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The purpose of this paper is to discuss the key regulatory, market, and political
failures that led to the 2008-2009 US financial crisis and to suggest appropriate recommendations
for reform.
Journal of Financial Economic Policy
The political, regulatory, and market failures that caused the US financial crisis: What
are the lessons?
David G. Tarr
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To cite this document:
David G. Tarr, (2010),"The political, regulatory, and market failures that caused the US financial crisis",
J ournal of Financial Economic Policy, Vol. 2 Iss 2 pp. 163 - 186
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The political, regulatory,
and market failures that caused
the US ?nancial crisis
What are the lessons?
David G. Tarr
The World Bank, Washington, DC, USA
Abstract
Purpose – The purpose of this paper is to discuss the key regulatory, market, and political
failures that led to the 2008-2009 US ?nancial crisis and to suggest appropriate recommendations
for reform.
Design/methodology/approach – The approach is to examine the underlying incentives that led to
the crisis and to provide supporting data to support the hypotheses.
Findings – While Congress was ?xing the savings and loan crisis, it failed to give the regulator of
Fannie Mae and Freddie Mac normal bank supervisory power. This was a political failure as Congress
was using government sponsored enterprise (GSE) resources and the resources of narrow
constituencies for their own advantage at the expense of the public interest. Second, in the mid-1990s,
to encourage home ownership, the Administration changed enforcement of the Community
Reinvestment Act, effectively requiring banks to use ?exible and innovative methods to lower bank
mortgage standards to underserved areas. Crucially, this disarmed regulators and the risky mortgage
standards then spread to other sectors of the market. Market failure problems ensued as banks,
mortgage brokers, securitizers, credit rating agencies, and asset managers were all plagued by
problems such as moral hazard or con?icts of interest.
Originality/value – The paper focuses on the political economy reasons for why Congress and US
administrations provided these perverse incentives to the GSEs and banks to lower mortgage
standards. It also proposes some innovative methods of improving bank regulation that address the
regulatory capture problem.
Keywords United States of America, National economy, Government policy, Borrowing, Regulation
Paper type General review
From the current handwringing, you’d think that the banks came up with the idea of looser
underwriting standards on their own, with regulators just asleep on the job. In fact, it was
the regulators who relaxed these standards – at the behest of community groups and
“progressive political forces.” Professor Stan Leibowitz, University of Texas (Liebowitz,
2008b).
The current issue and full text archive of this journal is available at
www.emeraldinsight.com/1757-6385.htm
JEL classi?cation – G00, G1, G2
The author would like to thank Gerald Caprio, Edward Kane, Peter Wallison, Wilfred Ethier,
Thomas Rutherford, Douglas Nelson, Fernando Saldanha, Kenneth Kopecky, Charles Calomiris,
Edi Karni, Will Martin, Asli Demirguc-Kunt, Robert Kahn, James Ferguson, Morris Morkre,
Robert Fenili, Gerald Moore, D. Bruce Allen, Adam Tarr, Paul Chandler, Linda Tarr,
Joshua Harrison, and seminar participants at the World Bank, Kiev School of Economics,
International School of Economics, Tbilisi and ETH-Zurich for helpful comments. The author
alone is responsible for the views in this paper.
Failures that
caused the US
?nancial crisis
163
Journal of Financial Economic Policy
Vol. 2 No. 2, 2010
pp. 163-186
qEmerald Group Publishing Limited
1757-6385
DOI 10.1108/17576381011070210
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I. Summary and literature review
Summary
In 2008-2010, the USA is in the worst ?nancial crisis since the Great Depression.
The core of the crisis is that 44 percent of all home mortgages (or 25 million mortgages)
are default prone, a ?gure that is unprecedented in US history[1]. Why did ?nancial
institutions and homeowners acquire so many mortgages that are in default or in
danger of wider default? I argue that the crisis is a result of regulatory failure, market
failure and, most of all, political failure.
First, the seeds of the crisis were sown while Congress was appropriately imposing
tougher regulation on banks and savings and loan associations in the early 1990s in
response to the savings and loan crisis. Congress made a grave error: it agreed to avoid
real regulation of the two government sponsored enterprises (GSEs) commonly known
as Fannie Mae and Freddie Mac, and allow them to take on unlimited risks with an
implicit government guarantee. Fannie and Freddie avoided real regulation by
proposing an “affordable housing” mission, which ultimately led to a lowering of their
standards for acquiring mortgages. Subsequently, Congress used Fannie and Freddie
projects like earmarked pork projects and taxpayers are now on the hook for an
estimated 50 percent (or $1.6 trillion) of the sub-prime, alt-A, and other default prone
mortgages. These mortgages are now defaulting at a rate eight times that of the GSEs
traditional quality loans (Pinto, 2008, Attachment 5). The failure to give the GSE
regulator normal bank supervisory power was a regulatory failure. But given that
Congress was in the process of ?xing the savings and loan crisis, Congress had to be
aware of the risks. Therefore, it was even more of a political failure. In other words,
the general social good was sacri?ced to appeal to narrow political constituencies.
Second, in the mid-1990s, the Clinton Administration changed enforcement of the
Community Reinvestment Act and effectively imposed quotas on commercial banks to
provide credit to underserved areas. The banks were told to use “innovative or ?exible”
methods in lending to meet the goals of the Community Reinvestment Act (Hossain,
2004, p. 57). Failure to meet the quotas would result in denial of merger or consolidation
requests. The evidence (cited below) reveals that bank mortgage standards fell as a
consequence of this regulatory change. Crucially, the risky mortgage standards then
spread to other sectors of the market. Encouraged by the home mortgage interest
deduction and low interest rates in the four to ?ve years prior to the crisis, speculators
and households trading up to bigger houses acquired a large number of high-risk
mortgages. Riskier mortgage standards by banks were not the consequence of
deregulation; rather the banks were compelled to change the standards by new
regulations at the behest of community groups. Again, this was a political failure as the
Administration sacri?ced the greater social good to appeal to narrow constituencies.
Once the banks were pressured by regulation to offer risky mortgages to underserved
areas, they (and mortgage brokers) found they could make money on them by selling
themto “securitizers,” who inturnpackaged the mortgages inpools andsoldthem. Akey
market failure problemwas that the ratings agencies were in?uenced by the securitizers
to underestimate the risk of the mortgage pools. Since the securitizers paid the rating
agencies for the ratings, this his was accomplished by awarding repeat business to
agencies that gave good rating, and by “rating shopping,” a practice in which
securitizers would ask multiple rating agencies how they would rate their pool of
mortgages, and then select a ratings agency that gave a very good rating. The problems
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were exacerbated by the fact that asset managers in the private sector who bought the
pools of mortgages had a con?ict of interest. Constrained to invest in high-quality assets,
rather than returnthe money of their clients and lose management fees, money managers
closed their eyes to the signals that the mortgage pools were riskier than the ratings.
These problems were market failures.
Within limits, a targeted program to expand home ownership to low or moderate
income families is a worthy social goal. A more ef?cient way to do it, however, is to
subsidize down payments of ?rst time low and moderate income home buyers, without
encouraging or forcing banks to lower lending standards. Politicians, however, often
prefer to mandate a regulation on ?rms to achieve a political objective, since this allows
them to avoid exposure of the costs of their programs while obtaining support from
narrow constituencies. In this further sense, the ?nancial crisis is, at its root, a political
failure. What is ominous is that the supporters of the programs that got us in this deep
?nancial mess appear to still be pushing the same policies.
There were numerous regulatory failures and there is a clear need for newregulation
and changes in regulation in several areas. The causes of the crisis, however, were
sub-prime lending andsecuritization. Securitizationwas available for banks, investment
banks and other ?nancial institutions since the 1970s, and sub-prime lending was
encouraged to promote wider home ownership. There is no connection between
securitization and sub-prime lending on the one hand and ?nancial deregulation of the
past three decades. Characterization of the problems as “deregulation” diverts attention
from the crucial task of ?xing the perverse regulations in place and identifying where
new regulation is needed.
In the next three sections, I explain these issues in more detail. This note concludes
with lessons for regulatory reform to help us avoid similar crises in the future.
Literature review
There is a vast literature on the ?nancial crisis – both overview studies and papers
that focus on speci?c problems and solutions. Among the most important overview
studies are Barth (2009), Brunnermeier (2009), Calomiris (2008b), Caprio et al. (2008),
Kane (2009), Taylor (2009), and Wallison (2008). An explanation of the incentive
problems of banks and credit rating organizations (CROs) that were important in
explaining the ?nancial crisis is included in the studies of Barth, Brunnermeier,
Calomiris, Kane, and Caprio et al. The Barth study is a very accessible explanation of
the causes of the crisis and provides the most factual detail of the mortgage and credit
markets. The analysis of Brunnermeier would be of interest to economists who want a
deep theoretical discussion of the incentive issues. A key recommendation of Caprio
et al. is that CROs should be paid by the buyers of the collateralized credit obligations,
not the sellers. Calomiris (2008b), however, believes this will not solve the problem due
to incentive problems of the buyers and recommends (Calomiris, 2009) tough new
regulations on CROs. (Below I discuss a recommendation by Richardson and White
that I believe is a superior mechanism for reform of the CROs.) Kane emphasizes the
incentive problems of regulators, the importance of limiting bailouts of ?nancial
institutions for fear of creating the next ?nancial crisis and the mischaracterization of
the crisis by the Obama Administration as a liquidity crisis rather than a solvency
crisis. Taylor (2009) argues that monetary policy of the Federal Reserve contributed
to the crisis, and provides evidence that the ?nancial crisis is not a liquidity crisis.
Failures that
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?nancial crisis
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Wallison emphasizes the government failures the led to the ?nancial crisis, especially
the failure to regulate the GSEs and the pressure on banks to lower mortgage
standards under changed regulations of the Community Reinvestment Act. Leibowitz
(2008) documents that “in an attempt to increase home ownership, virtually every
[relevant] branch of government undertook an attack on underwriting standards.”
In this paper, I build on the earlier work and try to explain the incentive problems of
banks, CROs, and other key private ?nancial institutions in a straightforward
accessible manner. A contribution of this paper that is not discussed in the literature is
the explanation of why political failure was a root cause of the ?nancial crisis, and the
reasons for that political failure.
II. The failure to regulate Fannie Mae and Freddie Mac
Top on the list of regulatory failures is the failure to regulate Fannie Mae and Freddie
Mac. Pinto (2008) has estimated that about $1.6 trillion or about 47 percent of the toxic
mortgages were purchased or guaranteed by these GSEs, and the government is now
on the hook for these mortgages. How did this happen? There were two key economic
principles that were ignored. One is that if the government and taxpayers stand behind
the ?nancial obligations of a company, the company should be regulated against
taking excessive risks for which the taxpayers are responsible. The government agreed
not to regulate the GSEs and even encouraged them to take on risky mortgages in
order to widen home ownership among low and moderate income households (and the
government also pressured banks to take on risky mortgages for the same reasons).
This regulatory failure, however, was essentially a political failure.
The economic theory of regulation (public choice theory)
The fact that special interests were successful in avoiding effective congressionally
mandated regulation of the GSEs at the expense of the public interest is explained by
the modern economic theory of regulation (or public choice theory). Public choice
theory characterizes the regulatory process as one of the competitions among interest
groups to use of the coercive power of the state to obtain rents at the expense of more
diverse groups (Olson, 1965; Grossman and Helpman, 1994). Producers of goods and
services, who are likely to receive concentrated gains from regulation, are typically
more effective at lobbying for their interests in regulation than consumers or
taxpayers. The latter groups are typically very diverse and suffer from a free-rider
problem that limits their contributions to lobbying. Pressure on regulators may come
from politicians who receive campaign contributions or votes and then pass legislation
favorable to the special interest. Or interest groups can in?uence regulators if
regulators believe that they may receive lucrative positions when they leave the
government. Producers are less likely to achieve a desired regulation if there is a group
that receives concentrated losses (and may, therefore, overcome the free-rider problem
and provide counter-lobbying) or if the inef?ciency costs to society are very large
(Becker, 1983; Stigler, 1971). And politicians may seek to spread the rents across
different interest groups to build a coalition for support (Peltzman, 1976). Kroszner and
Strahan have found this theory relevant to reform of banking supervision[2].
Government guarantees without regulation against excessive risk taking
Fannie Mae was chartered originally as a government enterprise to add liquidity to
the mortgage market and hopefully to lower the costs of borrowing for mortgages.
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Fannie borrowed money cheaply on capital markets because it was a government entity
and used it to buy mortgages. Fannie Mae was privatized in 1968, and Freddie Mac was
privatized in 1989 with an almost identical charter to Fannie. But even as private
enterprises, the GSEs were able to borrow at very attractive rates of interest because
investors believed that the government would back themin the event they went bankrupt.
This belief was validated in September 2008 when the US Government placed the GSEs in
“conservatorship,” and began to inject taxpayer dollars into the companies.
The affordable housing mission to avoid regulation
In the light of the S&L crisis of the late 1980s, many in Congress realized that it was
necessary to regulate the GSEs, since it was dangerous to allow private enterprises to
take on large risks with government guarantees. In order to stave off regulation,
Fannie Mae CEO Jim Johnson proposed that the GSEs add an affordable housing
mission to their objectives (Wallison and Pinto, 2008). Members of Congress saw they
could use GSE projects much as they use earmarked pork projects to boost popularity
in their home districts. Congressmen could request funding from the GSEs for projects
in their districts. For example, in 2006, Senator Charles Schumer’s of?ce issued a press
release headlined:
Schumer announces up to $100 million Freddie Mac commitment to address Fort Drum and
Watertown Housing Crunch.
The press release indicated that Senator Schumer had urged the commitment
(http://schumer.senate.gov/new_website/record.cfm?id¼266131). Jim Johnson realized
that the local projects could be used to in?uence Congress. He created Fannie Mae “local
partnership of?ces” (eventually totaling 51) in urban areas throughout the USA. These
of?ces performed a grassroots lobbying function, assuring congressional backers of
GSEs that they could tap into local supportive groups at election time (Wallison and
Pinto, 2008). Political support for congressional supporters of the affordable housing
mandate of the GSEs also came from community organizations such as the Association
of Community Organizations for Reform Now (ACORN). These organizations realized
that they could be more successful in pressuring banks to expand their sub-prime loans,
if the banks were able to sell the mortgages on the secondary market[3]. In addition,
Fannie and Freddie, through their PACs during the 1989-2008 period, cumulatively
contributed over $3 million to the campaigns of congressional supporters (and their
employees contributed an additional $1.8 million)[4]. In the end, the legislation that was
passed in the early 1990s provided for the GSEs to lend to low and moderate income
lenders, and in return their regulator lacked the authority routinely given bank
regulators[5]. As the problems withthe GSEs rose andbecame evident over the years, the
bargain that was struck, that Congress would not regulate seriously and the GSEs would
undertake an affordable housing objective (which was implemented through lower
mortgage standards), continued until the GSEbankruptcies in September 2008 (and may
be beyond since the fundamental political failure regarding the GSEs has not been
resolved).
