Arnold Kling  

The Insider Narrative

Neil Barofsky's Dog Whistle... Are Libertarians Especially Pr...

Michiko Kakitani reviews David Wessel's new book, In Fed We Trust. She likes it more than I do. I think it is too much of an insider's narrative.

There are two dimensions on which people differ about the financial crisis. There is Left and Right; and there is Insider and Outsider. The Left thinks that deregulation did it. "If only they had not repealed Glass-Steagall. If only they had put credit default swaps on an organized exchange. If only there had been a systemic risk regulator."

Anyone familiar with my views on the crisis knows that I think that all of these stories are silly. I think that the fundamental reason that we had a crisis in the mortgage market was bad housing policy. And the fundamental reason that we had a flimsy financial structure was regulatory capital arbitrage--structures designed to exploit loopholes in regulatory capital requirements.

The Left wants to resuscitate mortgage securitization with better regulation. I am for a more fundamental rethinking of housing policy, that does not try to push mortgage indebtedness to the limit in order to raise home "ownership" rates. I also believe that if capital requirements were sensibly tied to risk, then we not even see mortgage securitization, much less the layers of CDO's and SIV's that were built on top of it.

The difference between insiders and outsiders concerns whether troubled financial institutions needed to be propped up or shut down. The insider view is that the main problem was a loss of confidence, and government assistance is important to solving that problem. The outsider view is that the banks were too big, too highly leveraged, and took on too many bad mortgage assets.

The insider view is that the Lehman bankruptcy was the key event in the crisis. The outsider view is that not enough institutions were put out of their misery.

Although Wessel is generally a straight shooter, his book seems to be (I have only had time to skim it) a pure Left-insider narrative. If so, then it has little to offer other than personality gossip about players like Bernanke and Paulson.

The Left-outsider view is represented by Simon Johnson, James Kwak, and The Quiet Coup.

The Right-insider view is represented by Gary Gorton and Perry Mehrling. They think all that securitization needs is for the government to hold the super-senior risk.

The Right-outsider view is represented by yours truly.

UPDATE: I also received the other book reviewed in the Times, called A Colossal Failure of Common Sense, a diatribe about Lehman. I opened to a random page, and read

The goddamned cat was out of the bag, and we were staring at an ugly, sneering face engraved on a very hot potato

Not the style of writing that appeals to me.

On the other hand, I can recommend this short paper on credit default swaps. Although they recommend a clearing house for some swaps, they point out that a clearing house would have been no panacea and in particular would not have taken care of the AIG problem.

COMMENTS (8 to date)
gnat writes:

My reading is that housing policy trailed the market and did not constrain it rather than led the market and FHA and the GSEs lost market share.
From Wiki(subprime mrtgage crsis):
So why did lending standards decline? In a Peabody Award winning program, NPR correspondents argued that a "Giant Pool of Money" (represented by $70 trillion in worldwide fixed income investments) sought higher yields than those offered by U.S. Treasury bonds early in the decade. Further, this pool of money had roughly doubled in size from 2000 to 2007, yet the supply of relatively safe, income generating investments had not grown as fast. Investment banks on Wall Street answered this demand with financial innovation such as the mortgage-backed security (MBS) and collateralized debt obligation (CDO), which were assigned safe ratings by the credit rating agencies. In effect, Wall Street connected this pool of money to the mortgage market in the U.S., with enormous fees accruing to those throughout the mortgage supply chain, from the mortgage broker selling the loans, to small banks that funded the brokers, to the giant investment banks behind them. By approximately 2003, the supply of mortgages originated at traditional lending standards had been exhausted. However, continued strong demand for MBS and CDO began to drive down lending standards, as long as mortgages could still be sold along the supply chain

Steve Sailer writes:

Obviously, mortgages were to the the current troubles what Pearl Harbor was to American involvement in WWII. You can make a plausible argument that even without Pearl Harbor, we would have gotten involved in WWII later on anyway, but that's no reason to ignore Pearl Harbor.

