What Caused the Collapse?: An Exchange

To the Editors:

Jeff Madrick justifiably complains that the Obama administration’s financial reform plan “presents no persuasive hypothesis why the credit system collapsed in the fall of 2008” [“They Didn’t Regulate Enough and Still Don’t,” NYR, November 5, 2009]. But neither does Madrick. He does show, for example, that if the Fed had recognized an unprecedented nationwide housing bubble in the making (rather than local ones in a few “hot” cities), it might have done something to prevent it. But this doesn’t explain what did happen.

Madrick’s “they regulated too little” theme may have led him astray, because underregulation does not convey the whole picture at all. For instance, Madrick draws attention to the spectacular failures of two investment banks—Bear Stearns and Lehman Brothers—whose leverage was high and unregulated. But the fatal problem lay with commercial banks, not investment banks, and commercial banks’ leverage was tightly regulated by the internationally adopted Basel I accords of 1988.

Commercial banks (and mortgage specialists) originate mortgages, and in the run-up to the crisis, investment banks would pool mortgages into tranched mortgage-backed securities (MBS), shares of which were then sold as bonds to investors—including commercial banks themselves. When the housing market turned down, bankrupting the investment banks that had large stocks of MBS, the solvency of the commercial banks was also called into question, because they, too, held large stocks of MBS—an estimated $473 billion worth. The resulting commercial- bank panic and lending freeze caused the recession. So the question that must be answered to produce a credible account of the crisis is why the commercial banks were so heavily overinvested in one particular type of security: mortgage-backed bonds.

The answer appears to be the Recourse Rule, an amendment to the Basel I accords that was issued by the Fed, the FDIC, the comptroller of the currency, and the Office of Thrift Supervision in 2001. The rule conferred huge advantages on commercial banks that chose to increase their leverage by buying “safe” assets, such as mortgage-backed securities issued by an investment bank and carrying an AA or AAA rating from Moody’s, S&P, or Fitch—private companies, on which a 1995 SEC regulation had conferred a de facto oligopoly. By 2008, more than 93 percent of the mortgage-backed bonds held by US commercial banks fit the criteria of the Recourse Rule. The rule explains why commercial banks were so heavily invested in what turned out to be very risky MBS, despite their ratings. The rule therefore may be the best single explanation of the crisis.

Clearly the regulators were predicting that steering banks’ leverage into highly rated MBS would be prudent. This prediction proved disastrously wrong, but the Recourse Rule heavily tilted the field toward banks that went along with the regulators’ prediction. Heterogeneous behavior among competing enterprises normally spreads society’s bets among the different predictions (about profit and loss) made by various capitalists. Thus, the herd mentality is a danger under capitalism, as under every other system. Yet regulation produces the equivalent of a herd mentality by force of law. The whole point of regulation is to homogenize capitalists’ behavior in a direction the regulators predict will be prudent or otherwise desirable. If the regulators are wrong, the result is a system-wide failure. “Systemic risk regulation” may be a contradiction in terms.

Neither capitalists nor regulators can use crystal balls to avoid making bad bets. That highly rated mortgage-backed securities would be prudent turned out to be a very bad bet. But we all suffered because this bet was imposed by financial regulators on the whole system.

Jeffrey Friedman
Editor, Critical Review
Visiting Scholar, Department of Government, University of Texas, Austin

Jeff Madrick replies:

Jeffrey Friedman is correct that I did not offer a complete hypothesis to explain the credit crisis and ensuing recession. That was not my intention. I was analyzing the adequacy of the Obama administration’s reform plan.

But he does seem to think that he himself has solved the problem. It was, he believes, the government that did it. By enabling banks to buy AA-or-higher-rated securities (as permitted by the international Basel agreements), the government gave carte blanche to the banks to make all kinds of foolish investments in mortgage-backed and other collateralized debt securities. I believe this decision was a mistake, as do many others. But it was by no means the major cause of the catastrophe.

Friedman claims that government created herd behavior. Yet most investors know full well that an AA rating does not mean that a bond or other security deserves such a rating. Many securities with the same ratings trade at different prices (or interest rates) because investors don’t believe the credit-rating agencies. No one forced the banks and others to buy mortgage-backed securities. We have had a couple of centuries of damaging herd behavior in financial markets with no government meddling.

What Friedman doesn’t answer is why the banks really bought those securities. They bought them not because the government allowed them to do so. Drivers don’t violate the speed limit because the government gives them a driver’s license. The banks and other investors bought them because they were an easy way during those irrationally exuberant years to make a lot of money and they didn’t adequately consider the risks. The government could have stopped this on grounds of imminent danger, but it did not.

What is more, and this is a key point, conventional commercial banks did not do most of the lending. It is one of the comforting clichés for those who want to believe the government was the principal villain that the government-regulated banks were far and away the main source of trouble, not the less-regulated investment banks, hedge funds, money market funds, insurance companies, or pension funds. In fact, as the incisive analyst and former banker Charles Morris has noted, by the mid-2000s about 75 percent of the nation’s lending was done by nonregulated institutions—that is, not the traditional lending arms of the commercial banks, but what became known as the shadow banks.

What made the commercial banks dangerous was that they nimbly skirted regulations rather than abiding by them; they were able to do so by the use of their relatively new structured investment vehicles and other off-balance-sheet transactions, including trading in derivatives. A main cause of the crisis was precisely those over-the-counter derivatives, which were not regulated, and led many bankers, hedge funds, and investment banks astray by thinking they had adequately insured their investments and could take on more risk. (As an aside, going back a few years, this is why Citi group and JPMorgan Chase lent so much money to the likes of Enron and WorldCom, soon after to become the largest bankruptcies in American history.)

This derivatives free-for-all, too, should have and could have been stopped by able and nonideological regulators. It was not. Herd behavior always existed. Regulatory failure was the major cause of the crisis. Legislation put forward by the House Financial Services Committee headed by Barney Frank, and passed by the House on December 11, would at last require that over-the-counter derivatives now be traded on exchanges or through clearinghouses. The bill, however, included serious exemptions for companies who trade, not to speculate financially, but as part of their business to hedge, for example, currency fluctuations. This exemption from exchange trading will unfortunately dilute the effectiveness of the changes.