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.