Although the GSEs were willing accomplices, in the 1990s, Housing and Urban
Development (HUD) Secretary Mario Cuomo used the implicit bargain of the GSEs to
add pressure on them to take on a higher share of its mortgages to low and middle
income borrowers. As early as 1999, astute journalists warned that this meant that
Failures that
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?nancial crisis
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banks had to loan to progressively riskier borrowers and provide riskier mortgages,
increasing the risks to Fannie and Freddie (Holmes, 1999; Brownstein, 1999).
In 2003 and 2004, the GSEs were caught in Enron style accounting scandals that
eventually led to the resignation of Fannie CEO Franklin Raines, and there were calls
for tougher regulation. Moreover, Federal Reserve Board and Congressional Budget
Of?ce studies concluded that despite the implicit government guarantees that allowed
them to borrow cheaply, GSE activity had not signi?cantly lowered mortgage interest
rates[6]. Since they were creating risks for the taxpayer, what value were they
providing? Alan Greenspan called for tougher regulation.
At this time, internal documents of Fannie and Freddie show that its own risk
managers were sounding strong alarm bells in 2004, and they recognized that the GSEs
had the power to in?uence standards in the market.
Donald Besenius of Freddie Mac, in his April 1, 2004 letter to Mike May said “we did
no-doc lending before, took inordinate losses and generated signi?cant fraud cases. I’m
not sure what makes us think we’re so much smarter this time around.”
David Andrukonis of Freddie Mac said in an e-mail to Mike May on September 8,
2004 that “. . . we were in the wrong place on business or reputation risk [. . .] What
I want Dick [Freddie Mac CEO] to know that is that he can approve of us doing these
loans but it will be against my recommendation[7].”
But Freddie Mac’s management ignored these warnings. Instead Freddie Mac ?red
their chief credit of?cer[8] and the GSEs turned to their congressional allies. Senator
Charles Schumer stated in late 2003:
My worry is that we’re using the recent safety and soundness concerns, particularly with
Freddie, and with a poor regulator, as a straw man to curtail Fannie and Freddie’s affordable
housing mission (Anon., 2008).
At the House Financial Services Committee meeting in September 10, 2003, speaking
about GSE regulation, Representative Barney Frank said:
I do not think I want the same kind of focus on safety and soundness [. . .] I want to roll
the dice a bit more toward subsidized housing (http://online.wsj.com/article/
SB122290574391296381.html).
And roll the dice they did.
Seeing what they had to do to avoid regulation in a tougher political environment,
the GSEs increased their portfolios of sub-prime, alt-A, and high-risk mortgages from
,8 percent of their mortgages in 2003 to over 30 percent in 2008 (Pinto, 2008, p. 7). But
this worked in fending off the tougher regulation. Unfortunately, if defaults continue at
the current high rates, the $150 billion loss of the S&L crisis will easily be exceeded –
at considerable cost to taxpayers in the future (Pinto, 2008).
The political failure of tax regulation of the GSEs
As Edward Kane (who predicted the S&L crisis years in advance (Kane, 1985)) and
others have noted, in the early 1990s, Congress repeated with Fannie and Freddie
the mistake that caused the collapse of the S&L industry. In other words, it
gave government backing to private enterprises without adequately limiting the risks
these companies could take. But the Fannie and Freddie case is a far worse political
failure than the S&L debacle. First, taxpayers’ losses will be much greater than in the
S&L crisis. Second, in the S&L crisis, Congress might be excused for not recognizing
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that it should have imposed tighter limits on the risks assumed by government backed
institutions. But while Congress was passing tough new banking regulation to ?x the
S&L crisis, the decision not to regulate the GSEs must have been a conscious decision
on the part of the supporters of the GSEs in Congress. As documented above, the GSE
supporters in Congress received political contributions, grass roots organizing at
election time and used GSE resources like pork projects. They decided not to regulate
them so they could use GSE resources and the resources of others lobbying for the GSE
affordable housing mandate for their own interests.
Ominous signs for the future
In September 2008, Fannie and Freddie were placed in conservatorship under the
newly created US Federal Housing Finance Agency. Although the US Treasury has
been less de?nite, James B. Lockhart III, Director of the agency that serves as both
regulator and conservator of Fannie and Freddie stated “the conservatorship and the
access to credit from the US Treasury provide an effective guarantee to existing and
future debt holders of Fannie Mae and Freddie Mac[9].” This approach still fails to
address the underlying issue of guaranteed assets without constraints on risk taking.
In the middle of this crisis, James B. Lockhart III appears ready to forge ahead with the
same mistakes. He lamented, in testimony before the House Financial Services
Committee on September 25, 2008, that market turmoil of 2008 resulted in more
stringent loan criteria, for example, higher required down payments. He hoped that
both Fannie and Freddie would develop and implement ambitious plans to meet HUD
regulations for low and moderate income lending. Shockingly, rather than seeing
higher down payment requirements as a positive step toward stability in the housing
market, the regulator is still pushing for a lowering of mortgage standards. And as of
April 2010, despite frequent requests from Congressmen to the Administration for a
plan to restructure the GSEs, and a major ?nancial overhaul package before Congress,
the Administration has been silent on what to do about the GSEs.
III. Perverse incentives fromthe Community Reinvestment Act and market
failures in the private sector
Pinto (2008) estimates that Fannie and Freddie bought an estimated 47 percent of the
toxic mortgages. We still have to explain why the private sector created and bought the
rest. And we also have to explain why so many homeowners who are wealthier than low
or moderate income households are defaulting on mortgages. Part of the answer is that
Fannie and Freddie played a “market maker” role. Their dominant size in the market,
and their readiness to purchase these risky mortgages set standards in the market, and
meant that banks could pass on the risks of badly underwritten mortgages. They also
brought other actors into the business of trying to pro?t from risky mortgages
(Calomiris, 2008a, b). There is, however, another crucial component to the lowering of
bank mortgage standards. In the mid-1990s, the government changed the way the
Community Reinvestment Act was enforced and effectively compelled banks to initiate
risky mortgages. Moreover, there were incentive or market failure problems that
induced many of the key private actors to act in socially counterproductive ways.
Banks’ incentives and the role of the Community Reinvestment Act
The originators and servicers of the mortgages were the banks and mortgage brokers.
There were two problems that led to the banks issuing a lot of mortgages with
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excessive risks. First, the effort to lower mortgage underwriting standards was led by
the US Department of Housing and Urban Development. President Clinton directed
then HUD Secretary Henry Cisneros to develop a “National Homeownership Strategy”
that would “increase home ownership opportunities among populations and
communities with lower than average home ownership rates” (United States
Department of Housing and Urban Development, 1995a, p. 2, b). HUD stated that “the
National Homeownership Strategy commits both government and the mortgage
industry to a number of initiatives designed to [. . .] increase the availability of alternate
?nancing products in housing markets throughout the country” (United States
Department of Housing and Urban Development, 1995a, p. 9). Among the actions it
recommended was the following. “Lending institutions, secondary market investors,
mortgage insurers, and other members of the partnership should work collaboratively
to reduce homebuyer downpayment requirements [. . .] many low-income families do
not have access to suf?cient funds for a downpayment [. . .] in reducing this barrier to
homeownership, more must be done” (United States Department of Housing and Urban
Development, 1995b, Chapter 4, Action 35).
One of the principal means through which this policy was implemented was through
a change in the enforcement of the Community Reinvestment Act. This act was
originally passed in 1977, but weakly enforced prior to 1995. Newregulations phased in
between 1995 and 1997 called for banks to use “?exible or innovative standards” to
address credit needs of lowand moderate income (LMI) borrowers (Hossain, 2004, p. 57);
and banks would be evaluated on outcomes of their lending, i.e. quotas, not on efforts to
reach the of low and moderate income community. Failure to comply meant that banks
could not participate in mergers or acquisitions. So banks and mortgage brokers
developed many innovative products. Notably they lowered down payment
requirements below the traditional 20 percent minimum, and allowed loans to
borrowers with little or no credit history or documented source of income. And Fannie
and Freddie, under their affordable housing mandate, modi?ed their rules so they could
buy these innovative instruments. Hossain (2004) writes that the rule change:
[. . .] can be thought of as a shift of emphasis from procedural equity to equity in outcome.
In that, it is not suf?cient for lenders to prove elaborate community lending efforts directed
towards borrowers in the community, but an evenhanded distribution of loans across low and
moderate income and non- low and moderate income areas and borrowers.
Studies have documented that bank lending standards fell after this rule change
(DemyanykandvanHemert, 2008; England, 2002; Bhutta, 2008). For example, muchlower
down payments were accepted, and it had the desired effect of widening home ownership.
Thus, banks did not come up with the idea of looser underwriting standards and
slip these past regulators. Rather, in order to meet the objective of broadening home
ownership and providing credit to underserved areas, banks were compelled by the
regulators to lower mortgage standards. The real problem is that once bank regulators
initiated changes in enforcing the Community Reinvestment Act to require banks to
lower underwriting standards, they could hardly oppose similar loans to better
quali?ed borrowers. Then the relaxed standards spread to the wider mortgage market,
including to speculative borrowers and borrowers who wanted to trade up to bigger
homes. The key point here is not merely that low and moderate income earners
received loans that they could not afford. While that may be true to some extent,
it cannot account for the large number of sub-prime and alt-A mortgages that plague
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the housing market today. Between 2001 and 2006, the share of mortgages made up of
conventional mortgages fell from 57 to 33 percent (Wallison, 2008). The contagion of
poorly underwritten mortgages spread well beyond the low and moderate income
community groups.
What is securitization?
Prior to the 1970s, home mortgages were the most illiquid asset on a bank’s balance
sheet. Banks could not sell the mortgages on the secondary market due to what is
known as an “adverse selection” problem arising from asymmetric information.
In other words, buyers were afraid that banks, who knew their mortgages better,
would sell only the bad mortgages and keep the better mortgages on their own balance
sheets. Thus, prior to 1980, the vast majority of home mortgages were made by
?nancial institutions who originated, serviced and held the loans in their portfolios –
the “originate to hold” business model. In order to create a market for mortgages, in the
1970s “securitizers,” which can be banks themselves but were more frequently
investment banks, took pools of mortgages, had the pools of mortgages rated and then
sold the pools of mortgages. The large pools of mortgages were typically divided into
sections known as tranches, where each tranche offered differing risks or default. In the
event of default, the losses are absorbed by the lowest priority investors before the
investors with the higher priority claims are affected. These more complicated
offerings were known as collateralized debt obligations (CDOs). Over time, home
mortgages were increasingly securitized – the “originate to distribute” business model.
Crucially, this allowed loan originators to shift most of the risk to the secondary market
for mortgages.
The moral hazard problem of banks
Faced with a regulatory regime that pressured banks to make risky loans, the banks
?gured out how to make money on the risky mortgages. The banks and mortgage
brokers reaped signi?cant fees from the mortgages and then sold them on secondary
markets through securitization. So, the risks of default were borne by those who
purchased the pools of mortgages from the securitizers, while the loan originators got
the fees. Securitization was designed to address the adverse selection problem that
prevented resale of mortgages. Instead we got a “moral hazard” problem as the loan
originators collected fees on badly underwritten mortgages without bearing the risks.
An ef?cient capital market will allocate capital to where the risk adjusted rate of return
is highest. We now know that a large share of these mortgage backed securities had a
much lower rate of return than expected (Benmelach and Dlugosz, 2009a), and too
much capital was allocated to these investments relative to a social optimum, i.e. this
was a market failure problem. This market failure was due to moral hazard problems
at banks and CROs, and possibly a principal agent problem with asset managers. The
banks did keep some of the mortgages for themselves, and on these mortgages they
bore the risks, but overall this is a market failure problem as the capital was not
allocated ef?ciently[10].
Moral hazard and the CROs
The pools of mortgages were rated regarding their riskiness by Moodys, Standard and
Poor’s, or Fitch. These ?rms enjoyed a preferred designation of the Securities and
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Exchange Commission (SEC) as a “nationally recognized statistical rating
organization” (NRSRO), better known as CROs. Unfortunately, the CROs, who have
a responsibility to objectively evaluate the risks of the instruments they assess, had a
con?ict of interest. They had an incentive to undervalue the risk. These rating agencies
became heavily dependent on the fees from rating mortgage pools. Securitizers were
the ones who paid the ratings agencies, and repeat business for a CRO was dependent
on good ratings. Moreover, secritizers routinely employed the practice known as
“rating shopping.” A securitizer would ask a rating agency how the agency might
hypothetically rate a pool of mortgages. If the rating were low, the securitizer would go
to another rating agency. In what they call “the alchemy of the CDO credit ratings,”
Benmelach and Dlugosz (2009a) have shown that the CDOs received credit ratings that
were strikingly higher than the credit quality of the underlying collateral pools, and
Benmelach and Dlugosz (2009b) show that severe downgrading of these securities
started in 2007 leading to ?nancial institution write downs of more than $200 billion in
early 2009. Caprio et al. (2008) argue that a critical failure in the system was the fact
that the securitizers were the ones who paid the raters. In other words, the CROs had a
moral hazard problem as the fees too strongly in?uenced their evaluations. The result
was a gross undervaluation of the riskiness of these pools of mortgages and buyers
purchasing very risky assets they assumed had low risk. This led to a market failure of
buyers purchasing more of these risky securities than was ef?cient.
The poor performance of the CROs highlights long standing regulatory distortions
of the industry that arti?cially restricted their supply and increased demand for their
services. Supply was restricted by the SEC de?nition of the category of NRSRO in 1975
and subsequent SEC restraint on which ?rms could be so designated (there were never
more than ?ve and there were only three during the CDO ratings debacle). Demand
was increased by ?nancial regulators requirements that the institutions they regulate
must follow the judgments of these NRSROs. White (2001) noted this was a recipe for
rents and distortions[11].
Asset managers and a principal-agent problem
Calomiris (2008b) argues, in effect, that there is another market failure – that the
biggest problem in the private sector was that the asset managers of mutual funds had
a con?ict of interest between their own income and the interests of their clients
(a “principal-agent problem”). If they had not bought the mortgages, dramatically
fewer would have been issued – securitizers were supplying what was being
demanded by asset managers. In other words, the asset managers managed funds like
mutual funds or pension funds, where these funds were constrained to invest in only
very low risk ?nancial instruments. If these mortgage pools were not rated AAA, the
rules of the fund would have prohibited the asset managers from investing in them.
Calomiris maintains that there was a lot more money available for placement in AAA
rated mortgage funds than there were actual AAA mortgage pools available (if the
pools were properly rated). The asset managers were faced with a choice:
.
?nd pools of mortgages to buy at the rated quality required by the conditions of
the mutual fund; or
.
return the money to the investors.
