How can we discourage banks from taking excessive risks? (Scott Sumner of Money Illusion)
Peter Wallison: Other than through regulation, it's almost impossible to prevent banks from taking excessive risks. But there is one thing we could probably do that would help and that is to make sure that banks disclose more information to the market than they do today.
Right now, banks disclose a lot of information to their regulators. They disclose some information through their financial statements, but none of that gives creditors of banks enough information to understand whether the banks are really taking risks or not. So, we are relying in almost all circumstances on the regulators to prevent this risking and as it's turned out, I think it's fairly clear that the regulators are not very good at understanding the kinds of risks that the banks are taking. So, we have to rely on creditors and to rely on creditors, we should be giving them a lot more information.
But we will never be able to eliminate moral hazard from banking simply because the banks are backed by the government.
Should there be a minimum downpayment requirement on mortgatges? (Scott Sumner, Money Illusion)
Peter Wallison: I think that's a good idea. That used to be the case. We required minimum downpayments of 20%, then went to 10%, and then it went down to as low as no percent and that's one of the reasons why we have so many problems today.
A 20% downpayment would be a good way to start and that's the way it used to work. It turns out that the downpayment is the key to determining how sound a mortgage will be. The lowest downpayments result in the highest defaults, the highest downpayments are the ones that maintain solid prime mortgages better than any other system.
What happens if regulators are still unable to unwind non-banks? (Dan Indiviglio, The Atlantic Business Channel.)
Peter Wallison: You know, the different between a bailout and unwinding is a little hard to understand in some cases. If we're talking simply about the question whether an institution can be liquidated, and I think that's what most people mean by "unwinding." It's very hard to imagine that that can't be done by some organization, like the FDIC, or any other kind of organization.
Bailouts, however, are done not because an institution has failed, but because it's important to keep the institution going, and that has much more to do with the size and importance of the institution and what its effect will have on the rest of the market if it's allowed to fail.
I don't know exactly how we can say an institution can't be unwound, it can always be closed down. The question is whether we want it to be closed down, and in my view, very large commercial banks can create the kinds of, we'll call it a systemic breakdown, if they are not bailed out. Other kinds of financial institutions do not raise those questions for a variety of reasons, but non-bank financial – I’m sorry, bank financial institutions, that is, those that are commercial banks backed by the government could under some circumstances create serious systemic breakdowns and have to be bailed out. What we have to do, I think more than anything else, is through regulation and through the kinds of transparency that I talked about before, try to make sure that the market understands the risks that these institutions are taking so that they are deprived of the funds that they can take risks with because the market is well aware of how those funds are being used. If we don't do that, if we are relying entirely on the regulators to prevent these firms from taking excessive risks, well, I'm afraid we will have to engage in bailouts because we must keep some of these very large institutions alive under some circumstances.
How should capital ratios be determined? (Dan Indiviglio, The Atlantic Business Channel)
Peter Wallison: I'm afraid I have to go back again to talk about transparency here because it is exceedingly difficult to imagine any kind of formula that actually captures the risks that banks are taking. Under Basel 1, we had a formulat with a number of buckets and we cast all commercial loans into one bucket and all mortgages into another bucket, but in fact, they're not all the same. They do not all involved the same kind of risk. So we have to have a more refined system.
Under Basel 2, there was an effort to allow banks to use their own methods of risk measurement in order to determine what's risky and what isn't. Again, I don't think that is going to work out very well. We can see pretty clearly that banks have incentives not to disclose fully the kinds of risks that they're taking.
So, what I think we must do, and it's probably the most sensible thing to do, is to try to get much more information out into the public so creditors understand the risks that are being taken by banks, and they will then apply the kinds of market discipline that will keep banks from taking too many risks.
What is the minimum size at which a financial institution exhausts all economies of scope and scale? (Mark Thoma of The Economist's View)
Peter Wallison: I don't think anyone can possibly know the answer to that question. There have been a number of studies by economists of this question; what is the largest the bank can be in order to be efficient in terms of economies of scale or scope, but many of those studies have been flawed. And I think we ought to give up attempting to determine what is the right size for a bank. It actually could vary quite a bit depending on the kinds of assets that the bank holds.
So, this is not a good way to pursue the issue. I think a much better way to pursue the issue is to think about what happens to a bank that is not efficient in terms of its economies of scale or its economies of scope. That bank is going to be out competed by other banks. It will eventually go away.
Let's think, for example of General Motors. When I was on college, I was taught in my economics class that General Motors was so big and so powerful that it could never be broken up, never be out competed and that we needed a big government in order to control General Motors. Well, what we found out was that a company called Honda, or other companies, can take care of General Motors if they produce a better product. General Motors was probably too big, not well-managed and as a result it had to be rescued by the government.
So, I think we ought to let the market take care of this problem of banks getter very, very large. It doesn't necessarily mean that they're larger than they have to be in order to operate efficiently; the market will determine that by the kinds of competition that they have to face.
