The Greek Crisis and the Subprime Crisis

Ana Swanson writes,

Matthijs compares the situation to the U.S. subprime crisis. Who was really at fault for the housing crisis in the U.S.: The subprime borrowers who bought houses they couldn’t afford, or the predatory lenders who encouraged them to take them out?

I, too, see parallels with the subprime crisis. However, I do not think that predatory lenders are to blame for either. In both cases, bank regulators were responsible for allocating credit. In the first instance, the regulators encouraged banks to treat mortgage loans as low risk. In the second case, they encouraged banks to treat all European sovereign debt as low risk. See The Regulator’s Calculation Problem.

The irony is that after messing up credit markets, the regulators ask for and receive more power. With the sub-prime crisis, the regulators were rewarded with Dodd-Frank. I presume that the ultimate outcome of the Greek crisis will be similar.

Axel Leijonhufvud vs. Calomiris and Haber

Leijonhufvud writes,

The financial structure inherited from the 1930s divided the system into a number of distinct industries: commercial banks, savings and loan associations (S&Ls), credit unions, and others. It also divided it spatially. Banks located in one state could not branch across the line into another. This structure of the financial sector gave it great resilience. On another occasion I used the metaphor of a ship with numerous watertight compartments. If one compartment is breached and flooded, it will not sink the entire vessel.

This is directly the opposite of what Calomiris and Haber argue. They say that American cultural hostility to large banks produced an overly fragmented system, and that this fragmentation is the root cause of the peculiar instability of American finance.

Leijonhufvud elaborates,

At the time, the abolishment of all the regulations that prevented the different segments of the industry from entering into one another’s traditional markets was seen as having two obvious advantages. On the one hand, it would increase competition and, on the other, it would offer financial firms new opportunities to diversify risk. Economists in general failed to understand the sound rationale of Glass-Steagall. The crisis has given us much to be modest about.

In other words, economists championed open competition without thinking about how this would turn idiosyncratic risk into systemic risk.

The thing is, I was following these regulatory issues at the time, and I do not think that economists were as influential as we would like to believe. I think that the driving factors were computer technology, inflation, and massive lobbying. With high inflation, the regulatory ceilings on deposit interest rates that were a vital part of the regulatory structure became untenable. Moreover, with computer technology, it became easy for Wall Street to “disintermediate” banks using money market funds and securitization. These forces produced an inevitable turf battle between commercial banks and investment banks, which took years to resolve, as everybody lawyered up on the lobbying front. There were multiple possible political/regulatory outcomes, but hanging on to Glass-Steagall was not one of them.

Another Leijonhufvud quote:

Deregulation. . .allowed the great investment banks to incorporate and one by one they all did so. . .Incorporation meant limited liability for the investment bank and no direct liability for its executives. The incentives for executives in the industry changed accordingly. . .Now they are seen as jet-setting high rollers. Economists in general failed to predict this change in bankers’ risk attitudes. We have much to be modest about.

I cannot disagree with that.

However, I would instead put most of the emphasis on the regulations that directly affected housing finance. The pressure to lend with little or no money down and the designation of highly-rated mortgage securities as low risk for bank capital purposes are the main villains in the story as I tell it.

Public Availability of Freddie, Fannie Loan Performance Data

Todd W. Schneider has a write-up and some analysis.

I decided to dig in with some geographic analysis, an attempt to identify the loan-level characteristics most predictive of default rates, and more. As part of my efforts, I wrote code to transform the raw data into a more useful PostgreSQL database format, and some R scripts for analysis. The code for processing and analyzing the data is all available on GitHub.

I recommend reading the entire post.

Derailing the Narrative

Various politicians and pundits seized on the Amtrak derailment as a narrative of failure to spend on infrastructure. Then it turned out that at 100 miles per hour the train was going twice the speed limit in the area.

Similarly, when the financial crisis struck, politicians and pundits seized on it as showing an excess of greed and exploitation by banks and an “atmosphere of deregulation” that allowed the banks to run amok. In my view, this is as misleading as the narrative about the train derailment.

Some further comments.

1. Perhaps in the end both misleading narratives will dominate. Maybe that is just the way things work in matters where what matters is the political orientation of most journalists and historians.

