Russ Roberts has a paper that provides an excellent overview of the 2008 financial crisis. Many of the arguments might be familiar, but the cumulative impact of seeing all of his examples of moral hazard is quite sobering. I’ll have my students read it this fall.
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Continental Illinois was just the largest and most dramatic example of a bank failure in which creditors were spared any pain. Irvine Sprague, in his 1986 book:
“Of the fifty largest bank failures in history, forty-six””including the top twenty””were handled either through a pure bailout or an FDIC assisted transaction where no depositor or creditor, insured or uninsured, lost a penny.”
The 50 largest failures up to that time all took place in the 1970s and 1980s. As the savings and loan (S&L) crisis unfolded during the 1980s, government repeatedly sent the same message: lenders and creditors would get all of their money back. Between 1979 and 1989, 1,100 commercial banks failed. Out of all of their deposits, 99.7 percent, insured or uninsured, were reimbursed by policy decisions.
Then Russ discusses LTCM and the 1995 Mexican bailout before eventually arriving at the current crisis: 
That brings us to the current mess that began in March 2008. There is seemingly little rhyme or reason to the pattern of government intervention. The government played matchmaker and helped Bear Stearns get married to J. P. Morgan Chase. The government essentially nationalized Fannie and Freddie, placing them into conservatorship, honoring their debts, and funding their ongoing operations through the Federal Reserve. The government bought a large stake in AIG and honored all of its obligations at 100 cents on the dollar. The government funneled money to many commercial banks.
Each case seems different. But there is a pattern. Each time, the stockholders in these firms are either wiped out or see their investments reduced to a trivial fraction of what they were before. The bondholders and lenders are left untouched. In every case other than that of Lehman Brothers, bondholders and lenders received everything they were promised: 100 cents on the dollar.
A few comments:
1. Reading Russ’s paper makes me realize just how much our system is biased toward debt. And by the way, it isn’t just moral hazard; our tax system is also biased toward debt and against equity. People talk about Americans borrowing too much, but given all these distortions it’s surprising that we don’t have even more debt. Why didn’t I take out some mortgages and buy Florida condos? I’d like to think it was civic virtue, but I suppose it was just laziness.
2. This also made me realize the importance of Lehman’s failure. It wasn’t just an isolated bankruptcy; it was a regime change that made enormous quantities of debt appear to be far riskier than just a few days earlier. And the change was made just as the US was entering a severe recession. I’m all for cracking down on moral hazard—but September 2008 was not the best time to do so.
Here Russ discusses how the system encouraged abuse:
George Akerlof and Paul Romer describe similar incentives in the context of the S&L collapse. In Looting: The Economic Underworld of Bankruptcy for Profit, they describe how the owners of S&Ls would book accounting profits, justifying a large salary even though those profits had little or no chance of becoming real. They would generate cash flow by offering an attractive rate on the savings accounts they offered. Depositors would not worry about the viability of the banks because of FDIC insurance. But the owners’ salaries were ultimately coming out of the pockets of taxpayers. What the owners were doing was borrowing money to finance their salaries, money that the taxpayers guaranteed. When the S&Ls failed, the depositors got their money back, and the owners had their salaries: The taxpayers were the only losers.
This kind of looting and corruption of incentives is only possible when you can borrow to finance highly leveraged positions. This in turn is only possible if lenders and bondholders are fools””or if they are very smart and are willing to finance highly leveraged bets because they anticipate government rescue.
When you read Russ’s paper you begin to wonder if much of the US economy is just a giant Ponzi scheme:
1. Bank creditors ignore risk, knowing they will be bailed out.
2. Bank equity-holders have an incentive to borrow at low rates (due to the protection of creditors), and so they take highly leveraged gambles.
3. Bank presidents have an incentive to take big risks, as they can earn large bonuses if the gambles pay off.
4. Bank depositors have an incentive to look for the highest rate of return, regardless of how reckless the bank is.
5. Home-buyers have an incentive to take out mortgages with the smallest possible down-payments, particularly in non-recourse states.
Taxpayers are left holding the bag.
And that is just the banking system. Insurers like AIG (and their customers) had an incentive to take enormous ricks, knowing they would be bailed out. Hospitals in McAllen Texas spent vast amounts treating poor patients, knowing Medicare will bail them out. Then there is our pension system; corporations have an incentive to have underfunded pension plans. And does anyone think Uncle Sam would allow states like California or Illinois to default on pension obligations? And why stop at states? Perhaps whole countries are playing this game. What about lenders to Greece? How about Iceland; didn’t their citizens recently vote down a proposal that they pick up the cost of meeting deposit insurance obligations in British and Dutch branches of Icelandic banks? I am certainly not suggesting that the Icelandic banking fiasco was some sort of nefarious plot hatched by Icelandic taxpayers, but rather that there may be a good reason why they never contemplated the tax liability associated with the European branches of Icelandic banks. With the possible exception of taxes, government-created moral hazard is the primary factor distorting market economies around the world
Some of my commenters suggest that if we had my monetary nirvana of 5% expected NGDP growth, then people would take greater risks. Perhaps, but also think about this. The biggest single factor driving bailouts is the fear that failures would worsen a recession. If government policymakers knew there was going to be 5% expected NGDP growth regardless of whether Lehman was bailed out or not, then I think it would be easier for them to ‘do the right thing” and refrain from bailouts. I don’t recall all that many bailouts during the prosperous Clinton years. Gambles were made (in tech stocks) but for the most part those who lost money paid the price. My point is not that Clinton himself had anything to do with the difference, rather that we are more risk averse when a financial failure seems likely to trigger a recession.
