Charles Calomiris on the Financial Crisis
Oct 26 2009

Charles Calomiris of Columbia Business School talks with EconTalk host Russ Roberts about the financial crisis. Calomiris argues that it is important to put the crisis in historical perspective in the context of other bank crises. He argues that bank crises differ widely across time and place--some times and some places are placid, others are prone to regular crises. Calomiris argues that frequent episodes of failure are tied to government guarantees such as various forms of deposit insurance or similar incentives for risk-taking. Looking at the current crisis, Calomiris indicts "too big to fail," the government's reliance on ratings agencies as a measure of risk, and poor corporate governance as the key causes.

Gary Stern on Too Big to Fail
Gary Stern, former President of the Minneapolis Federal Reserve Bank, talks with EconTalk host Russ Roberts about Stern's book, Too Big To Fail (co-authored with Ron Feldman), a prescient warning of the moral hazard created when government rescues creditors of...
Richard Fisher on Too Big to Fail and the Fed
Richard Fisher, President of the Federal Reserve Bank of Dallas, talks with EconTalk host Russ Roberts about the problems with "too big to fail"--the policy idea that certain financial institutions are too large to face the bankruptcy or failure and...
Explore audio transcript, further reading that will help you delve deeper into this week’s episode, and vigorous conversations in the form of our comments section below.


Oct 26 2009 at 8:54am
Rob Molt
Oct 26 2009 at 11:02am

I do take exception to Mr. Calomiris’s logic concerning why banking crisis aren’t psychological. I think he misses the point. He criticizes that, if this were true, why would there be high variation in frequency? This is flawed for one simple reason: how does anyone know it’s not random? Many things in nature are appear random from a macroscopic point. That’s not a detraction, that’s just the way things are macroscopically.

Moreover, I question the number of data points he has legitimately concerning the banking crisis. I am not convinced that the factors leading to past banking crisis are in any way comparable to the present. They might be, and we should investigate them, but I distrust all that he said because he did not give any caveats about the limits of his data. I trust a person who runs off what the assumptions are in his model, and he listed none.

I have no faith that the causes of a crisis in the 20s or 30s has anything to do with the present. You could come up with a thousand reasons to reject those data points ( World War is a fundamentally different game than what we have now maybe, or perhaps the absence of World War is more irregular and contributes to falsely fewer banking crises, the technology is so different now vs then that the game is totally different, the list goes on and on). You could play this game with any decade; I am sure an opponent of Mr. Calomiris’s could make historical arguments far better than my own.

Rob Molt
Oct 26 2009 at 11:04am

Is there such a thing as a 101 Economics book from a Hayekian perspective students? Or perhaps 101 is too early; perhaps the basics of 101 are sufficiently universal that maybe it should be ~200 level or the like. But is there a textbook that represents Hayekian ideas that could be used to teach economics to undergraduates?

Oct 26 2009 at 1:53pm

This was great. I would love to hear a debate hosted between Calomiris and someone on the left who blames deregulation, or (for a more interesting debate, in my opinion) someone closer to the middle like Barry Ritholtz who blames a mix of government action and certain acts of deregulation.

T L Holaday
Oct 26 2009 at 3:18pm

It is obvious why someone who cares about how FNMA and FHMC personnel were allocating their hours on the job would be interested in the number of mortgages of various types. It is unclear why this would have any meaning to someone who cares about how FNMA and FHMC were allocating their exposure to default risk. What was the dollar volume of NINJA loans?

John Strong
Oct 26 2009 at 5:07pm

Wow. This was very rich. I just wish Mr. Calomiris had let Russ Roberts interrupt a bit more to frame the discussion.

Oct 26 2009 at 5:14pm

> Looking at 1978 to the present, the number of banking crises defined by the same criterion of large amount of loss relative to GDP–there are about 140 of them.

Exactly what are the criterion? Where do you get this data?


Russ Roberts
Oct 26 2009 at 5:23pm

T L,

I’m not just interested in Fannie and Freddie’s default risk but their role in pushing up the demand for and price of housing between in the 1990s and up through 2007. The actual number of loans tells you something about the magnitude of their involvement in the mortgage market. So does the dollar volume.

Oct 26 2009 at 8:32pm

“Experts are more persuasive when they seem tentative about their conclusions, a study soon to be published in the Journal of Consumer Research suggests.”

This was a good example of a finding that Tyler Cowen posted above on MR. Calomiris often comes across as unpersuasive, because he is not able to intelligently engage in counter-arguments. The “stupid” people who criticize deregulation include heavyweights like Nouriel Roubini, and his inability to engage in their criticisms in a serious way greatly detracts from his ability to be persuasive.

The great counterexample might be Canada, which has deposit insurance, but avoided most of the turmoil of this crisis. Canada has much greater regulation in the issuance of mortgages and heavy restrictions on leverage ratios. Did leverage ratios even come up in the podcast? Also, how silly is it to say that Goldman was covered? They had huge risk in AIG. If AIG hadn’t been bailed out they would have faced huge capital losses.

Oct 26 2009 at 9:27pm

The most illuminating moment in this podcast is when Calomiris is saying that Goldman Sachs limited its exposure to subprime after such-and-such date and Mr. Roberts makes the off-hand point that the ‘limiting’ was done by purchasing credit default swaps from AIG and Calomiris just blows right by. Right by the real reason subprime couldn’t be contained. It’s as if he thinks Goldman was being so responsible and so smart by making a bet with a bookie who actually had NO MONEY TO PAY OUT if Goldman won.

Seriously, aren’t there $50-65 trillion worth of swaps out there? But Calomiris is worried about $1.5 trillion in subprime loans? I just don’t think that $1.5 trillion in subprime loans got the world’s biggest banks into a 30-1 leverage situation. I believe Mr. Calomiris has missed the forest for a couple of small hedges at the edge of the forest.

But thanks for another fine podcast, Mr. Roberts. I do feel you could have been tougher with this guest and I felt you were on the verge of doing so several times but, for whatever reason, just didn’t follow through. For instance, I thought you were going to call him on the inconsistency of his advocacy for “concentrated ownership” of firms by institutional investors and his story about how/why the “buy side” (consisting of institutional investors) distorted the rating agencies’ work product. I was left wondering if Calomiris was being completely honest (maybe consistent is the better word) when it comes to incentives and institutional investors.

Regardless, I’m going to tweet that I loved this show and, hopefully, you’ll get a couple of new listeners.

Russ Roberts
Oct 26 2009 at 10:37pm

Charlie and keatssycamore,

I am sympathetic to your views on Goldman and skeptical of Calomaris’s claims. But it’s not clear.

I’ve spoken to Goldman’s PR people and they claim that much of their AIG exposure was collateralized. With what I asked. Liquid quality stuff, was the reply. Treasuries, etc. But of course we don’t know the real mix and how much of it was MBS that was actually very illiquid and worth much less than the loans they were backing. Not sure we’ll ever know.

But the charts I’ve seen show that they were basically leveraged in the same ballpark as Bear and Lehman. A little less but not much.

