Financial innovation, regulation, and reform.

• Author: Calomiris, Charles W.
• Position: Report

Financial innovations often respond to regulation by sidestepping regulatory restrictions that would otherwise limit activities in which people wish to engage. Securitization of loans (e.g., credit card receivables, or subprime residential mortgages) is often portrayed, correctly, as having arisen in part as a means of "arbitraging" regulatory capital requirements by booking assets off the balance sheets of regulated banks. Originators of the loans were able to maintain lower equity capital against those loans than they otherwise would have needed to maintain if the loans had been placed on their balance sheets. (1)

Capital regulation of securitization invited this form of off-balance-sheet regulatory arbitrage, and did so quite consciously. Several of the capital requirement rules for the treatment of securitized assets originated by banks, and for the debts issued by those conduits and held or guaranteed by banks, were specifically and consciously designed to permit banks to allocate less capital against their risks if they had been held on their balance sheets (Calomiris 2008a). Critics of these capital regulations have rightly pointed to these capital requirements as having contributed to the subprime crisis by permitting banks to maintain insufficient amounts of equity capital per unit of risk undertaken in their subprime holdings.

Investment banks were also permitted by capital regulations that were less strict than those applying to commercial banks to engage in subprime-related risk with insufficient budgeting of equity capital. Investment banks faced capital regulations under SEC guidelines that were similar to the more permissive Basel II rules that apply to commercial banks outside the United States. Because those capital regulations were less strict than capital regulations imposed on U.S. banks, investment banks were able to lever their positions snore than commercial banks. Investment banks' use of overnight repurchase agreements as their primary source of finance also permitted them to "ride the yield curve" when using debt to fund their risky asset positions; in that respect, collateralized repos appeared to offer a substitute for low-interest commercial bank deposits. (2) But as the collateral standing behind those repos declined in value and became risky, "haircuts" associated with repo collateral became less favorable, and investment banks were unable to roll over their repos positions, a liquidity risk that added to their vulnerability and made their equity capital positions even more insufficient as risk buffers.

There is no doubt that the financial innovations associated with securitization and repo finance were at least in part motivated by regulatory arbitrage. Furthermore, there is no doubt that if on-balance-sheet commercial bank capital regulations had determined the amount of equity budgeted by all subprime mortgage originators, then the leverage ratios of the banking system would not have been as large, and the liquidity risk from repo funding would have been substantially less, both of which would have contributed to reducing the magnitude of the financial crisis.

And yet, I do not agree with those who argue that the subprime crisis is mainly a story of government "errors of omission," which allowed banks to avoid regulatory discipline due to the insufficient application of existing on-balance-sheet commercial bank capital regulations to the risks undertaken by investment banks and off-balance-sheet conduits. The main story of the subprime crisis instead is one of government "errors of commission," which were far more important in generating the huge risks and large losses that brought down the U.S. financial system.

What Went Wrong and Why?

The subprime crisis reflected first and foremost the willingness of the managers of large financial institutions to take on risks by buying financial instruments that were improperly priced, which made the purchases of these instruments contrary to the interests of the shareholders of the institutions that invested in them. As Calomiris (2008a) shows, on an ex ante basis, risk was substantially underestimated in the market during the subprime boom of 2003-07. Reasonable forward-looking estimates of risk were ignored intentionally by senior management of financial institutions, and senior management structured compensation packages for asset managers to maximize incentives to undertake these underestimated risks. In the absence of "regulatory arbitrage," budgeting a little more regulatory capital would have reduced the amount of risk undertaken, and would have given the system more of a cushion for managing its losses, but the huge losses from underestimated subprime risk still would have occurred.

