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Across the Great Divide
New Perspectives on the Financial Crisis
By Martin Neil Baily, John B. Taylor
Hoover Institution PressCopyright © 2014 Board of Trustees of the Leland Stanford Junior University
All rights reserved.
How Efforts to Avoid Past Mistakes Created New Ones
Some Lessons from the Causes and Consequences of the Recent Financial Crisis
Sheila C. Bair and Ricardo R. Delfin
History doesn't repeat itself, but it does rhyme.
— MARK TWAIN
Much has been written about the causes of the 2008 financial crisis. Not enough attention, however, has been focused on how regulators' attempts to correct for behaviors that led or contributed to previous crises — particularly the savings and loan crisis and the Great Depression — created new problems which culminated in the 2008 financial crisis and continue to present ongoing risks to the financial system. In many instances, policies adopted to address the "lessons learned" from one crisis eventually grew into regulatory blind spots and artificial market asymmetries that helped fuel the next. What then are policymakers to do? On one hand, they need to learn from the past and correct for government lapses and missteps of prior years. On the other hand, they need to do so in a way that doesn't create new problems. Government policymakers need not be caught between the proverbial rock (those who cannot remember the past are condemned to repeat it) and a hard place (first, do no harm). This paper seeks to illustrate the observation and offer some thoughts on how we might find a way through this challenge.
Key drivers of the 2008 financial crisis
We begin with a review of commonly cited key drivers of the financial crisis. Much work has been done on these causes, and we do not endeavor to redo that work here. We do, however, seek to highlight how many of these key drivers relate to crises past — and potentially crises future. The particular drivers are:
Highly accommodative monetary policy
The rise of securitization
The self-regulating markets myth
Too big to fail
Highly accommodative monetary policy
The post-Volcker era has been characterized by monetary accommodation in response to periods of market or economic distress, with each round of monetary accommodation making the economy more reliant on the availability of easy credit. The resulting "Greenspan put" contributed to moral hazard by reducing losses (and downside risks) and effectively rewarding "upside" risk-takers at the expense of "downside" risk-avoiders. Given the very long run-up in asset prices — and the cushioning provided by the Federal Reserve to downside shocks — it is not surprising that a bias toward risk-taking and an overconfidence would develop in our financial markets and institutions over time.
Lower interest rates helped subsidize borrowing and leverage, particularly in housing. Over time, the search for yield among investors (and fees among originators) contributed to a dramatic loosening of mortgage underwriting standards. Increased demand and purchasing power by traditional home-buyers was buttressed by new (and, in some cases, previously unqualified) borrowers and even amateur and professional "flippers."
A positive feedback loop developed: increased housing prices fed increased demand for housing, and increased fee generation, securitization, and various risk-reduction efforts (and faulty risk assumptions) perpetuated increased capacity (and desire) for mortgage-related lending. Home prices rose dramatically.
This feedback loop spread to other parts of the economy as well. Increases in housing values and desire for mortgage-related lending brought with them a dramatic increase in consumer spending (and debt fueled by home equity)
This increase occurred during the same period real incomes were declining for most households.
Eventually, however, home prices stalled and over-leveraged financial institutions exposed to trillions of dollars in mortgage-related securities and derivatives positions began to face losses. They pulled back on issuing new credit and liquidated positions. A negative feedback loop developed.
Losses on mortgage-backed securities, synthetics, and hedging instruments cascaded through the markets, dramatically reducing aggregate wealth and contributing to a massive reduction in lending. Consumers — now facing larger (and potentially resetting adjustable-rate) mortgage debt, flat or falling housing prices, and a dramatically different economy — stopped spending. GDP and employment fell dramatically.
Crisis response and lessons from crises past
Though the Federal Reserve did increase interest rates in the years leading up to the crisis, it was not in time to stanch inflated housing values. As rates began to normalize in 2006, the housing market turned dramatically. The Fed was forced to reverse course, ratcheting the federal funds rate to near zero and pursuing unprecedented monetary easing (and massive market support) during and after the crisis. Not only did interest rates fall dramatically, the Federal Reserve Board has engaged in a series of positive monetary actions and quantitative easing efforts. Even with this significant support, the economy has been slow to recover.
The ghost of the Great Depression
Fears of the Great Depression were on policymakers' minds during, and after, the crisis. Given that tight money policies exacerbated, perhaps even caused, the Great Depression, it was certainly reasonable and appropriate for the Federal Reserve Board to take action to avoid a repeat. The recent effort, however, has been large and unprecedented, with the Federal Reserve not only using its traditional interest rate tools, but a host of new tools as well, with the aggressive bond buying called quantitative easing (QE) the most discussed. The Board's unprecedented intervention has been taking place for over five years now, and there are reasonable questions about the potential unintended consequences (and future problems) that might result from the Federal Reserve's experiment.
