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The government, not underregulated markets, spurred the economic meltdown.

THE CURRENT narrative regarding the 2008 systemic financial system collapse is that numerous seemingly unrelated events occurred in unregulated or underregulated markets, requiring widespread bailouts of actors across the financial spectrum, from mortgage borrowers to investors in money market funds. The Financial Crisis Inquiry Commission, created by Congress to investigate the causes of the crisis, promotes this politically convenient myth, and the 2010 Dodd-Frank Act operationalizes it by completing the progressive extension of Federal protection and regulation of banking and finance that began in the 1930s so that it now covers virtually all financial activities, including hedge funds and proprietary Wading. The Dodd-Frank Act further charges the newly created Financial Stability Oversight Council--made up of politicians, bureaucrats, and university professors--with preventing a subsequent systemic crisis.

Markets can become unbalanced, but they generally correct themselves before crises become systemic. Because of the accumulation of past political reactions to previous crises, this did not occur with the most recent crisis. Public enterprises had crowded out private enterprises, and public protection and the associated prudential regulation had trumped market discipline. Prudential regulation created moral hazard and public protection invited mission regulation, both of which undermined prudential regulation itself. This eventually led to systemic failure. Politicians are responsible for regulatory incompetence and mission-induced laxity.

The 2008 global financial collapse emanated from the U.S. subprime lending bubble. Economists generally resort to mass psychology to explain how the bubble could inflate to such an extent, assuming that borrower and lender behavior was irrational. The Fraud Enforcement and Recovery Act of 2009 created the Financial Crisis Inquiry Commission (FCIC) to investigate why the financial crisis became globally systemic. The FCIC was charged with conducting a comprehensive examination of 22 specific and substantive areas of inquiry relating to various and seemingly unrelated hypotheses advanced primarily by politicians, business executives, and university professors. The final FCIC report (2011) found varying degrees of merit for all of these hypotheses, blaming the financial crisis on a confluence of generally independent events, such as "recklessness of the financial industry and the abject failures of policymakers and regulators" to regulate the essentially deregulated or never regulated parts of the mortgage and deposit markets. This justified the 2,300-page Dodd-Frank Act's regulatory approach.

The basic difference between the U.S. and other market economies since 1975 has been that U.S. mortgage and related markets relied more on federally sponsored and regulated enterprises that were more pervasively--that is not to say appropriately--regulated. The conventional narrative is that the unregulated private-label securitizers (PLS) like Countrywide and Bear Stearns funded the subprime bubble, subsequently dragging down the giant government-created mortgage financers Fannie Mae and Freddie Mac with them. However, all of the markets contributing to the crisis already were subject to regulation in one way or another. The FCIC Report's conclusions succeed in diffusing the political responsibility for making the crisis systemic and hence fail as a guide to avoiding future systemic crises.

The specific regulatory failures necessary for Fannie Mae and Freddie Mac to become so heavily entwined in the subprime bubble were allowing them to bypass the primary mortgage insurers; permitting them extreme leverage; and requiting them to finance at least half of the subprime market.

The specific regulatory failures necessary for the private-label securitizers likewise to become heavily entwined in the subprime bubble were the Securities and Exchange Commission (SEC) designation of approved credit rating agencies without the necessary supervision; the use of the credit rating agency designations in risk-based capital requirements; the failure of bank regulators to prevent the deterioration of underwriting guidelines, regulatory arbitrage, off-balance sheet funding, and the rise of the "shadow banking" market; and woefully inadequate SEC capital regulations for investment banks and accounting rules that allowed the acceleration of income and delayed recognition of expense.

Still, all of these failures should not obscure a more general problem: Federal regulators did not understand and mitigate systemic risk.

Public protection of private enterprises creates a "moral hazard," wherein private enterprises are more willing to take risk when they know that they will be rescued if they get into trouble. As a result, protected enterprises will take excessive risks. Virtually all of the behavior that created the subprime lending debacle can be explained by incentive distortions, mostly moral hazard, and none of this behavior was new or irrational. It was not the lack of regulatory authority, but rather its pervasiveness and widespread failure, that not only allowed, but caused, the subprime lending debacle. Adding to this, purely political mission regulation--specifically, the government-embraced "mission" of expanding homeownership rates regardless of risk--pushed the bubble to systemic proportions.

