Arnold Kling  

Some Useful Notes on the Crisis

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Joe Stiglitz. Word!... Stossel and Me...

1. An FDIC document on the risk weights of different bank assets. The higher the weight, the more capital the bank has to hold against that asset. As I read table 1 and table 3, if you originate a loan with a down payment of 20 to 40 percent, the risk weight is 35. But if you buy a AA-rated security, the risk weight is only 20. So if a junk mortgage originator can pool loans with down payments of less than 5 percent, carve them into tranches, and get a rating agency to rate some of the tranches as AA or higher, it can make those more attractive to a bank than originating a relatively safe loan. If you want to know why securitization dominated the mortgage market, this explains it. Regulatory arbitrage, pure and simple.

2. A paper written in 2001 by Paul S. Calem and Michael Lacour-Little. The abstract reads,

We develop estimates of risk-based capital requirements for single-family mortgage loans held in portfolio by financial intermediaries. Our method relies on simulation of default and loss probability distributions via simulation of changes in economic variables with conditional default probabilities calibrated to recent actual mortgage loan performance data from the 1990s. Based on simulations with varying input parameters, we find that appropriate capital charges for credit risk vary substantially with loan or borrower characteristics and are generally below the current regulatory standard. These factors may help explain the high degree of securitization, or regulatory capital arbitrage, observed for this asset category.

Word!

3. Another "teach-in" (I'm showing my Vietnam-era age) on the crisis, this one at MIT. William Wheaton offers some interesting stats: home ownership rose from 64 percent to 69 percent in 8 years. 78% of mortgages are securitized; home building exceeded household formation by 6 percent.


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COMMENTS (21 to date)
JRip writes:

Regarding point 1 -

What if the stuff rated AA should never have been rated AA (or higher)?

What if Moody's and Standard & Poor's were playing games (giving high ratings) to earn fees and to post higher profits (by not doing the work just giving the rating)?

read about this deceit here - in 2 parts:

http://www.bloomberg.com/apps/news?pid=newsarchive&sid=ah839IWTLP9s

http://www.bloomberg.com/apps/news?pid=newsarchive&sid=ax3vfya_Vtdo

So perhaps some of the regulatory gaming was not the fault of the regulation but rather the rating agencies putting sheep's clothing on the fox so it could get into the hen house.

John Turner writes:
Danny writes:

As one of the few readers of yours young enough to have been considered a teen in this century, please stop. It's just painful to read.

Steve Roth writes:

"get a rating agency to rate some of the tranches as AA or higher, it can make those more attractive to a bank than originating a relatively safe loan. If you want to know why securitization dominated the mortgage market, this explains it. Regulatory arbitrage, pure and simple."

Or: failure to regulate ratings agencies, pure and simple.

taxtrumpet writes:

Would I be too cynical in suggesting that this was consistent with the federal government attempting to increase home ownership among the poor and minorities? The rules appear to have been manipulated at every point.

Isaac K. writes:

Steve:
You somehow suspect that with MORE loopholes, this wouldn't have happened?

I don't think it was too little regulation.
Or too much.
I think it was regulation that was targeted at the shadow of the problem rather then the issue itself.

Regardless of what we think the 'issue' or 'cause' is, I think [hope] most of us would agree that whatever regulations existed didn't actually address the underlying problems.

This is similar to ISPs being forced to "crack down" on infringement, child pornography, and other things. It doesn't SOLVE the actual issue at all, it just drives it further underground where it is harder for it to be detected, and brings more attention overall to the subject that wouldn't have existed otherwise.

Take, for example, Pirate Bay.
A haven for P2P filesharing [which, please remember, is not intrinsically copyright infringment], several countries have tried to "block" it from network access, most recently Italy.
Every single time this is tried, it just switches to another IP address, and now the situation is WORSE then before: People still have access, and now the issue has MORE publicity and MORE people know about it. Traffic to the sight is always MUCH HIGHER after one of these failed escapades.

In this case, improper regulation [not necessarily excessive] led to loopholes which the majority of the market tried to exploit, and when the results finally caught up to them, the resulting rush back through the loophole tore open the financial markets.

If bad regulation hadn't existed in the first place, would securitized mortgages have existed? Probably.
But the resulting market saturation with MBS wouldn't have been as wide spread as it was, and the inherent risk would have been MORE transparent, as there wouldn't have been a NEED to hide the risks [e.g.: real 'market' value] in the face of regulation.

Derek Christiansen writes:

In this case, improper regulation [not necessarily excessive] led to loopholes which the majority of the market tried to exploit, and when the results finally caught up to them, the resulting rush back through the loophole tore open the financial markets.

Isaac K.,

I would refer you to Dr. Kling's article on the notion the average voter is a failing econ 101 student; given that postulate, "regulation" is easy to sell to a polity which transfers power to the regulators who then sell that power to small groups who manipulate regulation via lobbying.

