Regulating Towards Depression

Ed.: This review was originally published at the Cobden Cetre and re-published at

[Engineering the Financial Crisis: Systemic Risk and the Failure of Regulation ♦ by Jeffrey Friedman and Wladimir Kraus ♦ University of Pennsylvania Press, 2011]

There have been a good deal of books attempting to find and explain the causes of the ongoing financial crisis.  Authors have approached the issue from all sorts of ideological perspectives and with different sets of evidence.  Most of these works are lacking, incomplete, or even flat-out wrong.  Many of them do not even care for the facts, instead using vague generalizations to justify the application of broad economic theories.  There has not, until recently, really been a meticulous analysis of the mechanics of the causes of the Great Recession, despite the enormous interest displayed by the economics profession in the subject.

This lacuna has been filled by Jeffrey Friedman, editor of Critical Review, and Wladimir Kraus, in their recently published book: Engineering the Financial Crisis.   The authors make the purpose of their study evident from the very beginning.  They shed themselves of any ideological priors which may have otherwise impaired their analysis, even going as far as to disprove a number of general theories from either side of the spectrum (insufficient regulation versus insufficient economic freedom), and task themselves simply with accumulating, analyzing, and interpreting the evidence.  The data they look at has to do with the regulations which governed the financial institutions which presided over the network of financial instruments which suddenly lost the bulk of their value.  The question they ask is a simple one: based on the facts, was the recession caused by under-regulation or was it something in the regulation itself which may have influenced the ways banks invested?

Friedman and Kraus give reason to believe that it was the latter — perverse regulations — which gave way to the great contraction which took place between 2007 and 2009.  Looking through the relevant legislature which dictates the laws governing the banking industry, the authors find that it was this regulatory web which led banks to invest into the specific financial assets that would soon after be deemed nearly worthless.

Friedman and Kraus emphasize the importance of the fact that the banking industry had no idea — what they call “radical ignorance” — about just what kind of quagmire they were investing themselves into.  They use evidence to illustrate the fact that, predominately speaking, the bankers, regulators, politicians, and other major actors in this crisis had absolutely no idea of the relevant potential for a recession to occur, let alone that the highly rated assets they invested into would soon become relatively valueless.

We can see now the broad thesis of Engineering the Financial Crisis.  Bankers did not buy large amounts of soon-to-be “toxics assets” because the risk had been externalized to the taxpayer.1  Neither is there any evidence suggesting that bankers purposefully ignored high risk in favor of pursuing high profits.  The majority of assets purchased were actually AAA rated, and because of this the risk-load they carried, as perceived at the time of purchase, was relatively low.  What manipulated the relevant price signals which funneled investment into the housing market were regulations which awarded these type of investments. To a lesser extent, the authors also point at government programs which pushed for house ownership and the relatively low rates of interest on new loans which made borrowing seemingly more affordable.

Leading up to the crisis, bankers were generally very risk sensitive, preferring assets with lower revenue returns.  Roughly 93 percent of mortgage bonds held by U.S. Commercial banks were AAA-rated mortgage backed securities (both private label [PLMBS] and agency rated [MBS]), and almost another 7 percent were AAA-rated collectivized debt obligations (CDO).2  Missing from this collection of assets were any mortgage bonds rated less than AAA, which were usually the bonds which the highest rate of return.

Most commercial banks in the United States were also above their legal capital reserve minimum on the eve of the financial crisis — the twenty largest banks held capital levels averaging 11.7 percent, where the legal minimum was 10 percent of a bank’s total assets (as dictated by the Federal law, whereas the Basel I accords had set it at 8 percent).  More specifically, if one only accounts for “Tier 1” capital3 banks retained a capital cushion of 50 percent, even while federal law required a minimum of 5%.  In other words, most banks opted to retain a substantial capital cushion, where one would expect a bank interested in maximizing profit (while ignoring risk) to push the boundaries of its legal requirements.4

The issue, then, was not about bankers with low risk aversion, seeking high profits by investing mostly in high-risk assets.  The evidence suggests quite the contrary, actually.  U.S. commercial banks invested in what were perceived as low-risk, low-return assets, and on top of this held higher than required capital cushions.  Also going out the window is the “too big to fail” theory, or any other case that argues that it was risk externalization which created an incentive for an over-concentration of investment into the mortgage market.  Simply put, there was a high aversion to risk during the years leading up to the crisis.

