How Politicians and Regulators Caused the Sub-Prime Financial Crisis of 2007 and the Subsequent Crash of the Global Financial System in 2008, and Likely Will Again

This is a summary of a working paper available at the links for which comments are welcome. (A later post on related topics appears here.)

Download the paper (1 MB pdf).

That the US financial system crashed and almost collapsed in 2008, causing a globally systemic financial crisis and precipitating a global recession is accepted fact. That US sub-prime lending funded the excess housing demand leading to a bubble in housing prices is also generally accepted. That extremely imprudent risks funded with unprecedented levels of financial leverage caused the failures that precipitated the global systemic crash is a central theme in most explanations. All of the various economic theories of why this happened, from the technicalities of security design (Gorton, 2009) to the failure of capitalism (Stiglitz, 2010) can be reduced to two competing hypotheses: a failure of market discipline or a failure of regulation and politics.

While still sifting through the wreckage and rebuilding the economy in mid July, 2010, the Congress passed the 2,315 page Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 to prevent a reoccurrence of this disaster. The disagreement in the debates regarding the appropriate policy prescription reflected the lack of a consensus on which of these two competing hypotheses to accept. The risk was that, following the precedent established in the Great Depression, politicians will blame markets and use the crisis to implement pre-collapse financial reform agendas and settle other old political scores. By having done just that, this Act  worsens future systemic risk.

That there was little or no market discipline is obvious. Contrary to the deregulation myths, regulation and politics had long since replaced market discipline in US home mortgage markets. Regulators didn’t just fail systemically to mitigate excessive risk and leverage, they induced it. This didn’t reflect a lack of regulatory authority or zeal, as politicians openly encouraged it.

The politically populist credit allocation goals that promoted risky mortgage lending, whether or not morally justifiable, are fundamentally in conflict with prudential regulation. The system of “pay-to-play” politically powerful government sponsored enterprises (GSEs) was a systemic disaster waiting to happen. The recent advent of the private securitization system built upon a foundation of risk-based capital rules and delegation of risk evaluation to private credit rating agencies and run by politically powerful too-big-to-fail (TBTF) government insured commercial banks and implicitly backed TBTF investment banks was a new disaster ripe to happen. Easy money and liquidity policies by the central bank in the wake of a global savings glut fueled a competition for borrowers between these two systems that populist credit policies steered to increasingly less-qualified home buyers. This combination created a perfect storm that produced a tsunami wave of sub-prime lending, transforming the housing boom of the first half decade to a highly speculative bubble. The bubble burst in mid-2007 and the wave crashed on US shores in the fall of 2008, reverberating throughout global financial markets and leaving economic wreckage in its wake. 

By the time the financial system finally collapsed bailouts and fiscal stimulus were likely necessary even as they risked permanently convincing markets that future policy will provide a safety net for even more risk and more leverage. Given this diagnosis, how to impose market and regulatory discipline before moral hazard behavior develops is the most important and problematic challenge of systemic financial reform.

The public policy prescription is simple and straightforward. Prudential regulation remains necessary so long as government sponsored deposit insurance is maintained, which seems inevitable. Prospectively the traditional regulatory challenge of promoting market competition and discipline while safeguarding safety and soundness remains paramount. But the prudential regulation of commercial banks needs to be de-politicized and re-invigorated, with greater reliance on market discipline where public regulation is most likely to fail due to inherent incentive conflicts. This means sound credit underwriting and more capital, including closing the off balance sheet loopholes typically employed by big banks and eliminating the incentives for regulatory arbitrage. Universal banking should remain, but divested of hedge fund and proprietary trading activity. In addition, firms that are “too big to fail” (TBTF) are probably too big to be effectively controlled by regulators and should either be broken up or otherwise prevented from engaging in risky financial activities by reducing or eliminating their political activities.

Most importantly, the two main sources of TBTF systemic risk and subsequent direct government bailout cost, Fannie Mae and Freddie Mac, no longer serve any essential market purpose. The excess investor demand for fixed income securities backed by fixed rate mortgages that fueled their early growth is long gone and now easily met by Ginnie Mae and Federal Home Loan Bank securities alone, as fixed nominal life and pension contracts have largely been replaced by performance and indexed plans. Fannie Mae and Freddie Mac should be unambiguously and expeditiously liquidated subsequent to implementing an adequate transition plan for mortgage markets.

