Category Archives: Financial Crisis of 2008

The Fed and Lehman Brothers

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I haven’t read Laurence Ball’s book, but I did see the movie working paper. Ball’s thesis is that the Fed could have and should have lent Lehman the money to enable it to reach a more orderly resolution than declaring bankruptcy at the peak of the financial crisis of 2008.

Long after the episode, Fed officials justified their (in-)action by claiming that Lehman lacked adequate collateral, and that this lack of adequate collateral made it technically illegal for the Fed to lend the amount required. Ball points out that at the time, this legal argument was not used in the internal discussion. Instead, Chairman Bernanke and others were thinking that (a) the Lehman bankruptcy would not cause major new problems and (b) public hostility toward the perceived “bailouts” of Bear Stearns and other firms made it politically dangerous to lend to Lehman.

My own views:

1. I am inclined to cut Bernanke and the Fed officials some slack in allowing them to dissemble about the rationales for not bailing out Lehman. I think that the case against bailing out Lehman is pretty strong, and I am not persuaded by the view of Ball and others that a Lehman bailout would have worked wonders for resolving the financial crisis. Even if Ball is right, I think that the officials’ view that a bailout had low economic benefits and high political costs was reasonable ex ante.

2. The doctrine of “lender of last resort” does not suggest that you have to lend to any particular firm. The point is to provide liquidity in order to keep the crisis contained. So, contrary to what Ball seems to be saying, the Fed could perform its lender-of-last-resort function without bailing out Lehman.

3. During the crisis, I thought that more attention should have been paid to reducing the demand for liquid assets, not just trying to make more supply available. A lot of the “collateral calls” and “haircuts” were outlandish. I would have used jawboning to try to scale those demands back to something more reasonable.

4. I am intrigued by analysis suggesting that the actual banking crisis was more severe in Europe than in the U.S. European finance is more concentrated in its banking system. If every financial institution with heavy exposure to U.S. mortgage securities had failed, the U.S. would still have had a lot of functioning banks and other financial institutions. Not so in some European countries. I don’t think that Lehman bailout would have solved the problems in Europe.

Were mortgage securities badly mis-rated?

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Juan Ospina and Harald Uhlig write,

AAA securities did ok: on average, their total cumulated losses up to 2013 are 2.3 percent. . .Losses for other rating segments were substantially higher, e.g. reaching above 50 percent for non-investment grade bonds. . .

Cumulative losses of 2.2% of principal on AAA-rated securities surely is a large amount, given that rating. Such losses after six years may be expected for, say, BBB securities, and not for AAA securities. AAA securities are meant to be safe securities, and losses should be extremely unlikely. From that vantage point, an average 2.2% loss rate is certainly anything but “ok”. We have chosen this label not so much in comparison to what one ought to expect from a AAA-rated security, but rather in comparison to the conventional narrative regarding the financial crisis, which would lead one to believe that these losses had been far larger. Ultimately, of course, different judgements can be rendered from different vantage points: our main goal here is to simply summarize the facts.

Authors’ emphasis. They also say,

these facts provide challenge the conventional narrative, that improper ratings of RMBS were a major factor in the financial crisis of 2008.

I object to this conclusion. The capital requirements for the securities depended on the ratings. Because of the AAA ratings, the capital requirement was less than what the loss percentage turned out to be.

As I see it, the facts in the paper support the conventional narrative. If the securities had been correctly rated, then there would have been no financial crisis. If the securities had been properly assigned BBB ratings, or any ratings below AA, banks could not have bought the securities without having at least five times the amount of capital that was required for AAA.

The charitable interpretation is that the authors do not appreciate the significance of capital regulations. The uncharitable interpretation is that they are trolls.

Wither the center? post-election Italy

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Alberto Mingardi writes,

A country like Italy ought to have a moderate, responsible, free enterprise-oriented right. But it is indeed an “ought”: not, in our case, an “is” and a truly felt tradition in this country.

