Arnold Kling of EconLog has done the hard work of setting out his theory of the financial crisis and what we should learn from it in a fifty-page but highly readable paper available here. I have some quibbles but think it is worth a read.
Here are the causes of the crisis in one table:
Basically, Kling says that the crisis was composed of the things along the top, which were caused by the things on the left. You can see that he places the blame squarely on poor capital requirements regulations, which gave various banks incentives to (a) originate-to-distribute instead of originate-to-hold; (b) securitize every which way they could; (c) use credit default swaps to reduce capital requirements even further; (d) stuff toxic securities into SIVs; etc.
I was surprised at the low weight Kling places on financial innovation, but this turns out to be a function of his conceptual structure: “Apart from practices that were developed for the purpose of regulatory capital arbitrage, financial innovation played a small role in the crisis.” He categorizes CDOs, credit default swaps, and SIVs as forms of innovation that arose for regulatory capital arbitrage purposes, and so the real villain there is lousy regulations in the first place. I could insert a long discussion here of what it means for something to be a cause of something else. Suffice it to say that at you could argue that the end of the day everything is always the government’s fault, since the private sector always does what it does in response to the incentives created by the government; put another way, from a public policy perspective the only actor is the government, since we have no control over the other ones. But I see Kling’s point. (That said, he gives exotic mortgages a pass — I’d be curious to know if he thinks those are also a consequence of bad capital requirements.)
Kling also gives industry structure a relatively low weight, which I think is because he doesn’t think Glass-Steagall would have prevented the crisis. I think he’s probably right there, since Lehman and Bear managed to become too big to fail despite remaining investment banks. (Although I hesitate because if Citi, JPMorgan, and Bank of America were not holding onto trillions of dollars of toxic MBS and CDOs, would the government have had to rescue Bear?) But I think he may overlook the importance of bank size, which made it easier for banks to place bad bets because of the implicit government guarantee. Which brings up the question: Did bank CEOs before, say, 2007 really make decisions because they thought they were too big to fail? It seems unlikely, but David Wessel does have that great story in In Fed We Trust about Goldman Sachs, all the way back in 1991, lobbying to change Section 13(3) of the Federal Reserve Act to allow the Fed to lend to an investment bank in a crisis.
Jumping ahead to the conclusion, Kling doesn’t talk a lot about what specifically should be done, but he does have this good distinction:
“If economic stability inevitably gives way to financial euphoria, then it may not be possible to devise a fool-proof regulatory regime. Instead, it may be more effective to aim for a system that is easy to fix than a system that is hard to break. This means trying to encourage financial structures that involve less debt, so that resolution of failures is less complicated. It also means trying to foster a set of small, diverse financial institutions.”
As you can imagine, when I see “easy to fix” I think that the key institutions should be smaller so they are not too big to fail. Kling instead focuses on scaling back securitization and the various incentives to take on debt, like the mortgage interest tax deduction and the tax preference for corporate debt over equity. But I don’t disagree with most of his recommendations.
My biggest quibble is the emphasis Kling puts on government pressure on Fannie and Freddie to lower their underwriting standards. I think he knows that the truth is somewhere in the middle here. He has a section called “CRA and the Under-Served Housing Market” which, when you read it, barely touches on the CRA (except to make the case that the CRA had nothing to do with the crisis: “Many mortgage loans that met the standards for CRA were of much higher quality than the worst of the mortgage loans that were made from 2004–2007. Thus, one must be careful about assigning too much blame to CRA for the decline in underwriting standards.”). Most of the section talks about the deterioration of mortgage underwriting standards in general, without linking that deterioration to the CRA, and the links to Fannie and Freddie are weak. For example, discussing why Fannie and Freddie were not able to stop private lenders from offering no-doc loans, he says:
“This time, the GSEs were not able to take a stand against the dangerous trends in mortgage origination. Their market shares had been eroded by private-label mortgage securitization. They were under pressure from their regulators to increase their support of low-income borrowers. Finally, they had been stained by accounting scandals in which they had allegedly manipulated earnings.”
I think that Fannie and Freddie contributed to the craziness in the mortgage market and to the housing bubble, but that they were relatively small factors compared to the originators themselves and the investment banks that were buying their toxic loans for securitization.
By James Kwak
The Baseline Scenario 
Quote: Suffice it to say that at you could argue that the end of the day everything is always the government’s fault, since the private sector always does what it does in response to the incentives created by the government; put another way, from a public policy perspective the only actor is the government, since we have no control over the other ones.
I know this is a straw man, but I’ve always thought that the reasoning behind this logic is flawed.
It’s like saying: “Officer, it’s not my fault that I put my car in the ditch, after all, I wasn’t speeding.” when going 65 on a snowy road with bald tires. Attempting to absolving oneself from any accountability for the consequences of your actions. (yes, another straw-man).
The point is that financial actors need to take responsibility for doing stupid things. It isn’t the government’s job to define stupid, just illegal, even if stupid carries real consequences.
That part made me think of Bart Simpson telling Lisa, “I’m going to swing my fist, and if your face gets in the way it’s your own fault.”
That’s exactly the way the banksters look at the American people. Except that after they punch you out they strip you of wallet, jewelry, clothes…
Exactly Ian! These people need to have consequences so other won’t do the same things.
The graph reminds me of a foreclosure graph that a senior v.p. of credit had devised during an earlier banking crisis. The graph ranked each horribly delinquent borrower so that the banker could identify the order of foreclosure actions. The graph wasn’t particularly helpful because the criteria determinations were subjective and the banker assigned the weight to the criteria to support his subjective conclusions.
There will always be tension between the banks and the regulators regarding capital requirements. Banks will use accounting tricks and develop products to defeat regulatory requirements. It is up to the regulators, the Administration and Congress to assess whether banks hold sufficient capital for the risks undertaken. Capital requirements failed to prevent the crisis because neither the regulators nor the banks took into account the systemic risks and the impact that systemic risks would have on institutions that had properly capitalized based on their own individual risk assessments. Perhaps rather than trying to order the size and complexity of banks, the emphasis should be on allowing the government to require higher capital requirements for every bank when a systemic risk is identified.
