The global financial crisis is not the result of the failure of markets but of a series of government policy mistakes — prescriptions for which have been circulating for a long time but were largely ignored, a U.S. expert told a recent seminar in Tokyo.
Charles Calomiris, professor of financial institutions at Columbia University Graduate School of Business, said the crisis is only the worst episode of what he described as “the most destructive 30 years of finance in world history.”
“Over the last 30 years, we’ve had 140 national financial crises around the world that have produced total losses in the financial system in those countries in excess of 1 percent of their GDP. In about 20 of those cases, the (losses reached) more than 10 percent of GDP,” he said. “Nothing like that has ever happened before.”
Calomiris was speaking May 15 at a seminar organized by Keizai Koho Center under the theme, “The subprime crisis: What went wrong, and why it is so hard to fix?”
What caused the crisis, the financial historian said, were government policies that “offered almost unlimited protection to banks, which has encouraged the worst kind of risk-taking and removed the only real source of discipline on banks, which is depositors.”
Thanks to virtually unlimited protection, depositors ceased being a source of discipline because they no longer had anything to lose, he said. And the failure of regulatory authorities to compensate that loss of discipline with more accurate ways of measuring risk led to “the most destructive 30 years of finance in world history,” he said.
“This was not a crisis that came as a result of mass insanity by the market. This was a crisis that came about as a result of very large government policy distortions” that created incentives for people to take risky actions that led to disaster, he said.
In the case of the United States, the first mistake was the “extremely loose monetary policy” it adopted in the early half of this decade, Calomiris said.
The Federal Reserve knew it was doing something unprecedented, and perhaps for good reason: There was a need to keep a sea of liquidity going amid the high oil prices and political risks that were prevailing in the post-9/11 terrorism environment, he said.
From this point on, regulators fell asleep, Calomiris said.
“Maybe it was a good policy . . . but if you are going to create a sea of liquidity, you know that you are going to create some potential problems. You have to be even more diligent from a regulatory standard” because of the anticipated risk of creating a bubble, the professor said.
Meanwhile, mechanisms were developed “to encourage people to borrow huge amounts to buy houses that they cannot afford,” he pointed out. In a program ironically called “affordable housing initiatives,” people with bad credit records were allowed to borrow 100 percent of the value of their house, and that behavior was encouraged by a variety of guarantees and subsidies on interest rates, he said.
“That has been the structure of U.S. housing policy,” Calomiris said. “Anyone who understood the mechanism of subprime mortgages knew the program was designed to be based on a continual rise in housing prices, and even a small decline, even a 10 percent decline, can cause a huge disaster when you have very high leverage.”
“As soon as prices flattened — long before they declined — the game was up. If you understood the securities you knew this . . . I don’t think I was the only one who recognized this” in 2006, when the housing bubble imploded, he said.
Compounding the problem was a lack of corporate governance in the major bank holding companies in the U.S., where managers purposely underestimated the risk of the financial instruments they were buying, thereby ignoring shareholders’ interests, Calomiris said.
This, he said, represents a regulatory failure because the U.S. regulatory system was shaped in such a way as to prevent shareholders in the banks from disciplining their managers. Pension funds, mutual funds, insurance companies and the like were barred from owning more than 1 or 2 percent of any single public company, allowing bank holding companies to fragment and weaken their ownership structure by regulatory design, he said.
The banks did this to take advantage of the bubble, he said. But the list of big banks with major exposure to the subprime market was “pretty much a small list,” he said, naming Fanny Mae, Freddie Mac, Citibank, UBS, and Merrill Lynch.
Calomiris emphasized that the people who were buying those risky instruments knew what they were doing.
“There were no retail investors . . . They were all sophisticated institutional investors who were buying these securitized instruments,” he said. “You have to be honest — there was a problem here on the buy side. People were consciously doing what they were doing to underestimate the risk and pretend that the risks were less than they were.”
In a banking crisis, the drop in prices of risky assets usually overshoots the fundamental problem due to the scramble for liquidity, but there might be effective measures to halt the panic, he said. But when Lehman Brothers collapsed last fall, the United States failed to halt the panic and contain a lot of unnecessary losses. Why?
“The answer is so simple. People are so angry in the U.S. about these banks, that any government policy that would stop the panic has to end up assisting the banks, and it’s so unpopular that it can’t be done,” Calomiris said. “So we’re in this terrible situation here — a very large part of the distress is avoidable through some sensible policy. One we could have done — and could still do — has no political feasibility because anything that would stop the panic would be too helpful to the banks and too politically unpopular.”
However, one of the things a crisis offers, Calomiris noted, is “the opportunity to make changes that might be politically difficult.”
Thus the professor said he is optimistic of the prospect for long-term regulatory reform in the United States.
The problems are not new and the ideas for reforms, which have been “around forever” among academics, are now being taken seriously by policymakers because of the crisis, he said.
One of the top regulatory reforms has to do with the measurement of risk, he said.
“How do we measure risk now in the banking system? Well, it’s a joke, really. We measure it, first of all, with rules of thumb” such as that mortgages are half as risky as commercial loans, Calomiris said. “You can see how that rule of thumb could create an incentive for people to make subprime mortgages, because the regulators will assume the risk is very low because it’s a mortgage.”
Another way is to ask the ratings agencies, believing they will provide an objective view, but “they will do what the buy side investors want them to do,” he said, calling them “passive players.”
One idea of improving risk measurement is to “bring the market into the regulatory risk measurement process because the market may have information that’s very useful.”
For example, loans with very high interest rates should be regarded as being risky and requiring more capital, and if this rule was in place in the U.S., “subprime loans could not have masqueraded as low-risk loans because their interest rates would have given them away, would have shown that they were very risky,” he said.