FINANCIAL MARKETS

MELTDOWN
What Can We Learn from Minsky?
i. v\xn\ii wv\s
Public Policy Brief
The Levy Economics Institute of Bard College
No. 94, 2008
Public Policy Brief
FINANCIAL MARKETS
MELTDOWN
What Can We Learn from Minsky?
i. v\xn\ii wv\s
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Editor: W. Ray Towle
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ISSN 1063-5297
ISBN 978-1-931493-75-8
Preface . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
Dimitri B. Papadimitriou
Financial Markets Meltdown . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
L. Randall Wray
About the Author . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48
Contents
The Levy Economics Institute of Bard College 5
Preface
The current financial crisis has not only gripped the media on a daily basis
and affected the average American in terms of housing and personal con-
sumption, but it has also raised questions about the viability of the finan-
cial system. The U.S. economy is heading toward, or may already be in, a
recession, and the Federal Reserve is attempting to stem the tide by reduc-
ing interest rates and acting as the lender of last resort. Stock markets have
declined and become increasingly volatile, and the extent of the economic
downturn is uncertain.
In a series of papers, Levy Institute scholars warned that the continu-
ation of current practices and policies in the United States meant that a cri-
sis was inevitable. Hyman P. Minsky’s financial fragility hypothesis is
frequently used to explain the current crisis. Minsky hypothesized that the
structure of a capitalist economy becomes more fragile over a period of
prosperity. As expressed in this brief by Senior Scholar L. Randall Wray, the
belief that the world is now more stable and less vulnerable to“shocks” (the
“Great Moderation”) allowed greed to trump fear. According to Wray,
Minsky would label the faith in the era of the Great Moderation a “radical
suspension of disbelief.”
Wray explains the historical development that led to today’s complex
and fragile financial system and how the seeds of crisis were sown long ago
by lax oversight, risky innovations, and deregulation during a lengthy period
of relative stability. Irrational exuberance, which was based on the belief in
the “new economy” in the 1990s, and unprecedented real estate appreciation,
which validated increasingly risky Ponzi finance in the 2000s, are the result
of long-term, policy-induced, profit-seeking financial innovations.
The traditional role of banks evolved in order to mitigate the risk of
another debt deflation rivaling the Great Depression. However, govern-
ment relaxed regulations so that banks could take direct positions in all
6 Public Policy Brief, No. 94
aspects of the financial system. According to Wray, many of today’s problems
can be traced back to securitization (the “originate and distribute” financial
model), leverage, the demise of relationship-based banking, and the dizzying
array of extremely complex instruments that only a handful understand.
Asset price depreciation will not be restricted to residential real estate.
As economic activity slows, there will be revelations of problems through-
out the entire financial sector. Wray estimates that the combined losses
could amount to several trillion dollars (in a $13 trillion economy).
Moreover, the United States will feel the effects of the current crisis for
some time—perhaps a decade or more.
Wray notes that the policy initiatives of the George W. Bush
Administration appear to be designed to help creditors rather than debtors,
and he instead recommends much larger stimulus packages, which are prob-
ably politically infeasible. A return to stagflation looks increasingly likely, as
it will be difficult for the United States to grow its way out of the problem.
Wray discusses lessons from Minsky that could be used to reformulate
policy and deal with the present crisis. He calls for mortgage relief that sta-
bilizes the real estate sector and reform that amends the bankruptcy laws.
He also calls for preserving home ownership and creating a new institution in
line with President Franklin D. Roosevelt’s Home Owners’ Loan Corporation.
According to Minsky, government should act as the employer of last resort
in order to eliminate involuntary unemployment and reduce inequality and
poverty. Minsky preferred policy that would promote small- to medium-size
financial institutions (rather than their consolidation), and policy that was
biased toward market segmentation.
We must return to a more sensible model, with enhanced oversight of
financial institutions, says Wray. Monetary policy should stabilize interest
rates, maintain direct credit controls, and strengthen its supervisory and
regulatory functions. Furthermore, bailouts will be required. As Minsky
put it, “A financial crisis is not the time to teach markets a lesson by allow-
ing a generalized debt deflation to ‘simplify’ the system.”
As always, I welcome your comments.
Dimitri B. Papadimitriou, President
March 2008
In previous work, I examined the problems in the securitized subprime
mortgage market that led to a crisis last summer (Wray 2007, 2008). Many
commentaries on the mortgage securities meltdown have referred to the
work of the late Hyman P. Minsky, probably the most astute observer of the
financial system of the past century, with some even calling it a “Minsky
moment” (Whalen 2007, Magnus 2007, Cassidy 2008). With 20/20 hind-
sight, pundits finally recognized the real estate bubble and the dangerous
financial practices that had developed in that sector over the previous four
or five years. A few now recognize that problems have spread far beyond
mortgages and real estate. Still, the conventional view is that the damage
will be contained through a combination of interest rate cuts and the fiscal
stimulus package that will send checks to most taxpayers in late spring 2008.
The majority of commentators, including officials at the Federal Reserve
(Fed), still project a moderate reduction of growth, with recovery later this
year. While it is believed that it could take residential real estate several years
to recover, and while there are calls for reregulation of the home mortgage
industry, few analyses recognize the true depth of the problems facing the
financial system.
This brief will provide a Minskyan analysis of the forces that have
brought us to the present situation, and will make some general policy rec-
ommendations to ameliorate the damage done to the financial structure
over the past couple of decades by lax oversight, risky innovations, and
deregulation. What we actually confront is a systemic failure resulting from
a fundamentally flawed model—what has been variously called “market
fundamentalism,” “transactions-oriented capitalism,” and, in Minsky’s
phrase, “money manager capitalism.” Indeed, Minsky’s writings can shed a
lot of light on the current problems, as well as on the direction that finan-
cial system reform ought to take. To be sure, this downturn might prove to
Financial Markets Meltdown
The Levy Economics Institute of Bard College 7
8 Public Policy Brief, No. 94
be shallow, the real estate sector might recover more quickly than most
expect, and losses and write-downs at financial institutions might subside.
Still, if the fundamental problem is with the design of the financial system
itself, yet another crisis will arrive shortly to expose other flaws. For that
reason, reform is needed.
Before proceeding, it is important to distinguish the framework adopted
here from popular explanations that blame real estate sector excesses for the
meltdown. Minsky would not attribute the crisis to “irrational exuberance”
or “manias” or “bubbles.” Those who were caught up in the boom behaved
“rationally,” at least according to the “model of the model” they had devel-
oped to guide their behavior. That model included the prospective course of
asset prices, future income, behavior of policymakers, and ability to hedge
risks or shift them onto others. It is only in retrospect that we can see the
boomfor what it was: mass delusion propagated in part by policymakers and
those with vested interests. However, a large part of the blame must be laid
on the relative stability experienced over the past couple of decades—the
tranquility that made the boom possible also created fragility because,
according to Minsky, stability is destabilizing. It is far too simple to attribute
the current crisis to a speculative boom in real estate, to excessive monetary
ease, or even to lax supervision. The causes are complex and have developed
over a very long period. As such, solutions will also be multifaceted, tentative,
and contingent upon continued evolution of the financial system, with an eye
to longer-term trends that have made the system much more prone to crisis.
Money Manager Capitalism and the Systemic Nature
of the Crisis
What was recently seen as “creative” and “innovative” democratiza-
tion of credit is now viewed as misguided and culpable bungling—or
worse.
—Alex J. Pollock (2007)
The financial system is a lot more trouble than it is worth.
—Warren Mosler (2008)
Speculators may do no harm as bubbles on a steady stream of enter-
prise. But the position is serious when enterprise becomes the bubble
on a whirlpool of speculation.
—John Maynard Keynes (1964)
Irrational exuberance? No, the seeds of the current financial crisis were sown
long ago. As I have previously documented, the story begins with the Fed’s
increasingly aggressive use of interest rate changes in an effort to fine-tune
the economy (Wray 2007, 2008). Each rate hike intended to fight inflation
caused problems for commercial banks and thrifts that were subject to
Regulation Q interest rate ceilings, as well as usury laws that limited loan
rates, causing them to suffer “disintermediation” (retail deposit withdrawals)
when market rates rose above legislated deposit rates. The interest rate ceil-
ings allowed the Fed to engineer “credit crunches” by pushing market rates
up. In addition, other rules and regulations that dated to the NewDeal finan-
cial reforms also constrained practice to preserve safety and soundness.
However, as in Minsky’s scenario, financial institutions responded to
each tight-money episode by innovating and creating new practices and
instruments—making the supply of credit ever more elastic (Wray 1994).
As time passed, the upside tendency toward speculative booms became cor-
respondingly more difficult to contain. In addition, the Fed and Congress
gradually removed constraints, allowing commercial banks to engage in a
wider range of practices in order to better compete with their relatively
unregulated Wall Street rivals. Still, deregulation and legal recognition of
new practices were not, by themselves, sufficient to bring us to the present
precipice. If these innovations had led to excessively risky behavior that gen-
erated huge losses, financial institutions would have been reluctant to retain
them. According to Minsky, the remarkable thing about the postwar period
is the absence of depressions. While recessions occur with regularity, they
are constrained; while financial crises arise from time to time, the fallout is
contained. This is due in part to the various reforms that date to the New
Deal, but also to countercyclical movement of the “Big Government” budget,
to lender-of-last-resort activity of the “Big Bank” Fed, and to periodic bail-
outs arranged by the Fed, the Treasury, or Congress. As Minsky always
argued, by preventing “it” (a debt deflation on the order of the 1930s col-
lapse) from happening again, new practices and instruments were validated.
The Levy Economics Institute of Bard College 9
10 Public Policy Brief, No. 94
In other words, irrational exuberance is just the end result of long-
term, policy-induced (and in turn, policy-validated), profit-seeking financial
innovations that stretched liquidity and enabled prices of real estate and
equity to reach unjustified and unsustainable levels. Just as the irrational exu-
berance that developed in equity markets in the 1990s was based on the belief
that a “new economy” had created conditions in which dot-com companies
could only rise in value—validating exploding stock prices—the 2000s saw
unprecedented real estate appreciation that validated increasingly risky Ponzi
finance. Yet, both bubbles were fueled by a combination of optimistic expec-
tations that developed over many years, and the search for high returns by
money managers of funds that had accumulated wealth over decades.
This growth of managed money continually eroded banks’ traditional
lines of business, as pension funds, insurance funds, hedge funds, and so on
provided an alternative source of funds in competition with bank loans.
Initially, bank funding had an advantage over market sources of funding
because banks could diversify risks across a large number of borrowers with
different income sources. Further, banks had access to insured deposits as
well as Fed lender-of-last-resort intervention, ensuring they could issue lia-
bilities without facing much chance of a run. However, by the early 1970s,
firms were already turning to the commercial paper market for short-term
borrowing, taking business away from banks. As Minsky (1986) noted, an
early crisis in the commercial paper market led to the practice of obtaining
backup lines of credit with banks. On the one hand, banks then could earn
fee income for provision of the backup facilities, but on the other hand, this
practice reduced their competitive advantage in direct funding of business.
Other market innovations allowed for diversification of risk in the form of
issued securities collateralized by pooled loans—apparently eliminating the
advantage banks had previously held.
Over time, new instruments continually eroded the bank share of assets
and liabilities—which fell by half between the 1950s and the 1990s, as shown
in Table 1.
1
The securities market share of private nonfinancial debt rose
from 27 percent in 1980 to 55 percent in February of this year (Greenlaw
et al. 2008). Banks were forced to become more market-oriented, settling
for a smaller share of the financial system, while servicing Wall Street firms
would replace some of the relationship banking they had lost. Minsky (1987)
observed that banks appear to require a spread of about 450 basis points
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The Levy Economics Institute of Bard College 11
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12 Public Policy Brief, No. 94
between interest earned on assets and that paid on liabilities. This covers
the normal return on capital, plus the required reserve “tax” imposed on
banks (reserves are nonearning assets) and the costs of servicing customers.
By contrast, financial markets can operate with much lower spreads pre-
cisely because they are exempt from required reserve ratios, regulated cap-
ital requirements, and much of the costs of relationship banking.
To restore profitability, banks would earn fee income for loan origina-
tion, but by moving loans such as mortgages off their books, they could
escape reserve and capital requirements. (They might continue to service
the loans, earning additional fees.) There was no need to develop relation-
ships with individual borrowers in order to assess creditworthiness, since
loan pools diversified risks, risk raters evaluated the risks of the overall
pools, and insurers protected against losses. To replace lost income, banks
began to take direct positions in the poolers, the securities, and the insur-
ers. They also provided backup liquidity guarantees to those involved in
packaging and selling securities, and even gave money-back guarantees to
holders of securities if the underlying loans went bad. Ironically, this meant
that they were now exposed to default risk of borrowers they had never
assessed. Indeed, as it turned out, no one had assessed those risks.
This is why the problem is not confined to subprimes or to an irra-
tional real estate market. It is a systemic problem resulting from the notion
that markets can properly assess risk based on complex, backward-looking
models; that markets can hedge and shift risk to those best able to bear it;
and that market forces will discipline decision making. In fact, each of
those presumptions proved to be woefully incorrect. The models were con-
structed based on data generated during an unusually stable period in
which losses were small, and required that the structure of the financial sys-
tem remain constant. However, as Minsky (1986) observed, relative stabil-
ity will necessarily encourage behavior that changes the financial structure
(he used the terms hedge, speculative, and Ponzi to describe the transforma-
tion). This evolution, in turn, rendered the models increasingly useless
even as they were used on a grander scale to justify falling interest rate
spreads that implied virtually no defaults would ever occur. Further, as is
now recognized, the models could not account for growing interrelations
among debtors, increasing the systemic risk that insolvency by some would
generate a snowball of defaults. This was another process that Minsky
The Levy Economics Institute of Bard College 13
always emphasized, and one that is enhanced by the high leverage ratios
that became common in the 2000s as margins of safety were reduced.
Further, as we now know, risk was not properly hedged, nor was it even
necessarily shifted. Much of it came back directly to banks through buy-
back guarantees, backup credit facilities, and bank purchases of securities.
And, finally, markets did not discipline behavior but in fact encouraged
ever-riskier activities. For example, the increased competition coming from
managed money narrowed interest rate spreads, but because managers of
funds were in a desperate search for high returns, they were forced to ignore
risk where it was underpriced. In other words, competition forced them to
take on excessive risk given returns. Many did not even pretend to under-
stand the instruments they were buying, as they were content either to rely
on ratings agencies or to simply followthe leader down the path to inevitable
destruction. As Keynes (1964) put it, “Worldly wisdom teaches that it is bet-
ter for reputation to fail conventionally than to succeed unconventionally.”
Securitization and Leverage
That which can be securitized will be securitized.
—Hyman P. Minsky (1987)
It’s not the things you don’t know that cause disasters; it’s the things
you do know, but aren’t true.”
—Mark Twain (quoted in Black 2007)
As we know, there are “known knowns”; there are things we know we
know. We also know there are “known unknowns”; that is to say we
know there are some things we do not know. But there are “unknown
unknowns”—the ones we don’t know we don’t know.
—Donald Rumsfeld (2002)
While the troubled instruments and institutions are varied, many of today’s
problems can be traced back to securitization—the pooling of assets to serve
as collateral against issued securities. While seemingly innocuous, securitiza-
tion has led to a dizzying array of extremely complex instruments that—
14 Public Policy Brief, No. 94
quite literally—only a handful understand. Warren Buffet has called the
new instruments “financial weapons of mass destruction.” An exasperated
Bank of America CEO proclaimed after massive losses on complex posi-
tions in such instruments, “I’ve had all the fun I can stand in investment
banking,” as his firm announced plans to scale back such operations
(Norris 2008a). Economist M. Cary Leahey (2007) said the problem is in
“opaque hard-to-value credit derivatives,” which is why a bank might value
derivatives at $90 billion one day and at $22 billion the next (Norris
2008b). Merrill Lynch (2007) opined that collateralized debt obligations
(CDOs) “are arguably the most complex financial instrument ever to
become mainstream.” Throughout the financial world, “mark to model” or
even“mark to myth”substituted for “mark to market”because markets could
not value the instruments.
2
By fall 2007, markets had lost faith in the mod-
els and the myths.
The current financial crisis began in the market for mortgage-backed
securities (MBSs), especially in the subprime section of that market. It
quickly spread to securities backed by “Alt A” mortgages (less risky than
subprime, but too risky to qualify for conventional loans), and then to
more exotic markets—CDOs, asset-backed commercial paper (ABCP), and
other asset-backed securities (ABSs, including other types of consumer
debt). Further, problems spread beyond specific asset classes to institutions
such as special purpose vehicles (including special investment vehicles, or
SIVs) and monoline insurers (which provide insurance for MBSs), and to
major financial institutions (including private banks as well as government-
sponsored enterprises like Fannie Mae). Still other financial instruments,
such as municipal bonds and credit default swaps (CDSs), are threatened,
although it is too early to say how hard they will be hit. Finally, the credi-
bility of real estate agents, property appraisers, accountants, credit-rating
agencies, mortgage brokers, and financial institution officers has been
called into question because of practices that have developed over the past
decade. It wasn’t supposed to happen this way—securitization was sup-
posed to reduce risk and to shunt it to those best able to handle it. But, as
George Soros (2008) said, “Everything that could go wrong did go wrong.” In
this section, we will examine the phenomenon of securitization; later, we
will look in more detail at its consequences.
Securitized Products Dollars (Billions) Percent
Total 10,228 100
MBSs 7,750 76
Residential 7,100 69
Subprime 1,300 13
Prime 5,800 57
Commercial 650 6
ABSs 2,478 24
Home Equity 596 6
Credit Card 343 3
Student Loans 236 2
Auto-related 199 2
CDOs/CLOs 302 3
Other* 802 8
Memo: CDSs 45,000
Memo: Nonfinancial Corporate Debt 9,000
Memo: Commercial Paper 2,500
Memo: Leveraged Buyouts 13,300
Table 2 U.S. Credit Instruments by Type, 2007 (in billions of dollars)
* Miscellaneous items, including equipment leases.
Sources: Leahey 2007, Lim 2007, Greenlaw et al. 2008
The Levy Economics Institute of Bard College 15
To put things in perspective, it is useful to get some idea of the relative
sizes of these credit instruments. As of last year, activity in the world’s over-
the-counter derivatives market was about $2.1 trillion per day, while world
trade was just $12 trillion per year. At the end of 2007, the total U.S. secu-
ritized bond market was estimated at about $10.2 trillion, of which resi-
dential MBSs made up $7.1 trillion (with subprimes totaling $1.3 trillion
of that) and commercial MBSs totaled $650 billion (Table 2). Other ABSs
totaled nearly $2.5 trillion, almost $600 billion of which was held in secu-
rities backed by home equity loans; securities backed by student loans and
auto-related borrowing amounted to another $435 billion; CDOs and col-
lateralized loan obligations together equaled just over $300 billion; and
credit card ABSs reached $343 billion. Total credit card debt has also been
fast growing—the growth rate reached 9.3 percent in the fourth quarter of
2007 and now totals roughly $1 trillion dollars (Merrill Lynch 2007; UBS
Investment Research 2007; Leahey 2007).
16 Public Policy Brief, No. 94
In recent years, nonfinancial corporate debt has also been growing
rapidly—three times faster than GDP—in spite of high profit rates, and
now totals over $9 trillion (Leahey 2007). Outstanding commercial paper
peaked at $2.5 trillion in mid-2007, withABCP equal to $1 trillion (Greenlaw
et al. 2008). Leveraged buyouts in the first half of 2007 reached $13.3 trillion
(Lim Mah-Hui 2007). Estimates of the total quantity of CDSs are as high
as $45 trillion, having grown ninefold in the past three years. Of course,