Are new bubbles forming?
While consumers have been de-levering (and large banks have also, to some extent), many are reasonably asking how much of the recent rise in financial asset prices is attributable to market expectations about continued Federal Reserve intervention, and how much is attributable to underlying improvements in economic fundamentals. While many academics and others have sought to analyze and quantify the impact, the markets' reaction to the Federal Reserve's statements has been striking.
While the most obvious example was the dramatic sell-off in Treasuries following the Federal Reserve's April — June 2013 statements about potentially ending its policy accommodation ("tapering"), the market's response to the Fed's apparent reversal in the summer and the significant reaction to its September 18 surprise "no-taper" news are also illustrative.
While short-term market movements do not a bubble make, the relationship between the Fed's actions and financial asset prices raises legitimate questions about whether and how existing monetary policies designed to avoid the problems of the Great Depression might be creating new risks for the future.
Looking at ten-year treasury yields (TNX), there was substantial volatility around the Federal Reserve's signals of a possible taper in April and May, a spike in yields following (May to September), and significant rebound in bond prices (reduction in yields) after its September "no-taper" surprise.
Equity markets also appear to have responded to Federal Reserve intervention over time.
Housing prices have also stabilized and rebounded during this period. What happens when the accommodation ends?
The rise of securitization
Funding thirty-year fixed-rate mortgages with short-term, re-pricing deposits proved disastrous in the 1980s savings and loan crisis. In response to that lesson, regulators and market participants sought to replace that traditional funding model with the originate-to-distribute ("securitization") model. Regulators provided strong incentives to banks to securitize mortgages instead of holding them in portfolio. By moving long-term assets off banks' balance sheets, the securitization model would, in theory, create much more resilient banks (and protect the federal safety net) by moving longer-term risk onto large investors who could appropriately price it and hold it to maturity. While over time, more and more speculation and risk-taking developed in the market, downside fears and concerns were masked, in part, by several factors:
Mortgages had been traditionally considered one of the safest and least exciting financial products.
While investors understood traditional mortgage risks (e.g., geographic, interest rate, and refinance risk), the conventional wisdom did not account for the potential for widespread decreases in home prices or for mortgage defaults. Moreover, widespread adoption of nontraditional mortgage features, including steep payment resets, negative amortization, high loan-to-values, and little if any income documentation, created new risks which investors simply did not understand or ignored.
While leverage increased, so did a host of perceived risk-reducing strategies. In addition to diversifying pools by geographies, mortgage pools and cash flows were tranched and resecuritized into other pools and synthetics — sometimes backed by a financial guarantee/wrap and a first-loss buffer, which was also hedged. Further credit protection could also be purchased on the open market.
Confidence continued even as the nature of the loans — and the funding channels — changed dramatically. Fannie Mae and Freddie Mac (whose underwriting standards helped provide some loan quality control) were losing market share to new "private label" securitizations. This channel not only created a market for traditionally "lower-quality/higher-risk" subprime loans, it also increased the pool of home-buyers (increasing home prices) and the embedded leverage on many consumers' balance sheets. This channel swelled before the crisis and froze after.
Securitization also severed the ownership of the mortgage from the decision to originate and fund it.
The mortgage production process itself became a profitable, volume (fee)-driven business. The traditional "pull dynamic" of the hopeful home-buyer trying to convince a risk-adverse bank lender was replaced by a new "push dynamic" of a commission/sales-driven mortgage broker/lender seeking fees and commissions for generating new loans to home-buyers and refinancers.
Mortgage servicing and workout incentives were also skewed by structures and incentives that made loss mitigation very difficult. Because of securitization, mortgages were locked (and sliced) in complicated investment vehicles with complicated rules. Investors with competing interests and those responsible for loan workouts had little or negative economic incentives to mitigate loan losses.
Ironically, in the end many banks (and even the government-sponsored enterprises) ended up bringing many of these risks back onto their books by purchasing mortgage-backed securities and by holding second liens and residual interests. Regulators helped by establishing regulatory capital requirements that first pushed securitization as a way to get loans off of banks' balance sheets and then made it advantageous to bring risky synthetic and securitized loans right back on.
The dramatic rise and fall of short-term wholesale funding
Moreover, while securitization may have sought to reduce some of the longer mortgage risk from traditional bank balance sheets, regulators still permitted significant duration mismatches (this time through increased reliance on short-term wholesale funding). Net repo and fed fund liabilities for private depository institutions and broker-dealers soared in the years leading up to the crisis (from under $1 trillion at the end of 2001 to $2.2 trillion in the second quarter of 2006). It is down to $637 billion in a post-crisis low.
The self-correcting markets myth
Another key driver was the myth that the market, left to its own devices, would self-correct and market actors could (and would) best police themselves. This paradigm revealed itself in a variety of policies — and in a general approach to markets, enforcement and market oversight — that allowed massive risk-taking (and abuse) to grow into a norm and eventually a crisis.
