Sep 15 2009
My best guess is that most insurance is bought not to reduce risk but instead to signal prudence and caring. The first life insurance companies had a terrible time selling "bets on their death," and only succeded when they framed insurance as what a caring and prudent husband and father did to take care of his family....
Sep 15 2009
If all goes according to schedule (unlikely), then about the time that this is posted, I should be in the middle of saying something along these lines:I was a kid when the Beatles came to America. Soon they were followed by the Rolling Stones, the Dave Clark Five, the Kinks, and other groups. The press dubbed it the ...
Sep 15 2009
READER COMMENTS
Philo
Sep 15 2009 at 11:10am
(I apologize for the following basic–i.e., ignorant–question:)
In a footnote (n. 4) you explain what REPO loans are: They are loans with collateral, but formally the lender is a *buyer* of the collateral–what really is a loan is formally a *sale*–and the payback of the loan is, again, formally a sellback of the already-once-sold collateral. My question is: what is the advantage of this clumsy process, instead of a simple loan against collateral? I assume the answer involves to governmental regulation or tax law; I’m just curious about the details.
Philo
Sep 15 2009 at 11:18am
“Domino effects and 21st-century bank runs exposed a weakness in the ability of regulators and courts to handle failures of large institutions. If bankruptcy or some other form of resolution could take place quickly with clear rules for determining the priorities of various creditors, then there would be less incentive for creditors to rush to exercise claims on troubled institutions. In addition, this practice would limit the domino effects because creditors could obtain quickly whatever assets to which they were entitled, rather than face months of legal uncertainty. Finally, with an effective resolution authority in place, government officials would not feel so compelled to bail out troubled institutions.”
This was a crucial factor in producing the financial crisis, yet I have seen very little discussion of the pressing need to improve bankruptcy procedures. On the face of it, the existing bankruptcy process is a gigantic *government failure*.
Bill
Sep 15 2009 at 1:37pm
A thriller, and want to know how it turns out.
I had a little trouble reading it because it portrayed, in parts, as regulation beging the problem. But, what it really is is an industry seeking to exempt itself from tighter regulation, and expanding the boundary of potential restrictions. Within that new boundary, true, it is regulated, but that is not to say, though, that regulations are the core of the problem.
Or, to put it a different way: let’s assume there were no regulations (which is, in effect, what you have if the boundaries are too large). You would still have actors–banks, creditors, shareholders–that would have a keen interest in not taking bad risks because they would ultimately bear the costs. They would know that AAA doesn’t mean AAA, and if they did not carefully select the risk, they would lose money.
So, if the market is unregulated in that sense–that is the boundaries of regulation are too loose and the actors within it do not act rationally–then we really have an issue of competitive market failure. In other words, if we had no regulation, we would have the same result.
So, the question then is, from a microeconomics perspective, what are the market mechnanisms that should be put in place, given that regulation is never perfect. Or, are we always doomed to failure–we cannot regulate well enough, and the market will never work.
Chuck
Sep 15 2009 at 3:53pm
@Philo
[Bankruptcy procedure] was a crucial factor in producing the financial crisis, yet I have seen very little discussion of the pressing need to improve bankruptcy procedures. On the face of it, the existing bankruptcy process is a gigantic *government failure*.
It seems to me that, to this point, no one has asked bankruptcy courts to be a financial crisis snuff point.
If it’s failing at that task, one would not be surprised since it was not designed for it.
On the other hand, isn’t FDIC insurance supposed to be the bankruptcy proceeding for banks and financial institutions (whose needs are quite different from businesses)? That seems to work really well when we have the regulation in place to prevent banks from getting too big. (Like the regulation limiting banks to geographic regions. Crude but easily enforced without ambiguity as a means of limiting bank size.)
Fritz
Sep 15 2009 at 3:59pm
Philo,
A repurchase agreement, “repo” is a delivery of collateral against payment. The lender takes possession and thereby has the assets to liquidate if the counter party defaults. In addition, the lender can also repo the collateral to others to raise cash.
mulp
Sep 15 2009 at 4:28pm
I must say I’m confused by the contradictory arguments made in regard to the GSEs.
First they are responsible for the flood of subprime backed bonds because they were pressured from the 90s to securitized subprimes which they did in 2006 and 2007 when they had lost maket share to all the other banks securitizing subprime. At that time, the regulators of the GSEs apparently feared the GSE stockholders weren’t getting the maximum profit returns, so to the preserve the financial safety of the GSEs they pushed GSEs to underwrite high risk subprimes?
Now if the GSE regulators hadn’t pushed the GSEs into subprimes in 2006, then the investment banks wouldn’t have underwritten an increasing number of subprimes before 2006, taking away market share from the GSEs which was a good thing, because by having banks like Lehman, Bear, and Goldman securitizing subprimes, this was reducing the risk of system wide failure?
Of course, I’m trying to figure out how the unregulated banks knew the GSEs would get into subprimes in 2006, and why these banks wouldn’t lobby to prevent the GSEs from being allowed into their high profit subprime securitization market.
