Free Our Markets

by Howard Baetjer Jr

  you will continue to lend even as your gambler friend becomes more leveraged.

  you will not require that your friend put in more of his own money and less of yours as he makes riskier and riskier bets.

  What will your friend do when you behave this way? He’ll take more risks than he would normally. Why wouldn’t he? He doesn’t have much skin in the game in the first place. You do, but your incentive to protect your money goes down when you have Uncle Sam as a potential backstop.

  Capitalism is a profit and loss system. The profits encourage risk taking. The losses encourage prudence. Eliminate losses or even raise the chance that there will be no losses and you get less prudence. So when public decisions reduce losses, it isn’t surprising that people are more reckless.

  Roberts holds that the expectation of rescue induced creditors to lend too liberally and borrowers to make the very risky housing bets that went bad. The tremendous amount of borrowing induced by creditors’ expectation of rescue if things went bad was another necessary condition of the financial fiasco:

  Without extreme leverage, the housing meltdown would have been like the meltdown in high-tech stocks in 2001—a bad set of events in one corner of a very large and diversified economy. Firms that invested in that corner would have had a bad quarter or a bad year. But because of the amount of leverage that was used, the firms that invested in housing—Fannie Mae and Freddie Mac, Bear Stearns, Lehman Brothers, Merrill Lynch, and others—destroyed themselves.

  Is it reasonable to believe that creditors in general expected rescue in the event of big financial trouble? Roberts makes a strong case that the record of the last twenty-five years supported such an expectation:

  In 1984, the government rescued

  Continental Illinois, then one of the top ten banks in the United States … before it could fail. … In the government rescue, the government took on $4.5 billion of bad loans. … Only 10 percent of the bank’s deposits were insured, but every depositor was covered in the rescue [emphasis added].

  That last is very significant; even the 90 percent of deposits in Continental Illinois not eligible for FDIC insurance were paid off with taxpayers’ money.

  Irvine Sprague reported a rash of rescues in his 1986 book, Bailout, here quoted by Roberts:

  Of the fifty largest bank failures in history, forty-six—including the top twenty—were handled either through a pure bailout or an FDIC assisted transaction where no depositor or creditor, insured or uninsured, lost a penny.

  Of the drawn-out collapse of the savings and loan industry through the 1980’s, Roberts writes,

  [The] government repeatedly sent the same message: lenders and creditors would get all of their money back. Between 1979 and 1989, 1,100 commercial banks failed. Out of all of their deposits, 99.7 percent, insured or uninsured, were reimbursed by policy decisions.

  In 1990, the government actually let a big financial firm fail without rescuing its creditors. The firm was Drexel Burnham. “The failure to rescue Drexel put some threat of loss back into the system,” says Roberts, “but maybe not very much—Drexel Burnham was a political pariah. The firm and its employees had numerous convictions for securities fraud and other violations.”

  In 1995, there was another rescue, not of a financial institution, but of a country—Mexico. The United States orchestrated a $50 billion rescue of the Mexican government, but as in the case of Continental Illinois, it was really a rescue of the creditors, those who had bought Mexican bonds and who faced large losses if Mexico were to default.

  In 1998, “Long-Term Capital Management (LTCM), a highly leveraged private hedge fund,” faced insolvency when billions of dollars’ worth of its investment bets went bad. Although the government did not use any taxpayer money to rescue LTCM, it did call a “voluntary” meeting of LTCM’s creditors, in which they agreed to take 90 percent ownership of LTCM in exchange for $3.625 billion of rescue funds. Roberts says,

  Ultimately, LTCM died. While creditors were damaged, the losses were much smaller than they would have been in a bankruptcy. No government money was involved. Yet the rescue of LTCM did send a signal that the government would try to prevent bankruptcy and creditor losses.

  In short, from the troubles of Continental Illinois to the beginnings of the current financial mess, the government let the creditors of only one major firm (Drexel Burnham) lose their loans to an insolvent major financial firm. Roberts reasons that “[g]iven the systematic rescue of creditors in recent decades, it is hard to believe that the strong possibility of rescue did not play a role in the increasing amounts of leverage and risk” that characterized the housing boom and made the financial mess so big.

  If creditors of the big players financing the housing boom did expect to be rescued should those big players get into trouble, they got it right in every case but that of Lehman Brothers:

  That brings us to the current mess that began in March 2008 ... The government played matchmaker and helped Bear Stearns get married to J. P. Morgan Chase. The government essentially nationalized Fannie and Freddie, placing them into conservatorship, honoring their debts, and funding their ongoing operations through the Federal Reserve. The government bought a large stake in AIG and honored all of its obligations at 100 cents on the dollar. The government funneled money to many commercial banks.

  Each case seems different. But there is a pattern. Each time, the stockholders in these firms are either wiped out or see their investments reduced to a trivial fraction of what they were before. The bondholders and lenders are left untouched. In every case other than that of Lehman Brothers, bondholders and lenders received everything they were promised: 100 cents on the dollar. Many of the poker players—and almost all of those who financed the poker players—lived to fight another day. It’s the same story as Continental Illinois, Mexico, and LTCM—a complete rescue of creditors and lenders.

