Would a Stricter Fed Policy and Financial Regulation Have Averted the Financial Crisis?, Cato Policy...

8/14/2019 Would a Stricter Fed Policy and Financial Regulation Have Averted the Financial Crisis?, Cato Policy Analysis No. 648

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Many commentators have argued that if theFederal Reserve had followed a stricter monetarypolicy earlier this decade when the housing bub-ble was forming, and if Congress had not deregu-lated banking but had imposed tighter financialstandards, the housing boom and bustand thesubsequent financial crisis and recessionwouldhave been averted. In this paper, we investigatethose claims and dispute them. We are skeptical

that economists can detect bubbles in real timethrough technical means with any degree of una-nimity. Even if they could, we doubt the Fedwould have altered its policy in the early 21st cen-tury, and we suspect that political leaders wouldhave exerted considerable pressure to maintainthat policy. Concerning regulation, we find thatthe banking reform of the late 1990s had littleeffect on the housing boom and bust, and that themany reform ideas currently proposed would havedone little or nothing to avert the crisis.

Commentators have also argued that thepopularization of financial products such asteaser-rate hybrid loans for subprime homebuy-ers and credit default swaps for investors is toblame for the financial crisis. We find little evi-dence for this. Housing data indicate that themajority of subprime hybrid loans that haveentered default had not undergone interest rateresets, and the default rate for subprime hybrid

loans is not much higher than for subprimefixed rate loans. Concerning swaps, althoughtheir introduction may increase financial inflowsinto risky sectors, their execution through aclearing-house or regulation via other meanswould not necessarily have avoided the mispric-ing of risks in underlying contracts. Capital re-quirements for the credit default swaps that wereused to insure mortgage-backed securities wouldhave been low because housing investments werenot considered risky.

Would a Stricter Fed Policy and FinancialRegulation Have Averted the Financial Crisis?

by Jagadeesh Gokhale and Peter Van Doren

_____________________________________________________________________________________________________

Jagadeesh Gokhale is a senior fellow at the Cato Institute and the author ofSocial Security: A Fresh Look atReform Alternatives (forthcoming). Peter Van Doren is a senior fellow at the Cato Institute and the editor ofCatos Regulation magazine.

Executive Summary

No. 648 October 8, 2009


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Introduction

Many commentators argue that the hous-ing market boom and bust, the subsequent

implosion of financial markets, and the reces-sion that followed have two important causes:inappropriately loose monetary policy during20032005 and financial market deregulation,including the 1999 Gramm-Leach-Bliley bank-ing reform act (GLB), the lack of regulation ofcredit default swaps, and loose capital and lever-age standards.1 The commentators claim thattighter Federal Reserve Policy and stricter capi-tal market regulation would have averted thecrisis and should be adopted now to avoidfuture crises.

We investigate these claims and disputethem. First, economists cannot detect asset-price bubbles in real time through technicalmeans with any degree of unanimity. Second,even if economists could detect asset-pricebubbles without significant controversy, theFed may not have enacted tighter monetarypolicy in the period prior to the housing bub-ble because of heightened concerns aboutdeflation at the time. And if the Fed had adopt-ed such policy, it would have faced severe bipar-tisan criticism from Congress and the White

House, which wanted low interest rates at atime when inflation was low and economicgrowth was sluggish following the 2001 reces-sion. Third, even if bubble detection were pos-sible and the Fed had political support to stopbubbles, it could not have used its short-termrate-setting power to stop housing bubblesduring the 20042006 period because Fedshort-term rates were no longer correlated withshort- or long-term mortgage interest rates.

Our discussion of financial market dereg-ulation includes discussion of three claims.

The passage of Gramm-Leach-Bliley Act hadthe accidental effect of lowering the capitalstandards governing investment banks, but itdid not mean the banks were operatingunder laissez faire. Instead, they were subjectto the Basel I and II regulatory framework,which considered investment in residentialmortgages to be fairly safe.

Second, we consider credit default swaps(CDSs), and argue that, although their intro-duction may increase financial inflows intorisky sectors, their execution through a clear-ing-house or regulation via other means would

not necessarily have avoided the mispricing ofrisks in underlying contracts. Capital require-ments for CDSs that insured mortgage-backedsecurities would have been low because hous-ing investments were not considered risky.

Third, many have argued that low teaser-rate hybrid loans and low capital standardsfor financial institutions are to blame.2 Yetthe data do not support the teaser-rate argu-ment because the majority of mortgages inforeclosure had not undergone interest rateresets, and increased capital standards would

likely have led to increased risk taking asfinancial firms pursued what appeared to besafe but high returns in the residential realestate market.

In short, the many policy proposals thatadvocates on the Left and Right now say arenecessary because of the financial crisissuchas stricter regulation of derivatives and bank-ing, higher reserve requirements, and moreconservative Fed policywould have done lit-tle to avert the financial crisis. The crisis issimply the product of the widespread belief

that residential real estate investment is safeas houses, and it is unclear what policy couldhave disabused both policymakers and finan-cial markets of a firmly held, but false, belief.

Detecting the Home PriceBubbleA Failure?

Many argue that an essential componentof any policy to prevent future financial crisesand their negative effects on the real econo-

my is the detection of asset-price bubbles.3

For such a policy to be successful, economistsmust be able to use the technical tools of thediscipline to distinguish sustainable fromunsustainable asset appreciation in real timeand inform decisionmakers about appropri-ate policy responses. We believe that the trackrecord of forecasts during the recent hous-

2

Economistscannot detect

asset-pricebubbles in real

time throughtechnical meanswith any degree

of uniformity.


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ing-price bubble suggests that such a faith inthe ability of technical analysis to reveal thecorrect answer is unwarranted. As housingappreciation occurred from 2000 to 2006,consider the quotations that follow from

some prominent economists who doubtedthat there was a housing bubble or who be-lieved that the bubble posed little risk to thebroader economy.

Suzanne Stewart and Ike Brannon, congres-sional staff economists, wrote in the spring of2006:

Predictions about home prices have gonefrom a sober questioning of future pricegrowth to shrill apocalyptic predictionsof an impending market collapse that

will trigger a deep recession. . . . With nospecter of inflation . . . relatively lowreturns . . . and a stagnant stock market. . . who is to say that . . . a family spend-ing another $100,000 on a nicer house isnot making a wise decision?4

Robert Van Order and Rose Neng Lai, profes-sors at the University of Michigans BusinessSchool and University of Macau, China, respec-tively, conducted statistical tests of momen-tum shifts in home price increases. They con-

cluded in November of 2006:

We find evidence of momentumthroughout the period (1980 and later)and some evidence that the momen-tum increased after 1999, but not by alot. We find no evidence of an increasein volatility. We also do not find evi-dence of explosive momentum after1999, nor do we find much differencein price growth behavior between thebubble and nonbubble candidate cities.

