Thursday, December 23, 2010

"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

Thursday, December 16, 2010

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.

Tuesday, May 18, 2010

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."

Monday, May 10, 2010

European Bank Bailout

The NY Times reports what may be the key part of the rescue package that is now rallying the markets: a bank bailout. "The European Central Bank reversed its position of just a few days ago and began buying government and corporate debt."

Why did the prospect of defaulting Greek government bonds--like the prospect in 2007-8 of underperforming AAA-rated mortgage-backed securities--cause a *banking* crisis? Because banks held so many of these securities. Why did they do that? In part, at least, because of banking regulations.

Under Basel I, banks received 100 percent capital relief for off-balance-sheet holdings of bonds purchased in short-term commercial paper markets with funds borrowed from money market funds, which are required by law to invest in AAA bonds.

Under the Recourse amendment to Basel I, enacted in the U.S. only in 2001 and implemented 1/1/2002, AA or AAA rated asset-backed securities received a 20 percent risk weight, meaning that $100 in ABS, such as MBS, could be bought using only $1.60 of capital: 8 percent regulatory capital minimum x .20 = 1.60. In comparison, whole (individual) mortgages were risk weighted at .50, requiring 60 percent more capital: $4 in capital to lend $100 in mortgages. And business loans and commercial bonds were risk weighted 100 percent, requiring $8 in capital per $100 in business loans.

Could that be why economic growth was comparatively slow in the 2000s, outside the housing sector?

Under Basel II, implemented outside the United States in 2006-7, the regulators favored highly rated sovereign debt. For the exact risk weights of Greek, Portugese, Spanish, and Italian government bonds, see yesterday's post here.

However, yesterday's reporting probably underestimated the amount of Greek sovereign debt in European banks' hands--$140 billion in sovereign plus private debt, according to today's WSJ, which has a good analysis of the role of the Basel rules in encouraging these bank holdings.

One might argue that banks would have bought sovereign debt anyway, for all the usual reasons one might buy any bonds. Yep, and the same is true of mortgage-backed securities, which were bought by many institutional investors that weren't covered by the Basel or Recourse rules. However, it would be ludicrous to think that the regulations therefore had no effect. The effect was to *magnify the quantity* of these particular assets that were purchased by commercial banks.

The purpose of regulation is to push behavior in the direction desired by the regulators. Purchases of AAA-rated MBS and of variously rated sovereign debt were *not* just governed by the usual considerations. Also weighing heavily on the scale were the financial inducements that the Basel rules provided for leveraging into "safe" assets, as defined by the Basel Committee on Banking Supervision. This is presumably why only banks, as a class of institutional investor, were nearly wiped out by their MBS holdings in 2008, and why banks needed to be bailed out last night.

It is thus misleading to argue, as do Johnson & Kwak and the few other economists who have discussed the Basel rules, that banks "exploited a loophole" by buying assets with low risk weights. Banks that did this were doing *exactly* what regulators wanted them to do: they were leveraging into securities that the regulators judged safe. Unfortunately, in both cases, the regulators' judgments were wrong.

Sunday, May 9, 2010

Greek Panic Update

It appears that, as hypothesized here three months ago, the Greek debt crisis may actually be another Basel-induced banking crisis.

Basel II (adopted outside the United States in 2007, but not yet adopted here, where Basel I (1991) and the Recourse Rule (2001) are still in effect) gave a zero risk weight to government bonds rated AAA to AA-; a 20 percent risk weight to government bonds rated A+ to A-; and a 50 percent risk weight to government bonds rated BBB+ to BBB-.

On April 21, Moody’s downgraded Greek debt to BBB+, suddenly requiring banks holding A- Greek government bonds to raise 60 percent more capital for these securities. Portugal’s AA rating is under pressure (according to Moody’s), as is Spain’s (according to S&P), although Italy's Aa2 (AA) Moody's rating, and S&P's rating of A+, seem stable. According to yesterday's New York Times, "French and German banks...have $1.16 trillion at risk in Spain and Italy, including government and private debt."

