By James Kwak
Arnold Kling of EconLog has done the hard work of setting out his theory of the financial crisis and what we should learn from it in a fifty-page but highly readable paper available here. I have some quibbles but think it is worth a read.
Here are the causes of the crisis in one table:
Basically, Kling says that the crisis was composed of the things along the top, which were caused by the things on the left. You can see that he places the blame squarely on poor capital requirements regulations, which gave various banks incentives to (a) originate-to-distribute instead of originate-to-hold; (b) securitize every which way they could; (c) use credit default swaps to reduce capital requirements even further; (d) stuff toxic securities into SIVs; etc.
I was surprised at the low weight Kling places on financial innovation, but this turns out to be a function of his conceptual structure: “Apart from practices that were developed for the purpose of regulatory capital arbitrage, financial innovation played a small role in the crisis.” He categorizes CDOs, credit default swaps, and SIVs as forms of innovation that arose for regulatory capital arbitrage purposes, and so the real villain there is lousy regulations in the first place. I could insert a long discussion here of what it means for something to be a cause of something else. Suffice it to say that at you could argue that the end of the day everything is always the government’s fault, since the private sector always does what it does in response to the incentives created by the government; put another way, from a public policy perspective the only actor is the government, since we have no control over the other ones. But I see Kling’s point. (That said, he gives exotic mortgages a pass — I’d be curious to know if he thinks those are also a consequence of bad capital requirements.)
Kling also gives industry structure a relatively low weight, which I think is because he doesn’t think Glass-Steagall would have prevented the crisis. I think he’s probably right there, since Lehman and Bear managed to become too big to fail despite remaining investment banks. (Although I hesitate because if Citi (C), JPMorgan (JPM), and Bank of America (BAC) were not holding onto trillions of dollars of toxic MBS and CDOs, would the government have had to rescue Bear?) But I think he may overlook the importance of bank size, which made it easier for banks to place bad bets because of the implicit government guarantee. Which brings up the question: Did bank CEOs before, say, 2007 really make decisions because they thought they were too big to fail? It seems unlikely, but David Wessel does have that great story in In Fed We Trust about Goldman Sachs, all the way back in 1991, lobbying to change Section 13(3) of the Federal Reserve Act to allow the Fed to lend to an investment bank in a crisis.
Jumping ahead to the conclusion, Kling doesn’t talk a lot about what specifically should be done, but he does have this good distinction:
“If economic stability inevitably gives way to financial euphoria, then it may not be possible to devise a fool-proof regulatory regime. Instead, it may be more effective to aim for a system that is easy to fix than a system that is hard to break. This means trying to encourage financial structures that involve less debt, so that resolution of failures is less complicated. It also means trying to foster a set of small, diverse financial institutions.”
As you can imagine, when I see “easy to fix” I think that the key institutions should be smaller so they are not too big to fail. Kling instead focuses on scaling back securitization and the various incentives to take on debt, like the mortgage interest tax deduction and the tax preference for corporate debt over equity. But I don’t disagree with most of his recommendations.
My biggest quibble is the emphasis Kling puts on government pressure on Fannie and Freddie to lower their underwriting standards. I think he knows that the truth is somewhere in the middle here. He has a section called “CRA and the Under-Served Housing Market” which, when you read it, barely touches on the CRA (except to make the case that the CRA had nothing to do with the crisis: “Many mortgage loans that met the standards for CRA were of much higher quality than the worst of the mortgage loans that were made from 2004–2007. Thus, one must be careful about assigning too much blame to CRA for the decline in underwriting standards.”). Most of the section talks about the deterioration of mortgage underwriting standards in general, without linking that deterioration to the CRA, and the links to Fannie and Freddie are weak. For example, discussing why Fannie and Freddie were not able to stop private lenders from offering no-doc loans, he says:
“This time, the GSEs were not able to take a stand against the dangerous trends in mortgage origination. Their market shares had been eroded by private-label mortgage securitization. They were under pressure from their regulators to increase their support of low-income borrowers. Finally, they had been stained by accounting scandals in which they had allegedly manipulated earnings.”
I think that Fannie and Freddie contributed to the craziness in the mortgage market and to the housing bubble, but that they were relatively small factors compared to the originators themselves and the investment banks that were buying their toxic loans for securitization.