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Monday, March 2, 2009

Did Deregulated Derivatives Cause the Financial Crisis?

Government Interventions, Not Laissez Faire, Caused the Financial Crisis

For a few months in 2008 I naively thought that the disastrous financial “rescue” actions led by Treasury Secretary Henry Paulson would at least be counterbalanced by widespread recognition that our economic turmoil had been government’s handiwork.

How wrong I was. By the time of this writing, the mainstream press had delivered the “consensus” judgment that blind faith in the free market fostered the housing bubble. Jacob Weisberg’s Slate column, “The End of Libertarianism,” sums up this official verdict: “We have narrowly avoided a global depression and are mercifully pointed toward merely the worst recession in a long while. This is thanks to a global economic meltdown made possible by libertarian ideas. . . . [A]ny competent forensic work has to put the libertarian theory of self-regulating financial markets at the scene of the crime.”

Just to make sure that the free market got the blame for the financial meltdown, Alan Greenspan himself testified to Congress that he had been “shocked” that self-interest (in the absence of paternalistic regulation) did not compel financial institutions to adopt adequate risk controls. Greenspan—viewed by the average pundit as a staunch libertarian—went so far as to say that he “found a flaw in the model that I perceived is the critical functioning structure that defines how the world works.”

I will argue that government interventions, not laissez faire, caused the housing bubble and the ensuing financial crisis. In addition to describing some of the general factors involved, we will focus specifically on the blame attributed to the “unregulated” market for credit default swaps.

Despite their confident judgments of guilt, critics such as Jacob Weisberg point to very few specific regulatory changes that (allegedly) fostered the housing boom and the related vulnerability of so many financial institutions to the ensuing crash in home prices. The only two concrete examples I have seen are the gradual repeal of Glass-Steagall throughout the 1990s and the Commodity Futures Modernization Act in 2000. To his credit, Weisberg candidly admits that he can’t point to a smoking gun: “[N]eglecting to prevent the crash of ’08 was a sin of omission—less the result of deregulation per se than of disbelief in financial regulation as a legitimate mechanism.”

Generally speaking, Weisberg and others accuse Alan Greenspan, Phil Gramm (former chairman of the Senate Banking Committee), and SEC chairman Christopher Cox of willfully ignoring, for ideological reasons, warnings about the growing market in credit derivatives.

At this point, we note that even if this were the whole story, it wouldn’t necessarily prove that these men (and other policy makers) were mistaken in their actions. Two exaggerated analogies will illustrate the point: Suppose an environmentalist group had lobbied for the government to ban all new house construction starting in 2002, or suppose a Marxist organization had lobbied for the nationalization of all real estate in 2002. Either of these moves, in retrospect, probably would have averted the housing bubble and its related consequences. But surely that doesn’t mean government officials back in 2002 would have been wrong to reject these proposals.

By the same token, Greenspan and others had valid reasons for resisting new regulations on the evolving markets in derivatives. As we will explain below, these complex assets can promote efficiency through risk transference. In other words, the world economy grew faster than it otherwise would have because of the proliferation of derivatives. So even if Weisberg and others are right, and the financial crisis is the fault of unregulated derivatives, it is still an empirical question whether avoiding the housing boom and bust would have been worth more than the extra consumption made possible all over the world from the market-driven growth in derivatives.

Government Mistakes: Sins of Commission

In contrast to the vague declaration that “someone should have done something!” offered by the critics of the Invisible Hand, proponents of the free market can point to specific government interventions that fostered the excesses of the housing boom. Most obvious is Greenspan’s handling of the Fed funds target rate and the growth of the monetary base following the dot-com crash. Greenspan’s easy-money policy coincided with the upswing in the housing boom. When the Fed began raising rates, housing prices tapered off and then began plunging. The connection between Fed policy and the housing bubble is so obvious that even mainstream analysts endorse the theory.

Other possible culprits include the Community Reinvestment Act (CRA), a Carter-era measure that was strengthened in 1995 and used to pressure banks and thrifts that enjoyed deposit insurance into lending in all neighborhoods where they accepted deposits, including low-income, weak-credit areas. Many analysts have also placed at least some blame on the Federal Housing Administration as well as the government-sponsored enterprises Fannie Mae and Freddie Mac. Through explicit or implicit federal backing, these agencies were able to bolster the secondary market for mortgages and allow applicants who otherwise would not have qualified to obtain mortgages.