The other part of the Goldman story is switching their status so they could get to that Fed window. It stinks. There’s no other way to look at it. Even if they’re clean it still stinks.

Oct 27 2009 at 12:25am
Joe Cushing
Oct 27 2009 at 9:21am

This was the best podcast since Milton Friedman. It wasn’t perfect as some commenters seem to want. There were points that got missed in the flow of the conversation like the AIG trade keatssycamore points out that Goldman made but overall, it was great.

keatssycamore Don’t completely believe numbers about the size of derivative markets. This is a issue that is far more complex than either the typical report of just the sum of all open contracts or the sum of all contracts net of all closed trades. I have never heard an economist address the this issue. The real answer is somewhere in between the two extremes I mentioned above. Some portion of closed trades should be netted out and some should not. One trade that should be clearly netted out is if two parties close their positions with each other. What ends up happening is that this closing trade that reduces the size of the derivatives market actually makes the reported size bigger. This effect greatly magnifies the size. That’s why the derivatives market appears to be bigger than it is.

Complexity enters when traders close positions by trading with people other than those they opened them with. It might not be a good idea to consider such a trade as reducing the size of the market but it is also not a completely right to say such a trade increases the size of the market.

On an exchange the exchange takes on the 3rd party risk so cosed positions should be netted out but instead they act in increase the reported size of the market.

Ryan Szabo
Oct 27 2009 at 10:16am


Is it possible for you to get Prof. Calomiris to recommend some of the “old dusty books” that he has read on past financial/banking crisis, especially the ones he listed that occured in the 19th/early 20th century? The conversation was fascinating and it was very clear that Prof. Calomiris has a deep understanding of the history of banking and finance. I’d love to add several of the books that Prof. Calomiris has read to my reading list. Also, if you are fortunate to receive such a list, can you cross post it to your Cafe Hayek blog?

ps. I am surprised by some of the previous comments. I find it bizarre that some listeners think because Prof. Calomiris left some aspects of the problem out or neglected to mention some components, then that somehow vitiates most of his argument. There is only so much ground one can cover in an hour and a half conversation. Prof. Calomiris demonstrated a substantial understanding of the history of banking and finance, as well as a deep understanding of the incentive effects of the various policies that were discussed. I think it’s up to the listeners to fill in the gaps, and this conversation should be treated as an introduction to the topic, not the be-all-end-all of the analysis. Pick up some books and essays and investigate further, then make up your own mind.

Thanks for the awesome episode Prof. Roberts. I greatly appreciate your podcast.

Oct 27 2009 at 12:03pm

I disagree; I think that Calomaris is broadly right. GS held collateral against its CDS trades with AIG and hedged any remaining exposure via CDS on AIG debt.

Of course, it is unimaginable that GS would have had so profitable a year had it not been for large scale government interventions into the financial markets. As far as that goes, it would be nice to wind-fall tax the excessive profits that mostly seem to end-up as excecutive comp. and not shareholder dividends.

I enjoyed this interview. However, there were quite a few papers mentioned that haven’t been posted. Is there any chance that there will be? In particular, I got the impression that Calomaris himself had recently written a paper on the crisis. Could you post that? Many thanks.

Oct 27 2009 at 1:43pm

Russ seems to really agree with Calomiris’s interpretation. Yet, if Calomiris is correct, how about Taleb, or Cohen? That can’t all be correct, unless he is trivially arguing everything matters to some degree.

Doug Coate
Oct 27 2009 at 3:45pm

from Homan Jenkins inverview with Goldman CEO Lloyd Blankfein 10-10-09

“AIG had been a big issuer of guarantees on subprime-backed paper; Goldman had been a big buyer of those guarantees. Nonetheless, when government officials rang up to ask what would be the potential impact of an AIG bankruptcy on Goldman, Mr. Blankfein says his answer was: “negligible.” He did not, he says, ask Washington to save AIG: “It never occurred to me, having lived through Lehman Brothers weekend, that there was government money for anything. People wanted to know how we were going to do when AIG went down. I was telling them we were fine.”

Mr. Blankfein points to what he calls a fundamental aspect of Goldman culture—its risk-management discipline. AIG had been regarded on Wall Street as a gold-plated client, not just a “Street” counterparty. But Goldman had nonetheless taken the usual step of requiring AIG to post collateral nightly against any deterioration in the market value of the guaranteed assets.

Mr. Blankfein placed some of the phone calls himself. “AIG was being beastly, difficult to deal with, not responding well to our calls for collateral. And I called them up and fought with them, and it was always because they were disagreeing with our ‘marks.’ They never said, and I never had reason to suspect, ‘We’re illiquid. We don’t have the money.’ It never occurred to me.”

Goldman, in its rigor, reinsured any shortfall with other counterparties, who were also required to post collateral nightly. “We had one day of exposure with them. It doesn’t mean I can’t lose $300 million if they don’t pay because that’s how much a market can move in a day, but basically I’m not worried about it.””

Trent Whitney
Oct 27 2009 at 5:53pm

I thoroughly enjoyed this podcast for personal reasons. I was lucky enough to take Prof. Calomiris’ “Economic History of the US” years ago at Northwestern University, and was equally lucky enough to take Prof. Roberts’ “Microeconomics for Managers” at Washington University.

Your discussion and analysis brought a welcome new perspective to the situation and also brought great depth to the analysis. Fantastic podcast, and I echo the comment that it’s the best since the Milton Friedman podcasts!

I hope to hear Prof. Calomiris again on EconTalk, particularly if he could take an in depth look at an event like the 1921 recession and what lessons we could take from that experience and apply to today’s economy.

Oct 27 2009 at 7:18pm

Mr. Calomaris has a lot of confidence in his views and little patience for the “stupid” people who disagree with him.

FDIC: His case for why the FDIC is a bad idea is not persuasive. I for one and glad for it and it convinced me to keep my money in even healthy banks.

REGULATIONS: He does not define what he means by “regulation” when he says the problem is there is too much of it. But assuming he means the rules that the banks have to go by (and not meaning government policy), I would encourage him and others to become immersed in a bank and how it operates at the detail level and not just look a things at the high level from the outside. The regulations are very important to a well run bank and standardize the way banks do business with each other.

Russ Roberts
Oct 27 2009 at 9:57pm


Here is Calomiris’s paper on the history of banking crises:

(Download at the bottom)

and a much longer one mostly devoted to the current crisis but also with lots of historical perspective:

Russ Roberts
Oct 27 2009 at 10:03pm


Everything does matter to some degree. But some factors are more important than others. Taleb is right–people relied on flawed models and convinced themselves. But why? Was it just a mania? I don’t think so. I hope to do a podcast soon on my view of the crisis and what I have learned from various guests, along with where I agree and disagree.

BTW, we now have a category for podcasts on the crisis:

Lee Kelly
Oct 28 2009 at 12:22am


This was a really interesting podcast. I didn’t realise the historical record was so rich with relevent information. Calomiris has got me thinking about recent events in a whole new way.

An economics question for you: if you get what you pay for, how come Econtalk is so consistently good?


Oct 28 2009 at 1:06am

This was one of the best podcasts ever. I’ve listened to it twice because it was so rich in intellectual content.

