In today’s FT, Gillian Tett, a fabulous journo and author of Fool’s Gold, quotes the legendary Paul Volcker as stating the best innovation that the financial system produced over the last decade or so was the automatic teller machine (ATM). Funny, but not really so true.
In her story today, she notes that fancy financial products will be scrutinized more carefully going forward. But I simply can’t agree with the oft-repeated statement that “financial innovation” is somehow the Great Big Bogeyman that nearly destroyed the financial system as we know it. Wait. Put another way: If the gub’ment (pronounce with your best Michigan Militia accent) would quit meddling in private economic transactions (and thereby screwing up the pricing mechanism), we wouldn’t have had the credit bubble in the first place.
A recent–(ish) Cato Institute paper (Yeah, I know, Cato is a libertarian think tank that is always going to blame the gub’ment) describes the true root of the disastrous and evil “financial innovation” of the “naughties” (as the FT has taken to calling this soon-to-be-past decade) that nearly brought down our financial system. Here is an excerpt:
“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?"
The study continues: "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 themost 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 caredmore 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 assetmanagers 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), FannieMae and FreddieMac to promote “affordable housing” by investing in high-risk subprime mortgages, (b) lending subsidies policies via the Federal Home 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