Kling is more realistic about the possibilities for financial regulatory reform than most critics, and I think this stems from his superb understanding of the history of financial innovation and reform.
His basic argument is that if one looks at the series of financial crises that have taken place in the United States, one can see how the “solutions” to a given crisis created the environment for the next crisis. People tend to forget that the market is dynamic and that market participants will respond to new restrictions in unanticipated, game-changing ways. We reform looking backward, and the next crisis will be caused by something else all together that was designed to circumvent the new restrictions.
He has also published some shorter pieces on this topic here:
http://www.finreg21.com/
Some of Kling’s analysis comes across as knocking down strawman arguments.
The heart of the industry structure change argument, for example, is not that Glass-Steagall repeal caused the problem, but that third party investor involvement in investment banks (which had traditionally been partnerships owned by senior employees) accompanied by investment banks trading on their own accounts instead of those of third parties screwed up the risk taking incentives in the industry. Another important development here was the growing importance of interstate banking which made it possible for a regional housing bubble collapse to have national and international financial system implications.
A large part of the financial innovation that was harmful took place at the retail level with products like Option ARMs, interest only loans, no document loans, and more generally, dramatically increased subprime and Alt-A lending that worked only in a real estate market where prices continued to rise because borrower repayment was not reliable. Related is the rise of retail level non-bank financing (i.e. the shadow banking system), where a disproportionate share of the problems took place.
Monetary policy probably was a marginal impact on the crisis, however.
For those who care to know, there will be a special tonight on Andrew Jackson 8:00 Central time on Public Television (PBS). It will be narrated by Martin Sheen. Andrew Jackson (America’s 7th President) had to deal with some big bullying bankers in his day and I imagine they will touch on that subject for a few minutes.
How can we protect ourselves from profoundly stupid (believing real estate prices would never dip and making loans that could not possibly be repaid has to be profoundly stupid) other than limiting the size of financial institutions and consequently the impact on the overall economy?
My own version of Kling’s table has just one row and one column. The column is labeled “Systemic Risk”, the row is labeled “Banks Too Big”, and the cell is labeled “Overwhelmingly High Weight”.
If only I could think of a policy solution…
Your statement pretty much mirrors my thoughts on the topic. Kling is a Republican hack in objective economist’s clothing. Kling can take his CRA finger-pointing, Gramm-Leach-Bliley excuse making and stick it up his wazoo.
Easy: Let those who purchase overpriced assets (e.g., real estate) lose money as prices return to fair value, and let those who make loans that cannot possibly be repaid lose money when those loans aren’t repaid. Let all institutions, public (e.g., the Fed), semi-private (e.g., Fannie and Freddie), and private (e.g., Bear, Lehman, AIG, BofA, Citi, GM, etc, etc, etc) that screw up fully experience the direct results of their actions with no bailouts, excuses, or accomodations.
Oh, you don’t want the real-world consequences of that to play out, because we’re too fragile to handle credit contraction, failure of casinos masquerading as banks and stock markets, and shrinkage of our lifestyle to something sustainable without living on ponzi credit and destroying the planet to chase ever greater wealth and power?
O.K., then you’re going to get next time exactly what you got this time, because the lifestyle we have designated for ourselves can only exist with everybody borrowing-to-gamble with the gov’t shielding us from losing and learning after the fact.
(That said, he gives exotic mortgages a pass — I’d be curious to know if he thinks those are also a consequence of bad capital requirements.)
I don’t know what Kling would say, but this was certainly cause to a large degree by a failure of regulation, AND by the government sponsored push for home ownership — at any cost!!
This shows as clearly as anything just how government (public) policy has far reaching implications, and that what seems like a great program can’t be sponsored in such a reckless way so as to overlook the potential risks in favor of perceived rewards. But this is so typical of what they do. They pass programs with rose colored glasses, rarely examining the potential for economic warpage and its destructive potential.
“Kling also gives industry structure a relatively low weight, which I think is because he doesn’t think Glass-Steagall would have prevented the crisis. I think he’s probably right there, since Lehman and Bear managed to become too big to fail despite remaining investment banks.”
Actually, there’s no doubt that Glass-Steagall could have prevented the crisis. But I also believe that its being in place could have exascerbated it. But, not in the absence of appropriate capital requirements and transparency regulations. I still believe that Glass-Steagall should be reinstated, that all derivatives should be traded on an exchange (and could not otherwise be bought or sold), and that very tough capital requirements should be set. I also happen to believe that certain hedges should be either (a) completely banned (primarily CDS’s) and (b) heavily taxed.
I wholeheartedly agree. It’s like training children: if we always solve problems caused by their stupid, or irresponsible, or irrational, behavior, what do we get? We get stupid, irresponsible, misbehaving children, and we get all the blame for waht they become. Wall Street is childlike in this way. So long as we show them that we will take care of problems caused by them, they will not change their (mis)behavior. It’s very simple. AND, so long as we propound policies that encourage that behavior, well, got save us, because what became a child who plays with matches, becomes a child that will burn down our house. We don’t need a fire department, but we need to reassert our parental authority and hire better fire inspectors.
CDOs and other derivatives with a similar structure are problematic at least in part because determining their correct price is computationally intractable. This is a fundamental limitation of their structure that no amount of regulation can fix. (The Princeton researchers who proved this suggest that it may be possible to avoid this issue if the structures and underlying assets are restricted in exactly the right way, or by relying on an independent, disinterested third party to construct them. I’m not confident that either bankers or regulators can be trusted to implement this correctly, given the incentive structure.)
To your last point, scary things happen when those originating loans are removed from the picture, and the picture is clouded further by completely opaque packaging. Securitizing the amazingly risky loans was the bottom line. Things could be dramatically changed if poorly underwritten mortgages all had to be held by the originator or funder, and not be the general securities market. If we couple securitization standards to underwriting standards, this would almost completely eliminate the problem from being foisted on ratings agencies (who were paid by those who generated the product being rated, egads.).
Hm, paper on economics by a GMU guy? I never read those not litter my head with some junk (that only looks logically consistent on the first read), promoting ‘end the fed’/’end the government intervention’ agenda one way or another.
