Wednesday, February 10, 2010

Jeff Friedman on the Financial Crisis

Jeff Friedman has a policy report on the Cato Blog about the financial crisis.

He correctly emphasizes the role of the "Recourse Rule" promulgated by U.S. regulators in 1982.

The FDIC, the Fed, the Comptroller of the Currency, and the Office of Thrift Supervision issued an amendment to Basel I, the Recourse Rule, that extended the accord's risk differentiations to asset-backed securities (ABS): bonds backed by credit card debt, or car loans — or mortgages — required a mere 2 percent capital cushion, as long as these bonds were rated AA or AAA or were issued by a government-sponsored enterprise (GSE), such as Fannie or Freddie.
With commercial loans requiring 10 percent capital, and ordinary mortgage loans requiring 5 percent, this special 2 percent exception for mortgage backed securities with a AA or AAA rating explains why banks ended up with large quantities of mortgage backed securities.

As for the rest of the world, Basel II adopted the clever U.S. approach of treating mortgage backed securities as nearly risk free, and then formed the basis of banking regulation in the rest of the world as well.
By steering banks' leverage into mortgage-backed securities, Basel I, the Recourse Rule, and Basel II encouraged banks to overinvest in housing at a time when an unprecedented nationwide housing bubble was getting underway, due in part to the Recourse Rule itself — which took effect on January 1, 2002: not coincidentally, just at the start of the housing boom. The Rule created a huge artificial demand for mortgage-backed bonds, each of which required thousands of mortgages as collateral. Commercial banks duly met this demand by lowering their lending standards. When many of the same banks traded their mortgages for mortgage-backed bonds to gain "capital relief," they thought they were offloading the riskiest mortgages by buying only triple-A-rated slices of the resulting mortgage pools.
Of course, since they were rated AA or AAA, they were especially safe. We know this because the three SEC approved ratings agencies, S&P, Moody's and Fitch, would never underestimate the risk in an entire class of securities. They would never assume that housing prices can never fall. Right?


  1. Everything you could possibly write is just more proof that free markets are unstable.

  2. I don't know whether free markets are "unstable," but it is apparent that regulators were encouraging financial firms to make the entrepreneurial error of lending against over priced assets.

    The CEO of BBT said that they did their own analysis and didn't trust the AAA ratings of S&P and so didn't buy them, (despite the low capital requirements.) There was no requirement that banks make this error.

    For markets to work those financial institutions that made these errors need to take the losses. Good entrepreneurial decisions need to generate profits and mistakes, losses.

    I don't know whether the result is "stable," or not. There is no need for this to result general gluts of goods and services and a generalized difficulty in finding employment. It is true, however, that people going into the construction business to profit on rapid growth in housing demand may end up having to do something else.

    My vision of the market system is one of constant change and flux. Quite unstable really--mostly due to changing technology, but also changing demands. However, massive entrepreneurial errors are possible.

  3. It’s tough to say about free market been unstable, but I believe we just need to be careful. I believe financial crisis can be really stressful and one has to be careful to get into serious zone. As a trader, I am forever comfortable ever since I have joined OctaFX broker with their outstanding rebate scheme that gifts me back 15 dollars profits per lot size trade including the losing trades too, so that’s pretty impressive facility to use for any one.