Wednesday, February 17, 2010

How government regulators help create financial crises and Great Recessions 

Greece is facing default on its debt as it runs a deficit of 13% of GDP. Not that this is an unfamiliar position for it, "Greece has been in default roughly one out of every two years since it first gained independence in the nineteenth century" -- Ken Rogoff

And default in Greece threatens the entire European banking system, as most of Greece's IOUs are held by major European banks that have already been hammered by the recession and Europe's own housing bubble collapse -- and which thus are in no condition to absorb a national default. There are serious worries that this could create Round #2 of the Great Recession, with very bad consequences all about.

But a question arises: In light of Greece's sorry fiscal history -- in default for half of its modern national existence! -- why would banks be so reckless as to load up on Greek national debt like this? Market failure? Short-sighted bankers made stupid by greed?

No ... because government regulators effectively paid them to do it!

Under the "Basel Accords" that set international capital standards for the banking industry -- with the intention of making it safer, by assuring banks have adequate capital behind their investments -- "sovereign debt" of EU nations is deemed the safest investment of all, requiring no bank capital to back it up.

So imagine you were a bank with a finite amount of money to lend, and were considering making either a commercial loan to a business or a loan to a sovereign government. Under the Basel rules, if you make a loan to the commercial business it is deemed "risky" so you have to set aside an amount equal to 8% of its value in your capital account, in case something goes wrong with it. But a loan to a sovereign European government is considered risk-free so you need set aside nothing, 0%, in your capital account, to cover it.

Obviously, that is a pretty strong incentive to make "safe" loans to the government, as it saves you 8% of your funds that you can then use elsewhere to make money -- such as by making more loans to that safe government. You might even load up on safe loans to the government.

Except that government is Greece. Oooops.

Now, how about here in the U.S. and the home price bubble-and-bust that triggered our financial crisis and the entire Great Recession?

Well, the curious thing is that asset prices bubble up-and-burst frequently without causing any kind of financial crisis or major recession. The stock market bubble of 1998-2001 was huge, but caused no financial crisis at all and only the most modest of recessions.

The difference this time was that securitized mortgage instruments (not mortgages themselves, but the securities made of them) were major bank investments -- very unlike stocks in 2001. So when the value of these securities collapsed or became indeterminate in an illiquid market, the solvency of many major banks was threatened, and there was a world-wide "bank run"

But why were banks so heavily invested in these securities? Again -- just as with Greek bonds -- because regulators drove them to be so.

While under Basel rules a commercial loan required 8% backup in capital, an investment in securitized mortgage loans carried only a "20% risk weight" and so required only a 1.6% holding in capital (with investment in unsecuritized mortgages requiring over twice as much: 4%).

This made perfect sense. After all, home mortgages had long been near the most safe of all investments -- because lenders required significant down payments on top of imposing stringent credit requirements on borrowers. And securitized mortgages were even safer, because they represented broadly diversified portfolios of mortgage holdings.

This mere under 2% capital requirement greatly increased bank demand for securitized mortgage investments. And that in turn increased the profitability to mortgage lenders of originating mortgages and selling the securities made of them.

How would mortgage originators -- including the banks themselves -- take advantage of this increased demand for mortgages? By originating more mortgages, via eliminating down payment requirements and stringent credit checks, and thus creating the new "Zero down payment subprime and liar loans!"

And these were then driven en masse into the banks' capital structures though their huge investments in securitized mortgages -- because they were deemed so "safe" by the Basel regulators who directed by incentives the major flow of bank investments into them. Oooops!

Is this the whole story of the financial crisis and the Great Recession. Of course not. Is it a significant part? Seems so.

For more thorough analysis along these lines see here, plus a note on Greece.

Lessons: Beware "the law of unintended consequences" ... Beware special interests who capture and co-opt regulators for their own gain (poor-credit governments like Greece who as part of the deal creating international bank capital regulation get the highest possible credit rating treatment for their own borrowing) ... Beware believing regulators know more than anyone else, or are more competent than anyone else, or operate with purer and less self-interested motives than anyone else.

The Economist:
Alas, the record of bank-capital rules is crushingly bad. The Basel regime (European and American banks use either version 1 or 2) represents a monumental, decades-long effort at perfection, with minimum capital requirements carefully calculated from detailed formulae. The answers were precisely wrong. Five days before its bankruptcy Lehman Brothers boasted a “Tier 1” capital ratio of 11%, almost three times the regulatory minimum.
"Who will regulate the regulators?"