Executive Summary
The current narrative regarding the 2008 sys-temic financial system collapse is that numer-ous seemingly unrelated events occurred in un-regulated or underregulated markets, requiringwidespread bailouts of actors across the financialspectrum, from mortgage borrowers to investorsin money market funds. The Financial Crisis In-quiry Commission, created by the U.S. Congressto investigate the causes of the crisis, promotesthis politically convenient narrative, and the 2010Dodd-Frank Act operationalizes it by complet-ing the progressive extension of federal protec-tion and regulation of banking and finance thatbegan in the 1930s so that it now covers virtually all financial activities, including hedge funds andproprietary trading. The Dodd-Frank Act furthercharges the newly created Financial Stability Over-sight Council, made up of politicians, bureau-crats, and university professors, with preventing a subsequent systemic crisis.Markets can become unbalanced, but they gen-erally correct themselves before crises become sys-temic. Because of the accumulation of past politi-cal reactions to previous crises, this did not occurwith the most recent crisis. Public enterprises hadcrowded out private enterprises, and public pro-tection and the associated prudential regulationhad trumped market discipline. Prudential regu-lation created moral hazard and public protectioninvited mission regulation, both of which under-mined prudential regulation itself. This eventually led to systemic failure. Politicians are responsiblefor both regulatory incompetence and mission-induced laxity.
What Made the Financial Crisis Systemic?
by Patric H. Hendershott and Kevin Villani
No. 693March 6, 2012
Patric Hendershott holds a chair in real estate economics and finance at the University of Aberdeen, Scotland. Previously he held tenure positions at Purdue University and Ohio State University. Hendershott is also aresearch associate at the National Bureau of Economic Research. Kevin Villani is a former chief economist for the U.S. Department of Housing and Urban Development and Freddie Mac.
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It wasn’t the lackof regulatory authority,but rather itspervasivenessand widespreadfailure, that notonly allowedbut caused thesubprime lendingdebacle.
Introduction and Overview
The 2008 global financial collapse ema-nated from the U.S. subprime lending bubble.Economists generally resort to mass psychol-ogy to explain how the bubble could inflateto such an extent, assuming that borrowerand lender behavior was irrational. The FraudEnforcement and Recovery Act of 2009 cre-ated the Financial Crisis Inquiry Commis-sion (FCIC) to investigate why the financialcrisis became globally systemic. The FCIC wascharged with conducting a comprehensive ex-amination of 22 specific and substantive areasof inquiry relating to various and seemingly unrelated hypotheses advanced primarily by politicians, business executives, and univer-sity professors. The final FCIC report (2011)found varying degrees of merit for all of thesehypotheses, blaming the financial crisis on a confluence of generally independent events,such as “recklessness of the financial industry and the abject failures of policymakers andregulators”
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to regulate the essentially deregu-lated or never regulated parts of the mortgageand deposit markets. This justified the 2,300-page Dodd-Frank Act’s regulatory approach.The basic difference between the UnitedStates and other market economies since 1975has been that U.S. mortgage and related mar-kets relied more on federally sponsored andregulated enterprises that were more perva-sively—that’s not to say appropriately—regu-lated. The conventional narrative is that theunregulated private-label securitizers (PLS)like Countrywide and Bear Stearns fundedthe subprime bubble, subsequently draggingdown the giant government-created mortgagefinancers Fannie Mae and Freddie Mac withthem. But all of the markets contributing tothe crisis were already subject to regulationin one way or another. The FCIC Report’sconclusions succeed in diffusing the politicalresponsibility for making the crisis systemicand hence fail as a guide to avoiding futuresystemic crises.The specific regulatory failures necessary for Fannie Mae and Freddie Mac to become soheavily entwined in the subprime bubble were
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allowing them to bypass the primary mortgage insurers;
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allowing them extreme leverage; and
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requiring them to finance at least half of the subprime market.The specific regulatory failures necessary for the private-label securitizers to becomelikewise heavily entwined in the subprimebubble were
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the Securities and Exchange Commis-sion (SEC) designation of approvedcredit rating agencies without the neces-sary supervision;
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the use of the credit rating agency des-ignations in risk-based capital require-ments;
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the failure of bank regulators to pre- vent the deterioration of underwritingguidelines, regulatory arbitrage, off–balance sheet funding, and the rise of the “shadow banking” market; and
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woefully inadequate Securities and Ex-change Commission capital regulationsfor investment banks and account-ing rules that allowed the accelerationof income and delayed recognition of expense.These will all be explained below. However, allof these failures should not obscure a moregeneral problem: federal regulators did notunderstand and mitigate systemic risk.