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If the asset managers returned the money to their clients, they would lose their bonuses
and management fees, and put their huge salaries at risk. Rather than return the
money, they held their noses and bought mortgage pools that they knew to be
improperly rated[12].
Solution to the problem of inappropriate ratings – SEC assignment
The conventional solution to the problem of underestimation of the risks of a portfolio by
the ratings agencies is to require that the buyers pay the fees of rating agencies
(Caprio et al., 2008). There are two problems, however, with this solution. First, there is a
free-rider problem, as prospective buyers may refuse to pay for a rating in hope that
another buyer would pay. Moreover, Calomiris (2009) argues that requiring the buyer to
pay for the rating will not ?x the problem, since the principal-agent problemwill still lead
to asset managers purchasing more risky assets than is economically warranted by an
ef?cient market. Instead he recommends that ratings agencies be required to provide a
quantitative assessment of the percentage of loans in a portfolio that will default. If the
default rate exceeds this percentage, then the ratings agencies will be penalized.
The Calomiris solution, however, also has problems as it would appear to provide an
opposite incentive for the ratings agencies – namely to overestimate the risks. What
appears to be the best solution comes fromRichardson and White (2009). They propose to
continue with the model in which the issuer pays for rating the CDOs, but they would
require that the issuer apply to SEC. The SEC would assign the CRO that would do the
rating. SEC assignments could be based on rating performance and other quali?cations.
Their recommendation would avoid the free-rider problem, eliminate rating shopping and
the CROs would have the incentive to perform well since their repeat business would
dependontheir reputation for quality ratings. The problemis that the solution depends on
the ability of the SEC to evaluate and reward good performance.
How to meet an affordable housing objective most ef?ciently
There is some evidence that home ownership conveys some bene?ts to the community
(what economists refer to as an externality) so there is some justi?cation for the
government to provide moderate targeting subsidies for home ownership (Glaeser and
Shapiro, 2002). But this has to be done ef?ciently and in a manner that does not induce
a ?nancial crisis. The second key economic principle that was ignored is that simply
mandating an objective onto ?rms and hoping that the market participants will not
change their behavior in ways that are socially undesirable is a na? ¨ve public policy. It is
better to impact incentives most directly. Based on a theorem developed by Bhagwati
and Ramaswami (1963), economists state the approach more generally as: the most
ef?cient way to achieve an objective not achieved by the market is to use the regulatory
instrument that impacts the objective most directly, we say “at the relevant margin.”
In this case, the objective not achieved by the market is wider home ownership for low
and moderate income families. As implemented by the GSEs, mortgage standards were
simply lowered for all. So speculators and wealthy individuals, who wanted to trade up
in a housing boom, could move into homes for which they ordinarily would not qualify.
This obviously was not the objective of Congress and there is no evidence that larger
home consumption conveys bene?ts to the wider community (Glaeser and Shapiro,
2002). More importantly, the most ef?cient way to encourage home ownership is the
way Australia has periodically done it: Australia has subsidized the down payment of
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?rst time low income home buyers (by 50 percent in their case)[13]. Banks in Australia
do not change their standards, but with the larger down payments, many low and
moderate income families, who could not qualify for mortgages without the down
payment assistance, are able to qualify. This would put the cost of the program on the
budget of the government, where the costs of the program would be transparent and
subject to public scrutiny and debate, rather than hidden in the costs of banks and
private ?nancial market participants. Many in Congress prefer to hide the cost of their
programs (the problem is not limited to housing ?nance). Consequently, they avoid
subsidies since they expose the costs of the program. But mandating a social objective
onto private ?rms (in this case telling banks and Fannie and Freddie to lower their
mortgage standards) and ignoring the adjustments that markets will inevitably make,
can have much greater costs, as we are all painfully learning.
Low interest rates as a contributor to the crisis – due to monetary policy
Taylor (2007, 2009) has argued that the low interest policy of the Federal Reserve from
about January 2002 to early in 2006 contributed to the housing boom and ultimate bust.
The Federal Reserve set the federal funds rate at ,2 percent from January 2002 to late
2004. This was considerably below (by about 3 percentage points in 2004) the level
needed for price stability based on historical data, i.e. less than prescribed by the
“Taylor rule.” Although this did not translate into an increase in the money
supply[14], Barth et al. (2009, p. 7) explain that this induced a drop in mortgage rates,
especially in the one year rate on adjustable rate mortgages which fell to about
4 percent during this period. Many borrowers opted for adjustable rate mortgages
during this period (as 30 year ?xed rate mortgages carried higher interest rates), and
lenders accommodated the borrowers since it shifted interest rate risk to the borrowers.
Fueled by these low interest rates, subprime mortgage originations rose dramatically
from 8 percent in 2001 to 21 percent in 2005[15,16].
The homeowner: why tax laws and homeowner options have contributed to the crisis
The more equity a homeowner has in her home, the less likely she will want to walk
away from a mortgage in a downturn in the housing market, and the more stable the
housing market will be. Our laws, however, have induced a very low positive equity
and now negative equity environment.
The right to re?nance is rare in the commercial world, but state laws generally
guarantee that right to homeowners without penalty. Moreover, home mortgage
interest and home equity loan interest are deductible on federal income tax returns,
while interest payments on car and consumer loans of all kinds are not deductible.
(Since low and middle income earners pay little or no federal income tax, this does not
make sense for the purpose of encouraging wider home ownership.) In this situation, it
was rational for the homeowner to use a home equity loan rather than alternate
?nancing for consumer expenditures. Combined with the gradual decline in lenders’
requirements for home mortgages, the result was the so-called “cash-out” re?nancing,
through which homeowners treated their houses like savings accounts, drawing out
funds to ?nance cars, boats, and other consumer expenditures. By the end of 2006,
86 percent of home mortgage re?nancing was cash out re?nancing ( Joint Center for
Housing Studies, 2008, p. 37). Thus, with the collapse of the housing bubble, many
homeowners found themselves with negative equity (“under water”); and this was true
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not just for sub-prime mortgages, but for prime mortgages as well. In this situation,
homeowners might prefer to default on the mortgage rather than make the payments.
The problem is exacerbated by additional government policies. In most states,
mortgages are either “without recourse,” meaning that a defaulting homeowner is not
responsible for paying the difference between the value of the home and the principal
amount of the mortgage, or else the law makes the process of enforcing the obligation
so burdensome that lenders take no action. Thus, homeowners with negative equity are
more likely to walk away from the mortgage given this regulatory protection,
contributing to the problems of banks.
Fair market accounting standards – not a cause of the crisis
Some critics, for example the Institute of International Finance (2008), have alleged that
“fair value accounting” standards that often compel ?nancial institutions to value assets
on the books at market values (“mark to market” accounting) have exacerbated the
?nancial crisis. These critics argue that mark to market accounting has forced write
downs of assets during the crisis, depleted bank capital and forced sales of assets at
distressed sale prices. It is alleged that these prices were considerably less than their
proper value in a normally functioning market, i.e. less than the present value of the cash
?ows of the asset. They argue that there is then a downward spiral or contagion as many
banks are forced to unload assets at distressed prices, further driving down prices.
Downward spirals in prices, however, arise for many reasons. Given the large
number of defaults in the underlying mortgage pools that back the value of
the mortgage backed securities and the resulting reduction in the cash ?ow of these
securities, an alternate plausible explanation for the reduced prices of the mortgage
backed securities is that they re?ect a more accurate assessment of the present value of
the cash ?ow of the securities. In support of this latter view, Laux and Leux (2010)
maintain that the allegations that fair market accounting contributed to the crisis are
not supported by evidence. They ?nd:
[. . .] little evidence that banks reported fair values suffered from excessive write-downs or
undervaluation in 2008, which in turn, could have contributed to downward spirals and
contagion. If anything the evidence points in the opposite direction [. . .] Fair values played
only a limited role for bank’s income statements and regulatory capital ratios except for a few
banks with large trading positions. For these banks, investors would have worried about
exposures to sub-prime mortgages and made their own judgments even in the absence of fair
value disclosures[17].
Companies such as investment funds, investment banks, and bank holding companies
that relied heavily on short-term borrowing and had substantial sub-prime exposure
would have had to sell assets regardless of the accounting regime.
IV. The myth of deregulation
Deregulation is unrelated to the instruments that are the problems. On the contrary,
what deregulation that has occurred has contributed to the stabilization of the crisis
There were numerous regulatory failures that led to the current ?nancial crisis and
there is a need for new regulations. The failure to give regulators normal bank
supervisory authority in the case of the GSEs and giving bank regulators con?icted
objectives under the Community Reinvestment Act where they are instructed to ignore
poor mortgage underwriting standards top the list. I discuss one additional perverse
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regulation below and Calomiris (2008b) discusses others. But contrary to the
allegations by non-specialists, there are no actual acts of deregulation that contributed
to the crisis. Paraphrasing Charles Calomiris we know the following.
The instruments that are the problems in the current crisis are sub-prime lending and
securitization. Securitization was available for banks, investment banks, and other
?nancial institutions since the 1970s. Sub-prime lending was facilitated by regulation
changes in the mid-1990s as a means of extending home ownership to lowand moderate
income households. There is no connection whatsoever securitization or sub-prime
lending and ?nancial deregulation of the past three decades. Financial deregulation in
the past three decades consisted of the removal of interest rate ceilings, allowing greater
consolidation through the relaxation of branching restrictions, and allowing commercial
banks to enter underwriting and insurance and other ?nancial activities.
On the contrary – deregulation and globalization have helped stabilize the crisis
The 1999 Gramm-Leach-Bliley Act repealed part of the 1933 Glass-Steagal Act and
thereby allowed commercial banks and investment banks to merge. But this merger
capability has helped to stabilize the ?nancial markets rather than contribute to it. In the
2008 ?nancial crisis, deregulation allowed Bear Stearns to be acquired by Morgan[18],
Merrill Lynch to be acquired by Bank of America and allowed Goldman Sachs and
Morgan Stanley to convert to bank holding companies and help shore up their positions.
Moreover, deregulation, consolidation, and globalization of the banking system has
permitted the banks to recapitalize to a far greater extent that in previous crises.
In other words, ?nancial crises periodically occur throughout the world. There were
100 in the world in the past 30 years alone. The two most serious in the USA were the
Great Depression and the crisis of 1989. What has been common to past crises has been
that banks have been unable to raise capital largely because potential investors are
uncertain about how deep the problems are with the bank seeking to recapitalize. What
has been different about the current US crisis is that banks have been able to
recapitalize to some nontrivial extent. For example, in the S&L crisis, bank
recapitalization averaged about $3 billion per year in 1989-1991[19]. In the year ending
September 2008 banks raised $434 billion in new capital[20]. What explains this
unprecedented ability to raise capital in a ?nancial crisis? Calomiris and others argue
that deregulation, consolidation, and globalization contributed to substantial pro?ts in
the banks in the past 15 years and left banks in a stronger position at the start of the
crisis so they could more credibly argue they would survive the crisis and thereby
attract investors. Moreover, many analysts have noted that regional concentration of
banks contributed to US ?nancial crises in the past, as regional banks are vulnerable to
regional shocks (Bernanke and Lown, 1991). With consolidation and deregulation of
interstate branching, however, banks are less vulnerable to regional shocks. As a
further bene?t, globalization of banking has allowed banks to access credit from
sovereign wealth funds and other international sources.
The SEC rule change in 2004 – or why international coordination of regulation does not
necessarily lead to improved regulation
The SEC rule change in 2004 that changed how the SEC ?gured the net capital
requirements is now seen as a signi?cant mistake. Some journalists have mistakenly
called this deregulation (Labaton, 2008). What these journalists fail to note is that this
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rule change was the antithesis of deregulation; rather it was the imposition of
internationally coordinated regulatory standards – rules known as the “Basel Rules.”
The Basel Committee rules were the consequence of years of work by the central bankers
of the world and are based on the belief that a common set of global banking standards
would result in more ef?cient use of capital and a more stable global ?nancial system.
The Basel rules call for banks to have capital reserves of 8 percent on a risk weighted
basis. Commercial loans hada risk weight of 100, so hadto be backedby8 percent capital
in reserve. But AAA rated securities (like the securitized mortgage pools) had a
substantially lower risk weight of 20 percent, so banks only had to have 1.6 percent
capital in reserve to back investments in AAA rated securities. Basel I rules were
replaced with Basel II rules in 2007, which allowfor more use of internal bank models in
the assessment of risk, something which we would all question today; but rules for
residential mortgages did not change. As I have explained, all those responsible for
assessing the risks earned large fees from underestimating the risk and the investment
banks ended up leveraging themselves far too highly. Swiss authorities are now raising
the minimumcapital requirements above those allowed under the Basel Rules. The SEC
rule change was one of the regulatory failures that contributed to the ?nancial crisis. But
rather than a deregulation problem, this is a cautionary tale against agreement to
internationally coordinated regulatory standards. If theysubstitute for sound prudential
regulation, they could be a lot worse.
V. Lessons and reforms
Eliminate the GSEs. As a second best solution, regulate the GSEs against excessive risk
taking like normal banks
The raison d’etre of the GSEs was to lower mortgage interest rates. Studies by the
Federal Reserve and the Congressional Budget Of?ce have shown that they have failed
in that objective. Consequently, the GSEs add risk to the ?nancial system without
bene?ts. A ?rst best solution would be to eliminate them. Failing elimination, since the
federal government is guaranteeing their debt, they need to be regulated against
excessive risk taking.
We need to ?x the perverse incentives in enforcement of the Community Reinvestment
Act (and other laws) that induce ?nancial crises. Market mandates, such as requiring
changes in bank lending standards are usually inef?cient, do not achieve wider home
ownership in the long run and involve unintended adverse consequences. This will take
political will to correct the political failures
Pressure on banks to lower mortgage standards under the Community Reinvestment
Act is at the top of the list of perverse regulations. It is na? ¨ve economics to believe that
we can simply impose a mandate on private ?rms and assume that the cost increases
or risk increases of the mandate will have no adverse consequences. The home
mortgage deduction on federal income taxes and related state homeowner regulations
have also contributed to the crisis, but are of lesser importance as the primary cause.
To address many of the most important problems, it will take political will and
economic sophistication from Congress that has been lacking in the past.
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Large ?nancial institutions are not too big to fail. It is necessary to take a ?nancial
institution that cannot survive without substantial infusion of public funds into receivership
Safety net subsidies must be limited for proper incentives. In order to reduce the
likelihood that the next new ?nancial instrument that is misunderstood induces a
?nancial crisis, we must allow large ?nancial institutions to fail. Financial institutions
have mismanaged risk on a grand scale. It is crucial that they internalize the risks
(Kane, 2009). Caprio et al. (2008) and others have noted that the incentives for managers
in many ?nancial institutions are not properly aligned with the long run risks. For
?nancial institutions to internalize the risks of large losses and to align their
compensation structures for their managers with the risk, they have to bear the costs of
their losses. This is not possible if bailouts are anticipated and there is no possibility of
bankruptcy or takeover by the government. Thus, bailouts should be avoided.