Oct 28 2009 at 3:47am

I also listened to it twice. And if there is some way to list Calomaris’ papers up among the blue links rather than bury them deep in the comments you should do so.

You omit from your notes Calomaris’ comment on the Fed intending to purge its balance sheet of MBS by engaging in reverse repos (using the MBS as collateral for loans to the Fed). Link, please. Now… the Fed is supposed to have spent $1.25T on these by the end of March 2010 at which point, if it stops, the interest rates will jump up and the market value of the Fed’s inventory will drop to considerably less than the book value. Now, how will this loss be recognized? Or hidden? In making loans to the Fed you presumably don’t really need collateral, since the Fed can just print the money to pay you off, so you may be willing to accept defective collateral, say MBS at book rather than market value. Will that work to hide the loss?

Rob Molt: How do you know it’s not random? Well, you have a hundred years with two or three events, then 30 years with 140. It’s not a random distribution, “macroscopically” or otherwise. See Gauss.

Charlie: Being a “heavyweight” like Nouri doesn’t make your arguments any less stupid. The people who led us into this mess were all “heavyweights” and some of them, as quoted, guaranteed we wouldn’t lose a penny on the crazy enterprises they were paid to promote. If you think Nouri has something to say on the subject that Calamaris hasn’t demonstrated is stupid, then spit it out. The intellectual cred of appeal to authority went out with Ptolemy, so don’t try it here and now.

[I’ve added Calomiris’s articles to the list at the top of the page.–Econlib Ed.]

Oct 28 2009 at 11:54am

I wonder if the silence re: deposit insurance and the hazard it created is in any way attributable to the Fed’s idea of doing reverse repos as part of their exit strategy? After all if the government is already on the hook for the risk and it is remaining on the hook by insuring money mkt funds then that could be perceived as less bad than if it was retaining the risk while offloading the securities.

Oct 28 2009 at 4:17pm

I just read that paper Fannie Mae paid Joe Stiglitz to write (Calomiris referred to it in the podcast) Here’s a line that will knock your socks off:

“Secondly, and more broadly, Fannie Mae and Freddie Mac would likely require government assistance only in a severe housing market downturn. Such a severe housing downturn would, in turn, likely occur only in the presence of a substantial economic shock. Regardless of the structure of the mortgage market, the government would almost surely be forced to intervene in a variety of markets — including the mortgage market — in such a scenario. Fundamentally, given the public’s aspirations to homeownership and the myriad ways in which government subsidies are channeled to homeownership, the government is indirectly exposed to risks from the mortgage market regardless of the existence of the GSEs.”

That’s pretty much the definition of moral hazard. The government will bail us out anyway… so it doesn’t matter whether we have GSE’s or not..

Oct 29 2009 at 2:51am

Government didn’t create complex financial products. They allowed commercial banks and investment banks to merge and seep these products into our 401K’s. Government didn’t push for opacity in the derivatives markets or non-regulation of CDO’s…. it allowed Wall Street to have its way. Government didn’t make these private banks leverage 100 to 1. It allowed Wall Street to have its way. Enforcement wasn’t pushed by regulatory agencies guys like Greenspan, Rubin and Summers all scoffed at enforcement…even of fraud. And low interest rates… they had no choice but to do as Wall Street commanded.

See Frontline’s The Warning

It’s clear which side predicted this disaster… Stiglitz, Rubini, Baker, Brooksly Born and which side cheered it on right to the edge of the cliff. And the ladder is the same side we see above rewriting history even as it unfolds. They do this with the Depression but this time I SAW WHAT HAPPENED! All they do is throw any credibility they had out the window and fool no one of serious intent. It’s very sad and it make discussions such as the one above more about human psychology then about economics.

You can see Professor Calomiris still missing the call as late as Oct 2007 while the above mentioned economist were making the call as early as 2004-5.

“None of this is good news. But in my view, it is too early to conclude that the U.S.
banking system will find itself unable to reallocate risk in an orderly fashion, and end up
having to dramatically curtail the supply of credit. ”

Charles W. Calomiris *

Revised: October 5, 2007

Oct 29 2009 at 9:13am

Something that interested me in the podcast was the discussion about deposit insurance. My initial reaction to someone saying that deposit insurance is the preeminent source of systemic risk would normally be “yeah, right”.

However, I was unfamiliar with CDARS and plan to do some reading up on the subject. I am also wondering whether anyone can suggest some empirical statistical work on the influence of deposit insurance on financial crises. Finally, I would like to see some data on de facto percentages of deposits insured over the last few decades.

Thanks all.

Russ Roberts
Oct 29 2009 at 9:42am


In their book Too Big to Fail, Stern and Feldman quote research over a ten year period (maybe ’89–’99 or ’79–’89) of bank failures and something like 99.7% of deposits ended up being paid, including some or many over the limit but that were covered through FDIC discretion. I have not been able to find out the proportion of deposits that were over the limit.

Oct 29 2009 at 11:06am

Awesome podcast!!! best critique yet. keep up the good work.


Helicopter Ben
Oct 29 2009 at 11:30am

This quote from Mr. Calomiris made my stomach turn…to put it mildly:

“…and it also meant that in September of 2008, when things started heating up for Goldman Sachs and Morgan Stanley that they could become bank holding companies which gave them immediate access to depository funding and to a more regular relationship with the federal reserve which also stabilized the system. So actually, the deregulation stabilized the system.”

I find this statement repulsive, offensive, and wrong on so many levels that I don’t even know where to begin. Did he actually say this? And then he proceeds to call people ignorant? This statement angers me so much.

Can someone explain to me how does it stabilize the system? Why should Goldman Sachs be allowed to become a bank holding company? Why should they have access to depository funding and thus debt guarantees and other government backstops? Do they take deposits? Do they have branches? Goldman Sachs (or should I say Government Sachs) already has a cozy relationship the Fed, the Fed is practically a branch of Goldman. Isn’t that a conflict of interest? In short, my opinion is that this has allowed Government Sachs to game the system and to post record profits WITH NO RISK, and has planted the seeds for a future crisis.

On the topic of regulation, PBS recently aired a program about then-CFTC Chair Brooksley Born’s attempt to regulate the dark market of over-the-counter derivatives (i.e. the CDS market), and the fierce resistance she encountered from Alan Greenspan, Robert Rubin, and Larry Summers. I believe more regulation and transparency in the area would have helped.

Also, when speaking of the Federal Reserve, Russ stated that “I thought the Fed was created to reduce bank crises to create a lender resort that had to be created because the private sector was so prone to this kind of problem.” Is it possible to do a podcast that seriously examines the question of why the Fed was created? Somehow I don’t think this is the real purpose of the Fed. I think it is more nefarious which is why it must exist as a black box. Does it really act in the public’s interests? If not, whose interests does it serve? Who owns the Fed? Does it make a profit and if so where do those profits go? Why was the Federal Reserve Act rushed through Congress during the Christmas holidays? If the Fed serves the public interests, why is it that they are so fiercely against being audited? I hope Ron Paul is successful in abolishing, or at least auditing the Fed.

