AEI Paper On The Credit Crisis

It is called A Silver Lining to the Financial Crisis: A More Realistic View of Capitalism By Jeffrey Friedman and Wladimir Kraus. Here is the abstract followed by the key exerpts:

"There is little evidence that deregulation or banks’ compensation practices caused the financial crisis. What did seem to cause it were capital regulations imposed on banks across the world. These regulations explain why bankers who are commonly seen as having recklessly bought risky mortgage-backed bonds in order to boost earnings—and bonuses—actually bought the least-risky, least-lucrative bonds available: those that were guaranteed by Fannie Mae or Freddie Mac or were rated AAA. These securities were decisively favored by capital regulations, raising the question of whether regulation actually increases systemic risk. By definition, regulations aim to homogenize the otherwise heterogeneous behavior of competing enterprises. Since one set of regulations has the force of law, it homogenizes the entire economy in that jurisdiction. But regulators are fallible, and if their ideas turn out to be wrong—as they appear to have been in the case of capital regulations—the entire system is put at risk."

"First, the Gramm-Leach-Bliley Act of 1999, which amended the Glass-Steagall Act of 1933, did not erase the distinction between commercial banks, which take deposits and make loans and investments, and (the somewhat confusingly labeled) investment banks, which underwrite and trade securities. The 1999 act merely allowed both commercial and investment banks to be subsidiaries of a common holding company, but they remained subject to the same restrictions on the nature of their activities as before. These restrictions were loose in the case of investment banks but tight for commercial banks—and as we shall see, the crisis took place within the commercial banks."

"...credit default swaps did not mysteriously “interconnect” banks and increase systemic risk. In essence, a credit default swap is a loss-protection insurance contract. This risk is swapped (for a fee) by the lender to a “counterparty”; the amount of the risk remains the same but has merely been transferred from the lender to the counterparty. This transfer no more increases overall risk levels than does a car insurance policy, which transfers risk from the driver to the insurance company."

"...past counterparties do not remain on the hook when they pass a policy to a new counterparty. There remain only two meaningfully connected parties—the ultimate insurer and the insured."

"...starting in the 1930s, regulations issued by the Securities and Exchange Commission (SEC) made the close supervision of corporations by “insiders” who financed these companies—the dominant practice before the SEC regulations—impossible. Since the 1930s, therefore, equity investors in most corporations have, by definition, been “outsiders” who have had to use publicly reported information to infer what is going on inside. In making these inferences, they rely on short-term, legally mandated heuristics for long-term performance, such as quarterly earnings reports."

"To date, there have been only two studies of the matter [on the role of executive compensation], the first of which found that the banks whose executives held the most stock in the bank lost the most money in the crisis—indicating that the executives did not engage in deliberate risk taking motivated by a quest for higher bonuses..."

"...most of the risk taking found by the authors was among insurance companies, not banks."

"there is decisive evidence against the thesis that incentives to take risks caused the financial crisis. The evidence is this: 93 percent of all the mortgage backed securities held by American banks either were issued by Fannie Mae or Freddie Mac, and were thus implicitly guaranteed by the U.S. Congress (as the American taxpayer soon found out), or were issued by investment banks and rated AAA by one of the three rating agencies: Moody’s, Standard and Poor’s, or Fitch."

"...these three private corporations had had a legally protected oligopoly since 1975, thanks to another SEC regulation."

"...as is true of all bonds, AAA-rated bonds paid less than lower-rated (AA, A, BBB, etc.), supposedly riskier bonds."

"If bankers were being lured by their banks’ compensation systems into acquiring risky but lucrative assets—on the basis of which the bankers would have gotten bigger bonuses—then they should never have bought AAA bonds. Instead, they should always have bought higher-paying AA-, A-, or BBB-rated bonds, but they did so only percent of the time."

[the crisis was] "...caused by a sharp drop, in September 2008, in the market price of mortgage-backed bonds, in anticipation of their declining value as the bubble deflated. The first victims of the falling price of mortgage-backed bonds were Fannie and Freddie; in quick succession came the investment bank Lehman Brothers; and finally came the commercial banks—because they held so many mortgage-backed bonds, not mortgages."

[an important cause is]"...an obscure regulation called the recourse rule. The recourse rule was enacted by the Federal Reserve, the Federal Deposit Insurance Corporation, the Comptroller of the Currency, and the Office of Thrift Supervision in 2001."

"...the after-tax cost of equity capital, say 12 to 15 percent, is substantially greater than the aftertax cost of debt, which is generally in the 3 to 5 percent range."

"By reducing their capital holdings, banks can, at least in principle, increase their profitability. But under the recourse rule, “well-capitalized” American commercial banks were required to spend 80 percent more capital on commercial loans, 80 percent more capital on corporate bonds, and 60 percent more capital on individual mortgages than they had to spend on asset-backed securities, including mortgage-backed bonds, as long as these bonds were rated AA or AAA or were issued by a government-sponsored enterprise (GSE), such as Fannie or Freddie. Specifically, $2 in capital was required for every $100 in mortgage-backed bonds, compared to $5 for the same amount in mortgage loans and $10 for the same amount in commercial loans. One can readily see that the recourse rule was designed to steer banks’ funds into “safe” assets, such as AAA mortgage-backed bonds."

"Unfortunately, these bonds turned out not to be so safe. Without the recourse rule, however, there is no reason for portfolios of American banks to have been so heavily concentrated in mortgage-backed bonds."

"...the recourse rule covered commercial banks, not hedge funds or anyone else. If not for the recourse rule’s privileging of mortgage-backed bonds, the burst housing bubble almost certainly would not have caused a banking crisis."

"Was there a connection between the recourse rule and the housing bubble?"

"The artificial demand for mortgage-backed bonds created by the recourse rule may therefore explain why, as the decade wore on and the pool of credit-worthy borrowers who made traditional down payments dried up, banks and mortgage specialists lowered their lending standards and made the terms of their mortgages more generous."

"Between the middle of 2001 and the beginning of 2002, mortgage securitization jumped from about $20 billion to $50 billion per quarter, peaking at nearly $150 billion per quarter in 2006."

"Citi jumped into mortgage-backed bonds with both feet, putting them on its balance sheet through the recourse rule but also buying them off-balance-sheet through SIVs (structured investment vehicles)..."

"...JP Morgan lost billions of dollars in potential revenue for years in order to avoid mortgage securitization. JP Morgan’s Jamie Dimon was among those who recognized the danger..."

"What explains this diverse behavior is that the individual bankers in question had different perceptions of the magnitude of the risk. In unregulated markets, that kind of diversity of viewpoints is precisely what makes capitalism work."

"The recourse rule, Basel I, and Basel II loaded the dice in favor of the regulators’ ideas about prudent banking. These regulations imposed a new profitability gradient over all bankers’ risk/return calculations, conferring 80 percent capital relief on banks that bought GSE-issued or highly rated mortgage backed bonds rather than commercial loans or corporate bonds, and 60 percent relief for banks that traded their individual mortgages for those “safe” mortgage-backed bonds."

"Bank-capital regulations inadvertently made the banking system more vulnerable to the regulators’ errors. But this is what all regulations do."