Federal reserve Bank oF dallas 2011 annual report
When competition declines, incentives oten turn per-verse, and sel-interest can turn malevolent. That’s whathappened in the years beore the fnancial crisis.
Flaws, Frailties and Foibles
Te nancial crisis arose rom ailureso the banking, regulatory and politicalsystems. However, ocusing on acelessinstitutions glosses over the undamen-tal act that human beings, with all theirfaws, railties and oibles, were behind thetumultuous events that ew saw comingand that quickly spiraled out o control.
Good times breed complacency—notright away, o course, but over time asmemories o past setbacks ade. In 1983,the U.S. entered a 25-year span disruptedby only two brie, shallow downturns, ac-counting or just 5 percent o that period
. Te economy perormedunusually well, with strong growth, lowunemployment and stable prices.Tis period o unusual stability andprosperity has been dubbed the GreatModeration, a respite rom the usual tumulto a vibrant capitalist economy. Beore theFederal Reserve’s ounding in 1913, recessionheld the economy in its grip 48 percent o the time. In the nearly 100 years since theFed’s creation, the economy has been inrecession about 21 percent o the time.When calamities don’t occur, it’s hu-man nature to stop worrying. Te worldseems less risky.Moral hazard reinorces complacency.Moral hazard describes the danger thatprotection against losses encourages riskierbehavior. Government rescues o troublednancial institutions encourage banks andtheir creditors to take greater risks, know-ing they’ll reap the rewards i things turnout well, but will be shielded rom losses i things sour.In the run-up to the crisis o 2008, thepublic sector grew complacent and relaxedthe nancial system’s constraints, explicitlyin law and implicitly in enorcement. Ad-ditionally, government elt secure enoughin prosperity to pursue social engineeringgoals—most notably, expanding homeownership among low-income amilies.At the same time, the private sectoralso became complacent, downplayingthe risks o borrowing and lending. Forexample, the traditional guideline o 20percent down payment or the purchaseo a home kept slipping toward zero, es-pecially among lightly regulated mortgagecompanies. More money went to thosewith less ability to repay.
You need not be a reader o AdamSmith to know the power o sel-inter-est—the human desire or material gain.Capitalism couldn’t operate without it.Most o the time, competition and the ruleo law provide market discipline that keepssel-interest in check and steers it towardthe social good o producing more o whatconsumers want at lower prices.When competition declines, incen-tives oten turn perverse, and sel-interestcan turn malevolent. Tat’s what happenedin the years beore the nancial crisis. Newtechnologies and business practices reducedlenders’ “skin in the game”—or example,consider how lenders, instead o retainingthe mortgages they made, adopted thenew originate-to-distribute model, allowingthem to pocket huge ees or making loans,packaging them into securities and sellingthem to investors. Credit deault swaps edthe mania or easy money by opening acasino o sorts, where investors placed betson—and a ew nancial institutions soldprotection on—companies’ creditworthi-ness.Greed led innovative legal minds topush the boundaries o nancial integrity