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”
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
allowing them to bypass the primary mortgage insurers;
allowing them extreme leverage; and
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
the Securities and Exchange Commis-sion (SEC) designation of approvedcredit rating agencies without the neces-sary supervision;
the use of the credit rating agency des-ignations in risk-based capital require-ments;
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
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