Receivership of a very large bank does not mean chaos. Although the Federal Deposit
Insurance Corporation (FDIC) routinely takes regional banks into receivership,
including over 130 in 2009, many are afraid to apply the same strategy with large
?nancial institutions. In receivership, the ?nancial institution need not fall into
disarray. The FDIC could take receivership of a large bank, defend the customer assets,
change the management, wipe out the stockholders’ equity entirely, and a share of the
bondholders claims, continue the operation of the institution in receivership, and
eventually sell or reissue the company to private ownership, leaving the bondholders
with the residual. This is how the largest bank failure in US history – Washington
Mutual was six times larger than the previous largest US bank failure – was handled
so seamlessly in 2008 that it was almost unnoticed. Washington Mutual was placed
into FDIC receivership and reopened literally the next day as Morgan Chase with the
customers having full access to their accounts and services of the bank.
Resolution of the Lehman Brothers bankruptcy shows fear of systemic ?nancial
market failure for a central player in the counterparty transactions is grossly
exaggerated – not too big to fail. Lehman Brothers is more worrisome to many than
Washington Mutual, since it was a central player in the counterparty operations. The
US experience, however, starting in mid-2008, shows that very large banks, even those
central to the counterparty operations, can be reorganized with little or no systemic
problems for the wider ?nancial system. When it went bankrupt, Lehman Brothers
was the third largest user of credit default swaps on mortgage backed securities
worldwide and the ?fth largest user of credit default swaps on government backed
securities. It had its massive credit default swap holdings unwound within four weeks
by the Depository Trust and Clearing Corporation (DTCC) and its subsidiaries, with all
parties receiving payment on the terms of their original contracts. Consequently, when
the Senior Supervisors Group (the of?cial ?nancial supervisors of the USA, France, the
UK, Canada, Germany, Japan, and Switzerland) investigated the impact on ?nancial
markets of the Lehman Brothers bankruptcy, as well as the impact of the ?nancial
failures of Fannie Mae, Freddie Mac, and Landsbanki Islands, it concluded that these
“credit events were managed in an orderly fashion, with no major operational
disruptions or liquidity problems[21].” Moreover, through the DTCC, there are private
?nancial market institutional mechanisms in place designed to assure that the smooth
resolution of credit default swaps, as occurred in the Lehman case, will hold in general
(Tarr, 2010).
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Regulate and ?nancial institution against excessive risk taking if its debts are
government guaranteed, either implicitly or explicitly
If the government is going to extend the safety net even partially to large private
banks, investment banks or insurance companies, they will also need greater
regulation. I have argued that on economic grounds, large ?nancial institutions are
not too big to fail. The ?rst best public policy is to allow them to fail. But possibly due
to a shared belief system in their importance, as argued by Johnson (2009), or other
reasons, many large ?nancial institutions received substantial bailout subsidies.
Large ?nancial institutions are likely to anticipate this in the future and take
excessive risks, gambling on a taxpayer bailout if things go bad. This moral hazard
problem must be controlled.
Use the market to inform regulators
The Obama Administration is proposing extensive new regulation of ?nancial
institutions, with tougher capital requirements to assure that the ?nancial crisis is not
repeated. Recent history suggests, however, that we should be cautious in assuming
that regulators will have suf?cient information and judgment in new ?nancial
instruments to be aware of when a ?nancial institution is at increased risk and needs
an additional capital infusion. The FDIC Improvement Act of 1991 gave the FDIC
substantially greater powers of supervision to assure that the S&L crisis did not
happen again. Under the expanded powers of this act, examiners from the Comptroller
of the Currency were inside Citigroup full time for years supervising its operations.
Despite these broad supervisory powers, in late 2008, the federal government stepped
into shore up Citigroup by guaranteeing or investing more than $300 billion of
Citigroup assets (and $118 billion of Bank of America assets). Although in late 2009
Citigroup was attempting to pay back its troubled asset relief program money to avoid
constraints on executive compensation, the loan guarantees of the FDIC, Treasury, and
Federal Reserve have slipped under the radar (Assistance to Citigroup and Assistance
to Bank of America, 2008).
Hart and Zingales (2009) have proposed the use of the price of credit default swaps as
a trigger mechanismto provide information to a regulator. When the price (“spread”) of a
credit default swap on a ?nancial institution rises, re?ecting the market’s assessment
that default is more likely, the regulator would require that the institution raises
additional equity until the price of the credit default swap falls back to an acceptable
level. (The price of a subordinated debt instrument could serve the same purpose[22].)
If the ?nancial institution fails to do so in an acceptable period of time, the regulator
would take over, acting as the receiver as in a FDIC takeover. In this manner, risk taking
by the institution and taxpayer liabilities would be limited. For this proposal to work,
however, it is essential that the government be willing to takeover large ?nancial
institutions.
Have the SEC assign the CRO that will do the rating
Require that the issuer of a debt that would like to have it rated apply to the SEC for a
rating. The SEC would assign the CRO that would do the rating. SEC assignments
could be based on rating performance and other quali?cations.
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To the extent that wider home ownership is seen as a desirable social objective, modest
subsidies for wider home ownership that are in the federal budget should be considered
Although large subsidies would be a problem, a modest program along the lines of the
Australian approach to the affordable housing problem would be more ef?cient. With
no economic rationale, tax policies of the federal government subsidize the mortgage
payments of well to do income earners, while denying subsidies to low and moderate
income earners (who get little or no tax break from the mortgage deduction).
Increase capital requirements of ?nancial institutions; it would also be useful to develop
counter-cyclical ?nancial instruments to ?nance ?nancial institutions
There is widespread agreement regarding the necessity of increasing capital
requirements for ?nancial institutions. A problem for the banks is that they can easily
raise capital during booms, but have great dif?culty in raising capital during
recessions or a ?nancial crisis. The creation of a subordinated debt instrument that
regulators could require the bank to convert to equity could help resolve this problem.
Regulators would insist on the conversion when the price of the subordinated debt
instrument (or credit default swap) suggests that the bank is too risky.
Require loan originators to be well capitalized and bear some of the risks of the
mortgages they underwrite
It is necessary to address the moral hazard problem that has plagued the sector
originating mortgages. As Pinto (2008) has explained, it would be useful to introduce
regulation to require loan originators to hold some percentage of the risk on any
loan they originate and to be well capitalized against possible default on these loans.
Rather than requiring this, ironically, existing regulations discourage it (Calomiris,
2008b, p. 33).
Notes
1. Testimony of Ed Pinto (2008, p. 8), former chief credit of?cer of Fannie Mae. The principal
database of the New York Fed under reports default prone mortgages. There are seven
million sub-prime loans in the Federal Reserve Bank of New York on-line database.
Second, there are about ten million sub-prime loans classi?ed in the “Loan Performance
Prime Database” as prime. (This database is mutually exclusive with the above mentioned
New York Fed database.) Contrary to the name of the index, there were about ten million
sub-prime loans among the 50 million loans in its Prime database (by the conventional
de?nition of a sub-prime loan as a loan with a FICO index of ,660). Third, there are alt-A
loans (such as “liar loans”) where the borrower had a FICO score above 660, but failed to
provide documentation. These were favorite instruments of speculators and have
conventionally been classi?ed as prime; but they are defaulting at a rate approaching
sub-prime. The New York Fed estimates that there are about 2.67 million alt-A loans,
excluding Fannie and Freddie exposure and Pinto reports 2.9 million alt-A loans held by
Fannie and Freddie. Finally, there are about 2.5 million other junk loans, such as
negatively amortizing option adjustable rate mortgages. See Pinto (2008, Annex I) for
further details.
2. They examined the votes of members of the House of Representatives on the ?nal passage of
the FDIC Improvement Act of 1991 as well as three amendments. They found consistent
support for both intra-industry and inter-industry rivalry, but little role for consumer
interests. They also found support for legislator ideology.
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3. Community organizations such as ACORN, Neighborhood Assistance Corporation of
America and the Greenlining Institute had much at stake in advancing the affordable
housing mandate of the GSEs and in putting teeth into enforcement of the Community
Reinvestment Act (as discussed below). They successfully negotiated agreements with
various banks to provide tens of billions in mortgages to underserved communities, typically
serving as mortgage servicers for these agreements. In addition, ACORN received $40
million in grants from various banks for dubious “counseling” services. See United States
House of Representatives (2010), Capital Research Corporation (2009), and The Washington
Examiner (2010).
4. Center for Responsive Politics (2008) calculations based on Federal Election Commission
data. A complete list of all 354 active members of Congress who received contributions (and
the amounts they received) is available in the paper.
5. The 1992 Federal Housing Enterprises Financial Safety and Soundness Act, also known as
the GSE Act. For further details of this act, see:http://online.wsj.com/article/
SB10001424052748703298004574459763052141456.html
6. The Congressional Budget Of?ce (2001) estimated that the GSEs lowered mortgage interest
rates by 25 basis points, i.e. 0.25 percentage points. See also Bhutta (2009).
7. Statements of Besenius and Andrukonis were submitted as part of the testimony of
Calomiris (2008a). Dona Cogswell of Freddie Mac wrote similar warnings in a memo to
Dick Syron, Mike May, and others on September 7, 2004.
8. See www.swamppolitics.com/news/politics/blog/2008/12/fannies_freddies_exchiefs_blas.
html. Ed Pinto notes that he was ?red as chief credit of?cer of Fannie Mae in 1989 for
early warnings about the dangers of the affordable housing mandate.
9. On November 25, 2008, the Federal Reserve announced it would buy $100 billion of debt of
the GSEs and $500 billion on the mortgage-backed securities guaranteed by the GSEs and
Ginnie Mae (Reuters, 2008).
10. The Lehman Brothers bankruptcy revealed that Lehman keep some of the riskiest tranches
of the mortgage pools on its own books. It is not clear if Lehman kept these tranches in order
to secure AAA ratings of the remaining mortgage pool or if it was willing to bear increased
risk to obtain a higher return.
11. Richardson and White (2009) suggest that a better outcome would have been achieved if
regulated ?nancial institutions were free to pick their own bond advisor (which could be a
NRSRO). They would be required to justify their choice to their regulator, but the bond
advisory market would become open. This solution, however, does not address the moral
hazard problem.
12. He cites a story of a rater, who had not been selected to rate the mortgage pool because he
gave too risky a rating. The rater warned an asset manager not to buy the pool, but the asset
manager replied: “we have to put our money somewhere.”
13. The costs of such a targeted subsidy program for low and moderate income earners
would have to be weighed against the bene?ts, and would likely justify a small subsidy
program. See Bourassa and Yin (2006) for a comparison of the impacts of the USA and
Australian approaches. In 2008, however, the US implemented a program of interest free
loans for ?rst time home buyers (or buyers who have not owned a home in the past three
years) for homes purchased between April 9, 2008 and July 1, 2009. The program allows
a tax credit of up to $7,500, which must be paid back interest free over a period up to
17 years.
14. Based on data available from the Saint Louis Federal Reserve web site, the rate of growth
of M2 for the ten-year period ending in 2006 was 6.2 or 6.1 percent in the seven years
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ending in 2006. This is a lower rate of money supply growth than in any of the ?nal four
?nal decades of the twentieth century, except for the 1990s. M3 growth, up until
discontinuance of the series in February 2006, tells a similar story. Speci?cally, the
average growth rates in M2 (M3) by decades are the following: 1960s, 7 (7.6) percent;
1970s, 9.5 (11.1) percent; 1980s, 8 (8.7) percent; 1990s, 4 (4.6) percent. M3 growth from
January 2000 to February 2006 was 7.7 percent, and 7.8 percent from January 1996 to
December 2005.
15. Taylor (2007) provides econometric evidence for this story by estimating the impact of
interest rates on housing starts. He infers that housing starts increased dramatically during
this period due to the low interest rate policies.
16. As Taylor (2009) has explained, it does not appear that the low interest rates were due to a
global savings glut, led by Chinese savings. World savings as a percentage of GDP were low
during the 2002-2004 period, especially compared to the 1970s and 1980s. (International
Monetary Fund, 2005). Savings exceeded investment outside of the USA, but this was offset
by negative savings in the USA.
17. Two examples of assets values on the books at more than market value are the following.
Merrill Lynch sold $30.6 billion of CDOs backed by mortgages for 22 cents on the dollar; but
at the time of the sale, the assets were valued on their books at 65 percent higher. In the ?rst
quarter of 2008, Lehman wrote down its $39 billion commercial mortgage backed securities
portfolio by 3 percent, when an index of these securities dropped 10 percent. Laux and Leux
(2010, p. 102).
18. The Bear Stearns-J.P Morgan merger was facilitated by a $30 billion government subsidized
loan. Jaffe and Perlow (2008).
19. Federal Reserve data cited in Bernanke and Lown (1991, p. 239).
20. For details of which ?nancial institutions raised capital and how much, see Calomris (2008b,
p. 106).
21. See Senior Supervisory Group (2009, p. 2). The USA was represented in the report by the
Board of Governors of the Federal Reserve, the Federal Reserve Bank of New York, the SEC,
and the Comptroller of the Currency.
22. Several studies (Fan et al., 2002) have suggested that a minimum subordinated debt
requirement would help. Banks would be required to issue some subordinated bonds (senior
bondholders would be paid prior to subordinated bondholders in the event of bankruptcy) to
?nance their lending. The market price of these bonds would provide a market measure of
the riskiness of the banks.
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number 2”, available at: www.huduser.org/publications/txt/hdbrf2.txt
United States House of Representatives (2010), “Follow the money: ACORN, SEIU and their
political allies”, Staff Report of the Committee on Oversight and Government Reform,
available at:http://republicans.oversight.house.gov/images/stories/Reports/20100218
followthemoneyacornseiuandtheirpoliticalallies.pdf (accessed February 18).
Wallison, P.J. (2008), “Cause and effect: government policies and the ?nancial crisis”, November,
available at: www.aei.org/docLib/20081203_1123724NovFSOg.pdf
Wallison, P.J. and Pinto, E. (2008), “What went wrong at Fannie and Freddie – and what still
might”, National Review, available at: www.aei.org/article/28810 (accessed October 21).
White, L. (2001), “The credit rating industry: an industrial organization effort”, Social Science
Research Network Working Paper 1292667, May, available at:http://papers.ssrn.com/sol3/
papers.cfm?abstract_id¼1292667
Further reading
Bernanke, B. (2009), “American International Group”, Testimony before the Committee on
Financial Services, US House of Representatives, available at: www.federalreserve.gov/
newsevents/testimony/bernanke20090324a.htm (accessed March 24).