As someone who for more than a decade been writing about how whacky the whole concept of capital requirements for banks which discriminate among perceived risks is; requirements made even worse when combined with the fact that the “perceiver” was going to be a small oligopoly of credit rating agencies; and that it all doomed us to the “mother of all systemic risks”, you will understand that I cannot but be in agreement with Arnold Kling when he identifies “Capital Regulations” as the overwhelming culprit.
Too big? That is also primarily a result of the capital requirements (and especially Basel II) which favour the big. And do not fool or excuse yourselves, this was all timely discussed, but not enough persons spoke out against it, as almost all were so busy protecting their academic or banking careers.
The problem though is that all this is even much worse than what now Arnold Kling puts forward, because not only did these capital requirements cause this crisis, they are also now preventing us from getting out of this crisis, since their continued use is making it so difficult for small businesses and entrepreneurs to access bank credit, especially while the banks are busy rebuilding their capitals after the AAAs went junk.
What an awkward document this must be for a blog that was set up primarily to blame it all on the bank oligarchs.
Theory of Arnold Kling is low-weight — due to its skewed emphases.
More than one story about how the firemen are arsonists…
We need to educate and vet a new breed of government administrator.
We have a garden full of weeds which grow back faster than we can pull them. Recommend: either salt the soil, or use Roundup. Systemic problem needs a systemic solution.
(That almost sounded profound)
So let me try to get this straight without “excusing myself”:
1. The oligarchs should of course be allowed to bloat their balance sheets to infinity with all this toxic garbage, and then keep it there at false values in perpetuity.
2. It’s then the regulations which are unreasonable in requiring them to maintain x capital in tandem with these bloated balance sheets.
No, the truth is the exact opposite. These balance sheets should never have been allowed to bloat in the first place, and that’s the main thing we need to fix now.
The toxic paper has to all be written down to its real value. That and only that will solve all the balance sheet problems and restore whatever “health” can actually be restored.
That’s what the free market has been wanting to do for several years now, effect a real price discovery.
Speaking more broadly, reality, the real free market, very much wants to deflate the whole phony anti-reality bubble, and ALL policy to date has been striving, with ever greater desperation, to keep the Big Lie inflated and stave off this reality-based outcome.
It’s just one big dop e fiend whose only policy is to keep shooting up because the greatest horror is to undergo withdrawal for a little while, even though after that we’d be free.
“These balance sheets should never have been allowed to bloat in the first place, and that’s the main thing we need to fix now.”
Absolutely but that requires “giving” the banks some profitability and/or requiring them to raise a lot of new capital, which is scarce and expensive, especially when so many out there speak for an immediate reduction in the profits of banks. And so meanwhile those who had no role in the crisis, the small businesses are getting clobbered because since regulators insist that they should carry the highest risk-weights, they generate the largest capital requirements.
By the way, in order for a bank to lend to an ordinary citizen it needs 8 percent in capital but when it lends to the government it gets away with zero capital. On this blog, this craziness is not even an issue.
Yes but we also told our firemen they were not able to detect fire and instructed them to heed the opinion of some fire detecting rating agencies, and so now many of our firemen have even forgotten to smell and see smoke.
Here is the logic guys like Kling use:
Banker=you, mortgagers=3 lazy cousins, credit default swaps and CDOs=poker game
You make 3 separate loans of money to 3 lazy cousins. You know the probability any of your cousins will ever pay you off is less than 25%. You take those 3 IOUs from your cousins and staple them together, pay some scam artist to stamp AAA on it, then bet those 3 IOUs as collateral in a poker game. You lose the poker game and then you point and say it was your cousins’ fault that you lost the poker game.
If you understand that logic, you understand why guys like Kling will use any graph, table, or F*^#ed up logic to blame everyone under the sun except—wait for it……. Bank CEOs and executives.
Not exactly because to that you would have to add that it was the regulators who told the bankers that, as their supervisors, and for the purpose of deciding how much capital they needed, they were going to follow the opinions of the scam artists they, as regulators, chose.
I think this is an important part of the problem. The loan originator has the best data (if any) on the borrower. One key reform would be to require the originator (at any level in the system, including those regulated, or not, by their states) to retain both a fixed percentage (5%) of the loan and final responsibility for straightening out the mess if the loan fails. Some kind of clawback? Or at least the responsibility for determining the fate of the property with full liability for the losses attached.
Then they presumably would have to proved a reserve for that, or buy insurance (which leads to AIG problems). Would we have to have some kind of assessable security for the owners of the originators?
The problems proliferate, but it beats letting them loose do whatever they want.
There are two things involved here: “bloat” and “risk”.
Basel I and II both treated mortgages as safer risks. First misteak. More importantly, risk is always difficult to assess ahead of time; it often comes from wherever the past statistics are scarce for the simple reason that risk managers look there to find it.
What is easier to see is “bloat”. Almost all (if not all) of the 20 or so financial crises of the past 30 years stemmed from aggressive competition among the big institutions for some particular market. This often sucks in the smaller institutions as well. That bloat is measurable, and visible even to a casual reader of financial pages. Just look for the hot market and start worrying.
I would suggest that the reserve requirements should track this growth and be increased on the way up, instead of on the way down, when it becomes nearly impossible to raise the money.
The Spanish set up a system like this called “dynamic provisioning”. They had the housing bubble, but the banks have weathered it better than they would have because they had extra reserves.
To be slightly more profound, if you allow me, I would venture to say that systemic risk needs systemic dissolutions… like getting rid of such things as imposing credit rating opinions and arbitrary risk weights on the banks.
If there is complexity, there is uncertainty. Structurally, capital market governance must move beyond risk management to include uncertainty. If Citigroup’s one-size-fits-all financial supermarket did not provide a net benefit, how can the SEC govern with a one-size-fits-all regulatory regime? If you can’t cross-sell, you can’t cross-regulate with non-correlative information that produces a discontinuous function.
The legacy, one-size-fits-all deterministic regime will be caught in a recursive loop of errors of commission (boom-bust bubble inefficiencies) and errors of omission (externality market inefficiencies). If you cannot think in 3-D, you will be overcome by randomness. Such inefficiencies will eventually render our source of economic wealth ineffective. As the book says, if this happens, we’re all screwed.
