Beginning in the mid-1990s, home prices in many American cities began a decade-long climb that proved to be an irresistible opportunity for investors. Along the way, a lot of people made a great deal of money. But by the end of the first decade of the twenty-first century, too many of these investments turned out to be much riskier than many people had thought. Homeowners lost their houses, financial institutions imploded, and the entire financial system was in turmoil.
How did this happen? Whose fault was it? Some blame capitalism for being inherently unstable. Some blame Wall Street for its greed, hubris, and stupidity. But greed, hubris, and stupidity are always with us. What changed in recent years that created such a destructive set of decisions that culminated in the collapse of the housing market and the financial system?
In this paper, I argue that public-policy decisions have perverted the incentives that naturally create stability in financial markets and the market for housing. Over the last three decades, government policy has coddled creditors, reducing the risk they face from financing bad investments. Not surprisingly, this encouraged risky investments financed by borrowed money. The increasing use of debt mixed with housing policy, monetary policy, and tax policy crippled the housing market and the financial sector. Wall Street is not blameless in this debacle. It lobbied for the policy decisions that created the mess.
In the United States we like to believe we are a capitalist society based on individual responsibility. But we are what we do. Not what we say we are. Not what we wish to be. But what we do. And what we do in the United States is make it easy to gamble with other people's money"”particularly borrowed money"”by making sure that almost everybody who makes bad loans gets his money back anyway. The financial crisis of 2008 was a natural result of these perverse incentives. We must return to the natural incentives of profit and loss if we want to prevent future crises.
My understanding of the issues in this paper was greatly enhanced and influenced by numerous conversations with Sam Eddins, Dino Falaschetti, Arnold Kling, and Paul Romer. I am grateful to them for their time and patience. I also wish to thank Mark Adelson, Karl Case, Guy Cecala, William Cohan, Stephan Cost, Amy Fontinelle, Zev Fredman, Paul Glashofer, David Gould, Daniel Gressel, Heather Hambleton, Avi Hofman, Brian Hooks, Michael Jamroz, James Kennedy, Robert McDonald, Forrest Pafenberg, Ed Pinto, Rob Raffety, Daniel Rebibo, Gary Stern, John Taylor, Jeffrey Weiss, and Jennifer Zambone for their comments and helpful conversations on various aspects of financial and monetary policy. I received helpful feedback from presentations to the Hoover Institution's Working Group on Global Markets, George Mason University's Department of Economics, and the Mercatus Center's Financial Markets Working Group. I am grateful for research assistance from Benjamin Klutsey and Ryan Langrill. None of the above bears any responsibility for any errors in this paper. In writing this paper, I've learned a little too much about how our financial system works. Unfortunately, I'm sure I still have much to learn. And as more of the facts come to light about the behavior of key players in the crisis, I'll be commenting at my blog, Cafe Hayek, under the category "Gambling with Other People's Money."
Executive Summary
1. Introduction
2. Gambling with Other People's Money
3. Did Creditors Expect to Get Rescued?
Figure 1: The Annual Cost to Buy Protection against Default on $10 Million of Lehman Debt for Five Years
4. What about Equity Holders?
5. Heads"”They Win a Ridiculously Enormous Amount. Tails"”They Win Just an Enormous Amount
6. How Creditor Rescue and Housing Policy Combined with Regulation to Blow Up the Housing Market
Figure 2: S&P/Case-Shiller House Price Indices, 1991"“2009 (1991 Q1=100)
7. Fannie and Freddie
Figure 3: Issuance of Mortgage-Backed Securities, 1989"“2009 (Billions of Dollars)
7A. It's Alive!
Figure 4: Combined Earnings of Fannie and Freddie, 1971"“2007 (Billions of 2009 Dollars)
Figure 5: Home-Purchase Loans Bought by GSEs, 1996"“2007
Figure 6: Total Home-Purchase Loans Bought by GSEs for Below-Median-Income Buyers, 1996"“2007
Figure 7: Total Home-Purchase Loans Bought by GSEs with Greater than 95% Loan-to-Value Ratios
Figure 8: Owner-Occupied Home Loans with Less than 5 Percent Down Purchased by Fannie and Freddie per Year
7B. What Steering the Conduit Really Did
8. Fannie and Freddie"”Cause or Effect?
9. Commercial and Investment Banks
Figure 9: Value of Mortgage Originations (Billions of Dollars)
10. Picking Up Nickels
11. Basel"”Faulty
12. Where Do We Go from Here?
Someday you guys are going to have to tell me how we ended up with a system like this. I know this is not the time to test them and put them through failure, but we're not doing something right if we're stuck with these miserable choices.
"”President George W. Bush, talking to Ben Bernanke and Henry Paulson when told it was necessary to bail out AIG 1
The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.
"”F. A. Hayek2
Beginning in the mid-1990s, home prices in many American cities began a decade-long climb that proved to be an irresistible opportunity for investors.
Along the way, a lot of people made a great deal of money. But by the end of the first decade of the twenty-first century, too many of these investments turned out to be much riskier than many people had thought. Homeowners lost their houses, financial institutions imploded, and the entire financial system was in turmoil.3
How did this happen? Whose fault was it?
