Does Moral Hazard from the Safety Net Help to Explain Deceptive Accounting?

William K. Black’s interesting contributions to this symposium, and in particular his drawing parallels to the S&L fiasco of the 1980s, prompt me to wonder what role financial safety nets, like the deposit insurance that fostered the S&L fiasco, have played in fostering the current crisis.

Professor Black focuses on the growth of deceptive (or fraudulent) accounting and ratings practices. Supervisors asleep at the switch enabled both. But why did the practices begin to grow? Their main purpose, according to a very informative working paper, “The 2007 Meltdown in Structured Securitization: Searching for Lessons not Scapegoats” by Gerard Caprio, Jr., Aslı Demirgüç-Kunt, and Edward J. Kane (CDK), was to mask overleveraging and excessive risk exposures from creditors and safety-net supervisors. (Note that Ed Kane was the analyst who warned about the developing S&L crisis years before it hit the newspapers.)

If they are right, then a key question becomes: what prompted the overleveraging and excess risk-taking in the first place? CDK argue that an important contributor was “safety-net subsidies,” i.e., moral hazard from implicit or explicit financial guarantees.

CDK write:

During the last forty years financial institutions in the US … became increasingly aware of opportunities to shift the deep downside of their risk exposures onto the safety net. … [In recent years] financial institutions increasingly concentrated on creating instruments and structures with which to exploit loopholes in the regulation and supervision of financial-institution leverage. (p. 6) … Securitization increased these firms’ access to safety-net subsidies not just by increasing their size, complexity or geographic footprint, but also and most importantly by concealing increases in effective leverage. (pp. 6-7)

In tolerating an ongoing decline in transparency, supervisors encouraged the very mispricing of risk whose long-overdue correction triggered the crisis. (p. 9)

Why were the deceptive practices especially keen in mortgage financing? And why were the supervisors asleep at the switch? The Federal Reserve’s cheap-money policy and its positive impact on housing prices contributed. Everything looked fine as long as house prices continued to rise: “Low interest rates and increasing housing prices encouraged an overly friendly regulatory environment both for highly leveraged mortgages and for securitization structures based on them.” (p. 12)

Like the FSLIC that practiced excessive forbearance toward zombie thrifts, hoping for the best, it is clear in retrospect that the FDIC practiced excessive deference toward the AAA risk ratings of mortgage-backed securities. It should have raised deposit insurance premiums or insisted on higher capital requirements for insured institutions heavily invested in MBSs. Likewise the OFHEO practiced forbearance toward Fannie Mae and Freddie Mac when it should have insisted on adequate capitalization for their risky portfolios.

I wonder whether Professor Black finds the CDK analysis complementary or contrary to his own.

Also from This Issue

Lead Essay

  • What Really Happened? by Lawrence H. White

    In the first of this month’s four accounts of the causes of the financial crisis, Lawrence H. White, the F.A. Hayek Professor of Economic History at the University of Missouri, St. Louis, makes his case. White argues that the housing boom and bust, and the resulting meltdown of financial markets, cannot have been the result of a laissez-faire monetary and financial system, since we never had one. Nor can deregulation have been the cause, since the most recent relevant deregulation has probably helped contain the turmoil. While admitting that “private miscalculation and imprudence made matters worse,” White argues that “to explain industry-wide errors we need to identify policy distortions capable of having industry-wide effects.” He points to two such distorting sets of policies: the overexpansion of the money supply by the Fed, and government mandates and subsidies to write riskier mortgages.

Response Essays

  • Adam Smith Was Right about Corporate CEOs’ Incentives absent Effective Regulation by William K. Black

    In our second anatomy of the financial crisis, William K. Black, associate professor of economics and law at the University of Missouri, Kansas City, says that key to the crisis was perverse compensation schemes that put the incentives of executives at odds with the interests of creditors and shareholders. Drawing on his concept of “control fraud,” Black argues that a failure of regulation encouraged executives to meet short-term earnings goals and to capture large bonuses by encouraging fraudulent mortgages – even when it could be foreseen that this might lead to the destruction of the firm. “When we do not regulate or supervise financial markets we, de facto, decriminalize control fraud. The regulators are the cops on the beat against control fraud – and control fraud causes greater financial losses than all other forms of property crime combined,” Black writes. Fannie and Freddie cannot have been the culprits, Black argues, because they were guilty of less mortgage control fraud than their fully private counterparts. “ ‘Modern finance’ has failed the market test,” Black concludes. “Its policies optimize the environment for control fraud and create perverse dynamics that create recurrent financial crises.”

  • Fundamental Origins of the Housing Boom and Bust by Casey B. Mulligan

    The housing boom and bust stands behind the financial turmoil of 2008. Therefore, in our third analysis of the financial crisis, University of Chicago economist Casey B. Mulligan explores various hypotheses about its underlying causes. Was it changes in tastes and technology? Public policy? Investor “exuberance”? Mulligan describes some of the empirical tests that would be needed to settle the question, and argues that at least part of the answer is already clear. Most of the housing boom, Mulligan finds, was based in expectations about the future, rather than in demand, supply, or subsidies during the boom. Mulligan says that additional empirical tests – especially about the aggregate wealth effects of the boom and bust – would help us form a more educated guess about whether boom expectations were based more to changes in tastes, changes in technology, or exuberance. But those tests have not been done, and therefore, Mulligan concludes we cannot yet reliably predict the future economic damage from the housing boom and bust, or formulate beneficial financial industry regulation.

  • Liquidity, Default, Risk by J. Bradford DeLong

    Our fourth and final anatomist, J. Bradford DeLong, notes that “in the past two years the wealth that is the global capital stock has fallen in value from $80 trillion to $60 trillion,” and lays out five reasons why this value might fluctuate. “Savings has not fallen through the floor. We have had no little or no bad news about resource constraints, technological opportunities, or political arrangements.” Therefore, DeLong says, we’re left with changes in the discounts for liquidity, default, and risk. The housing crash has increased default risk significantly, but central banks have actually pumped up liquidity. Almost the entire drop of the value of global capital, DeLong argues, comes from an “increase in the perceived riskiness … of income from capital.” The problem, DeLong says, is that “our models for why the risk discount has taken such a huge upward leap in the past year and a half are little better than simple handwaving and just-so stories. Our current financial crisis remains largely a mystery: a $2 trillion impulse in lost value of securitized mortgages has set in motion a financial accelerator that we do not understand at any deep level that has led to ten times the total losses in financial wealth of the impulse.” However, DeLong is confident that Larry White’s story – focusing on the money supply and government policy to encourage bad home loans – cannot be the right one.

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