Stephen A. Boyko
Author of “We’re All Screwed: How Toxic Regulation Will Crush the Free Market System” and a series of five SFO articles on capital market governance.
http://w-apublishing.com/Shop/BookDetail.aspx?ID=D6575146-0B97-40A1-BFF7-1CD340424361
EXTRACT from “We’re All Screwed”
The Subprime Crash of 2008 was a perfect storm that was born from excess good intentions. To analyze this bubble, a modified version of George Soros’ boom-bust model (SFO Magazine, April 2009) is used
for the purpose of illustration. The model contains two segments, a Schumpeterian entrepreneurial boom schematic and a Minsky moment bust schematic. The boom cycle integrates state-of-practice concepts with state-of-art applications. This changes the terms of competitive engagement and create investment opportunities for early-adapters. Trend analysis is a function of risk management. Increases in the trend’s risk are related to the trend’s biases.
The Schumpeterian boom schematic consists of an introductory phase, acceleration phase, tipping point, and manic phase of the boom cycle.
• The introductory phase found demand for home ownership and its assumptions mutually reinforcing. Low- and moderate-income (LMI) communities’ new home mortgages were financed through the Community Reinvestment Act (CRA). To qualify LMI applicants must have very low-, low- or moderate incomes. Very low-income is defined as below 50 percent of the area median income (AMI), low-income is between 50 and 80 percent of AMI; moderate income is below 115 percent of AMI. Families must be without adequate housing, but able to afford the housing payments, including principal, interest, taxes, and insurance (PITI). Applicants must be unable to obtain credit elsewhere, yet have an acceptable credit history. Qualifying repayment ratios are 29 percent for PITI to 41 percent for total debt. The CRA employed government and market forces to provide a formulaic solution that enabled federally insured banks and thrifts to increase conventional home loans to LMI borrowers from 14.4 percent in 1990 to 24.7 percent in 2001.
• The acceleration phase gives people the ability to do something they always wanted to do, if only they had thought of it. Increased profit opportunities created a mutual dependency between the existing market for home mortgages and a new application of mortgage-backed securities (MBS). MBS enabled prospective homeowners to have a stake in their and their country’s future. President Bush’s domestic vision for his second term was to create an “ownership society.” On June 17, 2004, the President stated “…if you own something, you have a vital stake in the future of our country. The more ownership there is in America, the more vitality there is in America, and the more people have a vital stake in the future of this country.” Created at Salomon Brothers in the 1980s, the MBS market grew to become a multi-trillion dollar a year business.
• The inflection, or tipping point of the boom cycle occurred when normative analysis was suspended for loans nicknamed “NINJA” (No Income, No Job, No Assets) and LIAR (where a lender does not require “documentation” of employment, income or credit history). These ill-advised loans have to be taken in the context of Congressional screams of “REDLINING!” —that sent banks scurrying for cover in low-income neighborhoods. Banks that did not comply with this political agenda were threatened with stiff penalties under the Community Reinvestment Act, or CRA. This law pressured banks to lower long-held industry standards for judging creditworthiness to make subprime loans to people with poor credit risks.
• In the manic phase all things were thought to be possible. A new reality occurred on April 28, 2004, in an SEC meeting that allowed the capital leverage ratio to increase from 12:1 to in excess of 30:1. The net capital and leverage ratio requirements determine the speed at which the market can operate. Raising the leverage ratio meant that an 8.5 percent capital cushion was reduced to a 3.3 percent capital cushion. Given the speed with which 3X derivatives (i.e Direxion Daily Financial Bull 3X Shares (FAS) and Direxion Daily Financial Bear 3X Shares (FAZ) on the NYSE) work, the reduced capitalization cushion provided scant protection against “bear raids” in financial securities. The net capital and leverage ratio requirements are to upward pressure of the boom cycle as circuit breakers are to the downward pressure of the bust cycle. Both slow throughput to ensure an orderly and rational market. Reducing liquidity standards put the capital market on steroids and allowed the bubble to reach manic proportions.
The bust schematic finds state-of-art concepts being introduced to change the terms of competitive engagement. Having picked the low-hanging fruit, practitioners increase market activity by extrapolating the state-of-art concepts’ hyperbolic growth projections. This was done to get funding to develop of next generation technology and capital goods, business plans’ financial pro formas employed long-term extrapolations based on short-term hyperbolic growth experience.
This resulted in far-from-equilibrium conditions that were unstable. Eventually the Minsky moment occurs with the bursting of the bubble. As the accompanying schematic illustrates, the bust schematic consists of the point of discontinuity, moment of truth, crash, and codification phases.
• The “point of discontinuity,” occurred when, the divergence between reality and the bubble’s presumed benefit was recognized. In other words, some of the tranches of mortgage-backed securities were not worth the paper on which they were printed. Advanced price discovery metrics occurred with the adoption of FASB 157 that defined fair value and established higher standards for AAA ratings. On April 2, 2009 the Financial Accounting Standards Board revised “mark-to-market” accounting rules to allow companies to use their judgment to a greater extent in determining the “fair value” of their assets.
• The “moment of truth” happened when J. Kyle Bass, a Dallas hedge fund manager, committed capital to his theory about a looming housing market meltdown. Bass bet on a crash in residential real estate by trading securities based on subprime mortgages to the least credit-worthy borrowers. Bass soon earned billions as delinquencies on home loans made to people with poor credit reached record levels and prices for mortgage-backed securities plunged.
• The “crash phase” found home owners were no longer able to support the indebtedness of their mortgage and/or home equity line. The net result of ill-advised NINJA and LIAR loans was to give renters property rights. If I put no money down and make a mortgage payment, what is the difference between a mortgage and rent payment other than the fact that I got a free warrant for the real estate upside by categorizing it as a mortgage payment.