We do find that momentum operateswith a long lag. There were always bub-bles, but not large regime shifts, at leastnot in our sample period.5

Writing in the Federal Reserve Bank of NewYorks Economic Policy Review in December2004, bank senior economist Jonathan

McCartney and vice president Richard W.Peach said:

Home prices have been rising strongly. . . prompting concerns that a bubble

exists . . . and that home prices are vul-nerable to a collapse. . . . A close analy-sis of the U.S. housing market . . . findslittle basis for such concerns. The . . .upturn in home prices is . . . attribut-able to strong market fundamentals. . . and regional price declines in the

past have not had devastating effectson the broader economy.6

John V. Duca, vice president and senior econ-omist at the Dallas Federal Reserve, wrote in

that banks Southwest Economy in spring of2004:

Overall home prices have risen . . . by 37percent since 1997 (26 percent whenadjusted for inflation). Such increaseshave raised concerns that low interestrates have spawned a housing-pricebubble. . . . One key finding is thatalthough there is little risk of a nation-al bubble, prices in some areas are vul-nerable if local economic conditions

deteriorate.7

One year later, he wrote in the same journal:

Mortgage innovations have made hous-ing a more liquid, and thus more attrac-tive, asset. In addition, the demand forowning more than one home has recent-ly increased. For these reasons, pricesmay not be as overvalued as [a chart inthe journal] suggests.8

Alan Greenspan, then chairman of the FederalReserve, told a congressional committee inJune 2005:

Although we certainly cannot rule outhome price declines, especially in somelocal markets, these declines, were theyto occur, likely would not have sub-

3

The majority ofmortgages inforeclosure hadnot undergoneinterest rateresets.


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stantial macroeconomic implications.Nationwide banking and widespreadsecuritization of mortgages make itless likely that financial intermediationwould be impaired than was the case in

prior episodes of regional house pricecorrections.9

Even as late as 2007, Austan Goolsbee of theUniversity of Chicago (now a top economicadviser to President Obama) said:

Lost in the current discussion aboutborrowers income levels in the sub-prime market is the fact that someonewith a low income now but who standsto earn much more in the future would,

in a perfect market, be able to borrowfrom a bank to buy a house. That is howeconomists view the efficiency of a capi-tal market: peoples decisions unre-stricted by the amount of money theyhave right now. . . . Measured this way,the mortgage market has become moreperfect, not more irresponsible. Peopletend to make good decisions abouttheir own economic prospects.10

Apart from these establishment econo-

mists, a few voiced warnings of a potentialhousing-price bubble. Among them wereWellesley College economist Karl Case and Yale economist Robert Shiller, cocreators ofthe Case-Shiller house-price index.11 However,even Case and Shiller said in 2003:

Judging from the historical record, anationwide drop in real housing pricesis unlikely, and the drops in differentcities are not likely to be synchronous:some will probably not occur for a

number of years. Such a lack of syn-chrony would blunt the impact on theaggregate economy of the bursting ofhousing bubbles.12

In hindsight, they were all wrong.13 Ifthese economists could not foresee the dan-ger posed by the housing bubble, then it

seems unclear how any new policy empower-ing such economists to steer the nation awayfrom future crises will be effective.14

Asset Price BubbleVersus Deflation:Which Is More Dangerous?

Even if these economists had clearly iden-tified the threat of runaway housing prices,Fed officials charged with preventing asset-price bubbles may have continued to insistthat no policy action to counter the bubblewas warranted because so many other factorsmade deflation an overriding concernDuring the early 21st century, the Fed had

investigated the implications of a deflation-ary environment for Fed policymakingUnder such an environment, with rising realdebt burdens and slowing economic activity,monetary policy would be rendered impotentbecause a low federal funds rate could not bereduced below 0 percent. That is, with pricelevels nearly stagnant and at risk of slidingbackwards, the Fed would be unable to lowerinterest rates in order to spur the economy.

Conventional inflation measures were verylow during this time period. Figure 1 shows

quarterly growth in the Consumer Price Indexand in the Personal Consumption Expendi-tures Price Index.15 Growth in both priceindices remained close to zero between 2001and 2005, with the CPI growth occasionallywandering into negative territory.16 Thus defla-tion, and not inflation, was of primary concern

Another rationale for a low federal fundsrate was low short-term market interest rates. As shown in Figure 2, the close associationbetween short-term market rates and the fed-eral funds rate is the result of rational fore-

casts of short-term interest rates based onavailable information made independentlyby market actors and Fed policymakers. Bothforecasts are predicated on the Feds objectiveof maintaining maximum economic growthunder price stability. Given the extremely lowinflationary environment soon after thestock-market implosion of 2000 and the eco-

4

If theseeconomists could

not foreseethe danger posed

by the housingbubble,

how couldpolicymakers?


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5

Figure 1

Real CPI and PCEQuarterly Growth at Annual Rate

Source: Bureau of Labor Statistics.

Date (quarter)

Date

Source: Federal Reserve Bank of St. Louis.

Figure 2

Federal Funds and 3-Month T-Bill Rates

Percent

Percent


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nomic recession of 2001, market rates andFed policy resulted in the low-interest-rateenvironment that some observers now blamefor triggering the housing price bubble.

The Fed ultimately did raise rates begin-

ning in 2004, but some would argue that itcould have done so earlier and at a speed con-sistently faster than any associated increasesin market interest rates. The Feds postPaul Volker reputation as an effective inflationfighter might have given it the credibility toinfluence market short-term interest rates tomove in lockstep with the federal funds rate.But repeated attempts to move market ratesin a direction inconsistent with underlyingmarket demands for liquid reserves andfinancial assets would have failedeventual-

ly. Indeed, attempts to increase market inter-est rates significantly during the 20032005period would have increased foreign savingsflows into the United Statesworsening thealready severe global financial imbalance.

Following such an alternative policy mayhave helped the Fed to avoid its current fate ofbeing criticized for allowing the home-pricebubble to grow larger. But by initiating inter-est-rate increases earlier, it could have directlytriggered a recession by constraining aggre-gate spending. Then the Fed would have been

blamed for the recession, but would not havebeen credited with preventing a housing-pricebubble because none would have beenobserved. How can an institution that attractsso much scrutiny and is the target of intensepolitical pressure inflict economic pain andsurvive if the benefits of its policies are notobservable?17

Home Prices and

Monetary PolicyAssume that economists saw the housing

bubble in real time and assume that both thetechnical and political tradeoffs betweeninflation and deflation had been resolved.Could the Fed have stopped the housingbubble through its control of short-terminterest rates? Alan Greenspan says no, but

prominent economist and Fed-watcher JohnTaylor says yes.

The housing bubble is attributed by Green-span to massive increases in saving relative toinvestment in developing countries such as

China, and the oil-exporting countries of theMiddle East.18As Figure 3 shows, net interna-tional capital inflows to the United States,which were near zero from 1987 through themid 1990s, grew in the late 1990s and early21st century.

However, a few prominent economists andFed-watchers have attributed the emergence ofthe housing-price bubble to poor monetarypolicy: the maintenance of low interest ratesfrom 2003 through 2005. Professor John Taylorof Stanford University places the blame square-

ly on monetary excesses by the Fed:

The classic explanation of financial crisesis that they are caused by excessesfre-quently monetary excesseswhich leadto a boom and an inevitable bust. Thiscrisis was no different: a housing boomfollowed by a bust led to defaults, theimplosion of mortgages and mortgage-related securities at financial institutions,and resulting financial turmoil. Mone-tary excesses were the main cause of the

boom.19

Taylor suggests that had the Fed adheredclosely to the eponymous Taylor rules pre-scription for setting the federal funds rate,the housing bubble could have been avoidedwithout tipping the economy into a reces-sion. But the Taylor rule works well as aguidepost for interest-rate policies when theeconomic environment is stable, and that hasnot been the case during this decade becauseof massive capital inflows to the United

States. Given increasing capital inflows, over-leveraged financial institutions, and a poten-tially deflationary environment, we cannotsay scientifically whether following theTaylor rule would have prevented a housingbubble without causing a significant eco-nomic slowdown.

If lax monetary policy were the chief cause

6

The Fed wouldnot have beencredited withpreventing a

housing-pricebubble because

none would havebeen observed.