these are not directly comparable to credit derivatives because most will
not be exercised.
3
Bank exposure to CDSs is estimated at $18.2 trillion, a
sum nearly equal to the total value of U.S. residential real estate ($20 tril-
lion). Naturally, just citing gross estimates of the size of financial instru-
ments does not necessarily say anything about risks to the financial system
or to the “real” economy. However, these numbers do help to clarify why
even single-digit percentage losses on financial assets can generate very big
numbers relative to GDP.
Securitization is a “market-oriented” financial practice, in contrast to
“bank-based” transactions in which activities are financed by loans held
on bank balance sheets against deposits held in the banking system.
Securitization has also been called the “originate and distribute” model,
which accurately captures a distinguishing feature of the process: the insti-
tution that arranges the finance of activities does not hold the loan. Lots of
presumptions about these instruments and practices have been exploded
in recent months, including the belief that securitization shifted risks off
bank balance sheets, that securitization allowed for diversification of risks
while efficiently allowing investors to achieve the proper risk/return trade-
off, and that securitization put risk into the portfolios of those best able to
handle it. These were little more than bedtime stories told on Wall Street
and in Washington to justify risky and unsupervised practices that were
characteristics of what was variously called “financialization,”“market fun-
damentalism,” or “transactions-oriented capitalism.”
Minsky (1987) argued that securitization was part and parcel of the
globalization of finance, as it creates financial paper that is freed from
national boundaries. German investors with no direct access to U.S. home-
owners could buy a piece of the action in U.S. real estate markets. The
problem is that the incentive structure in which mortgage originators oper-
ated was sure to create problems. In the aftermath of the 2000 equity market
The Levy Economics Institute of Bard College 17
crash, investors in dollar assets looked for alternative sources of profits. The
low interest rate policy of the Fed under former Chairman Alan Greenspan
meant that traditional money markets could not offer adequate returns.
Investors lusted for higher risks, and mortgage originators offered sub-
primes and other “affordability products” with ever-lower underwriting
standards. Greenspan gave the maestro seal of approval to the practice, urg-
ing home buyers to take on adjustable rate debt.
4
As originators would not hold the mortgages, there was little reason to
worry about borrowers’ ability to pay. Indeed, since banks, thrifts, and
mortgage brokers relied on fee income rather than interest, their incentive
was to increase throughput, originating as many mortgages as possible. By
design, the Orwellian-named “affordability products” were not affordable—
at the time of reset, the homeowner would need to refinance, generating
early-repayment penalties and more fees for originators, securitizers, holders
of securities, and all others in the home-finance food chain. Ironically,
this shift to “markets” reduced the portion of the financial structure that
the Fed is committed to regulate, supervise, and protect—something that
was celebrated rather than feared. The fate of homeowners was sealed by
bankruptcy “reform” that makes it virtually impossible to get out of mort-
gage debt—another very nice “credit enhancement,” provided in this case
by Congress.
5
Subprime lenders often require borrowers to carry credit life
insurance (conveniently sold by the lender’s subsidiary, with high premiums)
that would pay off the mortgage in the event of death, further enhancing the
securities.
Finally, some of the subprime loans are covered by mortgage insurance,
but more importantly, insurance was sold on the securities themselves. Such
insurers—often called monolines—include MBIA (the world’s largest
financial guarantor), AMBAC, FGIC Corporation, and CFIG. These firms
had traditionally insured municipal bonds and their foray into mortgage-
backed securities seemed to be a sensible extension to a much more prof-
itable sector that did not appear to be much riskier, since MBSs were rated
by the agencies (Moody’s, Standard and Poor’s, Fitch). The health of the
insurers, in turn, was assessed by the same ratings agencies, as well as by
the ABX subprime index, which tracks the cost of insuring against defaults
on subprime securities. Insurance allowed the debts to gain the highest
18 Public Policy Brief, No. 94
ratings—ensuring a deep market and low interest rate spreads (Richard
and Gutscher 2007).
6
The incentives to increase throughput, combined with credit enhance-
ments, led banks to abandon their reluctance to purchase securities with
the riskiest underlying debts. Ironically, while relationship banking had
based loans on the relevant characteristics of the borrower (such as income,
credit history, and assets), the new arrangements appeared to offer a nearly
infinite supply of impersonal credit with no need to evaluate borrowers’
ability to repay. Instead, “quant models” based on historical data regarding
default rates of purportedly similar borrowers would replace costly rela-
tionship banking, enhancing efficiencies and narrowing interest rate spreads
(Kregel 2007).
ABSs with high ratings would be purchased by hedge funds and oth-
ers that would use the securities as collateral to raise funds for their pur-
chase (much as in leveraged buyouts, where the firms to be purchased are
used as collateral for the funds borrowed for their takeover). In many cases,
banks provided the loans that were used to buy the ABS collateral that con-
tained the mortgages the banks were trying to move off their balance
sheets! The hedge funds, in turn, could leverage by factors of 20, 30, or
more to hold the ABSs. By contrast, banks could leverage capital by a fac-
tor of perhaps eight, no more.
7
This three- or fourfold increase of leverage
is one of the reasons that “markets” based on securities could operate much
more profitably than bank-based lending. As discussed, banks would live
on origination and servicing fees, while at higher leverage ratios, hedge
funds could be profitable at low interest rate spreads. These low spreads, in
turn, required extremely low default rates as well as layers of insurance and
backup lines of credit. Ironically, much of the risk returned to banks in the
form of loans made to buyers of the securities, promises to buy back bad
securities, and relations with monoline insurers.
It is even worse than that, however, because banks often kept the worst
loans out of the packages, holding them on their books for extra returns,
and because banks often retained an equity share in the securities—“skin
money,” used to demonstrate to buyers that the banks had confidence in
the underlying mortgages they had originated or packaged. Ultimately, the
move to “market-based” funding left banks holding much of the risks, but
without the assessment of borrowers’ ability to repay that relation-based
The Levy Economics Institute of Bard College 19
banking had used to reduce risk. Even the interest rate risk due to maturity
mismatching, which played an important role in inducing banks and
thrifts to move mortgages off their books, comes right back to banks in the
form of solvency risk of SIVs and hedge funds. The risk simply moved from
bank balance sheets, where it was regulated and more or less observable, to
a place where it isn’t regulated or observable—but where it still threatens
bank solvency (Das 2007). How much is uncertain, but the combined risk
could total $1 trillion to $2 trillion. And rather than shifting risk to those
best able to bear it, the new financial system shifted risk “on to the shoul-
ders of those least able to understand it” (Wolf 2007b).
Greed Trumps Fear: The Evolution to Fragility and Crisis
The abundance of liquidity is a function of creative debt leveraging.
Like all leverage, it feels wonderful on the upside, but watch out how
it can come back to bite you on the downside.
—Robert L. Rodriguez (2007)
Over a protracted period of good times, capitalist economies tend to
move from a financial structure dominated by hedge finance units to
a structure in which there is a large weight to units engaged in spec-
ulative and Ponzi finance.
—Hyman P. Minsky (1992)
Financial markets, and particularly the big players within them,
need fear. Without it, they go crazy.
—Martin Wolf (2007a)
Superimposed on these developments—indeed, a necessary precondition—
was a change in the “model of the model” adopted by market players. In the
last fewyears, a revised viewof economic possibilities has been developed that
goes by the name “the Great Moderation” (Bernanke 2004, Chancellor 2007).
The belief is that, due to a happy confluence of a number of factors, the world
is now more stable, a condition characterized by a new economy that is far
less vulnerable to “shocks.” Further, central banks have demonstrated both
20 Public Policy Brief, No. 94
willingness and a capacity to quickly deal with, and isolate, threats to the
financial system. For example, according to conventional views, Greenspan
was able to organize a successful response to the collapse of Long-Term
Capital Management (LTCM) in 1998, and later rapidly lowered interest
rates to steer the economy out of the recession triggered by the equity mar-
ket tumble. More recently, Fed Chairman Ben Bernanke is supposed to
have continued in the Greenspan tradition, responding to the subprime
crisis by “pumping liquidity” into markets,
8
by quickly lowering the Fed
funds rate, by taking some of the “frown costs” out of discount-window
borrowing—as a few of the major banks were induced to borrow unneces-
sary funds—and by lowering the penalty on such borrowing as the spread
between the Fed funds rate and the discount rate was lowered. Even as
energy and food prices fueled inflation, the Fed made it clear that it
remains on guard against any residual fallout from mortgage losses.
The Great Moderation allowed greed to trump fear, and the revela-
tions are piling up. First, there are the appraisers. New York State Attorney
General Andrew Cuomo has sued the First American Corporation for col-
luding with mortgage lender Washington Mutual to overstate the value of
homes (Barr 2007). Real estate appraisers across the country have com-
plained that they were strong-armed by lenders to inflate values. Indeed, an
industry group (Concerned Real Estate Appraisers from Across America)
circulated a petition that was presented to Ben Henson, executive director
of the Appraisal Subcommittee of the Federal Financial Institutions
Examination Council, enumerating unfair practices that included with-
holding of business or payment if appraisers refused to inflate values, guar-
antee a predetermined value, or ignore deficiencies in the property.
9
There
is little doubt that inflated appraisals played a major role in fueling the
speculative boom—just as they had helped to create the savings-and-loan
fiasco in the 1980s by rubber-stamping values in “daisy chains,” and other
fraudulent schemes (Wray 1994).
The ratings agencies were also complicit because their appraisals of the
securities were essential to generating markets for risky assets.
10
Ratings
agencies worked closely with the underwriters that were securitizing the
mortgages, to ensure ratings that would guarantee marketability.
11
Further,
they were richly rewarded for helping to market mortgages, since fees in
that area were about twice as high as those awarded for rating corporate
The Levy Economics Institute of Bard College 21
bonds—the traditional business of ratings firms. Moody’s got 44 percent of
its revenue in 2006 from rating “structured finance” (student loans, credit
card debt, and mortgages) (Lucchetti and Ng 2007).
12
Furthermore, mortgage
securitizers relaxed their due diligence tests even as lenders relaxed loan
standards (Rucker 2007). If anything, raters should have been lowering rat-
ings. But it wasn’t until the summer of 2007 that agencies finally began to
slash ratings when they were forced to recognize the flaws in their models.
Of course, much has already been written about borrower greed. The
subprime market bloomed, with increasingly risky instruments and prac-
tices, as “low doc” loans (less documentation required) evolved to“no docs”
and to “liar loans” (borrowers were allowed, and even encouraged, to lie
about income and other information relevant to the application process),
and finally, to “Ninja loans” (no income, no job, no assets). Certainly, some
of this was fraudulent (on the part of both lender and borrower), but much
was also based on the belief that real estate values could only go up—thus,
Ponzi finance was encouraged by the relative tranquility of the market.
Minsky would label the faith in the era of the Great Moderation a “rad-
ical suspension of disbelief.” As Alex Pollock (2007) testified before the U.S.
House of Representatives, “Booms are usually accompanied by a plausible
theory about how we are in a ‘new era,’ . . . It is first success, and then observ-
ing other people’s success, which builds up the optimism, which creates the
boom, which then sets up the bust.” The radical suspension of disbelief that
allowed markets to ignore downside potential created “optimism and a
euphoric belief in the ever-rising price of some asset class—in this case,
houses and condominiums—providing a surefire way for both lenders and
borrows to make money.”
13
In sum, the nature of the financial system
changed in a fundamental manner that ensured its evolution toward fragility.
The models used to value the securities could not take into account
structural changes to the economy or of systemic risk. Goldman Sachs said
that according to its computer models, its losses on one of its global equity
funds was a “25-standard deviation event,” something that should happen
once every 100,000 years (Tett and Gangahar 2007). Satyajit Das, a hedge
fund consultant, quipped, “People say these are one-in-a-100,000-years
events but they seem to happen every year” (quoted in Tett and Gangahar
2007). The models were based on data derived from only a few years’ expe-
rience that coincided with an unusually good period for house prices.
22 Public Policy Brief, No. 94
Further, since similar models are widely used, the models themselves drive
the market—generating “herding behavior” that can have devastating
results when all are simultaneously “selling out position,” as Minsky would
put it. James Norman, a managing director in Deutsche Asset Management’s
quantitative strategies group, admitted, “Quants are valuation-driven, and
when there is a lot of selling, valuations don’t matter” (Brewster 2007). The
new system required accurate appraisals of values of the underlying assets
and accurate evaluation of the risks of the securities. However, the appar-
ent success of the “originate and distribute” approach encouraged erosion
of margins of safety, ever-riskier practice, collusion, and misrepresentation
in the belief (or at least hope) that nothing could go wrong. But the behav-
ior induced by these beliefs changed the structure of the financial markets
so that everything would go wrong.
Retribution
To be exact, our economic leadership does not seem to be aware that
the normal functioning of our economy leads to financial trauma and
crises, inflation, currency depreciations, unemployment, and poverty
in the midst of what could be virtually universal affluence—in short,
that financially complex capitalism is inherently flawed.
—Hyman P. Minsky (1986)
It’s sort of a little poetic justice, in that the people that brewed this
toxic Kool-Aid found themselves drinking a lot of it in the end . . .
What has happened is a repricing of risk and an unavailability of
what I might call “dumb money,” of which there was plenty around a
year ago.
—Warren Buffet (quoted in Dabrowski 2008)
Hope is a crappy hedge.
—Erik R. Sirri (2007)
The combination of low interest rates and rising real estate prices encour-
aged a speculative frenzy that would end only if rates rose or prices stopped
The Levy Economics Institute of Bard College 23
rising. Of course, both events were inevitable, indeed, were dynamically
linked, because Fed rate hikes would slow speculation, attenuating rising
property values, and increasing risk spreads. When losses on subprimes
began to exceed expectations that had been based on historical experience,
prices of securities began to fall.
14
Problems spread to other markets, includ-
ing money market mutual funds and commercial paper markets, and banks
became reluctant to lend even for short periods. With big leverage ratios,
owners faced huge losses, greatly exceeding their capital, and began to
deleverage by selling, thus putting more downward pressure on prices.
15
By
early 2008, some of the credit markets for municipalities had dried up as
monoline insurers faced problems.
16
Projections of losses on residential MBSs range from about $200 bil-
lion to $500 billion, with some outside projections reaching $1 trillion.
17
Considering that total home values are more than $20 trillion, and given
that projections of eventual average house price declines of as much as 30
percent, this amounts to a total loss of household wealth of $6 trillion.
18
Of
course, all of these losses will not be realized—since only about half of the
value of homes is mortgaged, and since most people will not have to sell
their homes in a depressed market, total realized losses will be far less than
the notional loss. Thus, the estimate of $1 trillion might set an outside esti-
mate of losses to be realized in the residential real estate sector—with actual
losses depending on the ultimate depreciation of home values, on the
depths to be reached in the coming recession, and on the ease with which
households are allowed to work out debt positions.
It is also worth noting that problems are now showing up in home
equity loans. During the real estate boom, homeowners had used such loans
not only to remodel homes, but also to finance consumption purchases and
to pay down credit card debt. Delinquency rates doubled during 2007 and
are continuing to climb. JPMorgan Chase holds $95 billion of home equity
loans and expects losses of $450 million during the first quarter of 2008, ris-
ing to a billion dollars by the end of the year. Unfortunately, lenders are last
in line for payment when homeowners default on debt since mortgage
holders are paid first when a home is foreclosed. Indeed, some homeowners
seem to recognize that “there are few repercussions if they stop making
payments on their home equity loan” (Sidel 2008). Total losses are hard to
project, but some large lenders have 12 to 19 percent of their assets in home
24 Public Policy Brief, No. 94
equity loans, including National City Corporation, SunTrust Banks,
Washington Mutual, and Wells Fargo.
It is hard for many observers to believe that even double-digit default
rates on subprime loans could amount to large losses because (a) surely the
homes must have some value even after foreclosure, and (b) subprime loans
represent only about 6.5 percent of the total value of homes. However, the
loss on a typical subprime foreclosure can be substantial for two reasons.
First, down payments were small or nonexistent, and with falling real estate
prices, equity can be hugely negative. According to Greenlaw et al. (2008), if
home prices fall by 15 percent, the proportion of homeowners with nega-
tive equity will rise to 21 percent (10.5 million households), with perhaps
$2.6 trillion of mortgage debt under water.
19
Second, foreclosure can be a
long process, taking up to two years or even longer. During that process, the
loan servicer takes over mortgage payments and has first claim on proceeds
from the sale of the house. In a study of foreclosures, the financial services
firm UBS shows that losses can reach above 90 percent of the value of the
loan (UBS Investment Research 2007). Losses don’t stop there, however.
Vacant houses that are going through foreclosure negatively impact real
estate values in the neighborhood, and add to the inventory of unsold
homes. Further, local government suffers loss of tax revenue even as expen-
ditures rise to take care of vacant properties—meaning that other public
services must be reduced as the economy stagnates.
20
Delinquencies on sub-
primes are still rising, and historically, nearly half of subprime delinquen-
cies have resulted in foreclosures; that rate could go up as house values fall
and foreclosure cases tie up the courts. Hence, even if losses had not spread
beyond subprime loans, the impact on the economy would be large.
21
But problems have already spread far beyond residential real estate.
Small- and medium-size banks—squeezed out of the mortgage and credit
card business in recent years—focused on construction and commercial real
estate lending. Of particular concern are loans in the construction sector,
exposing banks to large direct losses. Many of them have more construction
loans outstanding than bank capital—up from only a third of capital a few
years ago. When construction loans go bad, they go very, very bad, because
unfinished projects result in big losses (Norris 2007). Further, small banks
hold commercial real estate loans equal to nearly 300 percent of their capi-
tal; at midsize banks, holdings equal 272 percent of capital. Even moderate
The Levy Economics Institute of Bard College 25
losses on such loans could wipe out much of their capital (Dash 2008). As
discussed, nonfinancial corporate debt has been growing three times faster
than GDP. Collateralized debt obligations (mostly business loans) are
another half trillion dollars. If default rates by firms rise to what has been
normal recession experience, total losses on nonfinancial corporate debt
could approach $400 billion (Veneroso 2007).
Banks have already taken significant hits due to conduits and SIVs they
set up to hold MBSs or CDOs. The banks received fee income and provided
backup credit, while SIVs borrowed short term in the commercial paper
market to invest long term in securities. SIVs currently hold about $450 bil-
lion in assets of which $168 billion is residential MBSs. While traditional
commercial paper has 100 percent bank backing in the form of lines of
credit, SIVs typically have only 10–15 percent. When problems appeared,
the banks were hit with a double whammy: they couldn’t roll over or issue
new commercial paper (a liquidity problem), and the value of their assets
plummeted (a solvency problem), thus forcing them to default on commer-
cial paper and to sell assets. In many cases, banks had to rescue their SIVs,
paying off the commercial paper and taking bad assets onto their books. On
November 7, 2007, Moody’s reviewed all 33 SIVs and took action on 16;
downgrades on some lowered asset values to 70 percent of liabilities (UBS
Investment Research 2007). If losses were typically in the range of 30 per-
cent, this could mean another $150 billion in losses overall.
Over the course of the real estate boom, households used their homes
as cash-out ATMs; when real estate markets started to collapse and home
equity loan standards tightened, homeowners turned to their credit cards.
Financial markets responded, following the securitization path blazed ear-
lier by subprime lending. Because bankruptcy reform made it hard for con-
sumers to get out of credit card debt, charge-off rates remain relatively low
(UBS Investment Research 2007). Historically, credit card debt (now about
$1 trillion) has been far riskier than mortgage debt, with high charge-offs
in recessions. Delinquency rates reached 6.3 percent in the 1991–92 reces-
sion and 5.6 percent in 1997–98, and already stood above 4 percent last