Politicians are responsible for regulatory oversight, but that oversight failed because of incompetence and incentive conflict. Politicians and their regulators consistently failed to understand how regulation would undermine and replace, rather than complement, market discipline. Market discipline cannot be said to have "failed" during the subprime lending bubble, because it did not exist; market forces had been replaced by regulatory oversight. Only market speculation operated largely outside of this regulatory regime, but politicians and their regulators always have tried to limit and even criminalize the stabilizing activity of speculators "shorting the market."

Pointing the finger

Banking deregulation often has been blamed for causing the financial crisis, but it is unclear why that would be the case. The so-called "Reagan Era" banking deregulation (which actually was signed into law by Pres. Jimmy Carter after being passed by a Democrat-controlled Congress) was the phase-out of deposit interest rate ceilings beginning in 1980, and that had nothing to do with housing finance.

The next piece of banking deregulation was the 1994 elimination of bank branching restrictions, which was passed by a Democrat-controlled Congress and signed into law in 1994 by Democratic president Bill Clinton, and which, again, had nothing to do with housing finance.

The 1999 banking reform, passed by a Republican Congress and signed by Pres. Clinton, eliminated the Glass-Steagall Act's forced separation of investment and deposit banking, but that did not seem to contribute to the financial crisis, as the institutions at the heart of the crisis--Bear Steams, Lehman Brothers, Ameriquest, Countrywide, AIG, and so on--were not "universal" banks (though many of those institutions later were merged into universal banks so as to stabilize them). These reforms all removed political distortions and strengthened the financial system.

The credit allocation goals of mission regulation, in contrast, directly conflicted with prudential regulation. In the case of Fannie Mae and Freddie Mac, political mission regulation and corruption explains most of the regulatory failure. In the case of the banks, mission regulation also likely explains why regulators did not raise the credit standards for their loans or increase capital requirements.

How did the U.S. mortgage markets become so much more politicized than those of other market economies? The numerous federally sponsored enterprises that insure deposits and mortgages, or lend against or make a market in mortgages, all trace their roots to the response of Federal politicians to the Great Depression.

Government-provided deposit insurance--introduced in 1933 to prevent bank runs and protect the payments mechanism--arguably had a positive effect over its first four decades of existence, but repressive government prohibitions on branching and paying interest eventually spawned the "shadow banking system," a financial system outside the formal regulated system of banks and thrifts.

Moral hazard grew in the banking system as deposit protection became comprehensive, regulators promoted bank consolidation over competition among banks, and large banks and other financial firms became "too-big-to-fair"--that is, so important to the U.S. economy that government would rescue them if they got into trouble. Moral hazard eventually affected the entire shadow banking system as well, which subsequently played a role in funding the subprime lending debacle.

Mortgage market enterprises such as Fannie Mae and Freddie Mac were introduced to maintain "liquidity" of mortgage lenders and stimulate housing construction and jobs. Instead of acting as traditional mortgage companies that raise money from investors and then use that money to extend loans to individual homebuyers, these government enterprises purchased from banks the mortgage contracts that the banks already had made with homebuyers. This reduced the banks' risk of default and provided them with cash to use for more home loans, while the enterprises received the long-term payments from the homebuyers.

Originally, the enterprises financed the purchases with money from Congress augmented by the mortgage payments from existing borrowers. This time, though, the enterprises began reselling the mortgages--as large "bundles" of diversified mortgages--to independent investors who then would receive the mortgage payments.

Ultimately, the two largest enterprises, Fannie and Freddie, partly were spun off from government, becoming government-sponsored enterprises (GSEs). Though they still had a public mission to boost the housing market and they were under special government oversight, they also had private investors and could hold mortgages and attempt to profit from doing so. For approximately the next four decades, these enterprises did no obvious harm. Home mortgage lending to households financed largely by private mutually chartered savings and loan, savings bank, and file insurance company intermediaries--the backbone of the U.S. housing finance system for more than a century--raised the U.S. homeownership rate from a level of about 45% in 1945 to 55% by the early 1950s as returning veterans received Veterans Administration loans, and then to 65% by 1975, prior to the GSE era, where the rate remained for approximately the next quarter-century.

