Abstract
Public officials have blamed Wall Street and its complex financial products for causing the 2008 economic downturn. This article addresses three popular claims saying that complex financial markets are at fault and need more regulation. It argues that even in the midst of a major economic downturn, the much-maligned mortgage-backed securities, collateralized debt obligations, credit default swaps, and unregistered hedge funds functioned almost exactly as designed. When macroeconomic conditions worsened, firms and investors that were paid to assume certain risks had to assume them. Those that opted for safer investment vehicles with more levels of private protection faced fewer problems. Although many investment vehicles lost money, one must differentiate between problems that manifested themselves in markets and problems with the market itself. Even though government policies caused many of the problems, public officials always have an incentive to point the finger at Wall Street and to argue for more regulations when their policies negatively affect markets.
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Notes
A more sophisticated variant of the “Wall Street is to blame” thesis is the “originate to distribute” thesis, which posits that banks stopped caring about asset quality because they were not keeping on their books all of the loans they originated (Financial Crisis Inquiry Commission 2011, p. 89). The New York Times (Morgenson and Story 2009) article, “Banks bundled bad debt, bet against it and won” is representative. For a discussion and critique, see Gorton (2010).
Posner and Weyl (2013, p. 1137) describe “the infamous CDOs of Asset-Backed Securities” and conclude, “given the numerous and clearly identifiable harmful uses and the tightly limited upside, it seems clear that a well-run agency would have rejected the introduction of such derivatives, had they been proposed for approval.”
Lewis’s (2010) bestseller, The Big Short, highlights how investors like Greg Lipmann profited by shorting mortgage-backed securities before the downturn, but Lewis has yet to highlight that Lipmann is long in many of these securities today.
Prime borrowers typically have credit scores of 660 or more and a loan to value ratio of 80 % or less. Ezarik (2005) writes, “In general, banking regulators consider subprime borrowers as those with: a FICO [Fair Isaac Corporation] score of 660 or lower; two or more 30-day delinquent payments in the past 12 months, or one 60-day delinquency in the past 24 months; a foreclosure or charge-off in the past 24 months; any bankruptcy in the last 60 months; qualifying debt-to-income ratios of 50 % or higher; limited ability to cover monthly living expenses.”
Many asset-backed securities and CDOs were special-purpose vehicles that depended on short-term debt for funding, and, similar to a bank that holds less than 100 % reserves, had the potential to be exposed to problems when short-term lending (or deposits) fell. I thank an anonymous referee for highlighting this point.
After the economic downturn, the rating agencies downgraded many tranches and securities, yet 87 % of Moody’s Aaa rated collateralized loan obligations kept their original ratings, and 98 % kept their original ratings or were downgraded only by one level. Among Aa2 and A2 collateralized loan obligations, the majority either kept their original ratings or were downgraded by one level (Sober Look 2012), indicating far-from-perfect foresight but not wildly incorrect ratings.
Imagine a leveraged investment that starts with $100,000 from investors and borrows $900,000 in short-term markets to buy $1 million of mortgage-backed securities. If the $1 million gains 10 %, or $100,000, the payoff to investors is high, but a $100,000 depreciation would wipe out investor equity completely. Lenders in overnight debt markets, or repurchase agreement (repo) markets, get repaid, and investors bear all of the losses, exactly as they agreed.
Gorton (2010, p. 132) writes, “Marking-to-market, however, implemented during a panic, has very real effects because regulatory capital and capital for rating-agency purposes is based on generally accepted accounting practices (GAAP). There are no sizable platforms that can operate ignoring GAAP capital. In the current situation, partly as a result of GAAP capital declines, banks are selling assets or are attempting to sell assets—billions of dollars of assets—to ‘clean up their balance sheets,’ raising cash and de-levering. This pushes down prices, and another round of marking down occurs, and so on. This downward spiral of prices—marking down, selling, marking down again—is a problem.”
The Securities and Exchange Commission (2008, p. 182) also writes, “Significant concerns have been raised that fair value accounting can induce a pro-cyclical downward pressure in asset prices, leading security prices and asset values to fall considerably below what some believe is their true ‘fundamental value.’ Further, concerns have been expressed about the fact that, in order to offset the write-downs caused by the fair value accounting for their investment securities, financial institutions may have been compelled to sell securities in illiquid markets (despite the institutions’ original intentions to hold those assets until maturity or recovery) or raise capital in a challenging environment. In illiquid or distressed markets, these forced sales may further weaken the market for the securities and reduce the resulting price for the observed trades, compelling additional sales to raise capital.”