November. UBS believes charge-offs could reach as high as 7 percent, as the
market is already pricing in spreads that indicate expected losses greater
than in 1997–98. However, the synergistic effects of massively negative home
equity, rising unemployment (should the recession deepen), and rising
26 Public Policy Brief, No. 94
inflation (especially of energy prices) could lead to higher defaults and losses.
“Never in history has the American family skidded into recession with so
much debt” (Elizabeth Warren, quoted in Nocera 2008). Perhaps $70 to
$100 billion of losses on credit cards and credit card ABSs can be expected
as an outside estimate.
As discussed, credit default swaps (CDSs) are above $45 trillion in
aggregate, having grown ninefold in the past three years (Seides 2007).
Much like MBSs, these were created (in the mid-1990s) to allow Wall Street
to take loans away from commercial banks—in this case, commercial loans.
These are much like giant insurance funds, but with almost no loss reserve.
If losses were to reach 5 percent, we are talking about real money on the
order of $2.25 trillion. Banks are the primary sellers of CDSs (40 percent of
the total), with estimated exposure at more than $18 trillion. Hedge funds
sold almost $15 trillion of the CDSs (for comparison purposes, total hedge
fund assets are currently about $2.5 trillion). Risk is supposedly fully hedged,
but judging from the bank experience with subprimes, a lot of the risk could
come back to haunt them. About a third of the CDSs are essentially deriva-
tives of “junk”—below-investment-grade credits. Just as with the case of sub-
primes, the “junk” was transformed into tranches that included highly rated
paper. As the historical mortality on “junk” is 28 to 47 percent, a 5 percent
loss experience on CDSs is not out of the question (Seides 2007).
Leveraged buyout operations have been booming, dwarfing those of the
Michael Milken era of the 1980s. The total euphemistically named “high
yield” bond market is up 70 percent since the last recession. In each year
since 2004, more than 40 percent of all new debt issued was junk (Seides
2007). Indeed, almost every aspect of the subprime story can be told by sub-
stituting“junk bonds”for “securitized subprimes”: paltry yield spreads; loose
lending standards; highly leveraged positions; emphasis on throughput, not
quality; separation of risk assessors from risk takers; and the imprimatur of
ratings agencies to bless them. Total “junk debt” now stands at $2.5 trillion.
In the last recession, defaults on similar debt ran about 22 percent, with
recoveries at only 40 percent of the value of the deals. It is not inconceivable
that losses on“junk” could reach $400 billion. As Seides puts it, never before
have we entered an economic downturn with so much risky paper riding on
the fortunes of companies known to have such poor credit quality. Those
The Levy Economics Institute of Bard College 27
left holding the bag will be the sellers of CDSs, the owners of CDOs, and the
guarantors. The magnitude of risk is a multiple of that in subprimes.
Hence, the aggregate losses on residential mortgages, SIVs, CDOs and
other consumer debt, commercial MBSs, and other business debt could
reach well over $1 trillion. The direct losses on residential real estate could
mount to several trillion. Adding in CDS losses (that are inherently hard
to project) as well as losses in the “unknown unknowns” category, we could
achieve realized losses amounting to another few trillion dollars. A trillion
here and a trillion there—it adds up to large numbers even in a $13 trillion
economy. One pundit remarked that the subprime fallout will be con-
tained—to planet Earth—as losses spread throughout the financial system
(Mauldin 2007). While some still deny that the MBS crisis will spill over
substantially into the “real” economy, it is clear that many policymakers, as
well as many of Wall Street’s elite, are no longer complacent.
In the postwar period, the United States has not seen a nationwide real
estate crisis. However, there have been regional crises in which house prices
fell significantly, and these can give some idea of the time that will be
required for recovery. California had a fairly severe housing downturn in the
1990s, with prices falling by 15 percent over a period of five years (Greenlaw
et al. 2008). The foreclosure rate began to rise (ultimately by about 20 per-
cent) as soon as home prices started falling, but it did not peak until home
prices started to rise six years later. It took over eight years for home prices
to fully recover, while foreclosure rates were still substantially higher even
a decade after the downturn began. If the California case is relevant, the
United States will be feeling the effects of the current crisis for a long
period—perhaps a decade or more (also similar to the Japanese experience).
Indeed, there are some reasons to believe that if the United States
moves into recession, the damage would be even more severe than it was in
California. California had an advantage in that the United States experienced
robust growth during the Clinton years, which no doubt helped to pull the
state out of the doldrums. Further, the current downturn comes after a
period in which lending standards were far looser than those that prevailed
in California shortly before its real estate bust, and after a decade of deficit
spending the private sector is much more indebted today than it was in the
early 1990s. Finally, as documented above, securitization spread far beyond
mortgages, with practices similar to those used in subprime securitization
28 Public Policy Brief, No. 94
adopted in other sectors. For these reasons, asset price depreciation will not
be restricted to residential real estate, and losses in one sector will generate
recursive losses in others. In short, recovery could be a long time coming.
Policy and Reform
Implicit in the legislation which I am suggesting to you is a declara-
tion of national policy. This policy is that the broad interests of the
Nation require that special safeguards should be thrown around
home ownership as a guarantee of social and economic stability, and
that to protect home owners from inequitable enforced liquidation in
a time of general distress is a proper concern of the Government.
—President Franklin D. Roosevelt, Message to Congress on
Small Home Mortgage Foreclosures (1933)
There is substantial evidence that financial markets succeed because
of strong enforcement and regulation, not in spite of it.
—Linda Chatman Thomsen, Enforcement Chief for the SEC
(quoted in Johnson 2007)
The history of capitalism is punctuated by deep depressions that are
associated with financial panics and crashes in which financial rela-
tions are ruptured and institutions are destroyed. . . . The history of
money, banking, and financial legislation can be interpreted as a
search for a structure that would eliminate instability. Experiences
show that this search failed and theory indicates that the search for
a permanent solution is fruitless.
—Hyman P. Minsky (1986)
Over the course of the real estate boom, home ownership rates rose from 64
to 70 percent; however, much of this growth was fueled by loans that were
Ponzi from the beginning. Former Federal Reserve Governor Edward M.
Gramlich tried to get Greenspan to intervene as early as 2000. Why, he
wondered, are the riskiest loans given to the least sophisticated borrowers
(Krugman 2007)? As it happens, the rise of ownership rates was nothing but
The Levy Economics Institute of Bard College 29
a mirage that at best sucked away what little accumulated wealth low-
income home buyers had managed to put toward a down payment; and
given revised bankruptcy laws, they might work for years to get out of the
debt they had incurred to acquire a house and furnishings they no longer
own. The financial engineers turned housing from mere abodes into assets
that could be traded like dot-com equities—with long-run consequences
(Goodman 2007).
Studies show that, of the ARMs made in 2003, almost all were refi-
nanced to avoid resets at higher interest rates. If there was a “business
model” behind the extension of finance to those who could not afford to
service their loans, it was based on rapidly rising home prices and the ease
of refinancing at lower rates—in other words, it was what Minsky called a
Ponzi finance scheme. But with house price appreciation far beyond any-
thing experienced in history and with the certainty that the Fed would even-
tually raise rates, there was no chance that this business model would be
sustainable. And, as we have discussed, it is not just subprimes that relied on
a “radical suspension of disbelief ”: even as the chickens have come home to
roost in the residential real estate sector, we await revelations of growing
problems throughout the entire financial sector as economic activity slows.
The problem is systemic and derives from a fundamentally flawed
model that viewed the move to markets as something that would increase
efficiency, lowering interest rate spreads while spreading and reducing risk.
This was accomplished by reducing reliance on relationship banking and
allowing markets to take over much of the financial sector. Yet, as Minsky
always argued, the fundamental banking activity is guaranteeing creditwor-
thiness. This requires a skeptical loan officer who carefully evaluates borrow-
ers, and who reduces the probability of default by establishing a long-term
relationship such that credit is renewable only if the borrower fulfills his obli-
gations. The shift to the market “originate and distribute” model meant that
individual creditworthiness was never assessed. However, banks guaranteed
creditworthiness anyway, through a wide variety of exceedingly complex
and mostly hidden agreements with the originators and holders of securi-
ties. Indeed, it is becoming apparent that banks are exposed to far more risk
than they had been under the old banking model, but without any of the
long-term relations with debtors that characterized it. Further, the interest
rate spreads had been reduced so low by a system that valued quantity over
30 Public Policy Brief, No. 94
quality that there was no hope that gross earnings could cover losses if
defaults rose even slightly. (Minsky always jokingly referred to business
models that try to make up for losses on the carry trade by increasing vol-
ume—but that is precisely what the entire financial system required.) Add to
the mix corruption, control fraud, rogue traders, deception, insider trading,
“pump and dump” campaigns, and predatory lending practices and you’ve
got a recipe for a painful outcome.
There are two immediate policy issues facing us: first, what, if anything,
can be done to ameliorate the fallout from the current crisis; second, what
can be done to prevent recurrence of such a situation in the future? Since
both of these issues will require further study and debate I only offer some
general guidelines. In the remainder of this section, I look at policy to deal
with the crisis; in the concluding section, I will discuss lessons we have
learned from Minsky that would help to formulate policy for the longer run.
There are a number of initiatives designed to deal with the current
crisis, some issuing from the private sector and others being pushed by pol-
icymakers. Unfortunately, most of those being put forward by the Bush
Administration appear to be designed to help creditors rather than debtors.
Treasury Secretary Henry M. Paulson Jr. had proposed that banks put
together a $75 billion stabilization fund—but this was vetoed by the private
sector. President Bush has proposed freezing mortgage rates for those who
are currently up-to-date on their payments—which will do nothing for
those who are already in trouble, and only postpones the day of reckoning
for others. The Fed has lowered rates and developed a new auction facility
to provide reserves without the frown costs of borrowing at the discount
window. It also is lending safe Treasury debt against asset-backed securities
in an effort to halt the ever-falling prices of such debt. However, credit
spreads were still widening even after the announcement of such policies in
early March.
After a run on Bear Stearns, the Fed arranged a loan to JPMorgan so
that it could lend against MBSs provided as collateral.
22
The problem began
because creditors of Bear Stearns demanded more collateral and the firmwas
not able to provide acceptable assets. JPMorgan is the main clearing bank
for Bear Stearns, and it apparently would not accept the risks imputed to
the MBSs offered; further, markets are so fearful of such assets that Bear
Stearns could not raise funds by selling them. The Fed’s loan to JPMorgan
The Levy Economics Institute of Bard College 31
is “nonrecourse,” which means that the firm faces no risk: if the MBSs go
bad, the Fed will suffer the loss. Ironically, the Fed’s intervention came on
the day of the 75th anniversary of President Roosevelt’s reopening of finan-
cial institutions after the “banking holiday” of 1933, and required invocation
of one of the New Deal era’s provisions that allows the Fed to lend to “indi-
viduals, partnerships, or corporations.” While some decried the Fed’s
“bailout,” it feared that the run could spread to other broker-dealer firms and
to their lenders and trading partners (Andrews 2008, Morgenson 2008).
The Fed appears to be willing to ignore inflation pressures as well as moral
hazard problems, putting its role as lender of last resort first and foremost in
an all-out effort to prevent a panic. This is, of course, the prescribed solu-
tion to liquidity problems; however, it cannot do much if real estate prices
continue to fall and delinquencies continue to rise.
Time and economic growth can go a long way toward restoring finan-
cial health: if incomes can grow sufficiently, it becomes easier to service
debt. Recent growth has been mostly fueled by exports, partly thanks to a
depreciating dollar. However, any serious U.S. slowdown will be contagious,
hurting exports as growth slows around the globe. The private sector can-
not be the main source of demand stimulus, as it has been running up debt,
spending more than its income for a decade. While the budget deficit will
increase as the economy slows, this results from deterioration of employ-
ment and income (which lowers taxes and increases transfers)—thus, the
rising deficit will not proactively create growth, although it will help to con-
strain the depths of recession. The president and Congress have agreed upon
a modest economic stimulus plan, but in current conditions it is far too small
to turn around the economy. A much bigger stimulus package is required,
but that is probably politically infeasible even with a change of administra-
tion. Matters are made worse by creeping inflation—mostly fueled by energy
and food prices—which will temper government’s willingness to use policy
to fuel growth. Indeed, the return of stagflation looks increasingly likely.
Thus, it is difficult to see how the United States can grow its way out of this
problem.
Washington has called on Freddie Mac and Fannie Mae to take a bigger
role in home lending in order to relieve pressures. The problem is that these
institutions are already experiencing their own problems. While limits on
their holdings have been lifted and there is discussion about relaxing loss
32 Public Policy Brief, No. 94
reserve requirements, there is a fundamental inconsistency in the mandates
given to these government-sponsored entities (GSEs): although expected to
support home ownership in a crisis, they must also maintain strong balance
sheets of their own. This makes it difficult for them to operate in the public
interest when such action is most needed. Markets are even shunning
agency-insured MBSs—and the problems are not limited to those based on
subprimes, as fears of losses have spread to Alt-A mortgages.
What is needed is mortgage relief. Congress proposed legislation to
allow modification of mortgage terms so owners could keep their homes,
though the Bush Administration and financial institutions are teaming up
to defeat the effort. If Congress prevails, this could help to stabilize the real
estate sector. Reform should go even further, with bankruptcy laws amended
to allow those who had been subjected to predatory lending to escape sub-
prime loans. The borrower should then be able to refinance the home at
its current market value, and with the borrower’s original equity (if any)
intact.
23
Relief might be limited to loans for primary residences, and up to a
limited home value (such as median price for the Standard Metropolitan
Statistical Area). As President Roosevelt argued in announcing his plan to
save the “small homes,” the goal would be to preserve home ownership, not
to protect real estate speculators.
24
Following Roosevelt’s lead, we may need
to create a new institution to get us through the worst real estate crisis since
the 1930s. He created an agency similar to the Reconstruction Finance
Corporation, the Home Owners’ Loan Corporation (HOLC), to take on the
tasks of saving small homeowners. The HOLC successfully refinanced 20
percent of the nation’s mortgages, issuing bonds to raise the funds. While
about 20 percent of those loans eventually were foreclosed, the agency actu-
ally managed to earn a small surplus on its activities, which was paid to the
Treasury when the HOLC was liquidated in 1951. Clearly, there are lessons
to be learned from that experience: refinance is preferable to foreclosure, as
it preserves home ownership and communities, while also putting money
where it is most needed.
Meanwhile, bailouts will be required (Magnus 2008). Of course, they
validate bad behavior and can encourage worse. However, a financial crisis is
not the time to teach markets a lesson by allowing a generalized debt defla-
tion to“simplify” the system, as Minsky put it, by wiping out financial wealth
so that only equity ownership remains.
25
There is a fine line that must be
The Levy Economics Institute of Bard College 33
walked, allowing the worst abusers (especially the perpetrators of fraud) to
lose while protecting the relatively innocent. Because financial markets can-
not be allowed to learn lessons “the hard way,” regulations and oversight
must be strengthened to slow the next stampede toward a speculative bub-
ble. Problems have already spread far beyond residential real estate, as this
brief has made clear. Even with the reforms outlined here, there could be
cascading failures across entire classes of financial assets. State and local
governments will probably require assistance as tax revenue falls, commu-
nity needs increase, and the ability to borrow and to service debt suffers. As
the value of assets held by pension funds, insurance companies, and hedge
funds plummets, pressures to sell will rise. Interest rate spreads have risen
throughout the financial system as trust in counterparties has evaporated.
Thus far, most of the schemes floated by public and private officials
have failed because no one has been able to persuade participants to go
against their own narrow private interests. The Bear Stearns rescue is a case
in point—JPMorgan agreed to provide lending only if it did not have to
bear risk. Norris (2008c) recalls the crisis of 1907, when J. P. Morgan was able
to pressure the presidents of NewYork trust companies to kick in contribu-
tions to forestall the crash by threatening to allow every one of them to fail
individually. Today, it is difficult to identify anyone willing and able to play
that role. Indeed, most of the prominent candidates (Greenspan, Robert
Rubin, Paulson) are too closely identified with the interests of particular
Wall Street firms.
26
At the Fed, Bernanke, Frederic Mishkin, and Donald
Kohn all seem to recognize the scope of the problem, and they seem to have
risen to the occasion. While the Fed will continue to play its role as lender of
last resort, the crisis has gone far beyond a liquidity problem, and addressing
insolvency will require participation of private players as well as the Treasury.
The White House has finally offered a plan; however, officials emphasized
that it is more geared toward preventing future crises than to resolving the
current one (Labaton 2008). It would rely mostly on state regulators and
private industry to tighten oversight of financial markets but might include
more regulation of mortgage lending that would require federal legislation.
The proposal would provide only a limited role for the federal government,
based on the administration’s wish to avoid “burdensome regulation.”
Not surprisingly, industry representatives welcomed this “regulation lite”
approach, which “relies on the same market participants—from mortgage
34 Public Policy Brief, No. 94
brokers to credit-rating agencies and Wall Street firms—that government
officials and other experts blame for the current crisis” (Labaton 2008).
Democrats criticized the plan and announced a proposal for federal fund-
ing to provide billions of dollars to states to allow them to buy homes in
foreclosures, and would permit FHA to guarantee loans used to refinance
troubled mortgages.
Congress is considering regulations on mortgage originators that would
establish new licensing requirements, put restrictions on incentives for
saddling borrowers with riskier loans, and provide liability for financial
institutions that sell mortgages (Hulse 2007). In addition, Congress would
set new standards to be met by originators regarding the ability of borrow-
ers to make payments. Unscrupulous lending was a big part of the subprime
boom, with little oversight of mortgage brokers and with substantial incen-
tive to induce borrowers to take on more debt than they could handle, at
interest rates that would reset at a level virtually guaranteed to generate
delinquencies. The evidence is overwhelming that variable rate mortgages
(VARs) lead to more foreclosures; hybrid VARs are even more dangerous.
There is a proper place for VARs and hybrid VARs, but that is not with the
typical subprime borrower, who has little reserve if things go bad. Congress
should investigate limits to marketing of VARs and hybrids to low-income
borrowers and first-time buyers.
Policy should avoid promoting the consolidation of financial institu-
tions—a natural result of financial crises that can be boosted by policy-
arranged bailouts. Minsky always preferred policy that would promote small-
to medium-size financial institutions. Unfortunately, policymakers who are
biased toward “free markets” instinctively prefer to use public money to sub-
sidize private-institution takeovers of failing financial firms. The Roosevelt
alternative should be adopted: temporary “nationalization” of failing institu-
tions, with a view to eventually returning them to the private sector at a small
profit to the U.S. Treasury. And, again following Minsky, policy should return
to a bias toward market segmentation, with greater regulation of the banking,
protected, sector. Minsky also always advocated smaller financial institutions,
but halting the trend to bigness will be difficult (Minsky 1986).
The “originate and distribute” model has shown its weakness and is
unlikely to survive in its present form. Risk raters, property appraisers,
quant models, and broker’s markets cannot substitute for relationship
The Levy Economics Institute of Bard College 35
banking. Managers of money funds that are too big to fail must be con-
strained, because they will inevitably get caught up in the next financial fad.
Market forces induce each to try to beat the market, but that requires ignor-
ing greater risk to obtain the higher returns. To be sure, there is nothing to
be gained by preventing everyone from taking on excessive risk. However,
there is a clear public interest in the management of pension and insurance