  The only exception to the rescue pattern was Lehman.

  Even the case of Lehman, however, supports Roberts’s thesis that creditors expected rescue. “The balance sheet at Lehman looked a lot like the balance sheet at Bear Stearns—lots of subprime securities and lots of leverage.” Accordingly, after the collapse of Bear Stearns many expected Lehman to collapse as well. Nevertheless, Lehman was able to continue borrowing. Think what this means: lenders were willing to lend to a firm that was likely to collapse and be unable to pay them back! Roberts asks, “How did [Lehman] keep borrowing at all given the collapse of Bear Stearns?” The answer must be that lenders “expected a rescue in the worst-case scenario.”

  To sum up:

  Depositors at the many banks making shaky mortgage loans or buying subprime mortgage-backed securities knew they’d be rescued by the FDIC if their banks’ investments failed, so they kept their deposits there anyway and took no actions to find out about, much less discipline, the banks’ risky investing.

  Large institutions, banks, and foreign governments that bought the bonds that financed Fannie Mae’s and Freddie Mac’s purchases of shaky mortgages and subprime mortgage-backed securities were almost certain—and certainly correct—that they’d be rescued by the U.S. government if Fannie and Freddie could not pay them back, so they kept buying Fannie and Freddie’s bonds and mortgage-backed securities.

  Lenders to Bear Stearns, Lehman Brothers, and other major private-label securitizers, who financed those firms’ purchases of billions of dollars’ worth of shaky mortgages that they bundled into mortgage-backed securities, had good reason to expect that they’d be rescued by the government if financial disaster occurred, so they kept lending to Bear Stearns, Lehman, and the others long after the risks became evident. (They lost confidence in Bear Stearns in March of 2008 and Lehman in September of 2008, but even so, the government made sure Bear Stearns’s creditors received 100 cents on every dollar they were owed.)

  As Chapter 2 stresses, profit is society’s indispensable means of rewarding the goods and services—and investments—that create value for people; loss is society
’s indispensable means of eliminating those that destroy value. Over the years, the government has protected creditors from losses their loans have earned, and doing so has systematically obstructed the healthy process by which losses clear bad investments out of the economy. And it was certainly a major culprit in creating the boom, bust, and financial mess. In Roberts’s words, “public policy over the last three decades has distorted the natural feedback loops of profit and loss.” For Roberts, this rescuing of creditors is the primary cause of the financial fiasco of 2008 and afterwards:

  The most culpable policy has been the systematic encouragement of imprudent borrowing and lending. That encouragement came not from capitalism or markets, but from crony capitalism, the mutual aid society where Washington takes care of Wall Street and Wall Street returns the favor. Over the last three decades, public policy has systematically reduced the risk of making bad loans to risky investors. Over the last three decades, when large financial institutions have gotten into trouble, the government has almost always rescued their bondholders and creditors. These policies have created incentives both to borrow and to lend recklessly.

  What government interventions generated the housing boom of 1997 to 2007? The culprits include special tax treatment of capital gains on housing, Congress’s requirement that Fannie and Freddie buy large quantities of shaky mortgages, the Fed’s creation of great quantities of new loanable funds in the absence of new investable resources, and the crony-capitalist protection of lenders just discussed. The unsustainable boom these interventions combined to create had to end in a painful bust. But the story didn’t end there, because after the housing bust came a financial crisis.

  Why?

  Chapter Twelve

  Why the Housing Bust Led to a Financial Crisis

  The interventions in mortgage-making and in money that we have discussed so far help to explain the housing boom and bust. But the bursting of an asset bubble does not always, or even usually, lead to a financial crisis. The dot-com bust did not. The stock market crash of 1987 did not. Why did the housing bust lead to financial turmoil?

  Intervention #6 - The Basel Bank Capital Restrictions

  It did so because so many banks and investment banks had invested heavily in mortgage-backed securities (MBSs). When the housing boom went bust, the banks holding all these MBSs were threatened with insolvency. But why were banks holding so many MBSs, including “toxic” subprime and low-down-payment mortgage-backed securities? After all, they were not holding a lot of technology stocks when the dot-com boom went bust. What made the difference this time around?

  Mortgage-backed securities are not inherently problematical. In a healthy economy, they serve the useful function of allowing banks to pass off to others the risk of investment in housing. When banks sell a pool of their mortgages to a securitizer, who then sells the MBSs to lots of different institutional investors, banks become less exposed to the risks of housing, not more, and the risk is spread among many different investors. But as it transpired, many banks themselves purchased a lot of the MBSs that securitizers had created. Indeed, banks purchased a disproportionate share of them. U.S. commercial banks by 2008 owned about thirty percent of all AAA-rated MBSs held in the U.S. (apart from those held by Fannie, Freddie, and the Federal Home Loan Bank). As a proportion of their total assets, U.S. banks invested in AAA-rated MBSs at a rate three times higher than that of non-bank investors. Accordingly, when the housing boom went bust and the MBSs lost value, the banks holding them got in trouble. That is why the problems in the housing industry caused problems in the financial industry. Banks had loaded up on MBSs, many of which turned out to be “toxic.”

