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How They Killed the Economy

Alan Greenspan; drawing by John Springs

Getting the federal funds rate to near 3 percent much more quickly would have introduced a healthy dose of caution to investors in the years when the housing bubble inflated most rapidly. Moreover, the versions of the Taylor rule used by Federal Reserve policymakers not only suggest that rate increases should have started earlier in 2004, but also show that rates should have reached 3 percent before the end of that year.

Why didn’t Greenspan act more aggressively to quickly raise interest rates to 3 percent or higher? He claims that it wouldn’t have mattered, that he “could not have ‘prevented’ the housing bubble” through monetary policy because the Fed could not influence longer-term interest rates, such as mortgage rates, which are most relevant to housing markets. In his view, the Fed was hamstrung by rapidly growing excess savings in developing countries—mainly China and oil-exporting countries—which were invested in the bond markets of both the United States and other advanced economies. By infusing so much money into these markets, China and others pushed “global long-term interest rates progressively lower between early 2000 and 2005.” These capital flows from emerging to developed economies not only financed government deficits. By pushing interest rates down, they funded the US housing boom and consumption binge as well.10

Such global imbalances did indeed make it more difficult for the Fed to influence longer-term interest rates, but they did not render it helpless to cool the housing bubble and offset the growing risks to the economy. At the very least, as both Taylor and Bernanke argue, higher federal funds rates would have limited the growth both of adjustable-rate subprime mortgages (which are based on shorter-term interest rates) and of the derivative securities linked to them. In fact after 2004 much of the most reckless behavior leading to the meltdown originated in irresponsible lending and trading in subprime mortgages and derivatives.11

We will never know how effective more forceful monetary policy would have been since it was never tried. The approach taken by the Fed failed, in part because of the way in which financial institutions and investors evaluate their risks. Most measures of risk are derived from the volatility of asset prices—basically how much they fluctuate—and the extent to which portfolios contain a diverse variety of securities. During booms these estimates of risk tend to fall because asset prices—the price not only of stocks and bonds but of real estate and other assets as well—rise and volatility tends to fall or rise only slowly. The resulting decline in estimated risk is taken by investors as a signal that it is safe to increase leverage and take on more risk; but it can be a seriously misleading signal.12

Greenspan’s monetary policy reinforced these failings of existing methods of risk control. Without the threat of a sharp rise in interest rates, estimated risks fell and restraint evaporated, encouraging the foolishly optimistic behavior of banks and investors. In such a heady environment, competitive pressures are hard to resist and financial institutions tend to gloss over the well-known limitations of their own risk models in order to pursue opportunities for short-term profit. The false precision of these mathematical models—they are well defined and superficially exact even while frequently deceptive—gave their predictions far greater credibility than they deserved and made it easier for bank executives to ignore more impressionistic judgments based on historical comparisons, anecdotal evidence, or common sense. All these would have called into question the reliability of estimates that indicated low risk amid a rapidly inflating housing bubble.

In addition, compensation schemes for managers and traders generally were linked to short-term profits, giving them outsized incentives to take risks regardless of the longer-term consequences. From some of his statements Greenspan seemed fitfully aware of some of these problems; yet he adopted policies that made them worse.

The Fed’s unwillingness to raise interest rates quickly would have been less serious if regulation had been more effective at curbing the emerging risks in the financial sector and the economy. But regulations were not well enforced. For example, Greenspan explicitly rejected Federal Reserve Governor Edward Gramlich’s warnings about the need for the Fed to curtail widespread abuses in mortgage markets. Earlier he also rejected the strong warnings of Brooksley Born, the head of the US Commodity Futures Trading Commission, about the many dangers of unregulated derivatives. Existing regulations also were inadequate. Partly that was because bank regulations did not cover investment banks such as Bear Stearns and Lehman Brothers, major bundlers of subprime mortgages for worldwide sale that were at the heart of the crisis. (They were regulated—quite superficially—by the Securities and Exchange Commission and the New York Stock Exchange.)

Nor did the regulations take full account of how much the “shadow” banking system added to potential losses for banks such as Citibank that sponsored “structured investment vehicles” (SIVs). These entities, which functioned much like investment funds, were established largely to circumvent regulatory limits on their sponsors. They didn’t take deposits and acquired their portfolios of illiquid mortgage-related securities mainly through short-term borrowing. Hedge funds often provided equity capital for the SIVs, which were managed by their sponsors who charged a fee for their services. The sponsors sometimes provided emergency lines of credit as well. When the value of the SIVs’ portfolios plunged and their funding sources dried up in the credit crunch, they had to be reabsorbed, adding to their parents’ losses.

In addition to such problems of scope, the existing bank regulations—primarily capital requirements and limits on leverage—also failed to sufficiently constrain leverage and risk-taking during the buildup to the crisis. These closely related concepts are the key components of bank regulation, probably of all financial regulation, and their breakdown during the crisis was largely a consequence of the way both variables were measured. Capital, rather than being limited to a bank’s tangible common equity—essentially the portion of its net assets due to its shareholders, which is subordinate to the interests of depositors and creditors—generally included intangible items such as goodwill as well as preferred shares and deferred tax credits, whose value depended on future profitability.

