In this talk, Hugo Banziger says that large banks are too complex to manage. He says that top management does not understand how complex banks make money and what risks they are taking.
Of course, if the bankers cannot understand their businesses, then regulators cannot understand, either.
He writes An Epistemology of the Financial Crisis, appearing in the current issue of Critical Review.
Subprime mortgages retained by U.S. banks for their own portfolios performed at least as badly as those they securitized for sale to others….A study by Wei Jiang, Ashlyn Nelson, and Edward Vytlacil [various versions available] examined one large lender and concluded that mortgage “loans remaining on the bank’s balance sheet are, ex post, of owrse quality than sold loans.” They concluded that RMBS [residential mortgage backed securities] investors had information advantages over banks. This is the very opposite of the view that banks sold the worst loans to unsuspecting third parties.
Robb’s theme is that the crisis was caused by imperfect knowledge rather than greed/adverse incentives. I have many comments
1. This same theme may be found in Jerry Muller’s similarly titled Our Epistemological Depression and my The Financial Crisis: Moral Failure or Cognitive Failure?, neither of which hare cited by Robb.
2. It is no surprise that Robb did not see the articles by Muller or me, nor is it likely that many people will see Robb’s. The mainstream narrative is available to everyone, while our narrative has been relegated to the most obscure publication outlets.
3. Robb writes,
One clue to what went wrong comes from a study that Fitch conducted [may be found here] on borrowers who defaulted within six months of taking out a mortgage. The study looked closely at 45 “early payment defaulters” from 2006. [It] found that 66 percent of them committed “occupancy fraud,” falsely claiming that they intended to occupy the home.
There are some forms of fraud that are often the fault of the lender, and the borrower is relatively blameless. Overstating borrower’s income is an example. But when it comes to occupancy fraud, you have to blame the borrower, and for lenders it is one of the most difficult forms of fraud to detect prior to making the loan. However, blaming the borrowers runs counter to the conventional narrative.
4. Contrary to what I have written, Robb argues that lenient risk-based capital rules for highly-rated mortgage securities were not implemented soon enough to be implicated in the financial crisis. On the Recourse Rule, a 2001 regulation that some of us believe encouraged subprime securitization, Robb writes,
While on the margin the Recourse Rule encouraged investment in highly rated ABS [asset backed securities], the incentives were not so great as to justify holding these securities unless banks thought they were safe.
5. Robb writes,
An unambiguous regulatory failure was the decision to allow Lehman Brothers to fail. The market expected the U.S. Treasury to cobble together a last-minute rescue over the weekend….largely because…Bear Stearns, had been rescued six months earlier by being absorbed into JPMorgan Chase. Lehman was 25 times large4r than Bear Stearns and far more interconnected…the Securities and Exchange Commission had no plan for an orderly transfer of clients’ assets…institutional clients with claims over $5000,000 had to wait until the summer of 2013.
6. According to Robb, the financial community never expected house prices to decline. But I would like to point out that you cannot just look at what investors were expecting on average. Instead, think of investors as assigning probabilities to various paths for house prices. I think it is fair to say that investors under-estimated the probability of a large decline in house prices. However, a sophisticated investor would not have assigned a zero probability to a path in which house prices declined.
7. Robb views post-crisis risk aversion as a major source of problems. He provides examples of assets that in hindsight were ridiculously undervalued by investors.
during a crisis, they learn to be skeptical of the probabilities, no matter how those probabilities are presented.
All in all, it is one of the most provocative essays I have read on the financial crisis.
As applied to the euro zone, the IMF claims that a 10% levy on households’ positive net worth would bring public debt levels back to pre-financial crisis levels. Such a tax sounds crazy, but recall what happened in euro-zone country Cyprus this year: Holders of bank accounts larger than 100,000 euros had to incur losses of up to 100% on their savings above that threshold, in order to “bail-in” the bankrupt Mediterranean state. Japanese households, sitting on one of the world’s largest pools of savings, have particular reason to worry about their assets: At 240% of GDP, their country’s public debt ratio is more than twice that of Cyprus when it defaulted.