Hunt, J. (2008), “Credit rating agencies and the ‘Worldwide Credit Crisis’: the limits of reputation,
the insuf?ciency of reform, and a proposal for improvement”, Columbia Business Law
Review, Vol. 2009 No. 1, Social Science Research Network Working Paper 1292667,
available at:http://papers.ssrn.com/sol3/papers.cfm?abstract_id¼1267625&rec¼1&
srcabs¼1292667
Jaffe, D. (2008), “Reforming Fannie and Freddie”, Regulation, Vol. 31 No. 4, pp. 52-7.
Failures that
caused the US
?nancial crisis
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Kroszner, R.S. and Strahan, P.E. (2000), “Obstacles to optimal policy: the interplay of politics and
economics in shaping bank supervision and regulation reforms”, in Mishkin, F. (Ed.),
Prudential Supervision: What Works and What Doesn’t, National Bureau of Economic
Research, Cambridge MA, available at: www.nber.org/chapters/c10762.pdf
Mason, J.R. (2008), “A national homeownership strategy for the new millenium”, mimeo,
February 26.
Tarr, D.G. (2009), “Bailouts and de?cits or haircuts: how to restore US ?nancial market stability”,
Social Science Research Network Working Paper 1401555, May, available at:http://ssrn.
com/abstract¼1401555
Corresponding author
David G. Tarr can be contacted at: [email protected]
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This article has been cited by:
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3. Linda Dezs?, George Loewenstein. 2012. Lenders’ blind trust and borrowers’ blind spots: A descriptive
investigation of personal loans. Journal of Economic Psychology 33, 996-1011. [CrossRef]
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doc_951576437.pdf
The purpose of this paper is to discuss the key regulatory, market, and political
failures that led to the 2008-2009 US financial crisis and to suggest appropriate recommendations
for reform.
Journal of Financial Economic Policy
The political, regulatory, and market failures that caused the US financial crisis: What
are the lessons?
David G. Tarr
Article information:
To cite this document:
David G. Tarr, (2010),"The political, regulatory, and market failures that caused the US financial crisis",
J ournal of Financial Economic Policy, Vol. 2 Iss 2 pp. 163 - 186
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The political, regulatory,
and market failures that caused
the US ?nancial crisis
What are the lessons?
David G. Tarr
The World Bank, Washington, DC, USA
Abstract
Purpose – The purpose of this paper is to discuss the key regulatory, market, and political
failures that led to the 2008-2009 US ?nancial crisis and to suggest appropriate recommendations
for reform.
Design/methodology/approach – The approach is to examine the underlying incentives that led to
the crisis and to provide supporting data to support the hypotheses.
Findings – While Congress was ?xing the savings and loan crisis, it failed to give the regulator of
Fannie Mae and Freddie Mac normal bank supervisory power. This was a political failure as Congress
was using government sponsored enterprise (GSE) resources and the resources of narrow
constituencies for their own advantage at the expense of the public interest. Second, in the mid-1990s,
to encourage home ownership, the Administration changed enforcement of the Community
Reinvestment Act, effectively requiring banks to use ?exible and innovative methods to lower bank
mortgage standards to underserved areas. Crucially, this disarmed regulators and the risky mortgage
standards then spread to other sectors of the market. Market failure problems ensued as banks,
mortgage brokers, securitizers, credit rating agencies, and asset managers were all plagued by
problems such as moral hazard or con?icts of interest.
Originality/value – The paper focuses on the political economy reasons for why Congress and US
administrations provided these perverse incentives to the GSEs and banks to lower mortgage
standards. It also proposes some innovative methods of improving bank regulation that address the
regulatory capture problem.
Keywords United States of America, National economy, Government policy, Borrowing, Regulation
Paper type General review
From the current handwringing, you’d think that the banks came up with the idea of looser
underwriting standards on their own, with regulators just asleep on the job. In fact, it was
the regulators who relaxed these standards – at the behest of community groups and
“progressive political forces.” Professor Stan Leibowitz, University of Texas (Liebowitz,
2008b).
The current issue and full text archive of this journal is available at
www.emeraldinsight.com/1757-6385.htm
JEL classi?cation – G00, G1, G2
The author would like to thank Gerald Caprio, Edward Kane, Peter Wallison, Wilfred Ethier,
Thomas Rutherford, Douglas Nelson, Fernando Saldanha, Kenneth Kopecky, Charles Calomiris,
Edi Karni, Will Martin, Asli Demirguc-Kunt, Robert Kahn, James Ferguson, Morris Morkre,
Robert Fenili, Gerald Moore, D. Bruce Allen, Adam Tarr, Paul Chandler, Linda Tarr,
Joshua Harrison, and seminar participants at the World Bank, Kiev School of Economics,
International School of Economics, Tbilisi and ETH-Zurich for helpful comments. The author
alone is responsible for the views in this paper.
Failures that
caused the US
?nancial crisis
163
Journal of Financial Economic Policy
Vol. 2 No. 2, 2010
pp. 163-186
qEmerald Group Publishing Limited
1757-6385
DOI 10.1108/17576381011070210
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I. Summary and literature review
Summary
In 2008-2010, the USA is in the worst ?nancial crisis since the Great Depression.
The core of the crisis is that 44 percent of all home mortgages (or 25 million mortgages)
are default prone, a ?gure that is unprecedented in US history[1]. Why did ?nancial
institutions and homeowners acquire so many mortgages that are in default or in
danger of wider default? I argue that the crisis is a result of regulatory failure, market
failure and, most of all, political failure.
First, the seeds of the crisis were sown while Congress was appropriately imposing
tougher regulation on banks and savings and loan associations in the early 1990s in
response to the savings and loan crisis. Congress made a grave error: it agreed to avoid
real regulation of the two government sponsored enterprises (GSEs) commonly known
as Fannie Mae and Freddie Mac, and allow them to take on unlimited risks with an
implicit government guarantee. Fannie and Freddie avoided real regulation by
proposing an “affordable housing” mission, which ultimately led to a lowering of their
standards for acquiring mortgages. Subsequently, Congress used Fannie and Freddie
projects like earmarked pork projects and taxpayers are now on the hook for an
estimated 50 percent (or $1.6 trillion) of the sub-prime, alt-A, and other default prone
mortgages. These mortgages are now defaulting at a rate eight times that of the GSEs
traditional quality loans (Pinto, 2008, Attachment 5). The failure to give the GSE
regulator normal bank supervisory power was a regulatory failure. But given that
Congress was in the process of ?xing the savings and loan crisis, Congress had to be
aware of the risks. Therefore, it was even more of a political failure. In other words,
the general social good was sacri?ced to appeal to narrow political constituencies.
Second, in the mid-1990s, the Clinton Administration changed enforcement of the
Community Reinvestment Act and effectively imposed quotas on commercial banks to
provide credit to underserved areas. The banks were told to use “innovative or ?exible”
methods in lending to meet the goals of the Community Reinvestment Act (Hossain,
2004, p. 57). Failure to meet the quotas would result in denial of merger or consolidation
requests. The evidence (cited below) reveals that bank mortgage standards fell as a
consequence of this regulatory change. Crucially, the risky mortgage standards then
spread to other sectors of the market. Encouraged by the home mortgage interest
deduction and low interest rates in the four to ?ve years prior to the crisis, speculators
and households trading up to bigger houses acquired a large number of high-risk
mortgages. Riskier mortgage standards by banks were not the consequence of
deregulation; rather the banks were compelled to change the standards by new
regulations at the behest of community groups. Again, this was a political failure as the
Administration sacri?ced the greater social good to appeal to narrow constituencies.
Once the banks were pressured by regulation to offer risky mortgages to underserved
areas, they (and mortgage brokers) found they could make money on them by selling
themto “securitizers,” who inturnpackaged the mortgages inpools andsoldthem. Akey
market failure problemwas that the ratings agencies were in?uenced by the securitizers
to underestimate the risk of the mortgage pools. Since the securitizers paid the rating
agencies for the ratings, this his was accomplished by awarding repeat business to
agencies that gave good rating, and by “rating shopping,” a practice in which
securitizers would ask multiple rating agencies how they would rate their pool of
mortgages, and then select a ratings agency that gave a very good rating. The problems
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were exacerbated by the fact that asset managers in the private sector who bought the
pools of mortgages had a con?ict of interest. Constrained to invest in high-quality assets,
rather than returnthe money of their clients and lose management fees, money managers
closed their eyes to the signals that the mortgage pools were riskier than the ratings.
These problems were market failures.
Within limits, a targeted program to expand home ownership to low or moderate
income families is a worthy social goal. A more ef?cient way to do it, however, is to
subsidize down payments of ?rst time low and moderate income home buyers, without
encouraging or forcing banks to lower lending standards. Politicians, however, often
prefer to mandate a regulation on ?rms to achieve a political objective, since this allows
them to avoid exposure of the costs of their programs while obtaining support from
narrow constituencies. In this further sense, the ?nancial crisis is, at its root, a political
failure. What is ominous is that the supporters of the programs that got us in this deep
?nancial mess appear to still be pushing the same policies.
There were numerous regulatory failures and there is a clear need for newregulation
and changes in regulation in several areas. The causes of the crisis, however, were
sub-prime lending andsecuritization. Securitizationwas available for banks, investment
banks and other ?nancial institutions since the 1970s, and sub-prime lending was
encouraged to promote wider home ownership. There is no connection between
securitization and sub-prime lending on the one hand and ?nancial deregulation of the
past three decades. Characterization of the problems as “deregulation” diverts attention
from the crucial task of ?xing the perverse regulations in place and identifying where
new regulation is needed.
In the next three sections, I explain these issues in more detail. This note concludes
with lessons for regulatory reform to help us avoid similar crises in the future.
Literature review
There is a vast literature on the ?nancial crisis – both overview studies and papers
that focus on speci?c problems and solutions. Among the most important overview
studies are Barth (2009), Brunnermeier (2009), Calomiris (2008b), Caprio et al. (2008),
Kane (2009), Taylor (2009), and Wallison (2008). An explanation of the incentive
problems of banks and credit rating organizations (CROs) that were important in
explaining the ?nancial crisis is included in the studies of Barth, Brunnermeier,
Calomiris, Kane, and Caprio et al. The Barth study is a very accessible explanation of
the causes of the crisis and provides the most factual detail of the mortgage and credit
markets. The analysis of Brunnermeier would be of interest to economists who want a
deep theoretical discussion of the incentive issues. A key recommendation of Caprio
et al. is that CROs should be paid by the buyers of the collateralized credit obligations,
not the sellers. Calomiris (2008b), however, believes this will not solve the problem due
to incentive problems of the buyers and recommends (Calomiris, 2009) tough new
regulations on CROs. (Below I discuss a recommendation by Richardson and White
that I believe is a superior mechanism for reform of the CROs.) Kane emphasizes the
incentive problems of regulators, the importance of limiting bailouts of ?nancial
institutions for fear of creating the next ?nancial crisis and the mischaracterization of
the crisis by the Obama Administration as a liquidity crisis rather than a solvency
crisis. Taylor (2009) argues that monetary policy of the Federal Reserve contributed
to the crisis, and provides evidence that the ?nancial crisis is not a liquidity crisis.
Failures that
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?nancial crisis
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Wallison emphasizes the government failures the led to the ?nancial crisis, especially
the failure to regulate the GSEs and the pressure on banks to lower mortgage
standards under changed regulations of the Community Reinvestment Act. Leibowitz
(2008) documents that “in an attempt to increase home ownership, virtually every
[relevant] branch of government undertook an attack on underwriting standards.”
In this paper, I build on the earlier work and try to explain the incentive problems of
banks, CROs, and other key private ?nancial institutions in a straightforward
accessible manner. A contribution of this paper that is not discussed in the literature is
the explanation of why political failure was a root cause of the ?nancial crisis, and the
reasons for that political failure.
II. The failure to regulate Fannie Mae and Freddie Mac
Top on the list of regulatory failures is the failure to regulate Fannie Mae and Freddie
Mac. Pinto (2008) has estimated that about $1.6 trillion or about 47 percent of the toxic
mortgages were purchased or guaranteed by these GSEs, and the government is now
on the hook for these mortgages. How did this happen? There were two key economic
principles that were ignored. One is that if the government and taxpayers stand behind
the ?nancial obligations of a company, the company should be regulated against
taking excessive risks for which the taxpayers are responsible. The government agreed
not to regulate the GSEs and even encouraged them to take on risky mortgages in
order to widen home ownership among low and moderate income households (and the
government also pressured banks to take on risky mortgages for the same reasons).
This regulatory failure, however, was essentially a political failure.
The economic theory of regulation (public choice theory)
The fact that special interests were successful in avoiding effective congressionally
mandated regulation of the GSEs at the expense of the public interest is explained by
the modern economic theory of regulation (or public choice theory). Public choice
theory characterizes the regulatory process as one of the competitions among interest
groups to use of the coercive power of the state to obtain rents at the expense of more
diverse groups (Olson, 1965; Grossman and Helpman, 1994). Producers of goods and
services, who are likely to receive concentrated gains from regulation, are typically
more effective at lobbying for their interests in regulation than consumers or
taxpayers. The latter groups are typically very diverse and suffer from a free-rider
problem that limits their contributions to lobbying. Pressure on regulators may come
from politicians who receive campaign contributions or votes and then pass legislation
favorable to the special interest. Or interest groups can in?uence regulators if
regulators believe that they may receive lucrative positions when they leave the
government. Producers are less likely to achieve a desired regulation if there is a group
that receives concentrated losses (and may, therefore, overcome the free-rider problem
and provide counter-lobbying) or if the inef?ciency costs to society are very large
(Becker, 1983; Stigler, 1971). And politicians may seek to spread the rents across
different interest groups to build a coalition for support (Peltzman, 1976). Kroszner and
Strahan have found this theory relevant to reform of banking supervision[2].
Government guarantees without regulation against excessive risk taking
Fannie Mae was chartered originally as a government enterprise to add liquidity to
the mortgage market and hopefully to lower the costs of borrowing for mortgages.
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Fannie borrowed money cheaply on capital markets because it was a government entity
and used it to buy mortgages. Fannie Mae was privatized in 1968, and Freddie Mac was
privatized in 1989 with an almost identical charter to Fannie. But even as private
enterprises, the GSEs were able to borrow at very attractive rates of interest because
investors believed that the government would back themin the event they went bankrupt.
This belief was validated in September 2008 when the US Government placed the GSEs in
“conservatorship,” and began to inject taxpayer dollars into the companies.
The affordable housing mission to avoid regulation
In the light of the S&L crisis of the late 1980s, many in Congress realized that it was
necessary to regulate the GSEs, since it was dangerous to allow private enterprises to
take on large risks with government guarantees. In order to stave off regulation,
Fannie Mae CEO Jim Johnson proposed that the GSEs add an affordable housing
mission to their objectives (Wallison and Pinto, 2008). Members of Congress saw they
could use GSE projects much as they use earmarked pork projects to boost popularity
in their home districts. Congressmen could request funding from the GSEs for projects
in their districts. For example, in 2006, Senator Charles Schumer’s of?ce issued a press
release headlined:
Schumer announces up to $100 million Freddie Mac commitment to address Fort Drum and
Watertown Housing Crunch.