funds, which are supposed to be biased toward safety and soundness. Hedge
funds and private equity funds are a different matter, but even these need
some supervision and regulation because of the potential impacts they can
have on the economy—as LTCM, Enron, and other examples have shown.
Conclusion: What We Learned from Minsky
Minsky argued that the Great Depression represented a failure of the small-
government, laissez-faire economic model, while the New Deal promoted a
highly successful Big Government/Big Bank model for financial capitalism.
The current crisis just as convincingly represents a failure of the Big
Government/Neoconservative (or, outside the United States, what is called
“neoliberal”) model that promotes deregulation, reduced supervision and
oversight, privatization, and consolidation of market power in the hands of
money manager capitalists. In the United States, there has been a long-run
trend that favors relatively unregulated “markets” over regulated banks that
has also played into the hands of neoconservatives. The current financial cri-
sis is a prime example of the damage that can be done by what has been
called the “post-regulatory environment” (Thomas 2008).
The New Deal reforms transformed housing finance into a very safe,
protected business based on (mostly) small, local financial institutions that
knew their markets and their borrowers. Home ownership was promoted
through long-term, fixed-rate, self-amortizing mortgages. Communities
benefited, and households built wealth that provided a path toward middle-
class lifestyles (including college education for baby boomers and secure
retirement for their parents). This required oversight by regulators, deposit
insurance courtesy of the FDIC and the Federal Savings and Loan Insurance
Corporation, and a commitment to relatively stable interest rates. Other
policies identified by Minsky as “paternalistic capitalism”also helped to build
a robust economy: cooperation with unions to ensure rising wages and thus
36 Public Policy Brief, No. 94
growing consumer demand; a social safety net that also encouraged con-
sumption; student loans that enhanced earnings capacity; and a sense of
shared responsibility to take care of the young, the old, and persons with dis-
abilities. Together, these policies reduced insecurity, enhanced trust, and pro-
moted economic stability.
Over time, however, the economy gradually evolved toward fragility. The
Cold War favored investment in the leading industries, where wages were
already high. Inequality grew as other sectors and workers with less educa-
tion fell behind. Social programs were cut, and trickle-down economics
favored the growth of inequality. Policy increasingly turned to promotion of
investment in particular, and business in general, to fuel growth—rather
than relying on growing consumption fueled by growing household incomes.
Because a large portion of investment in our type of economy must be
externally financed, this policy mix increased the importance of finance. At
the same time, the absence of a depression in the postwar period allowed
financial wealth to accumulate, albeit increasingly in the hands of an elite. A
formally “anti-government” bias led to the erosion of many of the New Deal
reforms. In practice, however, the rising conservative ideology never really
embraced a return to the prewar small-government form of capitalism, but
rather merely substituted a meaner “big government” for the paternalistic
government of the early postwar period. Hence, the Big Government/Neocon
model replaced the New Deal reforms with self-supervision of markets, with
greater reliance on“personal responsibility”as safety nets were shredded, and
with monetary and fiscal policy that is biased against maintenance of full
employment and adequate growth to generate rising living standards for
most Americans. In short, the government was neither smaller nor less inter-
ventionist. However, its constituency had shifted away from America’s mid-
dle class and toward Wall Street’s money managers.
27
The model is in trouble—and not just with respect to the mortgage
mess, as the United States faces record inequality and destruction of the mid-
dle class, a health care crisis, an incarceration disaster, and other problems
beyond the scope of this analysis (see Wray 2000, 2005). We must return to a
more sensible model, with enhanced oversight of financial institutions and
with a housing finance structure that promotes stability rather than specula-
tion. We need policy that promotes rising wages for the bottom half (or even
three-quarters) of workers so that borrowing is less necessary to maintain
The Levy Economics Institute of Bard College 37
middle-class living standards, and policy that promotes employment, rather
than transfer payments—or worse, incarceration—for those left behind.
Minsky always advocated job creation programs so that government would
act as an employer of last resort—the only way to ensure that the supply of
jobs would be adequate to maintain continuous full employment. Not only
would this eliminate involuntary unemployment, but he also showed that it
could be used to reduce inequality and poverty, while also ensuring that the
government’s budget would swing countercyclically to offset recessionary
forces as well as inflationary forces in a boom.
Monetary policy must be turned away from using rate hikes to preempt
inflation and toward stabilizing interest rates, direct credit controls to pre-
vent runaway speculation, and supervision and regulation—its proper role.
Minsky advocated support for small banks, and creation of a system of
community development banks—the latter only partially achieved under
President Clinton—as a viable alternative to the predatory lending prac-
tices that did increase the supply of credit to low-income borrowers and
neighborhoods, but which is now resulting in foreclosures and vacancies.
28
Unfortunately, we turned American home finance over to Wall Street, which
operated the industry as if it were a casino. The swing toward markets and
away from regulated banking greatly increased risk, while at the same time it
necessarily extended government assurance to the unregulated institutions
for the simple reason that the government cannot allow a financial crisis to
threaten the economy. What Bernanke called“The Great Moderation” is also
known as the “Greenspan put”—the belief that no activity is too risky
because the Fed will intervene if things go bad. Unfortunately, it is Chairman
Bernanke who is left to clean up the mess left by years of lax oversight and
deregulation that operated to the advantage of Wall Street.
Minsky insisted that “the creation of new economic institutions which
constrain the impact of uncertainty is necessary,” arguing that the “aim of
policy is to assure that the economic prerequisites for sustaining the civil and
civilized standards of an open liberal society exist. . . . If amplified, uncer-
tainty and extremes in income maldistribution and social inequality attenu-
ate the economic underpinnings of democracy, then the market behavior
that creates these conditions [has] to be constrained” (Minsky 1996). It is
likely that the current crisis will make it politically feasible to devise and to
put into place such institutions.
38 Public Policy Brief, No. 94
Acknowledgments
The author thanks Yeva Nersisyan for essential research assistance, and
Research Associate Robert W. Parenteau for his comments.
Notes
1. Not only did banks face competition in their loan business, but they also
lost retail deposits when market rates rose above Regulation Q limits.
They were forced to rely more heavily on costlier “hot money” jumbo
CDs packaged by Wall Street firms such as Merrill Lynch. By raising
deposit insurance limits to $100,000, policy encouraged Wall Street
competitors and took away another advantage that relationship banking
had relied upon.
2. For example, at the end of September 2007, Citibank put together a
package of mortgage securities, planning to sell CDOs that it valued at
$2.7 billion. However, it was unable to sell them and later wrote down
the value by $2.6 billion, or 95 percent (Norris 2008a).
3. As discussed below, CDSs are like credit insurance that expose sellers
to risk, some of which can be hedged. The problem is that loss reserves
held against CDSs are extremely small, so sellers’ equity is at risk should
default rates rise.
4. According to Greenspan (2004), fixed rate mortgages “effectively charge
homeowners high fees for protection against rising interest rates and
for the right to refinance.” The new financial instruments would not
only help homeowners but also allow for “dispersion of risk to those
willing, and presumably able, to bear”it, while acting as a shock absorber
to prevent “cascading failures” (Greenspan 2002).
5. However, in a ruling that has sent shockwaves through the mortgage
securities market, a federal judge in Ohio has thrown out 14 foreclo-
sure cases, ruling that mortgage investors had failed to prove they
actually owned the properties they were trying to seize (Morgenson
2007). Because the securities are so complex and documentation lax,
the judge found that their claims to the properties were weak. Josh
Rosner, a mortgage securities specialist, said, “This is the miracle of not
having securities mapped to the underlying loans. There is no industry
repository for mortgage loans. I have heard of instances where the same
The Levy Economics Institute of Bard College 39
loan is in two or three pools” (quoted in Morgenson 2007). It is possi-
ble that this could prove to be one of the weak links in the slice-and-
dice securities market. There have been similar cases throughout the
nation, as well as growing numbers of lawsuits against real estate buy-
ers’ agents (this is the first real estate crisis in which the majority of
residential purchases involved buyers’ agents with a fiduciary respon-
sibility to buyers) and mortgage brokers (Streitfeld 2008).
6. It is important to stress, however, that the AAArating of the MBSs relied
on anAAArating for the insurer; and if losses on the MBSs led to larger-
than-expected losses by the insurers, the monolines would be down-
graded, leading to downgrading of the MBSs they insured—generating
a recursive cycle of downgrading. That is, the whole business model of
the monolines requires a triple-A rating; in turn, the securities market
itself also relies on, and affects, the AAA ratings of the insurers. This is
why problems with the monolines have shaken markets in recent weeks.
7. This is due to capital requirements; for example, those imposed by
Basel II agreements. With a capital requirement equal to 12.5 percent,
banks leverage equity by a maximum factor of eight. Basel II does not
distinguish between corporate bonds, MBSs, or CDOs—if they are rated
triple-A, they are all treated the same. Banks were encouraged to“game”
the capital requirements by holding the riskiest assets given a rating.
This probably played a role in the large losses posted by banks on their
holdings (Rodriguez 2007). Further, though asset management was
designed to economize on capital, banks were able to increase leverage
ratios above eight. According to estimates provided by Greenlaw et al.
(2008), the actual leverage ratio averaged just under 10 for commer-
cial banks, 8.4 for thrifts and credit unions, 25 for GSEs, and 32 for
brokers and hedge funds.
8. This term is misleading, as it implies that the Fed could simply fly in
Milton Friedman’s helicopters and drop bags of Federal Reserve notes
where they’re needed most. Actually, the Fed stood ready to lend
reserves at the discount window and to supply them to the federal
funds market through bond purchases to keep the Fed funds rate on
target. To modify a popular old saying, “You can’t pump on a string”—
that is, the Fed could only supply the reserves desired by the market.
9. See www.appraiserspetition.com
40 Public Policy Brief, No. 94
10. Some consultation between raters and securitizers was, of course, nec-
essary to ensure that the pooled mortgages would find the appropriate
market. Problems would arise only if the ratings were not appropriate
to the pools.
11. In what could be interpreted as an attempt to shift blame away from
raters, Fitch claims that “poor underwriting quality and fraud may
account for as much as one-quarter of the underperformance of recent
vintage subprime RMBS[s]” (Pendley, Costello, and Kelsch 2007). In a
detailed examination of a sample of 45 subprime loans, Fitch found the
appearance of fraud or misrepresentation in virtually every one; it also
says that “in most cases” the fraud“could have been identified with ade-
quate underwriting, quality control and fraud prevention tools prior to
the loan funding.” Further, Fitch’s investigation concluded that broker-
originated loans have “a higher occurrence of misrepresentation and
fraud than direct or retail origination.”
12. Together, Moody’s and Standard and Poor’s control 80 percent of the
ratings market. In 2006, Moody’s generated $2 billion of revenue, with
pretax profits of $1.1 billion (a 50 percent profit rate!). Ironically, the top
shareholder of Moody’s is Warren Buffett, who floated a proposal to bail
out the municipal bond insurers after the monolines faced a crisis that
resulted in part from their move into provision of insurance for the
MBSs rated by Moody’s (Wolff 2008).
13. Or, as Charles Kindleberger put it, “The propensity to swindle grows
parallel with the propensity to speculate during a boom. The implosion
of an asset price bubble always leads to the discovery of fraud and swin-
dles” (quoted in Pollock 2007).
14. Modeling by the Bank of England (2007) shows that a hypothetical
portfolio of subprime mortgage credit default swaps (composed of
AAA and AA subprime mortgages originated in 2006) lost 60 percent
of value in July 2007.
15. Note that in a world of high leverage ratios, reducing exposure means
that many multiples of CDOs relative to one’s own funds must be sold
(if equity is $1 billion, to reduce exposure by half requires sales of $7.5
billion when leverage is 15-to-1).
16. The “auction-rate” market for securitized government debt has col-
lapsed—putting both holders of securities and debtors in a bind.
The Levy Economics Institute of Bard College 41
Essentially, these are long-termsecurities but with interest rates that reset
periodically in auctions. Sellers had expected the securities to have
unquestioned liquidity but now cannot sell them. Debtors are penalized
with very high interest rate resets due to collapse of the auctions—threat-
ening to turn yet another liquidity problem into a solvency problem.
17. Greenlaw et al. (2008) project mortgage debt losses at $400 billion, but
admit that number will grow if house prices continue to fall, with
defaults snowballing through conventional mortgages.
18. Nationwide, home prices plummeted at a pace of 8.9 percent in the
fourth quarter of 2007. The S&P/Case-Shiller National U.S. Home Price
Composite Index for 10 metropolitan areas fell by almost 10 percent
year-over-year in 2007, the biggest decline in the index’s history. For the
first time ever, prices fell in every market covered by the index. And the
pace of home price depreciation accelerated in the fourth quarter: the
composite index for the 10 markets fell at an annual rate of 21 percent.
19. It is estimated that more than 10 percent of American homeowners
(8.8 million) already have negative equity; that percentage is expected
to rise above 15 percent by the end of the calendar year (Andrews and
Uchitelle 2008). More than 30 percent of homeowners who purchased
homes in the past two years have negative equity (Kane 2008).
20. Twenty-four states had already reported declining tax revenue due to the
housing crisis by December 2007 (Simon 2007). The losses to local gov-
ernments average more than $34,000 per foreclosure (Morgenson 2008).
21. Greenlaw et al. (2008) estimate that if the loss on mortgage securities
amounts to $400 billion, then the hit to GDP will be as much as 1.5
percentage points, in addition to the more direct negative impacts of
collapsing residential investment and the wealth effects on consump-
tion resulting from depreciating real estate values. These additional
losses are attributed to impacts on financial institutions that force
them to deleverage, reducing credit availability.
22. Two days later, on March 16, it was announced that JPMorgan would buy
Bear Stearns for $2 per share (down from a high of $171 the previous
year), agreeing to take over all counterparty risks and using the likeli-
hood of losses and lawsuits to justify the low purchase price. At the same
time, the Fed made an unusual move in cutting the discount rate by 25
basis points on a Sunday evening in advance of a Federal Open Market
42 Public Policy Brief, No. 94
Committee meeting the following Tuesday. It also created yet another
lending facility for big investment banks to secure short-term loans of
reserves against a range of collateral. Later, JPMorgan raised its offer
price to $10 per share in response to widespread criticism that it had
perhaps received one of the best deals—arranged and guaranteed by
the Fed—in recent history.
23. Only if the creditor can show that the borrower had defrauded the orig-
inator (through, for example, doctored W-2 forms or bank account
statements) would the borrower be held liable for the original loan.
24. According to the Center for Responsible Lending, there is no difference
in the delinquency rates for speculators and owner-occupants. Further,
the proportion of all completed foreclosures on securitized subprime
adjustable rate loans made in 2006 that were attributable to speculators
was just 7 percent, while owner-occupants accounted for 93 percent. In
other words, speculators are a very small part of the problem in the uni-
verse of subprime ARMs.
25. See also, Samuelson (2007).
26. Ironically, Greenspan’s narrow interest would now seem to put him in
favor of snowballing defaults, as he has joined John Paulson’s hedge fund
as an advisor; Paulson has made billions betting against the housing
market boom that Greenspan’s policies helped to fuel (Zuckerman
2008). In a troubling piece published in the New York Times, Ben Stein
castigates Goldman Sachs, “whose alums are routinely Treasury secre-
taries, high advisers to presidents, and occasionally a governor or United
States senator,”questioning whether Henry Paulson (no relation) should
be running the Treasury given the questionable practices of his former
firmover the past fewyears. Stein argues that while “Goldman Sachs was
one of the top 10 sellers of CMOs for the last two and a half years,” it
“was also shorting the junk on a titanic scale through index sales—show-
ing . . . how horrible a product it believed it was selling” (Stein 2007).
27. Readers will remember President Bush’s famously candid remarks at a
fundraising dinner for the Archdiocese of New York in December
2000: “This is an impressive crowd—the haves and the have-mores.
Some people call you the elite. I call you my base.”
28. See Papadimitriou and Wray (1998) for a summary of Minsky’s policy
proposals.
The Levy Economics Institute of Bard College 43
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48 Public Policy Brief, No. 94
Senior Scholar L. Randall Wray is a professor at the University of Missouri–
Kansas City and director of research at the Center for Full Employment and
Price Stability. He is currently working in the areas of monetary policy,
employment, and Social Security. Wray has published widely in journals and
is the author of Money and Credit in Capitalist Economies: The Endogenous
Money Approach (Edward Elgar, 1990) and Understanding Modern Money:
The Key to Full Employment and Price Stability (Edward Elgar, 1998). He is
also the editor of Credit and State Theories of Money: The Contributions of
A. Mitchell Innes (Edward Elgar, 2004) and coeditor of the forthcoming
The Continuing Relevance of The General Theory: Keynes for the 21st Century
(Palgrave Macmillan). Wray received a B.A. from the University of the Pacific
and an M.A. and a Ph.D. from Washington University in St. Louis.
About the Author
The Levy Economics Institute of Bard College 49
Public Policy Brief Series
The full text of the Public Policy Brief and Public Policy Brief Highlights
series can be downloaded from the Levy Institute website, www.levy.org.
The site also includes a complete list and short summaries of all the titles
in the Public Policy Brief series.
Financial Markets Meltdown
What Can We Learn from Minsky?
i. v\xn\ii wv\s
No. 94, 2008 (Highlights, No. 94A)
Minsky’s Cushions of Safety
Systemic Risk and the Crisis in the U.S. Subprime Mortgage Market
)\x xvvcvi
No. 93, 2008 (Highlights, No. 93A)
The U.S. Credit Crunch of 2007
A Minsky Moment
cu\vivs ). wu\ivx
No. 92, 2007 (Highlights, No. 92A)
Globalization and the Changing Trade Debate
Suggestions for a New Agenda
1uox\s i. v\iivs
No. 91, 2007 (Highlights, No. 91A)
Cracks in the Foundations of Growth
What Will the Housing Debacle Mean for the U.S. Economy?
nixi1vi n. v\v\nixi1viou, cvvc u\xxscvx, and cvxx\vo zvzz\
No. 90, 2007 (Highlights, No. 90A)
50 Public Policy Brief, No. 94
The Economics of Outsourcing
How Should Policy Respond?
1uox\s i. v\iivs
No. 89, 2007 (Highlights, No. 89A)
U.S. Household Deficit Spending
A Rendezvous with Reality
vonvv1 w. v\vvx1v\u
No. 88, 2006 (Highlights, No. 88A)
Maastricht 2042 and the Fate of Europe
Toward Convergence and Full Employment
)\xvs x. c\inv\i1u
No. 87, 2006 (Highlights, No. 87A)
Rethinking Trade and Trade Policy
Gomory, Baumol, and Samuelson on Comparative Advantage
1uox\s i. v\iivs
No. 86, 2006 (Highlights, No. 86A)
The Fallacy of the Revised Bretton Woods Hypothesis
Why Today’s International Financial System Is Unsustainable
1uox\s i. v\iivs
No. 85, 2006 (Highlights, No. 85A)
Can Basel II Enhance Financial Stability?
A Pessimistic View
i. v\xn\ii wv\s
No. 84, 2006 (Highlights, No. 84A)
Reforming Deposit Insurance
The Case to Replace FDIC Protection with Self-Insurance
v\xos xoxs1\s
No. 83, 2006 (Highlights, No. 83A)
The Levy Economics Institute of Bard College 51
The Ownership Society
Social Security Is Only the Beginning . . .
i. v\xn\ii wv\s
No. 82, 2005 (Highlights, No. 82A)
Breaking Out of the Deficit Trap
The Case Against the Fiscal Hawks
)\xvs x. c\inv\i1u
No. 81, 2005 (Highlights, No. 81A)
The Fed and the New Monetary Consensus
The Case for Rate Hikes, Part Two
i. v\xn\ii wv\s
No. 80, 2004 (Highlights, No. 80A)
The Case for Rate Hikes
Did the Fed Prematurely Raise Rates?
i. v\xn\ii wv\s
No. 79, 2004 (Highlights, No. 79A)
The War on Poverty after 40 Years
A Minskyan Assessment
s1vvu\xiv \. nvii and i. v\xn\ii wv\s
No. 78, 2004 (Highlights, No. 78A)
The Sustainability of Economic Recovery in the United States
The Risks to Consumption and Investment
vuiiiv \vvs1is and vii\s x\v\xi1sos
No. 77, 2004 (Highlights, No. 77A)
Asset Poverty in the United States
Its Persistence in an Expansionary Economy
\svx\ c\xvv and vnw\vn x. woivv
No. 76, 2004 (Highlights, No. 76A)
52 Public Policy Brief, No. 94
Is Financial Globalization Truly Global?
New Institutions for an Inclusive Capital Market
vuiiiv \vvs1is and s\x1oxu n\su
No. 75, 2003 (Highlights, No. 75A)
Understanding Deflation
Treating the Disease, Not the Symptoms
i. v\xn\ii wv\s and nixi1vi n. v\v\nixi1viou
No. 74, 2003 (Highlights, No. 74A)
Asset and Debt Deflation in the United States
How Far Can Equity Prices Fall?
vuiiiv \vvs1is and vii\s x\v\xi1sos
No. 73, 2003 (Highlights, No. 73A)
What Is the American Model Really About?
Soft Budgets and the Keynesian Devolution
)\xvs x. c\inv\i1u
No. 72, 2003 (Highlights, No. 72A)
Can Monetary Policy Affect the Real Economy?
The Dubious Effectiveness of Interest Rate Policy
vuiiiv \vvs1is and x\icoix s\wsvv
No. 71, 2003 (Highlights, No. 71A)
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Public Policy Brief

