In an age where everyone seems to boil complex issues down into simple platitudes, such as “greed,” it is nice to see that Dr. Arnold Kling has taken the time to dissect the Financial Crisis of 2008. Of course, any comments I have on the paper will do it little justice, but (with apologies to Dr. Kling) I will endevour to try and provide some summary for our busy blog readers who may not have the time to read the entire paper.
Although there are many insights in the paper, perhaps the most profound is Dr. Kling’s discussion of how the regulatory remedies for past financial crises ended up contributing to the future ones. For example, after the record number of bank failures and home foreclosures in the 1930s (a problem exacerbated by regulatory prohibitions on bank branching), the government began encouraging 30 year mortgages, introduced the mortgage tax deduction, and added depositor insurance. Although very popular (the mortgage tax deduction is very popular with me), these measures rewarded indebtedness and encouraged folks to spend more on housing. If we fast forward to the rampant inflation of late 70s and early 80s, we find savings and loans holding portfolios of 30 year mortgages whose values were rapidly being destroyed by inflation. Additionally, the S&Ls were forbidden from raising the interest rates they paid above a specified “Q” rate. As potential depositors could get more for their money in money markets with the same amount of liquidity, they withheld their funds from the S&Ls. Subsequently, the S&Ls found themselves in the lose-lose situation of holding imploding assets and facing a dry creek for cash flow. Desperate, and with the knowledge that the government insured their customers’ deposits, many S&Ls went “long” on high risk deals with the potential to save them. Eager to keep these institutions open, regulators complied (another underlying current in Kling’s article is that the supposedly “un-greedy” regulators appeared at best indifferent and at worst played cheerleader to the actions of “greedy” bankers). After many S&Ls went bust, regulators started to explore ways of avoiding what had caused the S&L Crisis. The Q rate was phased out, but the problem of inflation eroding mortgage assets remained. The solution was to encourage the securitization of mortgages.
Securitization promised increased lending to poorer potential homebuyers while supposedly spreading the risk. However, the Basel Accords (an agreement reached in 1988 among the central bankers and regulators of ten countries including the U.S.) inadvertently increased the risks associated with securitization. As far as I can tell, the Basel Accords included a provision which attempted to set standards for capital reserves held by banks. However, banks often held reserves in many different forms (cash, government bonds, corporate bonds, and mortgaged-back securities). Basel tried to get regulators to agree on how “valuable” each of these different types of reserves were according to their risk, which was assessed by a risk multiplier against their face value. For example, as cash and government bonds hold little risk, every dollar of cash or bond counted as a dollar in capital reserves. Since corporate bonds are considered riskier than government bonds, a bank holding corporate bonds in reserves could not count them at face value but at a discount. For example, $1 in corporate bonds may only count as $0.50 worth of reserves. Although not in the top tier of gash or government bonds, guess which type of financial instruments were considered to have the next least risk? Yes, mortgage backed securities! Accordingly, the banks loaded up on them. This overvaluation of mortgaged-backed securities essentially allowed banks to lend more and keep lower capital reserves. Unfortunately, when the price of these mortgage-backed securities collapsed, banks’ reserves fell below minimum requirements leading to what is best described as the insolvency of the banking system.
Of course, there are many more worthy points to mention (for example how in 1968 the government used Fannie Mae and Freddie Mac as vehicles to keep government subsidized housing debt out of the federal budget deficit and thus avoid a budgetary procedure that allowed Congress to challenge appropriations for the Vietnam War), but the core of Kling’s argument is that over the course of seventy years the government created a regulatory environment that elevated mortgage lending above other forms lending (commercial lending for example). All that being said, I do not want to make out that the article is a government-bashing blame game; the article is an impartial look at the incentives created by regulatory structures. As a society and through a free and fair political process, a majority decided that we valued housing enough to subsidize it. Unfortunately, the realities of economics dictate that when you subsidize something, you tend to get too much of it.
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