Restrictions on branch banking and deposit rates caused regional capital shortages for banks by the 1970s, owing to huge demographic migrations. As a result, banks came to rely more heavily on wholesale funding sources like Fannie and Freddie. Mortgage bonds of the type commonly used in other developed market economies date back to the 1800s in the U.S., but American capital markets were fragmented by multiple state jurisdictions and overlapping state and Federal regulation.

Providing GSEs with regulatory exemptions was politically more expedient than streamlining securities laws or removing branch banking restrictions. Yet, politicians consistently have muddied the distinction between "liquidity" and "marketability," as well as the distinction between "market-making" and "trading," which can refer to both broker/dealer activities and speculation. The consequence often was that GSE policies justified as promoting liquidity often promoted only marketability and, frequently, only speculation. Moreover, the subsequent "privatization" of Fannie and Freddie created a huge incentive distortion of public risk for private profit, and their regulatory preferences that conveyed agency status allowed them to become public housing banks that crowded out the private market while inviting a public mission for political cover.

Politicians were not motivated to reform the U.S. financial system dramatically, but attempts to use regulation to favor both borrowers and savers did disturb the system's balance. With each successive economic crisis, politicians and bureaucrats have, not surprisingly, doubled down on regulation so as to protect the fiction that markets, rather than bureaucrats and politicians, had failed as well as to maintain and expand the Federal regulation and programs this fiction justified.

During the Depression, the Franklin D. Roosevelt Administration and bank regulators were much more concerned with the moral hazard consequences of regulation than Dodd-Frank is today, even though the New Dealers' attempts to mitigate it with arm's-length Federal sponsorship of insurers ultimately failed. Dodd-Frank will fail to achieve its goal of mitigating systemic risk because it does not distinguish between the deposigmoney markets that Congress should have comprehensively and appropriately regulated, and the investment markets, including mortgage markets, that, Congress did not and cannot regulate effectively.

Economists still are debating the relative causes of the Great Depression, but the central findings are indisputable. It was not caused by instability in unregulated financial markets. Unregulated private financial markets in the U.S. previously had produced regular, although smaller, self-correcting financial crises that were blamed--unfairly--for the Great Depression. Rather, politically induced distortions turned the recession into a depression and then made it "great." For instance, labor market distortions relating to the Wagner Act and Davis-Bacon kept wage rates as much as 40% above market clearing levels, and Smoot-Hawley tariffs reduced international trade by more than half.

The seeds of the Great Depression were planted two decades before the crash, with the creation of the Federal Reserve and America's embrace of "modern" monetary policy. When the Federal Reserve Act was passed in 1913 establishing the Federal Reserve, the American Banker hypothesized that "from this time forward the financial disorders which have marked the history of the past generation will pass away forever." Soon thereafter, though, the Fed was accused of fueling the asset bubble of the 1920s. Housing production had boomed, fueled by the Fed's easy credit policies, and then fell by more than 80%, from 753,000 units in 1928 to 134,000 in 1932. According to the research of economist Simon Johnson and law professor James Kwak: "Not only did the Federal Reserve system encourage excessive risk taking by bankers, the safety net, it turned out, had gaping holes that could not be fixed in the intense pressure of a crisis. The result was the Great Depression."

The Fed, in fact, did even more harm, spurring current Fed Chairman Ben Bernanke to apologize publicly to Nobel laureate economist Milton Friedman on behalf of the Fed, agreeing that the centralized monetary authority was the cause of the systemic deflation that perpetuated the Depression.

The Depression era spawned numerous Federal interventions in the financial system, including deposit insurance, mortgage insurance, and mortgage discount lending and market-making facilities.

The Federal Reserve's loose money policy during the first half of the last decade allowed a credit boom to develop somewhere, and the GSEs helped channel it to housing--but a subprime lending bubble in the U.S. kept the housing boom going for about three additional years, from mid 2004 through mid 2007, and it is this bubble that caused the collapse of the global financial system.

The conventional view is that unregulated private lenders financed weak or victimized borrowers, eventually dragging the GSEs down with them. The troth is that essentially the same investors that funded private label sccuritizers also funded GSE securities, and for essentially the same reasons.