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of the housing bubble, then higher rateswould have been the solution. What is theevidence that higher federal funds rates dur-ing the early 21st century would have pre-vented the housing bubble from developing? According to Greenspan, homes are long-

lasting assets and are priced based on long-term interest rates. Whatever the power ofthe Fed to influence short-term rates, long-term rates have not followed the short-ratessince the mid 1990s, making monetary poli-cyto the extent it could influence the termstructure of interest ratesrelatively ineffec-tive in influencing the opportunity costs ofhousing finance.

Gerald ODriscoll Jr., a former vice presi-dent at the Federal Reserve Bank of Dallas,argues that the subprime and low-teaser-rate

mortgages used in the boom-and-bust areasof California, Phoenix, Las Vegas, and Flori-da, are priced based on much shorter-termrates of one to three years because thesemortgages are funded by short-term borrow-ing.20 Thus, he suggests, Greenspans focuson the relationship between Fed policy andlong-term rates is irrelevant.

But even short-term mortgage rates weredecoupled from short-term (federal funds and3-month) interest rates. A casual look at theempirical evidence shows that Treasury short-term rates of one- to three-year terms failed tomove in lockstep with changes in the federal

funds rate during the early 21st century. Table1 shows how changes in Treasury and keymarket interest rates correlated with changesin the federal funds rate during three periodsbetween 1987 and 1993, between 1993 and2001, and after 2001. The market rates onTreasury securities are used to set the cost offunds for all kinds of loans, including mort-gages, at various time horizons. Although pre-1993 correlations between changes in the fed-eral funds rate and Treasury interest rates werequite highmuch closer to one than to zero

the correlations were smaller during the twosubsequent periods.

In addition, the decoupling of federalfunds rates and market rates appears to beconfined to housing. Correlations betweenchanges in the federal funds rate and banklending rates (the prime loan rate) and short-term commercial paper rates issued by finan-

7

The decouplingof federal fundsrates and marketrates appears tobe confined tohousing.

Figure 3

Net International Capital Inflows into the United States

BillionsofUSdollars

Source: Authors calculations, based on data from the Bureau of Economic Analysis.


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cial and nonfinancial companies remainedquite high during the early 21st century.21

The evidence in Table 1 of the potentialdichotomous impact of monetary policy onhousing finance versus other real-sector eco-nomic activity should caution those whosuggest that Fed errors of omission and com-mission are to blame for the housing bubbleand its subsequent collapse. The claims thatthe Feds interest-rate policy is the key cul-prit, or that manipulating it with the goal of

eliminating a tenuously observed housing-price bubble would have succeeded (withoutunintended consequences), appear to be mis-guided. Increases in the market short-termrates and the federal funds rate beginning in June 2004 certainly proved insufficient toprevent home price increases for another twoyears.22

Why a Systemic RiskRegulator is an Oxymoron

What lesson can we draw from the phe-nomenon we have just witnessedthat iden-tifying asset-price bubbles is tricky business,and even if one had been correctly identified,policymakers would have stood pat anyway?It is simply that judgments by even very sea-soned and seemingly disinterested observersabout whether statistical data on asset prices

indicate (the possibility of imminent) bub-bles, and whether systemic risks from asset-price reversal are high, are clouded by theenvironments within which they are madeIndeed, under a meta-macroeconomic frame-work, such professional economists opin-ions might even be considered to be integralelements of the economic system, serving to

8

Increases inthe market

short-term rates

and the federalfunds rate

certainly provedinsufficient toprevent home

price increases.

Table 1

Correlations of Changes in Market Interest Rates with Changes in the Federal Funds

Rate

Feb. 1987Oct. 1993 Nov. 1993July 2001 Aug. 2001March 2009

Treasury 1 month n.a. n.a. 0.64

Treasury 3 month 0.76 0.63 0.75

Treasury 6 month 0.78 0.56 0.79

Treasury 1 year 0.74 0.48 0.69





Treasury 10 year 0.55 0.08 0.12

Treasury 20 year n.a. 0.01 0.04

Conventional mortgage rate* 0.62 0.16 0.07

Bank prime loan rate 0.78 0.92 0.941 month CP(nf) n.a. n.a. 0.90

2 month CP(nf) n.a. n.a. 0.82

3 month CP(nf) n.a. n.a. 0.72

1 month CP(f) n.a. n.a. 0.72



*Contract interest rates on commitments for fixed-rate first mortgages.

Source: Authors calculations based on data from the Federal Reserve Bank of St. Louis.

Note: CP(f) = Commercial Paper (financial); CP(nf) = Commercial Paper (nonfinancial).


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temporarily sustain a macroeconomic equi-librium at high rates of consumption andinvestment spending, employment, homeprices, and stock-market values.

Notice that the earlier-cited economists who

provided evidence-based opinions about theabsence of a home-price bubble conditionedtheir arguments on variables that are, essential-ly, part of a mutually reinforcing system of arobust economy and high housing prices. Forexample, economists from the New YorkFederal Reserve, Columbia University, andWharton School based their conclusion of nobubble on a comparison between the imputedannual cost of homeownership relative to itsown history and fundamentals.23 Whetherhome prices accelerated too much must be

judged, the authors argue, with reference tochanges in long-term interest rates, expectedinflation, expected home-price appreciation,rental costs of similar residences, and taxes.Fundamentals are mainly proxied by the cost ofrental units compared to the imputed rental onowned homes. Other economists, among thosecited earlier, used such factors as estimatedincome and wealth elasticities of housingdemand and real improvements made byhomeowners to their residenceseven tohomes that never entered the market for sale

to determine that the fundamentals support-ed home price increases.

The problem with using such measures toassess whether housing prices are too high isthat those fundamentals may themselves bethe consequence of high asset prices, andthey exhibit vulnerability to macroeconomicshocks and become unstable at the sametime as asset prices. The point that economicfundamentals and asset prices may turn outto be jointly determined has been made byGeorge Akerlof and Robert Shiller in their

new bookAnimal Spirits.24

Most of the economists cited earlier areeither government economists or thoseinvolved directly or indirectly in the real estatesectorthat is, working for institutions withmandates to promote economic and housinggrowth. It is generally not in the interest ofthose institutions to promote and advertise

conclusions that would increase marketuncertainty and promote economic pes-simism among the public. Such opinionswould weaken the economy, which is not onlycontrary to the Feds mandated objectives,

but also contrary to the financial interests ofreal estate associations, home managementcompanies, and mortgage brokers. Moreover,the forecasts and opinions of professionaleconomists working for such institutionsreceive the most attention from the mediaand are accorded the most respect by the pub-lic because of their elevated status as knowl-edgeable oracles about the future course ofthe economya fact that maximizes theireffectiveness in sustaining an equilibrium at ahigh level of macroeconomic activity.

Our recent economic troubles indicatethat judgments made in real time about thecontemporary economic outlook, especiallythose by economists working for governmentagencies, are unlikely to be useful in assessingexposures to systemic risks. An externalshock to the system or an unanticipated con-straint that is sufficiently strong and beginsto bindsuch as a hard limit on energy-pro-duction capacity in the short-termcouldtrigger a financial and economic crisis, andrender those judgments false within a rela-

tively short period of time.25

Deregulation orReregulation?

In addition to the claim that the Fed candetect and stop asset bubbles in real timethrough monetary policy, many also argue thatderegulation of financial markets allowedexcessive risk-taking to occur and that respon-sible regulation would prevent such irre-

sponsible lending in the future.26 Threeclaims are made: first, the passage of the 1999Gramm-Leach-Bliley banking reform act elim-inated the barriers between investment bank-ing, commercial banking, and insurance, andpermitted banks to dilute the effectiveness ofcapital requirements by engaging in off-balance-sheet expansion of liabilities.27 Second,

9

Judgments madein real timeabout thecontemporary

economicoutlook areunlikely to beuseful inassessingexposure tosystemic risks.