The downgrade pressures on banks are in addition to the default threat from Greece. Yesterday's Financial Times reports that "French and German banks and insurance groups...hold just under 80 billion euros in Greek sovereign debt," and that banks are afraid to lend to each other for fear of counterparty insolvency. According to Bloomberg, "The cost of insuring against losses on European bank bonds soared to a record, surpassing levels triggered by the collapse of Lehman Brothers." Another FT story reports that "worried bankers from 47 European groups urged the ECB to become a 'buyer of last resort' of eurozone government bonds to steady markets. There was speculation that the central bank could be preparing a $762 billion loan facility for one-year loans at 1 percent to help more than 1000 banks in their funding."

And from today's NYT: "United States banks have $3.6 trillion in exposure to European banks."

Tuesday, February 16, 2010

Why the Greek Debt Panic?

The key to understanding the "Basel thesis" about the cause of the crisis, advanced in Critical Review's special issue on the crisis by coauthors Viral Acharya & Matthew Richardson, and by coauthors Juliusz Jablecki & Mateusz Machaj, as well as by Wladimir Kraus and me in our forthcoming Engineering the Perfect Storm: Banking Regulation, Capitalism, and Systemic Risk (University of Pennsylvania Press, 2010), is to understand one thing: The bursting of the housing asset bubble would not, alone, have caused (1) a financial crisis, and thus probably would not have caused (2) a worldwide recession of such depth.

This is also a point made by the other coauthor team in Critical Review's special issue, Steven Gjerstad and Nobel laureate Vernon L. Smith. Asset bubbles pop all the time, but worldwide financial crises are rare.

A financial crisis is a banking crisis. So why did the bursting of the asset bubble in housing cause a banking crisis, freezing interbank lending and then bank lending into the "real" economy?

Because, according to the Basel thesis, Basel I bank-capital regulations, enhanced in 2001 in the United States by the Recourse Rule, encouraged banks worldwide and especially in the United States to leverage into asset-backed securities, including mortgage-backed securities, that were either government guaranteed (by Fan or Fred) or were privately issued but had an AA or AAA rating. How did the Basel rules encourage this? By giving such securities a 20 percent risk weight.

Translation: An AAA-rated mortgage backed security worth $100 required only $2 in bank capital at the 8 percent Basel rate for adequately capitalized banks. $100 x .08 x .20 (the 20 percent risk weight assigned to asset-backed securities by the Recourse Rule) = $2. By contrast, a commercial loan of $100 required $8 of bank capital, because Basel gave such loans a 100 percent risk weight. $100 x 8 percent x 1.00 = $8. Similarly, a $100 whole mortgage retained by the bank required $4 of capital, because the Basel risk weight for unsecuritized mortgages was 50 percent. With these risk weightings, securitized mortgage-backed debt offered significant capital relief.

Today's FT brings the news that "European financial institutions have $235 billion worth of claims on Greek debt, most of which is thought to be in government bonds." Why do they hold so much Greek government debt? Because under Basel II, implemented (outside the United States) in 2007, Greek government bonds, rated A-, had the same 20 percent risk weight as AA/AAA asset-backed securities in the United States. That is, until S&P downgraded Greek debt from A- to BBB+. That raised the risk weight to 50 percent, suddenly requiring 60 percent more capital from banks holding Greek bonds.

This appears to be the reason that the possibility of Greek default has led to fears of another banking crisis.

Saturday, February 13, 2010

Too Big to Fail: The Evidence

Ironically, Cafe Hayek takes issue with my Austrian claim that bankers were (in general) ignorant of the risks they were taking, hence could not have been taking these risks due to their knowledge that they were "too big to fail" and thus would be bailed out. Or at least I think that's what Russ Roberts is suggesting, because he is disputing what I said, and what I said is that TBTF did not cause the crisis--not that the thought of a bailout never crossed any bankers' minds. (If I were one of them and it crossed my mind, however, I would have said to myself: "Maybe. But I'm not going to count on it.")