Weak financial institutions were consolidated through mergers and acquisitions. Some of these arrangements, like Bank of America and Merrill Lynch, could be described as a shotgun wedding. Bank of America Chief Executive Officer Kenneth Lewis testified that the federal government threatened to remove board members at his bank if it reneged on a promise to acquire Merrill Lynch, despite Merrill Lynch’s crumbling financial state. Lawmakers accused federal regulators of a gross misuse of power in orchestrating a “shotgun wedding” between Bank of America Corp. and Merrill Lynch & Co.—with U.S. taxpayers footing the $20 billion bill. The panel has been investigating whether federal officials pressured Lewis and urged him to keep quiet about Merrill Lynch’s financial problems. Lewis contends that divulging such information would have violated his fiduciary duty to the bank’s shareholders. In testimony before the committee, Lewis said publicly for the first time that his job was threatened after he expressed second thoughts about the merger. Lewis said then-U.S. Treasury Secretary Hank Paulson and federal regulators made clear that if the bank reneged on its promise they would force his ouster and that of board members.
• The “codification phase” addresses the most grievous boom-bust errors. For example, it is proposed to reinstate the Uptick Rule. The uptick rule generally prohibits short selling of securities except on an uptick. SEC Rule 10a-1(a)(1) provides that, subject to certain exceptions, a listed security may be sold short (A) at a price above the price at which the immediately preceding sale was effected (plus tick), or (B) at the last sale price if it is higher than the last different price (zero-plus tick). Short sales are not permitted on minus ticks or zero-minus ticks. The logic is that short-selling without a plus-tick rule takes liquidity out of the market by diminishing bid-side depth. The rule went into effect in 1938 and was removed when Rule 201 Regulation SHO became effective in 2007. In 2009, the reintroduction of the uptick rule was widely debated, and proposals for a form of its reintroduction by the SEC went to public comment.
Lessons learned: Policymakers’ 2-D remedies were slow to respond because they lacked the 3-D conceptual ability to tackle problems comprehensively. It is the difference between using maps and global positioning systems. Having GPS conceptual capability to govern-on-the-fly is a prerequisite for regulating global, robust markets. To illustrate, ProShares UltraShort Financials (symbol: SKF) are exchange-traded funds (ETFs) that correspond to twice (200%) the inverse (opposite) of the daily performance of the Dow Jones U.S. Financials. Yet what multi-dimensional governance alternatives were innovated to monitor SKF’s -200% impact?
Lessons remembered: It should be noted that whenever dealing in the realm of politics, historical context and logic are not necessary requirements. Given the negative publicity associated with NINJA and LIAR loans, it would seem likely that Congress would limit lending institutions from continuing these practices. Under the category of never missing an opportunity to miss an opportunity, Massachusetts Congressman Barney Frank is returning to the scene of the calamity—with taxpayer money of course. He and New York Representative Anthony Weiner have sent a letter to the heads of Fannie and Freddie exhorting them to lower lending standards for condo buyers. It helps to have a sense of humor.
I think this might miss JK’s intended point, which I take to be — if society as a whole can only influence private behavior through public institutions, then we must craft public institutions that do a good job of influencing private behavior.
The goal is not to absolve private interests, or to clean up after them whenever they do bad things on the carpet. We want to influence their behavior. However, we need to think in terms of a chain of actions. The ultimate goal is a healthy economy, which requires a sound financial system. The intermediate goal, then, is a sound financial system, which requires good regulation. The proximate goal, then, is to create good regulation, and good regulators to enforce those regulations. Focusing on anything else, to the extent it distracts us from creating a good regulatory regime, is a mistake.
Could you remind us what your occupation is again Sir??? Sometimes I forgot where you and “Bond Girl” got your daily bread. Did those regulators that big banks want to blame all their problems on hold a gun to bank CEOs head to get into the credit default swaps??? Big bankers are like the sixteen year old girl that wrecked Daddy’s car and then want to cry because Daddy gave you the keys. I have news for you: It was corrupt scumbags like Phil Gramm who gave you the keys to the car you wrecked, not regulators.
Kling is at George Mason and a Cato guy. He is a good economist, but read his work for the analysis and the facts. As far as subjective conclusions go, do not be surprised if his are “it’s the government’s fault” even if that link is tenuous.
If one can get past Kling’s “Great Recalculation” narrative – and his odd statements elsewhere that the Great Depression was functional – then he has some interesting points here. Interesting, but very one-sided.
JK’s point about Kling’s improper dismissal of financial innovation is entirely correct – financial innovation represented one of the mechanisms by which financial agents circumvented capital regulation (which he identifies as paramount). The other mechanism is of course political influence. Distinguishing between financial innovation and capital regulation is almost semantic.
As to the question of industry structure in this financial crisis, here’s an interesting comparison:
The ultimate cost of the S&L bailout was estimated at 160 billion according to the Resolution Trust Authority
http://en.wikipedia.org/wiki/Savings_and_loan_crisis
That was in 1980s dollars… When all is said and done, TARP’s direct costs may be in that range. In 2009 dollars. So, why has the impact on the US (and global) economy been so much more dramatic?
I would posit that much of this heralds back to the final item in Kling’s list – monetary policy (or lack thereof) – which Kling basically dismisses as unimportant. The sequence of events from August 08 through April 09 suggests that monetary policy was anything but unimportant, and was one of the key factors in making the crisis worse than it should have been. Partly, I suspect, this was because the models of auto-magic recovery that the Fed used to project peak unemployment of 8% (back in 2008) were based on historical data in which the Fed actually intervened countercyclically… But the Fed, believing history happens by itself, instead chose an 11% unemployment path.
BTW, even Kling recognizes that his views are – or should be – considered heterodox. What is truly amazing (and even Kling seems amazed) is that the _standard view_ (which he calls the Scholarly Consensus) seems to have vanished from debate.
http://econlog.econlib.org/archives/2009/12/what_was_mainst.html
“I am prepared to offer pushback against the Sumner-Hetzel viewpoint. However, it really deserves the status of the “null hypothesis.” In a more reasonable world, everyone would be starting from the presumption that Sumner and Hetzel are correct. Those of us arguing folk-Minskyism and telling the Recalculation Story should be the ones fighting an uphill battle to bring our ideas into the policy debates. That this is not the case, and that SC is now on the fringe, is one of the most remarkable stories of this whole macroeconomic episode.”
