More Government Induced CrisisMike Rappaport

Arnold Kling, who has taught me more about this crisis than anyone else, writes:

An FDIC document on the risk weights of different bank assets. The higher the weight, the more capital the bank has to hold against that asset. As I read table 1 and table 3, if you originate a loan with a down payment of 20 to 40 percent, the risk weight is 35. But if you buy a AA-rated security, the risk weight is only 20. So if a junk mortgage originator can pool loans with down payments of less than 5 percent, carve them into tranches, and get a rating agency to rate some of the tranches as AA or higher, it can make those more attractive to a bank than originating a relatively safe loan. If you want to know why securitization dominated the mortgage market, this explains it. Regulatory arbitrage, pure and simple.

In other words, the regulatory system promoted securitization rather than larger down payments.  And since larger down payments are probably the most important ingredient of safe mortgages, we have a significant incentive towards securitization. 

I had suggested something like this previously when talking about the rating agencies, but this is more specific.  The government failure story here just keeps on growing and growing. 

Update:

Dan Simon challenges this post in the comments. Well, Dan, I appreciate the attention and the challenges. They help me get clearer on the financial crisis. That said, I don’t agree with you.

Before getting into the narrow issue of these capital requirements, let me briefly note two wider aspects of the subject. First, I have previously argued, and won’t repeat here, how Fannie and Freddie were an important cause of the problem. This post here helps to explain why the securitization expanded beyond mortgages securitized by Fannie and Freddie – an issue you previously raised in your comments.

Now, to address your main point. You write:

The banks, bond dealers and bond rating agencies essentially colluded to exploit a subtle loophole in the regulations, allowing them to mask risky investments as safe ones so that they could dodge the reserve requirements and invest more heavily in high-risk, high-return securities. The risky investments went sour, and some banks became insolvent.

The obvious conclusion is not that ill-advised regulation led the banks astray ("regulatory failure", as you put it), but rather that an insufficiently stringent regulation regime allowed the banks to circumvent it, with disastrous results.

I believe your point is mistaken in a couple of ways. First, regulatory failure does not mean that the best response is to eliminate a regulation. It means that a bad regulation led to a problem, which is what happened here. Second, you write that the “banks, bond dealers and bond rating agencies essentially colluded to exploit a subtle loophole.” Well, not exactly. The banks were responding to a capital requirement that made it advantageous to buy securitized loans. It is not clear whether the banks understood that the securities were risky. But even if they did, they would have been responding to a regulatory environment where deposit insurance gives them a significantly reduced incentive to avoid risk. The capital requirements were set up to address that incentive, but they appear to have been badly written. Why the regulators made that mistake, and why they rely on the rating agencies which have been long known to be problematic (see my colleague Frank Partnoy’s work on this), I don’t know.

The bottom line is not that the regulations “led the banks astray,” but instead that the regulations set up poor incentives and those incentives led to bad results.

Comments

[Dan Simon]

Let's see if I understand this correctly: the FDIC had put in place an elaborate set of regulations designed to ensure that banks maintained reserves commensurate to the riskiness of their investments. The banks, bond dealers and bond rating agencies essentially colluded to exploit a subtle loophole in the regulations, allowing them to mask risky investments as safe ones so that they could dodge the reserve requirements and invest more heavily in high-risk, high-return securities. The risky investments went sour, and some banks became insolvent.

The obvious conclusion is not that ill-advised regulation led the banks astray ("regulatory failure", as you put it), but rather that an insufficiently stringent regulation regime allowed the banks to circumvent it, with disastrous results. Hence, if I believed that this particular issue were at the heart of the current crisis, then I would have to conclude that at least part of the solution is more regulation.

Now, as it happens, I don't believe that this particular issue is at the heart of the crisis. For one thing, most banks were relatively well-behaved, compared to other financial institutions, and for another, there were plenty of ways for those other financial institutions to inject their toxic waste into the financial system in dangerously high volumes, without relying on this particular loophole in bank reserve requirements. Once the entire financial industry had concluded that any sufficiently widespread risk was implicitly covered on the downside by the (in)famous "Greenspan put", *something*--be it emerging market debt, dotcom stocks or subprime mortgages--was bound to become the new high-yield, high-risk-but-Alan-will-save-us flavor of the month, however heavy-handed the regulators.

On the other hand, though, to believe that "regulatory failure" was the underlying problem, requires nothing short of quasi-religious faith that the evil hand of government interference in the holy marketplace is at the root of all misfortune. Greenspan's monetary policies had the seal of approval of the most ardent libertarian free-market loyalists. And if anything, the FDIC's reserve requirements saved far more banks than they undermined.

[Dan Simon]

Let's start with your question: "Why the regulators made that mistake, and why they rely on the rating agencies which have been long known to be problematic". It's rather ironic for you to be asking this, since the bond rating agencies would normally be considered by any self-respecting libertarian to be an excellent free-market alternative to the more obvious approach of having the government rate investments itself.

And in fact, the rating agencies have generally been quite reliable, over time. They have a clear incentive to preserve their reputations, lest investors discount their ratings and thus make their ratings worthless to the issuers that pay for them. And given the bond markets' reliance on them, the current crisis would have occurred decades ago if they hadn't been doing their job.

So why did they suddenly mess up so badly? Part of the problem is the rise of bond insurance, which has given raters an excuse to simply invoke the insurer in lieu of serious evaluation of risk. But that simply adds another party to the collusion. Why were banks, bond raters, bond insurers and bond issuers all comfortable with this elaborate charade, in which toxic waste bonds were issued, insured, highly rated and bought by banks as safe investments?

It's not enough to simply invoke flawed government regulation as the cause. The reserve requirements in question have existed for many years, and have successfully prevented past abuses of this type. And indeed, it ultimately took a collective betrayal of responsibility by multiple actors on a grand scale to create the current crisis. What led all these parties to shift from self-interested caution to suicidal recklessness?

The answer should be clear by now: the "Greenspan put" did it. The very low interest rates this decade have had two key effects: they made subprime loans extremely profitable, even at fairly high default rates, and they reinforced the consensus that the Fed could always be trusted to intervene to reverse any default-spiking downturn. For bond markets, this combination of temptation and complacency was disastrous.