When cataloging government interventions that may have contributed to the housing boom, we should mention the existence of the Working Group on Financial Markets—also known as the “plunge protection team”—that was established in response to the 1987 stock-market crash, as well as belief in the “Greenspan put,” the Fed’s perceived promise to provide bank liquidity when needed. As we will see, the financial crisis of 2008 was largely the result of institutions failing to protect themselves from (what seemed to be) improbable but catastrophic scenarios. Even though writers such as Nassim Nicholas Taleb have been famously warning about “fat tails” or “black swan” events, investors could quite rationally have downplayed these warnings. “After all,” high-level managers could have reasoned in the midst of the housing boom, “in the event of an absolute meltdown, the federal government will swoop in to save us. They couldn’t possibly stand back and let the entire investment banking industry collapse.” The bailouts engineered by Paulson and Bernanke have vindicated this belief. In retrospect it is not obvious that firms such as Lehman Brothers and Bear Stearns behaved foolishly. If politicians tell a man playing roulette that he can keep all of his winnings but will only suffer 20 percent of his losses, is it really irrational for him to borrow large sums of money to wager on the game?

Credit Default Swaps

The poster child for the (alleged) failure of the deregulated financial sector is the market for credit default swaps (CDSs). These contracts are traded over the counter, so no one knows exactly how much exposure they contain, but estimates place the worldwide notional value of all CDSs in the neighborhood of $50 trillion at the end of 2007. It was largely because of its issuance of CDSs that the giant insurer AIG needed a government bailout. The AIG episode showed that the financial panic was not limited to firms that foolishly overinvested in mortgage-backed securities but also could spread to those companies that had issued credit default swaps on the bonds of these now at-risk firms.

Although in practice CDSs can be complex, the idea behind them is simple. The seller of a CDS agrees to compensate the buyer in the event of a “credit event,” such as GM’s defaulting on its bonds. In return, the buyer makes periodic payments to the seller. The obvious analogy is to an insurance contract, but the difference is that people can buy a CDS on GM bonds even if they don’t own GM bonds. It is as if someone bought fire insurance on his neighbor’s house.

One reason these contracts are structured as “swaps,” rather than standard insurance, is to evade the regulations governing traditional insurance products. For example, if AIG wanted to sell life insurance to a man in Florida, it would have to set aside reserves according to Florida law in order to make it more likely that AIG could fulfill the policy if the man died a week later. In contrast, if AIG sold a Florida man protection against a bond default by GM, then the government allowed AIG much more discretion in how it handled this new potential liability on its books.

It is easy to see why critics of pure free markets have such disdain for the credit-default-swap market. This seems to be a clear case where short-term greed led to reckless behavior, which would have been prevented by prudent government oversight.

Yet matters are not so simple. After all, the shareholders and creditors of AIG were presumably not complete idiots. Did they care less about protecting their wealth than politicians in D.C. did? Did they understand derivatives less well than government bureaucrats understood them? Looking at the matter from a different angle, why would the buyers of

CDSs simply assume that the counterparty would make good on the contracts if government regulations did not enforce the same safeguards applied to traditional insurance?

It turns out the Invisible Hand did lead everyone to seek safety. Although all the details are not yet available, as of this writing it appears that AIG’s risk models (primarily developed by academic consultant Gary Gorton) were not to blame for sinking the company. Rather, AIG was driven into the arms of the government because its large clients (such as Goldman Sachs) insisted on larger and larger amounts of collateral as the financial crisis continued.

Plagued by Illiquidity

In other words, Gorton’s models may still prove to be fairly accurate. AIG was not crippled by a string of unexpected credit events (and consequent payouts). What actually happened is that the holders of CDSs issued by AIG became scared about its ability to honor its contracts, and AIG could not continue to operate while satisfying all of the growing calls to put up more collateral against these outstanding time bombs. In short, AIG was plagued by illiquidity, not necessarily by insolvency. It is true that AIG executives failed to prepare adequately for this contingency, but it nonetheless removes some of the mystery behind its failure when we realize that AIG may very well have correctly assessed the risk of its positions—it just failed to predict correctly how its customers would assess this risk, in the midst of a global financial panic and also during a period when there was a “credit crunch” among large institutions.

The case of AIG also reinforces our earlier point about government intervention muting the potency of market incentives. It takes two to tango. The problem of AIG on the eve of its rescue was the fault not just of AIG’s managers and shareholders, but also of the counterparties who had bought billions of dollars worth of CDSs from the insurer. In a completely free market, these counterparties would be subject to the hazards of a potential AIG bankruptcy. In reality, however, huge firms such as Goldman Sachs could rely on the U.S. government to rescue them from their reckless exposure to AIG. In fact, the New York Times reports that Lloyd Blankfein, the current CEO of Goldman Sachs, was the only investment bank executive in the room when federal officials decided to rescue AIG—and this was mere hours after they had decided to let Lehman Brothers fail. (As for Goldman’s demands for more AIG collateral, even “too big to fail” companies exercise some caution—just not enough.)