I, too, find this utterly baffling. It’s as if the entirety of the economics field has thrown away everything it learned over the last 50 years (including our understanding of monetary contraction in the Great Depression), and reverted into two primordial camps:
The Gold-Fetishists vs. the Populist-Keynesians.
The only bank I have worked for during the last 25 years was the World Bank as an Executive Director, 2002-2004, and there I warned over and over again about what these financial regulations were going to bring us. This in fact I did since 1997 when I first heard about the crazy regulatory paradigm that had captured the Basel Committee.
I guess there are very few out there that in this respect can like me evidence having spoken out in time… even when that meant exposing me to professional risks… so shut up making innuendos. And if you want proof of the above perhaps you could visit http://subprimeregulations.blogspot.com/and read what I wrote about it all, including the too big to fail, between 1997 and 2003.
The hero to the American Bankers Association, a friend of Newt Gingrich, and a man the American Enterprise Institute invited in 2009 to come and give his thoughts on the economic crisis. Read these 2 links (Pay attention to section 206B and section 206C of the Gramm-Leach-Bliley Act). Notice if there is any mention of the word SWAP in section 206B and 206C of the Gramm-Leach-Bliley Act then listen to Phil Gramm’s words at the American Enterprise Institute.
http://www.law.uc.edu/CCL/33Act/sec2A.html
http://www.law.uc.edu/CCL/34Act/sec3A.html
As you can see in this video, after he passed the law Phil Gramm went to work for UBS Investment Bank for a very nice salary.
Well I am not sure of where you want to get with that, but from what I see the event where Phil Gramm speaks in AEI is titled “Is Deregulation a Cause of the Financial Crisis”, and anyone who calls forcing the banks to hold capital based on risk assessments made by credit rating agencies a “deregulation” does not even begin to know the meaning of the word “deregulate”.
Good comment!
It says “A new reality occurred on April 28, 2004, in an SEC meeting that allowed the capital leverage ratio to increase from 12:1 to in excess of 30:1. The net capital and leverage ratio requirements determine the speed at which the market can operate. Raising the leverage ratio meant that an 8.5 percent capital cushion was reduced to a 3.3 percent capital cushion”
Also on June 26, 2004 the central bank governors and the heads of bank supervisory authorities in the Group of Ten (G10) countries met and endorsed the publication of the International Convergence of Capital Measurement and Capital Standards: a Revised Framework, the new capital adequacy framework commonly known as Basel II and which required only 1.6 percent capital for almost anything associated with a AAA rating and thereby authorized a 62.5:1 leverage. Basel II did not enter in effect that day but some banks proceeded immediately to build up their books in preparations for them.
It was these really incredible changes in regulations that created such a demand pull in the market that allowed NINJA and LIAR to be used as raw-material for AAA rated securities, since, as you must all surely understand, without an AAA rating, not one single of the NINJA, LIAR and other junk mortgages would have found a buyer… I REPEAT, WITHOUT AN AAA RATING, NOT ONE SINGLE OF THE NINJA, LIAR AND OTHER JUNK MORTGAGES WOULD HAVE FOUND A BUYER.
Yes, indeed “financial innovation represented one of the mechanisms by which financial agents circumvented capital regulation”… but that is only until the regulatory changes in mid 2004 which authorized extreme leverages…then financial innovation went into high-gear, not to circumvent, but to exploit the generous capital regulations. And it was then the problems really took off.
New Evidence, Growing Accepance on Role of Monetary Policy as a Causal Factor in Financial Crisis:
The author, Arnold Kling identifies leverage and monetary policy as causal factors in the current financial crisis. “In retrospect, it can be argued that expansionary monetary policy in 2001–2003 set the stage for the housing bubble. Low interest rates were an enabling factor in the increase in home purchases and the expansion of mortgage lending.. Moreover, the excesses of the bubble from 2004–2006 might have been curtailed by tightening monetary policy sooner …..In hindsight more should have been done to prevent the housing bubble from expanding ……..monetary easing that took place from 2001–2003 was excessive.”
“ Excessive leverage – Banks and other financial institutions took on significant risks without commensurate capital reserves. As a result, declines in asset values forced hese institutions either to sell hard-to-value assets or face bankruptcy. “
New evidence spurs a growing acceptance of the importance of monetary policy in promoting excessive risk-taking. For example, a recent BIS study finds low interest rates cause an increase in risk-taking by banks.:
“Monetary policy may influence banks’ perceptions of, and attitude towards, risk in at least two ways: (i) through a search for yield process, especially in the case of nominal return targets; and (ii) by means of the impact of interest rates on valuations,incomes and cash flows, which in turn can modify how banks measure risk. Using a comprehensive dataset of listed
banks, this paper finds that low interest rates over an extended period cause an increase in banks’ risk-taking.”
http://www.bis.org/publ/qtrpdf/r_qt0912f.htm
William C. Dudley, President and Chief Executive Officer of the Federal Reserve Bank of New York weighs in on monetary policy and leverage:
“there is evidence that monetary policy does have an impact on desired leverage through its impact on the shape of the yield curve. A tighter monetary policy, by flattening the yield curve, may limit the buildup in leverage.1”
1 There is a growing body of economics literature on this issue that links monetary policy to leverage. See, for example, Tobias Adrian and Hyun Shin, manuscript in preparation for the forthcoming Handbook of Monetary Economics, volume 3, currently circulated as Federal Reserve Bank of New York Staff Reports, No. 398, October 2009.
http://www.newyorkfed.org/newsevents/speeches/2009/dud091207.html
Not so easy. Suppose that we apply the same reasoning to speeding. Let those who speed die in crashes. The trouble is, other people, who are not speeding, die in those same crashes, too.
Yes, measures that make autos and highways safer for all carry a moral hazard because they make it safer for speeders as well. But that is why we also need other measures to reduce speeding. History has shown that letting the financial system crash and burn has severe consequences on the rest of us, lasting years, even decades.
“His basic argument is that if one looks at the series of financial crises that have taken place in the United States, one can see how the “solutions” to a given crisis created the environment for the next crisis. People tend to forget that the market is dynamic and that market participants will respond to new restrictions in unanticipated, game-changing ways. We reform looking backward, and the next crisis will be caused by something else all together that was designed to circumvent the new restrictions.”
