Arnold Kling  

What If

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A reader asks,

With regard to the recent financial crisis and current economic recession - if you were given the power to go back in time and change only one thing in an effort to prevent the crisis and recession, what year would you choose, and what one thing would you change?

Here are a few choices, in order of preference, along with my doubts about whether my ideas would have prevented a crisis:

1. 1995. Discourage--rather than encourage--mortgage loans with down payments of less than 20 percent. I am confident that this would have moderated the housing boom and bust. I am less confident that the propensity to take financial risk would have not found another outlet.

2. 1989. Take the advice of the Shadow Regulatory Committee and instead of relying on risk buckets to determine bank capital require banks to issue subordinated debt. The idea is to use market measures of risk. We know that the risk bucket system was completely gamed, through regulatory capital arbitrage. What we don't know is how subordinated debt might have been gamed. Certainly, if the debt were priced under "too big to fail" assumptions, it would lose its value as a market signal.

3. 1990. Limit the size of financial institutions to those whose failures can be resolved quickly without bailouts. This deals with the political economy problem that large banks are able to influence public policy to subsidize risk taking and provide bailouts when they go bad. It does not address the problem that small banks could still take risks that are highly correlated with one another.

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COMMENTS (9 to date)
dWj writes:

I think that first item could have prevented a lot of the problem (and palliated its consequences) even if effectively implemented in 2003 instead of 1995.

Marcus writes:

"Limit the size of financial institutions..."

Concerning this, I'd like to hear your ideas on how financial institutions would respond to this.

In other words, here's a bank, it's growing, it's doing well and wants to keep growing but comes up against this government imposed limit. Certainly they are going to try to think of ways around the limit. What might some of those ways be?

What about stock holders? Are they allowed to hold stock in more than one bank?

Lord writes:

Simply scrutinizing lending for soundness after the Fed dropped rates to 1% or even by 2003, as long as it looked at all lending and regulated for deficiencies, not saying investment banks must know what they are doing better than regulators, would have been sufficient. Not that we would have avoided recession, I doubt anything could have avoided that, but it would not have been nearly so bad and serious.

Lord writes:

The key is documenting and verifying assets and income backing the lending. Only that allows prices to detach from value. Where was the bubble in incomes? No where to be seen. Never has been. Never will be.

Nick writes:

You are not a big believer in the Taylor rule I take it?

Less Antman writes:

1. 1988 - Don't sign the first of the Basel Accords, which established international bank capital requirements that virtually guaranteed the mass securitization of mortgage loans to take advantage of the substantially lower capital requirements and destroyed the integrity of the rating agencies by creating an overwhelming global demand for agency-rated "AAA" securities.

2. 1933 - Don't approve the Banking Act that established the Federal Deposit Insurance Corporation, which has subsidized irresponsible risk-taking in increasing amounts with each amendment.

3. 1789 - Encourage Alexander Hamilton to publicly insult Aaron Burr now instead of waiting until 1804. Without the father of central banking serving as the first American Treasury Secretary, maybe free banking would have had a chance to take hold in the country, and there would be no regulators with the power to destroy the economy of the country nor banks able to rely on the taxpayers to protect them from all disastrous decisions.

Steve Sailer writes:

"1995. Discourage--rather than encourage--mortgage loans with down payments of less than 20 percent."

Zero downpayment mortgages didn't take off until George W. Bush started promoting them in 2002 as the chief policy of his 10/15/2002 White House Conference on Promoting Minority Homeownership. In Clinton's last year, less than 7% of first-time homebuyers in California (where the majority of the money in America was defaulted) made no downpayment. By 2006, it was over 40%.

I think if Gore had won in 2000, the mortgage bust would have been much milder. I don't think were going to understand what just happened to us without coming to terms with Bush's active role in pushing zero downpayment mortgages for everybody under the guise of fighting racist redlining.

Lord writes:

If there were one policy that could have prevented it, it would be not allowing inflation to fall below 5% and allowing it to increase over the last decade. This would have both justified asset price increases and operated as a tax on mercantilism. It would have favored equity over debt and allowed the negative real interest rates such behavior demanded.

Douglass Holmes writes:

Thank you, Steve, for finally pointing out something that George W. Bush did that can believably be tied to our economic woes.

One thing that I think has received too little attention is the tendency to distort the value of housing. People frequently paid less for their houses than they declared when they closed. One way they did this was to not deduct the value of builder's incentives to purchase. For example, a builder may sell a house for $400,000 but give the buyer a $40,000 purchase bonus. The sale price of the house is still listed as $400,000, so the bank is happy to loan the buyer $360,000. I am personally aware of someone who gave a buyer a rebate after the house sale closed in order to allow the buyer to borrow enough money to buy the house without a zero down payment loan. The sale price was listed as $5000 more than what the house actually sold for because the bank didn't want to finance 100% of the price of the house. This practice made the housing values appear to grow when they were actually falling.

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