“If all the economists were laid end to end, they would never reach a conclusion”
George Bernard Shaw
The Financial Crisis Inquiry Commission (FCIC) produced their final report on the causes and lessons of the financial crisis on January 27* (actually, the original mandate called for the report by December 15, 2010, but this was delayed). The Republican minority on the commission elected to deliver their own assessment (the “Financial Crisis Primer”**) on the originally prescribed date – December 15. Thus, we have two reports, the official report and the previously delivered rebuttal. These reports represent the two broad narratives that have dominated discussion of the crisis.
The majority report takes the view that market failure is the element in the crisis and the answer is improved and enhanced government regulation. The Republican rebuttal is that government intervention is the primary culprit and the solution is less government intervention. Evidently, Republicans on the Commission were concerned that their position would not receive adequate exposure in the final report, so they opted to release their version first (in addition, the four authors of the “Primer” have also drafted two dissents from the FCIC Report conclusions, both of which are included in the Report).
Republican Primer
The Republican story is that federal government policies largely drove the housing bubble. Easy monetary policy by the Federal Reserve along with pro-homeownership policies by Congress supported strong demand for housing and drove housing prices higher. Low capital requirements on mortgage securities and optimistic assessments of mortgage risk supported strong demand for mortgage backed securities, including securities based on “non-traditional” products.
Direct government guarantee of loans through the FHA and Government Sponsored Enterprises was a major factor driving demand for risky mortgages. In addition, overly optimistic credit ratings by the key credit ratings agencies induced private investors to become comfortable holding risky securities.
Pushed by wide availability of credit and demand for mortgage loans, largely driven by government policy, the housing boom turned into a bubble and, eventually, a bust. Overinvestment in residential construction generated a surplus of vacant homes for sale, and oversupply eventually led to a peak and downturn in housing prices.
Why did the housing price downturn have such devastating consequences for private financial institutions and the overall economy? According to the Primer, the answer is excess leverage and funding mismatches in large financial institutions, both banks and non-banks. While leverage and mismatching are essential components of bank management, in the extreme they can lead to fragility, and they did. The economic consequences of the crisis include large declines in housing prices and stock prices, a huge rise in unemployment and decline in real output, and massive increases in the federal budget deficit. The main conclusion is that we need to take seriously the need to reduce the deficit and the debt.
There is little direct discussion in the Primer of the role of the “shadow banking system” except insofar as “runs” are more likely and consequential for non-insured institutions. Neither is there much discussion of the process of mortgage securitization, nor the replacement of the “originate to hold” model of mortgage lending by the “originate to distribute” model.
Rebuttal to the Republican Rebuttal
Naturally, the Republican report has received a fair amount of scrutiny and criticism. The claim that government sponsored entities drove weaker underwriting standards and development of non-traditional mortgage products is disputed by the argument that GSE market share fell during the height of the boom (2004-2006) and that the riskiest loans wound up in private label securities rather than government or agency securities.
The claim that home ownership policies drove the crisis is disputed by noting that pro-homeownership policies have been in place since the 1930s, why it is that they are primarily responsible for a crisis starting in 2007?
The Republican report is criticized for ignoring the effects of financial deregulation since the 1980s, the failure of private sector risk management, and negative incentive effects inherent in the process of securitization.
Finally, the conclusion that we should focus on deficit and debt reduction leads opponents to argue that to the Republicans, every problem is a nail and the Republican hammer is lower government spending.
Which Rebuttal is right?
To me, both sides have a point. There was a failure of policy. Fed policy was easy in the mid 2000s and it probably did promote excess investment in housing. The drive to increase the homeownership rate certainly did include attempts to stimulate the demand for housing and to encourage greater availability of mortgage credit.
There was also a failure of management of private financial institutions. The Republican Primer mentions this in passing; that the crisis spread so aggressively across financial institutions thanks largely to excess leverage and mismatched funding, but does not highlight this factor. It seems to me clear that mortgage risk was underestimated, many mortgage products had design flaws, and risk-adjusted returns were wildly overestimated.
One striking feature of the housing bust and preceding boom is the pro-cyclicality. That is, events tended to feed upon themselves. During the boom several factors combined to turn the boom into a bubble. These factors included declining haircuts, rising leverage, weaker underwriting standards. Once housing prices peaked out and began to decline, the positive reinforcing factors went into reverse and began to reinforce the downturn.
Policy Initiatives
How can we fix policy failure? The obvious answer is to attempt to impose counter cyclicality. Perhaps monetary policy could return to the idea of taking away the punch bowl before the party explodes, rather than after. Capital levels for banks and other financial entities could be tied to risk levels (including systemic risks). Risk measures could be devised that show rising risk levels as asset prices and debt levels increase. The moral hazard inherent in TBTF could be addressed – if you are too big to fail then perhaps you are simply too big.
Is it feasible that policy can turn counter-cyclical? In his speech to the American Economic Association this past month, John Taylor*** argues that there is a fundamental problem with discretionary policy, it tends to be pro-cyclical and to amplify the boom bust cycle. Taylor argues that economic outcomes have been superior under rules-based policies. By superior, Taylor means less volatility and greater economic growth. As one example, Taylor mentions the Taylor Rule for setting the target funds rate.
How can we improve private sector risk management? Naturally, quantitative risk models are better now that we have a richer database of shock scenarios to consider. It is likely that tail risk will be better estimated in the future. But, what if financial failures were due to incentives and organization structure instead of faulty models? Even if the risk team comes up with measurements and reports that highlight excessive risk, there is no guarantee that senior management will not overlook or override these concerns in an effort to maximize expected return or to be as competitive as possible.
Surely there are lessons to be learned from the crisis. The problem is that there are competing narratives of the underlying causes along with conflicting implications for remedies. Someday this will all be sorted out, but not yet. With three separate conclusions emanating from the ten commissioners, the FCIC has not succeeded in supplying a definitive statement of the underlying problem, and therefore has not been able to produce a convincing set of remedies.
*The Financial Crisis Inquiry Report, Public Affairs, 2011.
**Republican Commissioners on the FCIC, “Financial Crisis Primer,” December 15, 2010.
***John Taylor, “Historical Evidence on the Benefits of Rules-Based Economic Policies,” American Economic Association Meetings, 2011.