I have a little trouble following that argument in regards to the current crisis, because very little remains of the regulatory environment created in the wake of 1929. Instead, it has been largely dismantled since 1980. It was impossible, it seems, to change the game to suit the big financiers without dismantling that environment. That is a good argument for reviving regulations that they did not like. No?
It was (and is) not a safety system based on reducing speeds but a system based on deviating the traffic into what the regulators perceive as safer lanes… AAA rated… and so much of the traffic naturally went where they could drive faster (higher leverage) and so these supposedly safer lanes turned into truly dangerous traps and the deathly crashes ensued.
“More importantly, risk is always difficult to assess ahead of time; it often comes from wherever the past statistics are scarce for the simple reason that risk managers look there to find it.
“What is easier to see is “bloat”.”
Excellent point!
Anti-regulation types want regulators to be able to discern risk when everybody else is blind to it. Better to regulate what is easy to see, even if it means some false alarms and some costs.
Kling: ““I am prepared to offer pushback against the Sumner-Hetzel viewpoint. However, it really deserves the status of the “null hypothesis.” In a more reasonable world, everyone would be starting from the presumption that Sumner and Hetzel are correct.”
In real life, nobody believes a null hypothesis. ;)
Your comments Mr. Perkurowski are with merit. In deed, many pundits seem to have a narrow vision to just accept the terms of statements that point to “deregulation”.
With the forthcoming repayment from Bank of America of TARP signals a significant metric of diluted values of the banks. The signals of these banks are showing exposure to the downturns predicted by Meredith Whitney as I have exposed before.
Now the rough ride is coming in reverse. The bears are trying to get the highest levels possible to get the swing in true spreads they figure they are due. Its repayment signal and the incredible campaign press from our Government and foreign counterparts to signal the Santa Clause vacuum of the retail investor and do not miss the train; you can still climb aboard upon, “The Polar Express” (Disney). http://www.youtube.com/watch?v=-RjWOoBR8_M
This is why the theme for this post was built upon:
Far-fetched, that Credit Ratings count, Even with Santa and the Grinch…
The banking and financial sector are starting to expose their fourth quarter as worthy credit questions have come front and center.
An article out of Bloomberg tells the real stories that support the calls made by Meredith Whitney and that she reiterated these concerns on CNBC 12/08/2009 with keeping with the theme presented by the Federal Reserve as consistent statements made by Mr. Bernanke.
One of the titles of concerns dealt with insider loans.
Insider Loans Distrusted by Bair as Georgia Failures Lead U.S.
http://www.bloomberg.com/apps/news?pid=20601109&sid=aukpiXHglqP4
By Peter Waldman, David Mildenberg and Laurence Viele Davidson
“The loan, which has since been restructured and stopped paying interest, provides a window into the role that insider lending and board oversight plays in regional bank stocks’ decline this year and the greatest number of U.S. bank failures since 1992, led by Georgia”(Waldman, Mildenberg, Davidson).
The facts of these concerns are quite warranted by the FDIC as they reflect to “deregulate” causing these problems and all those who hold and cherish God and Jesus Christ as referred to by these financial institutions keep hitting the press again and again.
When the sure ignorance of these financial executives within the banking sector have brought into the story, by whoever evokes his Holy name will find they must prepare for the fallout that will follow. Follow out that is consistent to where the real treasurer of the kingdom of God is kept. The surprise to maybe a few is it is not kept here on this earth. Certainly it is not in keeping with the voices of these financial barbarians; knocking at our door again–as they seem to never go away with their continued use of God as their partner.
This brings us back to the likes of Goldman Sachs; Lloyd Blankfein, JP Morgan’s Jamie Dimon, and that of Mr. Lewis of Bank of America keep trying to pass them off doing what they would like us all to believe by their public campaigns. A public campaign that is still using their hired guns; their lobbyist; lobbyist to sell their agendas of weak regulatory laws.
Remember, these are the same folks that Marcy Kaptur (D) Ohio had fully implied these banks are still causing folks to be displaced by foreclosure actions as their original planned profits were sought by the very words of Jamie Dimon. Even Wells Fargo, Citigroup, PNC cannot sneak under the radar on this unfolding credit crunch of the government holding the lion’s share of bad debt through Freddie and Fannie taking the hits.
This is again heightens the concerns of why the New York Federal Reserve Bank testing the reverse repo to the select group of contracts. This was uncovered by an article out of Wall Street Journal and how debt and credit woes affect a country and states coming under fire of the ratings being critically close to being downgraded as an article written out of Bloomberg had the countries being rated by the credit worthiness.
The wall-street investment folks have gotten very nervous on this type of data by the likes of Dubai, Greece, and other concerns as coming out of Japan and Germany; only to mention a few showing the Global recovery on critical life support and very frail to be considered only bed rest as the spinners keep spinning the “All is Okay Message as There No Need To Rush Out The Door”. Plenty are rushing out the door to lock in their profits and close it off for the year of 2009.
The (TBTF) “To Big to Fail Folks” may still go on claiming they are or were Gods bank and/or doing God’s work as pointed out again clearly by the Bloomberg article. The message is being sent by the Grinch as Far-fetched as many troubling with what the right thing is to do as to Morals and Ethics.
The story of the Grinch at the end learned his lessons, do you think it is possible for the many folks in the financial sector to learn about profit is to profit human conditions to a positive outcome. For now their worries will remain with the credit and debt crisis and the clear message sent for the Greed calling card has signaled the downturn for the markets here and abroad for the coming New Year and to stave off the double dip recession that is more than present till further notice.
The big investment folks are changing rapidly, their risk profiles. They all know as hopefully the retail investor has learned quickly, there is no longer the open short of the dollar to make easy money and the earnings warranting the current PE ratios as set for the fourth quarter reporting.
This easy money is now history as due impart to them building the bubble on the Carry Trade. The volume of pundits that cheered the shorting of the dollar; as the likes of James Cramer and placed the Bears as a great set up for losses is only selling what he pushed when he also slammed Meredith Whitney on the calls she had made over the several appearances even as recent as yesterday on 12/08/2009 on CNBC.
