with Michael Munger and Michael Konczal
What were the causes of the recent financial crisis, and what are the proper steps to recovery?
Conducted by Alexander D. Farris
Chairman of the Department of Political Science at Duke University, Professor of Political Science and Economics, & former Libertarian gubernatorial candidate in North Carolina
The financial crisis of 2008-2009 was a trap, set by financial authorities and baited with three kinds of tasty cheese. The trap was not set on purpose, but millions were caught. The three kinds of tasty cheese are: (1) subsidized down payments on home purchases; (2) artificially low interest rates, created by permissive Federal Reserve policy and intentionally suppressed rates on Federal Reserve funds; and (3) the promise of the government, from the Treasury Department to the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac), that home prices would go up forever.
The American government decided, first Clinton and then Bush, that home ownership is the stairway to the American dream. But we didn’t subsidize home ownership; we encouraged home purchase. Once millions of people were in homes financed by mortgages bigger than the value of the homes, the trap was sprung.
Between 1994 and 1997, the definition of a “conforming” loan, under the terms accepted for packaging by Fannie Mae and Freddie Mac, was changed. Where once conforming loans had required 20 percent down and a 30 percent ceiling on monthly mortgage payments as a proportion of income, now loans could be made and certified under much more liberal terms.
Home prices, which had remained between $120,000 and $170,000 in real terms since the second decade of the twentieth century spiked upward in a classic “asset inflation,” or bubble. To make matters worse, Fannie and Freddie (and Congress!) encouraged packaging hundreds of loans into collateralized debt obligations (CDOs). At one point in 2007, $20 billion in CDOs were being resold every quarter.
Real housing prices shot up to an average of more than $250,000 from their fifty-year average of less than $150,000. The promise of permanent increases seduced investors into pouring huge sums into CDOs. Those who had some sense of caution bought insurance in the form of credit default swaps from an aggressive and confident company named American International Group (AIG).
But housing prices peaked. It proved impossible to unwind the CDOs, and since the default rates were increasing, the actual value of these huge assets was difficult to know. Thousands of investors, banks, and hedge funds found themselves stuck with illiquid assets and no buyers. AIG defaulted on its promised payments as asset values fell below the striking price for the credit default swaps.
It is certainly true that this is a story of greed and frantic risk taking. But the government’s decision to relax the conditions under which Fannie and Freddie would repackage loans into “mortgage-backed securities” actually forced banks to take excessive risks. And the repackaging allowed risk-takers to disguise and resell the packages of risky loans.
The solution before the crisis was to recognize that home purchase is risky. Many people are not able to take the risk of home ownership because of their precarious financial positions. One health issue or car problem and they are likely to default on their home mortgage.
The solution after the crisis was to offer to buy up the CDO debt at forty cents on the dollar. This would have presented a “buyer of last resort” to the market and would have injected liquidity and stopped the panic. Further, at least some of these temporarily frozen or “toxic” assets are likely to prove to have some value. Buying CDOs would have given the government a chance to break even.
Instead, the Troubled Asset Relief Program (TARP) has bankrupted the system and painfully illustrates the time-inconsistency problem: bailing out huge risk-takers encourages huge risk-taking again in the future.
The current financial crisis is the result of three overlapping stories. The first is the explosive growth of a new type of banking model, a “shadow bank,” in which capital market lending has overtaken the traditional commercial banking model. The second is the lack of wage growth for the average American, a lack which was compensated for by taking on more debt. The third is a wave of financial deregulation predicated on the belief that the new forms of financial institutions would be able to monitor themselves and, if worse came to worst, would be able to fail without spilling over into the real economy. These all fed into each other, and these are the problems our country now faces.
Think of a generic commercial bank, the George Bailey bank. It took in short-term deposits and used them to give loans to businesses, to people in the forms of mortgages, and to other long-term investors. This bank is subject to a “bank run,” when depositors want to take out their loans faster than the long-term investments can be sold, and this causes the bank to collapse. The government regulates this by providing deposit insurance through the Federal Deposit Insurance Corporation (FDIC), provides liquidity from the “lender of last resort” in the Federal Reserve, and regulates the books of the banks to make sure they aren’t taking too many risks.
This is a business model that has been dying, replaced by a new model with higher risks and higher rewards. This new model is an overlap between investment banks and commercial banks, a type of bank that, instead of using deposits, takes money from the capital markets and uses it to fund long-term debt and loans. This debt is often securitized, like the mortgage-backed securities that have been at the center of this current crisis. The capital markets funding is very efficient and cheap; however, it is even less sticky than deposits. This funding is more likely to be pulled when worry or panic sets in, and the worry that came with the value of subprime securitizations caused a massive bank run on the financial institutions.
One of the secrets of subprime that often isn’t part of the conversation is that much of the volume of subprime mortgages was the result of refinancing. The Center for Responsible Lending has found that only 10 percent of all subprime loans went to first-time home buyers, failing to actually bring in a new wave of homeowners. As average wages have stagnated, families have responded by putting an additional worker into the workforce. This two-income trap has left families more vulnerable to either worker losing their job. Meanwhile, massive inequality has put additional pressure on housing values, bidding up prices in the areas most in demand. As wages hit their high point in 2000, never to recover during the next ten years, taking on debt became a new way to synthetically create earnings growth.
The last reason is that there has been a culture of deregulation over the past thirty years in the government. One can argue the successes and failures of this deregulation as it applies to other industries, but for the financial sector it has been a disaster. The most obvious moment came with the decision to keep the over-the-counter derivatives market, where the new credit default swap market was growing, unregulated. In July of 1998, then Deputy Secretary of the Treasury Lawrence Summers testified before a Senate Committee on the CFTC Concept Release that derivatives were only traded between “largely sophisticated financial institutions that would appear to be eminently capable of protecting themselves from fraud and counterparty insolvencies.”
This mind-set, that large financial institutions would be able to monitor themselves, turned out to be a disaster under the framework of the shadow banks. As other parts of the financial system used to keep institutions in-line were weakened, market discipline fell apart. More and more risky activities moved off the balance sheet of major financial firms. The normal standardization that is required to keep market prices working also failed. Securities that are full of mortgages had conflicting legal interpretations, and the servicers who were to maintain the securities found themselves with conflicts of interest. Simple, rule-based regulation had fallen by the wayside as government officials expected the market to be the best regulator of itself.
The way out is clear: regulation needs to come back to the financial sector. Shadow banks need to have prudent regulations that prevent them from being subject to devastating bank runs. This will include bringing back regulations to derivatives, fixing the way the balance sheet is organized, ensuring that no financial firm is “too big to fail,” and many other straightforward rule-based regulations. In addition, building an economy that rewards all working Americans with broad-based growth, rather than just rewarding a few at the very top, must be a priority in the twenty-first century.
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