What Went Wrong and How Can We Fix It?

That’s the title of an article I wrote for the UCSD Economics Department’s Economics in Action, which I reproduce below.

As the unemployment rate climbed to the highest levels in a generation and the nation’s output fell in an eighteen-month dive, it became clear that this was no ordinary recession. Why did the economy get so badly off track? What needs to be done to return to solid growth?

Bad Loans Lead to Lending Freeze

There was almost $8 trillion in new U.S. household mortgage debt issued between 2004 and 2006. A significant number of these loans had poor documentation of the borrowers’ incomes, required little or no money down, and called for huge increases in the borrowers’ monthly payments a few years into the loan.

As long as house prices continued to skyrocket, few of even the most dubious loans went bad because the borrower enjoyed a big enough capital gain to be able to refinance at a profit. And precisely because lenders were diverting such huge sums of money into housing, U.S. house prices continued to climb rapidly, doubling between 2000 and 2005.

But house prices could not continue to rise forever, and the recession that began in December 2007 helped to set the process into reverse. Rising oil prices reduced consumer spending and clobbered important sectors like the auto industry in early 2008. Then unemployment from the recession tipped many of the mortgages into default, and house prices began to fall rapidly. As house prices fell, more borrowers found themselves underwater and unable to refinance their loans or to meet their monthly payments. The many derivative financial instruments constructed from U.S. mortgage debt suffered a big loss in market value. This precipitated a classic bank run on financial institutions that counted on being able to roll over short-term debt in order to finance their long positions in mortgage-related securities. The result was a freezing of the interbank lending market and a severe contraction in credit that brought the world economy to its knees.

Moral Hazards Encourage Unsound Lending

What were the market failures that led to the destabilizing expansion of credit in the early part of the decade? The institutions that originally made the loans sold them off to private banks or to the government-sponsored enterprises Fannie Mae and Freddie Mac. This system created moral hazard incentives for the originators, encouraging them to fund unsound loans. When private banks bought the loans, they packaged them into complex securities that were in turn sold off to private investors, an additional step that permitted the securitizers to profit, even if the loans were poor quality. In the cases of Fannie and Freddie, the government created an asymmetric payoff structure in which the profits went to private investors while the losses were picked up by the taxpayers. Compensation schemes gave the individuals within the financial institutions that authorized unsound gambles a “heads I win, tails you lose” incentive structure that also favored excessive risk taking. Entities like the insurance giant AIG were allowed to write huge volumes of credit default swaps that purportedly would insure the holders of these mortgages against losses, even though AIG did not remotely have the financial ability to fulfill all the commitments it made.

New Fed Policies Not Enough

What can be done to address the problems that came out of this mess? Aggressive fiscal stimulus has been implemented in the hopes that an increase in federal spending would make up for the decline in demand from the private sector. So far, the economic performance has been significantly worse than the architects of that fiscal stimulus had originally anticipated. Our monetary stimulus gun ran out of bullets when the Fed funds rate was pushed essentially to the zero lower bound. The Fed also pursued less conventional tools of monetary policy, creating a huge volume of new types of loans and purchasing assets, such as mortgage-backed securities. The new Fed policies make sense for addressing the bank run aspect of the crisis. But to the extent that the low market prices on these securities represent a rational assessment of their true value, the Fed may have simply absorbed some of these losses onto an account that ultimately will be paid by the taxpayers.

Systemic Reforms Are Needed

Whatever the success of these fiscal and monetary measures, part of the response to the problems must come in the form of fundamental reforms to the financial system. The Treasury has recently proposed a number of ideas that make sense:

• Introduce a legal mechanism whereby large financial institutions that are not commercial banks (such as AIG or Bear Stearns) can be liquidated in an orderly manner without bankruptcy or bailouts, analogous to the authority that the FDIC currently has to take over failing banks.

• Subject the banklike functions of investment banks and structured investment vehicles (that is, the activity of borrowing short and lending long) to the same capital requirements as standard banking.

• Require either mortgage originators or the mortgage securitizers to retain 5 percent of the product they create. I would take that idea a step farther, endorsing Princeton Professor Alan Blinder’s proposal that originators and securitizers should each hold 5 percent.

• Move the trading of financial derivatives, like credit default swaps, to centralized exchanges where they would be subject to a robust regime of regulation including conservative capital requirements, margins, and reporting requirements. To the Treasury’s proposal, I would also recommend adding stop-loss provisions that regulators could use to limit the promises made and losses suffered by systemically important financial institutions as a result of their trading in financial derivative contracts.

• Set guidelines for individual compensation systems at systemically important financial institutions in order to better align the personal rewards of traders with the interests of shareholders and the public.

It appears that the worst of the recession of 2007–09 is now behind us. But that should not cause us to lose interest in ensuring that this costly tragedy is never repeated.