2. Perhaps the misleading narrative of the train derailment will not stand. Perhaps the facts will stand in the way. On the other hand, the complexity of the financial crisis makes it difficult to sift through the facts, and by the same token makes it easy to impose a dubious narrative.

3. Perhaps eventually historians will look more carefully and objectively at the financial crisis, and the misleading narrative will be set aside.

As of this writing, my money is on (1).

AIG in Hindsight

That is the title of a new NBER working paper by Robert McDonald and Anna Paulson (ungated versions). They conclude,

Much of the discussion about the crisis has focused on liquidity versus solvency. The two cannot always be disentangled, but an examination of the performance of AIG’s underlying real estate securities indicates that AIG’s problems were not purely about liquidity. The assets represented in both Maiden Lane vehicles have experienced write-downs that disprove the claim that they are money-good. While it may seem obvious with the benefit of hindsight that not all of these securities would make their scheduled interest and principal payments in every state of the world, the belief that they could not suffer solvency problems and that any price decline would be temporary and due to illiquidity was an important factor in their creation and purchase.

My random comments:

1. This is valuable work. I am really glad to see a retrospective audit of this important bailout.

2. I view the conclusion as saying that this truly was a bailout. The Fed was not acting as a hedge fund of last resort, buying temporarily undervalued assets that otherwise were just fine.

3. This also throws Gary Gorton under the bus. Gorton said that AIG’s problems were collateral calls, meaning illiquidity rather than insolvency. Note that Gorton is not included in the list of references, at least in the ungated version. Note also that the authors write that AIG’s problems were both liquidity and solvency.

4. Bob McDonald and I shared an apartment our first year as MIT grad students. He has written a treatise on derivatives.

Regulators and the Socialist Calculation Problem

My latest essay is on Engineering the Financial Crisis, by Jeffrey Friedman and Wladimir Kraus. I think that their book demonstrates that regulation falls victim to the socialist calculation problem.

Centralizing risk assessment through regulatory risk weights and rating agency designations has several weaknesses. Local knowledge, such as detailed understanding of individual mortgages, is overlooked. At a macro level, regulators’ judgment of housing market prospects were no better than those of leading market participants. Moreover, regulators imposed a uniformity of risk judgment, rather than allowing different assessments to emerge in the market.

The Banking Crisis and the Real Economy

How important was the financial crisis as a causal factor in the economic slump? Apparently, Brad DeLong and Dean Baker disagree. Baker wrote,

The $8 trillion in equity created by the housing bubble made homeowners feel wealthier. They consumed based on this wealth, believing that it would be there for them to draw on for their children’s education, their own retirement or for other needs.

When the bubble burst, homeowners cut back their consumption since this wealth no longer existed. However contrary to what you often read in the paper, consumption is not currently low, it is actually quite high when compared with any time except the years of the stock and housing bubbles.

DeLong replies,

in the absence of the financial crisis, the Federal Reserve’s lowering interest rates as consumption spending fell in response to the decline in home equity would have pushed down the value of the dollar and made further hikes in business investment a profitable proposition and so directed the additional household savings thus generated into even stronger booms in exports and business investment: in the absence of the financial crisis, what was in store for the U.S. was not a long, deep depression but, rather, a shallow recession plus a pronounced sectoral rotation.

Pointer from Mark Thoma. Conventional economics did not have a story of how stress in the financial sector could cause problems in the real economy. Even now, that view comes across as a just-so story. Baker argues that one does not need such a story, but DeLong says that we do need it.

I would note that if the financial crisis did not matter, then the bailouts, including interest payments on reserves, were simply transfers to bank shareholders. The more conventional view is that the bailouts prevented a horrible depression. So, the way I see it, the conventional view went from saying that the financial sector is nothing special to saying that you need to invoke specialness of the financial sector to explain how bad the recession was (Baker argues the opposite) and, moreover, the recession would have been even worse without the bailouts.

From a PSST perspective, I think that one must allow that it is possible that credit plays a big role in sustaining patterns of trade, and there may be something special about the financial sector. However, my own inclination is to see the financial sector as of 2007 as overgrown and to view the bailouts as making no contribution to the process of creating new patterns of specialization and trade.

George Selgin on Calomiris and Haber

He reviews their book Fragile by Design.

the observed interdependence of states and banks isn’t as deep-seated and inescapable as Calomiris and Haber claim. Consequently, keeping bankers and governments from getting too cozy with one another isn’t quite so difficult as they suppose.