Add to this equation economically illiterate politicians like Dodd, Biden, McCain, Obama, and you have a perfect storm of stupidity.

One need only look at the "war on drugs" viz Afghanistan or South Central LA to see there is no understanding of the most basic fundamentals of economics: moral hazard, rent seeking, risk reward, inflation vs deflation...nada, zip zilch, we are led by the ignorant who are empowered by people who think a law changes reality.

And absolutely no one thinks in terms of perverse outcomes or unintended consequences.

As long as the majority thinks in terms of static money amounts "shared" or "hoarded" by actors in the economy (socialist views) you will see regulatory subterfuges whereby the intentions of the ignorant are used to fleece them of their treasure.

I teach my sons to see it as an example of the Jedi mind trick: a politician (doesn't matter what stripe) waves his hand in front of a camera and says, "this law will make (poverty, drug addiction, crime, envy, class conscious inferiority complexes, scary terrorists, Mormon polygamists, etc. ad nauseam) go away and the world will be better! Never mind the reality, these are the laws you want, those aren't the droids you are looking for."

Jayson Virissimo writes:

Arnold, are you considering writing a book on the current financial situation? It seems you are taking your research seriously. It might be good to have something out there with all your thoughts about why it happened, what could have prevented it, and what we should do now. I think you have more inside knowledge about how these kinds of institutions work than most of the other econ bloggers, especialy the ones that are just academics. Just my 2 cents.

mr. Econotarian writes:

"Or: failure to regulate ratings agencies, pure and simple."

A lot of people claim that the Nationally Recognized Statistical Rating Organizations that are recognized by the U.S. Securities and Exchange Commission for financial firms to use for regulatory purposes were "not regulated well", as if we really expect government to be great regulators in the first place.

I put forward the notion: If the SEC actually did tell the NRSROs that they can't label any mortgage backed security AA or higher if it is packaged with loans of >80% loan-to-value, how exactly would the politicians have taken this? Would they have slapped the SEC?

Seeing as the Zero-downpayment FHA act:

http://www.alta.org/washington/news.cfm?newsID=488

was co-sponsored by 30 members, both Democrats and Republicans, there appeared to be bi-partisan support for >80% LTV loans.

Which just goes to show, government is often the worst regulator. Without FDIC regulation, much of the sub-prime mortgages might not have been bunched into MBS (which would be easier to price).

Without the implicit government backing of Fannie and Freddie and without government "oversight" pushing them into sub-prime, $1 trillion of sub-prime loans might not have happened.

Would trillions of dollars of other sub-prime been written by companies that now appear idiotic? Yes, but trillions less would have been written without the inept regulation of government.

Brad Hutchings writes:

The problem is that our political argument is between more regulation and less regulation. We rarely ever look at specific regulations except when they change or disappear and set off a weird nostalgia among those who liked the way they were controlled. Think of the uptick rule.

Just as Arnold proposed (to paraphrase badly) having some kind of independent health board that evaluates and publishes statistics that reveal the effectiveness of particular health procedures, it sure would be helpful to have some kind of independent regulation board which looks at particular regulations and tries to image and find examples of unintended or unfortunate consequences. Anyone who has worked 10 minutes in a regulated business, such as a pre-deregulation utility, knows that there are all sorts of arbitrage opportunities for anyone brave enough to figure the confusing mess out.

DensityDuck writes:

[Comment removed for supplying false email address. Email the webmaster@econlib.org to request restoring this comment. A valid email address is required to post comments on EconLog.--Econlib Ed.]

oinkoink writes:

Arnold,

You're missing the forrest for the tree you found.

"If you want to know why securitization dominated the mortgage market, this explains it. Regulatory arbitrage, pure and simple."

That is just a symptom of the problem. The real problem is that commercial banks, which borrow money from depositors, are currently allowed to invest that borrowed (leveraged) money in securities of any kind - including mortgage-backed securities. It wasn't always this way.

After the stock market crash of 1929, the United States Congress prohibited commercial banks from gambling with depositor's savings in the stock market. That prohibition lasted 66 years

That prohibition, known as Glass-Steagall, was repealed when President Bill Clinton signed the Gramm-Leach-Bliley Act into law in 1999 ... allowing banks once again to enter the stock market casino to gamble with your savings account.

The results have been predictable.

Commercial banks cannot be allowed to own stocks and other securities of any kind, whether they be based on mortgages, or based on anything else.

David Starr writes:

Rating agency vs the wily Mortgage Backed Security. How can S&P or Moodies estimate the odds of one mortgage, let alone a whole tranche of mortgages defaulting? On a single mortgage you have know the current sales value of the property. You have to know the borrowers income, marital status, age, credit history, and interview them. The guy making the mortgage can know this, but a bean counter in a Manhattan office cannot. An AA rating is just a guess based on no decent information.
And the raters are under strong pressure to issue good ratings, lest the bond issuer take his rating business elsewhere.
Once the mortgage issuers can sell their mortgages to a bigger sucker, they loose all interest in vetting them. They will make mortgages that the borrower doesn't have a chance in hell of repaying, just so long as they can dump said mortgage somewhere. The only real solution is to close the entire secondary mortgage market. When the lender holds all the risk, he will be more careful.
Investor's have wised up and will no longer touch mortgage backed securities. It will take a generation for this year's hurt to be forgotten.

