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What Caused the Financial Crisis?

Bill Thomas, Keith Hennessey, and Douglas Holtz-Eakin have a dissenting statement in response to the final report of the Financial Crisis Inquiry Commission:  

What Caused the Financial Crisis, by Bill Thomas, Keith Hennessey, and Douglas Holtz-Eakin, Commentary, WSJ:

Today, six members of the Financial Crisis Inquiry Commission … are releasing their final report. Although the three of us served on the commission, we were unable to support the majority’s conclusions and have issued a dissenting statement. …

We recognize that … other … narratives have popular appeal:… Had the government not supported housing subsidies (the first narrative) or had policy makers implemented more restrictive financial regulations (the second) there would have been no calamity.

Both of these views are incomplete and misleading. … We believe the crisis was the product of 10 factors. Only when taken together can they offer a sufficient explanation of what happened:

Starting in the late 1990s, there was a broad credit bubble in the U.S. and Europe and a sustained housing bubble in the U.S. (factors 1 and 2). Excess liquidity, combined with rising house prices and an ineffectively regulated primary mortgage market, led to an increase in nontraditional mortgages (factor 3) that were in some cases deceptive, in many cases confusing, and often beyond borrowers’ ability to pay.

However, the credit bubble, housing bubble, and the explosion of nontraditional mortgage products are not by themselves responsible for the crisis. Our country has experienced larger bubbles—the dot-com bubble of the 1990s, for example—that were not nearly as devastating… Losses from the housing downturn were concentrated in highly leveraged financial institutions. Which raises the essential question: Why were these firms so exposed? Failures in credit-rating and securitization transformed bad mortgages into toxic financial assets (factor 4). Securitizers lowered the credit quality of the mortgages they securitized, credit-rating agencies erroneously rated these securities as safe investments, and buyers failed to look behind the ratings and do their own due diligence. Managers of many large and midsize financial institutions amassed enormous concentrations of highly correlated housing risk (factor 5), and they amplified this risk by holding too little capital relative to the risks and funded these exposures with short-term debt (factor 6). They assumed such funds would always be available. Both turned out to be bad bets.

These risks within highly leveraged, short-funded financial firms with concentrated exposure to a collapsing asset class led to a cascade of firm failures. … We call this the risk of contagion (factor 7). In other cases, the problem was a common shock (factor 8). A number of firms had made similar bad bets on housing…

A rapid succession of 10 firm failures, mergers and restructurings in September 2008 caused a financial shock and panic (factor 9). Confidence and trust in the financial system evaporated, as the health of almost every large and midsize financial institution in the U.S. and Europe was questioned. The financial shock and panic caused a severe contraction in the real economy (factor 10). …

[I]t is dangerous to conclude that the crisis would have been avoided if only we had regulated everything a lot more, had fewer housing subsidies, and had more responsible bankers. Simple narratives like these ignore the global nature of this crisis, and promote a simplistic explanation of a complex problem. Though tempting politically, they will ultimately lead to mistaken policies.

I don’t think the conclusion that better regulation would not have stopped the crisis follows from the factors they list.

By their own admission, the reason that factors 1 and 2 led to factor 3 was “an ineffectively regulated primary mortgage market.” So right away better regulation could have stopped the chain of events the led to the crisis. 

Factor 3 was “nontraditional mortgages that were in some cases deceptive, in many cases confusing, and often beyond borrowers’ ability to pay.” Sure seems like regulation might help to prevent deception and confusion (through, among other things, a financial protection agency). One thing is clear in any case. The market didn’t prevent these things on its own.

On to factor 4: Securitizers lowering credit standards, a failure of credit agencies, and buyers failing to do their own due diligence. Once again, regulation can help where the private market failed. The ratings agencies exist because they help to solve an asymmetric information problem. The typical purchaser of financial assets does not have the resources needed to assess the risk of complex financial assets (which is why saying that they should have performed their own due diligence misses the mark). Instead, they rely upon ratings agencies to do the assessment for them. Unfortunately, the ratings agencies didn’t do their jobs — perhaps due to bad incentives arising from to how they were paid — and this is where regulation has a role to play.

Factor 5 is the accumulation of correlated risk — again something a regulator can stop once the accumulation or risk is evident. This seems like an easy one — when regulators see this type of risk building up, they should do something about it. The question, however, is how to give regulators better tools for assessing these risks. Backing off on regulation, as implied above, won’t help with this.

Factor 6 is “holding too little capital relative to the risks and funded these exposures with short-term debt.” Too little capital? Mandating higher capital requirements is the solution to this problem. Basel II is one example, but it doesn’t go far enough. (The other part of factor 6 is essentially too much exposure to risk which is covered in the previous paragraph.)

Factors 7 and 8 are risk contagion and widespread exposure to a common shock. The private sector didn’t prevent these risks from getting too high so, again, why wouldn’t we want a regulator to do something about excessive risks of this type? False positives is one worry — reacting to problems that aren’t there — but that is a matter of how high to set the threshold for action, not an argument against regulation itself. If anything, the threshold for action was too low prior to the crisis.

Factor 9 is “A rapid succession of 10 firm failures, mergers and restructurings in September 2008 that endangered the financial system.” Too big to fail? Guess who can fix that?

Finally, factor 10 is the effects on the real economy. I’ll concede that regulation could not have helped much here. Once the financial system crashed in the way that it did, the real economy was sure to follow. But remember, these factors are, for the most part, a chain of events. If the chain had been broken by more effective regulation anywhere along the way, the chain of events is interrupted and factor 10 does not come into play.

For almost every factor mentioned above, regulation could have reduced or completely eliminated the risk. Thus, it’s hard to see how a conclusion that ” it is dangerous to conclude that the crisis would have been avoided if only we had regulated everything a lot more” can possibly follow.


Originally published at Economist’s View and reproduced here with permission.

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