Michael Barone writes,

As in France, Austria, the Netherlands, and Germany, the traditional center-left party largely collapsed, with just over 20 percent of the vote

My guess is that if the U.S. had a similar electoral system, we would observe the same thing. As of now, a center-left party would do less well than a far-left party. The right would be split among libertarians (not a large bloc), Trump supporters, and traditional conservatives, with the latter possibly split into a faction that stresses social issues and a faction that stresses the economy and foreign policy.

It could be that Martin Gurri is correct, and that the new media environment helps to foster a revolt against elites. But another possibility is that the financial crisis of 2008 had an effect on the perception of elites in America not unlike the Vietnam War. That is, the “best and the brightest” looked really foolish, and they lost the trust of many people.

Taste-makers in the press have not been kind to Vietnam War architects Robert McNamara, McGeorge Bundy, and Dean Rusk. But for policy makers involved in the financial crisis, the outcome has been different. Henry Paulsen, Timothy Geithner, and especially Ben Bernanke are often described by journalists in heroic terms, and they have vigorously patted themselves on the back in their memoirs. Barney Frank and Chris Dodd etched their names in history as the co-author of post-crisis banking legislation, blotting out their prior role as bosom buddies of Freddie Mac, Fannie Mae, and Countrywide Funding when those firms were running up dangerous risks.

The public may have a better intuitive sense of the policy elite’s role in all this. For the center not to wither, it has to earn the trust of the people.

Cantercap Charlie on finance and the 2008 crisis

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He wrote,

if banks are doing their job, the banking system is illiquid, and the rest of the economy —us— have lots of cash. In Econ 101 this is known as “maturity transformation.” Liquidity-wise, the banking system is simply the mirror image of the economy. Thus, compelling banks to become more liquid inevitably drains cash from all of us who are not banks.

This is another way of saying what I like to say, which is that the public wants to issue risky, long-term liabilities and to hold riskless, short-term assets, and financial intermediaries accommodate this by doing the opposite. This implies that for financial firms, a liquidity crisis blends into a solvency crisis. Banks must shrink their activity if there is sudden pressure on them to make their balance sheets more liquid.

In a more recent post, he writes,

what did cause the crisis? The causes were complex, but one force overwhelmed all others: regulation. Bad regulation. Mainly, the Basel I and Basel II Capital Standards.

He is referring to the Financial Crisis of 2008. Actually, I don’t believe that Basel II was all that important, because it still was mostly unimplemented by the time of the crisis. I would focus on Basel I and also on the Recourse Rule of 2001, which we might think of as Basel I(a).

More interestingly, he goes on to say,

the great untold secret of the crisis was the strength of the US commercial banking industry.

As crazy as this sounds, it may be spot on. Yes, Citigroup was in trouble, as he acknowledges. But most other commercial banks were not in bad shape. Some U.S. investment banks (aka “shadow banks”) were shakier, but the real problems were in Europe. He writes,

European banks in 2007 had aggregate tangible equity of roughly 1 trillion euros (at the time, about $1.1 trillion.) With a sensible leverage ratio of 5.0%, this equity would have supported E20 trillion in assets. But by 2000, the average European bank leverage ratio already had dwindled to 3.8% (insufficient), and then fell further — to 3.0% (wow) in 2007.* That may not sound like a big deal, but it’s more than a 20% systemic increase in leverage in just 7 years. This meant that for European banks alone, the Basel Regs goosed asset demand by at least E7 trillion ($8 trillion).** To think of it another way, European bank assets in 2007 exceeded what would have been prudent leverage (i.e. 5%) by E13 trillion ($15 trillion) — a third of European banking system assets.

I would add that many of the beneficiaries of the “AIG bailout” were European banks.

There is a lot of potential for revisionist history here.