Roberts cites a speech by Andrew Haldane,an official of the Bank of England, who claims that at an undated meeting of unnamed bankers, an unnamed individual said that bankers had no incentive to run severe stress tests because in a severe event, they would lose their jobs and then "the authorities would have to step in."

Props to Russ for this interesting evidence, which I hadn't seen before. But it's not exactly unambiguous.

Consider a banker who, as posited in the anonymous scenario, thinks that a disastrous financial situation would get him fired. What difference would it make to this allegedly self-interested banker that the bank would subsequently be bailed out?

Of course, as the bailouts actually unfolded, the bankers did not get fired in many cases--but according to Haldane's anecdote, the bankers did not know that in advance.

So, as I said, when it comes to the TBTF, corporate-compensation, and ABCT theories of the crisis, we're in a high-conviction, low-evidence zone. However, we are not in an evidence-free zone. Consider, on TBTF:

1. Many banks that were too small to be bailed out (except by the FDIC, in which case the bankers would definitely be fired) invested in the same AAA-rated MBS as the big banks that got bailed out.

2. Commercial bankers like Sandy Weill and investment bankers (e.g., Jimmy Cayne, Ralph Cioffi, and Matthew Tannin at Bear Stearns) lost many millions--in Weill and Cayne's case, $1 billion each--because they were fully invested in their banks' stock right up to the end.

Cafe Hayek quotes Cayne: "The only people [who] are going to suffer are my heirs, not me. Because when you have a billion six and you lose a billion, you’re not exactly like crippled, right?" What is the point of this quotation: That Cayne didn't care about his heirs, so he didn't care about losing $1 billion, so that's why he knowingly allowed Bear Stearns to take risks that led to its collapse?

That is certainly not the implication of the passage when it is read in context.

3. If one reads the rest of the book from which the quotation is drawn, one finds that Cayne was consumed by the construction of a new skyscraper headquarters for Bear Stearns that would symbolize the permanence of the success of this once-underdog, scrappy, Jewish firm. Is it really plausible that Cayne would risk that success, his life's legacy, because, in the event that the risk brought down Bear Stearns, the firm might get bailed out (by being absorbed, in the event, into arch-rival JP Morgan)?

Similarly, as I document in my introduction to the Critical Review financial-crisis issue, Cioffi and Tannin, who were the only ones at Bear Stearns who actually knew what was going on, revealed in secret emails to each other (discovered by the FBI) that they were true believers in the accuracy of the triple-A ratings. They were mistaken.

Again, as the crisis unfolded, all the books on the crisis show that the principals were shocked, frantic, and bewildered. If they had deliberately taken risks because they had a bailout in the back of their minds, would they not have have reacted with knowing cynicism and serenity?

(More documentation will appear in the revised introduction to the book version of Critical Review's financial-crisis issue, The Causes of the Financial Crisis, forthcoming from the University of Pennsylvania Press.)

4. I'm still waiting for somebody to explain why these bankers who were supposedly insensitive to risk--due to being TBTF, or due to their compensation incentives--bought government-guaranteed or AAA-rated MBS 93 percent of the time.

AA-rated MBS were riskier, paid higher returns, and got exactly the same capital relief as AAAs. They would have been the MBS of choice if both the capital-relief theory of the crisis, which I favor, and the TBTF or corporate-compensation theories of the crisis were true. Subtract the capital-relief motive, though, and BBB or lower-rated securities would have been the choice. But never, ever, AAAs.

I submit that the bankers--like the regulators--simply did not realize that this was the first-ever significant nationwide housing bubble. And they did not realize how fragile the bubble was, due to subprime lending. Meanwhile, the Basel regulators encouraged them to leverage into the bubble by buying AA- or AAA-rated MBS. That is the crisis in three easy sentences.

The crisis has ideological ramifications. So economists of libertarian bent want to blame it on TBTF. Those of leftist bent want to blame it on bankers greedy for bonuses. Is it so difficult to imagine, though, that both the regulators and the bankers, being human, were ignorant of what was to come?

That, I think, is what Hayek might have said.

