Talk by Frederick Scherer: Deregulatory Roots of the Current Financial Crisis

Last Thursday I attended a talk by Frederick Scherer at the [Judge] entitled: “Deregulatory Roots of the Current Financial Crisis”. Below are some sketchy notes.

Notes

Macro story:

• Huge current account deficit for last 10-15 years
  • Expansionary Fed policy has permitted this to happen while interest rates are low
• Median real income has not risen since the mid-1970s
  • Cheap money mean personal savings have dropped consistently: 1970s ~ 7%, 2000s ~ 1%
• Basically overconsumption

Micro story:

• Back in the old days, banking was very dull — three threes story, “One reason I never worked in the financial industry: it was very dull when I got my MBA in 1958″
• S&L story of 1980s: inflation squeeze + Reagan deregulation
  • FMs: Fannie Mae, Freddie Mac get more prominent
  • [Ed]: main focus here was on pressure for S&L to find better returns without much mention of the thoughtlessness of Reagan deregulatory approach (deposits still insured but S&L can now invest in anything) and the fraud and waste it engendered — see “Big Money Crime: Fraud and Politics in the Savings and Loan Crisis” by Kitty Calavita, Henry N. Pontell, and Robert Tillman
• In 1920s there were $2 billion of securitized mortgages (securitazation before the 1980s!)
• Market vs. bank finance for mortgages: market more than bank by mid-1980s [ed: I think -- graph hard to read]
• To start with: FMs pretty tough when giving mortgages, but with new securitizers and lots of cheap money, standards dropped => moral hazard for issuers [ed: not quite sure why this is moral hazard -- securitizers aren't the ones who should care, it's the buyers who should care]
• Even if issuers don’t care, buyers of securitized mortgages should care and they depended on ratings agencies (Moodys, S&P etc)
• Unfortunately, ratings agencies had serious conflicts of interest as they were paid to do ratings by firms issuing the securities! Result: ratings weren’t done well
• Worse: people ignored systemic risk in the housing market and therefore made far too low assessment of risk of these securities [ed: ignoring systemic risks implies underestimating correlations -- especially for negative changes -- between different mortgage types (geographic, owner-type etc). Interesting here to go back and read the quarterly statement from FM in summer 2008 which claims exactly this underestimate.]
• Banks over-leveraged for the classic reason (it raises your profits if things are good — but you can get wiped out if things are bad)
  • This made banks very profitable: by mid 2000s financial corporations accounted for 30% of all US corporate profits
  • Huge and (unjustified relative to other sectors) wage levels. Fascinating evidence here provide by correlating wage premia to deregulation: fig 6 from Philippson and Reshi shows dramatic association of wage premium (corrected for observable skills) with (de)regulation. Wage premium goes from ~1.6 in 1920s to <1.1 in 1960s and 70s and then back up to 1.6/1.7 in mid 2000s
• Credit default swaps and default insurance: not entirely new but doubled every year from 2001 to the present ($919 billion in 2001 to $62.2 trillion in 2007)
  • Much of the time CDS issued without any holding of the underlying asset
  • There was discussion on regulating CDSes in 1990s (blue-ribbon panel reported in 1998) but due to shenanigans in the house and senate led by Phil Graham (husband of Wendy Graham who was head of Commodity Futures … Board), CDSes were entirely deregulated via act tacked onto Health-Education-Appropriations bill in 2001.

It goes bad:

• Housing bubble breaks in 2007 or even 2006
  • Notices of default starts trending upwards in mid 2006
• [ran out of time]

What is to be done:

• Need simple, clear rules
  • A regulator cannot monitor everything day-to-day
• Outlaw Credit Default Swaps
• Anyone who issues CDOs must “keep skin in the game”
• Leverage ratios. Perhaps? Hard to regulate.
• Deal with too big to fail by making it hard for “giants to form” and breaking up existing over-large conglomerates
• We need to remember history!

Own Comments

This was an excellent presentation though, as was intended, it was more a summary of existing material than a presentation of anything “new”.

Not sure I was convinced by the “remember history” logic. It is always easy to be wise after the event and say “Oh look how similar this all was to 1929″. However, not only is this unconvincing analytically — it is really hard to fit trends in advance with any precision (every business cycle is different), but before the event there are always plenty of people (and lobbyists) arguing that everything is fine and we shouldn’t interfere. Summary: Awareness of history is all very well but it does not provide anything like the precision to support pre-emptive action. As such it is not really clear what “awareness of history” buys us.

More convincing to me (and one could argue this still has some “awareness of history in it) are actions like the following:

1. Worry about incentives in general and the principal-agent problem in particular. Try to ensure long-termism and prevent overly short-term and high-powered contracts (which essentially end up looking like an call option).

   Since incentives can be hard to regulate directly one may need to work via legislation that affects the general structure of the industry (e.g. Glass-Stegall).

   Summary: banking should be a reasonably dull profession with skill-adjusted wage rates similar to other sectors of the economy. If things get too exciting it is an indicator that incentives are out of line and things are likely to go wrong (quite apart from the inefficiency of having all those smart people pricing derivatives rather than doing something else!)

2. Be cautious regarding financial innovation especially where new products are complex. New products have little “track record” on which to base assessments of their benefits and risks and complexity makes this worse.

   In particular, complexity worsens the principal-agent problem for “regulators” both within and outside firms (how can I decide what bonus you deserve if I don’t understand the riskiness and payoff structure of the products you’ve sold?). Valuation of many financial products such as derivatives depend heavily — and subtly — on assumptions regarding the distribution of returns of underlying assets (stocks, bonds etc).

   If it is not clear what innovation — and complexity — are buying us we should steer clear, or at least be very cautious. As Scherer pointed out (in response to a question), there is little evidence that the explosion in variety and complexity of financial products since the 80s has actually done anything to make finance more efficient, e.g. by reducing the cost of capital to firms. Of course, it is very difficult to assess the benefits of innovation in any industry, let alone finance, but the basic point that 1940s through 1970s (dull banking) saw as much “growth” in the real economy as the 1980s-2000s (exciting banking) should make us think twice about how much complexity and innovation we need in financial products.

Finally, and on a more theoretical note, I’d also like to have seen more discussion about exactly why standard backward recursion/rational market logic fails here and what implications do the answers have for markets and their regulation. In particular, one would like to know doesn’t knowledge of a bubbles existence in period T lead to its unwinding (and hence by backward recursion to its unwinding in period T-1, and then T-2 etc until the bubble never existed). There are various answers to this in the literature based on things like herding, presence of noise investors, uncertainty about termination, but it would be good to have a summary, especially as regards welfare implications (are bubbles good?), and what policy interventions different theories prescribe.