The press release indicated that Senator Schumer had urged the commitment
(http://schumer.senate.gov/new_website/record.cfm?id¼266131). Jim Johnson realized
that the local projects could be used to in?uence Congress. He created Fannie Mae “local
partnership of?ces” (eventually totaling 51) in urban areas throughout the USA. These
of?ces performed a grassroots lobbying function, assuring congressional backers of
GSEs that they could tap into local supportive groups at election time (Wallison and
Pinto, 2008). Political support for congressional supporters of the affordable housing
mandate of the GSEs also came from community organizations such as the Association
of Community Organizations for Reform Now (ACORN). These organizations realized
that they could be more successful in pressuring banks to expand their sub-prime loans,
if the banks were able to sell the mortgages on the secondary market[3]. In addition,
Fannie and Freddie, through their PACs during the 1989-2008 period, cumulatively
contributed over $3 million to the campaigns of congressional supporters (and their
employees contributed an additional $1.8 million)[4]. In the end, the legislation that was
passed in the early 1990s provided for the GSEs to lend to low and moderate income
lenders, and in return their regulator lacked the authority routinely given bank
regulators[5]. As the problems withthe GSEs rose andbecame evident over the years, the
bargain that was struck, that Congress would not regulate seriously and the GSEs would
undertake an affordable housing objective (which was implemented through lower
mortgage standards), continued until the GSEbankruptcies in September 2008 (and may
be beyond since the fundamental political failure regarding the GSEs has not been
resolved).
Although the GSEs were willing accomplices, in the 1990s, Housing and Urban
Development (HUD) Secretary Mario Cuomo used the implicit bargain of the GSEs to
add pressure on them to take on a higher share of its mortgages to low and middle
income borrowers. As early as 1999, astute journalists warned that this meant that
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banks had to loan to progressively riskier borrowers and provide riskier mortgages,
increasing the risks to Fannie and Freddie (Holmes, 1999; Brownstein, 1999).
In 2003 and 2004, the GSEs were caught in Enron style accounting scandals that
eventually led to the resignation of Fannie CEO Franklin Raines, and there were calls
for tougher regulation. Moreover, Federal Reserve Board and Congressional Budget
Of?ce studies concluded that despite the implicit government guarantees that allowed
them to borrow cheaply, GSE activity had not signi?cantly lowered mortgage interest
rates[6]. Since they were creating risks for the taxpayer, what value were they
providing? Alan Greenspan called for tougher regulation.
At this time, internal documents of Fannie and Freddie show that its own risk
managers were sounding strong alarm bells in 2004, and they recognized that the GSEs
had the power to in?uence standards in the market.
Donald Besenius of Freddie Mac, in his April 1, 2004 letter to Mike May said “we did
no-doc lending before, took inordinate losses and generated signi?cant fraud cases. I’m
not sure what makes us think we’re so much smarter this time around.”
David Andrukonis of Freddie Mac said in an e-mail to Mike May on September 8,
2004 that “. . . we were in the wrong place on business or reputation risk [. . .] What
I want Dick [Freddie Mac CEO] to know that is that he can approve of us doing these
loans but it will be against my recommendation[7].”
But Freddie Mac’s management ignored these warnings. Instead Freddie Mac ?red
their chief credit of?cer[8] and the GSEs turned to their congressional allies. Senator
Charles Schumer stated in late 2003:
My worry is that we’re using the recent safety and soundness concerns, particularly with
Freddie, and with a poor regulator, as a straw man to curtail Fannie and Freddie’s affordable
housing mission (Anon., 2008).
At the House Financial Services Committee meeting in September 10, 2003, speaking
about GSE regulation, Representative Barney Frank said:
I do not think I want the same kind of focus on safety and soundness [. . .] I want to roll
the dice a bit more toward subsidized housing (http://online.wsj.com/article/
SB122290574391296381.html).
And roll the dice they did.
Seeing what they had to do to avoid regulation in a tougher political environment,
the GSEs increased their portfolios of sub-prime, alt-A, and high-risk mortgages from
,8 percent of their mortgages in 2003 to over 30 percent in 2008 (Pinto, 2008, p. 7). But
this worked in fending off the tougher regulation. Unfortunately, if defaults continue at
the current high rates, the $150 billion loss of the S&L crisis will easily be exceeded –
at considerable cost to taxpayers in the future (Pinto, 2008).
The political failure of tax regulation of the GSEs
As Edward Kane (who predicted the S&L crisis years in advance (Kane, 1985)) and
others have noted, in the early 1990s, Congress repeated with Fannie and Freddie
the mistake that caused the collapse of the S&L industry. In other words, it
gave government backing to private enterprises without adequately limiting the risks
these companies could take. But the Fannie and Freddie case is a far worse political
failure than the S&L debacle. First, taxpayers’ losses will be much greater than in the
S&L crisis. Second, in the S&L crisis, Congress might be excused for not recognizing
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that it should have imposed tighter limits on the risks assumed by government backed
institutions. But while Congress was passing tough new banking regulation to ?x the
S&L crisis, the decision not to regulate the GSEs must have been a conscious decision
on the part of the supporters of the GSEs in Congress. As documented above, the GSE
supporters in Congress received political contributions, grass roots organizing at
election time and used GSE resources like pork projects. They decided not to regulate
them so they could use GSE resources and the resources of others lobbying for the GSE
affordable housing mandate for their own interests.
Ominous signs for the future
In September 2008, Fannie and Freddie were placed in conservatorship under the
newly created US Federal Housing Finance Agency. Although the US Treasury has
been less de?nite, James B. Lockhart III, Director of the agency that serves as both
regulator and conservator of Fannie and Freddie stated “the conservatorship and the
access to credit from the US Treasury provide an effective guarantee to existing and
future debt holders of Fannie Mae and Freddie Mac[9].” This approach still fails to
address the underlying issue of guaranteed assets without constraints on risk taking.
In the middle of this crisis, James B. Lockhart III appears ready to forge ahead with the
same mistakes. He lamented, in testimony before the House Financial Services
Committee on September 25, 2008, that market turmoil of 2008 resulted in more
stringent loan criteria, for example, higher required down payments. He hoped that
both Fannie and Freddie would develop and implement ambitious plans to meet HUD
regulations for low and moderate income lending. Shockingly, rather than seeing
higher down payment requirements as a positive step toward stability in the housing
market, the regulator is still pushing for a lowering of mortgage standards. And as of
April 2010, despite frequent requests from Congressmen to the Administration for a
plan to restructure the GSEs, and a major ?nancial overhaul package before Congress,
the Administration has been silent on what to do about the GSEs.
III. Perverse incentives fromthe Community Reinvestment Act and market
failures in the private sector
Pinto (2008) estimates that Fannie and Freddie bought an estimated 47 percent of the
toxic mortgages. We still have to explain why the private sector created and bought the
rest. And we also have to explain why so many homeowners who are wealthier than low
or moderate income households are defaulting on mortgages. Part of the answer is that
Fannie and Freddie played a “market maker” role. Their dominant size in the market,
and their readiness to purchase these risky mortgages set standards in the market, and
meant that banks could pass on the risks of badly underwritten mortgages. They also
brought other actors into the business of trying to pro?t from risky mortgages
(Calomiris, 2008a, b). There is, however, another crucial component to the lowering of
bank mortgage standards. In the mid-1990s, the government changed the way the
Community Reinvestment Act was enforced and effectively compelled banks to initiate
risky mortgages. Moreover, there were incentive or market failure problems that
induced many of the key private actors to act in socially counterproductive ways.
Banks’ incentives and the role of the Community Reinvestment Act
The originators and servicers of the mortgages were the banks and mortgage brokers.
There were two problems that led to the banks issuing a lot of mortgages with
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excessive risks. First, the effort to lower mortgage underwriting standards was led by
the US Department of Housing and Urban Development. President Clinton directed
then HUD Secretary Henry Cisneros to develop a “National Homeownership Strategy”
that would “increase home ownership opportunities among populations and
communities with lower than average home ownership rates” (United States
Department of Housing and Urban Development, 1995a, p. 2, b). HUD stated that “the
National Homeownership Strategy commits both government and the mortgage
industry to a number of initiatives designed to [. . .] increase the availability of alternate
?nancing products in housing markets throughout the country” (United States
Department of Housing and Urban Development, 1995a, p. 9). Among the actions it
recommended was the following. “Lending institutions, secondary market investors,
mortgage insurers, and other members of the partnership should work collaboratively
to reduce homebuyer downpayment requirements [. . .] many low-income families do
not have access to suf?cient funds for a downpayment [. . .] in reducing this barrier to
homeownership, more must be done” (United States Department of Housing and Urban
Development, 1995b, Chapter 4, Action 35).
One of the principal means through which this policy was implemented was through
a change in the enforcement of the Community Reinvestment Act. This act was
originally passed in 1977, but weakly enforced prior to 1995. Newregulations phased in
between 1995 and 1997 called for banks to use “?exible or innovative standards” to
address credit needs of lowand moderate income (LMI) borrowers (Hossain, 2004, p. 57);
and banks would be evaluated on outcomes of their lending, i.e. quotas, not on efforts to
reach the of low and moderate income community. Failure to comply meant that banks
could not participate in mergers or acquisitions. So banks and mortgage brokers
developed many innovative products. Notably they lowered down payment
requirements below the traditional 20 percent minimum, and allowed loans to
borrowers with little or no credit history or documented source of income. And Fannie
and Freddie, under their affordable housing mandate, modi?ed their rules so they could
buy these innovative instruments. Hossain (2004) writes that the rule change:
[. . .] can be thought of as a shift of emphasis from procedural equity to equity in outcome.
In that, it is not suf?cient for lenders to prove elaborate community lending efforts directed
towards borrowers in the community, but an evenhanded distribution of loans across low and
moderate income and non- low and moderate income areas and borrowers.
Studies have documented that bank lending standards fell after this rule change
(DemyanykandvanHemert, 2008; England, 2002; Bhutta, 2008). For example, muchlower
down payments were accepted, and it had the desired effect of widening home ownership.
Thus, banks did not come up with the idea of looser underwriting standards and
slip these past regulators. Rather, in order to meet the objective of broadening home
ownership and providing credit to underserved areas, banks were compelled by the
regulators to lower mortgage standards. The real problem is that once bank regulators
initiated changes in enforcing the Community Reinvestment Act to require banks to
lower underwriting standards, they could hardly oppose similar loans to better
quali?ed borrowers. Then the relaxed standards spread to the wider mortgage market,
including to speculative borrowers and borrowers who wanted to trade up to bigger
homes. The key point here is not merely that low and moderate income earners
received loans that they could not afford. While that may be true to some extent,
it cannot account for the large number of sub-prime and alt-A mortgages that plague
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the housing market today. Between 2001 and 2006, the share of mortgages made up of
conventional mortgages fell from 57 to 33 percent (Wallison, 2008). The contagion of
poorly underwritten mortgages spread well beyond the low and moderate income
community groups.
What is securitization?
Prior to the 1970s, home mortgages were the most illiquid asset on a bank’s balance
sheet. Banks could not sell the mortgages on the secondary market due to what is
known as an “adverse selection” problem arising from asymmetric information.
In other words, buyers were afraid that banks, who knew their mortgages better,
would sell only the bad mortgages and keep the better mortgages on their own balance
sheets. Thus, prior to 1980, the vast majority of home mortgages were made by
?nancial institutions who originated, serviced and held the loans in their portfolios –
the “originate to hold” business model. In order to create a market for mortgages, in the
1970s “securitizers,” which can be banks themselves but were more frequently
investment banks, took pools of mortgages, had the pools of mortgages rated and then
sold the pools of mortgages. The large pools of mortgages were typically divided into
sections known as tranches, where each tranche offered differing risks or default. In the
event of default, the losses are absorbed by the lowest priority investors before the
investors with the higher priority claims are affected. These more complicated
offerings were known as collateralized debt obligations (CDOs). Over time, home
mortgages were increasingly securitized – the “originate to distribute” business model.
Crucially, this allowed loan originators to shift most of the risk to the secondary market
for mortgages.
The moral hazard problem of banks
Faced with a regulatory regime that pressured banks to make risky loans, the banks
?gured out how to make money on the risky mortgages. The banks and mortgage
brokers reaped signi?cant fees from the mortgages and then sold them on secondary
markets through securitization. So, the risks of default were borne by those who
purchased the pools of mortgages from the securitizers, while the loan originators got
the fees. Securitization was designed to address the adverse selection problem that
prevented resale of mortgages. Instead we got a “moral hazard” problem as the loan
originators collected fees on badly underwritten mortgages without bearing the risks.
An ef?cient capital market will allocate capital to where the risk adjusted rate of return
is highest. We now know that a large share of these mortgage backed securities had a
much lower rate of return than expected (Benmelach and Dlugosz, 2009a), and too
much capital was allocated to these investments relative to a social optimum, i.e. this
was a market failure problem. This market failure was due to moral hazard problems
at banks and CROs, and possibly a principal agent problem with asset managers. The
banks did keep some of the mortgages for themselves, and on these mortgages they
bore the risks, but overall this is a market failure problem as the capital was not
allocated ef?ciently[10].
Moral hazard and the CROs
The pools of mortgages were rated regarding their riskiness by Moodys, Standard and
Poor’s, or Fitch. These ?rms enjoyed a preferred designation of the Securities and
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Exchange Commission (SEC) as a “nationally recognized statistical rating
organization” (NRSRO), better known as CROs. Unfortunately, the CROs, who have
a responsibility to objectively evaluate the risks of the instruments they assess, had a
con?ict of interest. They had an incentive to undervalue the risk. These rating agencies
became heavily dependent on the fees from rating mortgage pools. Securitizers were
the ones who paid the ratings agencies, and repeat business for a CRO was dependent
on good ratings. Moreover, secritizers routinely employed the practice known as
“rating shopping.” A securitizer would ask a rating agency how the agency might
hypothetically rate a pool of mortgages. If the rating were low, the securitizer would go
to another rating agency. In what they call “the alchemy of the CDO credit ratings,”
Benmelach and Dlugosz (2009a) have shown that the CDOs received credit ratings that
were strikingly higher than the credit quality of the underlying collateral pools, and
Benmelach and Dlugosz (2009b) show that severe downgrading of these securities
started in 2007 leading to ?nancial institution write downs of more than $200 billion in
early 2009. Caprio et al. (2008) argue that a critical failure in the system was the fact
that the securitizers were the ones who paid the raters. In other words, the CROs had a
moral hazard problem as the fees too strongly in?uenced their evaluations. The result
was a gross undervaluation of the riskiness of these pools of mortgages and buyers
purchasing very risky assets they assumed had low risk. This led to a market failure of
buyers purchasing more of these risky securities than was ef?cient.
