The written testimony is over 9000 words, which I calculate would take about 75 minutes to read out loud. Below is what I planned to say in my five minutes.
[UPDATE: My written remarks are here. Other folks' written remarks are here.]
Chairman Waxman, Ranking Member Davis, and Distinguished Members of the Committee:
It is a privilege to be asked to testify in this forum today regarding the collapse of Fannie Mae and Freddie Mac and the ongoing financial crisis. My name is Arnold Kling. My training is in economics, and in the late 1980's and early 1990's I worked at Freddie Mac, where I was present at the creation of several quantitative risk management tools that paved the way for innovations in mortgage finance.
Speaking as a former financial engineer, I have many regrets about the role played by modern financial methods in this crisis. Rather than speak defensively about financial innovation, I want to offer constructive suggestions for public policy going forward.
I emphatically disagree with the extreme partisan narratives for this crisis. To blame the Community Reinvestment Act for what happened is wrong, To blame financial deregulation for what happened is wrong. The narrative I present in my written testimony describes a combination of government failure and market failure.
I want to focus on how both industry executives and regulators were fooled about the risks in the system. In particular, perverse incentives in bank capital requirements encouraged unsound lending practices and promoted excessive securitization.
When a bank originates a low-risk mortgage, why would the bank pay Freddie Mac a fee to guarantee that mortgage against default? Freddie Mac has no intrinsic comparative advantage in bearing the credit risk. However, in practice, the bank was able to reduce its capital requirements by exchanging its loans for securities. For bearing the exact same credit risk, Freddie Mac was allowed by its regulator to hold less capital than the bank.
By requiring Freddie Mac and Fannie Mae to hold less capital than banks, our regulatory system encouraged Freddie Mac and Fannie Mae to grow at the expense of traditional depository institutions. That turned out to be dangerous.
The perverse regulatory incentives were even more striking with high-risk loans. If a bank originates a high-risk loan, you would think that there is no way to avoid high capital requirements. But it turns out that when a high-risk loan has been laundered by Wall Street, it can come back into the banking system in the form of a AAA-rated security tranche. This means that from the standpoint of capital requirements, bank regulators close their eyes and pretend that the risk has disappeared..
My reading of the history of the secondary mortgage market suggests the following lessons.
1. Capital requirements matter. Details that are easily overlooked by regulators can turn out to cause major distortions.
2. Securitization is not necessary for mortgage lending. On a level regulatory playing field, traditional mortgage lending by depository institutions probably would prevail over securitized lending. Rather than try to revive Freddie Mac and Fannie Mae, I would recommend that Congress encourage a mortgage lending system based on 30-year mortgages originated and held by old-fashioned banks and savings and loans. This would require instructing the regulators of Freddie Mac, Fannie Mae, banks, and savings and loans to all use the same capital standard for mortgages, one that is based on a stress test methodology.
3. Subsidized mortgage credit is an inefficient tool for promoting home ownership. Unless what you want is home buyers who are buried in debt and speculating on house price appreciation, I recommend that Congress not try to create cheap mortgages and instead use other means to encourage home ownership.
4. Recent financial innovations, particularly credit default swaps, have changed our financial system in ways that current policymakers fail to recognize. Bailouts and rescues are counterproductive in today's financial crisis. Within the financial sector, de-leveraging needs to slow down and the process of shutting down failed institutions needs to speed up. Relative to these necessities, handouts from the taxpayers are a hindrance, not a help.