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Congress chose not to regulate the over-the-counter market in credit default swaps and theresult was the failure, and taxpayer rescue, of AIG. Third, the Fed and other supervisoryagencies chose not to restrict qualification for

low-teaser-rate loans (sometimes called liarloans), which allowed aggressive lending prac-tices to proliferate and allowed too much lever-age into the financial system.

Gramm-Leach-BlileyPrior to the passage of GLB, economists

had concluded that the supposed virtues ofseparating investment from commercial bank-ing through the New Dealera Glass-Steagal Act followed from two incorrect theoriesabout the origins of the Great Depression.

The first theory emphasized conflicts ofinterest between jointly owned investment andcommercial banks. From this perspective thestock market crash of 1929 was the result ofinvestment banks selling poor-quality stocksto an uninformed public in order to raisefunds to repay the stock-issuing companysloans to the investment banks affiliate com-mercial bank. If the theory were true, securitiesunderwritten by investment banks that hadaffiliated commercial banks would defaultmore than ex antesimilar securities underwrit-

ten by independent investment banks. In fact,securities underwritten by banks with affiliateswere no more likely to default than similarsecurities issued by independent investmentbanks during 19241940.28

A second (and related) theory was thatinvestment banks were inherently riskier, andthus, combining them with commercial bankswould make the banking system more risky.But during the Depression, banks with invest-ment affiliates had no greater earnings volatil-ity than banks without and actually failed less

frequently than unaffiliated banks.29 And inthe modern era, GLB was not that radical adeparture from Glass-Steagall because GLBbasically ratified what already had occurredthrough regulatory experimentation in theUnited States and regulatory regimes in otherdeveloped economies.30

In contrast to both positive and negative

predictions made before the passage of GLB,and the claims made in 2008 by critics afterthe financial crisis started, an evaluation in2005 concluded that very few financial hold-ing companies had taken advantage of GLB to

form universal banks.

31

And the financiaholding companies formed after GLB werenot more profitable than traditional bankholding companies. So the current conven-tional wisdom that GLB changed the financialworld dramatically and for the worse is, atbest, a very selective reading of history.

GLB did affect investment banking regula-tion in one important way. Prior to GLB,investment banks were regulated as broker-dealers by the Securities and Exchange Com-mission and subject to its net capital rules,

which required 6.67 percent capital.32

AfterGLB, investment banks initially became part ofunregulated financial holding companiesEuropean countries then asked to subjectEuropean branches of U.S. investment banksto European (Basel II) regulation.33 Europeanregulation was preempted only when the SECagreed to implement Basel II risk-related regu-lation for U.S. investment banks.34 This hadthe effect of changing fixed capital require-ments to requirements that varied by invest-ment.

Under Basel Is bank capital regulations,which had governed the world since 1988,mortgages and AAA-rated asset-backed secu-rities were treated as much safer investmentsthan corporate debt. Commercial loans had arisk weight of 100 percent meaning that 8percent of the loan had to be backed by capi-tal. Residential mortgages had a risk weightof 50 percent, and thus only 4 percent (0.5 8%) had to be backed by capital; and AAA-rated asset-backed securities had a riskweighting of 20 percent, so only 1.6 percent

(0.2 8%) had to be set aside.35 Thus, the reg-ulatory system itself provided extremelystrong incentives for the financial communi-ty to shift to mortgages and from mortgagesto highly rated securities backed by pools ofmortgages.

Basel IIs innovation was to allow the use offlexible, rather than fixed, risk weights for dif-

10

Duringthe Depression,

banks withinvestment

affiliates had nogreater earnings

volatility thanbanks without.


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ferent classes of assets, which reduced the cap-ital requirement for mortgages to 2.8 percent.As Charles Calomiris of Columbia Universityquipped, Basel II was not a libertarian plotcooked up at the Cato Institute. . . . It was the

product of many years of effort by the worldsmajor central banks, intended to avoid crisessuch as the savings and loan disaster of the1980s. . . . [T]he SEC could be forgiven forthinking that if it was good enough for theworlds central bankers, it was good enoughfor the Commission.36

So to summarize, although GLB eliminatedthe Glass-Steagall law, it had very little effect onthe structure of U.S. financial institutions.Banking innovations, in providing financialproducts and services, had already consider-

ably eroded that laws constraints. But GLBhad the accidental effect of lowering the capitalrequirements for investment banksan out-come not of reducing or eliminating regula-tions, but of subjecting U.S. investment banksto the regulatory rules of Basel I and II that hadpreviously applied only to commercial banks.Within that framework, mortgages and highlyrated mortgage-backed securities were consid-ered safer than normal investment bank activi-ties. All participants in the world of bankingregulationinvestment banks, regulators, and

other policymakersaffirmed that consensusand affirmed its implications for investmentbanks capital requirements. This is anothercomponent of the mutually reinforcing high-growth meta-macroeconomic equilibriumthat we referred to earlier.

Commodity Futures TradingCommission Regulation

The second claim about deregulation isthat Congress chose not to regulate the over-the-counter (OTC) market in credit default

swapsvoluntary contracts in which investorsagreed to be liable for other investors unpaiddebts. According to conventional wisdom,CDSsespecially those held by insurancegiant AIGprompted irresponsible homemortgage lending.37

In journalists account of this story, in thespring of 1998, Brooksley Born, the head of

the Commodity Futures Trading Commis-sion, wanted to consider regulating OTCCDSs, but Federal Reserve chairman AlanGreenspan, Treasury secretary Robert Rubin,and SEC chair Arthur Levitt Jr. opposed the

effort.CDSs are insurance contracts against fail-ure to repay debtsin this case, mortgages.The AIG financial products business modelconsisted of using AIGs AAA bond rating,held by only a dozen or so U.S. companies, toborrow at low rates and write insurance con-tracts against mortgage defaults.38 Instead ofinvesting the proceeds from such contracts inlong-term bonds to accumulate reserves foreventual payout, AIG assumed defaults wouldbe rare and signaled such beliefs by binding

itself to the mast, that is, subjecting the CDScontracts to collateral calls if its AAA ratingwere ever downgraded.39

The important questions are whether theexistence of AIG CDSs induced counterpartiesto invest more in mortgage-backed securities(thereby injecting more funds into the housingsector and maintaining mortgage rates at verylow levels) than they would have in theirabsence. Alternatively, would mortgage fund-ing be less abundant under a regulated CDSmarket, and would such regulations have

resulted in larger capital requirements for AIG?Some analysts claim that CDSs do not

add to total financial risk in the economy,they simply transfer risk from the originalloan provider, such as a bank, to insurancefirms, such as AIG.40 However, the existenceof CDSs for redistributing risks and returnsprobably triggers additional debt creation onthe part of risk-averse lenders.

So, unregulated CDSs increased the quan-tity of mortgage debt. Would regulated CDSshave priced risk correctly and induced an

optimal level of additional mortgage debt?Although it is difficult to do so now, we ask

the reader to recall the environment in whichhousing prices and beliefs about housing priceappreciation and risk were mutually support-ive and positive. In such an environment, reg-ulated CDSs might have allowed the same,possibly even looser, capital requirements on AIG.

11

RegulatedCDSs might havallowed the sameand possibly evelooser, capitalrequirementson AIG.


12/20

Here, too, Basel II rules provide the clue: capi-tal requirements for CDSs that insured mort-gage-backed securities would have been lowbecause the housing investments were notconsidered risky. In fact, during 20002007,

investing in such instruments was consideredbrilliantly conceived normal arbitrage (takingadvantage of mispriced risk) rather than whatturned out to be enormously underpriced risk.