Regulation and Intervention
Public protection of private enterprises cre-ates a “moral hazard” wherein private enter-prises are more willing to take risk when they know that they will be rescued if they get intotrouble. As a result, protected enterprises willtake excessive risks. Virtually all of the behaviorthat created the subprime lending debacle canbe explained by incentive distortions, mostly moral hazard, and none of this behavior wasnew or irrational. It wasn’t the lack of regula-tory authority, but rather its pervasiveness and
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Market disciplinecan’t be said tohave “failed”during thesubprimelending bubble,because it didn’texist.
widespread failure, that not only allowed butcaused the subprime lending debacle. Add-ing to this, purely political mission regula-tion—specifically, the government-embraced“mission” of expanding homeownership ratesregardless of risk—pushed the bubble to sys-temic proportions.Politicians are responsible for regula-tory oversight, but that oversight failed be-cause of both incompetence and incentiveconflict.
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Politicians and their regulatorsconsistently failed to understand how regu-lation would undermine and replace, ratherthan complement, market discipline. Marketdiscipline can’t be said to have “failed” dur-ing the subprime lending bubble, becauseit didn’t exist; market forces had been re-placed by regulatory oversight. Only marketspeculation operated largely outside of thisregulatory regime, but politicians and theirregulators have always tried to limit and evencriminalize the stabilizing activity of specu-lators “shorting the market.”Banking deregulation has often beenblamed for causing the financial crisis, butit’s unclear why that would be the case. Theso-called “Reagan-era” banking deregula-tion (which was actually signed into law by President Jimmy Carter after being passedby a Democrat-controlled Congress) was thephase-out of deposit interest rate ceilings be-ginning in 1980, and that had nothing to dowith housing finance. The next piece of bank-ing deregulation was the 1994 eliminationof bank branching restrictions, which waspassed by a Democrat-controlled Congressand signed into law in 1994 by Democraticpresident Bill Clinton, and which, again, hadnothing to do with housing finance. The 1999banking reform, passed by a Republican Con-gress and signed by President Clinton, elimi-nated the Glass-Steagall Act’s forced separa-tion of investment and deposit banking. Butthat didn’t seem to contribute to the financialcrisis: the institutions at the heart of the cri-sis—Bear Sterns, Lehman Brothers, Ameri-quest, Countrywide, AIG, and so on—werenot “universal” banks (though many of thoseinstitutions were later merged into universalbanks so as to stabilize them). These reformsall removed political distortions and strength-ened the financial system.The credit allocation goals of mission regu-lation, in contrast, directly conflicted with pru-dential regulation. In the case of Fannie Maeand Freddie Mac, political mission regulationand corruption explains most of the regula-tory failure. In the case of the banks, missionregulation also likely explains why regulatorsdidn’t raise the credit standards for their loansor increase capital requirements.How did the U.S. mortgage markets be-come so much more politicized than thoseof other market economies? The numerousfederally sponsored enterprises that insure de-posits and mortgages, or lend against or makea market in mortgages, all trace their roots tothe response of federal politicians to the GreatDepression.
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Government-provided deposit insurance—introduced in 1933 to prevent bank runs andprotect the payments mechanism—arguably had a positive effect over its first four decadesof existence. But repressive government pro-hibitions on branching and paying interesteventually spawned the “shadow banking sys-tem,” a financial system outside the formalregulated system of banks and thrifts. Moralhazard grew in the banking system as depositprotection became comprehensive, regulatorspromoted bank consolidation over competi-tion between banks, and large banks and otherfinancial firms became “too-big-to-fail”—thatis, so important to the U.S. economy that gov-ernment would rescue them if they got intotrouble. Moral hazard eventually affected theentire shadow banking system as well, whichsubsequently played a role in funding the sub-prime lending debacle.
Intervention in Housing
Mortgage market enterprises such as Fan-nie Mae and Freddie Mac were introduced tomaintain “liquidity” of mortgage lenders andstimulate housing construction and jobs. In-stead of acting as traditional mortgage compa-nies that raise money from investors and thenuse that money to extend loans to individual
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What Made the Financial Crisis Systemic?, Cato Policy Analysis No. 693
The current narrative regarding the 2008 systemic financial system collapse is that numerous seemingly unrelated events occurred in unregulated or underregulated markets, requiring widespread bailouts of actors across the financial spectrum, from mortgage borrowers to investors…
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