I posted last month on one part of Russ Roberts’ interview with Charles Calomiris. Some of the commenters highly recommended the whole podcast and I agree. I’ve listened to it twice all the way through and taken notes. Calomiris often writes articles in the Wall Street Journal, but I tend to find them dense. He’s an amazingly clear interviewee, though, and Russ Roberts is establishing himself as the Brian Lamb of economics with, to boot, a Ph.D. and 30 years of experience as an economist. And now that I know how good Calomiris is, I’ll work my way through his articles. These are particularly important issues now, given that Congress seems hell-bent on regulation rather than on reversing the many perverse incentives that Calomiris talks about. To give one example of how it has changed my views, I had a clever, cutesy line in the fall of 2008 when I was opposing the bailout. I said, “I favored getting rid of the FDIC, but not this week.” Well, after hearing Calomiris, I favor getting rid of it this week.

Here are some of my notes, with the times if you want to go straight to that segment.

2:40: To get a banking crisis, there must be something wrong with microeconomic incentives.

3:15: People with bad credit can get no money down with no documentation. Government policies that contributed to this were FHA lending, pressures on Fannie and Freddie, and state government programs.

4:17: The SEC proposed regulations in 2007 to make it harder for ratings agencies to be tough on mortgage-backed securities that were subprime.

4:55: Credit card securitization has been going on for a long time. But that market didn’t collapse. Why the difference between that and mortgage securitization? The incentives established by government programs were a big part of the reason.

7:45: From 1874 to 1913, there was a lot of globalization. But worldwide there were only 4 big banking crises.

9:00: From 1978 to now, there have been 140 big banking crises, defined the same way as the earlier ones: total losses of banks in a country equalling or greater than 10% of GDP.

13:00: The founding of the Federal Reserve did reduce the frequency of bank panics, but one main reason we had so many bank failures before the Fed was primitive (my word, not his) laws that required unit banking.

15:00: Unit banking is the requirement that banks be one unit, not have branches, not just across state lines, but within state lines. [Me talking now, not Charles: I remember my friend Harry Watson, when he joined the faculty at the University of Chicago, pointing out that the big First National Bank of Chicago downtown having one branch–itself in that building.] Unit banking made it hard to diversify risk, thus causing many bank failures. Canada had branch banking from 1860 on and had no bank failures or panics.

16:20: The reason above is why central banking in the U.S. was helpful: not because it offset market failure but because it offset other government regulation.

18:00: We didn’t get these banking failures earlier than 1979 because deposit insurance, which Franklin Roosevelt opposed, wasn’t nearly as substantial back then as it had become by the late 1970s.

19:10: Henry Steagall of Alabama favored deposit insurance in the 1930s to help small banks. They could compete more easily with Uncle Sam standing behind them. Do you recognize his name?

20:40: Deposit insurance per deposit increased to $100K in 1980.

21:10: Alan Blinder helped invent CDARS and a firm that he is involved with is collecting royalties on the patent for CDARS.

23:30: Notice that deposit insurance went from being small and temporary to being a blanket protection.

25:20: Milton Friedman and Anna J. Schwartz thought deposit insurance was a good idea. 🙁

26:00: An interesting way to protect small depositors without deposit insurance is to reintroduce postal savings accounts.

26:40: Deposit insurance was reduced (de facto) in Mexico during the 1990s financial crisis and that caused risk to fall. Here’s where I started thinking that we should end FDIC sooner rather than later.

27:45: Interesting story about England. The Economist supported the Bank of England in no longer backing the debt of the banks. As a result, after this reform, banking crises in Britain were non-existent between 1866 and 1914.

31:15: The history of banking crises is the history of perverse incentives set up by the government.

31:50: Depositors no longer have skin in the game and so we need to depend on regulators.

32:30: Subsidizing risk in housing market while not tracking risk with “prudential” regulation. This is a big one.

33:00: He claims monetary policy in the early 2000s was loose, measured by interest rates. Here I think he’s wrong. To see why, look at Henderson and Hummel.

35:00: In 2004, Fannie and Freddie decide to get into no-doc mortgages. What happened to the most vocal risk manager who said, “Don’t do it.”? He was fired.

36:00: Why do people sometimes underestimate Fannie’s and Freddie’s loss exposure in the sub-prime market? Because they get confused by labeling. Sub-prime is not a labeling issue but a performance issue.

38:50: What fraction of the losses are due to no-docs? Half. What fraction are related to assumption that housing prices could never fall? Half.

40:00: By what date did it become clear that the basic assumptions underlying the subprime mortgages were wrong? By middle of 2006.

41:20: What did Deutsche Bank and Goldman Sachs do? Made sure they were covered for this risk.

42:10: What did Fannie Mae, Freddie Mac, UBS, Merrill, and Citibank do in late 2006 and early 2007? Kept buying.

