commentary on the book

From the New York Times Sunday Magazine, Marginal Revolution, Coordination Problem, CNBC, Econlog, the Financial Review of Books, CNBC again, CNBC again, RealClearMarkets, CNBC again, the Wall St. Journal, the Weekly Standard, 24 Ore (Italy), Corriere della Sera (PDF), Mark Hannam (one of the world's most intelligent and well-informed financial bloggers), 24 Ore again, CNBC again and once again (each CNBC link deals with a different regulatory aspect of the financial crisis, many of which we were unaware of when we wrote the book--they are all worth reading).

Here is the American Library Association's "Choice" magazine review of the book, and its subsequent announcement that the book has been named one of the "Choice" top 25 academic titles of 2012.

So far, all praise--where is the pushback? Surely we must have made at least one big mistake!

New Data on Bankers' Risk Aversion

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Probably the most controversial claim of the book will prove to be our suggestion that the behavior of bankers before the crisis was actually risk averse, at least in the aggregate. (A key point of Chapter 4, however, is that there was considerable heterogeneity underneath these aggregates.)

The risk-aversion claim rests on two facts: the much-higher-than-legally required capital ratios of commercial banks and savings and loans before the crisis; and the fact that commercial banks and S&Ls overwhelmingly bought the least lucrative and supposedly “safest” mortgage-backed securities: those implicitly guaranteed by the federal government through Fannie and Freddie’s congressional charters; and those rated AAA vs. those rated AA or lower.

Lower-paying bonds pay higher yields than higher-rated bonds, which in turn pay higher yields than “agency” (Fannie/Freddie) bonds. Reckless, greedy bankers should not have bought agencies or AAA bonds; they should have bought BB or BBB bonds.

In Table 2.2 of the book, we claim that banks bought more than twice the quantity of agency bonds as AAA mortgage bonds, and four times the quantity of AAA mortgage bonds as AAA CDOs. CDOs usually tranched mezzanine (sub-AAA) tranches of “regular” mortgage bonds, i.e., private-label mortgage-backed securities (PLMBS), so AAA CDOs were objectively riskier than AAA PLMBS. Thus, one way to view the collective risk profile of U.S. banks and savings and loans is to recognize that the following list shows the least risky and least lucrative of their mortgage bond holdings first, with the riskiest and most lucrative last:

$852 billion in agency bonds

$383 billion in AAA private-label mortgage-backed securities

$90 billion in AAA CDOs

Those are the figures on which row 1 of our Table 2.2 are based. However, none of our tables show bank holdings of actual AA, A, BBB, or BB tranches of PLMBS or CDOs. This is because our data on the distribution of the various types of mortgage bond in banks’ portfolios came from a famous Lehman Brothers study dated April 11, 2008: “Residential Credit Losses—Going into Extra Innings?” (We discuss this study in end note 1 to the conclusion of the book.) The Lehman figures assign PLMBS and CDO holdings by various types of investor (commercial banks and S&Ls, investment banks, hedge funds, etc.) by billions of dollars. But the 2008 Lehman table says that commercial banks held no PLMBS or CDOs rated lower than AAA. That seems implausible, unless the authors of the report could not find holdings totaling more than $500 million, so the figure got rounded down to zero billions of dollars. (We attempted to contact the authors of the report, but they all now work for hedge funds and are barred from communicating with members of the public.)

The Lehman figures have been widely cited by others (e.g., Arvind Krishnamurthy, “The Financial Meltdown: Data and Diagnoses”--download PDF--Table 1 [November 2008]; Viral Acharya and Matthew Richardson, Restoring Financial Stability: How to Repair a Failed System [2008], Table 5). They are more comprehensive and newer than the only comparable data source, a 2007 Lehman Brothers report entitled “Who Owns Residential Credit Risk” (cited by the Financial Crisis Inquiry Commission, “Preliminary Staff Report: Securitization and the Mortgage Crisis” [April 2010], Table 1). However, we wish there were a better source. Unfortunately, as of November 2010, when our book was completed, we knew of no other data. Now (ht Viral Acharya) we do—although this source, too, has limitations.

In August 2011, Isil Erel, Taylor D. Nadauld, and René M. Stulz released an NBER working paper, “Why Did U.S. Banks Invest in Highly Rated Securitization Tranches?” Erel et. al found a way to use regulatory filings from bank holding companies to “back out” their holdings of asset-backed securities, including mortgage bonds.