Complexity illustrated by the financial crisis

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This IGM poll of leading economists on the importance of various factors in the financial crisis of 2008 provides interesting results. The poll lists 12 factors, and all of them receive at least some positive weight. In fact, this under-estimates the complexity of the causal mechanisms, because some of the factors are themselves multi-faceted. For example, the first factor, “flawed financial sector regulation and supervision,” could mean many different things to many different people. It could mean the repeal of Glass-Steagall (a favorite among non-economists on the left) or it could mean the Basel accords (one of my personal favorites).

Overall, I think it vindicates the broad, multi-causal approach that I took in Not What they Had in Mind.

Regulatory miscalculation

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Two examples.

1. Stephen Matteo Miller writes,

While these findings do not establish that the Recourse Rule caused the financial crisis, they are consistent with the view that the rule encouraged securitizing banks, especially the largest ones, to hold the assets that turned out to be at higher risk of distress. In other words, though the Recourse Rule may have been intended to lower risk-taking, it may have encouraged greater risk-taking on the part of these banks.

The Recourse Rule got its name because its primary provision was to force banks to keep capital against assets that had been sold with recourse, meaning that the assets could be put back to the bank if they lost value. But another provision of the rule allowed banks to reduce capital against mortgage securities with AA and AAA ratings. Freddie Mac and Fannie Mae warned about the distortions this would create at the time the rule was issued, in 2001. I have discussed its role in the financial crisis of 2008 in Not What They Had in Mind and in The Regulator’s Calculation Problem, the latter focusing on the book by Jeffrey Friedman and Wladimir Kraus that emphasizes the role that capital (mis-)regulation played in the lead-up to the crisis.

2. Saad Alnahedh and Sanjai Bhagat write,

Regulations were announced by the U.S. Securities and Exchange Commission (SEC) in July 2014 to increase MMF [money market funds] disclosures, lower incentives to take risks, and reduce the probability of future investor runs on the funds. The new
regulations allowed MMFs to impose liquidity gates and fees, and required institutional prime MMFs to adopt a floating (mark-to-market) net asset value (NAV), starting October 2016. . .we find that institutional prime funds responded to this regulation by
significantly increasing risk of their portfolios, while simultaneously increasing holdings of opaque securities.

Two Thoughts on William Niskanen

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I had only one close encounter with him. That was when he went to a Congressman’s office to argue against TARP and he invited me to join in the meeting. My observations about him:

1. He was highly principled. If he disagreed with a libertarian article of faith (such as the view that “starve the beast” would lower spending), he would say so. But he was certainly no friend of the establishment’s belief in itself and in big government. He knew that the elites were solidly for TARP, and that made him all the more willing to try to stop it.

2. He was modest and gentlemanly. He would have been the last person to engage in trolling for self-aggrandizement.

What I’m Reading

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Two books that attack conventional economic modeling, especially in light of the financial crisis. I have a preview copy of Economics for Independent Thinkers, by Daniel Nevins. I have a review copy of The End of Theory, by Richard Bookstaber. I am likely to recommend the former. The latter is certain to make it onto my list of “best books of the year.”

It is interesting that both authors have backgrounds in applied option pricing. So do I. Is it a coincidence that we all ended up taking heterodox positions? If you toss in Fischer Black and Nassim Taleb, you start to wonder if there isn’t something in the option pricing water.

A reader points to Diane Coyle’s negative review of Bookstaber. She writes,

his complaints about economics are both wearily familiar territory and decreasingly true; economics is and has been changing a lot. In finance specifically, think of Andrew Lo’s new book, Adaptive Markets.

I disagree with her on all counts. One indication that Coyle has missed the point is that she thinks that Bookstaber’s critique applies only to macro/finance. I can readily apply it to the way economists model the demand for health insurance, the demand for home ownership, and principal-agent contracts, among other microeconomic phenomena.

I am drafting a review essay, which reads in part,

If I could reduce it to a bumper sticker, it would read, “Stare more at the world and less at your model.”

