (HR 4889), sponsored by Representative Jeb Hensarling (R-Texas); 2) a reduction in federal deposit insurance and other transparent policy rules to reduce or eliminate creditor expectations of future bailouts, especially the "too big to fail" guarantee; 3) the replacement of elaborate regulatory micromanagement with more equity capital; and 4) a monetary policy rule or quasi-rule to govern the Federal Reserve's policy making.
But just as the Patient Protection and Affordable Care Act ("ObamaCare") ignores the government's role in creating a crisis of runaway health costs and a low health-outcome-to-cost ratio, the Dodd-Frank Wall Street Reform and Consumer Protection Act, passed in July, was enacted on the faulty presumption that the fundamental cause of the financial crisis was financial market failure and under-regulation of the financial sector. In expanding government control over financial markets with more systemically imposed micro-regulations and inconclusive future bureaucratic rule-making, the Dodd-Frank Act is fundamentally flawed in its approach to reform Wall Street.
Many of the "Tea Party" Republicans swept into power in the November midterm elections ran on a platform of replacing or reforming ObamaCare. Their success at the polls partially reflects the correct perception of the majority of informed Americans that persistent problems in U.S. healthcare stem primarily from government failure. The same perception holds equally true for the U.S. financial system, and replacement or reform of the Dodd-Frank Act is an equally worthy undertaking.
Mark J. Perry is a visiting scholar at the American Enterprise Institute and professor of finance and economics at the University of Michigan in Flint. Robert Dell is a commercial real estate banker residing in Atlanta. They are co-authors of a forthcoming book, Back from Serfdom: A Republican New Deal for Pragmatic Democrats.
Originally printed in The American Magazine on December 26, 2010. Available at www.american.com.
1. Charles W. Calomiris, "Banking Crises Yesterday and Today," "Calomiris on the Financial Crisis," and "Banking Crises and the Rules of the Game."
2. "Posner on Friedman on Posner on the Crisis," Causes of the Crisis, September 20, 2009.
3. Charles W. Calomiris, "The Debasement of Ratings: What's Wrong and How We Can Fix It."
4. Congressional Oversight Panel, February 10, 2010, "Commercial Real Estate Losses and the Risk to Financial Stability."
5. Eugene N. White, "Lessons from the Great American Real Estate Boom and Bust of the 1920s."
6. Peter J. Wallison, "Not a Failure of Capitalism--A Failure of Government," and Peter J. Wallison and Charles W. Calomiris, "The Last Trillion-Dollar Commitment: The Destruction of Fannie Mae and Freddie Mac."
7. John R. Walter and John A. Weinberg, "How Large Is the Federal Financial Safety Net?"
8. Joseph E. Stiglitz, Freefall: America, Free Markets, and the Sinking of the World Economy (W.W. Norton & Company, 2010).