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Kling: Experts Knew What Went On

It is tempting to blame the financial crisis on lack of regulation. However, the problem was not the absence of oversight. Instead, the crisis resulted from policies that were self-defeating. In order to prevent another crisis, we need to change our approach.

[IMGCAP(1)]Until quite recently, very few people were aware of credit default swaps, collateralized debt obligations, structured investment vehicles and other financial innovations. Even well-informed citizens, journalists and Capitol Hill staffers learned about these financial instruments and financial relationships only when those innovations had brought the system to the brink of disaster.

It is natural to assume that regulators were equally unaware of these financial instruments and these financial relationships. The inclination is to think that these were dangerous schemes cooked up secretly by Wall Street while the regulators weren’t looking. However, a review of the history of the past few decades shows that regulators were aware of these innovations. They approved of these innovations. They collaborated with banks in constructing these innovations. And they applied pressure and provided incentives to banks to use these innovations.

The financial practices that we now understand to be dangerous were encouraged by regulators who believed that these practices served public policy goals. The regulators thought they were promoting homeownership and a more stable financial system.

To foster homeownership, policymakers promoted mortgage lending that was subsidized and lenient. Requirements for down payments were relaxed, as were requirements for borrowers to prove they had the ability to repay their loans.

In Washington, D.C., the phrase “affordable housing— became synonymous with buying houses with no money down. This was a self-defeating approach. It led to speculation in housing, with the proportion of loans for non-owner-occupied homes soaring from 5 percent in the 1990s to 15 percent in 2005 and 2006. This speculation drove up home prices, which made it harder for people to afford down payments. Washington responded to this decline in affordability by turning up the pressure on lenders for greater leniency, resulting in still more speculation and higher prices. When this process reached its limits, the housing market crashed.

Washington also was responsible for creating and supporting the process of mortgage securitization. At the time, this was viewed as a way to lower the cost of mortgage credit and stabilize the mortgage lending industry.

Finally, it was bank capital requirements designed by regulators that induced bankers to weave the crazy quilt of collateralized debt obligations, credit default swaps on mortgage securities and off-balance-sheet financing. This was a gradual process, but two dates stand out. First, in 1989, the Basel Accords established capital requirements that made it more profitable for banks to hold Freddie Mac and Fannie Mae securities than to hold ordinary mortgage loans. Then, on Jan. 1, 2002, bank regulators amended these capital requirements to give the same break to securities issued by anyone, provided that those securities received AA or AAA ratings from credit rating agencies. It was this regulatory ruling that effectively outsourced bank capital regulation to the rating agencies and produced the mad scramble to manufacture AA and AAA assets.

Going forward, we need to turn away from these self-defeating policies.

First, we need to recognize that mortgages with loan down payments are not the solution for affordable housing. We need to let the market set reasonable requirements for obtaining mortgage credit.

Second, we need to disconnect the mortgage securities market from the feeding tube of government subsidies, even if that would mean the death of mortgage securitization. Studies show that mortgage securities only reduced mortgage interest rates by a small amount. This questionable benefit (it is not clear that society is better off with more of its capital devoted to mortgage lending as opposed to other uses) was achieved at considerable cost, as shown by the magnitude of the crisis and the bailouts that were required.

Third, we must recognize that trying to make banks and other financial institutions too regulated to fail is a self-defeating approach. The more that institutions are viewed as failure-proof, the more they will attempt to profit from taking risk and the less they will be disciplined by the market. Instead, what we need are systems in place to ensure continuity of banking functions when a large bank or Wall Street firm fails. We should have processes and emergency response teams in place in order to ensure that when a large institution is insolvent, the ATMs still work, checks still clear and credit card transactions still function. With such critical transactions secured, we can permit bankruptcy procedures to take their course. Our goal should be not to prevent failure, but instead to keep the system running when there is failure. We want a system where failure on Wall Street is permitted, while the everyday financial transactions of Main Street are protected.

Arnold Kling is a member of the Mercatus Center Financial Markets Working Group. He was an economist on the staff of the Federal Reserve Board in the 1980s and an economist with Freddie Mac in the late 1980s and early 1990s. He co-hosts the blog

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