I consider this to be one of the most likely scenarios.
total fossil fuel resources owned by the Federal government are valued at over $150 trillion alone.
My guess is that land is the largest real asset of the government. So there is a case for saying that even with all the unfunded liabilities that the government has accrued, the government is not broke.
I think that the best argument against those of us who say that the U.S. will have to inflate away its debt at some point is the argument that the government could sell assets if it wanted to.
the past 13 years have chronicled the journey of valuations – from hypervaluation to levels that still exceed every pre-bubble precedent other than a few weeks in 1929. If by 2023, stock valuations complete this journey not by moving to undervaluation, but simply by touching pre-bubble norms, we estimate that the S&P 500 will have achieved a nominal total return of only about 2.6% annually between now and then.
He uses the Shiller P/E ratio as his measure of over- or under-valuation. Thanks to Timothy Taylor for the pointer.
What I found even more interesting was a paragraph later in Hussman’s essay.
On careful analysis, however, the clearest and most immediate event that ended the banking crisis was not monetary policy, but the abandonment of mark-to-market accounting by the Financial Accounting Standards Board on March 16, 2009, in response to Congressional pressure by the House Committee on Financial Services on March 12, 2009. The change to the accounting rule FAS 157 removed the risk of widespread bank insolvency by eliminating the need for banks to make their losses transparent. No mark-to-market losses, no need for added capital, no need for regulatory intervention, recievership, or even bailouts. Misattributing the recovery to monetary policy has contributed to a faith in its effectiveness that cannot even withstand scrutiny of the 2000-2002 and 2007-2009 recessions, and the accompanying market plunges. This faith is already wavering, but the loss of this faith will be one of the most painful aspects of the completion of the present market cycle.
And I cannot resist the subsequent paragraph:
The simple fact is that the belief in direct, reliable links between monetary policy and the economy – and even with the stock market – is contrary to the lessons from a century of history. Among the many things that are demonstrably not true – and can be demonstrated to be untrue even with simple scatterplots – are the notions that inflation and unemployment are negatively related over time (the actual correlation is close to zero and slightly positive), that higher inflation results in lower subsequent unemployment (the actual correlation is positive), that higher monetary growth results in subsequent employment gains (the correlation is almost exactly zero), and a wide range of similarly popular variants. Even “expectations augmented” variants turn out to be useless. Examining historical evidence would be a useful exercise for Econ 101 students, who gain an unrealistic sense of cause and effect as the result of studying diagrams instead of data.
Charles W. Calomiris and stephen H. Haber write,
The fact that the property rights system underpinning banking systems is an outcome of political deal-making means that there are no fully private banking systems; rather, all modern banking is best thought of as a partnership between the government and a group of bankers, and that partnership is shaped by the institutions that govern the distribution of power in the political system.
Read the whole thing. Another excerpt:
In 1977, Congress passed the Community Reinvestment Act to ensure that banks were responsive to the needs of the communities they served. The CRA required banks that wanted to merge with or acquire other banks to demonstrate that responsiveness to federal regulators; the requirements were later strengthened by the Clinton administration, increasing the burden on banks to prove that they were good corporate citizens. This provided a source of leverage for urban activist organizations such as the Neighborhood Assistance Corporation of America, the Greenlining Institute, and the Association of Community Organizations for Reform Now, known as ACORN, which defined themselves as advocates for low-income, urban, and minority communities. Such groups could block or delay a merger by claiming that the banks were not in compliance with their responsibilities; they could also smooth the merger-approval process by publicly supporting the banks. Thus, banks seeking to become nationwide enterprises formed unlikely alliances with such organizations. In exchange for the activists’ support, banks committed to transfer funds to these organizations and to make loans to borrowers identified by them. From 1992 to 2007, the loans that resulted from these arrangements totaled $850 billion.
In contrast,
In Canada, the government did not use the banking system to channel subsidized credit to favored political constituencies, so it had no need to tolerate instability.
