Financial Meltdown Fueled By Misguided Fed Policies
In an appearance before the Financial Crisis Inquiry Commission, FDIC Chairman Bair testified on behalf of the FDIC on the causes of the worst financial crisis since the Great Depression. Since the financial meltdown of 2008, many financial analysts and government officials have given eloquent after the fact explanations for the causes of the financial crisis that brought the world to the brink of monetary Armageddon. Ms. Bair’s lengthy testimony provides one of the most lucid and candid explanations of the financial crisis offered to date.
Less well explained and harder to comprehend is why armies of regulators failed to recognize or prevent the financial crisis. Even more unsettling is the growing consensus that new financial “reforms and regulations” would be equally ineffective at preventing the next financial meltdown, since the same regulators and agencies (perhaps with different titles) will still be in charge. Despite the possibility that little has been learned from the financial crisis, it is still well worth reading Ms. Bair’s dissertation on the causes and current state of the financial crisis.
Chairman Bair Rejects Bernanke’s Benign View Of Low Interest Rates
Ms. Bair is forcefully dismissive of Federal Reserve Chairman Bernanke’s assertion that low interest rates and easy monetary policy had no role in the financial crisis. Ms. Bair also implicates the Federal Reserve, the nation’s primary regulator of the financial system, for its inability to properly control and regulate the explosive growth of derivatives and the shadow banking system which fueled the credit boom beyond sustainable levels. Ms. Bair also makes it clear that misguided incentives to borrow and speculate lead to poor or nonexistent evaluation of risk by borrowers, loan originators, credit rating agencies, investors and loan securitizers. At the peak of the housing mania, every participant in the credit fueled housing boom believed that the bubble would never burst.
The Failure of Market Discipline and Regulation: Numerous problems in our financial markets and regulatory system have been identified since the onset of the crisis. Most importantly, these include stimulative monetary policies, significant growth of financial activities outside the traditional banking system, the failure of market discipline to control such growth, and weak consumer protections. Low interest rates encouraged consumer borrowing and excessive leverage in the shadow banking sector. The limited reach of prudential supervision allowed these activities to grow unchecked.
This growth in risk manifested itself in many ways. Overall, financial institutions were only too eager to originate mortgage loans and securitize them using complex structured debt securities. Investors purchased these securities without a proper risk evaluation, as they outsourced their due diligence obligation to the credit rating agencies. Consumers refinanced their mortgages, drawing ever more equity out of their homes as residential real estate prices grew beyond sustainable levels. These developments were made possible by a set of misaligned incentives among and between all of the parties to the securitization process—including borrowers, loan originators, credit rating agencies, loan securitizers, and investors.
The size and complexity of the capital-market activities that fueled the credit boom meant that only the largest financial firms could package and sell the securities. In addition to the misaligned incentives in securitizations, differences in the regulation of capital, leverage, and consumer protection between institutions in the shadow banking system and the traditional banking sector, and the almost complete lack of regulation of over-the-counter derivatives, allowed rampant regulatory arbitrage to take hold.
Many of the products and services of the non-bank financial institutions that comprised the shadow banking system competed directly with those provided in the traditional regulated banking system. Eventually, the largest bank and thrift holding companies expanded into the shadow banking system by incorporating products and services into their own more lightly regulated affiliates and subsidiaries. The migration of essential banking activities outside of regulated financial institutions to the shadow banking system ultimately lessened the effectiveness of regulation and made the financial markets more vulnerable to a breakdown.
Thus, it is not surprising that this crisis affected the largest non-bank financial institutions first. It was at this intersection of the lightly regulated shadow banking system and the more heavily regulated traditional banking system where the crisis was spawned and where many of the largest losses for consumers, investors and financial institutions were generated. Eventually, these traditional institutions also suffered extensive losses as many of their loans defaulted as a consequence of collateral damage from the deleveraging effects and economic undertow created by the collapse of the housing bubble.
Early in the 2000s, two destabilizing events occurred: the technology stock bubble burst and terrorists attacked the United States. In response, the Federal Reserve lowered interest rates to help calm financial markets. As can be seen in Figure 2, the Fed Funds target rate declined from 6.5 percent at the end of 2000 to 1.75 percent at the end of 2001 and further rate cuts continued until the target rate reached 1.0 percent in June 2003. The Federal Reserve didn’t begin to raise rates until June 2004. Many economists and commentators have attributed a part of the housing bubble to this extraordinarily long period of very low interest rates.
Chairman Bair also makes it clear that oceans of liquidity and easy credit that fueled asset growth was also responsible for the lack of sound underwriting. At the height of the mortgage boom, virtually any borrower could obtain approval for mortgage credit, with virtually zero regard to income or credit rating.
Why Market Discipline Failed: Over the past two decades, there was a world view that markets were, by their very nature, self-regulating and self-correcting—resulting in a period that was referred to as the “Great Moderation.” However, we now know that this period was one of great excess. Consumers and businesses had vast access to easy credit, and most investors came to rely exclusively on assessments by a Nationally Recognized Statistical Rating Agency (credit rating agency) as their due diligence. There became little reason for sound underwriting, as the growth of private-label securitizations created an abundance of AAA-rated securities out of poor quality collateral and allowed poorly underwritten loans to be originated and sold into structured debt vehicles. The sale of these loans into securitizations and other off-balance-sheet entities resulted in little or no capital being held to absorb losses from these loans. However, when the markets became troubled, many of the financial institutions that structured these deals were forced to bring these complex securities back onto their books without sufficient capital to absorb the losses. As only the largest financial firms were positioned to engage in these activities, a large amount of the associated risk was concentrated in these few firms.
Other topics covered by Chairman Bair’s testimony on the financial crisis include:
- Analysis of the role of government sponsored enterprises (GSE’s) in fueling the boom
- Lack of consumer protection from toxic mortgages
- The role of low interest rates in creating the housing bubble
- The risky growth of private label mortgage backed securities (MBS)
- The role of rating agencies
- The failure of regulation
- The need for regulatory reform including stronger consumer protection
The Chairman’s concluding remarks make it clear that the financial crisis was decades in the making and will not be readily resolved.
This crisis represents the culmination of a decades-long process by which our national policies have distorted economic activity away from savings and toward consumption, away from investment in our industrial base and public infrastructure and toward housing, away from the real sectors of our economy and toward the financial sector. No single policy is responsible for these distortions, and no one reform can restore balance to our economy. We need to examine national policies from a long-term view and ask whether they will create the incentives that will lead to improved and sustainable standards of living for our citizens over time.
Whatever the reasons, our financial sector has grown disproportionately in relation to the rest of our economy over time. Whereas the financial sector claimed less than 15 percent of total U.S. corporate profits in the 1950s and 1960s, its share grew to 25 percent in the 1990s and 34 percent in the most recent decade through 2008. The financial services industry produces intermediate products that are not directly consumed—transactions services and products that channel savings into investment capital. While these services are essential to our modern economy, the excesses of the last decade represented a costly diversion of resources from other sectors of the economy. We must avoid policies that encourage such distortions in economic activity. Fixing regulation will only accomplish so much. Longer term, we must develop a more strategic approach that utilizes all available policy tools—fiscal, monetary, and regulatory—to lead us toward a longer-term, more stable, and more widely-shared prosperity.