A related issue is the claim that by choos-ing not to extend CFTC regulation overCDSs, an opportunity was missed to reducerisks by adopting a clearinghouse for suchcontracts. In futures markets in which stan-dardized contracts are traded, buyer and sell-er trade with a clearinghouse, which has itsown capital to insure against default.

Could the existence of CFTC jurisdictionand an associated clearinghouse have prevent-ed the AIG calamity? In an article last year inRegulation, Craig Pirrong asked what wouldhave happened in September 2008 if CDScontracts had to be cleared.41 He concludesthat the existence of a clearinghouse affectsonly the distribution rather than the totalamount of losses from default. If a large num-ber of CDSs were to fail, the clearinghousewould have to cover the losses with its owncapital and perhaps even have to draw on addi-

tional capital from its members. Thus, a clear-inghouse would produce more efficient riskpricing and reduce aggregate risks only if itpriced risk more efficiently than current indi-vidual counterparty transactions on the OTCmarket.

However, more efficient risk pricing under aclearinghouse arrangement is unlikely. Clear-inghouses charge only for the risks created bybetting that prices of commodities will go upor down (so-called position risk) throughcollateral standards, the amount that an

investor must put up in cash, which are basedon the historical variance of prices for a partic-ular commodity. But adverse price changes canexceed collateral and thus require the use ofcapital to meet margin calls. Unless capital isinvested in treasuries, it is risky. That is, whensold to meet margin calls, capitals value maybe lower than its book value. Clearinghouses

do not charge for the riskiness of capital, theso-called balance sheet risk. And if clearing-houses attempted to price such risk, theywould be at a severe disadvantage relative tothe current bilateral deals struck by the traders

themselves. Pirrong concludes that the absenceof a CDS clearinghouse reflects an efficientmarket outcome, and that a hasty impositionof a clearinghouse could actually be ineffi-cient.

In addition, a clearinghouse would do noth-ing to price systemic risk correctly. The effect ofthe failure of a CDS market participant on thestability of financial markets as a whole wouldnot be taken into account by a clearinghouseSo a clearinghouse is not capable of pricing pri-vate default risk correctly for complex products

traded by information-intensive intermediariesand clearinghouses do not charge for systemicrisk, which is the basis for the AIG interventionClearinghouses are a solution for a limited classof problems, and they usually arise naturallywhen market participants believe they wouldproduce benefits.

So while the journalistic accounts of howBrooksley Born was bullied by Robert Rubinand Alan Greenspan into rejecting CDS regu-lation certainly provide a gripping narrative,CFTC regulation of capital requirements for

them would have been unlikely to differ fromthe Basel I and Basel II risk-related capitalrequirements that perceive little risk of slidingproperty values and widespread mortgagedefaults. And the imposition of a clearing-house on nonstandard CDSs would likelyhave increased, rather than decreased, moralhazard and risk taking.

Low Teaser RatesA third claim about the role of regulation is

that the Fed should have restrained subprime

borrowers from taking out hybrid mortgagesthat initially offered low introductory rates butthen reset to higher rates that the borrowerscould not afford.42 However, as of July 2007, 57percent of the 2-year/28-year and 83 percent ofthe 3-year/27-year hybrid subprime mortgagesthat were in foreclosure had never undergoneany interest rate resets.43 And of all the sub

12

The imposition ofa clearinghouse

on nonstandardCDSs would

likely haveincreased, rather

than decreased,moral hazard and

risk taking.


13/20

prime loans originated between January 1999and July 2007, 36 percent of the hybrid loanswere in foreclosurenot much different from31 percent of the fixed rate loans that were alsoin foreclosure as of September 2007.44 Mayer,

Pence, and Sherlund also find little evidencethat the rise in delinquencies through mid-2008 was linked to these [novel mortgage]products.45 The diminished market value ofthe home itself, rather than the characteristicsof the loan contract, appears to be more rele-vant as a foreclosure trigger.

Capital StandardsFalling home prices made the mortgages

supporting them untenable and increaseddefaults because with their equity (and more)

now lost in the bubble collapse, many home-owners are simply electing to walk away. Thishas led some observers to conclude that lever-age is the problem. They argue that highercapital standards for banks and larger downpayments for loans are essential componentsof the solution, as those changes would pro-tect banks and lessen homeowners incentiveto default on their mortgages.

But this raises the question about howlarge down payments and capital standardsshould be. There is no scientific answer to the

question. In practice, they are usually set abovethe levels that failed to prevent the last finan-cial crisis. In the 1840s, before deposit insur-ance, banks had a capital buffer in excess of 50percent of assets in order to induce willingdepositors.46 Prior to the savings and loandebacle in the 1980s, commercial banks had acapital ratio of 7.0 percent and savings andloan institutions had a minimum capital ratioof 5.0 percent. The Basel I standards, adoptedin 1988, set the ratio at 8.0 percent, but variedthe ratio for various classes of assetsrequir-

ing only 4 percent for mortgages and 1.6 per-cent for AAA-rated asset-backed securities.Basel II, however, reduced the capital set asidefor mortgages to 2.8 percent, kept the AAA-rated asset-backed security at 1.6 percent, andreset that for AAA-rated tranches of a collater-alized debt obligation funded by mortgages to0.56 percent.47

The Swiss have a reputation for extremelyconservative banking and high bank capitalstandardsrequiring as much as 20 percentmore capital than specified under Basel II.And Credit Suisse and UBS, the two largest

Swiss banks, are required to have a nonpublicamount of additional capital.48 But even suchhigh capital requirements proved insufficient,and the Swiss government was forced to inject6 billion Swiss francs into UBS in exchange fora 9-percent ownership stake, and also set up alarge fund to offload troubled mortgage assetsfrom the UBS balance sheet.49

The Swiss experience suggests that ever-increasing capital standards may not be theanswer. In fact, the market perceives bank equi-ty to be part of the problem because it keeps

bank managers on too loose a leashwithmore investor money in the vault, banks wouldbe more likely to lend to questionable borrow-ers. Naively requiring more equity capital prob-ably increases rather than decreases risk taking.

Maintaining a highly conservative capitalstandard has been proposed by some whoadvocate what is known as limited-purposebanking. Banks would be required to hold100 percent capital against loans, and a func-tional division between traditional and invest-ment banking would be strictly maintained.50

Banks would be protected with insurance fordeposits and regulatory constraints on activi-ties. In contrast, investment banking would befree to take more risks, but shareholderswould bear all losses.

What is the problem with this world? First,while we have not really tried narrow banking,we certainly did have a costly regulated capitalstandard banking system 40 years ago. Be-cause of its costs, investors and corporationsgradually avoided banks and interacted direct-ly through commercial paper and securitiza-

tion markets.51 Before the collapse of securiti-zation in the fall of 2008, banks accounted foronly about one-third of total lending, whilesecuritization accounted for about two-thirds.52 Thus, the banking crisis really is moreappropriately called a securitization crisis or,as Gorton describes it, a collapse of the shad-ow banking system.53

13

The diminishedmarket value ofthe home itself,rather than thecharacteristics ofthe loan contracappears to bemore relevant asa foreclosure

trigger.


14/20

Second, for narrow banking to be success-ful, all investment outside of the checkingaccount payments system would have to be atrisk without the possibility of governmentalassistance. But recent events show that gov-

ernments commitment not to intervene inthe event of financial distress occurring out-side the explicit FDIC-insured regulated bank-ing world is not credible. The assistance pro-vided to Fannie Mae, Freddie Mac, and AIG;the conversion of all investment banks to reg-ulated banks; and the provision of depositinsurance to money market funds would sug-gest that any commitment to separate riskyinvestment from regulated banking is unlike-ly to be credible and time-consistent.

