What I am Reading

Posted on by

1. Michael Shermer, The Moral Arc. I am only a few pages in, and he already has cited Bill Dickens and Bryan Caplan, among others.

2. Jeffrey Friedman and Wladimir Kraus, Engineering the Financial Crisis. This is a re-read for me. They share with me the view that risk-based capital rules contributed heavily to the crisis. They make a very subtle point, though. They do not believe that bankers went all-out to maximize the effective leverage of their banks. Thus, the authors reject the moral hazard arguments of deposit insurance and too-big-to-fail.

The way I would put their argument is this. Suppose that bank managers were, for whatever reason, actually quite concerned about risk exposure. They thought, even if incorrectly, that the value of keeping their franchises intact and avoiding trouble was very important. Even so, with the risk weights that regulators placed on different assets, the effective rate of return on mortgage securities was much higher than that on other asset classes, including low-risk mortgage loans. Thus, the risk-based capital rules, along with the lenient ratings by rating agencies of mortgage securities, served to steer capital into high-risk mortgage loans and thereby into feeding the housing bubble.

In making their argument that the crisis was in my terminology a cognitive failure rather than a moral failure, the authors point out that if bankers had merely wanted to maximize their exploitation of implicit and explicit guarantees, they could have acted differently. They could have held higher-risk, higher-return tranches of mortgage securities. They could have held less capital (before the crisis, major banks tended to have leverage ratios well below regulatory limits).

6 thoughts on “What I am Reading”

  1. Your last sentence phrase: “(before the crisis, major banks tended to have leverage ratios well below regulatory limits).” is interesting.

    It is my understanding that regulatory limits on leverage, for investment banks and investment banking operations at combined banks and bank holding companies, were dramatically increased in mid-2004 by Mr. Cox, then head of the SEC – from roughly 12:1 to 40:1.

    So, while “major” banks may have had leverage ratios below the limits, the elevated limits themselves set the fragility in the financial system. As you note, the retained capital upon which the leverage was based was typically mortgage-backed paper that was initially given near-risk-free ratings. Once the true risk profiles of that paper started to become apparent in 2007, the “capital” base of leverage began re-pricing – at values substantially less than 100 cents on the dollar.

    Investment banks (and/or investment banking operations) which had levered-up, yet below the new 2004 limits, began to exceed even the elevated 40:1 limits violating not only SEC regulation, but most loan covenants (technical default) as well.

    Or am I mis-informed regarding the 2004 SEC regulatory change?

      • I’m not sure the distinction is relevant. The first and most dramatic failures were in the investment banking, whether they were stand-alone investment banks, such as Bear-Sterns and Lehman, or investment banking operations (SEC regulated) of “commercial” banks (Fed regulated commercial operations) such as Citi. Even Bank of America wasn’t in any real trouble until management agreed to absorb failed investment operations of MS, etc. at Fed, Treasury and SEC behest.

        But a very critical point is that, whether the leveraging was on the part of a “commercial” side, or an “investment” side, it was, as you’ve noted, based on 100 cents on the dollar of debt on the capital requirement. As that “asset base” started to re-price, the larger issue for holders of that leverage was technical default of loan covenants, rather than regulatory breach.

  3. I would not put it that the return was higher but that lower risks were already saturated and they weren’t trying to increase returns as much as prevent them from falling faster and further. There was too much capital and not enough demand for it so all that can be done is undertake riskier projects hoping they work out or let them pile up, unlent.

Comments are closed.