Financial Crisis and Unintended Consequences
During most of this past decade, the housing market rose at an unprecedented rate (12.5% in one year alone), only to come crashing down in 2008 to such a degree that $4.5 trillion in US wealth was lost. What were the circumstances that converged to cause the rate of mortgage securitization to increase over seven-fold from 2001 to 2006, allowing the underwriting of high-risk loans without fear of having to hold those loans? The answer, surely, is a complicated one, but simply chalking it up to the greed of Wall Street while refusing to look below the surface is a bit too simplistic for me.
The banking crisis which stemmed from the bursting of the housing bubble was concentrated in commercial banks, but contrary to popular belief and the myth of “lack of regulation,” the commercial banks were more heavily regulated than were the investment banks. While the investment banks were caught holding large inventories of MBS’s they hadn’t yet sold off and mortgage loans that hadn’t yet been securitized, commercial banks held large numbers of mortgage-backed securities that became essentially worthless and put many at substantial risk of failure, all while being heavily regulated.
In 2001, the Federal Reserve, along with the FDIC, Comptroller of the Currency, and the Office of Thrift Supervision instituted what is known as the recourse rule. This rule was meant to steer the funds of banks into “safe” assets and make it attractive to buy MBS’s as opposed to actually lending out their own money. (In 2006, a similar rule was instituted for non-US banks, exposing them to the same types of risk just before the housing meltdown in 2008.)
[U]nder 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.
As the demand for MBS’s increased, so did the supply from Wall Street and the GSE’s. This timing coincided nicely with the fact that major pressure had been put on banks during the 1990s to make loans to individuals who wouldn’t qualify under traditional guidelines. The banks, of course, weren’t willing to hold on to those loans – they simply sold them off to Wall Street and bought back highly rated bonds that offered them a huge tax advantage.
As I’ve written in a previous post,
According to economist Milton Friedman, the use of political channels, as opposed to the market, for the provision of resources leads to the straining of social cohesion. The reason for this is that markets allow diversity, while government policies require conformity. In Capitalism and Freedom, he states that the more extensive the range of issues we attempt to solve through political means, the greater the strain on the “delicate threads that hold society together.”
The problems found in the issue of lack of diversity v. conformity apply when dealing with economic issues, as with other public policy issues. Regulations have the express purpose of homogenizing behavior, and in a capitalist system where competition reigns supreme, the natural state is one of diverse behavior, ideas, and experimentation.
If capitalists stop acting heterogeneously–if they compete through imitation, rather than innovation–the risk of systemic failure increases . . . Regulations are like mandatory instructions for herd behavior, automatically increasing systemic risk.
The more we expect the government to regulate, the more we can expect risk to increase throughout society and have a greater and greater negative impact on ever-larger numbers of people. Is there another way?