A second and more intriguing capital-

standard proposal is to allow for the use offinancial catastrophe bonds: debt instru-ments issued by financial institutions as partof their capital that would pay investorsinterest during normal times and result intotal loss of principal, and thus, a large infu-sion of capital into financial firms duringfinancial crises.54 Unlike higher fixed capitalstandards, which force financial institutionsto hold additional cash in a cookie jar fordecades for use in those rare moments ofmeltdown, and which induce greater risk tak-

ing by managers, catastrophe bonds pay offonly during instances of systemic riskwhenthe financial institutions really need capitaland cost much less in premiums during nor-mal times.

How would the catastrophe-bond resourcesbe invested to ensure that they could be con- verted into cash during a financial crisis? Toensure safety of principal and liquidity, U.S.treasuries seem to be a logical choice. The goodnews is that such insurance schemes wouldwork in the sense of creating stability among

financial firms. The bad news is that mandato-ry investments in treasuries will result inincreased consumption on the part of govern-ment rather than true investmentmuch asSocial Security trust-fund surpluses have beendissipated through additional governmentconsumption. Thus, future taxpayers, ratherthan private investors, would bear the financial

cost of servicing the bonds and amortizingthem to generate funds for bank bailouts whena crisis strikes.55 The support for catastrophebonds expressed by some economists over-looks the possibility that ex-post bailouts and

apparent prefunding through catastrophebonds may be equivalent.56

Conclusion

How should we design our financial andregulatory institutions? The lesson from the1970s was that rampant inflation andunchecked inflation expectations wouldeventually create obstacles to proper resourceallocation and growth. So we established the

Feds mandate to promote maximum growthwhile delivering price stability. The currentepisode suggests that the Feds current policygoals and instruments are not sufficient toprevent inflationary asset prices and priceexpectations.

The knee-jerk response by some observershas been to blame the Feds conduct of mone-tary policy. Some observers suggest that theFed should regulate financial companies moretightly, others that it should broaden the defi-nition of price stability to include asset prices

and yet others that the Feds objectives shouldbe broadened to include prevention of asset-price bubbles. Some observers, especiallyEuropean policymakers, have called for tighterregulation of financial institutions under anew global financial architecture. And theimmediate response of governments all overthe world has been to attempt to salvage theexisting financial institutions, instruments,and arrangements by injecting massive tax-payer funds into the financial companies thatare skirting economic collapse.

When will this process end and where willit lead? Recent government interventions havenow almost certainly created expectations ofsimilar future bailouts during the next finan-cial crisis. That means banking institutionswill feel more at ease in expending consider-able efforts at skirting whatever new regula-tions are created to prevent a similar financial

14

Any commitmentto separate riskyinvestment from

regulated bankingis unlikely to be

credible andtime-consistent.


15/20

crisis from recurring. Thus, the cat-and-mousegame of regulatory arbitrage in search of prof-its may intensify, rather than disappear, as aresult of adopting stricter financial regula-tions. But, for a time, stronger capital and risk

regulations may stifle financial intermedia-tion and slow the pace of recovery from thecurrent recession.

Some analysts are proposing the adoptionof smart regulations that are sequenced andmodulated according to movements in macro-economic variables such as the capital stan-dards that vary with the business cycle. Onecould call such regulatory measures financialautomatic stabilizers. However, as recent expe-rience with fiscal stimulus packages shows,political pressures prevent politicians from

leaving such systems well enough alone. Anywhiff of financial-sector problems will inciteCongress and Treasury bureaucrats to tinkerwith the rules. Which institutions and officialsare likely to be sufficiently prescient to correct-ly calibrate such regulations each time thefinancial sector hiccups? And would politi-cians be able to resist calls for regulatory reliefwhen financial sector lobbyists flood theiroffices as profit opportunities surge? Evenmore likely, any new regulatory attempt toglobally control profit-driven risk-taking will

spur new attempts to circumvent regulations.The key lesson from the current financial

crisis and recession is that a government-imposed financial architecture is unlikely topersist for any significant length of time.Global market developments, and the needto channel resources toward opportunitiesperceived to be the least risky and most prof-itable, will continue to modify institutionalfinancial arrangements. Imposing onerousfinancial regulations will only impede thereconstitution of financial institutions, delay

the recovery, and dampen the pace of long-term economic growth.

NotesWe wish to thank James Dorn, Angela Erickson,Thomas Firey, Chris Preble, John Samples, and

Jerry Taylor for their comments.

1. We do not discuss the role of Fannie Mae andFreddie Mac and the regulatory changes imposedby the Department of Housing and Urban Devel-opment during the Clinton administration. Thereis considerable controversy about whether Fannieand Freddie followed or led the market in creatingnew financial securities for lending to subprime

mortgage borrowers. See Charles Duhigg, Pres-sured to Take More Risk, Fannie Reached TippingPoint,New York Times, October 5, 2008, p. A1. Alsosee James Hamilton at http://www.econbrowser.com/archives/2008/10/cra_fannie_and.html.

2. Hybrid loans have fixed rates for an initial peri-od and are then indexed (adjustable) to marketinterest rates for the remainder of the mortgagecontract. Adjustable loans are indexed to marketrates from the beginning of the mortgage con-tract.

3. Tamar Frankel, Regulating the Financial Mar-kets by Examination, Boston University School ofLaw, Working Paper, February 2009, http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1339913;Ben Steil, Lessons of the Financial Crisis, Councilon Foreign Relations, March 2009, http://www.cfr.org/content/publications/attachments/Financial_Regulation_CSR45.pdf.

4. Suzanne Stewart and Ike Brannon, A CollapsingHousing Bubble?Regulation29, no. 1 (Spring 2006):1516.

5. Robert Van Order and Rose Neng Lai, A RegimeShift Model of the Recent Housing Bubble in theUnited States, University of Michigan, Ross School

of Business, Working Paper (November 2006): 45,http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1004803.

6. Jonathan McCarthy and Richard W. Peach,Are Home Prices the Next Bubble? Economic

Policy Review 10, no. 3 (December 2004): 1.

7. John V. Duca, How Vulnerable Are HousingPrices? Southwest Economy (March/April 2004): 1,11.

8. John V. Duca, Making Sense of ElevatedHousing Prices, Southwest Economy (September/October 2005): 9.

9. Alan Greenspan, Economic Outlook (testimo-ny before the Joint Economic Committee, U.S.Congress, June 9, 2005), http://www.federalreserve.gov/boarddocs/testimony/2005/200506092/default.htm.

10. Austan Goolsbee, Irreponsible MortgagesHave Opened Doors to Many of the Excluded,

New York Times, March 29, 2007, p. C3.

15


16/20

11. David Leonhardt, Be Warned, Mr. Bubble isWorried Again,New York Times, August 21, 2005,Sec. 3, p. 1.

12. Karl E. Case and Robert J. Shiller, Is There aBubble in the Housing Market? Brookings Paperson Economic Activity 2 (2003): 342.

13. Some economists still dispute the use of theterm bubble to describe housing prices in the ear-ly 21st century. James Kahn argues that housingprices do reflect fundamentals. Housing priceswent up after 1995 and down after 2007 because ofchanges in multifactor productivity growth, whichhe argues is a fundamental. James A. Kahn, Pro-ductivity Swings and Housing Prices, Federal

Reserve Bank of New York Current Issues (July 2009).

