Explaining the Financial Crisis: Government Creation of a Financial Investment Mono-culture

Arnold Kling on the recent financial crisis:

1. The facts are that one can just as easily blame the financial crash on an attempted tightening of regulation. That is, in the process of trying to rein in bank risk-taking by adopting risk-based capital regulations, regulators gave preference to highly-rated mortgage-backed securities, which in turn led to the manufacturing of such securities out of sub-prime loans.

2. The global imbalances that many of us thought were a bigger risk factor than the housing bubble did not in fact blow up the way that we thought that they would. The housing bubble blew up instead.

What he is referring to is a redefinition by governments in the Basel accords of how capital levels at banks should be calculated when determining capital sufficiency.  I will oversimplify here, but basically it categorized some assets as "safe" and some as "risky".  Those that were risky had their value cut in half for purposes of capital calculations, while those that were "safe" had their value counted at 100%.  So if a bank invested a million dollars in safe assets, that would count as a million dollar towards its capital requirements, but would count only $500,000 towards those requirements if it were invested in risky assets.  As a result, a bank that needed a billion dollars in capital would need a billion of safe assets or two billion of risky assets.

Well, this obviously created a strong incentive for banks to invest in assets deemed by the government as "safe".  Which of course was the whole point -- if we are going to have taxpayer-backed deposit insurance and bank bailouts, the prices of that is getting into banks' shorts about the risks they are taking with their investments.  This is the attempted tightening of regulation to which Kling refers.  Regulators were trying for tougher, not weaker standards.

But any libertarian could tell you the problem that is coming here -- the regulatory effort was substituting the risk judgement of thousands or millions of people (individual bank and financial investors) for the risk judgement of a few regulators.  There is no guarantee, in fact no reason to believe, the judgement of these regulators is any better than the judgement of the banks.  Their incentives might be different, but there is also not any guarantee the regulators' incentives are better (the notion they are driven by the "public good" is a cozy myth that never actually occurs in reality).

Anyway, what assets did the regulators choose as "safe"?  Again, we will simplify, but basically sovereign debt and mortgages (including the least risky tranches of mortgage-backed debt).  So you are a bank president in this new regime.  You only have enough capital to meet government requirements if you get 100% credit for your investments, so it must be invested in "safe" assets.  What do you tell your investment staff?  You tell them to go invest the money in the "safe" asset that has the highest return.

And for most banks, this was mortgage-backed securities.  So, using the word Brad DeLong applied to deregulation, there was an "orgy" of buying of mortgage-backed securities.  There was simply enormous demand.  You hear stories about fraud and people cooking up all kinds of crazy mortgage products and trying to shove as many people as possible into mortgages, and here is one reason -- banks needed these things.  For the average investor, most of us stayed out.   In the 1980's, mortgage-backed securities were a pretty good investment for individuals looking for a bit more yield, but these changing regulations meant that banks needed these things, so the prices got bid up (and thus yields bid down) until they only made sense for the financial institutions that had to have them.

It was like suddenly passing a law saying that the only food people on government assistance could buy with their food stamps was oranges and orange derivatives (e.g. orange juice).  Grocery stores would instantly be out of oranges and orange juice.  People around the world would be scrambling to find ways to get more oranges to market.  Fortunes would be made by clever people who could find more oranges.  Fraud would likely occur as people watered down their orange derivatives or slipped in some Tang.  Those of us not on government assistance would stay away from oranges and eat other things, since oranges were now incredibly expensive and would only be bought at their current prices by folks forced to do so.  Eventually, things would settle down as everyone who could do so started to grow oranges. And all would be fine again, that is until there was a bad freeze and the orange crop failed.

