Abstract
This paper analyzes the role that well-intentioned policies contributed to the crisis and increased its severity. It also examines the principal-agent problems in the public sector that enabled many of the principal-agent problems in the private sector often blamed for the crisis. The legacy of the crisis is a massive series of bailouts by public authorities in Europe and the United States that risked the equivalent of nearly one-fifth of world GDP in taxpayer funds. This moral hazard will lead to deeper and more frequent crises unless countered by a new approach to regulation that places greater emphasis on market discipline by creditors and counterparties.
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Notes
For additional details see Herring and Kane (2010), Herring (2009c) and Herring and Kane (2009). In private correspondence Stephen Kane suggested two additional reasons that grade inflation may have accelerated with securitizations: (1) it’s much harder to manipulate a corporate debt rating than the rating on a complex securitizations: (2) to the extent the Modigliani-Miller irrelevance theorem holds, making a corporation’s debt cheaper will make its equity more expensive.
This statement can be found on the HUD website at http://www.hud.gov/local/hi/working/nlwfal2001.cfm
This had a direct impact on the near failure of ING, which has run a very successful internet banking business in the United States and chose to fulfill its CRA obligations by buying highly rated, securitized sub-prime mortgages.
By dollars, 49% of the $9.42 trillion in outstanding first lien mortgages were subprime or Alt-A. See Pinto (2009).
This was, of course, always an aspiration rather than a fact because of substantial differences across countries in accounting conventions and the enforcement of capital regulations.
For an attempt to define SIFIs in terms of their key, measurable characteristics see Chapter 1 of Claessens et al. (2010).
It is telling in this regard that there was no international criticism of the decision of the US authorities to provide $183 billion in subsidies to AIG.
For additional discussion of blame avoidance and the challenge of holding bureaucrats accountable see Kane (1980).
Greenspan (2008): “Regulators, to be effective, have to be forward–looking to anticipate the next financial malfunction. This has not proved feasible. Regulators confronting real time uncertainty have rarely, if ever, been able to achieve the level of future clarity required to act preemptively.”
For additional discussion of fair value standards and the three tiered classification of assets see IMF (2008).
For example, S&P studied one bond, formerly rated AAA, backed by 9,000 second mortgages. Nearly one-quarter are delinquent and losses on those that have defaulted are 40%. One financial institution carries the bond on its books at 97 cents on the dollar. S&P ran a favorable scenario and concluded the bond was worth 87 cents on the dollar, but under a less favorable scenario it was worth only 53 cents on the dollar. It currently trades in the secondary market at 38 cents on the dollar (Bajaj and Labaton 2009).
See http://thomas.loc.gov/cgi-bin/query/z?c102:S.543.ENR: for details of the FDICIA legislation.
For a much more extensive exposition of wind down policy and why it is useful see Herring (2010b).
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Herring, R.J. How Financial Oversight Failed & What it May Portend for the Future of Regulation. Atl Econ J 38, 265–282 (2010). https://doi.org/10.1007/s11293-010-9237-z
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DOI: https://doi.org/10.1007/s11293-010-9237-z