  Why did they do that?

  They were pushed to do it by well-intended but misguided government intervention: restrictions on banks’ freedom to decide the kinds and amounts of capital they hold. Bank capital functions essentially as a cushion against unexpectedly large losses. (For an explanation of what bank capital is, and why it matters, please see Appendix B.) The kinds and amounts of capital banks must hold are mandated by the Basel capital adequacy rules, named for the Swiss city where they were developed (and are even now being revised again) in an international accord. Those rules linked the housing and financial markets by giving banks strong incentives to buy mortgage-backed securities.

  But let us step back a moment. Why does the U.S. government regulate American banks’ capital in the first place, instead of leaving that to market forces? It does so because of still another, earlier intervention (Intervention #7, to be discussed later in this chapter), the government’s insuring of deposits (up to $250,000) through the Federal Deposit Insurance Corporation (FDIC). Ultimately taxpayers’ money stands behind the FDIC’s insurance fund, so the government arguably has an obligation to those taxpayers to require insured banks to maintain a capital cushion adequate to absorb unexpected, large losses. That way the banks are less likely to fail, so the taxpayers are less likely to have to pay.

  But how much capital—and what kinds—are adequate? When governments take over capital regulation from market forces, regulators—imperfect human beings—must specifically answer those questions and impose their answers on all the banks they regulate. That’s a problem: if the regulators require a bad approach due to poor judgment or simple ignorance on their part, all banks must take that bad approach. That’s what happened, as we’ll see.

  Bank capital requirements are another case of well-intentioned restrictions on freedom of exchange. In a free economy, banks would be free to exchange their services with willing customers while holding any amount and description of capital they choose—or, indeed, no capital at all—so long as they do so without fraud and they honor their contracts. Of course, in a market free of tax-backed deposit insurance, banks suspected to have insufficient capital would have a hard time attracting customers.

  While government restrictions on the kinds and quantities of capital maintained by banks may be well intended, those restrictions block the operation of the Profit-and-Loss Guidance Principle: It makes it impossible for bankers and their insurers to discover, in an on-going process of entrepreneurial innovation and profit-and-loss selection, the different quantities, kinds and combinations of bank capital that sufficiently hold down the chances of insolvency. In place of that free-market discovery process, government regulation gives us a set of directives issued by a small number of legislators and agency officials, each of whom has only a limited view and understanding of the complex, dynamic system he is interfering with. Those directives are imposed on all banks and fixed until legislation or bureaucratic rule-making changes them.

  A good system for regulating bank capital cannot be achieved by such top-down design any more than can a good system for regulating the safety and efficacy of hairdressing or pharmaceuticals, as we saw in Chapters 5 and 6. No group of financial system planners can possibly know enough to come up with a good design. There is too much to know—too many factors interact: there is too much change, too much accident, too many different ways in which regulations and innovations and outside factors may interact—for anyone to know for sure what to allow and what to forbid.

  F.A. Hayek wrote, “The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.” When a system of restrictions is designed centrally, as was the Basel Accord, and imposed on enterprisers trying to cope with an uncertain world, more harm than good usually results. Such is the case with the Basel rules: their intended positive consequences are swamped by their unintended negative consequences.

  The Basel Rules

  The Basel rules, those known as Basel I, which were in place during the housing boom and bust and the onset of the financial mess, were implemented in the U.S. in 1991, and importantly amended ten years later in the United States by what is known as the “Recourse Rule.” How the Basel rules induced banks to load up on mortgage-backed securities is crucial to understanding the financial fiasco, and it is also a
great illustration of how well-intended regulation can do more harm than good through its unintended consequences.

  A bank’s “capital ratio,” in general terms, is the ratio of a bank’s capital to its assets (we’ll tighten the definition below). Capital adequacy rules such as the Basel rules have the worthy intention of making sure banks have big enough capital cushions to keep them solvent even if a lot of their assets go bad. But how much capital is enough?

  In the United States, the Federal Deposit Insurance Act gives the government’s answer to this question by restricting banks’ freedom of action more or less depending on their capital ratios.

  Accordingly, this ratio is very important to banks.

  Banking is one of the most highly regulated industries in the United States. Even when a bank is in good standing with its regulators because its capital ratio is high, coping with regulation is time-consuming and expensive, requiring bank employees to do paperwork for the government rather than create value for their customers. But when a bank gets into trouble as its capital ratio falls, its regulators, just doing their jobs, become increasingly intrusive and restrictive. The regulatory burden becomes suffocating.

  To appreciate the importance of the capital ratio, imagine that you are the manager of a bank and consider what it would mean to the tranquility of your life, not to mention the health of your bank, to have your bank at the different capital levels specified in the Federal Deposit Insurance Act (we’ll see how the percentages are calculated shortly).

  As long as your capital ratio is 10 percent or greater, your bank is considered “well capitalized;” accordingly your bank enjoys full privileges.