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Tuesday, July 14, 2009

The Case for Regulation (Not Deregulation) Causing the Financial Crisis

Introduction: In response to a comment, I want to make it clear that I don't blame regulation exclusively for the crisis. The crisis is a confluence of events. Here is my thesis. The reason for this piece is NOT to claim that regulation is the cause. More than that, as our policy makers debate new regulations, I want to point out how prior regulation turned counter productive as a frame for future regulations.

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Right after the mortgage crisis occurred, I bet most of the layman in the country got a quick lesson in the complicated nature that is our mortgage market. For instance, I'm sure that most folks thought that the banks that approved your loans also were the ones that kept them and made money on them. That's not so in the majority of cases because of a process known as mortgage securitization. In this process, a financial firm bundles hundreds, thousands, and even tens of thousands of loans together turn them into bonds and sell them on trading markets. We've learned that those that securitized often put far too many risky loans together with less risky loans. In fact, we've learned that credit cards were bundled together with loans. We've learned that there was so much excess in loan securitization that it was really nearly impossible to measure just how risky the end bundled products were.

Here's a question very few people have asked. Why would banks need to sell these loans so that someone else could securitize them? The process of securitization has all sorts of positive effects in the market. For instance, it keeps banks liquid so that they have more money to lend to new people. Without securitization, a lot less people would qualify for loans. It also spreads interest rate risk. Finally, it takes advantage of economies of scale to create lower rates.

So, why wouldn't banks merely securitize the loans themselves and turn them into bonds? After all, banks are sophisticated financial institutions with plenty of capital. The reason lies in a law first created in response to the depression, the Glass Steagall Act. This was a sweeping piece of legislation but the pertinent portion, for this discussion, mandated that there be a wall between commercial banks and investment banks. As such, if a bank lent money, it couldn't also be involved in investment activities, like mortgage securitization.

The irony is that at the time of the act there was no such thing as mortgage securitization. That wasn't created until later first by Congress itself through the creation of Fannie Mae, and later Freddie Mac, and then by Lew Ranieri, through Mortgage Backed Securities. Here's the logic behind this portion of the act.

In the nineteenth and early twentieth centuries, bankers and brokers were sometimes indistinguishable. Then, in the Great Depression after 1929, Congress examined the mixing of the “commercial” and “investment” banking industries that occurred in the 1920s. Hearings revealed conflicts of interest and fraud in some banking institutions’ securities activities. A formidable barrier to the mixing of these activities was then set up by the Glass Steagall Act.

Regulations often have a way of solving one problem by merely creating another one. Yes, there was fraud and conflicts in banks that did many different activities all at once. Yet, as financial products became more sophisticated, Glass Steagall forced multiple financial institutions to work together to create these sophisticated products. Glass Steagall was ironically enough repealed largely in 1999, but by then, our system of financial lending and securitization had already been designed and functioning in a manner that responded to the original Glass Steagall legislation.

Think of this as the story I tell you, you tell your friend, and so on. What started as me going to the ball game winds up as me partying with twelve strippers. It's the same thing here. Because sophisticated financial products had to pass through so many hands in order to comply with Glass Steagall, the end product was a perversion of what was meant to be created. Because one entity would underwrite the loans and another would securitize and package the loans, this made it much easier for the end product to pervert itself from its desired effect. These securitizers would often buy loans, credit card portfolios, and other debt instruments from many banks all at once. Then, they would be mixed and matched into a financial instrument who's risk was difficult to determine.

That would have been a lot less likely if the same bank that underwrote the loan was also the one that securitized the loan. Yet, it was government regulation that forced this to not be an option. First, Glass Steagall created a barrier between banks and securitizers. This forced an extra layer of financial firms in the process. Then, the creation of Fannie/Freddie meant that two securitizers would dominate the prime market. Ultimately, it was this layering of the creation of the financial product that contributed to the system's downfall much more than any supposed deregulation.

2 comments:

Rick Tan said...

I have trouble believing your thesis, that the Glass-Steagall Act was responsible for the financial crisis.

The Glass-Steagall Act was enacted in 1933, and repealed in 1999.

Are you saying that this financial crisis was 76 years in the making?

mike volpe said...

First of all, I should clear this up. My thesis is that regulation played a much bigger role than deregulation.

while Glass Steagall was repealed in 1999, the system was already set up in which banks did one thing and securitizers did another.

Certainly, many of the roots of the crisis were 76 years in the making.

MBS were only created in the late 1980's. My full thesis on this can now be found at the beginning of the piece.