The key data source, Schedule HC-R of form FR Y-9C, groups assets by risk bucket: 0%, 20%, 50%, 100%. This means that AAA and AA PLMBS, which were both risk weighted at 20%, are grouped together. And the 100% category contains so many different types of securities, such as corporate bonds and equities, that we cannot back out mortgage bonds in that category, namely those rated BBB or BB. Using Erel et al.’s method, however, we are able to provide the following results for the four biggest bank holding companies as of the end of 2006:

Citigroup:

$70 billion in agency bonds

$28 billion in AAA/AA ABS

$10 billion in A-rated ABS

Bank of America:

$157 billion in agency bonds

$4 billion in AAA/AA ABS

$2 billion in A-rated ABS

JPMorganChase:

$75 billion in agency bonds

$1 billion in AAA/AA ABS

$0 billion ($351 million) in A-rated ABS

Wells Fargo:

$27 billion in agency bonds

$27 billion in AAA/AA ABS

$1 billion in A-rated ABS

Aggregate:

$329 billion in agency bonds

$60 billion in AAA/AA ABS

$13 billion in A-rated ABS

In short, the Big Four invested in the safest two classes of asset-backed securities securities, agency mortgage bonds and AAA/AA-rated ABS, at a ratio of 28:1 compared to the riskiest, most lucrative category for which we have figures: A-rated ABS. One should keep in mind that, for example, in mid-2006, agencies paid a 9-bps spread over Treasuries, AAA mortgage bonds paid 18 bps, AA mortgage bonds paid 32 bps, and A mortgage bonds paid 54 bps (Ashcraft and Schuermann, "Understanding the Securitization of Subprime Mortgage Credit," p. 28, Table 16). Reckless, greedy bankers should have bought As--or lower-rated mortgage bonds (BBBs paid 154 bps, and BBB- paid 267 bps) every time--never agencies, AAAs, or AAs.

However, do the new data mean that the Lehman figures on which we relied are wrong, for showing zero (or less than $500 million) in sub-AAA mortgage-bond holdings among commercial banks and savings and loans? Not necessarily. The figures above are from the consolidated regulatory filings of bank holding companies, which include investment-banking arms. The Lehman figures do show $24 billion in sub-AAA bonds among investment banks. Moreover, the data above cover all ABS, including credit-card ABS, auto-loan ABS, student-loan ABS, and more exotic categories, not just mortgage ABS.

As for the data, then, we conclude that the full story remains to be told, but that our basic point stands: the bankers—even at Citigroup, which had the riskiest portfolio—were not behaving in patterns we would expect from reckless greedheads.

Corrections to "Engineering the Crisis"

We note in the introduction to the book Max Weber's rueful acknowledgement (in "Science as a Vocation") that empirical claims are bound to be superseded over time. We hope it takes more than a day or two for our claims to be superseded, but we are happy to contribute to the process and we invite others to help. Today is October 15, the release date of the book. Let's see how long any of our claims remain standing!

Juliusz Jablecki, formerly an economist at the central bank of Poland, points out an error in our discussion of AIG. AIG's inability to cover its CDS contracts was, as far as we know, the one case in which the CDS "insurance" system failed to work during the crisis. However, it was a major case. We contend on p. 33 that once AIG was bailed out on September 16, 2008, its CDS "were a nonissue in the interbank panic that was underway." Juliusz points out, first of all, that the AIG "bailout" was actually a collateralized line of credit from the Fed. More important, however, CDS on AIG (i.e., not CDS to which AIG was a counterparty, but CDS insuring against AIG's default), after falling precipitously after September 16, spiked again in November 2008 and even higher in April 2009. So concerns about AIG's ability to make good to its counterparties may well have been an ongoing contributor to the financial crisis, contrary to our claim. Thank you, Juliusz.

Here is an important typo on p. 76, 2/3 down page: should read "the spread for agency bonds was 0.04 percent," i.e., 4 bps, not "0.4 percent," or 40 bps.

Finally, we somehow picked up the notion that creditors of Long-Term Capital Management (LTCM) were not bailed out in 1998 (p. 58). This is wrong: they were bailed out.

We apologize for the errors.

--Jeffrey Friedman and Wladimir Kraus

Blog Transition Announcement

This blog was initially established by the Critical Review Foundation as a forum for contributors to What Caused the Financial Crisis, published by the University of Pennsylvania Press in 2010. That, in turn, was the book version of a special issue of Critical Review devoted to the causes of the financial crisis, published in 2009.

However, it's been a long time since there was activity on the site. (For a while, it seemed that the financial crisis might be fading away like a bad dream.) And now Penn has published a new book, Engineering the Financial Crisis, coauthored by Wladimir Kraus of the University of Aix-en-Provence (an Associate Editor of Critical Review) and myself. Since the new book is also about the causes of the financial crisis, and in the hope that nobody will object, I believe it's time to turn this into a blog about the new book.

And so we have done....

Jeffrey Friedman
Editor, Critical Review
Coauthor, Engineering the Financial Crisis: Systemic Risk and the Failure of Regulation

"What Caused the Financial Crisis" availability

Update on availability: the first shipment to Amazon sold out within a week of the December 15 release. As of today there are four copies of the second shipment left at Amazon, and they have reduced the original $10 discount to $1. However, copies are still available at BarnesandNoble.com, which has reduced its discount from $10 to $2.