Thursday, February 11, 2010

Another Good Thing about Austrian Economics

Bill Woolsey draws attention in the comments to the Austrian emphasis on malinvestment, as opposed to the mainstream preoccupation with aggregate investment levels.

That certainly does seem like an important theoretical contribution (but I am a mere political scientist).

But is it a contribution to understanding the causes of the 2008 financial crisis? I thought the mechanism of malinvestment is supposed to be the low interest rates themselves, not laws that encouraged housing investment, such as those pointed to by Gjerstad and Smith and Wallison.

I'd love to be corrected if I am wrong about that, and also about whether any empirical work has been done to test the ABCT hypothesis regarding what caused the financial crisis.

Against the New Consensus

For what it is worth, here is Wladimir's and my response to the new consensus: "A Silver Lining to the Financial Crisis: A More Realistic Understanding of Capitalism." In it, we move from a rebuttal of the Corporate Compensation Myth to an explanation of the homogenizing effect of capital regulations that privileged Fannie, Freddie, or AAA/AA-rated private-issue mortgage-backed securities; and we contrast regulatory homogenization against the normal situation in markets, namely competition among businesses with heterogeneous interpretations of what they should do to make profits and avoid losses. That heterogeneity, we maintain, is the chief justification of capitalism, and the best insurance against systemic risk.

From Diversity to Consensus, and Austrian Economics

The most shocking result of having researched the causes of the financial crisis for the last year and a half is this discovery: economists have no compunctions about answering empirical questions, such as what caused the specific crisis of 2008, with general theoretical models, whether macro- or micro- in nature, that may or may not have any applicability to the actual historical event at hand. The possibility that a good model may not be applicable in a specific circumstance never seems to cross their minds.

Or, to put it differently (since we all use models): economists seem particularly uninterested in testing their hypotheses against evidence. Why do that, if all economic models express "universal laws"?

During the first year after the peak of the crisis in September 2008, however, a positive side effect of the economists' apriorism was that it produced several different hypotheses that, in this case, were relatively easy to test against evidence.

For instance, there was the Austrian business-cycle theory. But it runs up against two (not necessarily fatal) questions when it is applied to the specific crisis at hand: "Why housing?" and "Why a banking crisis?"

I.e., if low interest rates were the cause of the crisis, why wasn't there a general overinvestment in capital goods, as the Austrian theory predicts? In fact, there was an overinvestment in housing, a labor-intensive good with a short production period (roughly 3 months). Why not, instead, an overproduction of jet airplanes or skyscrapers?

One may supplement the Austrian theory with explanations such as Stephen Gjerstad and Vernon Smith's Critical Review focus on the favorable tax treatment given to home-equity capital gains, or Peter Wallison's Critical Review focus on federal housing policy, which, via Fannie Mae and Freddie Mac, added to low interest rates even more favorable terms for home buyers (e.g., no down payments).

But then we aren't really talking about a specifically Austrian theory any more: nearly everyone, of every theoretical stripe, blames low interest rates as a facilitating condition of the crisis. And while low interest rates may (perhaps) have been necessary, they were not sufficient, to cause the crisis. And they did not operate in the specifically Austrian fashion of boosting spending on more "roundabout" methods of production.

Moreover--why should a housing crisis have turned into a banking crisis?

Brian S. Wesbury's new book, It's Not as Bad as You Think (Wiley 2010), demonstrates that the collapse of housing did not cause the recession. It was the banks' overinvestment in mortgage-backed bonds, whose value was called into question during the panic of September 2008, that caused the recession--by freezing bank lending. There is no known macroeconomic explanation for the banks' purchases of these bonds; so it must have been caused by institutional or microeconomic factors.

Nonetheless, some "Austrians" continue to push "the Austrian" theory, even though that theory is but a minor aspect of the rich Austrian legacy.

Back when I received an informal education in Austrian economics in New York City in the mid-1980s (via Israel Kirzner and Don Lavoie), and then, more intensively, through editing them and virtually every other Austrian economist in Critical Review in the early 1990s, Austrian business-cycle theory was seen by Austrians as an embarrassment. The distinctive thing about "Austrian" economics, it was thought, was not business-cycle theory but the Austrian focus on human ignorance.