Friedman’s and Kraus’ explanation of what caused the crisis can be divided into two parts: what caused the over-concentration of investment into mortgage-backed securities and why these securities, which by 2008 had lost the majority of their value, had been rated so highly by the major rating agencies.  The strength of their book is found in its accounting of the first — what led to the pattern of investment that characterized U.S. commercial bank assets prior to the recession.

Because different types of investments generally have different degrees of risk, a capital requirement minimum that encompasses all assets is illogical.  Rather, it makes more sense to create different capital reserve requirements for different sorts of investments, based on the general perceived riskiness of the different types.  The Basil I accords was an attempt to correct the issues of a homogenous treatment of assets by creating different categories and attaching a capital reserve minimum to each category.  Higher risk assets, therefore, were categorized into higher risk “risk buckets” and required a greater capital cushion.  In other words, the greater the risk the asset carried the more it cost the banks to protect against, by reducing the amount of capital available to invest.

The issue, as explained by Friedman and Kraus, is that these regulations led to “regulatory arbitrage”.  For example, a bank could invest into mortgage bonds with a risk-weight of 50 percent, then re-sell these bonds to a government sponsored enterprise (such as Freddie Mac and Fannie Mae), and buy them back as an agency bond.  These agency bonds were risk-weighted at 20 percent, effectively reducing the capital cushion necessary to back the asset, even though the composition of the asset remained exactly the same.  The Basel regulations made it more expensive to issue business loans than home loans, creating a financial incentive to issue more home loans.  Basel I created incentives for banks to make certain types of loans and then securitize them.

A further boon to securitization came with the adoption of the Recourse Rule, which borrowed the Basel II accord’s method of rating privately issued securitized assets by risk.  This system caused banks to increase investment in AAA-rated securitized mortgage bonds, especially since the risk-weigh of unsecuritized mortgages remained at 50 percent (as dictated by Basel I).  It remained cheaper to invest in mortgages, rather than other types of loans to consumers and businessmen, and then banks could further increase profitability by securitizing these mortgages and releasing part of their capital reserves for further investments.  This explains the concentration of investment in mortgage backed securities.

We see a pattern between 2001 and 2007 of an increase in housing loans and investment into mortgage backed securities.  We know that at the time that these types of investments being made were being pooled into buckets which were considered generally less risky than other forms of investment.  It was not an issue, therefore, of carrying on more risk.  In fact, this pattern of investment was created out of the fact that the regulations incentivized purchase of less risky assets.  The problem which led to the financial collapse, therefore, deals exclusively with the fact that these assets carried more risk than was originally perceived by the regulators (and banks).  In fact, the collapse of the subprime mortgage market came as a total surprise, both for the bankers and the regulators.

It was not just the architecture of the impending financial collapse that the regulatory web was responsible for, but also the magnification of the disaster.  Thanks to the capital reserve minima, many banks faced insolvency even though the circumstances did not really call for it.  In order to remain legally solvent, U.S. banks are forced to maintain a certain capital reserve minimum.  As the crisis unfolded, bonds which had been previously rated at AAA were suddenly downgraded, raising the necessary capital reserve minima for each risk-bucket.  In other words, as ratings fell for different types of bonds, banks were suddenly forced to raise new capital to cover their loss.

Furthermore, regulations forced banks to mark-to-market their assets to reveal their “true value”.  This process was not done on an individual basis; rather, different bonds were lumped together and them marked-to-market as a group.  So, even individual bonds which may have not actually lost  value were readjusted on a bank’s balance sheet as an asset that was suddenly worth less than it had been perceived prior to the crisis.  It was on the basis of these new market values that a bank’s solvency was judged at.  The issue is that by late 2009 many of these same bonds had recuperated much of their value, and so a bank that had been legally insolvent in early 2008 may not have been two years later.  In other words, many banks were forced into insolvency that could have survived the crisis, and other banks had to radically contract outstanding liabilities in order to remain solvent.

The consequence of these regulatory restrictions was a giant credit contraction — much larger than was actually necessary.  And, of course, the monetary contraction only worsened the situation, as it reduced the financial viability of the various investments that depended on this credit.

Friedman and Kraus blame the inadequate rating of mortgage bonds on the cartelization of the major rating agencies — Moody’s, Standard & Poor’s (S&P), and Fitch.  Basel II and the Recourse Rule had effectively tied their capital reserve requirements to the ratings provided by these three agencies.  It was these three rating agencies that had been classified as Nationally Recognized Statistical Rating Organizations by the Securities and Exchange Commission (SEC) in 1975, and the various regulations that relied on risk ratings depended exclusively on this cartel.  None of the three “nationally recognized” rating agencies, furthermore, had accounted for the possibility of a nationwide hosing crisis leading up to 2008.