Specifically, the investors' reasons for funding the GSEs were as follows: market discipline long since had been replaced by prudential regulation; prudential regulation conveyed agency stares on the GSEs, essentially giving them too-big-to-fail status, and that status was extended to non-GSE investment grade private-label securitizers; and prudential regulation by now was tromped politically by mission regulation, especially for the GSEs--speculators (the last remaining source of market discipline) may have been able to prick the bubble several years earlier but for the continued bubble inflation provided by the GSEs.

Subprime surprises

Peter Wallison, a fellow of Financial Policy Studies at the American Enterprise Institute, has provided a detailed discussion of credit risks in subprime lending. One stunning fact reveals much about the creditworthiness of subprime borrowers during this bubble: about one in five loans was delinquent within the first six months.

In spite of all the concern over predatory lending, most of the subprime borrowers had it pretty good. A majority of them put in little or no cash. Most could not afford the full monthly payment ex ante, obtaining a teaser rate for several years. Many early subprime borrowers were able to refinance, extending the teaser period for several more years. Some even got to take out cash when refinancing that they had not put in initially. Many lived rent-free for two, three, or even more years as foreclosures were delayed by political pressure. The ex post consequences suggest that borrowers and mortgage lenders were preying on investors, and indirectly on taxpayers.

Whether the borrowers were predators or prey, one thing is certain: historically, they would have been required to get mortgage insurance, but not during the past decade. The market share of the Federal Housing Authority (FHA) was halved from 2001-03 to 2005-07, and the share of conventional high LTV (loan-to-value) loans insured privately likely fell even more. The reason for this is simple: most subprime borrowers could not afford the normal insurance premium or, more importantly, qualify for insurance. Moreover, a much higher premium would have been required, but adverse selection would have been extreme. Put differently, the FHA and private mortgage insurance could not have insured these loans even if their risk models ignored the bubble in house prices, which they did not, and, as a consequence, the vast majority of subprime loans were not insured, but instead were funded by nontraditional means.

In place of insurance was the credit risk evaluation of the SEC-designated NRSROs (nationally recognized statistical rating organizations), which evaluated risks differently. Their ratings of second mortgage securities that substituted directly for insurance proved to be most instrumental in obtaining funding. These ratings proved wildly optimistic for two reasons:

First, the rating agencies treated the first mortgages on homes backed by second mortgages the same as if they had cash down payments or private mortgage insurance, even though they had default rates that were approximately five times greater.

Second, they rated pools of second mortgages as if they were home equity loans. Home equity loans became popular after the interest deduction was removed for consumer credit in the 1980s, and the default experience had been good because house prices kept rising, but this was not the case with the "piggyback" second mortgages that were replacing private mortgage insurance. Nevertheless, these piggyback seconds subsequently were securitized with almost as much leverage as the first mortgages. The excessively favorable ratings resulted in much less capital than regulated mortgage insurers were required to maintain to cover the same risk.

The conventional interpretation is that the credit rating agency models seriously were flawed, but it enabled the agencies that created them to make more profit in the last decade than in the previous century, mostly by rating private-label securities. Having granted the agencies an incredibly valuable franchise, the SEC did nothing to limit the exploitation of this franchise or to regulate the adequacy of its ratings. Bypassing the mortgage insurers was a necessary condition for the subprime lending debacle. Mission regulation compromised prudential regulators by enabling origination of junk mortgages, and SEC regulations regarding the credit raters enabled the junk to be financed.

The Dodd-Frank Act, meanwhile, requires a comprehensive extension of regulation across the financial markets, extending its reach to private equity, hedge funds, and derivatives while adding new agencies to "protect" consumers, mortgage borrowers, and investors. To mitigate systemic risk, it created the Financial Stability Oversight Council and the Office of Financial Research, both housed in the Treasury Department with the Secretary of the Treasury as the Council Chairman. The act is characterized as a lot more protection and a lot more regulation with the express purpose of mitigating systemic risk. This follows the pattern beginning a century ago with the 1913 Currency Act creating the Federal Reserve.

