Policy Missteps: Unraveling the 2008 Financial Crisis

1. Not What They Had in Mind: A History of Policies that Produced the Financial Crisis of 2008Arnold Kling Sept ‘09 Brad Jung Robert Samantha Varian

2. Arnold Kling • PhD Economics from MIT • Affiliated Senior Scholar at Mercatus Center at George Mason University • Worked as Economist for Freddie Mac and Federal Reserve

3. Introduction • Examines the Roots of Financial Crisis • Policy Considerations • Alternative Causes of Crisis

4. Four Components of the Financial Crisis • Bad Bets • Ex. Subprime Mortgage Loans • Excessive Leverage • Domino Effects • 21st-Century Bank Runs • Kling emphasizes that the financial crisis required all four elements

5. Causal Relationships

6. Capital Regulations • Most Important Causal Factor in the crisis • Capital regulations encouraged bad bets financed using excessive leverage financial structures subject to domino effects and 21st century bank runs

7. Past Crises Make Bad Policy • Housing Policy and Bank Regulatory Policy evolved out of previous crises • Reshape of Mortgage Market in 1930 • 5 Year Balloon Mortgage 30 Year Fixed Rate Mortgage and creation of FHA, FNMA, and Federal Deposit Insurance

8. Past Crises Make Bad Policy • 2nd Attempt at Reshaping Mortgage Market in 1970s-Late 1980s • Savings and Loans Holding 30 year mortgages went under (Inflation and Rising Interest Rates) • Excessive risk-taking due to Federal Deposit Insurance • Policy makers after S&L Crisis promote • Securitization of mortgages • Market-Value Accounting • Risk-Based Capital

9. Past Crises Make Bad Policy • Regulator response to S&L Crisis contributed to most recent crisis • Mortgage securities become “toxic assets” • Risk-Based Capital and Market-Value Accounting contribute to domino effects: • Bank forced to sell mortgage-backed securities • Lowers market value of securities • Triggered write-downs at other banks due to market-value accounting • Put other banks below regulatory minimum for capital

10. Housing Policy • Government encouraged home ownership • Mortgage Interest Deduction • Capital Gains Tax Exclusion • Eased mortgage writing standards • Stated Income and Stated Asset Loans where income and assets did not have to be documented • Cheaper • Reduced documentation becomes a magnet for fraud • Housing Prices began to fall in 2005

11. Hindsight is 20/20 • Government could have avoided crisis by: • Forcing banks and mortgage institutions to hold more capital • Cracking down on loose mortgage standards • Political landscape during Clinton, Bush administrations made cracking down unlikely

12. Bank Capital Regulations • Outsourcing credit ratings • Primary constituents were banks not investors • FED Researcher David Jones (2000) • Shows support for securitization and off-balance sheet entities to reduce capital requirements • Sympathetic Jailor • Essentially investors were purchasing assets with attractive returns in which they thought there was little or no risk, yet these assets were backed by risky long-term mortgages

13. Possible Bank Capital Solution • Economists Susan Woodward and Robert Hall propose: • Require banks to issue subordinated debt • Gives a better market idea of risk • Investors demand interest rates given their perception of bank risk • Cushion for taxpayers • Convert to equity in times of crisis (Contingent Convertibles) • Kling worries that new regulation will either fail to prevent or perhaps cause future financial crisis

14. Erosion of Competitive boundaries • Barriers to Entry • Glass-Steagall (1933) • Constantly challenged by technology and innovation • Inherently disliked by economists • Kling believes the case to remove these barriers is sound • Safety and Soundness • Dilemma • Allow banks to expand into non-bank financial activities • Keep banks separate from certain financial activities • Shadow Banking System • Gary Gorton • Paper written after financial crisis supports barriers to entry

15. Financial innovation • Mortgage credit scoring replaces human underwriting in 1990s • Saved fees • Finer grades of risk put into many risk buckets • Facilitated securitization by providing objective data for risk of underlying mortgages • Structured Finance • Credit risk split into three tranches • Senior tranches could obtain AA or AAA ratings • Credit Default Swaps • Insurance against default on security • Financial derivative but differ from currency or interest rate risk (Coin Flip) • Innovations emerged as banks demanded AAA ratings to lower capital requirements

16. Monetary Policy • Kling provides evidence that housing bubble was caused by expansionary policies from ’01-’03 • Monetary policy should stabilize GDP and not financial markets

17. Domino effects and bank runs • Minsky and Galbraith suggest instability is a characteristic of financial markets • Systematic Instability comes from signaling • Government backing is an extremely valuable signal (FDIC) • Signals have slow upward growth but rapid downward growth • Bank Runs

18. Aim for easy to fix rather than hard to break • Encourage financial structures that involve less debt • Tax policy encouraging Equity Financing • (Dot Com Bubble) • Weaker correlations between institutions

19. Conclusion • Core of ‘08 crisis consisted of unsound practices in mortgage finance boosted by regulatory developments that: • Essentially allowed for lower capital requirements • Encouraged securitization • Decreased lending standards • Financial innovations with negative consequences • Credit Default Swaps • Low rates contributed to housing boom • Did not enforce competitive boundaries allowing for “too big to fail” bank size