Jeffrey Friedman, editor. What Caused the Financial Crisis? University of Pennsylvania Press. 360 pages. $29.95
This book’s title is appropriate. In it, various economists and financial experts address the question: What caused the financial crisis? Not surprisingly, they disagree in their answers. Why, then, read the thing? Because it narrows the range of disagreement and supplies vital information that can help one judge which alleged causes are most likely, and which less so. As an economist I have followed this issue closely over the past two and a half years, and yet I still found this book illuminating. The bottom line for me: The case is fairly strong that government regulation was one of the major sources of the financial crisis.
The most important chapter is the first. This 66-page segment is editor Jeff Friedman’s overview of subsequent chapters, along with his own contributions to the debate. It is by far the densest part of the book, not in the sense of being hard to understand, but in the sense that if you miss even one paragraph, you may miss a lot. Friedman carefully sifts through the other authors’ arguments and evidence. His work would be impressive if done by a Ph.D. economist with twenty years of experience in the profession. What makes it more impressive is that Jeffrey Friedman is not an economist at all but a political scientist (he is a visiting scholar in the Department of Government at the University of Texas at Austin).
One point that almost all informed observers agree on is that the financial crisis started in the housing market and that the crash in housing prices caused a more-general banking and financial crisis. Therefore, to understand the cause of the financial crisis, one needs to understand two things: First, why the housing crisis happened and, second, how the housing crisis caused the larger financial crisis.
Friedman argues that both questions can be answered by looking to government regulation. As to the crisis’s cause, he points to the U.S. government’s push, under the Community Reinvestment Act of 1995, to have banks lend money to low-income people who would, in many cases, have a slim chance of repaying the loans. Friedman draws on a chapter written by Peter Wallison, an economically literate lawyer at the American Enterprise Institute and an expert on financial regulation. Wallison explains that to make banks lend these substantial funds, federal regulators held up approval of bank mergers and acquisitions. Friedman adds that in 1995, the U.S. Department of Housing and Urban Development ordered two government-sponsored enterprises, Fannie Mae and Freddie Mac, to direct 42 percent of their mortgage financing to low- and moderate-income borrowers. In 1997, to help achieve that goal, Fannie Mae introduced a three-percent-down mortgage — the traditional mortgage had required a twenty-percent down payment. With only three percent down, an owner whose house value fell only a bit below the original price would be tempted to walk away from it.
Of course, when the housing crisis caused huge losses for Fannie Mae and Freddie Mac, the federal government stepped in and bailed them out. Because of this bailout, notes Friedman, the U.S. government has an even bigger debt problem. Nevertheless, the bailout did not cause the crisis of 2008.
So how did the housing crisis lead to the financial crisis? Friedman’s argument is complex and detailed and can’t be justly explained here. His bottom line, though, is that banks and other investors relied too heavily on the aaa ratings given to mortgage-backed securities by the three sec-recognized ratings agencies: Standard and Poors, Moody’s, and Fitch. The problem, according to Friedman, was that “Even the most sophisticated investors seemed to have been ignorant of the fact that Moody’s, s&p, and Fitch were protected by sec regulations.” Friedman, drawing on a chapter by Lawrence J. White, an economics professor at New York University’s Stern School of Business, argues that these three ratings agencies did not have a strong incentive to give accurate ratings because of their sec-protected status. He points out that executives at giant investment firms were shocked when Moody’s “suddenly downgraded” some of its triple-A, private-label (as distinct from Fannie Mae and Freddie Mac), mortgage-backed securities in the second half of 2007. Had these investors known that Moody’s could prosper no matter how inaccurate its ratings, writes Friedman, “they surely would not have been stunned when its ratings turned out to be so inaccurate.” Nor, he writes, would they “have been so reliant on its ratings.”