Oct 29 2009 at 11:33am

Thanks Russ. Wow–that is quite a substantial amount.

Any idea about empirical studies of the relationship between deposit insurance and financial crises? It should be quite easy to come up with a correlation coefficient given a meaningful data set and SPSS, after all… Maybe there’s a dissertation idea in there, if not!

Oct 29 2009 at 2:07pm

“From 1874-1913, period of our first big globalization of markets, free entry into banking throughout most of the world, fixed exchange rates, big capital flows–similar in many ways to the current globalized economy. Where are the big banking crises?”

C. Calomiris

I guess we need to define what we are measuring.

From Wikipedia

Panic of 1873 and the Long Depression

– This is the longest period of economic contraction recognized by the NBER. The Long Depression is sometimes held to be the entire period from 1873–96.[

1899–1900 recession

– This was a mild recession in the period of general growth beginning after 1897.

1902–04 recession

-Though not severe, this downturn lasted for nearly two years and saw a distinct decline in the national product. Industrial and commercial production both declined, albeit fairly modestly. The recession came about a year after a 1901 stock crash.

Panic of 1907

-A run on Knickerbocker Trust Company deposits on October 22, 1907, set events in motion that would lead to a severe monetary contraction. The fallout from the panic led to Congress creating the Federal Reserve System.

Panic of 1910–1911

-This was a mild but lengthy recession. The national product grew by less than 1%, and commercial activity and industrial activity declined. The period was also marked by deflation.

Recession of 1913–1914

-Productions and real income declined during this period and were not offset until the start of World War I increased demand.[21] Incidentally, the Federal Reserve Act was signed during this recession, creating the Federal Reserve System, the culmination of a sequence of events following the Panic of 1907.

I’m not so sure this is the type of economy the modern world desires. Bank crises or no.

Raja Sekhar
Oct 30 2009 at 2:43am

This was a great podcast and the best discussion I’ve heard on the crisis so far. Calomiris has some great insights. While I was already opposed to deposit insurance on principle I hadn’t made the connection from the distorted incentives of depositors to the recent crisis until now. Preventing concentrated ownership of bank holding companies exacerbating principal/agent concerns … buyside firms pushing up credit ratings for regulatory arbitrage… very illuminating.

Oct 30 2009 at 4:39am

I usually enjoy these podcasts, but this one I did not. I found Calomiris arrogant, insulting, irritating, and so obviously a “free-market” fanatic as to loose all credibility. He is a menace to society and should be kept in the basement and only brought out to scare small children and minor government bureaucrats.

Get rid of FDIC insurance and let the plebs take all the risk of loosing their bank deposits? Oh, great idea! 1907, here we come again. That was such a great time for economic growth and stability. In the age of high speed communication, you would see bank runs and collapses (manipulated or not) that would make this credit crisis look like a cakewalk.

Get rid of regulation to limit imprudent leverage and risk at banks and let the markets themselves signal risk and stability? Have you looked at the common stock of Lehman leading literally two weeks before it declared bankruptcy? How about Bear Sterns before it was bought out for $2 (oh wait, then its $10 – great market pricing)? Rubbish.

Blaming the buy side for inflated ratings from the rating agencies? Come on! Follow the money, who was paying for these ratings? Who stood to benefit by the churning out more complex structured products with crappier underlying assets, and obfuscating and shopping to get AAA ratings. The originating banks, that’s who.

And my favorite was the argument that de-regulation actually helped pull us out of the credit crisis by allowing Goldman and Morgan to become bank holding companies. This beggars belief. If it was not for de-regulation or “self-regulation” (oxymoron) in the first place, the banks (&i-banks) would not have been able to use crazy amounts of leverage and ridiculously broken VAR models that they invented, to get us into the crisis. It was only massive government intervention that saved the day.

Banks control the money supply. Stable money supply is vital to our economic stability and well-being. It should not be the wild west, as Calomiris would have it. Banks should be highly regulated, boring institutions with severe limits on leverage and lending activities. Like a utility. My electricity and water work just fine.

Oct 30 2009 at 11:32am


Fantastic podcast. One of the best. The clearest, simplest explanation of the financial crisis I have heard yet. If he can’t convince people like Barny here they’ve got everything backwards, I don’t know what will.


Maybe you should listen to the podcast again. Calomiris is telling you you’ve got it all backwards. Regulating risk out of the market is what causes crises in the first place. Government control =! stability, for all kinds of reasons. Administrations change, regulators get captured, etc.

Put it this way, do you really think we could possibly have a WORSE crisis if we had a “wild west” banking market? Not likely, so give it a chance.

Randall Pozdena
Oct 30 2009 at 8:49pm

One of EconTalk’s best podcasts… One additional observation. Calomiris mentions 1994 as one of the watershed years in sparking the problem, but does not mention why. One obvious possibility is that is when CRA regulations were hardened into quantitative performance compliance rather than process compliance.

As a former Fed official/researcher consulting for banks at the time, the pressure on banks to make junk loans was tremendous. HMDA data was mined by the OCC under Eugene Ludwig, and hit men sent out to threaten any bank that dared to reject loans at a higher rate to protected classes and markets than to others. Credit history or quality did not matter. Only a few banks fought back and demonstrated (through consultants like me) that credit history explained the differences. (And even that was not always dispositively defensive.)

The role of CRA policy has been pooh-poohed as involving “too few loans to explain the subprime crisis.” In my opinion, this is a terrible misreading of history. CRA policy added stimulus to Wall Street’s need to securitize away CRA loan risk, and was a leg of the Fannie/Freddie politically-pushed rush to democratize credit. In a Gresham’s Law-like process, lenders were (essentially) regulated into riskier behavior than they would otherwise have practiced. They were terrorized and punished (by blocking merger and branch transactions) by CRA inspections and held hostage to “community group” extortion. Securitization and underpriced gov’t credit enhancement gave them a way to pass off the risk and no-doc/low-doc mortgages made sense since the credit-democratizers did not think that credit and employment history mattered anyway .

Calomiris is right; it was too much government intervention, not too little, lit the fuse on this financial crisis.

Mort Dubois
Oct 31 2009 at 8:07am

Interesting podcast. It seemed at the beginning that Calamaris was going to give us another “it’s government’s fault” rant, but he did acknowledge something which many of your more narrowly focused guests have missed: something this big, everyone has a piece of it. I have one other question and a comment:

Question: would the number of bank failures in any given period of time be broadly related to the size of the economy as a whole? Does some more or less constant percentage of banks fail at any given time? So is it surprising or not that there were more failures in this century than last?

Comment: towards the end of the podcast Russ and Calamaris both expressed disgust at the political reaction of many citizens to bailing out the banks, and wondered why there is anger at banks when the anger should be directed at the regulators. But this is minutes after an anecdote regarding the defeat of regulation that banks don’t want, by banks. I think what you are missing is the belief by many that the current regulatory scheme is largely a creation of the banks, i.e. rich companies with effective lobbyists own the legislature and are only regulated in ways they find acceptable. I haven’t heard anything in this or any other podcast that refutes that. It’s pretty clear that foxes write legislation for many of our henhouses, that the vast amount of money sloshing around the system is to blame, and that there’s nothing citizens acting within their rights can do about it. It makes me angry, and I doubt that I’m unique.