Government regulation -- completely well-intentioned -- had created a mono-culture.  The diversity of investment choices that might be present when every bank was making its own asset risk decisions was replaced by a regime where just a few regulators picked and chose the assets.  And like any biological mono-culture, the ecosystem might be stronger for a while if those choices were good ones, but it made the whole system vulnerable to anything that might undermine mortgages.  When the housing market got sick (and as Kling says government regulation had some blame there as well), the system was suddenly incredibly vulnerable because it was over-invested in this one type of asset.  The US banking industry was a mono-culture through which a new disease ravaged the population.

Postscript:  So with this experience in hand, banks moved out of mortage-backed securities and into the last "safe" asset, sovereign debt.  And again, bank presidents told their folks to get the best possible yield in "safe" assets.  So banks loaded up on sovereign debt, in particular increasing the demand for higher-yield debt from places like, say, Greece.  Which helps to explain why the market still keeps buying up PIIGS debt when any rational person would consider these countries close to default.  So these countries continue their deficit spending without any market check, because financial institutions keep buying this stuff because it is all they can buy.  Which is where we are today, with a new monoculture of government debt, which government officials swear is the last "safe" asset.  Stay tuned....

Postscript #2:  Every failure and crisis does not have to be due to fraud and/or gross negligence.  Certainly we had fraud and gross negligence, both by private and public parties.  But I am reminded of a quote which I use all the time but to this day I still do not know if it is real.  In the great mini-series "From the Earth to the Moon", the actor playing astronaut Frank Borman says to a Congressional investigation, vis a vis the fatal Apollo 1 fire, that it was "a failure of imagination."  Engineers hadn't even considered the possibility of this kind of failure on the ground.

In the same way, for all the regulatory and private foibles associated with the 2008/9 financial crisis, there was also a failure of imagination.  There were people who thought housing was a bubble.  There were people who thought financial institutions were taking too much risk.  There were people who thought mortgage lending standards were too lax.  But with few exceptions, nobody from progressive Marxists to libertarian anarcho-capitalists, from regulators to bank risk managers, really believed there was substantial risk in the AAA tranches of mortgage securities.  Hopefully we know better now but I doubt it.

Update#1:  The LA Times attributes "failure of imagination" as a real quote from Borman.  Good, I love that quote.  When I was an engineer investigating actual failures of various sorts (in an oil refinery), the vast majority were human errors in procedure or the result of doing things unsafely that we really knew in advance to be unsafe.  But the biggest fire we had when I was there was truly a failure of imagination.  I won't go into it, but it resulted from a metallurgical failure that in turn resulted form a set of conditions that we never dreamed could have existed.

By the way, this is really off topic, but the current state of tort law has really killed quality safety discussion in companies of just this sort of thing.  Every company should be asking itself all the time, "is this unsafe?"  or "under what conditions might this be unsafe" or "what might happen if..."   Unfortunately, honest discussions of possible safety issues often end up as plaintiff's evidence in trials.  The attorney will say "the company KNEW it was unsafe and didn't do anything about it", often distorting what are honest and healthy internal discussions on safety that we should want occurring into evidence of evil malfeasance.  So companies now show employees videos like one I remember called, I kid you not, "don't write it down."

  • jimc5499

    "Failure of imagination" sometimes goes by the name "Murphy's Law". Unfortunately our legal system tends to not recognize either of these. A company I used to work for stopped doing safety evaluations on new products because we were more liable for what we didn't think of during these evaluations than for not having the evaluations.

  • Georg Thomas

    Where does that leave Austrian Business Cycles Theory?

  • Matthew Slyfield

    "Which helps to explain why the market still keeps buying up PIIGS debt
    when any rational person would consider these countries close to
    default."

    As long as the banks are forced to buy sovereign debt, the PIIGS can avoid default almost indefinitely by paying off old debt with new debt.

  • Jerryskids

    Unfortunately, the mortgage bundling business wasn't a bit risky - banks wrote loans to anybody with a pulse knowing that Fannie and Freddie would buy the paper and Fannie and Freddie bought the worthless paper knowing that the American taxpayer would bail them out when the whole thing collapsed. So where was the risk? Forbes magazine had been warning for several years that the whole thing was a Ponzi scheme and that the taxpayers were going to get stuck with the tab.

