Epilogue 2010–2020
The global economic crisis that began in 2008 led to extensive discussion of changes in the regulations that would forestall a similar train of events and reduce the likelihood that the US government and the governments of other countries would need to ‘bail out’ their large banks in 2020 or 2025. Most of the reform proposals reflect a view – implicit if not explicit – about the cause or causes of the crisis. The standard themes include that the bubble in real estate and subprime mortgages resulted from greed, reckless lending, skewed compensation arrangements for bankers, or regulatory failures.
The prelude to the panic and crash that began in September 2008 was a rapid expansion in credit that began in 2002 that financed both purchases of real estate in the United States, Britain, South Africa, and Iceland and large fiscal deficits in Greece, Portugal, and Spain. US real estate prices peaked at the end of 2006; the subsequent decline in housing starts led to a recession that began in January 2008. Some financial institutions began to fail in the summer of 2007; both Countrywide Financial and Northern Rock needed financial assistance in August 2007.
Subsequently there were runs on Bear Stearns in February 2008 and on Lehman Brothers in August and September 2008. After Lehman failed in mid-September, the credit markets froze, and other financial institutions were subject to runs, which abated only after the public credit of governments was committed to support these firms. The government money extended to these firms was viewed as a ‘bail out’ and the cliché ‘too big to fail’ dominated the discussion, even though the shareholders of these banks as well as the shareholders of AIG lost 90 to 95 percent of their money, the firms became wards of the government, and their managements were replaced. US government assistance was intended to prevent the implosion of the US and global payments arrangements, which would have led to the failure of many otherwise solvent banks and firms and a sharp increase in unemployment. The immediate beneficiaries of the government financial assistance were the bondholders and other unsecured creditors of the banks – as well as the general public.
One group of reform proposals seeks to limit the amounts and types of assets that the firms that benefit from government deposit insurance can acquire. For example, these firms would be restricted in their investments in hedge funds and in private equity firms. Another group of proposals would limit the transactions by banks for their own accounts in various types of derivatives. Still another proposal is that bank transactions in derivatives could occur only on an organized exchange much like the futures markets in currencies and in gold, rather than in the over-the-counter market.
A large set of proposals was directed at the capital structure of banks. One generic proposal was to increase the bank capital requirement, which is the thrust of the next update to the Basel Accords (‘Basel III’). A variant is that the required capital of each bank would depend on the composition of the bank’s assets, the higher the share of ‘risky assets’, the higher the required capital. Another variant is that the capital requirements would be keyed to the rate of growth of bank assets; the higher the rate, the higher the requirement. A different approach is that the banks have ‘contingent capital’ – if loan losses lead to a decline in capital below a regulatory minimum, then some of the bonds issued by the banks would be converted into equity. Hence each bond holder – or the holders of certain types of bonds that had been issued by the banks – would be a contingent shareholder.
A third group of proposals focuses on changes in the institutional structure of the banking and financial services industry. One generic recommendation (the ‘Volcker Plan’) is that the investment banking activities of banks be separated from their conventional commercial banking activities, the distinction that had been legislated in the Glass-Steagall Act of 1933. Another proposal is that the very largest banks be ‘downsized’, so that thereafter, no bank would be too big to fail because of the concern that closing the bank might trigger runs on its competitors.
One set of proposals centers on the need to change the institutional location of the bank regulators. The premise is that the regulators failed to enforce the rules, either because they had been ‘captured’ by the firms that they were supposed to regulate or because of bureaucratic indolence – regulation seems superfluous in good times and so individuals who want a quiet life become regulators.
The regulation of banks began when they were first chartered by governments; they were subject to various constraints in exchange for the privilege of producing money. The pattern is incremental regulation; each crisis leads to the adoption of new regulations to forestall the likelihood that the same type of crisis might recur. Banks are subject to portfolio regulations, capital requirements, liquidity requirements, branching restrictions, interest rate ceilings, and deposit insurance. Regulations limit self-dealing by bankers and loans to bank owners and officers.
In the US, the Dodd-Frank ‘Wall Street Reform and Consumer Protection Act’ requires that banks hold more capital and that the same requirement apply to bank holding companies. There are constraints on compensation payments for mortgage originators, who are required to hold 5 percent of mortgages that they originate. There are limits on the amount of shares in hedge funds and private equity firms that the banks can own, and there are also limits on their participation in some risky derivative transactions. Moreover the Office of Thrift Supervision is to be merged into the Office of the Controller of the Currency.
Would the financial history of the last ten years have been significantly different had the regulations mandated in the Dodd-Frank legislation been adopted in 2000? Would the extraordinary increase in the prices of US residential and commercial real estate that occurred over the next seven years have been significantly smaller?
The bubble in the US housing market resulted from an extraordinary increase in the supply of credit, or what is the same thing, an extraordinary increase in the demand for mortgages and for mortgage-related securities. Part of this demand was from foreign firms, including central banks in Asia, and part of the demand was from the US government-sponsored lenders, Fannie Mae and Freddie Mac, and the Federal Home Loan Banks. (Agents of Freddie and Fannie encouraged central banks to believe that their IOUs were effectively guaranteed by the US Treasury – which proved to be true.) Part of the increase in the supply of credit was from US pension funds and US insurance companies. Moreover US investment banks had acquired tens of billions of dollars of mortgages that they would eventually securitize, which were held in inventories until they could be transferred to the trusts that would issue the mortgage-backed securities.