Oct 31 2009 at 10:59am


Regulatory capture, the phenomenon you are referring to, has happened since the beginning of regulation. It is practically a law of political economy, there is no way to stop it. The specific regulation Calamaris was in favor of was only necessary as a band-aid to combat all the OTHER regulation that distorted incentives.

If any commenter here really thinks regulators could have prevented the financial crisis, you need to read what is coming out of the investigation into the SEC and Bernie Madoff:

The SEC wasn’t bribed or sabotaged, it was just utterly incompetent. The botched 6 separate investigations of Madoff. This is pretty strong evidence that the enforcers at the SEC simply don’t know how to detect rule-breaking. Obviously the smartest financial minds are going to be working for the private sector, not the SEC.

Regulation is not enough, you also need enforcement. This also applies to positive programs like the $7K Housing Credit, cash for clunkers, and FDIC. All of these programs were defrauded at a significant rate.

So even if there had been a regulation on the books that SHOULD have prevented the crisis (maybe there was? who knows), the government simply has no way to enforce such regulation because it is too easy to cloak violations. Just look at the inflated ratings problems, how exactly was the SEC supposed to investigate that? Bernie Madoff is proof of the futility of regulation.

Oct 31 2009 at 2:48pm

I am sympathetic to the guest’s views, and found much here interesting, but he should probably be given the award for “interviewee who most likes to hear himself talk” – and given the company that is quite a feat.

Prof. Roberts, your normally excellent interviewing skills were tramelled. I would have found the podcast more illuminating and less irritating if you had a button that could have cut off his microphone, so to speak.

Nov 1 2009 at 1:24pm

I also saw the Frontline program, “The Warning.”

Calomiris seems to add a bit more to it in his “the bankers don’t want market discipline” comments, and what happened with proposed legislation and bank lobbying.

But why on earth refer to Jeffrey Sachs – he and his buddies got caught in a huge conflict of interest in Russia, which even led to Harvard having to settle a lawsuit for a few million dollars.

Ben Hughes
Nov 1 2009 at 8:26pm

I’ve been away and listened to the last 3 podcasts one after another yesterday – some seriously high quality work Russ, thank you.

This podcast in particular was very interesting, my major complaint being that I have trouble believing anyone who is so sure of the correctness of their argument. Still, it exposed me to new data and ideas and was very entertaining.

Thanks again,


Nov 1 2009 at 9:01pm

Calomiris starts out with “it’s all Government’s fault.”

Then backtracks somewhat when noting that Citi, UBS, etc
were responsible for half of the bad MBS market; and, the GSEs
(fannie & freddie) were responsible for the other half.

So, Calomiris concludes that if not for fannie and freddie,
this crises would only be half as bad.

At that point, the obvious question should have been asked:
“Only half as bad? or just taken longer ?”

Nov 2 2009 at 5:04pm

Just got round to listening to this one. Fantastic. What makes Econtalk so great is not only the content but also the difference in personality of the guests – just compare the interactions between Mike Munger and Calomiris with yourself Russ; both great yet so different in the interactions, which is what makes the show so fascinating and always so different even when the topics have been touched on previously. Good job I have a nice train journey lined up to catch up with this week’s show..

Nov 15 2009 at 8:42pm

Agree with many others this was one of the best EconTalk sessions ever. For that reason Russ, it begs for a follow up interview with someone who has an opposing point of view and counter arguments.

Nov 20 2009 at 8:31pm

I was surprised that Calomiris used the Taylor rule as an argument. Any “rule” regulating the money supply is nonsense. The “correct” interest rate can only be discovered by market forces, i.e. by the demand and supply of money (real money, not fiat money).

Many “free-market economists” don’t seem to realize that monetary policy always messes up the economy. There’s no way any one institution can now what the interest rate on money in an economy should be.

The idea is just as absurd as regulating the price of wheat, and then coming up with a rule that says that when the supply of wheat goes down 10 % we have to increase the price of wheat 10 %, and vice-versa.

