FMM: Returning to “The Great Recession,” it is interesting that you, essentially, charge the SEC with creating adverse information problems in securities markets.
“In the late 1960s, after some investment scandals, the SEC created a cartel by authorizing only a limited number of these agencies to be officially-designated raters. With that government-created cartel in place, the agencies slowly shifted from serving investors to serving the issuers of bonds.”
Can you elaborate on the nature of the SEC-created cartel and in what ways it is serving the issuers of bonds rather than the investors?
SH: The SEC authorized those agencies to have privileged status in the wake of some financial problems in the late 60s and early 70s. The thinking, I guess, was to more closely oversee the officially approved firms. The SEC then said that banks could only hold fancy securities rated by one of these three agencies. Once that happened, the big shift occurs. Before that, the agencies served the buyers by, like Consumer Reports, giving them information and ratings about the instruments. But once their approval was needed in order for the securities to be marketed, the sellers started going to them to get the ratings they wanted. The raters then had an incentive to provide good ratings so as to not lose the business to their other two co-cartelists. They also then had reason to eliminate the costs of inter-firm competition by coming to more agreement on how to do things. The results, as you can see, were not pretty.
In the absence of free entry into this market, there was no way to correct the mistakes of the cartelists. There was no Hayekian learning process in place.
We read in The Sellout:
At the same time, government-anointed credit raters were assigning triple-A ratings to mortgage-backed securities that in no way deserved them. The Federal Reserve's so-called Basel capital standards gave banks more credit for owning mortgage-backed securities than many other assets, and in 2004 the SEC applied those standards to investment banks, with dramatic results. In 2003, Lehman Brothers held roughly equal amounts of U.S. Treasury bonds and mortgage- and other asset-backed securities. By 2006 the firm's Treasury holdings had barely budged while its mortgage- and asset-backed holdings had almost tripled. Meanwhile, the Fed's easy money policies of the early 2000s subsidized credit and sent the banks looking for higher yields. Mortgage bonds offered high returns and the "safety" of AAA ratings.
As credit spreads began to widen in 2007 and then continued to widen in 2008 it was clear that distress was increasing in the financial system. It wasn't that difficult to understand how investment banks heavily involved in mortgage backed securities were having problems. What didn't make sense was the level of distress I was hearing about at many regular commercial banks. The role of the little known but rather significant recourse rule is explained at some length here: (and in a more limited version here)
There is little evidence that deregulation or banks' compensation practices caused the financial crisis. What did seem to cause it were capital regulations imposed on banks across the world. These regulations explain why bankers who are commonly seen as having recklessly bought risky mortgage-backed bonds in order to boost earnings--and bonuses--actually bought the least-risky, least-lucrative bonds available: those that were guaranteed by Fannie Mae or Freddie Mac or were rated AAA. These securities were decisively favored by capital regulations, raising the question of whether regulation actually increases systemic risk. By definition, regulations aim to homogenize the otherwise heterogeneous behavior of competing enterprises. Since one set of regulations has the force of law, it homogenizes the entire economy in that jurisdiction. But regulators are fallible, and if their ideas turn out to be wrong--as they appear to have been in the case of capital regulations--the entire system is put at risk.
...why did the bursting of the housing bubble cause a financial crisis, that is, a banking crisis?
This might not seem so puzzling at first: commercial banks made many of the mortgage loans that were financed by the Federal Reserve's low interest rates. But the financial crisis was not caused by mortgage defaults directly: it was caused by a sharp drop, in September 2008, in the market price of mortgage-backed bonds, in anticipation of their declining value as the bubble deflated. The first victims of the falling price of mortgage-backed bonds were Fannie and Freddie; in quick succession came the investment bank Lehman Brothers; and finally came the commercial banks--because they held so many mortgage-backed bonds, not mortgages. The question, then, is why the commercial banks held so many mortgage-backed bonds. If deregulation or the quest for high earnings, hence high compensation, did not cause the banks to buy these bonds, what did?
To answer this question, we have to turn in a direction that has been overlooked by the conventional wisdom: an obscure regulation called the recourse rule. The recourse rule was enacted by the Federal Reserve, the Federal Deposit Insurance Corporation, the Comptroller of the Currency, and the Office of Thrift Supervision in 2001. It was an amendment to the international Basel Accords governing banks' capital holdings, and all over the world, these regulations appear to have contributed significantly both to the housing boom and to the financial crisis.
But under 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.
One can readily see that the recourse rule was designed to steer banks' funds into "safe" assets, such as AAA mortgage-backed bonds. The fact that 93 percent of the banks' mortgage-backed securities were either AAA rated or were issued by a GSE shows that this is exactly what the rule accomplished. Unfortunately, these bonds turned out not to be so safe. Without the recourse rule, however, there is no reason for portfolios of American banks to have been so heavily concentrated in mortgage-backed bonds.