Similarly, capital requirements were based on different assets’ supposed “riskiness,” which tended to fall during the boom, and leverage ratios were calculated by comparing a bank’s capital to its risk-adjusted assets. Measuring capital so generously and adjusting assets in this way made leverage appear lower and capital seem more adequate than they were.

In this respect the regulations were very much like the risk models that investors and financial firms used. Indeed, the highly influential Bank for International Settlements, an organization of central banks that seeks to coordinate bank regulations, proposed in 2004 that, in determining banks’ capital requirements, regulators should rely in part on banks’ own risk models as well as on data provided by credit-rating agencies such as Moody’s or Standard and Poor’s, agencies that were paid by the very financial institutions whose credit they were assessing.

These proposals were widely adopted—and turned out to be dangerously misleading. As a consequence of procedures like these, which justified extremely low capital requirements for AAA-rated mortgage derivatives—1.6 percent of the holdings, equivalent to leverage of more than 60 to 1 for these securities and less than half the capital required to hold individual mortgages—Lehman was thought to be well capitalized just a week before its bankruptcy. Absurdly low capital requirements also explain why banks retained such vast quantities of mortgage-related securities on their own books, setting themselves up for huge losses when the housing bubble burst.13

When a regulatory mechanism has failed to mitigate boom/bust cycles,” the authors of The Fundamental Principles of Financial Regulation (a “Geneva Report” by an international group of economists)14 observe, tinkering around the edges is not likely to be sufficient. What is required is a new approach that concentrates on the need for financial regulation to moderate the business and credit cycles, acting as a “countervailing force” to the rising use of leverage and risk-taking during a boom and helping to offset the damage in a collapse. Moreover, the regulatory mechanism should be based as much as possible on clear, mandatory rules, since regulators often are loath to slow down a boom and have been susceptible to lobbying by financial firms, factors that may help to explain Greenspan’s failures. The United States and most other developed countries have now endorsed the need for such new rules—although so far, it must be stressed, little has been done to implement them.

The Geneva economists propose a deceptively simple mechanism for linking capital requirements to the changing risks that major financial institutions pose to the entire banking system. They would multiply current or improved capital requirements—the Bank for International Settlements is now considering such a revamped set of requirements—by a series of factors, one based on how fast a bank’s assets and leverage grow; a second geared to the extent to which a bank’s assets are financed by shorter-term borrowing that might dry up in a crisis; and possibly a third based on the degree to which a bank’s bonus and other compensation schemes encourage excessive risk-taking.

This approach, which could be applied incrementally to a nation’s most important and interconnected financial institutions as an expansion grows, seems promising, and the elements it incorporates are critical. As the financial crises of the last two years have shown, the combination of high bank leverage, extensive reliance on short-term borrowing, and management compensation schemes that reward short-term results can be lethal.

The Geneva plan would apply to all financial institutions—commercial banks and bank holding companies, investment banks, insurance companies, and hedge funds—whose health might have a significant impact on the entire financial system. And the new capital requirements would take account of the companies’ affiliates and their liabilities, even if these obligations don’t appear explicitly on their balance sheets. The plan is comprehensive, straightforward, and clear—great virtues, especially in the world of opaque bank regulations. But how effective such a system would be will depend on how well the proposed new multiples are chosen.

In late January President Obama outlined several new elements that he believes should be added to the financial reform measures that are slowly working their way through Congress. The new proposals focus primarily on the problem of financial institutions that are thought to be “too big” or “too important” to fail because their failure might trigger an economic crisis like the one we’re emerging from now. As a consequence, such institutions benefit from an implicit government guarantee against total collapse, one that became explicit during the crisis when many banks were rescued at great initial cost to taxpayers. As the President observed on January 21, in order to avert a worse calamity,

the American people—who were already struggling in their own right—were forced to rescue financial firms facing crises largely of their own creation. And that rescue…was deeply offensive but it was a necessary thing to do, and it succeeded in stabilizing the financial system and helping to avert that [threatened] depression.

Although a large chunk of these bail-out costs has` been repaid as the economic climate improved, Obama wants to impose a fee on the largest financial firms in order to repay the remaining cost of the rescues over the next ten years. This proposal, which has yet to come before Congress, is, if anything, too limited, since the government’s need to protect major financial institutions from system-threatening disasters will not expire after ten years. A continuing fee levied on important financial firms would thus be warranted as a payment for the catastrophe insurance that the government will continue to provide. This insurance, whether implicit or explicit, allows these companies to raise capital more cheaply than they otherwise could; not surprisingly, it also has encouraged risk-taking and enhanced their profitability, a consequence of insurance that economists call “moral hazard,” i.e., such insurance could work as an incentive for companies to take on risks that they may not have to pay for if they go bad. The fee would pay for some of these benefits and might constrain moral hazards.