Bank transactions account protection got off on the wrong foot with deposit insurance, initially enacted as a politically expedient way of dealing with the risks of bank runs due to bank branching restrictions, but the bailout of the Reserve Primary Fund in 2008 predictably extended protection to money market funds and the rest of the shadow banking system. Federal protection of the payments mechanism now is comprehensive and permanent--as there is no turning back--and hence there is no role for market discipline. The logical implication is that the shadow banking system must be brought out of the shadows into the regulated banking system. For example, money market funds could continue, but should be limited to investing in short- and medium-term direct U.S. Treasury obligations.

However, the Dodd-Frank Act virtually ignores money markets, focusing instead on investment markets. While the act's Financial Stability Oversight Council was hashing out bureaucratic turf during its first year, European banks invested more than $150,000,000,000 in Greek debt and two trillion dollars in the debt of Portugal, Ireland, Spain, and Italy due, in part, to their zero risk-based capital requirement. The U.S. money market funds simultaneously invested half their assets in the debt of European banks, apparently attracted by the yield premium reflecting the possibility of default. Now, either American taxpayers must subsidize Greek (and other European) profligacy or face another systemic financial system failure before recovering from the last one, and the U.S. Treasury is underwriting this moral hazard by planning the bailout. That was quick--and predictable!

Feds should 'fess up

The continued systemic regulatory failures through the fall of 2008 and the resulting moral hazard are the primary causes of the systemic financial crisis. The Federal government and prudential regulators did not lack regulatory authority to mitigate moral hazard, just the political will and technical competence to do so. As argued by economists at the Organisation for Economic Co-operation and Development, "Indeed, if current policy responses increase moral hazard in the banking system, then future crises may not only be likely, but possibly larger than the current one." Mitigating systemic risk requires nothing more or less than eliminating the potential for regulatory arbitrage and mitigating moral hazard.

When politicians and their regulators are faced with the choice between either a massive ex post bailout or a systemic financial system collapse, they always will choose the former. When sufficiently incompetent, they do both. Hence, regulation creates the same moral hazard as insurance and protection. Dodd-Frank seems destined to make moral hazard and systemic risk worse in three ways:

First, the focus on consumer protection likely will further politicize U.S. mortgage markets. Second, the focus on regulating hedge funds and derivatives will diminish the last source of mortgage market discipline. Third, housing the Financial Stability Oversight Council and Office of Financial Research in Treasury, with the Treasury Secretary responsible for mitigating systemic risk, is particularly ironic, as excessive Treasury deficit financing historically has been the root cause of systemic financial crises.

The premise underlying current proposals for GSE hybrids--that government sponsorship is necessary, but can be limited, with moral hazard mitigated--obviously is false. FDR first introduced the Federal Housing Authority as a limited, federally sponsored mutual insurance fund to stimulate housing. That spawned Fannie Mae and Ginnie Mae directly and Freddie Mac indirectly as a political compromise. None were, or are, backed today by the Federal government, but you would never know it.

Ginnie Mae is a direct government agency but cannot guarantee credit risk. Housing and Urban Development officials claim that the FHA guarantee became "full faith and credit of the U.S. government" by virtue of the sentence in the 1968 Housing Act that requires the HUD secretary to require the FHA to maintain adequate reserves. With this line of reasoning, even the most arms-length Federal sponsorship implies complete taxpayer backing. The alternative to a return to the status quo ante, which virtually would assure a future systemic failure, is reliance on an appropriately budgeted government housing bank, or a return to a market-based system.

Restoring market discipline will not be easy, as regulations attempting to define a relatively risk-free "Qualifying Residential Mortgage" have become politicized. Sen. Chris Dodd (D.-Conn.), of course, is infamous for his rationale for voting against a proposal to require five percent down: "Passage of such a requirement would restrict home ownership to only those who can afford it."

Repealing the NRSRO designations, altering bank risk-based capital roles for mortgage securities, eliminating GSEs, and implementing covered bond and asset-backed securities regulations that require a market determination and allocation of risks is the easy part because we have both U.S. historical and contemporary international experience as a guide. The hard parts are establishing capital requirements for the new enlarged and protected too-big-to-fail banks that will prevent arbitrage between capital market investments and portfolio lending and convincing investors that the current pervasive political risks to mortgage lending will be mitigated.

