Tuesday, September 29, 2009

Why Capital Regulations did Not Cause the Mortgage Crisis

I still read many different takes on what caused the subprime housing bubble. The least compelling to me is the capital regulations. Mortgages were historically the lowest loss rates of any asset class, for the entire dataset anyone looked at. Think of a capital regulation as a rule enforced by government. If the rule is binding, this merely makes the activity more expensive, as when you amortize the cost of getting caught smoking pot (including potential career repercussions, which vary considerably by profession). Many rules we think are unnecessary are worked around, as for instance, ProShares has many stocks that allow you 3-to-1 leverage, which is technically illegal if done directly (it violates Reg-T for retail brokerage accounts). There are shares that allow you to be short, which for 401ks is otherwise illegal, but now legal.

Now, generally, the government allows you to do many things you can do, but shouldn't. Moderation in all things is a good rule, and what prevents most people from excess is discipline. People generally don't do things to excess because it causes various hangovers, real and metaphorical. So, if the government assigned a low capital ratio to mortgages, this did not cause banks to invest in mortgages in excess unless they also believed these were of low risk. It was a common mistake. So common, in fact, I think it strains credulity to think the regulation was extremely important. There were enough investors and companies not bound by US banking regulations involved to note this was bigger than them.

The fact that I can drink a bottle of Scotch every night is no reason to blame the government if I choose to do so.


Anonymous said...

I agree. As a former practitioner, how seriously do you think the banks take their economic capital modeling?

Eric Falkenstein said...

I think it is still something done ex post. It explains, does not inform. mainly done to satisfy regulators and rating agencies, neither of whom are really thoughtful.

On the other hand, if one can not present data consistent with an economic capital allocation exercise, I would worry they do not have a good handle on their situation.

So, necessary, not sufficient.

Anonymous said...

What's the solution? Let large institutions fail? Agree that taxpayers will periodically be responsible for subsidizing the finance industry? Something else?

ed said...

Maybe, but there is another part to the argument that you didn't address.

The capital regulations allowed banks to hold more mortgages in securitized form than they would have been able to hold in un-securitized form. As you wrote, the banks believed mortgages were generally safe, so they wanted to hold more of them and they bought lots of mortgage-backed securities. But this removed the banks from looking at the details of individual mortgages, so they were less likely to see the deterioration in underwriting standards. Without securitization, banks would have been more aware of the true risks, and securitization was primarily driven by capital regulations. Thus, the capital regulations were important in causing the breakdown.

(I believe this is Arnold Kling's argument.)

Anonymous said...

I think you meant to say Direxion is and not Proshares gives you 3-1 leverage

Michael Stack said...

As Tyler Cowen says, if the government subsidizes bananas, and you purchase lots of bananas and store them on the roof of your house, and the roof caves in, that is in fact market failure, not a government failure.


Matthew Gunn said...

What about regulatory arbitrage where banks could significantly reduce their capital requirements by holding the same underlying pool of mortgages in the form of securitized products (rather than as plain vanilla mortgages)? I think you can come up with other examples where regulation encouraged complexity and opacity in order to evade regulation.

If the government gives you $500 to drive with a blindfold on, sure, they didn't cause you to crash. You shouldn't have taken the $500 and driven with a blindfold, but government was part of the problem, not the solution. It's government subsidies for market failure.