I have been a long-time foe of Fannie and Freddie (going back 20 years) and I am pleased that Russ was able to dig up a lot of dirt. Here is just one of many examples:
The most important change at Fannie and Freddie, however, was their approach to the down payment. In 1997, fewer than 3 percent of Fannie and Freddie’s loans had a down payment of less than 5 percent.
But starting in 1998, Fannie created explicit programs where the required down payment was only 3 percent. In 2001, it even began purchasing loans with zero down. With loans that had a down payment, it stopped requiring the borrower to come up with the down payment out of his own funds. Down payments could be gifts from friends or, better still, grants from a nonprofit or government agency.
A few weeks ago I was kind of shocked to see respected bloggers speak well of the financial reform package. I can’t see how it addressed ANY of the major causes of the 2008 fiasco. But easily the most inexcusable aspect of the bill was that it didn’t even address Fannie and Freddie. People excuse that on the basis that there is a lot of political support for F&F. But if you can’t reform them right after a $165 billion taxpayer bailout, when will they be unpopular enough that we can address their flaws? (And the best way to address the flaws would be to phase them out of existence.)
And no ban on sub-prime mortgages? I thought that was the cause of the crisis. You’d think a minimum 20% down-payment would have been the centerpiece of the bill. Two years ago all my left wing friends said; “See how bad capitalism is? All those unregulated banks made lots of sub-prime loans.” OK left-wing friends, where is the regulation that prevents banks from reverting back to sub-prime lending?
When the crisis broke in 2007 I was completely ignorant about some of the details of what had been going one. Of course I had heard that there were lots of sub-prime loans, and that in recent years almost anyone could get a mortgage. But when I bought my house in 1991 I was told I needed to put 20% down or else buy mortgage insurance. I had no idea that the practice had been phased out. Here is Russ describing what happened:
When the down payment was less than 20 percent, Fannie and Freddie required private mortgage insurance (PMI). On a zero down payment loan, for example, the borrower would take out insurance to cover 20 percent of the value of the loan, protecting Fannie and Freddie from the risk of the borrower defaulting. But starting in the 1990s, an alternative to PMI emerged””the piggyback loan, a second loan that finances part or all of the down payment. The use of piggyback loans grew quickly beginning in the 1990s through 2003 and even more dramatically in the 2004-2006 period. For example, in a study of the Massachusetts mortgage market, the Warren Group found that in 1995, piggyback loans were 5 percent of prime mortgages. The number grew to 15 percent by 2003. By 2006, over 30 percent of prime mortgages in Massachusetts were financed with piggyback loans. For subprime loans in Massachusetts, almost 30 percent were financed with piggybacks in 2003 and more than 60 percent by 2006.
Here is something I haven’t heard many people talk about. Couldn’t one argue that moving away from mortgage insurance for less than 20% downpayment mortgages was a factor in the crisis? Maybe I am missing something simple here, but it seems to me that with mortgage insurance you actually have institutions with “skin in the game.” Perhaps the mortgage insurance companies would have been just as reckless as AIG, and allowed O% no -income verification mortgages with phony appraisals. But even in that worst case scenario the existence of mortgage insurance have reduced the losses to the banking industry. Even if the mortgage insurance companies had to be bailed out, at least they would have absorbed some of the losses now absorbed by banks and taxpayers. And I think in practice they would not have been quite that reckless.
My second observation is that the big mistakes were made in the 1990s, when we allowed F&F to dramatically lower their standards and stopped requiring mortgage insurance on less than 20% down mortgages. And this loosening of standards occurred right after one of the biggest banking fiasco’s in American history–the S&L crisis, which required an enormous taxpayer bailout of our deposit insurance system. When this happened everyone was running around saying “See deregulation doesn’t work, we need to re-regulate the banking system.” And I think that they did tighten up in a few areas like capital requirements. But the most important trend in the 1990s was actually deregulation, the dramatic lowering of the standards on who could get a mortgage. I don’t know how much of this was explicit deregulation, and how much was a failure of regulators to do something affirmative in the face of financial “innovation.” So I am not trying to make an ideological point here, or point fingers at one party of the other. My point is that we responded to the S&L crisis by talking about the need for tighter regulation, and then acted in a completely contrary way. As far as I can see our current actions also have little to do with the 2008 crisis.
I think the debate over regulation gets clouded by ideology. What does “increased regulation” mean? Does it mean more government involvement in banking, or less? Consider our current banking system in America, where we essentially nationalized all bank liabilities in 1934. When you deposit $100 in the bank, you are loaning it to the Treasury, which re-loans it at the same rate to the bank. Those are insured deposits. Now consider a “regulation” that said banks could only lend out money from insured deposits on mortgages with more than 20% down-payments. While this proposal would increase “regulation,” it would also reduce the role of government in our banking system. Instead of the government being liable for deposits in any bank failure, they would only be liable for those where banks were engaged in relatively safe behavior. It would dramatically reduce the scope of deposit insurance.
I agree with Russ’s Hayekian perspective, we can’t solve these problems by trying to micromanage the economy. But I also think that libertarians must be careful in offering policy advice in complex environments. When Iceland’s government deregulated banking, and allowed Icelandic banks to open extensive branches in Europe, the Icelandic government was in many was becoming more involved in the Icelandic economy, exactly the opposite of how it may have initially appeared. Their government took on vast new liabilities associated with the British and Dutch deposits of Icelandic banks. That’s a responsibility that the Icelandic government did not have before deregulation. Deregulation is usually good, but not when it increases the role of government in our financial system. I’m afraid that much of the banking “deregulation” of the 1990s did exactly that, it enormously increased our government’s explicit and implicit liabilities.