Or is the argument that if the GSEs were smaller, forcing banks to fund their mortgages from deposits, the investment banks wouldn’t have setup mortgage originators to sell subprimes for them to securitize?
I guess my question comes down to, if the GSEs didn’t exist and thus bank mortgages ceased to be securitized, then what business would the investment banks made money on, and why wouldn’t they have gone into business setting up mortgage originators to push subprimes in competition with the banks so they could make money securitizing them?
Philo
Sep 15 2009 at 11:45pm
Fritz,
Thanks for your answer, but this is the only thing in it that looks like a possible *advantage* of repurchase agreements over traditional loans with collateral: “In addition, the lender can also repo the collateral to others to raise cash.” However, for *overnight* repurchase agreements this can hardly be a factor. And what happens in a repo if, when it comes time for the “borrower” to repurchase his “collateral,” the “lender” doesn’t have it any more because he has sold it to someone else to raise cash?
Fritz
Sep 16 2009 at 1:34pm
Philo,
In the repo market that is called a “sale fail” giving the borrower an interest free loan. Operation areas do everything possible to prevent such an event, but it does happen.
Bill
Sep 16 2009 at 5:03pm
Arnold,
Thank you for making this available. It will be my bedtime reading for the next couple nights.
Being somewhat of an Austrian, my first inclination was to head right for the monetary policy section, and I want to ask a question about that. I think you covered much of it well, but there is one secondary impact of loose monetary policy I did not see discussed.
If you look at housing starts, you see that the monthly figures rise steadily from 2000 to the beginning of 2006, when they start declining rapidly.
What impact do you think loose monetary policy had on the construction industry during this period? As more and more new houses were hitting the market, and prices were not dropping, can we say that, combined with the housing policy and capital regulation, this added to the crisis by putting less qualified people into houses? And if so, is this an impact due to monetary policy?
If this is covered elsewhere in the paper that I haven’t gotten to yet, I apologize.
Thomas Esmond Knox
Sep 17 2009 at 12:57am
“if we are to avoid repetition..”
I hope not. It’s the only way a guy can get ahead in this world.
The thing to do now is to start saving for the next time.
mulp
Sep 18 2009 at 3:02am
I’m not sure I understand who was responsible for the decline in underwriting standards.
It isn’t the CRA:
“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. It is possible that, even in the absence of CRA, many lenders would have pursued the market for low-quality mortgages simply in pursuit of profits.”
It isn’t the GSEs:
“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, so that they had little political capital to throw into a fight to maintain underwriting standards.”
If subprimes were needed to serve the low income market and the mortgage market had exploded with unregulated subprime mortgage origination reducing the GSE market share, why was there a need for the GSEs to further expand the subprime market which had exploded in market share?
Who was responsible for this weakening of credit standards?
“The weakening of mortgage credit standards was destabilizing for the housing market. This was particularly the case with the trend toward lower down payments and innovative mortgage designs that required less repayment of principal. As a result, many homeowners relied on house price appreciation for the equity in their homes. As long as prices were rising, home purchases could be sustained at high levels, including speculative purchases and homes that were too expensive for the borrowers to afford.”
You state the regulators saw this as bad:
“At the time that mortgage credit quality was deteriorating, the main regulatory concern was with consumer protection. Those who had this concern, such as Edward Gramlich of the Federal Reserve Board, thought that lenders were exploiting consumers by providing loans that were dangerous, costly, and poorly understood by borrowers.”
What I find puzzling is the lack of any role of shareholders. I thought the benefit of seling Fannie to shareholders and creating and doing likewise to Freddie was to put shareholders in charge of risk management. If merely getting Fannie off the Federal books were the equirement, it could have been made independent like the post office. You do say:
“To the extent that a financial institution was the victim of bad bets and excessive leverage, one is tempted to argue that those were its own choices and its managers and shareholders should suffer the consequences. These are losses due to bad decisions.”
From reading through the analysis, I conclude that all the financial institutions should be nationalized and run as GSEs. The report effectively argues that the government didn’t prevent the banks of all sorts from making bad bets, and the only decision making in the banks is to go right up to the limits, if any exist, that the government sets. And as the investment banks had no regulatory limits on leverage, they went to insane limits way beyond the limits set for regulated banks.
Clearly it would make more sense to have the banks owned by the people so the people could take the profits, set compensation rationally so the bankers were working to serve the people, not looking for any way possible to get a bonus or commission, and these benefits would compensate for the system failing because the people lobbied to have the regulation be too lax. As it is, we have had the banks lobbying to get the regulation relaxed and not enforced so the bankers can profit while the people pick up the pieces and bail out the banks in order to limit the damaged to the people.
Unless, of course, the real cause of the financial crisis was incorrect incentives to the bankers and their employees to make bad bets because they got richly rewarded for bad bets that didn’t cause disaster, and paid no price for bad bets that imploded.
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