The US commercial banks accounted for no more than 20 percent of the increase in the supply of credit for real estate. The massive loan losses that the banks incurred between 2007 and 2010 resulted because their judgments about the trend of real estate prices were wrong; these firms – and the financial regulators – underestimated the credit risks attached to mortgages and mortgage-related securities because they did not believe that the price of residential real estate could decline, perhaps because they believed that prices had never before declined on a national basis. (The lenders did not realize that real estate prices had declined on a national basis in the Great Depression.) The losses that the banks incurred on their transactions in esoteric derivatives – except for those associated with mortgage-related securities – were small; these transactions had a significant impact on the solvency of only one firm, AIG, which was primarily an insurance conglomerate (although AIG owned a small bank). AIG needed increasingly large amounts of cash as margin for the credit default swaps that it sold as the credit-rating agencies downgraded its risk profile. The rationale for massive government assistance to AIG was that if it failed, many of the counterparties that had bought the swaps that it had sold would also fail.
The supply of credit available for the purchase of mortgages and the scope of the real estate bubble that began in 2002 may have been modestly stronger because of the belief that the bonds of Fannie Mae and Freddie Mac were effectively guaranteed by the US Treasury. Similarly the supply of credit may have been modestly larger because the credit-rating agencies were corrupted by the investment banks in their assessments of the risk attached to various mortgage-related securities. Moreover, the supply of credit may have been modestly larger because some of the firms that originated mortgages that would be securitized were less meticulous in the appraisal of the credit risks than if they planned to hold the mortgages in their own portfolios – hence the requirement that the originators hold 5 percent of the credit risk.
One of the stylized facts is that as credit bubbles expand, the lenders extend credit to borrowers who are increasingly less attractive in terms of their repayment histories and their ability and willingness to adhere to the contracts. The increase in the share of subprime loans from 6 per cent to 20 percent of the total market for residential real estate mortgages that occurred between 2004 and 2005 resulted because there weren’t enough prime mortgages to satisfy the demand for mortgage-related securities. Some of the lenders wanted the higher rates of return associated with mortgage-related securities. The borrowers on the borderline of being creditworthy were able to obtain money because there were no binding macro constraints on the increases in the supply of credit. Many firms, including Countrywide Financial, Washington Mutual, and Northern Rock, took on more credit risk because they wanted to increase their market shares while many of their competitors were reluctant to cede market share with the result that credit standards declined.
The Dodd-Frank legislation will increase the costs of banks. One of the standard features of financial market development is that when the costs of regulation imposed on various firms become significant, new institutions are developed that circumvent these regulations. The parallel financial system developed alongside the traditional system in response to the regulations imposed on traditional banks; thus money market funds, offshore banking, and special investment vehicles are components of this system. Fannie Mae and Freddie Mac had a cost advantage relative to traditional mortgage lenders because of the implicit government guarantee of their bonds, but they also had an advantage because they had much lower capital requirements. During the financial crisis, the money market funds were brought under the umbrella of the federal deposit insurance guarantees to staunch incipient runs – a free lunch for the owners of money market funds and for the firms that issue these IOUs.
It is too soon to determine whether the increase in the costs of regulation that will follow from the Dodd-Frank Law will lead to a significant expansion in the roles of firms in the parallel financial system. Some of these new unregulated firms might be owned by the regulated institutions. There is nothing in the Dodd-Frank Act that would prevent a surge in the supply of credit available for real estate or an increase in real estate prices comparable to the one that occurred after 2002 – or to even more extensive increases. The share of credit from regulated banks would be somewhat smaller because of the regulations. Nevertheless when the real estate bubble of 2020 implodes, some banks will incur such large loan losses that they will be forced to close or to seek a well-capitalized partner for a merger; others will be protected because of the higher level of required capital. How many banks will be forced to close will depend on the scope of the increase in real estate prices during the bubble relative to the increase in bank capital. When real estate prices begin to decline, it is inevitable that there will be runs on the firms in the parallel banking system, much like the runs on the investment banks and the money market funds and the large insured banks in 2007 and 2008 and 2009. The regulators will have said during the bubble years and perhaps earlier: ‘We will not bail out or otherwise support the lenders that have circumvented regulation.’ Perhaps the authorities at the time of the crisis will adhere to this commitment – but the lesson of history is that they will not, and that institutions that were developed to circumvent regulation will receive government financial assistance during the crisis because their failure would be costly for the regulated institutions, because the prices of most assets – except for government bonds – would decline.
The premise for many of the proposed changes in financial regulation and for the major features of the Dodd-Frank legislation is that the cause of the financial crisis was on the demand side and the reckless lending by individual banks and other firms. The competing view is that the cause of the crisis was that the supply of credit had increased at too rapid a rate in the United States, Britain, Ireland, Spain, Iceland, and South Africa; similarly the supply of credit available for the purchase of bonds of the governments of Greece and Portugal had increased at too rapid a rate. Reckless lending and greed had only a minor impact on the supply of credit; the lenders were responding to the rapid increase in the supply of credit. The banks were one of the channels for credit flows. The supply of credit would have been satisfied in some other way if the banks had been more cautious in buying mortgages and mortgage-related securities.
The shortcoming of the proposals for financial reform and the Dodd-Frank legislation is that they do not affect the supply of credit and the increase in the demand for mortgage-related securities. The likelihood is high that if the US financial regulatory regime had been restructured in 2000 along the lines of the Dodd-Frank legislation, the monetary history of the next ten years would not have been significantly different.