Six ways government helped cause the financial crisis

December 22, 2010

Market failure or government failure? The BigGov party is promoting the former narrative, but the latter is more accurate in explaining how government created incentives for disaster. Mark Perry and Robert Dell lay it all out. Here is a sampling, but I urge you to read the whole thing:

1. Bank misregulation, in particular the international Basel capital rules, including a U.S. adaptation to them—the 2001 Recourse Rule—and the outsourcing of risk assessment by regulators to government-sanctioned rating agencies incentivized (not merely “allowed”) the creation and highly-leveraged systemic accumulation of the highest yielding AAA- and AA-rated securities among banks globally.

2. Continually increasing leverage—driven largely by Fannie Mae and Freddie Mac credit policies and the political obsession with taking credit for increased homeownership—into the U.S. mortgage system.

3.  The enlargement of the riskier subprime and Alt-A mortgage markets by Fannie and Freddie through the abandonment of proven credit standards (e.g., dropping proof of income requirements) during the 2004-2007 period, and their combined accumulation of a $1.6 trillion portfolio of these loans to meet the affordable housing goals Congress mandated. As of mid-2008, government entities had purchased, guaranteed, or compelled the origination of 19 million of the 27 million total U.S. subprime and Alt-A mortgages outstanding.6

4. The FDIC, Federal Reserve, Treasury Department, and Congress undertook explicit or implicit creditor bailouts for large financial institutions starting in the 1980s (First Pennsylvania, Continental Illinois, the thrift industry, the Farm Credit System, etc.) and continuing to 2008 (Bear Stearns). These regulatory decisions led to an absence of creditor discipline of financial institution leverage and risk-taking (especially at Fannie and Freddie) and the “too big to fail” expectation of a government bailout.

5. The increase in FDIC deposit insurance from $40,000 to $100,000 per account in 1980 combined with the unchecked expansion of coverage up to $50 million under the Certificate of Deposit Account Registry Service beginning in 2003. These regulatory errors of commission and omission reduced the incentives of business, institutional, and high net-worth depositors to monitor and discipline excessive bank leverage and risk-taking.

6. Artificially low and sometimes negative real federal funds rates from 2001 to 2005—a result of expansionary Fed monetary policy—fueled the subprime and Alt-A mortgage boom and widened the asset-liability maturity gap for banks (see chart below).


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Wow – this is amazing stuff. I really wish I didn’t have deposit insurance so I could spend my time poring over the financial statements of the bank holding my checking account to make sure it was safe. I mean, they would never lie about their excessive risk-taking.

Posted by silliness | Report as abusive

So, according to this, Republican congresses caused all the problems that caused the crisis. How is that a repudiation of Obama or the govt in power now?

Posted by CDN_finance | Report as abusive

I would not blame fannie/freddie for the subprime mess. the banks and mortgage companies got into it first and drove the market. This sounds like another pin head argument that the subprime mess was caused by the community reinvestment act – a little more analysis and common sense reveals this is not true. It’s so easy to blame the weakest victims….. not a hint of classism here is there ?

Posted by diatonic | Report as abusive