The poor performance of the CROs highlights long standing regulatory distortions
of the industry that arti?cially restricted their supply and increased demand for their
services. Supply was restricted by the SEC de?nition of the category of NRSRO in 1975
and subsequent SEC restraint on which ?rms could be so designated (there were never
more than ?ve and there were only three during the CDO ratings debacle). Demand
was increased by ?nancial regulators requirements that the institutions they regulate
must follow the judgments of these NRSROs. White (2001) noted this was a recipe for
rents and distortions[11].
Asset managers and a principal-agent problem
Calomiris (2008b) argues, in effect, that there is another market failure – that the
biggest problem in the private sector was that the asset managers of mutual funds had
a con?ict of interest between their own income and the interests of their clients
(a “principal-agent problem”). If they had not bought the mortgages, dramatically
fewer would have been issued – securitizers were supplying what was being
demanded by asset managers. In other words, the asset managers managed funds like
mutual funds or pension funds, where these funds were constrained to invest in only
very low risk ?nancial instruments. If these mortgage pools were not rated AAA, the
rules of the fund would have prohibited the asset managers from investing in them.
Calomiris maintains that there was a lot more money available for placement in AAA
rated mortgage funds than there were actual AAA mortgage pools available (if the
pools were properly rated). The asset managers were faced with a choice:
.
?nd pools of mortgages to buy at the rated quality required by the conditions of
the mutual fund; or
.
return the money to the investors.
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If the asset managers returned the money to their clients, they would lose their bonuses
and management fees, and put their huge salaries at risk. Rather than return the
money, they held their noses and bought mortgage pools that they knew to be
improperly rated[12].
Solution to the problem of inappropriate ratings – SEC assignment
The conventional solution to the problem of underestimation of the risks of a portfolio by
the ratings agencies is to require that the buyers pay the fees of rating agencies
(Caprio et al., 2008). There are two problems, however, with this solution. First, there is a
free-rider problem, as prospective buyers may refuse to pay for a rating in hope that
another buyer would pay. Moreover, Calomiris (2009) argues that requiring the buyer to
pay for the rating will not ?x the problem, since the principal-agent problemwill still lead
to asset managers purchasing more risky assets than is economically warranted by an
ef?cient market. Instead he recommends that ratings agencies be required to provide a
quantitative assessment of the percentage of loans in a portfolio that will default. If the
default rate exceeds this percentage, then the ratings agencies will be penalized.
The Calomiris solution, however, also has problems as it would appear to provide an
opposite incentive for the ratings agencies – namely to overestimate the risks. What
appears to be the best solution comes fromRichardson and White (2009). They propose to
continue with the model in which the issuer pays for rating the CDOs, but they would
require that the issuer apply to SEC. The SEC would assign the CRO that would do the
rating. SEC assignments could be based on rating performance and other quali?cations.
Their recommendation would avoid the free-rider problem, eliminate rating shopping and
the CROs would have the incentive to perform well since their repeat business would
dependontheir reputation for quality ratings. The problemis that the solution depends on
the ability of the SEC to evaluate and reward good performance.
How to meet an affordable housing objective most ef?ciently
There is some evidence that home ownership conveys some bene?ts to the community
(what economists refer to as an externality) so there is some justi?cation for the
government to provide moderate targeting subsidies for home ownership (Glaeser and
Shapiro, 2002). But this has to be done ef?ciently and in a manner that does not induce
a ?nancial crisis. The second key economic principle that was ignored is that simply
mandating an objective onto ?rms and hoping that the market participants will not
change their behavior in ways that are socially undesirable is a na? ¨ve public policy. It is
better to impact incentives most directly. Based on a theorem developed by Bhagwati
and Ramaswami (1963), economists state the approach more generally as: the most
ef?cient way to achieve an objective not achieved by the market is to use the regulatory
instrument that impacts the objective most directly, we say “at the relevant margin.”
In this case, the objective not achieved by the market is wider home ownership for low
and moderate income families. As implemented by the GSEs, mortgage standards were
simply lowered for all. So speculators and wealthy individuals, who wanted to trade up
in a housing boom, could move into homes for which they ordinarily would not qualify.
This obviously was not the objective of Congress and there is no evidence that larger
home consumption conveys bene?ts to the wider community (Glaeser and Shapiro,
2002). More importantly, the most ef?cient way to encourage home ownership is the
way Australia has periodically done it: Australia has subsidized the down payment of
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?rst time low income home buyers (by 50 percent in their case)[13]. Banks in Australia
do not change their standards, but with the larger down payments, many low and
moderate income families, who could not qualify for mortgages without the down
payment assistance, are able to qualify. This would put the cost of the program on the
budget of the government, where the costs of the program would be transparent and
subject to public scrutiny and debate, rather than hidden in the costs of banks and
private ?nancial market participants. Many in Congress prefer to hide the cost of their
programs (the problem is not limited to housing ?nance). Consequently, they avoid
subsidies since they expose the costs of the program. But mandating a social objective
onto private ?rms (in this case telling banks and Fannie and Freddie to lower their
mortgage standards) and ignoring the adjustments that markets will inevitably make,
can have much greater costs, as we are all painfully learning.
Low interest rates as a contributor to the crisis – due to monetary policy
Taylor (2007, 2009) has argued that the low interest policy of the Federal Reserve from
about January 2002 to early in 2006 contributed to the housing boom and ultimate bust.
The Federal Reserve set the federal funds rate at ,2 percent from January 2002 to late
2004. This was considerably below (by about 3 percentage points in 2004) the level
needed for price stability based on historical data, i.e. less than prescribed by the
“Taylor rule.” Although this did not translate into an increase in the money
supply[14], Barth et al. (2009, p. 7) explain that this induced a drop in mortgage rates,
especially in the one year rate on adjustable rate mortgages which fell to about
4 percent during this period. Many borrowers opted for adjustable rate mortgages
during this period (as 30 year ?xed rate mortgages carried higher interest rates), and
lenders accommodated the borrowers since it shifted interest rate risk to the borrowers.
Fueled by these low interest rates, subprime mortgage originations rose dramatically
from 8 percent in 2001 to 21 percent in 2005[15,16].
The homeowner: why tax laws and homeowner options have contributed to the crisis
The more equity a homeowner has in her home, the less likely she will want to walk
away from a mortgage in a downturn in the housing market, and the more stable the
housing market will be. Our laws, however, have induced a very low positive equity
and now negative equity environment.
The right to re?nance is rare in the commercial world, but state laws generally
guarantee that right to homeowners without penalty. Moreover, home mortgage
interest and home equity loan interest are deductible on federal income tax returns,
while interest payments on car and consumer loans of all kinds are not deductible.
(Since low and middle income earners pay little or no federal income tax, this does not
make sense for the purpose of encouraging wider home ownership.) In this situation, it
was rational for the homeowner to use a home equity loan rather than alternate
?nancing for consumer expenditures. Combined with the gradual decline in lenders’
requirements for home mortgages, the result was the so-called “cash-out” re?nancing,
through which homeowners treated their houses like savings accounts, drawing out
funds to ?nance cars, boats, and other consumer expenditures. By the end of 2006,
86 percent of home mortgage re?nancing was cash out re?nancing ( Joint Center for
Housing Studies, 2008, p. 37). Thus, with the collapse of the housing bubble, many
homeowners found themselves with negative equity (“under water”); and this was true
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not just for sub-prime mortgages, but for prime mortgages as well. In this situation,
homeowners might prefer to default on the mortgage rather than make the payments.
The problem is exacerbated by additional government policies. In most states,
mortgages are either “without recourse,” meaning that a defaulting homeowner is not
responsible for paying the difference between the value of the home and the principal
amount of the mortgage, or else the law makes the process of enforcing the obligation
so burdensome that lenders take no action. Thus, homeowners with negative equity are
more likely to walk away from the mortgage given this regulatory protection,
contributing to the problems of banks.
Fair market accounting standards – not a cause of the crisis
Some critics, for example the Institute of International Finance (2008), have alleged that
“fair value accounting” standards that often compel ?nancial institutions to value assets
on the books at market values (“mark to market” accounting) have exacerbated the
?nancial crisis. These critics argue that mark to market accounting has forced write
downs of assets during the crisis, depleted bank capital and forced sales of assets at
distressed sale prices. It is alleged that these prices were considerably less than their
proper value in a normally functioning market, i.e. less than the present value of the cash
?ows of the asset. They argue that there is then a downward spiral or contagion as many
banks are forced to unload assets at distressed prices, further driving down prices.
Downward spirals in prices, however, arise for many reasons. Given the large
number of defaults in the underlying mortgage pools that back the value of
the mortgage backed securities and the resulting reduction in the cash ?ow of these
securities, an alternate plausible explanation for the reduced prices of the mortgage
backed securities is that they re?ect a more accurate assessment of the present value of
the cash ?ow of the securities. In support of this latter view, Laux and Leux (2010)
maintain that the allegations that fair market accounting contributed to the crisis are
not supported by evidence. They ?nd:
[. . .] little evidence that banks reported fair values suffered from excessive write-downs or
undervaluation in 2008, which in turn, could have contributed to downward spirals and
contagion. If anything the evidence points in the opposite direction [. . .] Fair values played
only a limited role for bank’s income statements and regulatory capital ratios except for a few
banks with large trading positions. For these banks, investors would have worried about
exposures to sub-prime mortgages and made their own judgments even in the absence of fair
value disclosures[17].
Companies such as investment funds, investment banks, and bank holding companies
that relied heavily on short-term borrowing and had substantial sub-prime exposure
would have had to sell assets regardless of the accounting regime.
IV. The myth of deregulation
Deregulation is unrelated to the instruments that are the problems. On the contrary,
what deregulation that has occurred has contributed to the stabilization of the crisis
There were numerous regulatory failures that led to the current ?nancial crisis and
there is a need for new regulations. The failure to give regulators normal bank
supervisory authority in the case of the GSEs and giving bank regulators con?icted
objectives under the Community Reinvestment Act where they are instructed to ignore
poor mortgage underwriting standards top the list. I discuss one additional perverse
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regulation below and Calomiris (2008b) discusses others. But contrary to the
allegations by non-specialists, there are no actual acts of deregulation that contributed
to the crisis. Paraphrasing Charles Calomiris we know the following.
The instruments that are the problems in the current crisis are sub-prime lending and
securitization. Securitization was available for banks, investment banks, and other
?nancial institutions since the 1970s. Sub-prime lending was facilitated by regulation
changes in the mid-1990s as a means of extending home ownership to lowand moderate
income households. There is no connection whatsoever securitization or sub-prime
lending and ?nancial deregulation of the past three decades. Financial deregulation in
the past three decades consisted of the removal of interest rate ceilings, allowing greater
consolidation through the relaxation of branching restrictions, and allowing commercial
banks to enter underwriting and insurance and other ?nancial activities.
On the contrary – deregulation and globalization have helped stabilize the crisis
The 1999 Gramm-Leach-Bliley Act repealed part of the 1933 Glass-Steagal Act and
thereby allowed commercial banks and investment banks to merge. But this merger
capability has helped to stabilize the ?nancial markets rather than contribute to it. In the
2008 ?nancial crisis, deregulation allowed Bear Stearns to be acquired by Morgan[18],
Merrill Lynch to be acquired by Bank of America and allowed Goldman Sachs and
Morgan Stanley to convert to bank holding companies and help shore up their positions.
Moreover, deregulation, consolidation, and globalization of the banking system has
permitted the banks to recapitalize to a far greater extent that in previous crises.
In other words, ?nancial crises periodically occur throughout the world. There were
100 in the world in the past 30 years alone. The two most serious in the USA were the
Great Depression and the crisis of 1989. What has been common to past crises has been
that banks have been unable to raise capital largely because potential investors are
uncertain about how deep the problems are with the bank seeking to recapitalize. What
has been different about the current US crisis is that banks have been able to
recapitalize to some nontrivial extent. For example, in the S&L crisis, bank
recapitalization averaged about $3 billion per year in 1989-1991[19]. In the year ending
September 2008 banks raised $434 billion in new capital[20]. What explains this
unprecedented ability to raise capital in a ?nancial crisis? Calomiris and others argue
that deregulation, consolidation, and globalization contributed to substantial pro?ts in
the banks in the past 15 years and left banks in a stronger position at the start of the
crisis so they could more credibly argue they would survive the crisis and thereby
attract investors. Moreover, many analysts have noted that regional concentration of
banks contributed to US ?nancial crises in the past, as regional banks are vulnerable to
regional shocks (Bernanke and Lown, 1991). With consolidation and deregulation of
interstate branching, however, banks are less vulnerable to regional shocks. As a
further bene?t, globalization of banking has allowed banks to access credit from
sovereign wealth funds and other international sources.
The SEC rule change in 2004 – or why international coordination of regulation does not
necessarily lead to improved regulation
The SEC rule change in 2004 that changed how the SEC ?gured the net capital
requirements is now seen as a signi?cant mistake. Some journalists have mistakenly
called this deregulation (Labaton, 2008). What these journalists fail to note is that this
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rule change was the antithesis of deregulation; rather it was the imposition of
internationally coordinated regulatory standards – rules known as the “Basel Rules.”
The Basel Committee rules were the consequence of years of work by the central bankers
of the world and are based on the belief that a common set of global banking standards
would result in more ef?cient use of capital and a more stable global ?nancial system.
The Basel rules call for banks to have capital reserves of 8 percent on a risk weighted
basis. Commercial loans hada risk weight of 100, so hadto be backedby8 percent capital
in reserve. But AAA rated securities (like the securitized mortgage pools) had a
substantially lower risk weight of 20 percent, so banks only had to have 1.6 percent
capital in reserve to back investments in AAA rated securities. Basel I rules were
replaced with Basel II rules in 2007, which allowfor more use of internal bank models in
the assessment of risk, something which we would all question today; but rules for
residential mortgages did not change. As I have explained, all those responsible for
assessing the risks earned large fees from underestimating the risk and the investment
banks ended up leveraging themselves far too highly. Swiss authorities are now raising
the minimumcapital requirements above those allowed under the Basel Rules. The SEC
rule change was one of the regulatory failures that contributed to the ?nancial crisis. But
rather than a deregulation problem, this is a cautionary tale against agreement to
internationally coordinated regulatory standards. If theysubstitute for sound prudential
regulation, they could be a lot worse.
V. Lessons and reforms
Eliminate the GSEs. As a second best solution, regulate the GSEs against excessive risk
taking like normal banks
The raison d’etre of the GSEs was to lower mortgage interest rates. Studies by the
Federal Reserve and the Congressional Budget Of?ce have shown that they have failed
in that objective. Consequently, the GSEs add risk to the ?nancial system without
bene?ts. A ?rst best solution would be to eliminate them. Failing elimination, since the
federal government is guaranteeing their debt, they need to be regulated against
excessive risk taking.