  • J Calvert

    I'm not an engineer, but I work on the infrastructure side of networks, specifically in data centers designed for 99.999% uptime. I've learned two things in this career.

    1. The law of large numbers will eventually catch everyone. You can look like a genius for a long time with a small population and/or a short timeline, but growth and time will make you look like a fool.

    2. 1st and 2nd order failures are easy, 3rd and longer failure scenarios are hard. (i.e. Event A caused failure B. If left uncorrected for X amount of time and/or during a specific window each month, causes failure C. When failures B and C both happen at the same time, Really Bad Things happen.)

  • Chris Smith

    No, Murphy's Law is different. Murphy's law includes any sort of failure. A "Failure of Imagination" is a particular type of catastrophic failure.

  • Sam L.

    Beyond the Law Of Unintended Consequences, there is The Ingenuity Of Man: Somewhere, somehow, there's a way to take advantage of this situation that those bastards did not think of.

  • Sam L.

    "By the way, this is really off topic, but the current state of tort law
    has really killed quality safety discussion in companies of just this
    sort of thing. Every company should be asking itself all the time, "is
    this unsafe?" or "under what conditions might this be unsafe" or "what
    might happen if..." Unfortunately, honest discussions of possible
    safety issues often end up as plaintiff's evidence in trials. The
    attorney will say "the company KNEW it was unsafe and didn't do anything
    about it", often distorting what are honest and healthy internal
    discussions on safety that we should want occurring into evidence of
    evil malfeasance. So companies now show employees videos like one I
    remember called, I kid you not, "don't write it down."" Or............ lawyers only make things worse.

  • STW

    It is posited that the USSR had a fire similar to the Apollo fire and that is why they did not use pure oxygen in their spacecraft. The secrecy around their space program kept US engineers from being alerted to the danger and to their failure of imagination.

  • Incunabulum

    So, Warren, have you seen the stories about Harvard's faculty flipping out now that PPACA costs are going to be passed on to them?

  • marque2

    Another similar side point, in reverse. the first commercial passenger jetliner was the De-Havilland Comet. After few years, the things kept blowing up in flight, and it was discovered that the reason was metal fatigue, something which was little understood at the time, the company made changes including making round instead of square windows, and making the shell thicker, but the industry passed them by. By the time they fixed their jet, Boeing and Douglas already had new jets, that were faster and more efficient - though not nearly as beautiful.

    A Boeing executive admitted that, if Boeing had been first with the plane, that Boeing planes would have blown up mid flight as well. Boeing and Douglas were able to learn from the lack of imagination of De-Davilland. Unfortunately, the moral here is, sometimes, it isn't best to be first.

    http://en.wikipedia.org/wiki/De_Havilland_Comet#Legacy

  • marque2

    The whole system was forced upon Fanny Freddy and the Banks by congress. If banks objected to giving loans, they were accused of blacklisting undesirable zipcodes, which meant they were racist. Banks would get sued all the time over this, and they eventually gave up, since congress wanted that anyway. Fanny and Freddy were also encouraged to lend more to subprime, and lower the standards for prime even, because of politicians goal of wanting everyone to have a home.

    Yes the whole thing was presented as greedy banks and bad Freddie, but if you look behind the cause, it really was congress forcing their hand.

  • mesocyclone

    I don't think this "explains" the crisis, but it certainly highlights an important factor that I had not been previously aware of. Like most plane crashes, the crisis had several nasty causes that added up. Almost all of them were cause by government action.

  • Joe

    All the same geniuses who told us back in 2005-07 that everything was fine and that, at worst, we will only have a minor economic slowdown from declining housing prices are the same people today that are telling us not to worry about sovereign debt.

    In the Kling piece you linked to he talks about narrative being "out" and facts being "in" for 2015. One of the biggest narratives fed to the American people was that Janet Yellen predicted the financial crisis. The fact is she did no such thing. She was one of the main "there's nothing to see here" cheerleaders.