The insurance fee could also be used to fund the operations of new “resolution authority,” a critical part of most financial reform efforts, including the bill passed by the House of Representatives. Such authority would allow regulators to seize control of a shaky but important financial institution and dissolve or reorganize it without messy and lengthy bankruptcy proceedings, and do so in a way that minimizes the need for taxpayer funds. Before government funds were tapped, shareholders and creditors would have to be wiped out. The Fed and the Federal Deposit Insurance Corporation have these powers to control bank holding companies and banks, respectively, and the House legislation would make them applicable to insurance companies and investment banks such as AIG or Lehman.

In addition to the fee, Obama also proposed limiting banks’ size and banning activities such as proprietary trading—trading for their own accounts—and sponsoring or investing in hedge funds or private equity funds. The prohibitions are called the “Volcker Rule” after their principal advocate, former Federal Reserve Chairman Paul Volcker. These two initiatives are intended to limit further domination of the financial sector by a small number of firms and to limit the risks that financial firms can take, in particular banks that benefit from government-insured deposits. They complement other financial reform proposals, including the insurance fee, the imposition of beefed-up countercyclical capital requirements such as those proposed by the Geneva economists, and the establishment of resolution authorities.

Some people contend that the Volcker rule is unnecessary, that its goals could be accomplished more effectively through higher capital requirements, and that it would be very difficult to distinguish proprietary trading from what the trading banks do to hedge the potential losses they take on in serving their clients. In addition, such a rule may cause firms like Goldman Sachs to give up their banking licenses—which were acquired during the crisis so that they would be eligible for Fed support. They do a lot of proprietary trading and run large hedge funds and private equity funds, but don’t raise much money through deposit-taking. Moreover, the critics point out, the activities affected by the Volcker rule were not major contributors to the crisis.

There’s some truth in all these comments but hardly enough to rule out Volcker’s proposals, especially if institutions like Goldman Sachs would be subject to stricter new capital, leverage, and liquidity requirements, and be covered by a strong resolution authority, even if they no longer are banks. For if there’s one thing we should have learned from the crisis, it’s that there are no magic bullets to protect our financial systems and economies forever and that new sources of dangerous behavior may well appear. The Bank for International Settlement’s elaborate capital requirements have not worked well; nor have the judgments of bank executives, investors, regulators, or the Fed’s monetary policymakers been sound. In fact, many of the rules and judgments have been harmful, not helpful. We can hope that lessons from this crisis, like those from the Great Depression, will be reflected both in better rules and in better judgments. But memories will fade, financial systems will evolve, and no matter how hard we try to put in place effective safeguards, there can be no assurances that it won’t happen again.

February 25, 2010

  1. 10

    Alan Greenspan, “The Fed Didn’t Cause the Housing Bubble,” The Wall Street Journal, March 11, 2009, online.wsj.com/article/SB123672965066989281.html. On global imbalances, see Brad Setser, “The Savings Glut: Controversy Guaranteed,” blogs.cfr.org/setser/2009/06/30/, and Ben S. Bernanke, “The Global Savings Glut and the US Current Account Deficit,” March 10, 2005, federalreserve.gov/boarddocs/speeches/2005/200503102/default.htm.

  2. 11

    In his January 3 defense of Fed policy, Bernanke speculated that low interest rates may have encouraged the proliferation of exotic subprime mortgages, which drove house prices higher; but he does not consider the likelihood that the measured pace with which the Fed raised interest rates was a more fundamental element in the process.

  3. 12

    The modern approach to risk analysis evolved from work done by Harry Markowitz in the early 1950s when he was a graduate student at the University of Chicago. Markowitz won the 1990 Nobel Prize in Economics for his theory of portfolio analysis, which argued that investment portfolios could be evaluated by analyzing the tradeoff between their returns and risks, with risk measured by the variability, or variance, of returns. His analysis showed that diversification could reduce overall risk without sacrificing returns provided the elements of the portfolio truly were diverse, i.e., not closely correlated. Applying Markowitz’s approach requires several important qualifications, particularly that the data used are representative of the range of possibilities. These requirements are rarely satisfied fully, which is why the models cannot substitute for judgment, especially during booms when real risks may be masked by misleading measures.

  4. 13

    Base Camp Basel,” The Economist, January 21, 2010, and John Carney, “Why Banks Bought So Many Toxic Mortgage Bonds,” Business Insider, August 7, 2009, www.businessinsider.com/why-banks-bought-so-many-toxic-mortgage-bonds-2009-8.

  5. 14

    Begun in 1999, the Geneva Reports on the World Economy are produced through a collaboration between the International Center for Monetary and Banking Studies, which is affiliated with the Graduate Institute of International Studies in Geneva, and the Center for Economic Policy Research, a network of researchers based mainly in European universities. The reports focus on reform of the international financial and economic systems and are written by groups of well-known economists.

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