Another strand of Friedman’s analysis involves deposit insurance. Instituted under Franklin Roosevelt to prevent bank runs, deposit insurance distorted banks’ incentives: They could make riskier loans than they otherwise would, knowing that a large percentage of their losses would be borne, not by the banks, but by taxpayers. This “moral hazard” inevitably led to government regulation for capital adequacy so that the banks would be unlikely to lose their depositors’ money. The capital adequacy rules were part of the Basel I rules that regulators in many countries adopted. Friedman refers to the chapter by Viral V. Acharya and Matthew Richardson, both finance professors at New York University’s Stern School of Business, to make his case. Acharya and Richardson explain that many of the banks engaged in “regulatory arbitrage.” Under Basel I, the less risky the rating of an asset, the lower the capital requirements. So, for instance, if a bank held mortgages, it had to hold capital equal to a certain percentage of the assets’ value. But if the bank sold the mortgages and used the funds to buy mortgage-backed securities that the rating agencies had rated aaa, it needed to hold a lower percentage of the value, freeing up funds to invest elsewhere. Thus the term “regulatory arbitrage.”
In a later chapter, aptly titled, “A Regulated Meltdown: The Basel Rules and Banks’ Leverage,” economists Juliusz Jablecki of the National Bank of Poland and Mateusz Machaj of Wroclaw University in Poland also make the point about regulatory arbitrage, and they do it particularly well. In commenting on the Basel rules, they write: “Unfortunately, obeying a rule designed to minimize risk is not the same thing as minimizing risk. It is adherence to a bureaucratic requirement, nothing more.”
Jablecki and Machaj are also among the few authors in the book who analyze the likely effects of the further regulations imposed in response to the crisis. They reach a scary but plausible conclusion: that the natural tendency is to pile on more rules to the point where “bureaucratic controls increasingly substitute for market mechanisms.” When that happens,
government decrees replace the knowledge-discovery process of profit (when one has discovered a useful product that consumers are willing to buy) and loss (when one merely thinks one has done so).
The result, they say, is likely to be cartelization, which “could actually aggravate the systemic risk that already pervades the financial markets.”
Most people, myself included, tend to get fearful when they hear about a new, complex economic institution. And their fear often leads them to be credulous about claims based on fear. So, for example, many people got scared when they heard about credit default swaps (cds), a term that sounds complicated, and then heard further that the “notional value” of such swaps was in the tens of trillions of dollars. The book’s short chapter by Wallison goes far in describing credit default swaps and, in the process, reducing the fear generated by those who should know better. Wallison writes: “The best analogy for a cds is an ordinary commercial loan. The seller of a cds is taking on virtually the same risk exposure as a lender. It is no more mysterious than that.”
Credit default swaps, he points out, simply allow lenders to offload the risk of a default on a loan to someone else who, for a price, is willing to take on this risk. No new risk is created in the process. Did the sellers of these swaps underprice them because they understated the risk of default? Absolutely, says Wallison; we know that now. But, he writes, “If we wanted to prevent losses that come from faulty credit analysis, we would have to prohibit lending.” Wallison also notes that if regulators are allowed to second-guess risks we have no basis for thinking that their guesses “will be any more insightful into actual creditworthiness than the judgments of those who are making the loans.”
And what about the idea of “notional value” of the amounts on which the cdss are written? Wallison quotes financier George Soros’ 2008 statement that “The notional amount of cds contracts outstanding is roughly $45 [trillion] . . . To put it into perspective, this is about equal to half the total U.S. household wealth.”
Wallison’s response? “This is not putting credit default swaps ‘into perspective.’” Wallison shows that each time a cds is traded, the “notional amount” increases, even though the amount of risk is unchanged. He shows that the “net notional amount” is “actually about 5 percent of the figure Soros used.” The problem with credit default swaps, concludes Wallison, is not their financial effects but their political effects. They can become, he writes, “political piñatas” and “divert scrutiny from the actual causes of problems.”
A highlight of Fried-man’s introductory chapter is his rebuttal of the widely-held view that the way that high-level employees in financial firms were paid gave them an incentive to take on inordinate risk. Friedman points out that this view was accepted early in the crisis despite a complete lack of evidence. Three studies of the issue came along after this consensus had been reached. One study found some evidence in favor of the consensus view — “Financial companies that paid large incentive bonuses tended to perform slightly worse during the crisis” — but a second study found that the higher the proportion of stock compensation for banks, the worse the banks did. Friedman indicates that had the bank executives realized that their banks were taking excessive risks, they would have cut the risk or sold their stock. By not doing so, they took heavy losses. A third study found that some executives did sell large amounts of stock in the eight years preceding the crisis. But Friedman makes the obvious point that if you get almost all your compensation in stock and want to have purchasing power, you must sell a lot of your stock. Moreover, he notes, banking executives “did not cash in the bulk of their stock compensation.” Jimmy Cayne of Bear Stearns, for example, sold $289 million in stock during the preceding eight years but held on to $1 billion in stock, which he later sold — for $61 million.