Speculating in GSE Securities: The Case of Orange County

In 1994, Orange County, Calif., one of the highest family-income counties in history, was forced to declare bankruptcy. Its investment manager, Robert Citron, had collected all the cash that numerous local governments held in their local bank accounts to meet the public payroll and deposited them at Merrill Lynch. He then leveraged them with repurchase agreements and invested them directly in supposedly liquid risk-free government sponsored enterprise (GSE) securities. However, they actually were derivative securities employed in "risk-controlled arbitrage" strategies largely designed by Merrill Lynch.

Citron was considered a hero for years as the higher earnings from this speculation allowed local politicians to keep taxes down. He essentially was "playing the yield curve" by investing in long-term securities as well as speculating by earning excess "quoted yield" that reflected not higher expected returns but rather the "option premium" for prepayment risk and other derivative trading strategies, a form of tail risk. When GSE mortgage-backed security prices subsequently plummeted as interest rates rose, past gains were wiped out, bankrupting Orange County and severely wounding San Diego County finances.

Orange County blamed its demise on Wall Street greed. Citron and other cash managers obviously had no business transferring taxpayer bank accounts to the shadow banking system and then speculating with options trading.

Whose responsibility was it to stop them? The answer in this case was that politicians who provided oversight took credit when the bets paid off, and Wall Street investment banks took the blame when they did not, a political lesson that has been repeated elsewhere.

1989 Savings and Loan Crisis

The conventional explanation for why the S&L industry collapsed in 1989 is much the same as that for subprime lenders two decades later: the product of deregulation and greed. Of course moral hazard was a problem, as the industry was highly leveraged, and many economists argued that this caused the industry to "go for broke" as a result. Some economists even contend that the cause of the systemic failure was that they purposely tried to "go broke," with management "looting" the already failed and sure-to-be-closed thrifts.

Charles Keating of Lincoln Savings and Loan in Phoenix, Ariz., was the poster boy of the decade and jailed for "looting" as a result of the failure of his institution, but the government spent an unprecedented amount on "looting" prosecutions in the search for scapegoats, with little to show for the effort.

By the early 1980s, virtually the entire S&L industry was underwater, and the reason was entirely political. Federally chartered S&Ls were forced into an interest rate maturity mismatch by politicians who refused to allow them to invest in anything other than fixed-rate mortgages. State-chartered S&Ls had issued mostly adjustable rate loans, minimizing the maturity mismatch, but William Proxmire (D.-Wis.), chairman of the Senate Banking, Housing and Urban Affairs Committee, refused to allow federally charted S&Ls to do so.

Not surprisingly, the industry went for broke, but this, too, was at least partially caused by explicit Federal policy. The deposit insurance coverage maximum was increased from $40,000 to $100,000 and the Garn St. Getmaine Act of 1982 gave thrifts new powers to invest in risky commercial real estate and high-yield bond investments, after they already technically were insolvent--and utilize them the S&Ls did. The share of S&L assets in home mortgages plunged from 73% in 1981 to 57% in 1985.This shift and the 1981 tax act with its incredibly generous depreciation allowances caused massive overbuilding of commercial real estate and large losses on the new thrift investments.

That political distortion of the industry eventually, but inevitably, would lead to systemic failure had been predicted widely in numerous congressionally mandated study commissions spanning four decades, and so it did. Two political forces culminated in the passage of the Financial Institutions Regulatory Reform and Enforcement Act (FIRREA) of 1989 that phased out thrifts. First, bank regulators at the Fed and Federal Deposit Insurance Corporation (FDIC) did not like the idea of S&Ls with money-like liabilities regulated by the Federal Home Loan Banks, which also had a housing support mission. The regulators essentially won a bureaucratic turf war, as the passage of FIRREA eliminated the prudential regulation duties of the FHLB and consolidated the Office of Thrift Supervision into Treasury (and, in 2011, the Controller of the Currency within Treasury).

Second, with the S&L industry and Fannie Mae technically insolvent in the late 1980s, Congress could allow only one to increase market share, at the expense of the other, to grow out of its problem. It chose the politically too-big-to-fail Fannie Mae, for which lawmakers could not dodge accountability, by signaling markets that the government would stand behind Fannie's debts no matter how great the losses.

Politicians nevertheless claimed they did not see this failure coming and blamed greedy thrift owners (in spite of the fact that most thrifts were nonprofit mutual institutions) and their managers (of which courts subsequently found virtually no evidence of guilt).