The recourse rule did not apply outside the United States, but the first set of Basel accords on bank capital, adopted in 1988, included provisions for even more profitable forms of "capital arbitrage" through off-balance-sheet entities such as structured investment vehicles (SIVs), which were used extensively in Europe. Moreover, in 2006, a second set of bank-capital accords, "Basel II," began to be implemented outside the United States. Basel II took essentially the same approach as the recourse rule, encouraging foreign banks to acquire mortgage-backed securities, just as in the United States.
Here, then, we may have the genesis of the global financial crisis. If so, it turns out to have been caused by the very device--regulation--to which most people now, as they did throughout the twentieth century, look for the "reform" of capitalism. But is it really capitalism when it is so heavily regulated?
In a complex world like ours, nobody really knows what will succeed until it is tried. Competition, which pits entrepreneurs' divergent ideas against each other, is the only way to test these ideas through anything but the highly unreliable process of verbal debate (in which the debaters' competing ideas cannot be simultaneously tested against each other in the real world, instead of in the imaginations of their audience).
Capitalism will probably always be prone to asset bubbles and other manifestations of homogeneous behavior, but only because it is part of human nature for people to go along with the crowd. This is a risk that can be mitigated but not eliminated. But capitalism has a unique feature, competition, that does mitigate it by both encouraging and taking advantage of heterogeneous behavior, that is, innovation.
Homogeneity, on the other hand, is the ineradicable curse of socialism, in which the community as a whole, through its elected (or self-appointed) representatives, decides on the allocation of resources. One plan is imposed on all, as thoroughly as if everyone spontaneously decided to join a herd. And we maintain that homogeneity is also the problem with regulation. Regulations, by their very nature, align the behavior of those being regulated with the ideas of those doing the regulating. Regulations are like mandatory instructions for herd behavior, automatically increasing systemic risk.
The recourse rule, Basel I, and Basel II loaded the dice in favor of the regulators' ideas about prudent banking. These regulations imposed a new profitability gradient over all bankers' risk/return calculations, conferring 80 percent capital relief on banks that bought GSE-issued or highly rated mortgage-backed bonds rather than commercial loans or corporate bonds, and 60 percent relief for banks that traded their individual mortgages for those "safe" mortgage-backed bonds. Only bankers with the most extreme perceptions of the downside, such as JP Morgan's Jamie Dimon, escaped unharmed.
Bank-capital regulations inadvertently made the banking system more vulnerable to the regulators' errors. But this is what all regulations do. Whether by forbidding one activity or encouraging a different one, the whole point of regulation is, after all, to change the behavior of those being regulated. And the direction of change is, obviously, the one the regulators think is wise.
The whole system crashed when the financial regulators' ideas about prudent banking backfired, but such failures are inevitable unless modern societies are so ¬simple that the solutions to social and economic problems will be self-evident to a generalist voter, or even a specialist regulator. That modern societies really are that simple is, in truth, the hidden assumption of modern politics. This is why political conflicts get so ugly: neither side can understand why their adversaries oppose what "self-evidently" should be done, so both sides ascribe evil motives to each other. But the financial crisis has exposed this simplistic view of the world for what it is. In the wake of the crisis, nobody can plausibly deny anymore that modern societies are bafflingly complex. The solutions to social and economic problems are thereby unlikely to be self-evident. The theories that seem so obviously true to voters or regulators may turn out to be disastrously false--unless regulators or citizens are infallible.
That surely would be magical. But there is no more magic to politics than there is to markets. The question raised by the ongoing intellectual contest between socialism and capitalism, and the ongoing practical battle between regulation and competition, is how best to guard against human frailties: By putting all our eggs in one politically decided basket? Or by spreading our bets through the only practical means available: competition?
The complicated interaction of all of the pieces of the puzzle are discussed further in a podcast with Charles Calomiris (notes available but no transcript).
Economist Brian Wesbury informs us of the significant problem of MTM here:
In November 2007, the Financial Accounting Standards Board (FASB) reinstated mark-to-market accounting for the first time since 1938. This rule uses bids (exit prices) to value assets. So far, so good. However, in 2008, the market for asset-backed securities dried up. The prices of bonds that were still paying in full fell by 60 or 70 percent, and these losses often were driven through income statements. This wiped out regulatory capital, caused bankruptcies, and created a vicious downward spiral in the economy.
In retrospect, it is clear that this accounting rule was a potent pro-cyclical force behind the 2008 panic.
Finally, on April 2, 2009, the FASB allowed banks to use “cash flow” to value bonds when the markets are illiquid — the same sentiment that Bernanke expressed before Congress. This fixed the immediate problems in the system, and the economy and financial markets have been on the mend ever since. In fact, the stock market bottom of March 9, 2009, came on the very day news broke that Reps. Barney Frank and Paul Kanjorski would hold a hearing to force the FASB to change the misguided accounting policy.