One main reason so many people think more financial regulation is the answer is that they have been told over and over that the financial sector is unregulated. Unfortunately, mit’s Daron Acemoglu, in his chapter, does some of this telling. Acemoglu claims, although he presents no evidence, that policy makers in Washington “were lured by ideological notions derived from Ayn Rand novels rather than from economic theory.” Acemoglu concludes, “In reality, what we are experiencing is not a failure of capitalism or free markets per se, but the failure of unregulated markets — in particular, of an unregulated financial sector and unregulated risk management.”
It takes some chutzpah for an economist to claim that one of the most regulated industries in the country is “unregulated.” In a previous chapter, Wallison argues that the financial sector is under “the most comprehensive regulatory oversight of any industry.” I’m not sure that Wallison is right — medical care and health insurance have been highly regulated for decades and are surely a close competitor for the dubious honor — but it’s clear that the financial industry does, indeed, operate under intense regulation.
In the book’s afterword, the prolific Judge Richard Posner takes on some of Friedman’s arguments. One such argument is that the various bond-rating agencies’ ratings were inaccurate. Posner notes, correctly, that whether they were inaccurate “depends on how likely it seemed that the securities rated triple-a were likely to tank.” This probability, he writes, seemed small to “regulators, financial journalists, economists, and the professional investment community.” That’s true, but were they right to think the probability was low, and could the lack of incentives for the three agencies to make accurate ratings matter? Posner argues, without providing evidence, that the “limitations of the credit-rating agencies were well known to professional investors.” He concludes his argument by writing, “Professional investors who failed to treat their ratings of complex securities with a degree of skepticism despite knowing all this had only themselves to blame.” Maybe, but then isn’t that Posner’s way of admitting that even professional investors might have been too credulous? People make mistakes. Investors made mistakes. Regulators made mistakes. Posner’s point seems petulant rather than illuminating.
In discussing the high ratings of various bonds, Posner reminds us that we “must be wary of hindsight bias” — that is, seeing as obvious after the fact what was obvious to very few people before the fact. He’s right. But Posner’s own solution for preventing or reducing the probability of future financial crises is a grand example of hindsight bias. Posner recommends more regulation, buying into the Acemoglu view that the financial sector is “unregulated.” But how, exactly, given Posner’s own admission that regulators thought the probability of a collapse was small, are regulators supposed to do better in the future? We, including regulators, never know, except after the fact, that a low-probability event will occur. So isn’t future regulation likely to be closing the barn door only after the horses’ low-probability escape?
Fortunately, Friedman has much of value to say on this issue. He points out that when regulators impose rules, the people they regulate must follow them and that, therefore, the rules homogenize behavior and prevent diversity. The advantage of diversity is that not all participants will walk off the cliff. Friedman notes that Wells Fargo Bank, J.P. Morgan, and Goldman Sachs all became aware of the risks of mortgage-backed securities and took actions to reduce or hedge their risks. Had regulation been even tighter, this would have been impossible. However heterogeneous are the regulators’ opinions of a regulation, he notes, only one regulation becomes law. Diversity among market participants, by contrast, “takes the more concrete form of different enterprises structured by different theories.”
For that reason, regardless of what caused the financial crisis the way to avoid a future crisis is not through more regulation. Why? Friedman says it best:
Where there are competing powers, as in a capitalist economy, there is more chance of heterogeneity than when there is a single regulator with power over all the competitors. At worst, in the limited case of a market that, through herd behavior, completely converged on an erroneous idea or practice, unregulated capitalism would likely be no worse than regulated capitalism, since an idea or practice that is homogeneously accepted by all market participants in a given time and place is likely to be accepted by the regulators of that time and place, too. But at best, competing businesses will embody different theories, with the bad ones tending to be weeded out.