The way forward: incentives, not regulations.

• Author: Poole, William
• Position: Viewpoint essay

Most of the world today is concentrating not on the way forward after the crisis, but the way out of the crisis. This concentration brings the very real danger that steps taken now will cause problems later. The most obvious danger, perhaps, is that enormous government spending, here and abroad, will increase outstanding debt to a degree that will increase temptation to attempt to finance government budget deficits through inflation. Moral hazard is the less obvious, but perhaps more serious, problem we will face.

Before I dig into this subject further, I want to make clear that my perspective on the source of the financial crisis is that the crisis was fundamentally caused by mistakes in the private sector--mistakes in private financial firms--and not by mistakes of the federal government. I know that is not a view, as we have heard, that is necessarily universally shared. I'll proceed by first outlining the case for that view. Then, I'll discuss the role of the federal and state governments in creating the crisis, a secondary role as I have already argued. And finally, based on my analysis of the source of the crisis, I will discuss steps that would help create a more stable financial environment in the future.

Mistakes by the Private Sector

Many firms--commercial banks, investment banks, hedge funds, and others--became enamored of subprime mortgage products because of the expectation of a high return in what was otherwise a low-return world. These investors were sloppy in their credit analysis. Although it is true that residential real estate prices had not declined on a national average basis since the Great Depression, particular regions of the United States had experienced declines. Moreover, particularly after the collapse of the tech bubble in the early part of this decade investors should have considered the possibility of falling house prices. The rating agencies especially were responsible for poor credit analysis. The issue, incidentally, is not whether a forecast of declining house prices was appropriate, but whether there was a risk of declining house prices. Surely, no knowledgeable analyst would ever say that there was no risk of decline in an asset price.

Beyond weak credit analysis, many managers exposed their portfolios to extreme asset/liability duration mismatch. Mortgages are inherently long-term assets. Portfolio managers should not have financed them with short-term liabilities, such as commercial paper. And to compound the mistake, portfolios were highly leveraged. Capital ratios of 3-5 percent were not uncommon. AIG would have failed in mid September, were it not for the Federal Reserve bailout. The problem there was that AIG sold credit default swaps without maintaining an adequate reserve against possible losses.

The federal government did encourage the subprime mortgage market in a general way, but did not put its stamp of approval on any particular subprime products, or push any commercial or investment bank to buy subprime mortgages. An asterisk to this statement is that the Community Reinvestment Act did encourage, and even require, commercial banks to invest in lower-quality...