FINANCIAL MARKETS MELTDOWN
What Can We Learn from Minsky?
.  

The Levy Economics Institute of Bard College, founded in 1986, is an autonomous research organization. It is nonpartisan, open to the examination of diverse points of view, and dedicated to public service. The Institute is publishing this research with the conviction that it is a constructive and positive contribution to discussions and debates on relevant policy issues. Neither the Institute’s Board of Governors nor its advisers necessarily endorse any proposal made by the authors. The Institute believes in the potential for the study of economics to improve the human condition. Through scholarship and research it generates viable, effective public policy responses to important economic problems that profoundly affect the quality of life in the United States and abroad. The present research agenda includes such issues as financial instability, poverty, employment, gender, problems associated with the distribution of income and wealth, and international trade and competitiveness. In all its endeavors, the Institute places heavy emphasis on the values of personal freedom and justice.

Editor: W. Ray Towle Text Editor: Barbara Ross The Public Policy Brief Series is a publication of The Levy Economics Institute of Bard College, Blithewood, PO Box 5000, Annandale-on-Hudson, NY 12504-5000. For information about the Levy Institute, call 845-758-7700 or 202-887-8464 (in Washington, D.C.), e-mail info@levy.org or visit the Levy Institute website at www.levy.org. The Public Policy Brief Series is produced by the Bard Publications Office. Copyright © 2008 by The Levy Economics Institute. All rights reserved. No part of this publication may be reproduced or transmitted in any form or by any means, electronic or mechanical, including photocopying, recording, or any information-retrieval system, without permission in writing from the publisher. ISSN 1063-5297 ISBN 978-1-931493-75-8

Contents

Preface . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 Dimitri B. Papadimitriou Financial Markets Meltdown . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 L. Randall Wray About the Author . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48

Preface

The current financial crisis has not only gripped the media on a daily basis and affected the average American in terms of housing and personal consumption, but it has also raised questions about the viability of the financial system. The U.S. economy is heading toward, or may already be in, a recession, and the Federal Reserve is attempting to stem the tide by reducing interest rates and acting as the lender of last resort. Stock markets have declined and become increasingly volatile, and the extent of the economic downturn is uncertain. In a series of papers, Levy Institute scholars warned that the continuation of current practices and policies in the United States meant that a crisis was inevitable. Hyman P. Minsky’s financial fragility hypothesis is frequently used to explain the current crisis. Minsky hypothesized that the structure of a capitalist economy becomes more fragile over a period of prosperity. As expressed in this brief by Senior Scholar L. Randall Wray, the belief that the world is now more stable and less vulnerable to “shocks” (the “Great Moderation”) allowed greed to trump fear. According to Wray, Minsky would label the faith in the era of the Great Moderation a “radical suspension of disbelief.” Wray explains the historical development that led to today’s complex and fragile financial system and how the seeds of crisis were sown long ago by lax oversight, risky innovations, and deregulation during a lengthy period of relative stability. Irrational exuberance, which was based on the belief in the “new economy” in the 1990s, and unprecedented real estate appreciation, which validated increasingly risky Ponzi finance in the 2000s, are the result of long-term, policy-induced, profit-seeking financial innovations. The traditional role of banks evolved in order to mitigate the risk of another debt deflation rivaling the Great Depression. However, government relaxed regulations so that banks could take direct positions in all
The Levy Economics Institute of Bard College 5

I welcome your comments. Bush Administration appear to be designed to help creditors rather than debtors. Papadimitriou. Minsky preferred policy that would promote small.to medium-size financial institutions (rather than their consolidation). Wray estimates that the combined losses could amount to several trillion dollars (in a $13 trillion economy). 94 . According to Wray. Roosevelt’s Home Owners’ Loan Corporation. many of today’s problems can be traced back to securitization (the “originate and distribute” financial model). and strengthen its supervisory and regulatory functions. A return to stagflation looks increasingly likely. and he instead recommends much larger stimulus packages. “A financial crisis is not the time to teach markets a lesson by allowing a generalized debt deflation to ‘simplify’ the system. Furthermore. We must return to a more sensible model.aspects of the financial system. bailouts will be required. and the dizzying array of extremely complex instruments that only a handful understand. Monetary policy should stabilize interest rates. and policy that was biased toward market segmentation. maintain direct credit controls. He also calls for preserving home ownership and creating a new institution in line with President Franklin D. the United States will feel the effects of the current crisis for some time—perhaps a decade or more. No. says Wray. which are probably politically infeasible. leverage. Dimitri B. According to Minsky. the demise of relationship-based banking. Wray discusses lessons from Minsky that could be used to reformulate policy and deal with the present crisis. with enhanced oversight of financial institutions. He calls for mortgage relief that stabilizes the real estate sector and reform that amends the bankruptcy laws. Moreover.” As always. as it will be difficult for the United States to grow its way out of the problem. government should act as the employer of last resort in order to eliminate involuntary unemployment and reduce inequality and poverty. President March 2008 6 Public Policy Brief. Wray notes that the policy initiatives of the George W. As economic activity slows. As Minsky put it. there will be revelations of problems throughout the entire financial sector. Asset price depreciation will not be restricted to residential real estate.

still project a moderate reduction of growth. and while there are calls for reregulation of the home mortgage industry. the conventional view is that the damage will be contained through a combination of interest rate cuts and the fiscal stimulus package that will send checks to most taxpayers in late spring 2008.Financial Markets Meltdown In previous work. 2008).” and. few analyses recognize the true depth of the problems facing the financial system. this downturn might prove to The Levy Economics Institute of Bard College 7 . With 20/20 hindsight.” Indeed. To be sure. A few now recognize that problems have spread far beyond mortgages and real estate. “money manager capitalism. risky innovations. I examined the problems in the securitized subprime mortgage market that led to a crisis last summer (Wray 2007. The majority of commentators. probably the most astute observer of the financial system of the past century. and will make some general policy recommendations to ameliorate the damage done to the financial structure over the past couple of decades by lax oversight. Still. in Minsky’s phrase. Minsky’s writings can shed a lot of light on the current problems. Magnus 2007. including officials at the Federal Reserve (Fed). with some even calling it a “Minsky moment” (Whalen 2007.” “transactions-oriented capitalism. While it is believed that it could take residential real estate several years to recover. Many commentaries on the mortgage securities meltdown have referred to the work of the late Hyman P. with recovery later this year. and deregulation. pundits finally recognized the real estate bubble and the dangerous financial practices that had developed in that sector over the previous four or five years. as well as on the direction that financial system reform ought to take. This brief will provide a Minskyan analysis of the forces that have brought us to the present situation. Minsky. Cassidy 2008). What we actually confront is a systemic failure resulting from a fundamentally flawed model—what has been variously called “market fundamentalism.

The causes are complex and have developed over a very long period. if the fundamental problem is with the design of the financial system itself. it is important to distinguish the framework adopted here from popular explanations that blame real estate sector excesses for the meltdown. Money Manager Capitalism and the Systemic Nature of the Crisis What was recently seen as “creative” and “innovative” democratization of credit is now viewed as misguided and culpable bungling—or worse. However. No. with an eye to longer-term trends that have made the system much more prone to crisis. stability is destabilizing.” Those who were caught up in the boom behaved “rationally. —Warren Mosler (2008) 8 Public Policy Brief. and contingent upon continued evolution of the financial system. yet another crisis will arrive shortly to expose other flaws. Minsky would not attribute the crisis to “irrational exuberance” or “manias” or “bubbles. Pollock (2007) The financial system is a lot more trouble than it is worth. according to Minsky. Before proceeding.” at least according to the “model of the model” they had developed to guide their behavior. to excessive monetary ease. —Alex J. behavior of policymakers. or even to lax supervision. As such. solutions will also be multifaceted. the real estate sector might recover more quickly than most expect. tentative. It is far too simple to attribute the current crisis to a speculative boom in real estate. Still. 94 . For that reason. a large part of the blame must be laid on the relative stability experienced over the past couple of decades—the tranquility that made the boom possible also created fragility because. and losses and write-downs at financial institutions might subside. It is only in retrospect that we can see the boom for what it was: mass delusion propagated in part by policymakers and those with vested interests. reform is needed. future income. That model included the prospective course of asset prices.be shallow. and ability to hedge risks or shift them onto others.

2008). sufficient to bring us to the present precipice.Speculators may do no harm as bubbles on a steady stream of enterprise. deregulation and legal recognition of new practices were not. the Treasury. In addition. by themselves. other rules and regulations that dated to the New Deal financial reforms also constrained practice to preserve safety and soundness. As Minsky always argued. In addition. causing them to suffer “disintermediation” (retail deposit withdrawals) when market rates rose above legislated deposit rates. as in Minsky’s scenario. to lender-of-last-resort activity of the “Big Bank” Fed. and to periodic bailouts arranged by the Fed. new practices and instruments were validated. but also to countercyclical movement of the “Big Government” budget. the fallout is contained. by preventing “it” (a debt deflation on the order of the 1930s collapse) from happening again. the remarkable thing about the postwar period is the absence of depressions. while financial crises arise from time to time. allowing commercial banks to engage in a wider range of practices in order to better compete with their relatively unregulated Wall Street rivals. Each rate hike intended to fight inflation caused problems for commercial banks and thrifts that were subject to Regulation Q interest rate ceilings. they are constrained. —John Maynard Keynes (1964) Irrational exuberance? No. As time passed. financial institutions responded to each tight-money episode by innovating and creating new practices and instruments—making the supply of credit ever more elastic (Wray 1994). If these innovations had led to excessively risky behavior that generated huge losses. the story begins with the Fed’s increasingly aggressive use of interest rate changes in an effort to fine-tune the economy (Wray 2007. The Levy Economics Institute of Bard College 9 . financial institutions would have been reluctant to retain them. However. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation. the upside tendency toward speculative booms became correspondingly more difficult to contain. This is due in part to the various reforms that date to the New Deal. as well as usury laws that limited loan rates. the seeds of the current financial crisis were sown long ago. or Congress. Still. the Fed and Congress gradually removed constraints. While recessions occur with regularity. According to Minsky. The interest rate ceilings allowed the Fed to engineer “credit crunches” by pushing market rates up. As I have previously documented.

However. Just as the irrational exuberance that developed in equity markets in the 1990s was based on the belief that a “new economy” had created conditions in which dot-com companies could only rise in value—validating exploding stock prices—the 2000s saw unprecedented real estate appreciation that validated increasingly risky Ponzi finance. policy-validated). and the search for high returns by money managers of funds that had accumulated wealth over decades. new instruments continually eroded the bank share of assets and liabilities—which fell by half between the 1950s and the 1990s. No. 94 . 2008). this practice reduced their competitive advantage in direct funding of business. profit-seeking financial innovations that stretched liquidity and enabled prices of real estate and equity to reach unjustified and unsustainable levels. Banks were forced to become more market-oriented. as shown in Table 1. Over time.1 The securities market share of private nonfinancial debt rose from 27 percent in 1980 to 55 percent in February of this year (Greenlaw et al. while servicing Wall Street firms would replace some of the relationship banking they had lost. This growth of managed money continually eroded banks’ traditional lines of business. Initially. by the early 1970s. insurance funds. As Minsky (1986) noted. banks then could earn fee income for provision of the backup facilities. Further. banks had access to insured deposits as well as Fed lender-of-last-resort intervention. as pension funds.In other words. firms were already turning to the commercial paper market for short-term borrowing. Minsky (1987) observed that banks appear to require a spread of about 450 basis points 10 Public Policy Brief. Yet. Other market innovations allowed for diversification of risk in the form of issued securities collateralized by pooled loans—apparently eliminating the advantage banks had previously held. ensuring they could issue liabilities without facing much chance of a run. an early crisis in the commercial paper market led to the practice of obtaining backup lines of credit with banks. hedge funds. both bubbles were fueled by a combination of optimistic expectations that developed over many years. bank funding had an advantage over market sources of funding because banks could diversify risks across a large number of borrowers with different income sources. taking business away from banks. On the one hand. and so on provided an alternative source of funds in competition with bank loans. irrational exuberance is just the end result of longterm. but on the other hand. settling for a smaller share of the financial system. policy-induced (and in turn.

804 (13%) 4.595 (11%) 9. and closed-end and exchange-traded funds. and federal government retirement funds) pensions. 4 Includes money market mutual funds.877 (36%) 5.731 (13%) 2.095 (13%) 3.507 (100%) 2.116 (100%) 60.541 (100%) 4.221 (3%) 2.716 (8%) 1. real estate investment trusts.079 (5%) 1.552 (100%) 1985 1995 2000 2005 2007 20.722 (20%) 1. 5 Includes finance companies and mortgage companies.458 (12%) 1. and credit unions.944 (10%) 1.127 (4%) 4.192 (17%) 11.998 (11%) 7.387 (18%) 4.365 (11%) 10. 3 Includes private and public (state and local government employee retirement funds.170 (18%) 7.498 (11%) 8.769 (23%) 6.626 (13%) 1960 1970 Total 635 (100%) 1.342 (52%) 646 (14%) 786 (17%) 146 (3%) 309 (7%) 692 (8%) 497 (6%) 1. 1960 to 2007 (in billions of dollars) 1980 1990 13.795 (24%) 5.787 (44%) 8.111 (18%) 8.579 (21%) 6. Source: Federal Reserve Board Flow of Funds Accounts .447 (100%) Depository 1 Institutions 347 (55%) 788 (54%) Insurance 2 Companies 142 (22%) 252 (17%) Pensions 3 75 (12%) 212 (15%) Mutual Funds 4 23 (4%) 53 (4%) GSEs and Agencyand GSE-backed Mortgage Pools 12 (2%) 51 (4%) Nonbank Lenders 5 29 (5%) 71 (5%) 213 (5%) 45 (1%) 19 (0%) 187 (2%) 363 (4%) 156 (2%) 262 (2%) 547 (4%) 596 (4%) 705 (3%) 568 (3%) 1.128 (23%) 4.255 (10%) Security Brokers and Dealers 7 (1%) 16 (1%) Others 6 0 (0%) 5 (0%) 1 The Levy Economics Institute of Bard College 2 11 Includes commercial banks.775 (21%) 1.911 (3%) 3. savings institutions.361 (13%) 13.817 (28%) 2.885 (14%) 2.857 (4%) 2. mutual funds.961 (100%) 35.384 (100%) 11. 6 Includes asset-backed securities issuers.327 (17%) 6.095 (5%) 6.213 (3%) 1.155 (9%) 1.Table 1 Financial System Assets Held by Type of Institution.468 (12%) 3.701 (100%) 50.789 (23%) 2. Includes life insurance and property-casualty insurance companies. and funding corporations.

Indeed. each of those presumptions proved to be woefully incorrect. and insurers protected against losses. They also provided backup liquidity guarantees to those involved in packaging and selling securities. rendered the models increasingly useless even as they were used on a grander scale to justify falling interest rate spreads that implied virtually no defaults would ever occur. the securities. no one had assessed those risks. To replace lost income. Ironically. relative stability will necessarily encourage behavior that changes the financial structure (he used the terms hedge. By contrast. as is now recognized. and Ponzi to describe the transformation). This was another process that Minsky 12 Public Policy Brief. they could escape reserve and capital requirements.between interest earned on assets and that paid on liabilities. plus the required reserve “tax” imposed on banks (reserves are nonearning assets) and the costs of servicing customers. and that market forces will discipline decision making. but by moving loans such as mortgages off their books. 94 . banks began to take direct positions in the poolers.) There was no need to develop relationships with individual borrowers in order to assess creditworthiness. and required that the structure of the financial system remain constant. financial markets can operate with much lower spreads precisely because they are exempt from required reserve ratios. earning additional fees. speculative. This covers the normal return on capital. regulated capital requirements. this meant that they were now exposed to default risk of borrowers they had never assessed. since loan pools diversified risks. as it turned out. banks would earn fee income for loan origination. and even gave money-back guarantees to holders of securities if the underlying loans went bad. This evolution. that markets can hedge and shift risk to those best able to bear it. Further. It is a systemic problem resulting from the notion that markets can properly assess risk based on complex. (They might continue to service the loans. and the insurers. backward-looking models. risk raters evaluated the risks of the overall pools. The models were constructed based on data generated during an unusually stable period in which losses were small. This is why the problem is not confined to subprimes or to an irrational real estate market. the models could not account for growing interrelations among debtors. No. increasing the systemic risk that insolvency by some would generate a snowball of defaults. and much of the costs of relationship banking. To restore profitability. as Minsky (1986) observed. In fact. in turn. However.

finally. but because managers of funds were in a desperate search for high returns. We also know there are “known unknowns”. they were forced to ignore risk where it was underpriced. that is to say we know there are some things we do not know.” —Mark Twain (quoted in Black 2007) As we know. In other words. Minsky (1987) It’s not the things you don’t know that cause disasters. As Keynes (1964) put it. there are things we know we know. there are “known knowns”. as we now know. and bank purchases of securities. Much of it came back directly to banks through buyback guarantees. many of today’s problems can be traced back to securitization—the pooling of assets to serve as collateral against issued securities. as they were content either to rely on ratings agencies or to simply follow the leader down the path to inevitable destruction. —Donald Rumsfeld (2002) While the troubled instruments and institutions are varied. Many did not even pretend to understand the instruments they were buying. But there are “unknown unknowns”—the ones we don’t know we don’t know. While seemingly innocuous. nor was it even necessarily shifted. —Hyman P.” Securitization and Leverage That which can be securitized will be securitized. backup credit facilities.always emphasized. And. it’s the things you do know. and one that is enhanced by the high leverage ratios that became common in the 2000s as margins of safety were reduced. securitization has led to a dizzying array of extremely complex instruments that— The Levy Economics Institute of Bard College 13 . “Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally. the increased competition coming from managed money narrowed interest rate spreads. For example. competition forced them to take on excessive risk given returns. markets did not discipline behavior but in fact encouraged ever-riskier activities. Further. risk was not properly hedged. but aren’t true.

Cary Leahey (2007) said the problem is in “opaque hard-to-value credit derivatives. the credibility of real estate agents. or SIVs) and monoline insurers (which provide insurance for MBSs). 94 . are threatened. It quickly spread to securities backed by “Alt A” mortgages (less risky than subprime. we will examine the phenomenon of securitization.2 By fall 2007. as George Soros (2008) said. and then to more exotic markets—CDOs. asset-backed commercial paper (ABCP). Further.” which is why a bank might value derivatives at $90 billion one day and at $22 billion the next (Norris 2008b). although it is too early to say how hard they will be hit. especially in the subprime section of that market. No. we will look in more detail at its consequences.” In this section. markets had lost faith in the models and the myths. “mark to model” or even “mark to myth” substituted for “mark to market” because markets could not value the instruments. It wasn’t supposed to happen this way—securitization was supposed to reduce risk and to shunt it to those best able to handle it. Finally.quite literally—only a handful understand. Still other financial instruments. and financial institution officers has been called into question because of practices that have developed over the past decade. and other asset-backed securities (ABSs. 14 Public Policy Brief. such as municipal bonds and credit default swaps (CDSs). “Everything that could go wrong did go wrong. Warren Buffet has called the new instruments “financial weapons of mass destruction. The current financial crisis began in the market for mortgage-backed securities (MBSs). credit-rating agencies. including other types of consumer debt).” as his firm announced plans to scale back such operations (Norris 2008a). But. “I’ve had all the fun I can stand in investment banking. Merrill Lynch (2007) opined that collateralized debt obligations (CDOs) “are arguably the most complex financial instrument ever to become mainstream. later. problems spread beyond specific asset classes to institutions such as special purpose vehicles (including special investment vehicles. mortgage brokers. Economist M.” An exasperated Bank of America CEO proclaimed after massive losses on complex positions in such instruments. accountants. property appraisers. and to major financial institutions (including private banks as well as governmentsponsored enterprises like Fannie Mae). but too risky to qualify for conventional loans).” Throughout the financial world.