William Galston has some facts.
Many frustrated liberals, and not a few pundits, think that people who share these beliefs must be downscale and poorly educated. The New York Times survey found the opposite. Only 26% of tea-party supporters regard themselves as working class, versus 34% of the general population; 50% identify as middle class (versus 40% nationally); and 15% consider themselves upper-middle class (versus 10% nationally). Twenty-three percent are college graduates, and an additional 14% have postgraduate training, versus 15% and 10%, respectively, for the overall population. Conversely, only 29% of tea-party supporters have just a high-school education or less, versus 47% for all adults.
Although some tea-party supporters are libertarian, most are not. The Public Religion Research Institute found that fully 47% regard themselves as members of the Christian right, and 55% believe that America is a Christian nation today—not just in the past. On hot-button social issues such as abortion and same-sex marriage, tea partiers are aligned with social conservatives. Seventy-one percent of tea-party supporters regard themselves as conservatives.
Galston also has delivers some insinuations and assumptions. In particular, he assumes that the the Tea Party movement is some sort of dysfunctional emotional reaction and that the establishment is correct on the fundamental policy issues.
It is possible that this view is correct. However, the probability is not zero that the establishment view on the budget (spend more now; the future will take care of itself, or brilliant health care technocrats will take care of it, or something) is more dangerous than the view of the Tea Party. In fact, the establishment strikes me as suffering from a dysfunctional emotional reaction every time the topic of future budget commitments is brought up.
I received some pushback on this post. This is a response.
There is a narrative of the housing bubble/crash which tries to fit it into a neat oppressor-oppressed model. Greedy banks exploited naive borrowers in an era of libertarian deregulation. Emotionally, it as a satisfying story. Analytically, it is not. Here is why.
There are conflicts of interest between borrowers and mortgage originators, and there are conflicts between originators and investors. The financial crisis was created by the latter, not the former.
The main conflict of interest between borrowers and originators is that it is almost always in the interest of the mortgage originator to induce the borrower to pay an excessive fee and/or interest rate.
In my view, this conflict was not much of a factor in the housing crisis. The vast majority of the defaults were the result of the collapse of house prices, not the cost of mortgage loans.
Nonetheless, I have spent a lot of time thinking about this conflict and how to deal with it, because it bothers me that the most vulnerable people are the ones who are most likely to get ripped off. I do not think that market competition works very well to protect consumers, because a sophisticated lender can make it appear that he is offering the most competitive rate and then turn around and rip off the consumer. I do not think that letter-of-law regulation works very well, because you can never close all of the loopholes.
One possibility would be reputation systems. If an entity like Consumer Reports were to rate lenders and loan offerings, and enough consumers use that entity, then bad actors would be driven out of the lending market. Unfortunately, the most vulnerable consumers do not use these sorts of consumer rating services, so I do not think that solution will work.
The other possibility is principles-based regulation. Audit firms to ensure that their products, policies, procedures, and internal incentives are designed not to exploit vulnerable consumers.
The oppressor-oppressed narrative has lenders giving loans to borrowers when the lenders should know better but the naive borrower does not realize that he or she should not be getting the loan. Some comments on this.
1. Lenders are not omniscient. They make mistakes. A Type I error is making a loan that you think will be repaid, and it turns out to default. A Type II error is turning down a loan that would have been repaid. Until 2007, the main oppressor-oppressed narrative was that lenders were making Type II errors, particularly with respect to minorities. That is, the evil lenders were turning down too many good borrowers. When the crisis hit, the oppressor-oppressed narrative suddenly became the opposite. Lenders supposedly forced loans on unwitting borrowers who could not pay them, and we need to regulate lenders to make sure this never happens again. That is, originators deliberately committed Type I errors.
2. Under the old-fashioned originate-to-hold model, there is never an incentive for lenders to make loans that will not be repaid. You lose money on those loans. In this model, the bank pays its loan origination staff not on sheer volume, but on quality decisions, including rejecting loans as warranted.