Third parties who care about a reference entity defaulting can also buy protection. Although critics disparage “naked credit default swaps” as equivalent to buying insurance on someone else’s health, such contracts allow firms to hedge their position if their well-being is affected by others defaulting. Goldman Sachs, for example, was highly dependent on the market for housing-related securities, but it also hedged in case many loans in that market defaulted. Naked credit default swaps also enable synthetic CDOs to offer various amounts of protection. For an excellent overview of credit default swaps, see Stulz (2010).
I thank an anonymous referee for encouraging me to highlight this point.
In August 2008, 5-year credit default swap contracts on Fannie Mae notes cost 364 basis points per year, or $36,400, to insure $1 million (Biggadike and Harrington 2008).
As the International Swaps and Derivatives Association (2014b) explains, “notional amounts are only loosely related to risk. For most OTC derivatives, cash flow obligations are normally a small percent of notional amounts and so are mark-to-market exposures. Further, netting of obligations under a master agreement and collateralization of exposures reduces credit exposures to less than one percent of notional amount.”
One Goldman Sachs employee recalls a 2007 phone conversation in which the head of AIG Financial Products stated, “It is hard for us, without being flippant, to even see a scenario within any kind of realm or reason that would see us losing $1 in any of these transactions” (Bankers Anonymous 2012). But, as the Congressional Oversight Panel (2010, p. 7) correctly concluded, AIG’s “insatiable appetite for risk and blindness to its own liabilities” ultimately brought it down.
For a discussion of the importance of applying economic analysis to rules and regulations, see Leeson (2009).
Since then, numerous regulations have been passed that require hedge funds to register with the SEC and “deliver an unprecedented breadth of information to the SEC,” which KPMG (2013, p. 12) reports “creates unique challenges for the hedge fund industry, particularly since the scope of compliance extends beyond the traditional legal and compliance functions to also include finance, operations and others.” Ernst and Young (2012, p. 3) reports on the regulations’ “many ambiguous questions that will require significant discussion with outside counsel, accountants, other fund advisers, and the SEC.”
When the SEC asked how such returns were possible, Madoff responded, “Some people feel the market. Some people just understand how to analyze the numbers that they’re looking at” (Kotz 2009, p. 19).
Stigler (1975, p. 169) says that one should always ask the following questions about regulators: “Is he qualified? Is he given proper incentives? Is there an audit of his performance? And, is it possible to challenge failures or weaknesses in his performance?”
Third-party administrators can be independent companies such as Citco Fund Services, or subsidiaries of banks such as Citigroup, Goldman Sachs, and JP Morgan. They can handle everything from back-office functions like accounting to managed accounts where the hedge fund manager becomes more like an advisor without control of the fund’s assets (HFM 2010; Rose 2009).
One of my friends who works on Wall Street states, “The regulations have turned our industry upside down,” and another states, “I don’t much care what the eventual regulations turn out to be, I just wish they would stop changing them so much” (personal interviews, Boston and New York, June 2011 and November 2013).
Buchanan and Wagner (1977[1999], p. 53) discuss how officials may create political business cycles, which in turn fosters “an antibusiness or anticapitalist bias in public attitudes, a bias stemming from the misplaced blame for the observed erosion in the purchasing power of money and the accompanying fall in the value of accumulated monetary claims. This bias may, in its turn, be influential in providing support to political attempts at imposing direct controls, with all the costs that these embody, both in terms of measured economic efficiency and in terms of restrictions on personal liberty.” For a list of reasons why politicians may create a business cycle, see Aidt et al. (2011), Grier (1989), and Shughart II and Tollison (1985).
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Acknowledgments
I thank Peter T. Leeson, William F. Shughart II, Peter J. Boettke, Amy Fontinelle, two anonymous referees, and members of the Financial Policy Council for helpful comments and suggestions.
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Stringham, E.P. It’s not me, it’s you: the functioning of Wall Street during the 2008 economic downturn. Public Choice 161, 269–288 (2014). https://doi.org/10.1007/s11127-014-0198-7
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DOI: https://doi.org/10.1007/s11127-014-0198-7