2008 Dollars (Billions) 10.3 trillion of that) and commercial MBSs totaled $650 billion (Table 2).000 9. As of last year. and credit card ABSs reached $343 billion. Other ABSs totaled nearly $2. activity in the world’s overthe-counter derivatives market was about $2. of which residential MBSs made up $7. Credit Instruments by Type. 2007 (in billions of dollars) Securitized Products Total MBSs Residential Subprime Prime Commercial ABSs Home Equity Credit Card Student Loans Auto-related CDOs/CLOs Other* Memo: CDSs Memo: Nonfinancial Corporate Debt Memo: Commercial Paper Memo: Leveraged Buyouts * Miscellaneous items.478 596 343 236 199 302 802 45. including equipment leases. securities backed by student loans and auto-related borrowing amounted to another $435 billion.1 trillion (with subprimes totaling $1.5 trillion. Total credit card debt has also been fast growing—the growth rate reached 9. it is useful to get some idea of the relative sizes of these credit instruments.300 5.100 1.500 13.300 Percent 100 76 69 13 57 6 24 6 3 2 2 3 8 To put things in perspective. while world trade was just $12 trillion per year. CDOs and collateralized loan obligations together equaled just over $300 billion.750 7.2 trillion.000 2. Greenlaw et al. almost $600 billion of which was held in securities backed by home equity loans.1 trillion per day.S. Sources: Leahey 2007. At the end of 2007. securitized bond market was estimated at about $10. the total U.Table 2 U. The Levy Economics Institute of Bard College 15 .800 650 2.3 percent in the fourth quarter of 2007 and now totals roughly $1 trillion dollars (Merrill Lynch 2007.228 7. Leahey 2007).S. UBS Investment Research 2007. Lim 2007.

Securitization has also been called the “originate and distribute” model. residential real estate ($20 trillion). Leveraged buyouts in the first half of 2007 reached $13. that securitization allowed for diversification of risks while efficiently allowing investors to achieve the proper risk/return tradeoff. However.5 trillion in mid-2007. In the aftermath of the 2000 equity market 16 Public Policy Brief.S. German investors with no direct access to U. Securitization is a “market-oriented” financial practice.” “market fundamentalism. having grown ninefold in the past three years.” Minsky (1987) argued that securitization was part and parcel of the globalization of finance.” or “transactions-oriented capitalism. these are not directly comparable to credit derivatives because most will not be exercised. The problem is that the incentive structure in which mortgage originators operated was sure to create problems. these numbers do help to clarify why even single-digit percentage losses on financial assets can generate very big numbers relative to GDP. with ABCP equal to $1 trillion (Greenlaw et al. in contrast to “bank-based” transactions in which activities are financed by loans held on bank balance sheets against deposits held in the banking system.In recent years.S. Of course. Lots of presumptions about these instruments and practices have been exploded in recent months. including the belief that securitization shifted risks off bank balance sheets. 94 . Estimates of the total quantity of CDSs are as high as $45 trillion.3 trillion (Lim Mah-Hui 2007). nonfinancial corporate debt has also been growing rapidly—three times faster than GDP—in spite of high profit rates. real estate markets. 2008).S. No.3 Bank exposure to CDSs is estimated at $18. Naturally. which accurately captures a distinguishing feature of the process: the institution that arranges the finance of activities does not hold the loan. and that securitization put risk into the portfolios of those best able to handle it. just citing gross estimates of the size of financial instruments does not necessarily say anything about risks to the financial system or to the “real” economy.2 trillion. These were little more than bedtime stories told on Wall Street and in Washington to justify risky and unsupervised practices that were characteristics of what was variously called “financialization. a sum nearly equal to the total value of U. and now totals over $9 trillion (Leahey 2007). as it creates financial paper that is freed from national boundaries. Outstanding commercial paper peaked at $2. homeowners could buy a piece of the action in U.

and protect—something that was celebrated rather than feared. urging home buyers to take on adjustable rate debt. The low interest rate policy of the Fed under former Chairman Alan Greenspan meant that traditional money markets could not offer adequate returns. and all others in the home-finance food chain. AMBAC. Ironically. their incentive was to increase throughput. further enhancing the securities. supervise. originating as many mortgages as possible. FGIC Corporation. generating early-repayment penalties and more fees for originators.” provided in this case by Congress. this shift to “markets” reduced the portion of the financial structure that the Fed is committed to regulate. Such insurers—often called monolines—include MBIA (the world’s largest financial guarantor).crash. Greenspan gave the maestro seal of approval to the practice. with high premiums) that would pay off the mortgage in the event of death. investors in dollar assets looked for alternative sources of profits.4 As originators would not hold the mortgages. but more importantly. holders of securities. securitizers. and mortgage brokers relied on fee income rather than interest. The health of the insurers. the Orwellian-named “affordability products” were not affordable— at the time of reset.5 Subprime lenders often require borrowers to carry credit life insurance (conveniently sold by the lender’s subsidiary. thrifts. since banks. Fitch). since MBSs were rated by the agencies (Moody’s. which tracks the cost of insuring against defaults on subprime securities. Indeed. Standard and Poor’s. some of the subprime loans are covered by mortgage insurance. there was little reason to worry about borrowers’ ability to pay. insurance was sold on the securities themselves. By design. in turn. was assessed by the same ratings agencies. These firms had traditionally insured municipal bonds and their foray into mortgagebacked securities seemed to be a sensible extension to a much more profitable sector that did not appear to be much riskier. Insurance allowed the debts to gain the highest The Levy Economics Institute of Bard College 17 . and mortgage originators offered subprimes and other “affordability products” with ever-lower underwriting standards. Finally. the homeowner would need to refinance. and CFIG. The fate of homeowners was sealed by bankruptcy “reform” that makes it virtually impossible to get out of mortgage debt—another very nice “credit enhancement. as well as by the ABX subprime index. Investors lusted for higher risks.

but without the assessment of borrowers’ ability to repay that relation-based 18 Public Policy Brief. because banks often kept the worst loans out of the packages. could leverage by factors of 20. the new arrangements appeared to offer a nearly infinite supply of impersonal credit with no need to evaluate borrowers’ ability to repay.” used to demonstrate to buyers that the banks had confidence in the underlying mortgages they had originated or packaged. and assets). 94 . Instead. the move to “market-based” funding left banks holding much of the risks. where the firms to be purchased are used as collateral for the funds borrowed for their takeover). enhancing efficiencies and narrowing interest rate spreads (Kregel 2007). hedge funds could be profitable at low interest rate spreads. By contrast. in turn. In many cases. promises to buy back bad securities. As discussed. while relationship banking had based loans on the relevant characteristics of the borrower (such as income. No. no more. banks provided the loans that were used to buy the ABS collateral that contained the mortgages the banks were trying to move off their balance sheets! The hedge funds. holding them on their books for extra returns. combined with credit enhancements. banks would live on origination and servicing fees.or fourfold increase of leverage is one of the reasons that “markets” based on securities could operate much more profitably than bank-based lending.7 This three. It is even worse than that. led banks to abandon their reluctance to purchase securities with the riskiest underlying debts. and because banks often retained an equity share in the securities—“skin money. while at higher leverage ratios. Ironically. banks could leverage capital by a factor of perhaps eight. 30. Ultimately. Ironically. or more to hold the ABSs.6 The incentives to increase throughput. “quant models” based on historical data regarding default rates of purportedly similar borrowers would replace costly relationship banking. however. ABSs with high ratings would be purchased by hedge funds and others that would use the securities as collateral to raise funds for their purchase (much as in leveraged buyouts. credit history. and relations with monoline insurers. required extremely low default rates as well as layers of insurance and backup lines of credit. in turn. much of the risk returned to banks in the form of loans made to buyers of the securities. These low spreads.ratings—ensuring a deep market and low interest rate spreads (Richard and Gutscher 2007).

need fear. The risk simply moved from bank balance sheets. —Hyman P. In the last few years. The belief is that. which played an important role in inducing banks and thrifts to move mortgages off their books. How much is uncertain. capitalist economies tend to move from a financial structure dominated by hedge finance units to a structure in which there is a large weight to units engaged in speculative and Ponzi finance. due to a happy confluence of a number of factors. a revised view of economic possibilities has been developed that goes by the name “the Great Moderation” (Bernanke 2004. where it was regulated and more or less observable. And rather than shifting risk to those best able to bear it. but the combined risk could total $1 trillion to $2 trillion. a condition characterized by a new economy that is far less vulnerable to “shocks. comes right back to banks in the form of solvency risk of SIVs and hedge funds. —Robert L. Without it. the world is now more stable.” Further. it feels wonderful on the upside. to a place where it isn’t regulated or observable—but where it still threatens bank solvency (Das 2007). Greed Trumps Fear: The Evolution to Fragility and Crisis The abundance of liquidity is a function of creative debt leveraging. and particularly the big players within them. but watch out how it can come back to bite you on the downside. Minsky (1992) Financial markets. the new financial system shifted risk “on to the shoulders of those least able to understand it” (Wolf 2007b).banking had used to reduce risk. Even the interest rate risk due to maturity mismatching. a necessary precondition— was a change in the “model of the model” adopted by market players. they go crazy. Rodriguez (2007) Over a protracted period of good times. Like all leverage. —Martin Wolf (2007a) Superimposed on these developments—indeed. central banks have demonstrated both The Levy Economics Institute of Bard College 19 . Chancellor 2007).

10 Ratings agencies worked closely with the underwriters that were securitizing the mortgages. by taking some of the “frown costs” out of discount-window borrowing—as a few of the major banks were induced to borrow unnecessary funds—and by lowering the penalty on such borrowing as the spread between the Fed funds rate and the discount rate was lowered. More recently. New York State Attorney General Andrew Cuomo has sued the First American Corporation for colluding with mortgage lender Washington Mutual to overstate the value of homes (Barr 2007). Indeed. The Great Moderation allowed greed to trump fear. Greenspan was able to organize a successful response to the collapse of Long-Term Capital Management (LTCM) in 1998. The ratings agencies were also complicit because their appraisals of the securities were essential to generating markets for risky assets. No.9 There is little doubt that inflated appraisals played a major role in fueling the speculative boom—just as they had helped to create the savings-and-loan fiasco in the 1980s by rubber-stamping values in “daisy chains. threats to the financial system. according to conventional views. they were richly rewarded for helping to market mortgages. since fees in that area were about twice as high as those awarded for rating corporate 20 Public Policy Brief.willingness and a capacity to quickly deal with. to ensure ratings that would guarantee marketability. responding to the subprime crisis by “pumping liquidity” into markets. and the revelations are piling up. guarantee a predetermined value.11 Further. 94 . an industry group (Concerned Real Estate Appraisers from Across America) circulated a petition that was presented to Ben Henson. enumerating unfair practices that included withholding of business or payment if appraisers refused to inflate values. and isolate. there are the appraisers. Fed Chairman Ben Bernanke is supposed to have continued in the Greenspan tradition. Even as energy and food prices fueled inflation. First. executive director of the Appraisal Subcommittee of the Federal Financial Institutions Examination Council. Real estate appraisers across the country have complained that they were strong-armed by lenders to inflate values.” and other fraudulent schemes (Wray 1994). For example. the Fed made it clear that it remains on guard against any residual fallout from mortgage losses. and later rapidly lowered interest rates to steer the economy out of the recession triggered by the equity market tumble.8 by quickly lowering the Fed funds rate. or ignore deficiencies in the property.

no assets). to lie about income and other information relevant to the application process). House of Representatives. the nature of the financial system changed in a fundamental manner that ensured its evolution toward fragility. some of this was fraudulent (on the part of both lender and borrower). much has already been written about borrower greed. But it wasn’t until the summer of 2007 that agencies finally began to slash ratings when they were forced to recognize the flaws in their models. credit card debt. but much was also based on the belief that real estate values could only go up—thus. which then sets up the bust. quipped.”13 In sum. Goldman Sachs said that according to its computer models. a hedge fund consultant. If anything. The models were based on data derived from only a few years’ experience that coincided with an unusually good period for house prices. which creates the boom. and mortgages) (Lucchetti and Ng 2007).” something that should happen once every 100. and then observing other people’s success. Satyajit Das.000-years events but they seem to happen every year” (quoted in Tett and Gangahar 2007). mortgage securitizers relaxed their due diligence tests even as lenders relaxed loan standards (Rucker 2007).000 years (Tett and Gangahar 2007).12 Furthermore. which builds up the optimism. “People say these are one-in-a-100. raters should have been lowering ratings.” As Alex Pollock (2007) testified before the U.bonds—the traditional business of ratings firms. and even encouraged. to “Ninja loans” (no income. Minsky would label the faith in the era of the Great Moderation a “radical suspension of disbelief.S. . The subprime market bloomed. “Booms are usually accompanied by a plausible theory about how we are in a ‘new era. Certainly. Moody’s got 44 percent of its revenue in 2006 from rating “structured finance” (student loans. its losses on one of its global equity funds was a “25-standard deviation event. houses and condominiums—providing a surefire way for both lenders and borrows to make money. .’ . no job.” The radical suspension of disbelief that allowed markets to ignore downside potential created “optimism and a euphoric belief in the ever-rising price of some asset class—in this case. as “low doc” loans (less documentation required) evolved to “no docs” and to “liar loans” (borrowers were allowed. Ponzi finance was encouraged by the relative tranquility of the market. and finally. The Levy Economics Institute of Bard College 21 . The models used to value the securities could not take into account structural changes to the economy or of systemic risk. It is first success. with increasingly risky instruments and practices. Of course.

our economic leadership does not seem to be aware that the normal functioning of our economy leads to financial trauma and crises. —Hyman P.” as Minsky would put it. and poverty in the midst of what could be virtually universal affluence—in short. admitted. —Erik R. ever-riskier practice. Minsky (1986) It’s sort of a little poetic justice. the models themselves drive the market—generating “herding behavior” that can have devastating results when all are simultaneously “selling out position. But the behavior induced by these beliefs changed the structure of the financial markets so that everything would go wrong. and when there is a lot of selling. —Warren Buffet (quoted in Dabrowski 2008) Hope is a crappy hedge. No. currency depreciations.Further. the apparent success of the “originate and distribute” approach encouraged erosion of margins of safety. James Norman. The new system required accurate appraisals of values of the underlying assets and accurate evaluation of the risks of the securities. What has happened is a repricing of risk and an unavailability of what I might call “dumb money. and misrepresentation in the belief (or at least hope) that nothing could go wrong. unemployment. Sirri (2007) The combination of low interest rates and rising real estate prices encouraged a speculative frenzy that would end only if rates rose or prices stopped 22 Public Policy Brief. that financially complex capitalism is inherently flawed. .” of which there was plenty around a year ago. 94 . . collusion. “Quants are valuation-driven. since similar models are widely used. in that the people that brewed this toxic Kool-Aid found themselves drinking a lot of it in the end . valuations don’t matter” (Brewster 2007). However. a managing director in Deutsche Asset Management’s quantitative strategies group. Retribution To be exact. inflation.

attenuating rising property values. and began to deleverage by selling. and given that projections of eventual average house price declines of as much as 30 percent. some of the credit markets for municipalities had dried up as monoline insurers faced problems. JPMorgan Chase holds $95 billion of home equity loans and expects losses of $450 million during the first quarter of 2008. with some outside projections reaching $1 trillion. Of course. this amounts to a total loss of household wealth of $6 trillion. and since most people will not have to sell their homes in a depressed market. homeowners had used such loans not only to remodel homes. When losses on subprimes began to exceed expectations that had been based on historical experience. including money market mutual funds and commercial paper markets. because Fed rate hikes would slow speculation.17 Considering that total home values are more than $20 trillion. lenders are last in line for payment when homeowners default on debt since mortgage holders are paid first when a home is foreclosed. Total losses are hard to project.16 Projections of losses on residential MBSs range from about $200 billion to $500 billion. Unfortunately. total realized losses will be far less than the notional loss. Indeed. and on the ease with which households are allowed to work out debt positions. some homeowners seem to recognize that “there are few repercussions if they stop making payments on their home equity loan” (Sidel 2008). all of these losses will not be realized—since only about half of the value of homes is mortgaged. on the depths to be reached in the coming recession.15 By early 2008. and increasing risk spreads. both events were inevitable.18 Of course.14 Problems spread to other markets. Thus. the estimate of $1 trillion might set an outside estimate of losses to be realized in the residential real estate sector—with actual losses depending on the ultimate depreciation of home values. and banks became reluctant to lend even for short periods. owners faced huge losses. but some large lenders have 12 to 19 percent of their assets in home The Levy Economics Institute of Bard College 23 . It is also worth noting that problems are now showing up in home equity loans. were dynamically linked. thus putting more downward pressure on prices.rising. but also to finance consumption purchases and to pay down credit card debt. greatly exceeding their capital. Delinquency rates doubled during 2007 and are continuing to climb. indeed. With big leverage ratios. rising to a billion dollars by the end of the year. During the real estate boom. prices of securities began to fall.

because unfinished projects result in big losses (Norris 2007).20 Delinquencies on subprimes are still rising.6 trillion of mortgage debt under water. nearly half of subprime delinquencies have resulted in foreclosures. Small. holdings equal 272 percent of capital. exposing banks to large direct losses. Washington Mutual.and medium-size banks—squeezed out of the mortgage and credit card business in recent years—focused on construction and commercial real estate lending. the financial services firm UBS shows that losses can reach above 90 percent of the value of the loan (UBS Investment Research 2007). Many of them have more construction loans outstanding than bank capital—up from only a third of capital a few years ago. Vacant houses that are going through foreclosure negatively impact real estate values in the neighborhood. small banks hold commercial real estate loans equal to nearly 300 percent of their capital. and with falling real estate prices. very bad. the proportion of homeowners with negative equity will rise to 21 percent (10. the loss on a typical subprime foreclosure can be substantial for two reasons. In a study of foreclosures.equity loans. and historically. Further. When construction loans go bad. During that process. down payments were small or nonexistent. the impact on the economy would be large. It is hard for many observers to believe that even double-digit default rates on subprime loans could amount to large losses because (a) surely the homes must have some value even after foreclosure. 94 . however. at midsize banks. and add to the inventory of unsold homes. (2008). local government suffers loss of tax revenue even as expenditures rise to take care of vacant properties—meaning that other public services must be reduced as the economy stagnates. foreclosure can be a long process. even if losses had not spread beyond subprime loans.19 Second. and (b) subprime loans represent only about 6. and Wells Fargo. Further.5 percent of the total value of homes. Even moderate 24 Public Policy Brief. including National City Corporation. that rate could go up as house values fall and foreclosure cases tie up the courts. However.21 But problems have already spread far beyond residential real estate. SunTrust Banks. According to Greenlaw et al. Losses don’t stop there. they go very. taking up to two years or even longer. Of particular concern are loans in the construction sector. No. First. with perhaps $2. the loan servicer takes over mortgage payments and has first claim on proceeds from the sale of the house. equity can be hugely negative. Hence.5 million households). if home prices fall by 15 percent.