There were private rating agencies, though, that had recognized the potential for crisis.  According to Friedman and Kraus one such company was First Pacific Advisors, which sold its $1.85 billion investment in mortgage-backed bonds in late 2005.

Friedman’s and Kraus’ analysis hinges on the notion that what was ultimately at fault were these rating agencies.  Had they been more accurate in their risk assessments then banks would not have malinvested in so many mortgage-backed bonds.  But, why had the banks relied exclusively on the risk-assessment provided by the three “nationally recognized” agencies?  Were these banks not aware of the risk assessments being made by private investment companies?

Perhaps the authors put too much weight on the notion that it was this cartelization of the rating agencies which made possible the crisis, and that had there been more competition in this industry the recession may have been less destructive than it turned out to be.  But, Friedman and Kraus do not make clear exactly how many private agencies had foreseen the crisis, or at least were aware of the likely possibility of an impending crash.  It seems as if the number of investors who had sold off their mortgage-backed bonds in the face of a threat of a market-crash were in the few.  Indeed, the majority of investors were still fairly confident in the strength of the housing market.

Here is where the explanation of the crisis becomes more detached from the data.  Friedman and Kraus leave room for further interpretation, since their explanation for why the different bonds were assessed as they were comes off as inadequate (or, at least, incomplete).  Understandably, they are looking to separate themselves from ideology — even though the book’s conclusions are extremely pro-market — and thus avoid applying far-reaching theories to the evidence they were able to collect.

However, that there is still room for further interpretation is not necessarily a bad thing.  As far as their analysis on the impact of regulations on the housing boom and the consequent financial crisis goes, it is difficult to refute.  That there is still room for the application of theory means that their empirical findings can easily be assimilated into grander explanations of the financial crisis.

For the task it sets out to accomplish, Engineering the Financial Crisis is undoubtedly one of the best books written yet on the causes of the Great Recession.  Jeffrey Friedman and Wladimir Kraus painstakingly dig through the data to provide a solid picture of why there was such an over-concentration of investment in the mortgage market.  The evidence clearly shows that it was the web of regulation on the banking industry that shaped the structure of banking investment by favoring certain investments over others.  The entire system collapsed when it turned out that these regulations had depended on agency assessments that had totally miscalculated the risk these favored assets carried.  Thus, banks had loaded themselves up with mortgage backed bonds, completely unaware of the fact that these bonds would soon be relatively valueless.  It was not the market which caused the crisis, rather the distortions to the market that were created by government intervention.


1. That banks did not buy mortgage-backed securities and other similar assets because the bankers knew that there was no risk for them is a very specific claim, and it does not include many banking practices which are undertaken because of risk externalization (such as the extent of fiduciary expansion, which in our present banking system is a product of its cartelization under the Federal Reserve System).

2.  Friedman and Kraus 2011, p. 42 (table 1.3).

3.  Basel I divides bank capital by the type of asset, Type I being the safest pool.  Type I is composed of “funds received frm sales of common equity shares and from retained earnings.” Ibid., p. 40

4.  A capital reserve basically allows banks to take losses, since it gives it a cushion of assets it can capitalize on to make up for net losses (before liabilities exceed assets).

8 thoughts on “Regulating Towards Depression

  1. Bob Roddis

    1. Excellent analysis. I’m totally with you on the importance of historical data as you spelled out in this comment response.

    Heck, as Rothbard pointed out, the subjectivity of values and the objectivity of prices is actually empirical.

    2. I stand by my same-old same-old beating of the same dead horse: Non-Austrians are apparently engaged in some form of psychological avoidance regarding familiarizing themselves with “the subjectivity of values and the objectivity of prices”, aka the fundamental Austrian concepts. As John Carney of CNBC wrote:

    MMTers do not seem to fully appreciate the problems of ignorance and calculation that inform Austrian economics. They seem to recoil at even thinking about them because of the implications for the limits of political action.

  2. UnlearningEcon

    I’m not much of an expert on the crisis, but Yves Smith (highly knowledgeable) has a go at the ‘demand for AAA securities reflects overcaution rather than undercaution’ story here:

    The general argument seems to rest on what Duncan Foley calls ‘Adam’s Fallacy’ – that banks responded to various regulations by actually creating more risk is deemed to be the fault of the regulations rather than the banks.