14. While prominent economists did not see thebubble or its demise, did the market see it coming?

Allen Ferrell argues that the market did not see thehousing downturn as a possibility until the fourth

quarter of 2007. Allen Ferrell and Atanu Saha,Securities Litigation and the Housing MarketDownturn, Journal of Corporation Law (forthcom-ing), http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1400998.

15. The Personal Consumption Expenditures PriceIndex (PCE_PI) uses variable rather than fixedweights to account for adjustments made by con-sumers in response to changes in relative priceswhich make it less variable than the ConsumerPrice Index (CPI).

16. The Federal Open Market Committee favors

the broader PCE_PI measure, which grew by lessthan 1 percent per year between early 2001 andearly 2007. These data are taken from the Bureauof Economic Analysis website: http://www.bea.gov/national/nipaweb/TableView.asp?SelectedTable=64&Freq=Qtr&FirstYear=2006&LastYear=2008.

17. Peter Wallison, Bear Facts: The Flawed Casefor Tighter Regulation of Securities Firms, AEIFinancial Services Outlook, April 2008, http://www.aei.org/docLib/20080411_22974FSOApril_g.pdf.

18. Alan Greenspan, The Fed Didnt Cause the

Housing Bubble, Wall Street Journal, March 11,2009, p. A15.

19. John B. Taylor, How Government Created theFinancial Crisis, Wall Street Journal, February 9,2009, p. A19. John B. Taylor, Getting Off Track: HowGovernment Actions and Interventions Caused, Pro-longed, and Worsened the Financial Crisis (Stanford,CA: Hoover Institution Press, 2009). Taylor doesnot blame the Fed alone. He also discusses the gov-

ernments prodding of Fannie Mae and FreddieMacgovernment-sponsored home-mortgage fi-nance companiesto expand their balance sheetsto make loans available to low-income householdsliving in poorer neighborhoods.

20. Gerald P. ODriscoll Jr., What Savings Glut?

Wall Street Journal, March 27, 2009, p. A13According to Gary Gorton, once the broad expectation of continuing home-price appreciation wasfirmly in place, financial innovations in the mort-gage market were designed to exploit and extractthose appreciations via loan contracts that com-pelled financial firm borrowers, who would thenlend to homebuyers, to refinance their contractsafter intervals as short as 18 months. Gary BGorton, The Panic of 2007,Federal Reserve Bank of

Kansas City Economic Policy Symposium 2008, p. 155.

21. The correlations are very similar when thetime period is restricted to 20032005.

22. We acknowledge that some may view the cor-relations shown in Table 1 as superficial evidenceabout the potential effects of federal funds ratechanges (monetary policy) on other market rates

A more complicated, and possibly more correctapproach would be to first isolate the exogenouscomponent of federal funds rate changes and cor-relate them with monetary-policy-induced com-ponents of changes in market interest ratesresidual changes after removing the effect ofother economic variables and shocks. But thesimple correlations shown in Table 1 appear to bebetter than the almost nonexistent empirical evi-dence on which the issue of whether monetary

policy was too lax during the early 21st century isbeing publicly debated.

23. Charles Himmelberg, Christopher Mayer, andTodd Sinai, Assessing High House PricesBubbles, Fundamentals, and Misperceptions,

Journal of Economic Perspectives 19, no. 4 (Fall 2005)6792.

24. George A. Akerlof and Robert J. Shiller,AnimalSpirits (Princeton: Princeton University Press2009).

25. Jagadeesh Gokhale, Financial Crisis and PublicPolicy, Cato Institute Policy Analysis no. 634,

March 23, 2009. James Hamilton, Causes and Con-sequences of the Oil Shock of 20072008,Brookings

Papers on Economic Activity (2009): 215261.

26. Eric Lipton and Stephen Labaton, Deregula-tor Looks Back, Unswayed, New York Times, No-

vember 17, 2008, p. A1. Binyamin Appelbaum andEllen Nakashima, Banking Regulator Played

Advocate over Enforcer, Washington Post, November23, 2008, p. A1.

16


17/20

27. Charles W. Calomiris, The Subprime Tur-moil: Whats Old, Whats New, and Whats Next,

American Enterprise Institute Paper, October 2008,p. 33, http://www.aei.org/paper/28720.

28. Randall Kroszner and Raghuram G. Rajan, Isthe Glass-Steagall Act Justified? A Study of the

U.S. Experience with Universal Banking Before1933, American Economic Review 84, no. 4,(September 1994): 81032.

29. Eugene White, Before the Glass-Steagall Act:An Analysis of the Investment Banking Activitiesof National Banks, Explorations in Economic

History 23, no. 1 (January 1986): 33-55.

30. James R. Barth, Dan Brumbaugh Jr., andJames Wilcox, The Repeal of Glass-Steagall andthe Advent of Broad Banking,Journal of Economic

Perspectives 14, no. 2 (Spring 2000): 191204.

31. Ellen Harshman, Fred C. Yeager, and Timothy

J. Yeager, The Door Is Open, but Banks Are Slowto Enter Insurance and Investment Arenas, Re-

gional Economist, October 2005, pp. 59.

32. Office of Inspector General, Securities andExchange Commission, SECs Oversight of BearStearns and Related Entities: The ConsolidatedSupervised Entity Program, September 25, 2008,p. ix, http://www.sec-oig.gov/Reports/AuditsInspections/2008/446-a.pdf.

33. Stephen Labaton, S.E.C. Concedes OversightFlaws Fueled Collapse, New York Times, Septem-ber 27, 2008, p. A1.

34. Charles Calomiris, Another DeregulationMyth, American Enterprise Institute, October2008, http://www.aei.org/publications/filter.all,pubID.28851/pub_detail.asp. Office of Inspector Gen-eral, Securities and Exchange Commission, SECsOversight of Bear Stearns and Regulated Entities.

35. Peter Wallison, Cause and Effect: Govern-ment Policies and the Financial Crisis, FinancialServices Outlook, American Enterprise Institute,November 2008, p. 8. Under Basel I, adequate cap-ital was considered to be 8% of assets.

36. Charles Calomiris, Another Deregulation

Myth, p. 1

37. Peter Goodman, Taking Hard New Look at aGreenspan Legacy, New York Times, October 9,2008, p. A1. Anthony Faiola, Ellen Nakashima,and Jill Drew, What Went Wrong, Washington

Post, October 15, 2008, p. A1.

38. Joe Nocera, Propping Up a House of Cards,New York Times, February 28, 2009, p. B1.

39. Eric Dash and Andrew Ross Sorkin, Throw-ing a Lifeline to a Troubled Giant, New YorkTimes, September 18, 2008, p. C1.

40. Peter Wallison, Everything You Wanted toKnow About Credit Default Swapsbut WereNever Told, Financial Services Outlook, American

Enterprise Institute, December 2008, p. 4.

41. Craig Pirrong, The Clearinghouse Cure,Regulation 31, no. 4 (Winter 20082009): 4451.

42. Remember that Austan Goolsbee reminded usthat well-working capital markets should providecapital to those who have a low income now, buthigher future income prospects, who invest inassets with good appreciation possibilities.

43. James R. Barth, et al., Mortgage Market Tur-moil: The Role of Interest-Rate Resets, Milkin In-stitute, December 2007, p. 2, http://www.milkeninstitute.org/pdf/Mortgage-Market-Turmoil.pdf.

44. Ibid., p. 4, Figure 4.

45. Christopher Mayer, Karen Pence, and Shane M.Sherlund, The Rise in Mortgage Defaults,Journalof Economic Perspectives 23, no. 1 (Winter 2009): 28.

46. Alan Greenspan, Remarks on Systemic Risk,American Enterprise Institute, June 3, 2009, http://www.aei.org/speech/100052.