We need to ?x the perverse incentives in enforcement of the Community Reinvestment
Act (and other laws) that induce ?nancial crises. Market mandates, such as requiring
changes in bank lending standards are usually inef?cient, do not achieve wider home
ownership in the long run and involve unintended adverse consequences. This will take
political will to correct the political failures
Pressure on banks to lower mortgage standards under the Community Reinvestment
Act is at the top of the list of perverse regulations. It is na? ¨ve economics to believe that
we can simply impose a mandate on private ?rms and assume that the cost increases
or risk increases of the mandate will have no adverse consequences. The home
mortgage deduction on federal income taxes and related state homeowner regulations
have also contributed to the crisis, but are of lesser importance as the primary cause.
To address many of the most important problems, it will take political will and
economic sophistication from Congress that has been lacking in the past.
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Large ?nancial institutions are not too big to fail. It is necessary to take a ?nancial
institution that cannot survive without substantial infusion of public funds into receivership
Safety net subsidies must be limited for proper incentives. In order to reduce the
likelihood that the next new ?nancial instrument that is misunderstood induces a
?nancial crisis, we must allow large ?nancial institutions to fail. Financial institutions
have mismanaged risk on a grand scale. It is crucial that they internalize the risks
(Kane, 2009). Caprio et al. (2008) and others have noted that the incentives for managers
in many ?nancial institutions are not properly aligned with the long run risks. For
?nancial institutions to internalize the risks of large losses and to align their
compensation structures for their managers with the risk, they have to bear the costs of
their losses. This is not possible if bailouts are anticipated and there is no possibility of
bankruptcy or takeover by the government. Thus, bailouts should be avoided.
Receivership of a very large bank does not mean chaos. Although the Federal Deposit
Insurance Corporation (FDIC) routinely takes regional banks into receivership,
including over 130 in 2009, many are afraid to apply the same strategy with large
?nancial institutions. In receivership, the ?nancial institution need not fall into
disarray. The FDIC could take receivership of a large bank, defend the customer assets,
change the management, wipe out the stockholders’ equity entirely, and a share of the
bondholders claims, continue the operation of the institution in receivership, and
eventually sell or reissue the company to private ownership, leaving the bondholders
with the residual. This is how the largest bank failure in US history – Washington
Mutual was six times larger than the previous largest US bank failure – was handled
so seamlessly in 2008 that it was almost unnoticed. Washington Mutual was placed
into FDIC receivership and reopened literally the next day as Morgan Chase with the
customers having full access to their accounts and services of the bank.
Resolution of the Lehman Brothers bankruptcy shows fear of systemic ?nancial
market failure for a central player in the counterparty transactions is grossly
exaggerated – not too big to fail. Lehman Brothers is more worrisome to many than
Washington Mutual, since it was a central player in the counterparty operations. The
US experience, however, starting in mid-2008, shows that very large banks, even those
central to the counterparty operations, can be reorganized with little or no systemic
problems for the wider ?nancial system. When it went bankrupt, Lehman Brothers
was the third largest user of credit default swaps on mortgage backed securities
worldwide and the ?fth largest user of credit default swaps on government backed
securities. It had its massive credit default swap holdings unwound within four weeks
by the Depository Trust and Clearing Corporation (DTCC) and its subsidiaries, with all
parties receiving payment on the terms of their original contracts. Consequently, when
the Senior Supervisors Group (the of?cial ?nancial supervisors of the USA, France, the
UK, Canada, Germany, Japan, and Switzerland) investigated the impact on ?nancial
markets of the Lehman Brothers bankruptcy, as well as the impact of the ?nancial
failures of Fannie Mae, Freddie Mac, and Landsbanki Islands, it concluded that these
“credit events were managed in an orderly fashion, with no major operational
disruptions or liquidity problems[21].” Moreover, through the DTCC, there are private
?nancial market institutional mechanisms in place designed to assure that the smooth
resolution of credit default swaps, as occurred in the Lehman case, will hold in general
(Tarr, 2010).
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Regulate and ?nancial institution against excessive risk taking if its debts are
government guaranteed, either implicitly or explicitly
If the government is going to extend the safety net even partially to large private
banks, investment banks or insurance companies, they will also need greater
regulation. I have argued that on economic grounds, large ?nancial institutions are
not too big to fail. The ?rst best public policy is to allow them to fail. But possibly due
to a shared belief system in their importance, as argued by Johnson (2009), or other
reasons, many large ?nancial institutions received substantial bailout subsidies.
Large ?nancial institutions are likely to anticipate this in the future and take
excessive risks, gambling on a taxpayer bailout if things go bad. This moral hazard
problem must be controlled.
Use the market to inform regulators
The Obama Administration is proposing extensive new regulation of ?nancial
institutions, with tougher capital requirements to assure that the ?nancial crisis is not
repeated. Recent history suggests, however, that we should be cautious in assuming
that regulators will have suf?cient information and judgment in new ?nancial
instruments to be aware of when a ?nancial institution is at increased risk and needs
an additional capital infusion. The FDIC Improvement Act of 1991 gave the FDIC
substantially greater powers of supervision to assure that the S&L crisis did not
happen again. Under the expanded powers of this act, examiners from the Comptroller
of the Currency were inside Citigroup full time for years supervising its operations.
Despite these broad supervisory powers, in late 2008, the federal government stepped
into shore up Citigroup by guaranteeing or investing more than $300 billion of
Citigroup assets (and $118 billion of Bank of America assets). Although in late 2009
Citigroup was attempting to pay back its troubled asset relief program money to avoid
constraints on executive compensation, the loan guarantees of the FDIC, Treasury, and
Federal Reserve have slipped under the radar (Assistance to Citigroup and Assistance
to Bank of America, 2008).
Hart and Zingales (2009) have proposed the use of the price of credit default swaps as
a trigger mechanismto provide information to a regulator. When the price (“spread”) of a
credit default swap on a ?nancial institution rises, re?ecting the market’s assessment
that default is more likely, the regulator would require that the institution raises
additional equity until the price of the credit default swap falls back to an acceptable
level. (The price of a subordinated debt instrument could serve the same purpose[22].)
If the ?nancial institution fails to do so in an acceptable period of time, the regulator
would take over, acting as the receiver as in a FDIC takeover. In this manner, risk taking
by the institution and taxpayer liabilities would be limited. For this proposal to work,
however, it is essential that the government be willing to takeover large ?nancial
institutions.
Have the SEC assign the CRO that will do the rating
Require that the issuer of a debt that would like to have it rated apply to the SEC for a
rating. The SEC would assign the CRO that would do the rating. SEC assignments
could be based on rating performance and other quali?cations.
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To the extent that wider home ownership is seen as a desirable social objective, modest
subsidies for wider home ownership that are in the federal budget should be considered
Although large subsidies would be a problem, a modest program along the lines of the
Australian approach to the affordable housing problem would be more ef?cient. With
no economic rationale, tax policies of the federal government subsidize the mortgage
payments of well to do income earners, while denying subsidies to low and moderate
income earners (who get little or no tax break from the mortgage deduction).
Increase capital requirements of ?nancial institutions; it would also be useful to develop
counter-cyclical ?nancial instruments to ?nance ?nancial institutions
There is widespread agreement regarding the necessity of increasing capital
requirements for ?nancial institutions. A problem for the banks is that they can easily
raise capital during booms, but have great dif?culty in raising capital during
recessions or a ?nancial crisis. The creation of a subordinated debt instrument that
regulators could require the bank to convert to equity could help resolve this problem.
Regulators would insist on the conversion when the price of the subordinated debt
instrument (or credit default swap) suggests that the bank is too risky.
Require loan originators to be well capitalized and bear some of the risks of the
mortgages they underwrite
It is necessary to address the moral hazard problem that has plagued the sector
originating mortgages. As Pinto (2008) has explained, it would be useful to introduce
regulation to require loan originators to hold some percentage of the risk on any
loan they originate and to be well capitalized against possible default on these loans.
Rather than requiring this, ironically, existing regulations discourage it (Calomiris,
2008b, p. 33).
Notes
1. Testimony of Ed Pinto (2008, p. 8), former chief credit of?cer of Fannie Mae. The principal
database of the New York Fed under reports default prone mortgages. There are seven
million sub-prime loans in the Federal Reserve Bank of New York on-line database.
Second, there are about ten million sub-prime loans classi?ed in the “Loan Performance
Prime Database” as prime. (This database is mutually exclusive with the above mentioned
New York Fed database.) Contrary to the name of the index, there were about ten million
sub-prime loans among the 50 million loans in its Prime database (by the conventional
de?nition of a sub-prime loan as a loan with a FICO index of ,660). Third, there are alt-A
loans (such as “liar loans”) where the borrower had a FICO score above 660, but failed to
provide documentation. These were favorite instruments of speculators and have
conventionally been classi?ed as prime; but they are defaulting at a rate approaching
sub-prime. The New York Fed estimates that there are about 2.67 million alt-A loans,
excluding Fannie and Freddie exposure and Pinto reports 2.9 million alt-A loans held by
Fannie and Freddie. Finally, there are about 2.5 million other junk loans, such as
negatively amortizing option adjustable rate mortgages. See Pinto (2008, Annex I) for
further details.
2. They examined the votes of members of the House of Representatives on the ?nal passage of
the FDIC Improvement Act of 1991 as well as three amendments. They found consistent
support for both intra-industry and inter-industry rivalry, but little role for consumer
interests. They also found support for legislator ideology.
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3. Community organizations such as ACORN, Neighborhood Assistance Corporation of
America and the Greenlining Institute had much at stake in advancing the affordable
housing mandate of the GSEs and in putting teeth into enforcement of the Community
Reinvestment Act (as discussed below). They successfully negotiated agreements with
various banks to provide tens of billions in mortgages to underserved communities, typically
serving as mortgage servicers for these agreements. In addition, ACORN received $40
million in grants from various banks for dubious “counseling” services. See United States
House of Representatives (2010), Capital Research Corporation (2009), and The Washington
Examiner (2010).
4. Center for Responsive Politics (2008) calculations based on Federal Election Commission
data. A complete list of all 354 active members of Congress who received contributions (and
the amounts they received) is available in the paper.
5. The 1992 Federal Housing Enterprises Financial Safety and Soundness Act, also known as
the GSE Act. For further details of this act, see:http://online.wsj.com/article/
SB10001424052748703298004574459763052141456.html
6. The Congressional Budget Of?ce (2001) estimated that the GSEs lowered mortgage interest
rates by 25 basis points, i.e. 0.25 percentage points. See also Bhutta (2009).
7. Statements of Besenius and Andrukonis were submitted as part of the testimony of
Calomiris (2008a). Dona Cogswell of Freddie Mac wrote similar warnings in a memo to
Dick Syron, Mike May, and others on September 7, 2004.
8. See www.swamppolitics.com/news/politics/blog/2008/12/fannies_freddies_exchiefs_blas.
html. Ed Pinto notes that he was ?red as chief credit of?cer of Fannie Mae in 1989 for
early warnings about the dangers of the affordable housing mandate.
9. On November 25, 2008, the Federal Reserve announced it would buy $100 billion of debt of
the GSEs and $500 billion on the mortgage-backed securities guaranteed by the GSEs and
Ginnie Mae (Reuters, 2008).
10. The Lehman Brothers bankruptcy revealed that Lehman keep some of the riskiest tranches
of the mortgage pools on its own books. It is not clear if Lehman kept these tranches in order
to secure AAA ratings of the remaining mortgage pool or if it was willing to bear increased
risk to obtain a higher return.
11. Richardson and White (2009) suggest that a better outcome would have been achieved if
regulated ?nancial institutions were free to pick their own bond advisor (which could be a
NRSRO). They would be required to justify their choice to their regulator, but the bond
advisory market would become open. This solution, however, does not address the moral
hazard problem.
12. He cites a story of a rater, who had not been selected to rate the mortgage pool because he
gave too risky a rating. The rater warned an asset manager not to buy the pool, but the asset
manager replied: “we have to put our money somewhere.”
13. The costs of such a targeted subsidy program for low and moderate income earners
would have to be weighed against the bene?ts, and would likely justify a small subsidy
program. See Bourassa and Yin (2006) for a comparison of the impacts of the USA and
Australian approaches. In 2008, however, the US implemented a program of interest free
loans for ?rst time home buyers (or buyers who have not owned a home in the past three
years) for homes purchased between April 9, 2008 and July 1, 2009. The program allows
a tax credit of up to $7,500, which must be paid back interest free over a period up to
17 years.
14. Based on data available from the Saint Louis Federal Reserve web site, the rate of growth
of M2 for the ten-year period ending in 2006 was 6.2 or 6.1 percent in the seven years
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ending in 2006. This is a lower rate of money supply growth than in any of the ?nal four
?nal decades of the twentieth century, except for the 1990s. M3 growth, up until
discontinuance of the series in February 2006, tells a similar story. Speci?cally, the
average growth rates in M2 (M3) by decades are the following: 1960s, 7 (7.6) percent;
1970s, 9.5 (11.1) percent; 1980s, 8 (8.7) percent; 1990s, 4 (4.6) percent. M3 growth from
January 2000 to February 2006 was 7.7 percent, and 7.8 percent from January 1996 to
December 2005.
15. Taylor (2007) provides econometric evidence for this story by estimating the impact of
interest rates on housing starts. He infers that housing starts increased dramatically during
this period due to the low interest rate policies.
16. As Taylor (2009) has explained, it does not appear that the low interest rates were due to a
global savings glut, led by Chinese savings. World savings as a percentage of GDP were low
during the 2002-2004 period, especially compared to the 1970s and 1980s. (International
Monetary Fund, 2005). Savings exceeded investment outside of the USA, but this was offset
by negative savings in the USA.
17. Two examples of assets values on the books at more than market value are the following.
Merrill Lynch sold $30.6 billion of CDOs backed by mortgages for 22 cents on the dollar; but
at the time of the sale, the assets were valued on their books at 65 percent higher. In the ?rst
quarter of 2008, Lehman wrote down its $39 billion commercial mortgage backed securities
portfolio by 3 percent, when an index of these securities dropped 10 percent. Laux and Leux
(2010, p. 102).
18. The Bear Stearns-J.P Morgan merger was facilitated by a $30 billion government subsidized
loan. Jaffe and Perlow (2008).
19. Federal Reserve data cited in Bernanke and Lown (1991, p. 239).
20. For details of which ?nancial institutions raised capital and how much, see Calomris (2008b,
p. 106).
21. See Senior Supervisory Group (2009, p. 2). The USA was represented in the report by the
Board of Governors of the Federal Reserve, the Federal Reserve Bank of New York, the SEC,
and the Comptroller of the Currency.
22. Several studies (Fan et al., 2002) have suggested that a minimum subordinated debt
requirement would help. Banks would be required to issue some subordinated bonds (senior
bondholders would be paid prior to subordinated bondholders in the event of bankruptcy) to
?nance their lending. The market price of these bonds would provide a market measure of
the riskiness of the banks.
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Corresponding author
David G. Tarr can be contacted at: [email protected]
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