This doesn't mean the book has sold out yet, just that it is hard to buy at discount. The University of Pennsylvania Press still has copies. Unfortunately, the Critical Review Foundation is out of extras.

JF

"What Caused the Financial Crisis" is in print

"What Caused the Financial Crisis," edited by Jeffrey Friedman, is now available from the University of Pennsylvania Press and from Amazon. It contains Critical Review's special issue on the financial crisis, along with a completely revised introduction by the editor and an Afterword by Judge Richard Posner.

Review copy requests and suggestions should be sent to the Critical Review Foundation.

"Capitalism and the Crisis" to Be Published by Penn

The University of Pennsylvania Press has concluded the peer review of "Capitalism and the Crisis: Regulation, Competition, and Systemic Risk," by Jeffrey Friedman and Wladimir Kraus. The book will be published on September 1, 2011.

This book takes up the "Basel thesis" laid out in Critical Review's special issue on the crisis by Viral Acharya and Matthew Richardson ("Causes of the Financial Crisis") and by Juliusz Jablecki and Mateusz Machaj ("The Regulated Meltdown of 2008"): capital-adequacy regulations promulgated in the Basel I accords (1988), the U.S. financial regulators' Recourse Rule (2001), and Basel II (2004) significantly contributed to the financial crisis by inadvertently encouraging banks to purchase triple-A-rated mortgage-backed securities.

Chapter 1 rebuts various myths about the crisis, including the notion that the "too big to fail doctrine" and the performance incentives used by banks encouraged deliberately reckless risk-taking; that the crisis was caused by "irrational exuberance"; and that it was caused by deregulation.

Chapter 2 briefly reviews the rationale for capital-adequacy regulation and the provisions of Basel I, the Recourse Rule, and Basel II. The chapter also shows that U.S. commercial banks invested three times the proportion of their portfolios in mortgage bonds as did other U.S. investors, yet that banks preferred the safest mortgage bonds, those issued by GSEs, at a 2:1 ratio to privately issued mortgage bonds; and that all of the privately issued mortgage bonds bought by banks appear to have been relatively low-yielding, less-risky triple-A bonds. These facts suggest that capital arbitrage was a major motive. Yet under the Recourse Rule and Basel II, the same capital relief could have been achieved by buying higher-yielding, riskier double-A bonds, suggesting that banks were being prudent while operating within the Basel/Recourse Rule framework. Finally, the chapter discusses the paradox that capital arbitrage did not--contrary to the conventional wisdom--increase banks' leverage overall. Why, then, did banks want capital relief? The chapter answers by distinguishing between regulatory capital cushions and actual capital cushions. Regulatory capital cushions entail legal penalties if they are used, and thus are as good as worthless to banks. Real capital cushions, in contrast, offer security against future losses. By purchasing assets such as triple-A and GSE mortgage bonds that required less regulatory capital, banks were able to increase their real capital cushions.

Chapter 3 discusses the interaction of the Basel rules with fair-value (mark-to-market) accounting regulations that translated market unease (and eventually panic) about the value of mortgage-backed bonds into dollar-for-dollar subtractions from banks' regulatory (and real) capital cushions, dramatically reducing banks' lending capacity from the summer of 2007 through 2008. It also discusses the interaction of the Basel rules with the SEC's regulatory protection of the incumbent rating agencies--Moody's, S&P, and Fitch--whose ratings were given legal status by capital-adequacy regulations.

Chapter 4 considers the reasons for these regulatory errors and the implications for capitalism and regulation. The basic conclusion is that the regulators, like the bankers, were ignorant of the unintended consequences of their actions, but that the regulations had the inadvertent effect of making the entire economic system more fragile by homogenizing banks' asset purchases in pursuit of regulatory capital relief.

This book was written and edited for adoption in courses on the financial crisis, modern government, and related subjects in courses offered by American Studies, economics, history, political science, and sociology departments. It is accessible to educated laymen and nonspecialists.

--Jeffrey Friedman and Wladimir Kraus

Amar Bhide's New Book

Critical Review contributor Amar Bhide's "A Call for Judgment" is now available from Oxford University Press. Bhide presents a meticulous history and critique of economic doctrines that implied market omniscience and that may have contributed to the financial crisis.

It's a Banking Crisis

From the New York Times:

"seemingly safe institutions in more solid economies like France and Germany hold vast amounts of bonds from their more shaky neighbors, like Spain, Portugal and Greece....For example, Portuguese banks owe $86 billion to their counterparts in Spain, which in turn owe German institutions $238 billion and French banks $220 billion. American banks are also big owners of Spanish bank debt, holding nearly $200 billion, according to the Bank for International Settlements, a global organization serving central bankers."