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Podcast Episode Highlights
0:36Intro. [Recording date: October 21, 2009.] Financial crisis: put it in historical perspective. One event and about 20 different explanations. All have some truth; what weight do you attach to each? By putting this crisis on the historical regression line of other crises, you get a lot more useful perspective on what was really important. What do they have in common that we should be focusing on this time? First, banking crises are different from other crises historically. While all financial crises--banking, stock market, real estate, sovereign debt--all have a cyclical timing story that has to do with monetary looseness that gets cycles going, what's different about banking crises is that that isn't enough to get them to happen. Right that monetary policy explains the timing; but missing that banking crises pretty much uniformly have to have something wrong with the microeconomic incentives in the banking system. Not going to get a crisis of this magnitude just coming from a normal business cycle reaction of the banking system. Something deeply wrong with microeconomic incentives. In particular, incentives produced by government policy? Yes. If you are telling people with poor credit history that they can get credit with almost no money down and without verifying their documents, and you are making that a government policy through a variety of channels--FHA lending, pressures placed on Fannie Mae and Freddie Mac, and a variety of other means such as state programs. Also, the mortgage tax deduction, but that's not a large effect because the people getting subprime mortgages are not paying a lot of income tax. Big deal was FHA and affordable housing push since 1994 that the government had on Fannie and Freddie. Also other changes. There was a government legislation in 2006 with the SEC proposing rules in early 2007 to make it harder for ratings agencies to be tough on mortgage-backed securities that were subprime. All sorts of Congressional actions pushing subprime lending to happen more and faster. Credit card securitization has been going on for a long time. Some say this is all about securitization, and the so-called "originate and distribute" model having flaws in it. But if that were true, why didn't credit card securitization also fail? In contrast, all the lessons learned for 30 years in the credit card securitization business and which are continuing to be applied, were completely put aside in the mortgage securitization business. That's because of the incentives established by government programs that made it possible for people to put those incentives aside--in large part. Other aspects of the microeconomic incentives.
5:48Current crisis; history, reverse myopia, viewing it as unique, perfect storm. In fact, extraordinarily large number of these banking crises in the United States and elsewhere in the world going back to the 19th century. A lot of people conclude from the frequency of those crises that the banking system is inherently at the mercy of human psychology. Minsky explanation, "Madness of Crowds" story: humans are frail; all of a sudden we get nervous and there is a run on the bank. Or, all of a sudden we just get greedy and want to have a higher rate of return. What's wrong with this story? Economic historians today do not subscribe to it. Basic facts are wrong with it: If it were true that banking crises were pervasive historically and tended to accompany business cycles generally, then we wouldn't see huge variation across time and place in the likelihood of having a banking crises. What we do see actually is banking crises were much more pervasive in some places and some times than in other places and other times. Example: From 1874-1913, period of our first big globalization of markets, free entry into banking throughout most of the world, fixed exchange rates, big capital flows--similar in many ways to the current globalized economy. Where are the big banking crises? There aren't too many if you mean by bank crisis waves of bank failures with lots of losses. Can list them on one hand: Argentina in 1890; Australia in 1893 were really the only two big ones. Each had negative net worth of failed banks of 10% of GDP. A couple of others: Norway in 1900; Italy in 1893. All share features having to do with distortions of government policy that were risk-inviting. Most important: only four of them. Looking at 1978 to the present, the number of banking crises defined by the same criterion of large amount of loss relative to GDP--there are about 140 of them. Twenty of those are significantly bigger than the two previous big ones--Argentina and Australia. About 20 of them have cost more than 20%. Looking at an era when something is very different. Couldn't it be that people got greedier? Historian familiar with human nature--unlikely that human nature has changed in the greed dimension. So what did change? Government policies that invite risk--government protections and bailout policies, which were present in Argentina and Italy, and different kinds of policies that were promoting development of real estate important in Australia. Common argument: If Fannie Mae and Freddie Mac had something to do with the current crisis, how do you explain the real estate bubble elsewhere? As if no other government thought it was a good idea in the last 15 years to over-promote home ownership. But it's not unique to the United States. Very widespread phenomenon. Norway in 1900 actually had a Fannie Mae prior to its financial crisis. Governments sometimes do things that aren't wise in terms of promoting risk in real estate and in protecting banks in ways that removes market discipline and often leads to excessive risk taking because the banks are doing it at someone else's expense.
11:27Play skeptic for a minute. Two points: One, 1978 as starting point for recent wave of bank crises. But FDIC started around 1934; 1938 was start of Fannie Mae, when it was a truly Federal program. Why are the recent years so much worse? Second, a lot of people believe that when the Fed was created in 1913, it was created as a lender of last resort that had to be created because the banking sector was so prone to this kind of problem. Second one: We do have evidence that the Fed reduced the propensity in the United States for financial panics. Want to distinguish between banking panics and the crisis phenomenon of large amounts of bank failures. Not the same, though they sometimes overlap. The Fed, through its stabilizing seasonal fluctuations in the market for borrowing, particularly having to do with the cotton market in the United States, had an important effect on making things more stable at a seasonable frequency; it was that seasonal instability that made liquidity problems that gave rise to panics--but only in the United States, which had a peculiar structure of unit banking. The Fed reduced the frequency of panics; but we didn't have a history of bank failures as in recent times. Panics versus large waves of failures. The richness of the historical record is pretty great; consensus has developed. What is unit banking? Banks were constrained by regulation to only operate in one location. At its peak, over 20,000 banks operating in the United States, and with only a few exceptions, with virtually no branches. Couldn't cross state lines. Highly undiversified banks, so shocks to agricultural markets could cause many problems. Also, because so many players, they couldn't really coordinate their behavior in response to the shocks. Canada, to the north, has a branch banking system from the 1860s on--during periods of U.S. banking panics 1873, 1884, 1890, 1893, 1896, 1907--experienced none of those panics. Canada had a different microeconomic structure. Canada didn't have a Central Bank until 1935. Central Banking was helpful in the United States, but only because of the fragility of the U.S. banking structure. Whole different topic. Broader history of causing over-speculation which leads to very large losses in banks was avoided in the United States with exception of agricultural losses in the 1920s or complete destruction of the world economy in the 1930s. Bank losses--story is a story of distorted microeconomic incentives.
17:31Back to first question: Incredible number--140 banking crises since 1978. For story to be correct, would need to see an increase in encouragement of risk-taking, particularly moral hazard--encouraging risk-taking without worries about the downside risk. How come it started in the United States in 1979 with the Savings and Loan (S&L) crisis? Why didn't we get this earlier? Simple answer: First, deposit insurance wasn't always so generous. Franklin Roosevelt opposed deposit insurance; irony is that people think of deposit insurance as one of his great legacies. Why was he opposed? During the late 1910s and 1920s, every state deposit insurance program that had been created--all eight of them--failed disastrously and much worse than any other systems. At the time everyone understood this. Why did it get created? Created as a temporary measure for small deposits only; pressed by Henry Steagall of Alabama who came from a state where small banks were politically influential and saw this as a way to prevent competition by preventing consolidation. Why would it prevent consolidation? When you protect deposits, it would remove competition along the dimension of risk. Large banks, like those Canadian branching banks, could compete with small banks by saying "Look how stable we are." If small banks want to compete, they want to have Uncle Sam behind them. Big deal in Alabama, less important in New York. Over time that coverage increased. In 1980, increased to $100,000; by statute. Gary Stern podcast. In practice, 99.7% of all deposits ended up being insured regardless of the limit in the 1980s. Alan Blinder didn't help matters by inventing something called CDARS. Great if you are rich. How deposit insurance works: Suppose you are a family of four. First, you are covered in the old days before this crisis to $100,000--can open an account singly for each of the four; then any pair can open a joint account; then any three can open another account; and then all four. Can have 13 accounts at same bank covered up to $1.3 