This focus is evident in the best explicitly Austrian books ever written: Lavoie's Rivalry and Central Planning: The Socialist Calculation Debate Reconsidered (CUP 1985) and Mario Rizzo and Gerald P. O'Driscoll's The Economics of Time and Ignorance (2nd ed. Routledge 1996). This tradition continues with Amar Bhide's forthcoming masterpiece, A Call to Judgment: Sensible Finance for a Dynamic World (OUP 2010), which attributes the crisis to the spread of mistaken theories of finance, such as the Capital Asset Pricing Model.

Karen Vaughn's Austrian Economics in America (CUP 1998) is a challenging, exciting history of this epistemically oriented Austrian economics, now largely abandoned. Most Austrians have now, sadly, adopted (perhaps due to the influence of Public Choice theory) the mainstream economists' obsession with rational-choice game theory (the strategic interaction of knowledgeable self-interested agents), which tends to reduce error to perverse incentives rather than genuine ignorance. So all that Austrians have left to distinguish themselves from the mainstream is Hayek's old business-cycle theory, which may or may not explain some business cycles but does not seem sufficient to explain this one.

Meanwhile, non-Austrian economists have gravitated toward two game-theoretic "moral hazard" stories that fit with their predisposition to reduce human error to misaligned incentives.

First, the moral hazard of "too big to fail" (TBTF). Empirical problem: Before the bailouts, nothing of this scale had ever happened, so no bank could have been sure they would be bailed out. And if one actually reads accounts of the decision making in the years leading up to the crisis, such as Gillian Tett's Fool's Gold and William D. Cohan's House of Cards, no decision makers factored bailouts into their calculations. Why? Because they didn't think they were doing anything particularly risky (an ignorance-based human error), so they didn't even consider the chances of being bailed out.

Second, the moral hazard of "corporate compensation systems," i.e., bonuses.

Empirical problem #1: When this theory took hold, there was virtually no evidence for it (whereas now there is one study for it and one against it)--see Wladimir's and my post on the topic (below).

Empirical problem #2: There was, and remains, the following overwhelming evidence against the theory: 93% of the banks' mortgage-backed securities were either guaranteed by the U.S. government (i.e., Fannie and Freddie) or were rated AAA--the "safest" and lowest-yielding securities available. Triple-A bonds are the last thing revenue-seeking, bonus-hungry, risk-indifferent (i.e., risk-knowledgeable, rather than risk-ignorant) bankers would have bought.

Yet now the Corporate Compensation Myth is the hegemonic story of the crisis, all but universally accepted by financial journalists, politicians, regulators--and scholars.

Why? Because it fits the scholars' rationalistic predilection for incentives stories that reduce an apparently widespread error to the knowing, deliberate actions of selfish actors--i.e., "greedy bankers." And guess what? That is exactly the simplistic model that journalists, politicians, and the general public are inclined to believe, evidence or not.

The Critical Review Book(s)

It has been a long while since anyone has posted here. One reason is that the creative frenzy of last year, in which many different ideas about the financial crisis were debated, has lapsed into a hegemonic consensus about the causes of the crisis (see next post), so there hasn't been much for us to link to.

But the other reason is that the University of Pennsylvania Press is republishing Critical Review's special issue on the crisis in book form, under the title The Causes of the Financial Crisis, and Shterna Friedman (the managing editor) and I (the editor) have had our hands full preparing the volume for republication, including a complete revision of my introduction to the issue in light of more recent developments and research.

The new book should be on sale by September and is available for discounted group purchase and, of course, classroom use. Contact me about this at

Making matters worse (or better, depending on your perspective), the University of Pennsylvania Press has also commissioned Causes of the Crisis Blog editor Wladimir Kraus and me to coauthor a second book, Engineering the Perfect Storm: How Reasonable Regulations Caused the Financial Crisis, and we have been hard at work on it. Our target completion date is September 1, which would allow the book to be available for course adoption for Spring 2011.

Sorry that we have therefore been out of touch.

Jeffrey Friedman