Why Capital Regulations Didn't Cause the Mortgage Crisis

I still read many different takes on what caused the subprime housing bubble. The least compelling to me is the capital regulations. Mortgages were historically the lowest loss rates of any asset class, for the entire dataset anyone looked at. Think of a capital regulation as a rule enforced by government. If the rule is binding, this merely makes the activity more expensive, as when you amortize the cost of getting caught smoking pot (including potential career repercussions, which vary considerably by profession). Many rules we think are unnecessary are worked around, as for instance, ProShares has many stocks that allow you 3-to-1 leverage, which is technically illegal if done directly (it violates Reg-T for retail brokerage accounts). There are shares that allow you to be short, which for 401ks is otherwise illegal, but now legal.

Now, generally, the government allows you to do many things you can do, but shouldn't. Moderation in all things is a good rule, and what prevents most people from excess is discipline. People generally don't do things to excess because it causes various hangovers, real and metaphorical. So, if the government assigned a low capital ratio to mortgages, this did not cause banks to invest in mortgages in excess unless they also believed these were of low risk. It was a common mistake. So common, in fact, I think it strains credulity to think it was extremely important. There were enough investors and companies not bound by US banking regulations involved to note this was bigger than them.

The fact that I can drink a bottle of Scotch every night is no reason to blame the government if I choose to do so.

Comments

[D_Virginia:]

Sure, the government didn't cause the crisis, but it did allow it to get way out of hand.

The alcohol analogy is a pretty good one.

Yes, you can drink your bottle of Scotch every night.

But the government says you can't drive afterward. Nor can you be drunk and disorderly. You also can't drink on a public street. Nor in your car. If you operate heavy machinery while drunk, you can be put in jail for negligence. Etc, etc...

So yes, you can drink. And you can even drink to excess if you like, but only in certain situations, and only when it doesn't adversely affect others.

If you end up inflicting the negative repercussions of your drunkenness on others, you get smacked down by the law.

That's what's still missing. No one is getting in trouble for this mess (except homeowners, naturally). In fact, the bankers are being helped with their lending hangovers, and are no doubt planning on getting drunk all over again.

What's worse: nothing has changed that might get people in trouble for this in the future when they do it again.

Sep 30 08:02 AM

[nym:]

Mortgages were low risk back when responsible firms and their employees verified incomes etc. on applications. On the other hand, rating agents may have always been whores.

Sep 30 09:06 PM

[Russ Wetherill:]

Governmental regulations may not have been the sole cause, the primary cause or even a principal cause of the subprime crisis. But that does not mean that they weren't a contributory cause, either.

The Community Reinvestment Act was amended in the late 90's to require that banks reinvest a certain portion of their deposits within the communities where the deposits originated if the banks wanted to receive regulatory approval for mergers. At the same time the two Government Sponsored Entities (Fannie Mae and Freddie Mac) reduced their downpayment and credit verification requirements. Congress also repealed portions of the investment banking regulations that allowed Lehman Brothers, Bear Sterns and others to purchase and securitize mortgages and resell these as investment products.

To use your analogy, on the one hand the government stood by oblivious to the fact that everyone was drinking until they were plastered, getting into their cars and inevitably crashing into innocent people. On the other hand the government was acting as the bar tender through Fannie Mae and not only supplying the booze a cut-rate prices but encouraging the customers to have one more for the road. At some point a duty of due diligence and care arises for bartenders and regulators alike.

Oct 01 03:04 PM