47. Susan Wachter, Andrey Pavlov, and ZoltanPozsar, Subprime Lending and Real Estate Mar-kets, August 2008, p. 8, http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1319757.

48. Nicholas Kulish, Switzerland Rejects Inter-vention, Expecting Its Banks to Grow Stronger,New York Times, October 16, 2008, p. B11.

49. Nelson D. Schwartz, UBS Given an Infusion ofCapital,New York Times, October 17, 2008, p. B1.

50. See Christophe Chamley and Laurence J.Kotlikoff, Limited Purpose BankingPutting anEnd to Financial Crises, Financial Times, TheEconomists Forum, January 27, 2009. See also OzShy and Rune Stenbacka, Rethinking the Roles ofBanks: A Call for Narrow Banking, The Economists

Voice 5, no. 2 (February 2008); and Amar Bhid, InPraise of More Primitive Finance, The EconomistsVoice 6, no. 3 (February, 2009).

51. Gary Gorton, Slapped in the Face by theInvisible Hand: Banking and the Panic of 2007(paper presented at the Federal Reserve Bank of

Atlantas 2009 Financial Markets Conference, May2009), http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1401882.

17


18/20

52. John V. Duca, Danielle DiMartino, and Jessica J.Renier, Fed Confronts Financial Crisis by Ex-panding Its Role as Lender of Last Resort, Federal

Reserve Bank of Dallas Economic Letter4, no. 2(February/March 2009): 5.

53. In fact, bank lending actually increased in

December 2008 relative to December 2007, butsecuritized lending has fallen drastically. SeeRobert Samuelson, Beyond Wall-Street Bashing,Washington Post, February 9, 2009, p. A17.

54. Amil K. Kashyap, Raghuram G. Rajan, andJeremy C. Stein, Rethinking Capital Regulation, Federal Reserve Bank of Kansas City Economic PolicySymposium 2008, p. 435, http://www.kc.frb.org/home/subwebnav.cfm?level=3&theID=10976&SubWeb=10660.

55. The evidence comes from the proceeds from

the 1983 Social Security tax increase. The rev-enues from the tax increase were invested by theSocial Security Trust Fund in treasuries and theresult was increased consumption rather thaninvestment. Kent Smetters, Is the Social SecurityTrust Fund Worth Anything? National Bureauof Economic Research, Working Paper 9845, July

2003.

56. Bailouts and catastrophe bonds are equivalentonly in the sense that taxpayers pay the bill. Theyare not equivalent in terms of moral hazard.Government bailouts dull the incentives for pri-

vate insurance arrangements such as catastrophebonds. If the government can precommit not tobail out those institutions that fail to utilize cata-strophe bonds in their capital structure, and arobust catastrophe bond market develops, thensuch bonds could provide superior protectionagainst systemic risk.

STUDIES IN THE POLICY ANALYSIS SERIES

647. Why Sustainability Standards for Biofuel Production Make LittleEconomic Sense by Harry de Gorter and David R. Just (October 7, 2009)

646. How Urban Planners Caused the Housing Bubble by Randal OToole(October 1, 2009)

645. Vallejo Con Dios: Why Public Sector Unionism Is a Bad Deal forTaxpayers and Representative Government by Don Bellante, David

Denholm, and Ivan Osorio (September 28, 2009)

644. Getting What You Paid ForPaying For What You Get Proposals for theNext Transportation Reauthorization by Randal OToole (September 15, 2009)

643. Halfway to Where? Answering the Key Questions of Health Care Reformby Michael Tanner (September 9, 2009)

642. Fannie Med? Why a Public Option Is Hazardous to Your Health byMichael F. Cannon (July 27, 2009)

641. The Poverty of Preschool Promises: Saving Children and Money with theEarly Education Tax Credit by Adam B. Schaeffer (August 3, 2009)

640. Thinking Clearly about Economic Inequalityby Will Wilkinson (July 14, 2009)

639. Broadcast Localism and the Lessons of the Fairness Doctrine by JohnSamples (May 27, 2009)


19/20

638. Obamacare to Come: Seven Bad Ideas for Health Care Reformby Michael Tanner (May 21, 2009)

637. Bright Lines and Bailouts: To Bail or Not To Bail, That Is the Questionby Vern McKinley and Gary Gegenheimer (April 21, 2009)

636. Pakistan and the Future of U.S. Policyby Malou Innocent (April 13, 2009)

635. NATO at 60: A Hollow Alliance by Ted Galen Carpenter (March 30, 2009)

634. Financial Crisis and Public Policyby Jagadeesh Gokhale (March 23, 2009)

633. Health-Status Insurance: How Markets Can Provide Health Securityby John H. Cochrane (February 18, 2009)

632. A Better Way to Generate and Use Comparative-Effectiveness Research

by Michael F. Cannon (February 6, 2009)

631. Troubled Neighbor: Mexicos Drug Violence Poses a Threat to theUnited States by Ted Galen Carpenter (February 2, 2009)

630. A Matter of Trust: Why Congress Should Turn Federal Lands intoFiduciary Trusts by Randal OToole (January 15, 2009)

629. Unbearable Burden? Living and Paying Student Loans as a First-YearTeacher by Neal McCluskey (December 15, 2008)

628. The Case against Government Intervention in Energy Markets:Revisited Once Again by Richard L. Gordon (December 1, 2008)

627. A Federal Renewable Electricity Requirement: Whats Not to Like?by Robert J. Michaels (November 13, 2008)

626. The Durable Internet: Preserving Network Neutrality withoutRegulation by Timothy B. Lee (November 12, 2008)

625. High-Speed Rail: The Wrong Road for America by Randal OToole

(October 31, 2008)

624. Fiscal Policy Report Card on Americas Governors: 2008 by Chris Edwards(October 20, 2008)

623. Two Kinds of Change: Comparing the Candidates on Foreign Policyby Justin Logan (October 14, 2008)


20/20

622. A Critique of the National Popular Vote Plan for Electing the Presidentby John Samples (October 13, 2008)

621. Medical Licensing: An Obstacle to Affordable, Quality Care by ShirleySvorny (September 17, 2008)

620. Markets vs. Monopolies in Education: A Global Review of the Evidenceby Andrew J. Coulson (September 10, 2008)

619. Executive Pay: Regulation vs. Market Competition by Ira T. Kay and StevenVan Putten (September 10, 2008)

618. The Fiscal Impact of a Large-Scale Education Tax Credit Program byAndrew J. Coulson with a Technical Appendix by Anca M. Cotet (July 1, 2008)

617. Roadmap to Gridlock: The Failure of Long-Range Metropolitan

Transportation Planning by Randal OToole (May 27, 2008)

616. Dismal Science: The Shortcomings of U.S. School Choice Research andHow to Address Them by John Merrifield (April 16, 2008)

615. Does Rail Transit Save Energy or Reduce Greenhouse Gas Emissions? byRandal OToole (April 14, 2008)

614. Organ Sales and Moral Travails: Lessons from the Living Kidney VendorProgram in Iran by Benjamin E. Hippen (March 20, 2008)

613. The Grass Is Not Always Greener: A Look at National Health CareSystems Around the World by Michael Tanner (March 18, 2008)

612. Electronic Employment Eligibility Verification: Franz Kafkas Solutionto Illegal Immigration by Jim Harper (March 5, 2008)

611. Parting with Illusions: Developing a Realistic Approach to Relationswith Russia by Nikolas Gvosdev (February 29, 2008)

610. Learning the Right Lessons from Iraq by Benjamin H. Friedman,

Harvey M. Sapolsky, and Christopher Preble (February 13, 2008)

609. What to Do about Climate Change by Indur M. Goklany (February 5, 2008)

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