million--each account up to $100,000. Then can go to every other bank and get same. Hard work. CDARS created a swap concept so banks could set up syndicates. Say you have $50 million and go to one bank; ask to swap it out to other banks. With the current $250,000 deposit insurance limit, your bank has to find 200 banks that are willing to participate in your deposit. Each bank gets, nominally, $250,000 deposits of yours, but from your perspective you have $50 million at one bank. The banker wants you to stay just with him. So the bank says, don't worry. Now we've created CDARS that allows people to effectively have all of their money insured. So deposit insurance went from being a temporary measure only for very small deposits pushed by an Alabama advocate of small rural banks, known to be as special interest legislation, to be increasingly protective of more and more banks. Can see why bankers like to not have to compete on the dimension of risk. Also, monetary policy and fiscal policy became much more volatile, particularly after the 1960s as inflation went up. Powerful generator. The 1960s were extremely low risk in terms of volatility of the stock market or price level. In the 1970s, cranked it up, had risks to bet on; coverage went up dramatically. Combination of expanding coverage and expanding risk that allows you to see what happens with the S&L crisis in the late 1970s. Even Friedman and Schwartz, thought to be politically conservative, thought deposit insurance was generally okay; in 1963 wrote this system seems to work well. Were looking at a placid period. Used to have "postal savings" in the United States--alternative system if people were worried about putting money in the bank. Invest in U.S. Treasury Securities instead--no risk at all. Don't need deposit insurance to protect against risk. Deposit insurance has been the single most important contributor to risk in the financial system. Hopeless probably to get rid of it; spread throughout the world. Which is why we have had so many banking crises.
26:45If you look cross-sectionally at times when deposit insurance is reduced, you actually see less risk. Mexico: 100% de jure deposit insurance in the 1990s. Had their big crisis; and deposit insurance went down. Didn't go down de jure, but there were so many losses that people started saying they weren't sure the government could cover that many losses. Banks with weak assets started seeing people withdraw their money; first discipline in a long time. Also in England, which had historical banking panics with costly resolution problems: 1819, 1825, 1836, 1847, 1857--reflected that the government was pressuring the Bank of England. In the London bills market, put options--if things started to go bad for you and you are holding a bill of exchange that you worried might have some losses--a form of lending--you could just "put" it to the Bank of England at the discount rate and let it be the Bank of England's problem collecting on the bill. Why did this happen? Parliament required as a quid pro quo that in exchange for certain privileges that it gave the Bank of England that the Bank of England give this kind of put option. Sounds a lot like Fannie and Freddie--get this privilege but had to give something back. Gave back huge systemic risk. Every time a crisis happened, relax restrictions on abilities to lend. Bank of England would say "Please don't relax the restrictions! We don't want to lend!" and Parliament would say "You know what you have to do." Finally after the 1857 crisis, the Bank of England, with the support of the press and Parliamentary hearings that backed them up, said "Enough." Public statement--implicit put option no longer exists. One more banking crisis--Overend Gurney crisis--largest bill broker in England, bailed out by the Bank of England in 1857, but in 1866 when they came looking for money again the Bank of England said No and didn't bail them out. That was the last banking crisis until WWI--different kind of crisis. This is the mainstream interpretation going back over 100 years--can read about it in dusty old books. Protection of banks--we rely now entirely on regulation and supervision. Used to be supervised by depositors, but they no longer have skin in the game. We now have to depend on regulators. Bankers have lobbied against reforms that have been proposed. Combination of subsidizing risks in the housing market and not tracking risks in prudential regulation in an environment where there is no depository discipline any more because of deposit insurance--and furthermore even beyond the explicit protection--and implicit protection of "too big to fail" starting in 1984 with Continental Illinois. Now have a system where we rely entirely on prudential regulators to stop risk, while the government out of its other pocket is subsidizing huge risks, particularly in housing. No surprise that when we finally get another government-caused problem in the form of very loose monetary policy from 2002-2005, negative real Fed Funds rate, departures from the Taylor rule--combine these government mistakes and end up with a huge banking crisis that looks a lot like what other banking crises look like in other places and other times.
34:07Skeptical view: All that's true, but the worst excesses of the crisis occurred in 2004-2006, when subprime securitization exploded--a little over $1.5 trillion--mostly generated by Wall Street firms, not Fannie and Freddie; mostly bought and held by Wall Street firms using models of risk that were overly optimistic. Greedy and myopic. Nothing to do with the government. In 2004, Fannie and Freddie decided to get into subprime mortgages in a big way, particularly in low-docs and no-docs (documents) mortgages. Sent emails in February; read the emails because testified before Congress. Risk managers thought it was crazy--know from the late 1980s that if you tell people you are not going to check on them you attract low credit risks. Most vocal was fired. Fannie and Freddie the big players. If Fannie and Freddie decided they were going to make markets in those securities, the securities are going to take off; and they tripled in 2004. How do you quantify that? Data in paper. Ed Pinto: when you look at outstanding paper, Freddie and Fannie hold $1.6 trillion of the non-FHA--who are also doing this--$3 trillion loss exposure to subprime lending. Start with the fact that prime and subprime mortgages are not just labeling issues but performance issues. Different buckets for mortgages. If the bucket has performance that looks identical to subprime then it's essentially subprime. On their face they are subprime--Fannie and Freddie had their own naming conventions; but if you don't believe they are subprime on their face, then observe that they are subprime in performance--ten times worse than prime loans. Ex ante or on delinquency basis--both subprime. Pinto on firm ground saying that Fannie and Freddie understated. People who financed them didn't need to look because they were counting on the bailout. First: Fannie and Freddie did play a huge role. No just the no-docs. Half of subprimes are related to no-docs. Other half relating to the modeling assumption that you would never have housing prices go down. Very fast process--2004-first quarter of 2007. Also weird: starting in the middle of 2006, as Joseph Ackerman said in a speech in December 2008 at the European Central Bank, that the gig was up.
40:17In the middle of 2006, it's clear that it was an unreasonable assumption to believe that housing prices would never go down. Also unreasonable to believe that no-docs wouldn't attract bad credit risks. We already knew that. How did we forget? People are greedy? Even if you wanted to pretend you didn't know till then, the ratings agencies were telling you that housing prices have stalled, modeling assumptions too optimistic, and the 2004-2005 cohorts starting to see excessive delinquencies. Joseph Ackerman: Deutsche Bank--makes sure it has no exposure--Goldman Sachs does the same. JP Morgan Chase never got into it. Deutsche Bank gets covered sort of by buying credit default swaps. Big story aside from 2004 beginning: Fannie and Freddie continue to buy at peak levels for the second half of 2006 and the first quarter of 2007. So do UBS, Citibank, and Merrill Lynch. Shocking. The problem wasn't originate-distribute. Bear Stearns and Lehman Brothers were also involved, but they were small players. If the other five larger institutions had stopped doing this in 2006, we wouldn't be having this conversation. Side note: In 2007, 23% of all of Freddie and Fannie's home purchase loans--as opposed to refinancing--was for low-downpayment mortgages. Shocking. What were they thinking? We know what Freddie and Fannie were thinking--heavily involved in the Washington politics; accounting scandal in 2003; Alan Greenspan had turned against them in 2000; started having a few people starting to be vocal opponents. Congress was always defending them; starting to come apart at the seams.