A 2009 study by the U.S. Congressional Research Service identified 26 causes of the crisis.4 The Financial Crisis Inquiry Commission is studying 22 different potential causes of the crisis.5 In the face of such complexity, it is tempting to view the housing crisis and subsequent financial crisis as a once-in-a-century coincidental conjunction of destructive forces. As Alan Schwartz, Bear Stearns's last CEO, put it, "We all [messed] up. Government. Rating agencies. Wall Street. Commercial banks. Regulators. Investors. Everybody."6
In this commonly held view, the housing market collapse and the subsequent financial crisis were a perfect storm of private and public mistakes. People bought houses they couldn't afford. Firms bundled the mortgages for these houses into complex securities. Investors and financial institutions bought these securities thinking they were less risky than they actually were. Regulators who might have prevented the mess were asleep on the job. Greed and hubris ran amok. Capitalism ran amok.
To those who accept this narrative, the lesson is clear. As Paul Samuelson put it,
And today we see how utterly mistaken was the Milton Friedman notion that a market system can regulate itself. We see how silly the Ronald Reagan slogan was that government is the problem, not the solution. This prevailing ideology of the last few decades has now been reversed. Everyone understands now, on the contrary, that there can be no solution without government.7
The implication is that we need to reject unfettered capitalism and embrace regulation. But Wall Street and the housing market were hardly unfettered. Yes, deregulation and misregulation contributed to the crisis, but mainly because public policy over the last three decades has distorted the natural feedback loops of profit and loss. As Milton Friedman liked to point out, capitalism is a profit and loss system. The profits encourage risk taking. The losses encourage prudence. When taxpayers absorb the losses, the distorted result is reckless and imprudent risk taking.
A different mistake is to hold Wall Street and the financial sector blameless, for after all, investment bankers and other financial players were just doing what they were supposed to do"”maximizing profits and responding to the incentives and the rules of the game. But Wall Street helps write the rules of the game. Wall Street staffs the Treasury Department. Washington staffs Fannie Mae and Freddie Mac. In the week before the AIG bailout that put $14.9 billion into the coffers of Goldman Sachs, Treasury Secretary and former Goldman Sachs CEO Henry Paulson called Goldman Sachs CEO Lloyd Blankfein at least 24 times.8 I don't think they were talking about how their kids were doing.
This paper explores how changes in the rules of the game"”some made for purely financial motives, some made for more altruistic reasons"”created the mess we are in.
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.9 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.
When large financial institutions get in trouble, equity holders are typically wiped out or made to suffer significant losses when share values plummet. The punishment of equity holders is usually thought to reduce the moral hazard created by the rescue of creditors. But it does not. It merely masks the role of creditor rescues in creating perverse incentives for risk taking.
The expectation by creditors that they might be rescued allows financial institutions to substitute borrowed money for their own capital even as they make riskier and riskier investments. Because of the large amounts of leverage"”the use of debt rather than equity"”executives can more easily generate short-term profits that justify large compensation. While executives endure some of the pain if short-term gains become losses in the long run, the downside risk to the decision-makers turns out to be surprisingly small, while the upside gains can be enormous. Taxpayers ultimately bear much of the downside risk. Until we recognize the pernicious incentives created by the persistent rescue of creditors, no regulatory reform is likely to succeed.
Almost all of the lenders who financed bad bets in the housing market paid little or no cost for their recklessness. Their expectations of rescue were confirmed. But the expectation of creditor rescue was not the only factor in the crisis. As I will show, housing policy, tax policy, and monetary policy all contributed, particularly in their interaction. Though other factors"”the repeal of the Glass-Steagall Act, predatory lending, fraud, changes in capital requirements, and so on"”made things worse, I focus on creditor rescue, housing policy, tax policy, and monetary policy because without these policies and their interaction, the crisis would not have occurred at all. And among causes, I focus on creditor rescue and housing policy because they are the most misunderstood.
In the United States we like to believe we are a capitalist society based on individual responsibility. But we are what we do. Not what we say we are. Not what we wish to be. But what we do. And what we do is make it easy to gamble with other people's money"”particularly borrowed money"”by making sure that almost everybody who makes bad loans gets his money back anyway. The financial crisis of 2008 was a natural result of these perverse incentives.
Imagine a superb poker player who asks you for a loan to finance his nightly poker playing.10 For every $100 he gambles, he's willing to put up $3 of his own money. He wants you to lend him the rest. You will not get a stake in his winning. Instead, he'll give you a fixed rate of interest on your $97 loan.
The poker player likes this situation for two reasons. First, it minimizes his downside risk. He can only lose $3. Second, borrowing has a great effect on his investment"”it gets leveraged. If his $100 bet ends up yielding $103, he has made a lot more than 3 percent"”in fact, he has doubled his money. His $3 investment is now worth $6.
But why would you, the lender, play this game? It's a pretty risky game for you. Suppose your friend starts out with a stake of $10,000 for the night, putting up $300 himself and borrowing $9,700 from you. If he loses anything more than 3 percent on the night, he can't make good on your loan.
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