Adam writes:

I'm with you Arnold. I see three decades of legislation and regulatory changes that led to massive investment dislocations and a massive housing price bubble. It's time to write books and piece it all together.

Maniel writes:

Arnold wrote: "I am for a more fundamental rethinking of housing policy, that does not try to push mortgage indebtedness to the limit in order to raise home "ownership" rates. I also believe that if capital requirements were sensibly tied to risk..."

Well said, as far as it goes. My question is, why do we need a "housing policy" and who is qualified to tell me whom I can buy from, borrow from, live with, sell to, etc? With government continuing to subsidize home mortgages, the demand-side bias for debt is still in place. This is a little bit like our "eating policy" where we subsidize farmers to grow corn, corn, and more corn, as well as to produce more milk products than we need. And it's not unlike our "drug policy" where we restrict the sale of certain substances to criminal organizations (by definition). Beware the coming expansion of our "health care policy."

Lib outsider

Dean Kalahar writes:

Mr. Kling,

I enjoy your blog and agree with the comment on not enjoying that sort of writing. Cute and offensive is usually a sign of a weak and emotionally based argument void of understanding the reality of a little thing we call scarcity.

You may not remember me, but you reviewed my book Practical Economics last year for me- again thank you very much- and I thought I would let you know it has been published and is ready for consumption by hopefully thousands of high school and college students who have not a clue as to the workings of economcs. For that matter, most adults could benefit from its scope and sequence.

Let me know if you would like a free copy and please visit my blog devoted to the book at

Dean Kalahar

Marc Resnick writes:

Another dimension is short term v long term fixes. Encouraging MORE housing would be a short term fix to reduce the housing oversupply. It would also rejuvenate the construction industry and employment. Of course this would make the long term problems worse.

The problem is that politicians work on barely a 1-2 year election cycle. So many are happy to focus on short term fixes that get them re-elected, even at the expense of long term fundamentals.

B.B. writes:

This crisis is so new and big and abstract, it is hard to get our arms around it. So think back to an older example. The tragic sinking of the Titantic. The same set of issues.

(1) The cause of the sinking was bad decisions by the captain and inadequate survellience by the night crew. (Analogy: It was the fault of Bad Bush and stupid investment bankers. Replace them and we would have had no crisis.)

(2) Moral hazard: because the passengers thought they would be, so to speak, bailed out, they had no incentive to monitor the condition of the ship and crew. (Analogy: Let Lehman got bankrupt to teach them a lesson.)

(3) The cause of the sinking was bad luck, it hit a random iceberg. (Analogy: The US had a string of random bad events. We were unlucky, and there is no reason to change anything.)

(4) The Titantic's sinking may have been unavoidable but the deaths of 1800 people was avoidable. The company was negligent in not providing enough lifeboats. We need regulation. (Analogy: investment bankers leveraged too much, a reckless gamble.)

(5) The Titantic was built to be unsinkable, so why worry? (Analogy: we have the Fed and SEC, and we have the Great Moderation. Why worry?)

(6) We need to build ocean liners even better so that they won't sink even hitting an iceberg. (Analogy: make the financial system crash proof.)

For what it is worth, there was an Anglo-American commission after the sinking. It made recommendations: tracking of icebergs, 24/7 radio watch, sufficient lifeboats. We have not lost another ocean liner to an iceberg hit. Policies and institutional change can make a big difference.

Mike Rulle writes:

The issue, similar to what Arnold has written about securitization and regulatory arbitrage, is not whether we need a clearinghouse per se in CDS. It is whether the collateral requirements are comparable for OTC and exchange traded derivatives.

Bottom line on AIG: They never would have written as much CDS as they did if they had to post collateral, per rules of the exchanges AND the standard practice of OTC dealers. They would not have had the cash to do it. At worst, there would not have been a sudden "long" squeeze of forced collateral posting--as the cash would have already been there.

But the real answer is they never would have gotten as big. "Standardization" and "Clearinghouses" per se are red herrings. It was, once again, the existence of uneven or inconsistent regulations that created the excess leverage at AIG. The market always "magically" finds the weakest link in the chain.

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