Echoes of the 2008 financial crisis continue to reverberate through election year politics, regulatory policy discussions, and even Hollywood films like The Big Short. Below are five questions about the crisis that are currently receiving attention, and that presidential candidates should be equipped to answer, together with my own answers.
- Should Glass-Steagall be reinstated?
No one who knows anything about either Glass-Steagall or the causes of the financial crisis would ask this question, but it is often heard in Congress and elsewhere. The so-called “repeal” of Glass-Steagall in 1999 — it wasn’t repealed and is still applicable to banks — had absolutely nothing to do with the financial crisis. The 1999 changes in one sector of Glass-Steagall Act made only one changed in existing law: it permitted affiliations between commercial banks and investment banks. But by the time of the 2008 crisis, none of the large investment banks (like Goldman Sachs, Morgan Stanley or Lehman Brothers) had affiliated with any of the large commercial banks (like Citi, JP Morgan Chase or Bank of America). Commercial banks and investment banks had remained fierce competitors with one another right up to the time of Lehman Brothers’ bankruptcy.
REUTERS/Mike Segar.
The simplest way to think about the financial crisis is that the largest investment banks and commercial banks got into financial trouble by acquiring and holding risky mortgages or mortgage backed securities based on these risky loans. This was permitted for both of them before Glass-Steagall was “repealed,” and it was permitted afterward.
In other words, if Glass-Steagall had never been touched by Congress in any way, the financial crisis would have unfolded exactly as it did in 2008. Calls to reinstate Glass-Steagall are disingenuous; many of those in Congress and elsewhere who back this idea know that it is a meaningless proposal, but also that their case for tighter regulation of the financial system is helped if they can claim some connection between reduced regulation and the financial crisis.
2. Should the big banks be “broken up?”
This is another idea that has been thrown about, but it cannot be considered a serious proposal until some major issues it raises are addressed. The argument for a break-up is that the biggest banks — several of which have more than $1 trillion in assets — are “too big to fail” (TBTF). This is a problem because the government will feel the need to rescue them if they become financially troubled, and that could cause losses to the taxpayers. As discussed below, the Dodd-Frank Act, despite the claims of its supporters, did nothing to solve this problem. It continues to be a real concern, but that doesn’t mean it would be a sensible solution to break up these massive financial institutions.
The trouble is that the people who support this idea have never confronted even the first questions one would ask about how such a policy would be implemented. For example:
(1) What size is not TBTF–$50 billion? $250 billion? $500 billion? If we don’t know that, how could we be sure that breaking them up to that or any other size will mean that the government will not rescue them when they in danger of failing?
(2) What if we decided arbitrarily that a bank is TBTF when it has, say, $250 billion in assets? Would we then say that no matter how successful and well-managed it might be, that bank could not grow beyond $250 billion? Not only would that penalize success, it would also mean that successful banks would not be able to acquire failing banks if that would make them larger than the TBTF limit.
(3) What would we do, then, to pay off the insured depositors of failing banks, and who would pay for it if not the taxpayers?
(4) What do these large banks actually do? Most of those who advocate breaking them up seem to think they just make loans, but in fact that is not true of the largest banks. Of course, they make some loans, but the largest US companies are financed in the capital markets, by selling shares, bonds and notes, not by borrowing from banks. But the largest banks support US companies around the world, with currency conversion, letters of credit, payroll services, advice of all kinds, and dozens of other services. Who would perform this role if banks were broken up to a size that was not large enough to operate abroad?
Until some proponent of breaking up the banks addresses these questions, this idea is a non-starter.
3. Didn’t the Dodd-Frank Act solve the TBTF problem?
Ever since Dodd-Frank’s enactment, its proponents have claimed that it solved the TBTF problem. But it’s hard to believe that they’ve read the act. The largest privately held financial institutions in the US are four government-insured commercial banks (JP Morgan Chase, Citi, Bank of America, and Wells Fargo), each of which has more than $1 trillion in assets. These are the financial institutions that the proponents of breaking up the banks — most recently Neel Kashkari, the head of the Minneapolis Federal Reserve Bank — are talking about. If TBTF is a real problem, these banks are the financial firms that could be TBTF. Yet, the Dodd-Frank Act doesn’t cover them.
The applicable section is Title II, the so-called Orderly Liquidation Authority (OLA), which gives the FDIC authority — with the approval of the Secretary of the Treasury — to take over and resolve failing nonbank financial firms. The language of the OLA specifically states that it does not apply to banks.
What this means is that, in the wake of Dodd-Frank, the FDIC’s authority to resolve failing banks is the only way to deal with the failure of a TBTF bank. However, the agency and its resources are too weak to meet this test.
The FDIC has three possible ways to resolve an insolvent bank : recapitalize it, sell it to a healthy bank, or take it over and operate it. The FDIC does not have the financial resources to recapitalize one of the trillion dollar behemoths; it can’t sell one of those giants to one of the others without making the buyer even bigger and thus more TBTF; and if it actually attempts to take over and operate a giant bank, depositors, creditors and customers would flee immediately, leaving the taxpayers with an ever-expanding liability.
So after the Dodd-Frank Act, despite the claims of the Obama administration and its sponsors in Congress, we have no solution to the TBTF problem where it might actually exist.
4. Are we headed for another financial crisis?
Today, the media are full of suggestions by various market specialists that the global decline in stock market prices is the forerunner of another financial crisis. This reflects a misunderstanding of the special factors that caused the 2008 crisis and why it was so different from any normal economic downturn.