Rich Egan writes:

Re: David Starr
This sounds good but my understanding is that lender sell the mortgages to free up money to be able to lend again. Is that true and if so how does what you propose effect this?

I am just asking as I do not know the answer and have had the same thought.

cameron writes:

I just heard a commercial in the Houston area for home loans with just 5% down issued (or backed) by the FHA! We are still doing it!

Quilly Mammoth writes:

What's really stunning, in light of your comments Mr. Kling, is that no one has brought up this comment by Jaime Gorelick on special security issues in May of 2001

“Our approach to our lenders is `CRA Your Way’,” Gorelick said. “Fannie Mae will buy CRA loans from lenders’ portfolios; we’ll package them into securities; we’ll purchase CRA mortgages at the point of origination; and we’ll create customized CRA-targeted securities. This expanded approach has improved liquidity in the secondary market for CRA product, and has helped our lenders leverage even more CRA lending. Lenders now have the flexibility to use their own, customized loan products,” Gorelick said.

Looks like Ms. Gorelick has put the same special touch on our economic security that she did on our national security.

DWAnderson writes:

OinkOink, you post reveals a myriad of misunderstandings of Glass-Steagall, but to name just one Banks were encouraged to invest in securitized mortgages long before 1999.

Arnold, your implicit point (why not add a sentence or two and make it explicit!) is that regulators underestimated the risk of rated mortgage securities and overestimated the risk of normal mortgage loans held in a bank's portfolio with the result being that banks were encourgaged by regulation to increase the risk in their mortgage portfolios.

This isn't just an issue of poor regulation that better regulation could have addressed, but one that is inherent in these sorts of bright line regulations-- because even if an omnicient regulator set the bright lines, there will always be marginal cases not correctly dealt with by the bright line rules. Of course, regulators aren't omnicient so the odds of getting setting up optimal rules are pretty small (the degree of suboptimality may vary of course).

These aren't dispositive arguments against ANY regulation because the moral hazard associated with deposit insurance makes regulation necessary. (Someone needs to watch the credit risk of financial institutions because insured depositors won't.)

In theory the ratings agencies should have acted as a superior private alternative to government regulation and analysis of risk. I would be interested in knowing more about why the ratings agencies weren't able to perform this function very well.

Lastly missing in this analysis is any discussion of the magnitude of the effects I describe above because I don't know much about it. Does anyone?

Reprinted at www.peoplesrepublicof.com.

Jeff Weimer writes:

oinkoink writes:

Arnold,

You're missing the forrest for the tree you found.

"If you want to know why securitization dominated the mortgage market, this explains it. Regulatory arbitrage, pure and simple."

That is just a symptom of the problem. The real problem is that commercial banks, which borrow money from depositors, are currently allowed to invest that borrowed (leveraged) money in securities of any kind - including mortgage-backed securities. It wasn't always this way.

After the stock market crash of 1929, the United States Congress prohibited commercial banks from gambling with depositor's savings in the stock market. That prohibition lasted 66 years

That prohibition, known as Glass-Steagall, was repealed when President Bill Clinton signed the Gramm-Leach-Bliley Act into law in 1999 ... allowing banks once again to enter the stock market casino to gamble with your savings account.

The results have been predictable.

Commercial banks cannot be allowed to own stocks and other securities of any kind, whether they be based on mortgages, or based on anything else.


Unfortunately, you mostly missed the mark. The vast majority of commercial banks haven't failed. Now, WaMu was heavy into this paper, but they had actual subprime mortgages pulling them down too. AIG is mostly an insurance company - not subject to Glass-Steagall. Nearly all of the failures were with wall-street investment banks (who would have been trading in these anyway) and were bought up by commercial banks or became bank holding companies themselves - enabling them to spread their exposure by now being able to accept deposits and hand out actual loans. Gramm-Leach-Bliley actually SAVED these corporations form failing by allowing them to be bought out by other, real banks or diversifying. Just think what would have happened if these investment banks failed and there was no one to buy the assets.

Peter Buxton writes:

Arnold: I apologize if your blog is written to the professional economist, but could I get a definition in the article (maybe an update) as to what regulatory arbitrage means? Or perhaps a link to a post that explains it?

Again, if the audience you're aiming at is the professional economists, ignore this. Thanks.

Obs writes:

I just wanted to say that Arnold's dedication to bringing back the phrase "Word!" is full of win.

parviziyi writes:

Dear Peter Buxton, see the definition of regulatory arbitrage at:
http://en.wikipedia.org/wiki/Arbitrage#Regulatory_arbitrage

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