3. On the other hand, with securitization, the originator’s idea of a good loan is any loan that can be sold to an investor, without regard to whether it can be repaid. When you deny a loan application, you cannot possibly make money on it. If you approve the loan and it cannot be repaid, that is someone else’s problem. This is primarily a conflict of interest between originators and investors, not between borrowers and lenders. At Freddie Mac, this conflict of interest occupied us constantly. Trying to keep originators from funneling bad loans to us drove enormous amounts of our staff time, business functions, policies, procedures, and contractual arrangements.
4. One of the illustrations of the conflict between originators and investors is that loan applications often include fraud and misrepresentation. The most common examples include over-stating the borrower’s income and/or lying about whether the borrower is going to occupy the home. Income misrepresentation is often initiated by the originator, trying to “help” the borrower get a loan. Occupancy fraud, on the other hand, is almost always initiated by the borrower. It can be hard for the originator to prevent this fraud, because it only becomes clear after the loan has been sold that the borrower never intended to occupy the home and instead is a speculator.
Taking all this together, I do not find the story of deregulation leading to the housing crisis to be very compelling. The main conflict of interest that caused the problem was the conflict between originators and investors. Basically, originators were able to foist bad loans on investors. This is not a case of the rich and sophisticated taking advantage of the poor and naive. On the contrary, the typical originator is a low-class guy working for a poorly-capitalized company in a highly competitive business. The typical investor is a sophisticated money manager.
Regulation was part of the problem, not part of the solution. The regulators’ perverse risk-based capital requirements encouraged the risk-laundering AAA-rated tranche business. And their attack on Type II errors prior to the crisis was at worst a major cause of the crisis and at best spectacularly poorly timed.
Adam J. Levitin and Susan M. Wachter write,
We argue that the bubble was, in fact, primarily a supply-side phenomenon, meaning that it was caused by excessive supply of housing finance. The supply glut was not due to monetary policy or government housing finance. The supply glut was not due to monetary policy or government affordable-housing policy, although the former did play a role in the development of the bubble. Instead, the supply glut was the result of a fundamental shift in the structure of the mortgage-finance market from regulated to unregulated securitization.
Pointer from Reihan Salam.
The implication is that if government regulates securitization, things will be fine. Some problems I have with this analysis:
1. They do not examine how the market for “unregulated” securitization was in fact bolstered by capital market regulations. Take away the regulatory advantage for AAA-rated and AA-rated securities, and I do not think that the securitization market is able to take off. Remember that capital requirements for banks were so perverse that holding a tranche in a pool backed by sub-prime mortgages required more less capital than originating and holding a low-risk mortgage.
2. The “regulated” sector, namely Freddie and Fannie, lowered its standards at exactly the wrong time, in 2005 through 2007. Several private players, including AIG, either exited the market or tightened standards before the bubble burst.
3. The problem with private securities is not that they lack standardization. It is that the whole securitization model is flawed. It introduces more costs than benefits into the mortgage finance system. That fact has been obscured by all of the support that government has given to securitization, including the “too big to fail” status of Freddie and Fannie and the perverse capital requirements noted in (1) above.
Either Google “Charlie Rose Stanley Fischer” or try this link.
I am particularly interested in Fischer’s view that (a) the financial crisis had the potential to cause another Great Depression and (b) that the policy responses of the United States worked quite well and (c) fiscal expansion was needed, because monetary policy could not do enough. He does not offer a list of evidence on these points. Instead, he says, in effect, that experts agree on these points. Some possibilities:
1. There is a lot of evidence, but in an oral interview he could not give footnotes.
2. Fischer’s circle is an echo chamber that takes these views, without much need for evidence.
3. Fischer formulated an opinion early on in the crisis, and he has seen no need to change his views, because hypotheses about the financial crisis are untestable (we cannot undertake controlled experiments in macro).
I am particularly curious about (1), and where one could find the list of observations that supports the view that we were headed toward another Great Depression without the bank bailouts and fiscal stimulus.