The Eugene Fama interview I linked to yesterday created some Twitter discussion that I managed to catch. There was a hint of a suggestion that government sponsored enterprises (GSEs), specifically those responsible for assisting mortgage markets, were, at least partially, responsible for the 2007–09 crisis. The reasoning is that by buying mortgage backed securities and related financial instruments the risk of these assets was transferred to the public. Since GSEs were willing to buy these assets, paying very little scrutiny, banks were willing to accept and package riskier loans that otherwise wouldn’t have been made.

The evidence, however, suggests that the role played by GSEs was relatively minor. It’s true that GSEs purchased large amounts of mortgage-backed assets and securitized private assets. This latter action, in particular, distorted risk assessment, since mortgage-backed securities were categorized under a lesser risk basket under the recourse rule. But, these distortions were relatively minor, knowing that the recourse rule already benefited investment into the mortgage market — not to stimulate mortgage creation, but because these were considered low-risk assets, at the time.

Investment banks were also loading up on mortgage-backed financial instruments, driven in large part because of the United States’ macroprudential regulations (Friedman and Kraus [2011]). These banks were preforming a role similar to that of the GSEs, and this becomes clearer when we separate the conventional banking industry into two parts: commercial and investment banks. Commercial banks were the “loan originators,” or the institutions which directly financed commercial and residential mortgages. These were then purchased by investment banks, transferring the risk of the loan away from the originator. Investment banks, and GSEs, then packaged securities to hedge risks between individual loans, with loans of different quality organized into tranches. In theory, this reduces risk, therefore reducing interest rates and benefiting borrowers. The point is, if it was risk distribution that caused the financial crisis, then investment banks were just as, or more, responsible than the GSEs.

Why did investment banks begin to concentrate their portfolios on mortgage-backed assets? As aforementioned, existing capital regulations rewarded “low-risk” investments by requiring lower reserves. Mortgage-backed assets were highly rated; individual loans that were poorly rated were simply pooled with higher quality debt, and the security received a high rating. This has led many scholars to point their fingers at rating agencies, with some authors suggesting that the system was “gamed” by investment banks. An uncompetitive rating market — since only three rating agencies are considered “nationally recognized” — may be partially at fault (White [2009]), but I don’t think it’s the full story. Rating agencies were operating under some basic assumptions, including,

1. Housing prices were likely to continue to rise;
2. Declines in housing prices would be local and isolated, rather than nation-wide (justifying the pooling of subprime tranches).

The crisis comes down to changes in housing prices. Why did they rise, why did they stagnate, and why did they fall? The Austrian explanation for the first part of the question is: credit expansion. Following the 01–03 recession Alan Greenspan’s Fed lowered the Federal Funds rate, stimulating loan extension, especially for investments particularly sensitive to changes in central bank policy — i.e. mortgages. Housing prices rose, especially where purchases were concentrated, and bubble began to form. The common explanation for the stagnation that occurred between 2005–06 is usually attributed to the increase in the Federal Funds rate, inciting loan originators to issue higher volumes of adjustable rate mortgages (ARMs). These had teaser rates to draw borrowers, but allowed for changes in the rate of interest in accordance with changes in Fed policy. Banks weren’t particularly worried about the risk that some borrowers wouldn’t be able to re-pay loans at higher rates, because it was assumed that the borrower would simply refinance.

In conjunction with a higher volume of ARM loans, we also see a steady rise in the rates of default. What this suggests is that housing was becoming less affordable; credit expansion slowed and the rate of price change fell and soon stagnated. Without rising prices investment in housing soon became even more unaffordable, ultimately targeting a reversal in price changes (i.e. a decline in prices). The banking crisis followed, as mortgage-backed assets plummeted in value and secondary markets dried up. The fact that multiple local markets collapsed simultaneously is a strong indication that there was a common factor, and I think the evidence favors the Austrian story of price distortion.

There is a second way of considering the role of GSEs. Remember, the idea is that GSE involvement distorted risk assessment by transferring risk to essentially public balance sheets. This implies that bankers were knowingly taking greater risks in allocating capital. While not directly commenting on the role of GSEs, there is a literature that deals with financial risk-taking before the crisis. It revolves around the question of whether CEO compensation promoted risk-taking, increasing management compensation through short-term profits at the expense of long-term health. There is strong evidence that there was no significant relationship between compensation and risk taking (see: Fahlenbrach & Stulz [2011]; Acrey, McCumber, & Nguyen [2011]; Murphy [2012]). Further, most banks were over-capitalized and management took huge hits during the crisis, usually because much of their income was in the form of claims on equity (in a paper written as a reply to Fahlenbrach & Stulz [2011], which was originally published as a working paper, Bebchuk, et. al., concede that the losses of 07–09 were greater than whatever gains CEOs earned between 2000–06). The evidence simply doesn’t support the thesis that banks purposefully, or knowingly, chose higher-risk investments. This applies to the GSE thesis as well as it does to the compensation thesis.

(Also, the evidence against the purposeful risk-taking thesis is slight support for Austrian business cycle theory, in the sense that it hurts the case of alternative explanations of unstable price bubble, viz. Minsky’s financial instability hypothesis. This doesn’t mean that some loan originators weren’t extending loans to people they knew wouldn’t be able to re-pay, but ultimately these originators are restricted or financed by investment banks.)

I certainly don’t think that GSE involvement in mortgage markets are a good thing, but history simply doesn’t support the argument that it was this involvement which caused the financial crisis. Overall, GSE involvement only accounts for a small part of the crisis, and it definitely had little to do with the root cause: price distortions caused by fiduciary over-expansion.