Download the paper (1 MB pdf).

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Kevin Villani is former SVP/acting CFO and Chief Economist at Freddie Mac and Deputy Assistant Secretary and Chief Economist at HUD, as well as a former economist with the Federal Reserve Bank of Cleveland. He was the first Wells Fargo Chaired Professor of Finance and Real Estate at USC. He has spent the past 25 years in the private sector, mostly at financial service firms involved in securitization. He is currently a consultant residing in La Jolla, Ca. He may be reached at kvillani at san dot rr dot com.

This is Profoundly Stupid…

The city of Philadelphia, Pennslyvania is home to USS Olympia:

USS Olympia was a protected cruiser in the United States Navy during the Spanish-American War. She is most notable for being the flagship of Commodore George Dewey at the Battle of Manila Bay. The cruiser continued in service throughout World War I and was decommissioned in 1922. As of 2010, Olympia is a museum ship at the Independence Seaport Museum in Philadelphia, Pennsylvania. Olympia is the world’s oldest steel warship still afloat.

Not for long, it seems:

Now the Olympia – the last surviving vessel from that 1898 conflict – could face an ignoble end as an artificial reef off Cape May if a new benefactor cannot be found.
 
The Independence Seaport Museum and the Navy have already checked with officials of New Jersey’s Artificial Reef Program on the possibility of sinking the ship, once a source of national pride.
 
“Another option would be scrapping Olympia,” said James McLane, interim president of the museum, which owns the ship and is adjacent to it at Penn’s Landing. “But the Navy has told us that ‘reefing’ is better because it would allow divers to go down on it and would preserve Olympia.”
 
The museum can no longer afford the ship’s upkeep, McLane said. At least $20 million is needed to tow, restore, interpret, and endow the deteriorating vessel.

Fortunately, as Dmitri Rotov points out, the state of Pennsylvania has its priorities straight:

Tough economic times – but the $20 million needed to rehab the Olympia is exactly the amount allocated in the new state budget for an Arlen Specter library and a John Murtha “Center for Public Policy.”

Why Big City Incompetents Like “Gun Control”

A lot of the big urban areas of the Northeast have turned into war zones. Virtually, without exception, they place the blame on lax “gun control” (really, people control) laws for their sky-high murder rates. I wonder if their voters have ever asked themselves why their mayors are so obsessed?

I think the answer is simple: It give the mayors external actors to blame so they don’t have to answer for their own incompetence.

Think about it. What is every one of those mayors really saying when they talk about disarming the citizenry? They’re really saying, “Hey, it’s not my fault our city has become a shooting gallery, it’s the fault of those rednecks three states over! You can’t blame me because I can’t control what those rednecks do! Oh, if only we could overturn two centuries of Constitutional law we would have safe streets! Until that happens, don’t even think of voting me out! It wouldn’t be fair!

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Gary Death Countdown II

The original Gary Death Countdown can be found here.

Some residents of Gary, Indiana are impatient for the death clock to count down to 2012 and have asked the Indiana Distressed Unit Appeals Board to not wait so long. The Miller Citizen’s Corp President Douglas Grimes said it straight out:

The board must insist that the city explore Chapter 9 bankruptcy, receivership and other options which could allow the city to reset its compass and move forward

Chapter 9 bankruptcy is not a liquidation but a reorganization under the federal bankruptcy code. To do it now would be admitting that the DUAB process is a farce that will not lead to a Gary government that can live within its means. An early bankruptcy is a vote of no confidence in the political tadalafiltablets class of the city and the ability of the DUAB to do its job helping that political class change the way the city does business.

Bankruptcy would help the city get out from under its $34 million (or more) in obligations beyond the structural imbalances imposed by the tax caps. It wouldn’t help with the imbalances themselves. For that, the DUAB process would need to work its way through to a successful conclusion or Gary’s elected officeholders need to be replaced by a state appointed receiver and committee that would be willing to make the changes needed and given the powers necessary to negotiate the pay reductions needed to bring expenditures in line with revenues.