Mark-to-market accounting does not solve problems; it creates them by acting as a pro-cyclical force. Milton Friedman understood this, and he wrote about the devastating link between mark-to-market accounting and the Great Depression bank failures. Franklin Delano Roosevelt finally figured this out in 1938 — he suspended the rule and the Depression ended soon thereafter. Coincidence? We think not.
But as long as bank regulators still impose mark-to-market-style rules — indeed, as long as such rules remain even a threat to the system — the system will not fully heal.
More on the role of mark-to-market accounting in Bob McTeer's post here and Bill Isaac's testimony linked to within is worth a read:
Having trading entities such as proprietary trading desks or hedge funds mark-to-market may be appropriate. Requiring lending institutions which hold assets with a longer term orientation to do so is simply asking for financial instability.
I use the term “mark to market accounting,” rather than “fair value accounting.” Everyone’s goal is a fair and descriptive accounting system. There is nothing “fair” about the misleading and destructive accounting regime promoted by the Securities and Exchange Commission and the Financial Accounting Standards Board under the rubric “fair value accounting.” MTM accounting has destroyed well over $500 billion of capital in our financial
system. Because banks are able to lend up to ten times their capital, MTM accounting has also destroyed over $5 trillion of lending capacity, contributing significantly to a severe credit contraction and an economic downturn that has cost millions of jobs and wiped out vast amounts of retirement savings on which millions of people were counting.
...we believed that MTM accounting would make it very difficult for banks to perform their fundamental function in our economy, which is to convert relatively short-term money from depositors into longer-term loans for businesses and consumers. Banks necessarily have some mismatch in the maturities of their assets and liabilities – it is up to bank management, regulators, and investors to make sure the mismatch is not excessive. Accounting rules made to influence behavior are no substitute for good judgment and can interfere with appropriate business conduct.
...we felt that MTM accounting would be pro-cyclical (which is never a good thing in bank regulation) and would make it very difficult for regulators to manage future banking crises.
The accounting profession, scarred by decades of costly litigation, keeps forcing banks to mark down the assets as fast and far as possible. This is contrary to everything we know about bank regulation. When there are temporary impairments of asset values due to economic and marketplace turmoil, regulators must give institutions an opportunity to survive the temporary impairment. Permanent impairments should be recognized, but assets should not be marked to unrealistic fire-sale prices. Regulators must evaluate the assets on the basis of their true economic value over a reasonable time horizon.
The current world-wide crisis in the financial system demonstrates conclusively that major principles of accounting are much too important to be left solely to accountants.
It is extremely important that bank regulation be counter-cyclical, not pro-cyclical. The time for banks to create reserves for losses is when the sun is shining, not in the middle of a hurricane.
Peter Wallison has some thoughts on deregulation here:
There has been a great deal of deregulation in our economy over the last 30 years, but none of it has been in the financial sector or has had anything to do with the current crisis. Almost all financial legislation, such as the Federal Deposit Insurance Corp. Improvement Act of 1991, adopted after the savings and loan collapse in the late 1980s, significantly tightened the regulation of banks.
The repeal of portions of the Glass-Steagall Act in 1999--often cited by people who know nothing about that law--has no relevance whatsoever to the financial crisis, with one major exception: it permitted banks to be affiliated with firms that underwrite securities, and thus allowed Bank of America Corp. to acquire Merrill Lynch & Co. and JPMorgan Chase & Co. to buy Bear Stearns Cos. Both transactions saved the government the costs of a rescue and spared the market substantial additional turmoil.
None of the investment banks that got into financial trouble, specifically Bear Stearns, Merrill Lynch, Lehman Brothers Holdings Inc., Morgan Stanley and Goldman Sachs Group Inc., were affiliated with commercial banks, and none were affected in any way by the repeal of Glass-Steagall.
In a more extensive article here he concludes:
The causes of the financial crisis remain a mystery for many people, but certain causes can apparently be excluded. The repeal of Glass-Steagall by GLBA is certainly one of these, since Glass-Steagall, as applied to banks, remains fully in effect. In addition, the fact that a major CDS player like Lehman Brothers could fail without any serious disturbance of the CDS market, any serious losses to its counterparties, or any serious losses to those firms that had guaranteed Lehman's own obligations, suggests that CDS are far less dangerous to the financial system than they are made out to be. Finally, efforts to blame the huge number of subprime and Alt-A mortgages in our economy on unregulated mortgage brokers must fail when it becomes clear that the dominant role in creating the demand--and supplying the funds--for these deficient loans was the federal government.
If you don't know about the recourse rule, the Basel Accords and mark-to-market accounting rules at a minimum, you can't begin to understand the regulatory failure which gave us the Great Recession.
see also The Myth of Financial Deregulation