There is an excellent paper available today from CATO institute on how the financial crisis got to be so bad. It fits well with the theory in Nicole Gelinas’ book, After the Fall, which I reviewed here.
This paragraph is critical.
Given the large number of contributory factors — the Fed’s low interest rates, the Community Reinvestment Act, Fannie and Freddie’s actions, Basel I, the Recourse Rule, and Basel II — it has been said that the financial crisis was a perfect storm of regulatory error. But the factors I have just named do not even begin to complete the list. First, Peter Wallison has noted the prevalence of “no-recourse” laws in many states, which relieved mortgagors of financial liability if they simply walked away from a house on which they defaulted. This reassured people in financial straits that they could take on a possibly unaffordable mortgage with virtually no risk. Second, Richard Rahn has pointed out that the tax code discourages partnerships in banking (and other industries). Partnerships encourage prudence because each partner has a lot at stake if the firm goes under. Rahn’s point has wider implications, for scholars such as Amar Bhidé and Jonathan Macey have underscored aspects of tax and securities law that encourage publicly held corporations such as commercial banks — as opposed to partnerships or other privately held companies — to encourage their employees to generate the short-term profits adored by equities investors. One way to generate short-term profits is to buy into an asset bubble. Third, the Basel Accords treat monies set aside against unexpected loan losses as part of banks’ “Tier 2” capital, which is capped in relation to “Tier 1” capital — equity capital raised by selling shares of stock. But Bert Ely has shown in the Cato Journal that the tax code makes equity capital unnecessarily expensive. Thus banks are doubly discouraged from maintaining the capital cushion that the Basel Accords are trying to make them maintain. This litany is not exhaustive.
Banks were allowed to use Mortgage Backed Securities as capital assets and were encouraged to do so by regulations.
In 1988, financial regulators from the G-10 agreed on the Basel (I) Accords. Basel I was an attempt to standardize the world’s bank-capital regulations, and it succeeded, spreading far beyond the G-10 countries. It differentiated among the risks presented by different types of assets. For instance, a commercial bank did not have to devote any capital to its holdings of government bonds, cash, or gold — the safest assets, in the regulators’ judgment. But it had to allot 4 percent capital to each mortgage that it issued, and 8 percent to commercial loans and corporate bonds.
When MBS vehicles were devised, they were rated as AAA.
The United States implemented it in 1991, with several different capital cushions; a 10 percent cushion was required for “well-capitalized” commercial banks, a designation that carries privileges that most banks want. Ten years later, however, came what proved in retrospect to be the pivotal event. 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. Thus, where a well-capitalized commercial bank needed to devote $10 of capital to $100 worth of commercial loans or corporate bonds, or $5 to $100 worth of mortgages, it needed to spend only $2 of capital on a mortgage-backed security (MBS) worth $100. A bank interested in reducing its capital cushion — also known as “leveraging up” — would gain a 60 percent benefit from trading its mortgages for MBSs and an 80 percent benefit for trading its commercial loans and corporate securities for MBSs.
This is why the crash is a failure of regulation and not just a result of “greed.”
Outstanding, doc!
BILL
Seems like the term “Bubble” in relation to any asset class is this years equivalent to 2007’s term “a perfect storm”. It’s a great term for cocktail party conversation but it isn’t particularly useful in assessing an investment strategy. A bubble is only recognized in hindsight. People were predicting a real estate bubble as early as 2000. It wasn’t until 2008 that the prediction came true. Every asset class with returns that exceed the long term averages is potential bubble. If you?re worried about a bond bubble you may wish to worry more about a gold bubble.
Actually, I recognized the bubble in 2006 when I spent some time looking at houses other than my own. I could not believe the prices that people were paying for them when they were obviously not worth the price and the people could not afford the mortgages.
Had I been a young guy with no family, it might have been an option to sell and rent, as several people I know of did. It wasn’t an option for me so I sat tight and, as a result, I have lost several hundred thousand dollars of paper equity but did not get in deep water.
My son has seen the same loss of paper equity but is secure in his home. He actually rode the bubble with a condo I helped him buy before he was married and then he traded up to a nice home with the equity gain in the condo. He then did not attempt any more trading. As Bernard Baruch once said when asked how he made his fortune, “I sold out too soon.”
You get the feeling that the investment bankers have paid shills to warn about a bond market bubble every month or so in order to get some IPO’s not worth their weight out the door. If you actually buy the bond in the secondary market, the worst you can do is get the yield you bought it at to maturity. But selling them back with 1-2 years left to maturity has been a winning strategy recently. How is this a bubble?
I agree you get the yield but selling a bond after an interest rate spike, like I anticipate in two years, is going to be ugly.
It’s just a set up so the party of “NO” can hit another home-run…being obstructionists. I expect he will get to the jobs thing soon enough.. Next fall, you can expect the insurance industry to crank up the prices and Then the party of NO will not be looking so hot… Our President has become the Chicago politician, pragmatist, we always suspected he was. Too bad the only thing our statesmen (sic) are only interested in is their own job security! I guess unemployment is an infection that is going around.
If you have 100,000 dollars in your closet, that’s no different than a stack of printer paper, but if you trade those dollars for a yacht, then you have something real and practical. If you trust the dollar, save it. Hold it. If you trust gold, do the same. But if you trust neither, trade the dollars your employer pays you for bars of soap. They have value and are useful. THE BOTTOM LINE: Don’t owe anybody any money, and convert the dollars your boss pays you into something YOU control, like gold (if you want it), land, canned food, etc. Or take your chances on the dollar. It’s your choice
Our national debt nearly doubled under the Bush administration.
Tampa, how much has it increased under Obama in one year ? I was no fan of Bush’s domestic agenda and said so. What we are seeing now is unprecedented and will end in repudiation of the debt. You might look at this chart of deficits.