The mere statements made within the article by Bloomberg writers of, “The Federal Deposit Insurance Corp. cited failures of board oversight in 83 percent of its post-mortems of failed banks nationwide this year, based on reports by the agency. Directors failed to “ensure that bank management identified, measured, monitored, and controlled the risk of the institution’s activities,” FDIC investigators wrote in several of the reports, called Material Loss Reviews”(Waldman, Mildenberg, Davidson).
These statements and thoughts as recorded by this journalist still reveal the tone that congress must not entertain the lobbyist of the banking and financial sectors hidden agendas.
Time to keep the financial firms honest–if this is even possible for these folks. God truly knows how they have thrown out the books on Moral and Ethics guides and are in need for very tough reforms that have real teeth to protect the American and Global economies from this ever occurring again, at least in our life time and our grand kids.
Far-fetched, not anymore; this is a tide of failures built upon greed that is where you will never find God. This is in keeping for “The Reason for the Season”. The reason is Peace and Goodwill to Man brought by the savor of the world as we only know it to exist. Guaranteed, it is not the thoughts of the financial folks or those within our government that would sell out their own family to make a buck. Let’s try to not allow the likes of the financial institutions to spoil what is and always remain, the most of Holy times of the liturgical season for so many around the entire world.
Continue to go to the sites that are provided as links, such as http://www.baseline.com as you will be on the cutting edge of what is moving economic choices for or against the call for true and sustainable reforms to ensure a long-term recovery and many to become able to find a job and repair the damages brought by the decisions of a few that put greed before the human condition.
If you want to read other posts calling for true reforms, just, “Google James Gornick Far-fetched” and you will be given the paths to research and gather your own thoughts on these matters presented.
http://www.google.com/search?q=james+gornick+far-fetched&sourceid=ie7&rls=com.microsoft:en-us:IE-SearchBox&ie=&oe=
Min,
Have you looked into Spain’s experience with “dynamic provisioning”? They had a system in place that, as I understand it, built reserves up to 300% of the normal requirement, BEFORE the crash. Sounds like a plan.
That’s because the regulatory structure was influenced by the S&L crisis in between. The paper is worth reading.
It could be a plan… but never forget that those 300% or whatever extra… do not come free and have to be paid by the lenders
The best dynamic provisioning system that exits is having good credit analysts. Unfortunately the way we are heading most bank credit analyst will be replaced by credit rating readers and that is the most certain way to lose the dynamism that comes from diversity of opinions and the most certain way to again have the markets, like herds, following ratings, going over a precipice, like the subprime one.
Risk is not always difficult to assess it is impossible to assess because risk has many dimensions.
For instance one could make a case for the best rated credits risks having to have the largest capital requirements because they represent the largest risk of carelessness being present.
And, what about all the other risks? Are banks not supposed to take risks? Do you believe we can have a world without bank failures without risking the general failure of society?
I think that risk analysis is hard to do and difficult for regulators to enforce ahead of the demonstration thereof.
In my experience these cycles start with a competition among the larger banks to capture the largest share of some new market. This implies:
that there is rapid growth in some lending area, and
that there is high correlation of the risks.
If you look at it the way an engineering systems analyst (which is one of the things I have been) would, you want to apply negative feedback (rate damping) which, in this case, would be increasing reserves on the upswing. This would serve two purposes, it would dampen the competitive frenzy a bit, and it would raise the reserves when the capital is cheap, not when it is verry expensive on the downswing.
Seems to me that at least one goal of this conversation is to try to head off the cycles, not just respond to them better. I think rate damping has a lot to recommend it.
There are a great many narratives out there – and many have small parts of the truth. But all seem intent to supplant the Scholarly Consensus with their own homemade theories. Even though it is quite clear that the remedies endorsed by the Scholarly Consensus have not even been implemented.
Everyone is so absolutist in their tones – so unforgiving of anyone else’s observations… I thought this article was helpful as a middle ground:
http://economistsview.typepad.com/timduy/2009/12/structural-and-cyclical.html
Basically, every narrative out there is either Structural or Cyclical, or some combination of both. Clearly, the economy has structural problems and cyclical problems.
While we need to fix the structural problems – and we have many – failing to address the cyclical problems (for which we have well known therapies) makes it MUCH harder to address the structural problems. It cuts tax revenue, destroys political credibility, decreases labor participation, ups the strain on social welfare programs… But there is no will, and perhaps the lack of will to fix the cyclical problem is itself structural. Consider:
TD Ameritrade is mounting a public relations campaign against a transaction tax on securities trades (to help cover the cost of, say, a future bailout). Does anyone think it’s really to protect retail traders? Or are they concerned a decrease in (unnecessary) volatility could depress trading volume, which would cut down on high-activity trading (and those precious fees)?
Why should finance (now 6% of the population) support policies that reduce risk, when sellers of risk protection have a direct interest in manufacturing it?
Paul Volker – love him or hate him – pretty much nails it. What has financial innovation achieved, except larger salaries in finance and a larger financial sector?
Kling missed the point that expansionary monetary policy ==> higher asset prices (notably housing prices), which were held as collateral against loan failures. They failed to anticipate that the value of collateral would itself plummet (both decreasing recovery rates and increasing defaults from people who could not sell their houses above the loan value).
Of course, this doesn’t fit into the story of the Great Recalculation, because it implies that had the Fed properly reflated the currency in September-December, the level of mass defaults would have dwindled, and with it much of the the demand-component of the crisis.
Bond Girl’s true goal on this site is true throw out red herrings and see who goes running after it. She in fact has no interest in true bank reform or any type of finance regulation with teeth to it.
One can almost say that about all of Kling’s thoughts on credit market history, actually (i.e., that he overlooks the role of monetary policy). But at least he tries to provide a broader historical perspective, which is more than one can say for most people on this topic, who talk about the Great Recession and the Great Depression with nothing in between…
Do you have any links/references to credible websites which back up (support) your last sentence’s assertion??? New York Times, Fortune magazine, LA Times, Reuters etc… ?