People Make Mistakes in the Market

In situations such as the present crisis, there is a temptation for libertarian economists to look for specific government interventions that “caused” the problems. This is understandable, and indeed we have listed some of these factors. Yet we should also remember that failure is a normal part of the market process. Investors and entrepreneurs are not omniscient. Bankruptcies do not signal the inefficiency of the market any more than the overthrow of Newtonian physics proved the weakness of the scientific method—let alone that government should take charge of all scientific research.

In addition to the definite contributions of government policies, it is also true—and proponents of the free market should feel no shame in admitting—that many institutions were seduced by fancy mathematical finance models. Part of what happened is that the whiz kids from MIT and other top-flight programs made simplifying assumptions on the underlying probabilities of various events. For example, Moody’s might have rated a particular mortgage-backed security as extremely safe, since it was composed of thousands of small bits of mortgages spread all over the country. Before the housing crash, the conventional wisdom held that “real estate is local.” It was considered virtually impossible that all markets—from San Francisco to Las Vegas to Miami to Chicago—would experience a large spike in mortgage-default rates simultaneously. Nobody had ever seen such a correlated fall, so it seemed like a reasonable assumption. The models, based on this assumption, produced results confirming the safety of mortgage-backed securities.

When confronted with this reality many free-market thinkers want to blame a government policy. In the case of the ratings agencies, we do have some contenders. The most obvious example is that the dominant firms (Moody’s, Standard and Poor’s, Fitch) benefit from government regulations placed on banks and other institutions. If a bank or insurance company wants to invest in bonds the government insists that these bonds meet a certain level of safety. Of course, the bank can’t simply hire Joe the Bond Rater to slap “AAA” on them. The regulations insist that a reputable ratings agency meet certain criteria. In practice these rules ossify the ratings market, and partially protect Moody’s and the others from the repercussions they would have suffered after their disastrous evaluations of mortgage-backed securities during the housing boom.

But even if the critics were right and the present crisis was largely caused by faulty forecasts made in the private sector, it would not prove a crushing defeat for free markets. After all, there are plenty of examples of horrible business decisions made by private individuals. The Edsel and “New Coke” flops, Decca Records’ 1962 rejection of the Beatles because “guitar music is on the way out,” and the rejection by a dozen publishers of the initial Harry Potter manuscript are all examples of stupendous entrepreneurial error. Given the advantage of hindsight, it is easy enough for us to laugh at the businesspeople who made such boneheaded calls, and critics of the marketplace could easily enough infer that the free market can’t be trusted with the task of innovation.

However, the mere existence of entrepreneurial error is not an indictment of free markets. People can only achieve bold successes when they take risks. The virtue of the market is that it allows individuals the freedom to risk their own money—or that of investors whom they can convince to fund them voluntarily—reaping the rewards if they succeed and bearing the losses if they fail. There is no reason to suppose that government bureaucrats would have designed better models of risk assessment. Indeed, two Fed economists wrote a paper in 2005 claiming that there was no housing bubble!

What is truly ironic is that the government’s rescue efforts—supposedly made “necessary” by the “unregulated” market—only ensure that market discipline will be weaker. Not all major institutions were taken in by the derivatives hysteria during the housing boom. Warren Buffett famously warned his own investors in 2002 that derivatives were “financial weapons of mass destruction” that would at some point wreak unexpected havoc. The takeovers of AIG, Fannie, and Freddie, as well as the $700 billion bailout, reduce the relative strength of those firms that behaved more sensibly during the boom. If and when the next crisis occurs, it will be in part because the government has just shown that playing it safe and adopting a long-term perspective doesn’t pay in U.S. financial markets. It’s much more profitable to go for the risky yet lucrative payouts, and then run to the government if things turn sour.

Amidst the efforts to “control the narrative” and assign blame for the financial crisis, fans of the free market should not lose sight of the real benefits of derivatives. Futures contracts on oil, for example, allow producers and major consumers such as airlines to lock in guaranteed prices and confidently engage in long-term projects that would otherwise be too risky. Even the much-maligned credit default swap allows the transfer of risk in mutually beneficial trades. Especially in an uncertain financial environment, CDS contracts allow certain firms to raise cash more easily—because those lending them money can buy CDSs on their bonds—and the price of a particular CDS contract itself communicates information about the market’s view of the firm being insured. These benefits will all be seriously muted if the government stampedes in and imposes top-down regulations.

Despite the claims of their critics—and even of some of their fair-weather friends—unregulated markets are not to blame for the systematic mistakes of the housing boom. Yet even if private errors were the primary cause, it still would not follow that government bureaucrats would make wiser decisions in the future.

  • Robert P. Murphy is senior economist at the Independent Energy Institute, a research assistant professor with the Free Market Institute at Texas Tech University, and a Research Fellow at the Independent Institute.