Later, Selgin writes,

they seem unaware of the adverse effects of the “bond-deposit” provisions included in misnamed state “free banking” laws. These provisions allowed banks to issue notes only after tendering eligible securities to state authorities for the ostensive purpose of securing the notes’ holders from loss. Calomiris and Haber (p. 169) note that, by making their own bonds eligible for this purpose, states were able to force banks to lend to them “in exchange for their right to operate.” Still they fail to point out that some states force-fed their banks, not “high-grade” bonds (ibid.) but junk ones, and that it was this practice, rather than unit banking, that was the main cause of bank failures during the so-called “free banking” era

…In Canada, in contrast, banks’ almost unrestricted ability to issue notes
contributed to the banking system’s stability no less than banks’ branch networks did.

You may also wish to read my review of the book.

I Disagree with Brad DeLong

He writes,

Martin Wolf’s The Shifts and the Shocks; and my friend, patron, teacher, and (until the last reshuffle) office neighbor Barry Eichengreen ‘s Hall of Mirrors. Read and grasp the messages of both of these, and you are in the top 0.001% of the world in terms of understanding what has happened to us–and what the likely scenarios are for what comes next.

Pointer from Mark Thoma.

These are ultra-Keynesian treatments of the financial crisis and its aftermath. The all-purpose causal variable is a glut of savings and a dearth of government spending.

I cannot prove that this view is wrong. However, I am more convinced by Jeffrey Friedman and Wladimir Kraus, Engineering the Financial Crisis. The easiest way to summarize the book is that (with a nod to a different Kraus) risk-based capital regulations were the disease that they purported to cure.

The Friedman-Kraus story is one in which regulators suffer from the socialist calculation problem. With risk-based capital regulations, regulators determined the relative prices of various investments for banks. The prices that regulators set for risk told banks to behave as if senior tranches from mortgage-backed securities were much safer than ordinary loans, including low-risk mortgage loans held by the bank. The banks in turn used these regulated prices to guide their decisions.

In 2001, the regulators outsourced the specific risk calculations to three rating agencies–Moody’s, S&P, and Fitch. This set off a wave of securitized mortgage finance based on calculations that proved to be wrong.

Friedman and Kraus challenge the basic mindset not only of DeLong but of 99 percent of all economists. That mindset is that the socialist calculation problem, if it matters at all, only matters for full-on socialists, not for regulators in an otherwise capitalist system. In the conventional view, regulators can fail for ideological reasons, or because they are manipulated by special interests. But Friedman and Kraus offer a different thesis. When information discovery is vital, regulators, like socialist planners, are doomed to fail because they are unable to mimic the market’s groping, evolutionary approach to learning.

In Friedrich von Hayek’s Nobel Lecture, The Pretence of Knowledge, he concludes,

The recognition of the insuperable limits to his knowledge ought indeed to teach the student of society a lesson of humility which should guard him against becoming an accomplice in men’s fatal striving to control society–a striving which makes him not only a tyrant over his fellows, but which may well make him the destroyer of a civilization which no brain has designed but which has grown from the free efforts of millions of individuals.

What Friedman and Kraus claim is that well-intended but now well-informed bank regulations were the destroyer, not of an entire civilization, but of a financial system. Like Hayek, they offer a profound critique of mainstream thinking. Like Hayek, they are sadly likely to be ignored.

How to Live Beyond Your Means

1. The WaPo reports,

Today, they struggle under nearly $1 million in debt that they will never be able to repay on the 3,292-square-foot, six-bedroom, red-brick Colonial they bought for $617,055 in 2005. The Boatengs have not made a mortgage payment in 2,322 days — more than six years — according to their most recent mortgage statement. Their plight illustrates how some of the people swallowed up by the easy credit era of the previous decade have yet to reemerge years later.

Living rent-free in a $600,000 house is a “plight” only in the sense that at some point you may have to stop.

2. John Cochrane relays,

80% of Greek debt is now in the hands of “foreign official.” Now you know why nobody is worrying about “contagion” anymore. The negotiation is entirely which government will pay.

I must be really old-fashioned or something. But paying taxes so that Greek governments can live beyond their means or that people can live in houses twice the size of mine rent-free is not really my idea of “the things we all do together.”