At Coyote Blog, Warren Meyer explains how what must have seemed to be a simple, common-sense regulation change led almost inevitably to a housing market melt-down:
… a redefinition by governments in the Basel accords of how capital levels at banks should be calculated when determining capital sufficiency. I will oversimplify here, but basically it categorized some assets as “safe” and some as “risky”. Those that were risky had their value cut in half for purposes of capital calculations, while those that were “safe” had their value counted at 100%. So if a bank invested a million dollars in safe assets, that would count as a million dollar towards its capital requirements, but would count only $500,000 towards those requirements if it were invested in risky assets. As a result, a bank that needed a billion dollars in capital would need a billion of safe assets or two billion of risky assets.
Well, this obviously created a strong incentive for banks to invest in assets deemed by the government as “safe”. Which of course was the whole point — if we are going to have taxpayer-backed deposit insurance and bank bailouts, the prices of that is getting into banks’ shorts about the risks they are taking with their investments. This is the attempted tightening of regulation to which Kling refers. Regulators were trying for tougher, not weaker standards.
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Anyway, what assets did the regulators choose as “safe”? Again, we will simplify, but basically sovereign debt and mortgages (including the least risky tranches of mortgage-backed debt). So you are a bank president in this new regime. You only have enough capital to meet government requirements if you get 100% credit for your investments, so it must be invested in “safe” assets. What do you tell your investment staff? You tell them to go invest the money in the “safe” asset that has the highest return.
And for most banks, this was mortgage-backed securities. So, using the word Brad DeLong applied to deregulation, there was an “orgy” of buying of mortgage-backed securities. There was simply enormous demand. You hear stories about fraud and people cooking up all kinds of crazy mortgage products and trying to shove as many people as possible into mortgages, and here is one reason — banks needed these things. For the average investor, most of us stayed out. In the 1980’s, mortgage-backed securities were a pretty good investment for individuals looking for a bit more yield, but these changing regulations meant that banks needed these things, so the prices got bid up (and thus yields bid down) until they only made sense for the financial institutions that had to have them.
It was like suddenly passing a law saying that the only food people on government assistance could buy with their food stamps was oranges and orange derivatives (e.g. orange juice). Grocery stores would instantly be out of oranges and orange juice. People around the world would be scrambling to find ways to get more oranges to market. Fortunes would be made by clever people who could find more oranges. Fraud would likely occur as people watered down their orange derivatives or slipped in some Tang. Those of us not on government assistance would stay away from oranges and eat other things, since oranges were now incredibly expensive and would only be bought at their current prices by folks forced to do so. Eventually, things would settle down as everyone who could do so started to grow oranges. And all would be fine again, that is until there was a bad freeze and the orange crop failed.
Government regulation — completely well-intentioned — had created a mono-culture. The diversity of investment choices that might be present when every bank was making its own asset risk decisions was replaced by a regime where just a few regulators picked and chose the assets. And like any biological mono-culture, the ecosystem might be stronger for a while if those choices were good ones, but it made the whole system vulnerable to anything that might undermine mortgages. When the housing market got sick (and as Kling says government regulation had some blame there as well), the system was suddenly incredibly vulnerable because it was over-invested in this one type of asset. The US banking industry was a mono-culture through which a new disease ravaged the population.