Congress: Gramm-Leach Bliley and the Commodity Futures Modernization Act. In spite of the S&L crisis, by the late 1990s to mid-2000s significant deregulation came to the financial services — particularly for the largest, most complex firms. After years of regulatory softening, in 1999 Congress enacted the Gramm-Leach-Bliley Act, permitting more competition — and more consolidation — among traditionally separated financial services providers (banks, insurance, and broker-dealers). The following year, Congress enacted the Commodity Futures Modernization Act, effectively eliminating oversight over the burgeoning over-the-counter derivatives market.
Financial regulators also followed suit. Perhaps the best example is the Basel II capital framework whereby regulators effectively replaced traditional, standardized regulator-set capital charges with a deferential advanced internal models-based approach that allowed companies to build their own models and effectively set their own capital requirements (subject to regulatory oversight of the model) amid expectations of effective self-policing and counterparty/market-policing. During this period of massive changes in the mortgage market, the Office of the Comptroller of the Currency (OCC) thwarted state efforts to impose mortgage lending standards by granting the banks it regulated — including the nation's largest — preemption of state-imposed consumer protections. At the same time, the Federal Reserve Board refused to use its authority under the Home Ownership and Equity Protection Act to adopt mortgage lending standards, even though it was the only federal agency with power to set national standards for bank and nonbank mortgage originators.
These approaches were central to the pre-crisis period and failed dramatically, spawning a new approach.
From hands-off to command-and-control?
Given past regulatory shortcomings — and clear examples of systematic abuse, gaming, and manipulation — we have seen a significant change in direction. Congress, in the Dodd-Frank Act (DFA), not only laid the groundwork for a new regulatory regime, it required minimum standards for mortgages (section 1411), floors for capital at the largest firms (section 171), and enhanced standards for the largest firms (section 115). International regulators have strengthened the capital regimes to establish a leverage ratio (a complete turnaround from the Basel II era), and US regulators have promulgated a supplemental leverage ratio for the largest firms and an FBO (foreign banking organizations) rule that would require the establishment of an intermediate holding company to help ensure that sufficient capital exists to buffer — and potentially resolve — a foreign institution's US operations. These efforts are radical departures from the former paradigm — and positive developments. But But five years after the crisis, they have yet to be fully implemented.
Excerpted from Across the Great Divide by Martin Neil Baily, John B. Taylor. Copyright © 2014 Board of Trustees of the Leland Stanford Junior University. Excerpted by permission of Hoover Institution Press.
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Table of Contents
ContentsIntroduction Martin Neil Baily and John B. Taylor,
PART I Causes and Effects of the Financial Crisis,
Chapter 1 How Efforts to Avoid Past Mistakes Created New Ones: Some Lessons from the Causes and Consequences of the Recent Financial Crisis Sheila C. Bair and Ricardo R. Delfin,
Chapter 2 Low Equilibrium, Real Rates, Financial Crisis, and Secular Stagnation Lawrence H. Summers,
Chapter 3 Causes of the Financial Crisis and the Slow Recovery: A Ten-Year Perspective John B. Taylor,
Chapter 4 Rethinking Macro: Reassessing Micro-foundations Kevin M. Warsh,
PART II The Federal Reserve's Role,
Chapter 5 The Federal Reserve Policy, Before, During, and After the Fall Alan S. Blinder,
Chapter 6 The Federal Reserve's Role: Actions Before, During, and After the 2008 Panic in the Historical Context of the Great Contraction Michael D. Bordo,
Chapter 7 Mistakes Made and Lesson (Being) Learned: Implications for the Fed's Mandate Peter R. Fisher,
Chapter 8 A Slow Recovery with Low Inflation Allan H. Meltzer,
PART III Is Too Big to Fail Over? Are We Ready for the Next Crisis?,
Chapter 9 How Is the System Safer? What More Is Needed? Martin Neil Baily and Douglas J. Elliott,
Chapter 10 Toward a Run-free Financial System John H. Cochrane,
Chapter 11 Financial Market Infrastructure: Too Important to Fail Darrell Duffie,
Chapter 12 "Too Big to Fail" from an Economic Perspective Steve Strongin,
PART IV Bankruptcy, Bailout, Resolution,
Chapter 13 Framing the TBTF Problem: The Path to a Solution Randall D. Guynn,
Chapter 14 Designing a Better Bankruptcy Resolution Kenneth E. Scott,
Chapter 15 Single Point of Entry and the Bankruptcy Alternative David A. Skeel Jr.,
Chapter 16 We Need Chapter 14-And We Need Title II Michael S. Helfer,
Remarks on Key Issues Facing Financial Institutions Paul Saltzman,
Concluding Remarks George P. Shultz,
Summary of the Commentary Simon Hilpert,