    We will continue to have crisis after exceedingly worse crisis up until our leaders stop listening to the same crop of unimaginative talking heads they have always listened to. For this to truly happen the media and the American people have to be willing to call BS on narrative, no matter how politically incorrect it may be, and demand that facts be adhered to.

  • Xmas

    The term you are looking for is "redlining". It was a bad practice, but at the same time an argument could be made that a factual analysis that had similar results isn't a bad practice.

  • slocum

    Here's a bit of irony for you -- Kling is responding to Brad DeLong. Warren's discussion of regulations creating a state-imposed monoculture of bank investments brought to mind the discussion of state regulations of forestry practices in "Seeing Like A State", and when I googled for a link, here's a helpful summary that showed up as one of the first results:

    II. Seeing the Forest

    Scott's Seeing Like a State begins with a ride through eighteenth- and nineteenth-century German forestry. In Germany, "scientific" forestry led to the planting and harvesting of large monocrop forests of Norway spruce and Scotch pine. And for the first century or so the pockets of forest-owners bulged as more and more valuable trees were harvested from the increasingly-ordered and managed forests.

    But the foresters did not understand the ecological web that they were trying to manage: Clearing of underbrush to make it easier for lumberjacks to move about in the forest "greatly reduced the diversity of insect, mammal, and bird populations" (p. 20); the absence of animals and the absence of rotting wood on the forest floor greatly reduced the replenishment of the soil with nutrients. In places where all the trees are mature, of the same age and of the same species, storms can wreak catastrophe as trees knock each other over like bowling pins. Pests and parasites that attack a particular species find a bonanza and grow to epidemic proportions when they find a monocrop forest.

    Where did those paragraphs come from? None other than Brad DeLong:

    http://delong.typepad.com/sdj/2007/10/james-scott-and.html

  • SineWaveII

    Failure of imagination is why one cannot allow government management of every aspect of life. Because even the very best and brightest cannot not imagine every possible way that failure can occur and the people doing the regulating are usually far from the best and brightest.

  • SineWaveII

    The corollary to that is part of Murphy's law. "Nothing can be made foolproof because fools are so ingenious".

  • SineWaveII

    Murphy's law: "If something can go wrong it will go wrong". Failure of imagination often stems from forgetting Murphy's law.

  • http://matthewjudebrown.com/ Morven

    Now, the thing is that at one time banks did indeed red-line undesirable zip codes, as well as other things that were indicators of people being racial minorities. They did this with government encouragement (federal, state and local), both officially and unofficially. This was indeed a thing we should not encourage and should get rid of, which probably includes punishment once it is prohibited.

    Unfortunately, there is no incentive for rule-enforcers to only go after legitimate cases, especially once the actual practice becomes rarer. After all, bureaucracy finds ways to keep itself continually employed. And thus, enforcement against banks who were only avoiding actual risk.

    Also, some of that risk was probably indeed to do with racism, but not racism in the banks. Lower employment prospects, greater chance of poverty due to fines and/or incarceration because of biases in the justice system, etc etc. Should it have been the banks' responsibility to correct those problems?

    There are also allegations of banks pushing minority customers into more-expensive subprime loans when they qualified for regular loans, but I haven't dug into that very much to see if there's truth there.

  • Tom Lindmark

    Good post but I would take exception to this part:

    "But with few exceptions, nobody from progressive Marxists to libertarian anarcho-capitalists, from regulators to bank risk managers, really believed there was substantial risk in the AAA tranches of mortgage securities. Hopefully we know better now but I doubt it."

    I think if you do a bit of research that you'll find that the AAA tranches experienced a low level of default and in fact were a good investment. The problem rested with the lower tranches which the banks had trouble off-loading and kept on their balance sheets or in pseudo off-balance sheet subsidiaries. The logic of securitization was relatively sound, the execution was deplorable.