The risk-taking mistakes of financial managers were not the result of random mass insanity; rather, they reflected a policy environment that strongly encouraged financial managers to underestimate risk in the subprime mortgage market. Risk-taking was driven by government policies; government's actions were the root problem, not government inaction. How do government policy actions account for the disastrous decisions of large financial institutions to take on unprofitable subprime mortgage risk? In what follows, I review each of the major areas of government policy distortions (see also Calomiris 2008a and 2008b, Calomiris and Wallison 2008, and Eisenbeis 2008) and how they encouraged the conscious undertaking of underestimated risk in the market.

Four categories of government error were instrumental in producing the crisis: First, lax Fed interest rate policy, especially from 2002 through 2005, promoted easy credit and kept interest rates very low for a protracted period. The history of postwar monetary policy has seen only two episodes in which the real Fed funds rate remained negative for several consecutive years; those periods are the high-inflation episode of 1975-78 (which was reversed by the anti-inflation rate hikes of 1979-82) and the accommodative policy environment of 2002-05. According to the St. Louis Fed, the Federal Reserve deviated sharply from its "Taylor Rule" approach to setting interest rates during the 2002-05 period; Fed funds rates remained substantially and persistently below the levels that would have been consistent with the Taylor Rule, even if that rule had been targeting a 3 percent or 4 percent long-run inflation target.

Not only were short-term real rates held at persistent historic lows, but because of peculiarities in the bond market related to global imbalances and Asian demands for medium- and long-term U.S. Treasuries, the Treasury yield curve was virtually flat during the 2002-05 period. The combination of low short-term rates and a flat yield curve meant that long-term real interest rates on Treasury bonds (which are the most relevant benchmarks for setting mortgage rates and other long-term fixed income assets' rates) were especially low relative to their historic norms.

Accommodative monetary policy and a flat yield curve meant that credit was excessively available to support expansion in the housing market at abnormally low interest rates, which encouraged overpricing of houses. There is substantial empirical evidence showing that when monetary policy is accommodative, banks charge less for bearing risk (reviewed in Calomiris 2008a), and this seems to be a pattern common to many countries in the present and the past. According to some industry observers, low interest rates in 2002-05 also encouraged some asset managers (who cared more about their fees than about the interests of their clients) to attract clients by offering to maintain preexisting portfolio yields notwithstanding declines in interest rates; that financial alchemy was possible only because asset managers decided to purchase very risky assets and pretend that they were not very risky.

Second, numerous government policies specifically promoted subprime risk-taking by financial institutions. Those policies included (a) political pressures from Congress on the government-sponsored enterprises (GSEs), Fannie Mae and Freddie Mac to promote "affordable housing" by investing in high-risk subprime mortgages, (b) lending subsidies policies via the Federal Horne Loan Bank System to its member institutions that promoted high mortgage leverage and risk, (c) FHA subsidization of high mortgage leverage and risk, (d) government and GSE mortgage foreclosure mitigation protocols that were developed in the late 1990s and early 2000s to reduce the costs to borrowers of failing to meet debt service requirements on mortgages, and--almost unbelievably--(e) 2006 legislation that encouraged ratings agencies to relax their standards for measuring risk in subprime securitizations.

All of these government policies contributed to encouraging the underestimation of subprime risk, but the politicization of Fannie Mae and Freddie Mac and the actions of members of Congress to encourage reckless lending by the GSEs in the name of affordable housing were arguably the most damaging policy actions leading up to the crisis. In order for Fannie and Freddie to maintain their implicit (now explicit) government guarantees on their debts, which contributed substantially to their profitability, they had to cater to the political whims of their masters in the government. In the context of recent times, that meant making risky subprime loans (Calomiris and Wallison 2008, Calomiris 2008b). Fannie and Freddie ended up holding $1.5 trillion in exposures to toxic mortgages, which constitutes half of the total non-FHA outstanding amount of toxic mortgages (Pinto 2008).

A review of e-mail correspondence between risk managers and senior management at the GSEs (Calomiris 2008b) reveals that those positions were taken despite objections by risk managers, who viewed them as imprudent, and who predicted that the GSEs would lead the rest of the market into huge overpricing of risky...