The Extension of Moral Hazard

Long-Term Capital Management was a hedge fund established by former Salomon Brothers proprietary trader John Meriwether to take advantage of what he perceived to be small anomalies in the prices of fixed-income securities. To do this, LTCM employed massive leverage, exceeding 1,000:1, mostly with bank-funded repos. Despite having two Nobel Prize winners in finance on its board and its renown for massive modeling capacity, LTCM simply played the tail risk and failed spectacularly in 1998.

Timothy Geithner, then-CEO of the New York Federal Reserve Board (and current Secretary of the Treasury) organized a bailout by arm-twisting the too-big-to-fail banks and investment banks to socialize the loss by committing $300,000,000 each of their firms' capital to the bailout. Lehman Brothers, the weak sister at the time, only was asked to pony up $100,000,000, and Bear Stearns, which was not exposed, notably refused. The CEOs, some of whom may have been conflicted as they had personally invested significant sums in LTCM, all agreed to contribute their independent stockholders' capital.

In the wake of the LTCM crisis, banks significantly raised haircuts and stopped financing much of their repo activity. This forced a widespread deleveraging by hedge funds that depressed asset prices and slowed asset-backed securitization until significant deleveraging had occurred. The Fed's role in the aftermath was to flood the market with liquidity and keep interest rates extremely low.

The LTCM bailout and subsequent comments about the Fed's role in the aftermath of a bubble created the perception of a "Greenspan put," a bailout in the event of trouble that many believe exacerbated subsequent moral hazard. Essentially, the Fed--led by Chairman Alan Greenspan--thought that an immediate hit to the banking system's capital was better than the prolonged uncertainty of a bankruptcy proceeding.

The tradeoff is the long-term economic cost of subsequent moral hazard behavior engendered by a short-term bailout. The bailout of LTCM arguably prevented a more systemic problem to avoid the economic consequences of the aftermath, but whether the precedent was worth the moral hazard created is questionable.

The Role of the "Shadow Banking" System

Money market funds initially were invested entirely in liquid U.S. Treasury securities, reflecting the arbitrage between market rates on Treasury securities and regulated deposit rates while avoiding the minimum Treasury purchase requirements. This investment strategy eliminated the need for systemic liquidity support and confidence-building necessary for bank deposits but, when this source of arbitrage revenue was eliminated by deregulation, the funds eventually bought government sponsored enterprise securities and highly rated--typically AAA--commercial paper. Additionally, they relied on the theory that prices could not change very much based on credit deterioration over the short (typically 30-day) life span of these securities.

Money markets provide a convenience for retail and small institutional customers, but large corporate customers can fund and invest directly in the money markets, bypassing money market funds. Some operate on a significant cash deficit, relying on the ability to roll over outstanding paper. Others invest directly in commercial paper of other firms, investment banks, and structured investment vehicles of commercial banks. They also make direct short-term repo loans collateralized by "liquid"--that is, marketable--securities to obtain higher yields than available on bank deposits. Hence, the shadow banking market ultimately issued banklike deposits and purchased banklike investments, but without bank regulation and systemic liquidity support.

While it is true that the shadow banking market was not highly regulated prior to the financial crisis, that was not because of a lack of regulatory authority. Bank regulators had total authority to regulate SIVs and repo lending, and the Securities and Exchange Commission had regulatory authority over money market funds, corporate cash management, and investment banks. Regulators simply did not understand the danger of muddling the concepts of marketability with liquidity and the consequent systemic risk when the shadow banking system directly or indirectly funded illiquid investments.

Pattie H. Hendershott holds a chair in real estate economics and finance at the University. of Aberdeen, Scotland, after holding tenured positions at Purdue University, West Lafayette, Ind., and Ohio State University, Columbus. Kevin Villani is a former chief economist for the U.S. Department of Housing and Urban Development and Freddie Mac. This article is adapted from a Policy Analysis for the Cato Institute, Washington, D.C.


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Title Annotation:The Great Recession
Author:Hendershott, Patric H.; Villani, Kevin
Publication:USA Today (Magazine)
Geographic Code:1USA
Date:Jul 1, 2012
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