when real estate markets started to collapse and home equity loan standards tightened. following the securitization path blazed earlier by subprime lending. In many cases. Collateralized debt obligations (mostly business loans) are another half trillion dollars. this could mean another $150 billion in losses overall. UBS believes charge-offs could reach as high as 7 percent. downgrades on some lowered asset values to 70 percent of liabilities (UBS Investment Research 2007).losses on such loans could wipe out much of their capital (Dash 2008). and the value of their assets plummeted (a solvency problem). Moody’s reviewed all 33 SIVs and took action on 16. Delinquency rates reached 6. and already stood above 4 percent last November. 2007. On November 7. total losses on nonfinancial corporate debt could approach $400 billion (Veneroso 2007). If losses were typically in the range of 30 percent. SIVs currently hold about $450 billion in assets of which $168 billion is residential MBSs. The banks received fee income and provided backup credit. homeowners turned to their credit cards. the synergistic effects of massively negative home equity. Over the course of the real estate boom. SIVs typically have only 10–15 percent. If default rates by firms rise to what has been normal recession experience. nonfinancial corporate debt has been growing three times faster than GDP. Historically. as the market is already pricing in spreads that indicate expected losses greater than in 1997–98. and rising The Levy Economics Institute of Bard College 25 . while SIVs borrowed short term in the commercial paper market to invest long term in securities. While traditional commercial paper has 100 percent bank backing in the form of lines of credit. Financial markets responded. rising unemployment (should the recession deepen). charge-off rates remain relatively low (UBS Investment Research 2007).3 percent in the 1991–92 recession and 5. paying off the commercial paper and taking bad assets onto their books. However. Because bankruptcy reform made it hard for consumers to get out of credit card debt. When problems appeared.6 percent in 1997–98. As discussed. Banks have already taken significant hits due to conduits and SIVs they set up to hold MBSs or CDOs. credit card debt (now about $1 trillion) has been far riskier than mortgage debt. thus forcing them to default on commercial paper and to sell assets. households used their homes as cash-out ATMs. the banks were hit with a double whammy: they couldn’t roll over or issue new commercial paper (a liquidity problem). with high charge-offs in recessions. banks had to rescue their SIVs.

a 5 percent loss experience on CDSs is not out of the question (Seides 2007). Hedge funds sold almost $15 trillion of the CDSs (for comparison purposes. defaults on similar debt ran about 22 percent. loose lending standards. quoted in Nocera 2008). commercial loans. emphasis on throughput. In the last recession.5 trillion). Banks are the primary sellers of CDSs (40 percent of the total). Risk is supposedly fully hedged. Just as with the case of subprimes. Total “junk debt” now stands at $2.25 trillion. these were created (in the mid-1990s) to allow Wall Street to take loans away from commercial banks—in this case. In each year since 2004. Perhaps $70 to $100 billion of losses on credit cards and credit card ABSs can be expected as an outside estimate. Indeed. highly leveraged positions. with recoveries at only 40 percent of the value of the deals. total hedge fund assets are currently about $2. About a third of the CDSs are essentially derivatives of “junk”—below-investment-grade credits. Leveraged buyout operations have been booming. but judging from the bank experience with subprimes. The total euphemistically named “high yield” bond market is up 70 percent since the last recession. As Seides puts it. credit default swaps (CDSs) are above $45 trillion in aggregate. and the imprimatur of ratings agencies to bless them.5 trillion. separation of risk assessors from risk takers. almost every aspect of the subprime story can be told by substituting “junk bonds” for “securitized subprimes”: paltry yield spreads. “Never in history has the American family skidded into recession with so much debt” (Elizabeth Warren. dwarfing those of the Michael Milken era of the 1980s. the “junk” was transformed into tranches that included highly rated paper. we are talking about real money on the order of $2. but with almost no loss reserve. having grown ninefold in the past three years (Seides 2007). more than 40 percent of all new debt issued was junk (Seides 2007). If losses were to reach 5 percent. never before have we entered an economic downturn with so much risky paper riding on the fortunes of companies known to have such poor credit quality. a lot of the risk could come back to haunt them. not quality. As the historical mortality on “junk” is 28 to 47 percent.inflation (especially of energy prices) could lead to higher defaults and losses. No. It is not inconceivable that losses on “junk” could reach $400 billion. with estimated exposure at more than $18 trillion. Much like MBSs. 94 . As discussed. Those 26 Public Policy Brief. These are much like giant insurance funds.

However.left holding the bag will be the sellers of CDSs. Hence. the damage would be even more severe than it was in California. the owners of CDOs. One pundit remarked that the subprime fallout will be contained—to planet Earth—as losses spread throughout the financial system (Mauldin 2007). California had an advantage in that the United States experienced robust growth during the Clinton years. SIVs. In the postwar period. as documented above. Indeed. Finally. we could achieve realized losses amounting to another few trillion dollars. are no longer complacent. while foreclosure rates were still substantially higher even a decade after the downturn began. 2008). A trillion here and a trillion there—it adds up to large numbers even in a $13 trillion economy. and other business debt could reach well over $1 trillion. there have been regional crises in which house prices fell significantly. as well as many of Wall Street’s elite. the United States has not seen a nationwide real estate crisis. there are some reasons to believe that if the United States moves into recession. CDOs and other consumer debt. but it did not peak until home prices started to rise six years later. Further. the United States will be feeling the effects of the current crisis for a long period—perhaps a decade or more (also similar to the Japanese experience). with prices falling by 15 percent over a period of five years (Greenlaw et al. While some still deny that the MBS crisis will spill over substantially into the “real” economy. and these can give some idea of the time that will be required for recovery. the aggregate losses on residential mortgages. and the guarantors. it is clear that many policymakers. It took over eight years for home prices to fully recover. If the California case is relevant. California had a fairly severe housing downturn in the 1990s. with practices similar to those used in subprime securitization The Levy Economics Institute of Bard College 27 . the current downturn comes after a period in which lending standards were far looser than those that prevailed in California shortly before its real estate bust. which no doubt helped to pull the state out of the doldrums. The magnitude of risk is a multiple of that in subprimes. The direct losses on residential real estate could mount to several trillion. The foreclosure rate began to rise (ultimately by about 20 percent) as soon as home prices started falling. commercial MBSs. Adding in CDS losses (that are inherently hard to project) as well as losses in the “unknown unknowns” category. and after a decade of deficit spending the private sector is much more indebted today than it was in the early 1990s. securitization spread far beyond mortgages.

not in spite of it. . The history of money. 94 . Experiences show that this search failed and theory indicates that the search for a permanent solution is fruitless. and that to protect home owners from inequitable enforced liquidation in a time of general distress is a proper concern of the Government. Minsky (1986) Over the course of the real estate boom. are the riskiest loans given to the least sophisticated borrowers (Krugman 2007)? As it happens. Policy and Reform Implicit in the legislation which I am suggesting to you is a declaration of national policy. . This policy is that the broad interests of the Nation require that special safeguards should be thrown around home ownership as a guarantee of social and economic stability. Enforcement Chief for the SEC (quoted in Johnson 2007) The history of capitalism is punctuated by deep depressions that are associated with financial panics and crashes in which financial relations are ruptured and institutions are destroyed. and losses in one sector will generate recursive losses in others. Roosevelt.adopted in other sectors. —President Franklin D. . For these reasons. however. In short. Message to Congress on Small Home Mortgage Foreclosures (1933) There is substantial evidence that financial markets succeed because of strong enforcement and regulation. he wondered. banking. home ownership rates rose from 64 to 70 percent. Gramlich tried to get Greenspan to intervene as early as 2000. Why. —Linda Chatman Thomsen. Former Federal Reserve Governor Edward M. No. recovery could be a long time coming. and financial legislation can be interpreted as a search for a structure that would eliminate instability. much of this growth was fueled by loans that were Ponzi from the beginning. asset price depreciation will not be restricted to residential real estate. the rise of ownership rates was nothing but 28 Public Policy Brief. —Hyman P.

Yet. The financial engineers turned housing from mere abodes into assets that could be traded like dot-com equities—with long-run consequences (Goodman 2007).a mirage that at best sucked away what little accumulated wealth lowincome home buyers had managed to put toward a down payment. they might work for years to get out of the debt they had incurred to acquire a house and furnishings they no longer own. the interest rate spreads had been reduced so low by a system that valued quantity over The Levy Economics Institute of Bard College 29 . it was what Minsky called a Ponzi finance scheme. This was accomplished by reducing reliance on relationship banking and allowing markets to take over much of the financial sector. it is becoming apparent that banks are exposed to far more risk than they had been under the old banking model. Indeed. of the ARMs made in 2003. we await revelations of growing problems throughout the entire financial sector as economic activity slows. However. But with house price appreciation far beyond anything experienced in history and with the certainty that the Fed would eventually raise rates. as we have discussed. the fundamental banking activity is guaranteeing creditworthiness. as Minsky always argued. but without any of the long-term relations with debtors that characterized it. and who reduces the probability of default by establishing a long-term relationship such that credit is renewable only if the borrower fulfills his obligations. The problem is systemic and derives from a fundamentally flawed model that viewed the move to markets as something that would increase efficiency. banks guaranteed creditworthiness anyway. This requires a skeptical loan officer who carefully evaluates borrowers. Further. it is not just subprimes that relied on a “radical suspension of disbelief ”: even as the chickens have come home to roost in the residential real estate sector. lowering interest rate spreads while spreading and reducing risk. Studies show that. there was no chance that this business model would be sustainable. through a wide variety of exceedingly complex and mostly hidden agreements with the originators and holders of securities. If there was a “business model” behind the extension of finance to those who could not afford to service their loans. And. The shift to the market “originate and distribute” model meant that individual creditworthiness was never assessed. it was based on rapidly rising home prices and the ease of refinancing at lower rates—in other words. almost all were refinanced to avoid resets at higher interest rates. and given revised bankruptcy laws.

However. Treasury Secretary Henry M. in the concluding section. In the remainder of this section. Unfortunately. JPMorgan is the main clearing bank for Bear Stearns. and only postpones the day of reckoning for others. 94 . had proposed that banks put together a $75 billion stabilization fund—but this was vetoed by the private sector. if anything. second. what.22 The problem began because creditors of Bear Stearns demanded more collateral and the firm was not able to provide acceptable assets. There are a number of initiatives designed to deal with the current crisis. There are two immediate policy issues facing us: first. and predatory lending practices and you’ve got a recipe for a painful outcome. what can be done to prevent recurrence of such a situation in the future? Since both of these issues will require further study and debate I only offer some general guidelines. President Bush has proposed freezing mortgage rates for those who are currently up-to-date on their payments—which will do nothing for those who are already in trouble. I look at policy to deal with the crisis. deception. rogue traders. The Fed has lowered rates and developed a new auction facility to provide reserves without the frown costs of borrowing at the discount window. It also is lending safe Treasury debt against asset-backed securities in an effort to halt the ever-falling prices of such debt. credit spreads were still widening even after the announcement of such policies in early March. can be done to ameliorate the fallout from the current crisis. further. “pump and dump” campaigns. No. the Fed arranged a loan to JPMorgan so that it could lend against MBSs provided as collateral. markets are so fearful of such assets that Bear Stearns could not raise funds by selling them. (Minsky always jokingly referred to business models that try to make up for losses on the carry trade by increasing volume—but that is precisely what the entire financial system required. After a run on Bear Stearns. insider trading. The Fed’s loan to JPMorgan 30 Public Policy Brief. and it apparently would not accept the risks imputed to the MBSs offered.) Add to the mix corruption.quality that there was no hope that gross earnings could cover losses if defaults rose even slightly. I will discuss lessons we have learned from Minsky that would help to formulate policy for the longer run. some issuing from the private sector and others being pushed by policymakers. most of those being put forward by the Bush Administration appear to be designed to help creditors rather than debtors. control fraud. Paulson Jr.

slowdown will be contagious. Time and economic growth can go a long way toward restoring financial health: if incomes can grow sufficiently. however. the return of stagflation looks increasingly likely. the rising deficit will not proactively create growth. The Fed appears to be willing to ignore inflation pressures as well as moral hazard problems. but that is probably politically infeasible even with a change of administration. this results from deterioration of employment and income (which lowers taxes and increases transfers)—thus. partnerships. or corporations. it becomes easier to service debt. any serious U. the Fed will suffer the loss. This is. However. of course.” While some decried the Fed’s “bailout. Thus. the prescribed solution to liquidity problems. hurting exports as growth slows around the globe. and required invocation of one of the New Deal era’s provisions that allows the Fed to lend to “individuals.” which means that the firm faces no risk: if the MBSs go bad. Ironically.” it feared that the run could spread to other broker-dealer firms and to their lenders and trading partners (Andrews 2008. as it has been running up debt. While limits on their holdings have been lifted and there is discussion about relaxing loss The Levy Economics Institute of Bard College 31 . the Fed’s intervention came on the day of the 75th anniversary of President Roosevelt’s reopening of financial institutions after the “banking holiday” of 1933. While the budget deficit will increase as the economy slows. Washington has called on Freddie Mac and Fannie Mae to take a bigger role in home lending in order to relieve pressures.is “nonrecourse. Morgenson 2008). it cannot do much if real estate prices continue to fall and delinquencies continue to rise. but in current conditions it is far too small to turn around the economy. although it will help to constrain the depths of recession. Matters are made worse by creeping inflation—mostly fueled by energy and food prices—which will temper government’s willingness to use policy to fuel growth. spending more than its income for a decade. The president and Congress have agreed upon a modest economic stimulus plan. The problem is that these institutions are already experiencing their own problems. Recent growth has been mostly fueled by exports. putting its role as lender of last resort first and foremost in an all-out effort to prevent a panic. The private sector cannot be the main source of demand stimulus.S. Indeed. partly thanks to a depreciating dollar. it is difficult to see how the United States can grow its way out of this problem. A much bigger stimulus package is required.

While about 20 percent of those loans eventually were foreclosed. As President Roosevelt argued in announcing his plan to save the “small homes. bailouts will be required (Magnus 2008). we may need to create a new institution to get us through the worst real estate crisis since the 1930s. If Congress prevails. Of course. by wiping out financial wealth so that only equity ownership remains. Meanwhile. and with the borrower’s original equity (if any) intact. This makes it difficult for them to operate in the public interest when such action is most needed.25 There is a fine line that must be 32 Public Policy Brief. as Minsky put it. 94 . though the Bush Administration and financial institutions are teaming up to defeat the effort. which was paid to the Treasury when the HOLC was liquidated in 1951. the Home Owners’ Loan Corporation (HOLC). Reform should go even further. to take on the tasks of saving small homeowners. issuing bonds to raise the funds. as fears of losses have spread to Alt-A mortgages.24 Following Roosevelt’s lead. not to protect real estate speculators. No. Congress proposed legislation to allow modification of mortgage terms so owners could keep their homes.” the goal would be to preserve home ownership. a financial crisis is not the time to teach markets a lesson by allowing a generalized debt deflation to “simplify” the system. The HOLC successfully refinanced 20 percent of the nation’s mortgages. they must also maintain strong balance sheets of their own. Markets are even shunning agency-insured MBSs—and the problems are not limited to those based on subprimes.23 Relief might be limited to loans for primary residences.reserve requirements. they validate bad behavior and can encourage worse. The borrower should then be able to refinance the home at its current market value. this could help to stabilize the real estate sector. However. there is a fundamental inconsistency in the mandates given to these government-sponsored entities (GSEs): although expected to support home ownership in a crisis. there are lessons to be learned from that experience: refinance is preferable to foreclosure. and up to a limited home value (such as median price for the Standard Metropolitan Statistical Area). the agency actually managed to earn a small surplus on its activities. as it preserves home ownership and communities. He created an agency similar to the Reconstruction Finance Corporation. while also putting money where it is most needed. with bankruptcy laws amended to allow those who had been subjected to predatory lending to escape subprime loans. What is needed is mortgage relief. Clearly.

State and local governments will probably require assistance as tax revenue falls. pressures to sell will rise. and Donald Kohn all seem to recognize the scope of the problem. based on the administration’s wish to avoid “burdensome regulation. insurance companies. officials emphasized that it is more geared toward preventing future crises than to resolving the current one (Labaton 2008).walked. most of the schemes floated by public and private officials have failed because no one has been able to persuade participants to go against their own narrow private interests. however. The proposal would provide only a limited role for the federal government. Indeed. As the value of assets held by pension funds. community needs increase. Even with the reforms outlined here. the crisis has gone far beyond a liquidity problem. P. Thus far. Morgan was able to pressure the presidents of New York trust companies to kick in contributions to forestall the crash by threatening to allow every one of them to fail individually. Interest rate spreads have risen throughout the financial system as trust in counterparties has evaporated. and they seem to have risen to the occasion. it is difficult to identify anyone willing and able to play that role. Because financial markets cannot be allowed to learn lessons “the hard way. which “relies on the same market participants—from mortgage The Levy Economics Institute of Bard College 33 . and hedge funds plummets. Norris (2008c) recalls the crisis of 1907. It would rely mostly on state regulators and private industry to tighten oversight of financial markets but might include more regulation of mortgage lending that would require federal legislation. Robert Rubin. Bernanke. The Bear Stearns rescue is a case in point—JPMorgan agreed to provide lending only if it did not have to bear risk. Today. as this brief has made clear. Problems have already spread far beyond residential real estate. and the ability to borrow and to service debt suffers. allowing the worst abusers (especially the perpetrators of fraud) to lose while protecting the relatively innocent. and addressing insolvency will require participation of private players as well as the Treasury. Frederic Mishkin. industry representatives welcomed this “regulation lite” approach. most of the prominent candidates (Greenspan.” Not surprisingly.26 At the Fed. The White House has finally offered a plan. there could be cascading failures across entire classes of financial assets. Paulson) are too closely identified with the interests of particular Wall Street firms. when J. While the Fed will continue to play its role as lender of last resort.” regulations and oversight must be strengthened to slow the next stampede toward a speculative bubble.

The “originate and distribute” model has shown its weakness and is unlikely to survive in its present form. but that is not with the typical subprime borrower. protected. at interest rates that would reset at a level virtually guaranteed to generate delinquencies. and provide liability for financial institutions that sell mortgages (Hulse 2007).brokers to credit-rating agencies and Wall Street firms—that government officials and other experts blame for the current crisis” (Labaton 2008). Minsky always preferred policy that would promote smallto medium-size financial institutions. Unfortunately. policy should return to a bias toward market segmentation. 94 . but halting the trend to bigness will be difficult (Minsky 1986). policymakers who are biased toward “free markets” instinctively prefer to use public money to subsidize private-institution takeovers of failing financial firms. and broker’s markets cannot substitute for relationship 34 Public Policy Brief. and would permit FHA to guarantee loans used to refinance troubled mortgages. Congress should investigate limits to marketing of VARs and hybrids to low-income borrowers and first-time buyers. Democrats criticized the plan and announced a proposal for federal funding to provide billions of dollars to states to allow them to buy homes in foreclosures. who has little reserve if things go bad. Risk raters.S. hybrid VARs are even more dangerous. with a view to eventually returning them to the private sector at a small profit to the U. quant models. with greater regulation of the banking. No. And. again following Minsky. Congress is considering regulations on mortgage originators that would establish new licensing requirements. Treasury. Congress would set new standards to be met by originators regarding the ability of borrowers to make payments. The evidence is overwhelming that variable rate mortgages (VARs) lead to more foreclosures. In addition. The Roosevelt alternative should be adopted: temporary “nationalization” of failing institutions. put restrictions on incentives for saddling borrowers with riskier loans. There is a proper place for VARs and hybrid VARs. sector. Policy should avoid promoting the consolidation of financial institutions—a natural result of financial crises that can be boosted by policyarranged bailouts. property appraisers. Minsky also always advocated smaller financial institutions. with little oversight of mortgage brokers and with substantial incentive to induce borrowers to take on more debt than they could handle. Unscrupulous lending was a big part of the subprime boom.