The unprecedented 2008 event did not occur simply because a number of large financial institutions suffered the kinds of losses they routinely incur in a recessionary period. The crisis was far greater than that because it was caused by a US government policy that grossly distorted the market for residential mortgages, a major financial asset of banks and other financial institutions.
In the early 1990s, Congress enacted legislation that established “affordable housing goals” for Fannie Mae and Freddie Mac, the government-backed mortgage firms that were then (and are still today) the dominant players in the US housing finance market. At the time, Fannie and Freddie — which do not make mortgages themselves, but buy mortgages from lenders and other originators— generally acquired only prime (high quality) mortgages. That kept mortgage defaults in the US market under 1% in normal times, but it also meant that potential home buyers without good credit records or 10% downpayments were often not able to buy homes. The affordable housing goals, then, required Fannie and Freddie, when they bought mortgages from lenders and other originators, to meet a quota of mortgages made to borrowers at or below the median income in the communities where they lived.
HUD was given the authority to increase these quotas, and between 1996 and 2008 it did so, aggressively, raising the quotas to 50% by 2000 and 56% by 2008. These increases forced Fannie and Freddie to reduce their underwriting standards; there were simply not enough prime mortgages among borrowers at or below median income to meet the quotas established by the goals. Because Fannie and Freddie were, in effect, the standard-setters in the housing finance market, their reduced underwriting requirements spread to the wider market. Soon, even homebuyers who could afford prime mortgages were able to get mortgages with low or even no downpayments. This added buyer credit leverage, and the presence in the market of many more potential buyers, built an enormous housing price bubble — nine times larger than any previous bubble — between 1997 and 2007.
By 2008, more than half of all mortgages in the US were subprime or otherwise weak. Of these, 76% were on the books of government agencies, primarily Fannie and Freddie. The remaining 24% — which still amounted to almost $2 trillion — were held by private institutions, including the largest banks and other financial firms, which had borrowed the funds to buy these assets. When the bubble deflated in 2007, housing and mortgage values fell 20-30% on a nationwide basis; the banks and others that held these mortgages found, like millions of homeowners, that their mortgage assets were worth far less than the debts they had incurred to buy them. The resulting losses impaired their capital, making them look illiquid and possibly insolvent. When Lehman Brothers failed, a full-scale panic ensued — what we now call the financial crisis.
If the fall in global stock markets is correctly forecasting a recession, banks and other financial firms will suffer losses on loans and other investments, but this will not cause a financial crisis. The 2008 crisis was unique because it originated in government policies that caused a wholesale reduction in the quality of a major asset class — residential mortgages — widely held by financial institutions. There is nothing in any near-term downturn that is likely to cause the kind of sudden, deep and widespread losses to financial firms that came from this government policy failure.
5. What was the role of Wall Street in the financial crisis?
Films like The Big Short, as well as statements by government officials and private commentators, have created the impression among the American people that the private sector, and particularly Wall Street, was responsible for the financial crisis. The result was the Dodd-Frank Act, which has suppressed the economic recovery.
However, as noted above, the financial crisis was actually the unintended result of a specific government policy — the affordable housing goals — which caused the deterioration in underwriting standards throughout the housing finance market. The lesson we should have taken from the crisis, then, is not that we needed additional regulation of the private sector but that badly designed government policies can create destructive incentives in a market-based system.
The individual steps that produced the crisis are clearly set out in my 2015 book, Hidden In Plain Sight: What Caused the World’s Worst Financial Crisis and Why it Could Happen Again, and can be outlined in a series of four steps:
First, the deterioration in underwriting standards discussed earlier caused the development of a housing price bubble of unprecedented size. How this occurs is reasonably clear. If a potential homebuyer has $10,000 for a downpayment on a home, and the underwriting standard requires a 10% downpayment, the homebuyer could purchase a $100,000 home. But if the underwriting standard is reduced to 5% — as happened when Fannie and Freddie reduced their underwriting requirements — the homebuyer could suddenly afford a $200,000 home. Instead of a $90,000 loan, the buyer would now take out a $190,000 loan. This had two effects. It created substantial upward pressure on home prices, starting and powering the housing bubble; but it also created a lot of financially stressed homeowners — people who were more indebted and thus more likely to default when the bubble deflated.
Second, as a bubble grows, mortgage defaults decline. This occurs because the increasing value of all homes allows homeowners who can’t meet their mortgage payments to refinance their loans. The increased value of the home serves as collateral for a longer-term or lower cost loan.
Third, when mortgage defaults decline, potential investors become more interested in acquiring mortgages or mortgage-backed securities (MBS). This is particularly true for subprime or other weak mortgages, which ordinarily have somewhat higher interest rates. So as underwriting standards continued to deteriorate before 2008, and loans became riskier, defaults actually continued to decline. This made investment in risky mortgages seem to be a very good bet from the risk/reward perspective, and investors wanted more exposure to these mortgages, or to the MBS based on them.
Finally, to satisfy the widespread investor demand for these subprime or risky mortgages — first from Fannie and Freddie, to comply with the affordable housing goals, and then from private investors all over the world — banks and other financial firms, including those on Wall Street, produced them. Although it is sometimes alleged that the issuers or underwriters knew that these loans would default, that seems unlikely in light of the fact that the banks and other financial firms that were distributing these loans suffered so many losses themselves. That suggests that they, too, were misled by the initial decline in defaults as the bubble grew, and thought these mortgages and MBS would be good investments.
It is always popular to beat on Wall Street and large financial institutions; it makes for good entertainment when it’s a Hollywood film, but the role of the private sector in the financial crisis was a derivative of government policies. It responded to the incentives the government created.
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