44:00: What were the execs at Fannie and Freddie thinking? They needed to defend themselves from criticisms by U.S. Treasury (Clinton and Bush), Alan Greenspan, and some Republican politicians.

45:30: What was Fannie’s and Freddie’s “insurance policy?” Please Barney Frank.

46:00: Which of the banks were worst at creating value for stockholders? At ethics? UBS and Citibank.

48:00: Why were some bank managers doing these investments when they should have known better? He says that regulation makes these banks “relatively immune to corporate governance.” The 1940 Bank Holding Act limited concentrated ownership of banks.

49:00: Why don’t we have concentrated ownership of banks? The regulations don’t allow hedge funds and private investors to own large stakes in banks.

50:20: The argument for preventing concentrated ownership is a “lawyer’s” argument that concentrated ownership is bad. The economist’s perspective is that concentrated ownership is good.

52:30: Economist Jeff Sachs advised the Poles in the early 1990s to have concentrated ownership of banks when they moved away from Communism.

53:30: Hedge funds and investment funds are barred from becoming controlling investors in banks.

55:20: The ratings agencies were willing to pretend that the mortgage-backed securities were AAA long after they knew better because they were catering, not to the sellers of the securities, but to the buyers of the securities.

57:30: The grade inflation in the securities markets was in the securitization-related markets, not the corporate debt market, because the buyers wanted loosened constraints.

58:40: Why does grade inflation work only if the buy side wants grade inflation? Because if, say, Moody’s is the toughest and the sponsor drops the sell side, then buyer knows that. So buy side wants it to be that way.

59:40: “Why did you buy it [some crap investment]?” Answer: “We have to put our money to work.” He explains further in 1:01:30 below.

1:00:00: Note the distinction between hedge funds on the one hand and pensions, mutuals, etc. on the other. Note the difference in incentives.

1:01:30: “If you’re making your 1% on assets, you want your assets to be large.”

1:03:00: Regulation was “outsourced” to the ratings agencies.

1:03:45: Agency problem. “Ratings agencies were a coordination device for plausible deniability.”

1:05:40: Mutual funds are not legally allowed to have fee structures like hedge funds: not allowed to have profit sharing in upside only.

1:06:30: No money manager will write a symmetric contract: sharing equally on upside and downside. Reason: no manager with that amount of funds at stake would be willing to take that risk. But they are allowed to have fees that are proportional to assets managed.

1:07:30: We “poor people” can’t go to hedge funds.

1:08:00: We don’t have everything figured out. But look at what we do have figured out: all the bad policies–deposit insurance that encourage risk taking and regulations that make it hard to control people who invest our money. It’s a clusterf**k [my word.]

1:09:20: To their credit, Obama administration has stopped blaming problems on deregulation.

1:09:40: What were the kinds of deregulation that occurred. (1) Ending Regulation Q, which allowed banks to compete for deposits by paying interest. (2) Elimination of restrictions on branch banking. This deregulation stabilize banks. (3) Removal of Glass-Steagall restrictions on banks underwriting corporate securities.

1:10:40: Do banks take risk when they underwrite securities? Not much.

1:11:00: Without any of this deregulation, the banks could have done everything they did that is at issue in this crisis.

1:12:40: In sum, deregulation stabilized the system and had zero effect on the risks taken that caused the crisis.

1:14:15: Gramm-Leach-Bliley had within it a promising measure to make things better. It was to have Fed and Treasury consider a subordinated debt requirement for banks, what Calomiris calls “the greatest promise for restoring some discipline to banking.”

1:15:00: Subordinated debt requirement: Have banks raise a % of their funds from lenders (subordinated debt) that would never receive a bank bailout come hell or high water.

1:16:00: Federal Reserve paper said this Gramm proposal made sense.

1:16:50: “Why would any banker want discipline?”

1:17:10: Fed punted on subordinated debt requirement: “More research is needed.”

1:18:00: In Obama proposals for financial regulation, failure to measure risk by Basel II is never mentioned.

1:19:00: Basel I and Basel II were in place. They failed. Therefore the problem can’t be attributed to deregulation.

1:20:00: “Protecting banks from market discipline is something that populist politics does very well.” Calomiris does this nicely.

1:21:00: The investment banks were under Basel II. SEC was the Basel II regulator for the investment banks.

1:21:30: Basel II gave a false sense of security. Risk measurement is not even on the agenda.

1:23:10: Optimistic comment: “Economists agree a lot on these things. Congress might be willing to listen.”

1:24:20: What did Fannie Mae pay Joe Stiglitz and Peter Orszag (currently head of Obama’s OMB) to do? See my earlier post. What are Fannie and Freddie costing us? $350 billion.

1:25:40: What plan did Fed announce to shrink its current balance sheet? Won’t sell, but will engage in reverse repurchase agreements: lend crumby securities in a way that retains all the credit risk.