Other policies identified by Minsky as “paternalistic capitalism” also helped to build a robust economy: cooperation with unions to ensure rising wages and thus The Levy Economics Institute of Bard College 35 . Home ownership was promoted through long-term. and a commitment to relatively stable interest rates. reduced supervision and oversight. local financial institutions that knew their markets and their borrowers. In the United States. Managers of money funds that are too big to fail must be constrained. Communities benefited. The New Deal reforms transformed housing finance into a very safe. but that requires ignoring greater risk to obtain the higher returns.banking. because they will inevitably get caught up in the next financial fad. and other examples have shown. deposit insurance courtesy of the FDIC and the Federal Savings and Loan Insurance Corporation. The current financial crisis is a prime example of the damage that can be done by what has been called the “post-regulatory environment” (Thomas 2008). Enron. To be sure. laissez-faire economic model. Market forces induce each to try to beat the market. there is nothing to be gained by preventing everyone from taking on excessive risk. privatization. and households built wealth that provided a path toward middleclass lifestyles (including college education for baby boomers and secure retirement for their parents). there is a clear public interest in the management of pension and insurance funds. which are supposed to be biased toward safety and soundness. Conclusion: What We Learned from Minsky Minsky argued that the Great Depression represented a failure of the smallgovernment. outside the United States. and consolidation of market power in the hands of money manager capitalists. This required oversight by regulators. However. The current crisis just as convincingly represents a failure of the Big Government/Neoconservative (or. while the New Deal promoted a highly successful Big Government/Big Bank model for financial capitalism. but even these need some supervision and regulation because of the potential impacts they can have on the economy—as LTCM. what is called “neoliberal”) model that promotes deregulation. Hedge funds and private equity funds are a different matter. self-amortizing mortgages. fixed-rate. there has been a long-run trend that favors relatively unregulated “markets” over regulated banks that has also played into the hands of neoconservatives. protected business based on (mostly) small.

the rising conservative ideology never really embraced a return to the prewar small-government form of capitalism. albeit increasingly in the hands of an elite. the Big Government/Neocon model replaced the New Deal reforms with self-supervision of markets. Because a large portion of investment in our type of economy must be externally financed. We need policy that promotes rising wages for the bottom half (or even three-quarters) of workers so that borrowing is less necessary to maintain 36 Public Policy Brief. the economy gradually evolved toward fragility. In short. and with monetary and fiscal policy that is biased against maintenance of full employment and adequate growth to generate rising living standards for most Americans. however. Social programs were cut. Policy increasingly turned to promotion of investment in particular. and a sense of shared responsibility to take care of the young. and other problems beyond the scope of this analysis (see Wray 2000.27 The model is in trouble—and not just with respect to the mortgage mess. to fuel growth—rather than relying on growing consumption fueled by growing household incomes. a social safety net that also encouraged consumption. and persons with disabilities. In practice. At the same time. student loans that enhanced earnings capacity. and trickle-down economics favored the growth of inequality. A formally “anti-government” bias led to the erosion of many of the New Deal reforms. the absence of a depression in the postwar period allowed financial wealth to accumulate. with enhanced oversight of financial institutions and with a housing finance structure that promotes stability rather than speculation. No. Hence. where wages were already high. However. We must return to a more sensible model. Inequality grew as other sectors and workers with less education fell behind. enhanced trust. but rather merely substituted a meaner “big government” for the paternalistic government of the early postwar period. a health care crisis. and promoted economic stability. 2005). an incarceration disaster.growing consumer demand. 94 . its constituency had shifted away from America’s middle class and toward Wall Street’s money managers. Over time. these policies reduced insecurity. the government was neither smaller nor less interventionist. however. and business in general. as the United States faces record inequality and destruction of the middle class. this policy mix increased the importance of finance. with greater reliance on “personal responsibility” as safety nets were shredded. Together. the old. The Cold War favored investment in the leading industries.

we turned American home finance over to Wall Street. The Levy Economics Institute of Bard College 37 . and policy that promotes employment. direct credit controls to prevent runaway speculation.28 Unfortunately. What Bernanke called “The Great Moderation” is also known as the “Greenspan put”—the belief that no activity is too risky because the Fed will intervene if things go bad. and supervision and regulation—its proper role.middle-class living standards. incarceration—for those left behind.” arguing that the “aim of policy is to assure that the economic prerequisites for sustaining the civil and civilized standards of an open liberal society exist. while at the same time it necessarily extended government assurance to the unregulated institutions for the simple reason that the government cannot allow a financial crisis to threaten the economy. it is Chairman Bernanke who is left to clean up the mess left by years of lax oversight and deregulation that operated to the advantage of Wall Street. uncertainty and extremes in income maldistribution and social inequality attenuate the economic underpinnings of democracy. . The swing toward markets and away from regulated banking greatly increased risk. If amplified. Minsky insisted that “the creation of new economic institutions which constrain the impact of uncertainty is necessary. Unfortunately. rather than transfer payments—or worse. which operated the industry as if it were a casino. and creation of a system of community development banks—the latter only partially achieved under President Clinton—as a viable alternative to the predatory lending practices that did increase the supply of credit to low-income borrowers and neighborhoods. Monetary policy must be turned away from using rate hikes to preempt inflation and toward stabilizing interest rates. . Minsky advocated support for small banks. Not only would this eliminate involuntary unemployment. then the market behavior that creates these conditions [has] to be constrained” (Minsky 1996). Minsky always advocated job creation programs so that government would act as an employer of last resort—the only way to ensure that the supply of jobs would be adequate to maintain continuous full employment. while also ensuring that the government’s budget would swing countercyclically to offset recessionary forces as well as inflationary forces in a boom. but which is now resulting in foreclosures and vacancies. It is likely that the current crisis will make it politically feasible to devise and to put into place such institutions. but he also showed that it could be used to reduce inequality and poverty. .

said. The problem is that loss reserves held against CDSs are extremely small. Citibank put together a package of mortgage securities.” The new financial instruments would not only help homeowners but also allow for “dispersion of risk to those willing. CDSs are like credit insurance that expose sellers to risk. policy encouraged Wall Street competitors and took away another advantage that relationship banking had relied upon.7 billion. fixed rate mortgages “effectively charge homeowners high fees for protection against rising interest rates and for the right to refinance. and Research Associate Robert W. 4. but they also lost retail deposits when market rates rose above Regulation Q limits.6 billion. Not only did banks face competition in their loan business. For example. to bear” it. Notes 1. There is no industry repository for mortgage loans. 3. in a ruling that has sent shockwaves through the mortgage securities market. Josh Rosner. However. 5. a federal judge in Ohio has thrown out 14 foreclosure cases. According to Greenspan (2004). it was unable to sell them and later wrote down the value by $2. so sellers’ equity is at risk should default rates rise. at the end of September 2007. some of which can be hedged. 2. “This is the miracle of not having securities mapped to the underlying loans. and presumably able.000. However. while acting as a shock absorber to prevent “cascading failures” (Greenspan 2002). They were forced to rely more heavily on costlier “hot money” jumbo CDs packaged by Wall Street firms such as Merrill Lynch. 94 . As discussed below. a mortgage securities specialist. Because the securities are so complex and documentation lax. ruling that mortgage investors had failed to prove they actually owned the properties they were trying to seize (Morgenson 2007).Acknowledgments The author thanks Yeva Nersisyan for essential research assistance. No. By raising deposit insurance limits to $100. planning to sell CDOs that it valued at $2. or 95 percent (Norris 2008a). the judge found that their claims to the properties were weak. I have heard of instances where the same 38 Public Policy Brief. Parenteau for his comments.

and 32 for brokers and hedge funds. Actually. 7. 8. 8. and if losses on the MBSs led to largerthan-expected losses by the insurers. This is why problems with the monolines have shaken markets in recent weeks. (2008). as it implies that the Fed could simply fly in Milton Friedman’s helicopters and drop bags of Federal Reserve notes where they’re needed most. that the AAA rating of the MBSs relied on an AAA rating for the insurer.5 percent. That is.4 for thrifts and credit unions. MBSs. “You can’t pump on a string”— that is. 25 for GSEs. as well as growing numbers of lawsuits against real estate buyers’ agents (this is the first real estate crisis in which the majority of residential purchases involved buyers’ agents with a fiduciary responsibility to buyers) and mortgage brokers (Streitfeld 2008). This term is misleading. those imposed by Basel II agreements. the actual leverage ratio averaged just under 10 for commercial banks. and affects.com The Levy Economics Institute of Bard College 39 . To modify a popular old saying. With a capital requirement equal to 12. This is due to capital requirements. 9. Basel II does not distinguish between corporate bonds. the monolines would be downgraded. According to estimates provided by Greenlaw et al. or CDOs—if they are rated triple-A. the securities market itself also relies on. though asset management was designed to economize on capital. banks were able to increase leverage ratios above eight. the AAA ratings of the insurers. This probably played a role in the large losses posted by banks on their holdings (Rodriguez 2007). It is important to stress. Further. however. Banks were encouraged to “game” the capital requirements by holding the riskiest assets given a rating. See www. banks leverage equity by a maximum factor of eight. leading to downgrading of the MBSs they insured—generating a recursive cycle of downgrading. the whole business model of the monolines requires a triple-A rating.6. the Fed could only supply the reserves desired by the market. loan is in two or three pools” (quoted in Morgenson 2007). they are all treated the same. There have been similar cases throughout the nation.appraiserspetition. in turn. the Fed stood ready to lend reserves at the discount window and to supply them to the federal funds market through bond purchases to keep the Fed funds rate on target. for example. It is possible that this could prove to be one of the weak links in the slice-anddice securities market.

the top shareholder of Moody’s is Warren Buffett. who floated a proposal to bail out the municipal bond insurers after the monolines faced a crisis that resulted in part from their move into provision of insurance for the MBSs rated by Moody’s (Wolff 2008). Fitch claims that “poor underwriting quality and fraud may account for as much as one-quarter of the underperformance of recent vintage subprime RMBS[s]” (Pendley. Ironically. with pretax profits of $1. Fitch found the appearance of fraud or misrepresentation in virtually every one. Or. it also says that “in most cases” the fraud “could have been identified with adequate underwriting. Moody’s generated $2 billion of revenue. Costello. Modeling by the Bank of England (2007) shows that a hypothetical portfolio of subprime mortgage credit default swaps (composed of AAA and AA subprime mortgages originated in 2006) lost 60 percent of value in July 2007. Moody’s and Standard and Poor’s control 80 percent of the ratings market. 14. reducing exposure means that many multiples of CDOs relative to one’s own funds must be sold (if equity is $1 billion. Together. The implosion of an asset price bubble always leads to the discovery of fraud and swindles” (quoted in Pollock 2007).1 billion (a 50 percent profit rate!). necessary to ensure that the pooled mortgages would find the appropriate market. The “auction-rate” market for securitized government debt has collapsed—putting both holders of securities and debtors in a bind. No. of course. Some consultation between raters and securitizers was.” 12. Fitch’s investigation concluded that brokeroriginated loans have “a higher occurrence of misrepresentation and fraud than direct or retail origination. 11. 13. quality control and fraud prevention tools prior to the loan funding. 94 . to reduce exposure by half requires sales of $7.5 billion when leverage is 15-to-1). 15. In what could be interpreted as an attempt to shift blame away from raters. 40 Public Policy Brief. as Charles Kindleberger put it. and Kelsch 2007). In 2006.” Further.10. Problems would arise only if the ratings were not appropriate to the pools. In a detailed examination of a sample of 45 subprime loans. Note that in a world of high leverage ratios. 16. “The propensity to swindle grows parallel with the propensity to speculate during a boom.

the biggest decline in the index’s history. Essentially.17. Sellers had expected the securities to have unquestioned liquidity but now cannot sell them. home prices plummeted at a pace of 8. These additional losses are attributed to impacts on financial institutions that force them to deleverage. it was announced that JPMorgan would buy Bear Stearns for $2 per share (down from a high of $171 the previous year). The S&P/Case-Shiller National U.000 per foreclosure (Morgenson 2008). reducing credit availability.9 percent in the fourth quarter of 2007. agreeing to take over all counterparty risks and using the likelihood of losses and lawsuits to justify the low purchase price. in addition to the more direct negative impacts of collapsing residential investment and the wealth effects on consumption resulting from depreciating real estate values. (2008) estimate that if the loss on mortgage securities amounts to $400 billion. Greenlaw et al.5 percentage points. (2008) project mortgage debt losses at $400 billion. 22. these are long-term securities but with interest rates that reset periodically in auctions.8 million) already have negative equity. It is estimated that more than 10 percent of American homeowners (8. the Fed made an unusual move in cutting the discount rate by 25 basis points on a Sunday evening in advance of a Federal Open Market The Levy Economics Institute of Bard College 41 . 18. that percentage is expected to rise above 15 percent by the end of the calendar year (Andrews and Uchitelle 2008). More than 30 percent of homeowners who purchased homes in the past two years have negative equity (Kane 2008). 19. 21. prices fell in every market covered by the index. with defaults snowballing through conventional mortgages. The losses to local governments average more than $34. Nationwide. Debtors are penalized with very high interest rate resets due to collapse of the auctions—threatening to turn yet another liquidity problem into a solvency problem. then the hit to GDP will be as much as 1. At the same time.S. For the first time ever. Twenty-four states had already reported declining tax revenue due to the housing crisis by December 2007 (Simon 2007). 20. on March 16. Home Price Composite Index for 10 metropolitan areas fell by almost 10 percent year-over-year in 2007. Two days later. Greenlaw et al. but admit that number will grow if house prices continue to fall. And the pace of home price depreciation accelerated in the fourth quarter: the composite index for the 10 markets fell at an annual rate of 21 percent.

. I call you my base. JPMorgan raised its offer price to $10 per share in response to widespread criticism that it had perhaps received one of the best deals—arranged and guaranteed by the Fed—in recent history. In a troubling piece published in the New York Times. 26. Samuelson (2007). as he has joined John Paulson’s hedge fund as an advisor.” questioning whether Henry Paulson (no relation) should be running the Treasury given the questionable practices of his former firm over the past few years. while owner-occupants accounted for 93 percent. and occasionally a governor or United States senator. “whose alums are routinely Treasury secretaries. Later. 27. . how horrible a product it believed it was selling” (Stein 2007). doctored W-2 forms or bank account statements) would the borrower be held liable for the original loan. 24. Ben Stein castigates Goldman Sachs. 28. Stein argues that while “Goldman Sachs was one of the top 10 sellers of CMOs for the last two and a half years.” See Papadimitriou and Wray (1998) for a summary of Minsky’s policy proposals. Readers will remember President Bush’s famously candid remarks at a fundraising dinner for the Archdiocese of New York in December 2000: “This is an impressive crowd—the haves and the have-mores. Further. 94 42 . high advisers to presidents. Only if the creditor can show that the borrower had defrauded the originator (through. No. 25. Ironically. there is no difference in the delinquency rates for speculators and owner-occupants. Committee meeting the following Tuesday. See also. Some people call you the elite. Public Policy Brief. It also created yet another lending facility for big investment banks to secure short-term loans of reserves against a range of collateral. speculators are a very small part of the problem in the universe of subprime ARMs. Greenspan’s narrow interest would now seem to put him in favor of snowballing defaults. According to the Center for Responsible Lending. Paulson has made billions betting against the housing market boom that Greenspan’s policies helped to fuel (Zuckerman 2008). the proportion of all completed foreclosures on securitized subprime adjustable rate loans made in 2006 that were attributable to speculators was just 7 percent.” it “was also shorting the junk on a titanic scale through index sales—showing .23. for example. In other words.

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from the University of the Pacific and an M. 1990) and Understanding Modern Money: The Key to Full Employment and Price Stability (Edward Elgar. 94 . and a Ph.A.A. 1998). Louis. and Social Security. employment. Mitchell Innes (Edward Elgar.D. No. He is currently working in the areas of monetary policy. from Washington University in St. He is also the editor of Credit and State Theories of Money: The Contributions of A. 2004) and coeditor of the forthcoming The Continuing Relevance of The General Theory: Keynes for the 21st Century (Palgrave Macmillan).About the Author Senior Scholar L. 48 Public Policy Brief. Wray has published widely in journals and is the author of Money and Credit in Capitalist Economies: The Endogenous Money Approach (Edward Elgar. Randall Wray is a professor at the University of Missouri– Kansas City and director of research at the Center for Full Employment and Price Stability. Wray received a B.

90. No. No. 2008 (Highlights.  No. 2007 (Highlights.S. Subprime Mortgage Market   No.  No. 91A) Cracks in the Foundations of Growth What Will the Housing Debacle Mean for the U. 94A) Minsky’s Cushions of Safety Systemic Risk and the Crisis in the U. 2007 (Highlights.levy.org.S. 91. No. . 92A) Globalization and the Changing Trade Debate Suggestions for a New Agenda  . Financial Markets Meltdown What Can We Learn from Minsky? . 2007 (Highlights. Credit Crunch of 2007 A Minsky Moment  .   No. 94. and   No.  . www. 2008 (Highlights. The site also includes a complete list and short summaries of all the titles in the Public Policy Brief series. 92. Economy?  . 93.Public Policy Brief Series The full text of the Public Policy Brief and Public Policy Brief Highlights series can be downloaded from the Levy Institute website. 90A) The Levy Economics Institute of Bard College 49 . No. 93A) The U.S. No.

The Economics of Outsourcing How Should Policy Respond?  . 2006 (Highlights. and Samuelson on Comparative Advantage  . 2006 (Highlights. 89A) U. 85A) Can Basel II Enhance Financial Stability? A Pessimistic View . No. 2007 (Highlights. No. No. 89.S.  No. No. 87. 94 . 85. No. 88. Baumol. 84A) Reforming Deposit Insurance The Case to Replace FDIC Protection with Self-Insurance   No. No. 2006 (Highlights. 87A) Rethinking Trade and Trade Policy Gomory. 2006 (Highlights. 83. 86A) The Fallacy of the Revised Bretton Woods Hypothesis Why Today’s International Financial System Is Unsustainable  . Household Deficit Spending A Rendezvous with Reality  . 84. 2006 (Highlights. 88A) Maastricht 2042 and the Fate of Europe Toward Convergence and Full Employment  . 86. No. 2006 (Highlights.   No. 83A) 50 Public Policy Brief.  No.  No. No.  No.  No.

  No. 82A) Breaking Out of the Deficit Trap The Case Against the Fiscal Hawks  . 76.  No. 76A) The Levy Economics Institute of Bard College 51 . 2004 (Highlights. Part Two . 2005 (Highlights. 81A) The Fed and the New Monetary Consensus The Case for Rate Hikes. 82. No. 79.   No. . 2004 (Highlights. No. 2004 (Highlights.  and . 2004 (Highlights. 77A) Asset Poverty in the United States Its Persistence in an Expansionary Economy   and  . No. 80A) The Case for Rate Hikes Did the Fed Prematurely Raise Rates? . No. No. 81. 80. 78.   No. 78A) The Sustainability of Economic Recovery in the United States The Risks to Consumption and Investment   and   No. 79A) The War on Poverty after 40 Years A Minskyan Assessment  . 2004 (Highlights.   No. No. 2005 (Highlights.  No. .The Ownership Society Social Security Is Only the Beginning . 77. No. .

No. No. 2003 (Highlights. 74A) Asset and Debt Deflation in the United States How Far Can Equity Prices Fall?   and   No. No. 2003 (Highlights.   and  .  No. 73A) What Is the American Model Really About? Soft Budgets and the Keynesian Devolution  . 2003 (Highlights. 73. No. 2003 (Highlights. 2003 (Highlights.  No. 75A) Understanding Deflation Treating the Disease.Is Financial Globalization Truly Global? New Institutions for an Inclusive Capital Market   and   No. 75. 94 . 74. 71A) 52 Public Policy Brief. 71. No. Not the Symptoms . 72. No. 72A) Can Monetary Policy Affect the Real Economy? The Dubious Effectiveness of Interest Rate Policy   and   No.

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