    Again, I’m no expert and I haven’t read the book, but that’s just my impression.

    1. Jonathan Finegold Catalán Post author

      Thank for the link. I will have to carefully read and consider Yves Smith’s argument. I’m actually surprised that Critical Review did not have a second symposium on the crisis just to review Friedman’s and Kraus’ book. Has Smith reviewed the book, that you know?

  3. Pingback: On Banking Models | Economic Thought

  4. Meng Hu

    Lot of people mistakenly believe that competition is bad for credit rating agencies (CRA). On the other hand, libertarians tend to believe it’s the actual lack of regulation that has caused CRA to be bad raters and to generate conflict of interests (which seems also to be the opinion held by the authors, as you suggest). I think both views are wrong.

    Competition is harmful among CRA because of regulations, notably, the SEC. When the SEC grants the so-called NRSRO, it signals something to these CRAs. That they have an inflated demand for ratings because investors believe NRSRO ratings must necessarily be very reliable, because it is certified by the authority of regulation. Certainly they become less alert and less vigilant. At the same time, the CRAs do not have motivation to provide accurate ratings. They can, after all, reject the fault and guilt to the SEC.

    See here.

    Without the regulation, CRAs would compete essentially for credibility, but under SEC regulations, I guess they don’t fear (lack of) credibility anymore.

    See here.

    Then as now, Moody’s graded bonds on a scale with 21 steps, from Aaa to C. (There are small differences in the agencies’ nomenclatures, just as a grande latte at Starbucks becomes a “medium” at Peet’s. At Moody’s, ratings that start with the letter “A” carry minimal to low credit risk; those starting with “B” carry moderate to high risk; and “C” ratings denote bonds in poor standing or actual default.) The ratings are meant to be an estimate of probabilities, not a buy or sell recommendation. For instance, Ba bonds default far more often than triple-As. But Moody’s, as it is wont to remind people, is not in the business of advising investors whether to buy Ba’s; it merely publishes a rating.

    Until the 1970s, its business grew slowly. But several trends coalesced to speed it up. The first was the collapse of Penn Central in 1970 — a shattering event that the credit agencies failed to foresee. It so unnerved investors that they began to pay more attention to credit risk.

    Government responded. The Securities and Exchange Commission, faced with the question of how to measure the capital of broker-dealers, decided to penalize brokers for holding bonds that were less than investment-grade (the term applies to Moody’s 10 top grades). This prompted a question: investment grade according to whom? The S.E.C. opted to create a new category of officially designated rating agencies, and grandfathered the big three — S.&P., Moody’s and Fitch. In effect, the government outsourced its regulatory function to three for-profit companies.

    Bank regulators issued similar rules for banks. Pension funds, mutual funds, insurance regulators followed. Over the ’80s and ’90s, a latticework of such rules redefined credit markets. Many classes of investors were now forbidden to buy noninvestment-grade bonds at all.

    Issuers thus were forced to seek credit ratings (or else their bonds would not be marketable). The agencies — realizing they had a hot product and, what’s more, a captive market — started charging the very organizations whose bonds they were rating. This was an efficient way to do business, but it put the agencies in a conflicted position. As Partnoy says, rather than selling opinions to investors, the rating agencies were now selling “licenses” to borrowers. Indeed, whether their opinions were accurate no longer mattered so much. Just as a police officer stopping a motorist will want to see his license but not inquire how well he did on his road test, it was the rating — not its accuracy — that mattered to Wall Street.

    In general, as i said, by granting NRSRO, the SEC could have induced the idea that ratings from CRAs is an obligation. If true, I can easily understand why investors (for what I have been told, and read sometimes) do not trust ratings from non-NRSRO institutions.

    If you’re interested in why Enron has collapsed, which also explains why CRAs failed terribly during the subprime bubble, I recommend you this article here:

    Padilla Alexandre (2005). The Regulation of Insider Trading as an Agency Problem.

    I hoped these authors would have talked about insider trading, but given your review, it seems not to be the case.

    1. Meng Hu

      “On the other hand, libertarians tend to believe it’s the actual lack of regulation that has caused CRA to be bad raters”

      Error. It should have been “lack of competition” because they say there are only too few institutions whereas the opposite view is that even competition this low would generate conflict of interest. They seem to suggest a monopoly for CRAs is the best alternative.


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