…All of the major fields in economics are inclined to follow strict technical procedures at the expense of realism. In the 1500s, if mapmakers had been similarly inward-looking and rigid, they would have continued to draw maps of the globe that ignored the lands discovered by Columbus and subsequent explorers, insisting that “The state of cartography is good.”

Turning to a relatively minor passage that resonated with me, here is Bookstaber’s description of the role of collateral in repurchase agreements and derivative bets on p. 159:

Let’s say your bookie demands that you put up $20,000 of collateral for a marker on a $15,000 bet. You give him your gold Rolex watch, worth $20,000. He comes back to you a week later and tells you that you need to put up another $3,000. Why? “People, they aren’t so much interested in these Rolexes anymore. It’s marked down to $17,000.” …You say, “Wait, I see prices for watches just like it, anywhere from $20,000 to $24,000.” He says, “Hey, do you owe them money or do you owe me money? You’ve got the marker, and I’ve got the watch, and I say that today it’s worth $15,000.”

By appraising collateral, notably mortgage securities, at low values, investment banks like Goldman Sachs caused runs on other firms. Gary Gorton termed it the “run on repo.”

[note: the following paragraph is my own. Although I cannot confirm that Bookstaber would endorse it, to me it seems likely that he would.]

But it was not just repo. The run on AIG was to demand collateral for credit default swaps. Think of a credit default swap as flood insurance and think of collateral as used because you don’t entirely trust that the insurance company will have the wherewithal to pay off. You have a house near a river, and when you get flood insurance you have the insurance company give you some Treasury bills as collateral, until the insurance policy expires. Then, a big rain comes, and the river starts to rise. Your house is still dry, but you are more worried, so you ask for more Treasury bills as collateral. That is what Goldman Sachs and the other investment banks did to AIG during the crisis. As it turned out, most of the houses never got flooded (that is, most of the bonds that AIG insured did not default), but the demands to put up more safe securities as collateral became impossible to meet, especially because similar demands were being made all over Wall Street for firms engaged in derivatives and repurchase agreements.

The quoted passage does not in any way capture the book’s larger, more ambitious theme. I was struck by it because it fit my understanding of what happened, which policy makers at the time seemed to me to miss. Had they been cognizant of the real problem, they would have applied a remedy closer to the one that I was proposing at the time. I called this the “stern sheriff” model, and it would have meant telling Goldman and other firms to stop making their outlandish collateral calls.

The Source of Systemic Financial Risk

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Charles Calomiris says that it is the political system.

There are two important systemic threats to financial stability: government policies that subsidize mortgage risk, and government policies that insure bank debts (and, more generally, that subsidize bank default risk through a variety of channels, including—but not limited to—“toobig-to-fail” protection).

As you know, I have some simple solutions to the problem of subsidizing mortgage risk.

1. Do not provide government guarantees or subsidies for investor loans, meaning mortgages on non-owner-occupied homes. I have linked to a study that found that over one third of mortgage lending in 2006 went to people who were buying a house in addition to the one that they occupied.

2. Do not provide government guarantees or subsidies for loans that extract equity from homes, including second mortgages and cash-out refinances.

These simple, logical steps would have been sufficient to prevent the financial crisis of 2008. However, they would be fiercely opposed by industry trade groups, such as the Mortgage Bankers Association.

Revisiting My Former Life

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Susan Wharton Gates, a former Freddie Mac employee, recently published a book delving into the collapse of that housing finance enterprise. In my review, I write,

The fall of Freddie Mac came as a shock to those of us who were there in the late 1980s and 1990s, who refer to ourselves as “old Freddie.” Was the tree that seemed so sturdy twenty-five years ago knocked down by a storm or did it rot from within? Gates says that it was both. She tells the story of Freddie Mac’s fall as a combination of both external pressure and internal rot.

My review essay is long and personal. You might see at as an exercise in therapeutic reminiscence.