45:52Still have to try to understand Merrill and Citi and UBS? If you had asked specialists in corporate governance before the crisis: Which of the banks do you think is best at creating value for its stockholders? Probably Citibank and UBS would have come toward the bottom. Also from an ethical standpoint. Cultures not good cultures. Stockholders are the ones who really got hurt--if they didn't get out in time. A lot of them made a lot of money. For a long time these banks generated high rates of return. Especially for their own senior managers. Key question: Why were these managers willing to do these investments when they should have known better? Salient that not everybody that's doing it. Can understand about Freddie and Fannie, but not such a clean story for Citi and UBS. We've designed these institutions by regulation to be relatively immune to corporate governance--not a large number of stockholders with a large enough share. Citi, have one person. Need concentrated ownership. A few banks with bad corporate governance could take very large risks. Expand: Regulations were put in place to restrain concentrated ownership. Argument: make sure the institutional investors--who would be involved in other transactions--public companies, wouldn't have too high ownership. Lawyers think ownership creates conflict. Economists think ownership creates the right kind of conflict. Stewardship. Lawyers run the legal process; 1940 Act. As a result, ownership stakes are de-concentrated. Sanjay Bagat (sp?) paper--corporations work better with concentrated ownership, particularly with ownership by sophisticated institutional investors. If somebody has 10-20% ownership of a firm they want to make sure the managers are doing things well. With two or three people--get together for dinner and can jointly decide to throw out a bad manager. Myth of fragmented ownership hasn't penetrated lawyers. Poland restructuring in 1990s: Jeff Sachs and others convinced the Poles that they needed to establish concentrated ownership in the newly privatized firms. The new mutual funds that were created were assigned big chunks of interest. Opposite of United States. Design flaw. Hedge funds and private equity funds are not covered by the 1940 Act in other areas; in the banking area they are barred from becoming controlling investors because of concern about the overlap of commerce and banking. We've set up large holding banks in the United States to be the most undisciplined places for corporate governance in the world. Doesn't always go wrong, but went wrong hugely for Citibank. Bebchuk and Spamann paper: incentives for management within bank holding companies.
54:42Ratings agencies: a lot of people think they are a major part of the problem. Reflecting another problem, related to last question. Not just why these banks originated these things but why they bought them. Also want to try to understand why insurance companies, pension funds, and mutual funds bought huge amounts of this stuff in 2006 going into 2007. Why were the ratings agencies willing to pretend that these things were still triple AAAA long after they should have known better? And they did know better in the middle of 2006. Standard argument--they were being paid by the people issuing the securities; conflict of interest. Wrong. It was not a secret that they had a conflict of interest. Sponsors are selling. Ratings agencies are working for the buy side whether the buy side is paying them or not. Two issues about the buy side: one, the buy side are the ones for whom the ratings are used for regulatory purposes. If you are a pension fund, mutual fund, or insurance company, or a bank and you buy these securities, the ratings matter because you are regulated by the amount you buy. They let you leverage them differently; they might have prohibitions on how much of a certain class you can buy; you get to do more things as a buy side investor if you have more favorable ratings. Cantor and Packer paper: Securitizations, which are all bought by corporate institutions, not individuals--all of the grade inflation starting in the 1980s was located in securitization-related markets, not in corporate debt markets. The institutional investors wanted grade inflation because grade inflation loosened the regulations that bound it. That's where "too big to fail has to come in." Story told by someone at one ratings agency: Sponsors go out and ask ratings agency if it will give them a favorable rating; then go out and ask another agency; and they go with the agency that gives the best story. Agency shopping. Why would that work? It only works if the buy side wants it to work. Let's say Moody's is the best--most demanding, most trustworthy--of the three. When Moody's is dropped by the sponsor, the buyer knows Moody's would have rated it higher, so he says he's not going to pay so much for it. If the buy side behaved that way, ratings couldn't have gotten inflated. Agent asked by buyer why a rating was so off: "We didn't rate that because it was so horrible. Why did you buy it?" Answer was: "We have to put our money to work." What does that mean? If you are out there running a fund, mutual fund, whatever. Hedge funds have better incentives about risk. Other institutional investors say they have to put their money to work. They are making their fees for managing risky investments. Nobody is giving them a hard time. They are the ones who drove ratings shopping and the race to the bottom. Why? If you are making your 1% on assets managed, you want assets managed to be large. Not consistent. Consistent: have to be able to think of more than one idea. If we hadn't had the monetary policy blunder of 2002-2005 we wouldn't be here talking today. If we hadn't had Fannie and Freddie pushing to get affordable housing to happen with virtually no money down, we wouldn't be here today. And if we had had good prudential regulation for measuring risk credibly we wouldn't be here today. Didn't have that third thing because we were relying on the banks to tell them what the risk was--a joke--or to have the ratings agencies tell them what the risk was--a double joke. The ratings agencies are working for the buy side--the institutional investors and the banks. The ratings agencies' incentives were that as soon as regulation was outsourced to them they would become grade inflators because they got paid for it. People who paid them were the buy side.
1:03:32Then question has to be: why were these three banks--we already understand Fannie Mae and Freddie Mac--but what about Citi, UBS, and Merrill Lynch--willing to buy so much of their own bad stuff? Agency problems: why people are willing to invest other people's money badly. They earn fees on other people's investing. Two problems: why would I keep giving such companies my money? Because ratings agencies were a coordination device for plausible deniability. Everybody investing can say they did the same thing as everyone else. Where are you going to put your money instead if everybody's under the same compensation rules? Problem with that, for two reasons: One, that would conflict with the Lehman Brothers, Bear Stearns, Goldman Sachs, JP Morgan Chase division--doing well before the bubble started to pop. Pressure on other banks to do as well. Some resisted it, and they are profiting now. Missing the point: those institutions were run by people who were operating in good corporate governance environments maximizing shareholder value, including their own CEO shareholder value but not just their own. There is another regulation: mutual funds. Mutual funds are not allowed to have fee structures like hedge funds. Not allowed to have profit sharing on the up-side only. If you are running a mutual fund, if you want to take 20% of the profits and 0% of the losses and a flat fee of 2%--standard fee for hedge funds--that's not legal. No money manager is going to write that contract. Can't afford to take the downside. Optimal contract probably doesn't look very different from the hedge fund contract. Pensions also not allowed. They are allowed to have fees that are proportional to assets managed. Want to keep assets managed growing. But as an investor you know they have that incentive. Who do you go to instead? Some incentive for someone to establish a better-run mutual fund. Poor people--ordinary middle class folks--can't use CDARS and neither can we go to hedge funds because we don't have enough. So we have to play the game with the mutual funds, which are all coordinated by the same bad regulation. Don't want to put everything on regulation. JP Morgan Chase was regulated the same way--why didn't they do badly? We have to explain these things. Most of story so far, though, is bad government monetary policy, bad government subsidization of risk in the mortgage market, bad government prudential regulatory policies that outsourced stupidly to ratings agencies with bad incentives which in turn outsourced to the banks themselves to tell them what the risks were, and bad policies that limit the concentration of ownership within banks and bad policies that limit the incentives of institutional investors to not have skin in the game. Then we are surprised that the private markets aren't working perfectly.
1:08:52Discussion from before started taping: a lot of critics of markets have suggested that the above story is wrong; it's all about deregulation and we let banks get into too many things, all the Graham Leach Bliley Act. Institutionally wrong. To Obama administration's credit, though they said these things before the election, have stopped saying them. Deregulation did three things since 1980. First, removing Regulation Q, which was a limit on interest banks could pay on savings deposits. Didn't make sense to begin with and everybody glad we got rid of it. Number 2: eliminating restrictions on branching--at state level, regional level, and finally in 1994 nationwide branching. This clearly stabilized banks and made banks more efficient. Number 3: removal of restrictions on underwriting of corporate securities, which had been phased out starting in 1987 with experimentation that was done; testified--never made sense--that somehow banks got too risky when they underwrite corporate securities. No real risk associated with underwriting, a very short term period when you are making a market. All we are talking about, having to do with Glass Steagall, is allowing banks to get into the underwriting business, without limit, which had been phased out 1987-1989. This has nothing to do with subprimes. We wish they would have done more with underwriting corporate securities and less with subprime debt. If none of the deregulation just described had been done, banks could still have done everything that they did. Stand-alone investment banks were very much a part of this problem. They weren't even covered any of this. Merrill Lynch, Bear Stearns, and Lehman Brothers weren't even affected by any of these regulations. Two other reasons it's nonsensical: When the investment banks like Merrill Lynch got into trouble, the fact that we had relaxed the Glass Steagall barrier meant that Bank of America could buy Merrill Lynch, which stabilized the system; and JP Morgan Chase could buy Bear Stearns. Also meant that in September 2008 when things started heating up for Goldman Sachs and Morgan Stanley, that they could become bank holding companies, which gave them immediate access to depository funding and a more regular relationship with the Federal Reserve, which also stabilized the system. So actually, the deregulation stabilized the system. Zero effect on the risks at the heart of this.