What should be done to eliminate too big to fail? (Mark Thoma, Economist’s View)
Peter Wallison: If we're talking about banks, I don't think there really is an answer here except what I believe is the only effective answer. We must have regulation of banks because they are backed by the government. We're talking here about commercial banks, the kind that take deposits. And we should have more transparency.
If we are talking about non-banks and financial institutions, large non-banks and financial institutions like insurance companies, or securities firms, or hedge funds and so forth, I don't think there's anything we have to do about those. I think if they fail, they should go right to bankruptcy and they ought to be treated as the bankruptcy laws treat failed companies. I don't see that they will cause any problems, any kind of systemic problems because they failed. In fact, we have evidence of that in Lehman Brothers. When Lehman Brothers failed, yes, there was a problem in the market afterward, but it was not a problem that came out of Lehman Brothers being unable to meet its obligations. It was a problem that came from the fact that no one expected a very large financial institution like Lehman Brothers to be allowed to fail, and when it was, they became very worried about who else they were dealing with who might be in bad financial condition.
But the studies since Lehman Brothers have shown that all of Lehman Brothers' major counterparties, 30 of them, suffered no adverse results from Lehman Brothers' failure; and that's what I would expect. So, we should not be trying to rescue non-bank and financial institutions. We should just let them fail and focus entirely on the banks.
Should Fannie Mae and Freddie Mac been allowed to fail? (Mark Thoma, Economist’s View)
Peter Wallison: Yeah. I think the answer to that question is that I would not favor government intervention under any circumstances except in the case of a very large commercial bank. But a large non-bank institution should be allowed to fail, and if we start interfering in the financial condition of non-bank financial institutions, we will introduce huge amounts of moral hazard into our system. People will no longer be sure which company will fail, which companies will be rescued, and that will be far worse than anything that can occur if a major financial institution, non-bank financial institution should faile.
Why were people reluctant to admit that Fannie and Freddie were out of control?
Peter Wallison: One of the problems with Fannie Mae and Freddie Mac, in particular, was the fact that they were very, very powerful companies. They were probably the most powerful companies in Washington that -- most powerful companies of any kind that we have ever seen. They had terrific networks between their own staff and the staffs of Congress, between themselves and Congress people, members of Congress, Senators. They had a very shrewed system of giving Congress people credit for the things that Fannie and Freddie were doing, and listening to the requests of the people from Congress. So, it was very hard to break that bond that existed between Fannie Mae and members of Congress.
Another aspect, of course, was campaign finance and they were clever in that they not only make contributions themselves to the most important people to them in Congress, but they organize various groups that depended on them, like the securities industry, the realtors, the home builders, they organized them to contribute to special Congress people who were a help to them. So, they actually built a virtually impermeable shield around themselves in Washington. And no matter how much criticism they received from anyone, it did not result in any significant change in Washington.
I was one of their critics, but obviously not a very important one. But some of the things that I wrote did enlist Alan Greenspan as one of their critics and he, as the Chairman of the Federal Reserve at the time, was an extremely important person. Every time he testified he complained about Fannie and Freddie and the risks that they were creating, but it never made any progress. Occasionaly, there would be a bill that would come out of one of the congressional committes, but it never got to a vote on the floor.
How will Fannie Mae and Freddie Mac be regulated in the future?
Peter Wallison: There actually isn't anything currently in prospect in Congress that will have any affect on them. And one of the reasons for that is that they made themselves into institutions that was so central to the housing finance system in this country that we cannot do without them until the entire housing finance system returns to normal. We are in a crisis there right now, housing prices continue to fall, it's very hard to find financing except through Fannie Mae and Freddie Mac. And so we have to keep them in business, we have to keep them functioning. The government has to keep feeding money to them as they suffer losses, in order to keep our housing finance system operating.
So, there's nothing going on now, and there will be, in my view, nothing significant going on in Congress, or from the administration, until we reach the point where the housing market has returned to normal and we can start thinking about alternative methods of financing mortgages. We can't do it now.
How is the government still entangled in the housing market?
Peter Wallison: There are several ways actually that the government has involved itself. FHA has been, that is the Federal Housing Administration, has been important in supporting low income housing for many, many years, but it was always very small. Fannie and Freddie actually competed with FHA and made it even smaller during the time they were operating because they took away a lot of it's sub prime andother non prime business and used those morgages themselves to satisfy some of the obligations that the government had put on them.
Another significant government involvment in the housing business is something called the Community Reinvestment Act which requires banks to make loans in communities that are said to be underserved. Now to make a loan that qualifies for CRA treatment, that is Community Reinvestment Act treatment, it has to be to someone whose income is 80% to the median income, that is 20% below the median income. That's the way a loan is classified as a Community Reinvestment Act loan. But you can understand that large numbers of such loans would not be prime loans. Many people who are at that level do not have steady jobs, do not have steady income, have blemished credit, and banks are required to make these loans to people in those circumstances because it was government policy to increase housing in this country, and that, in fact, succeeded. We did raise homeownership from about 64% where it had been for about 30 years, to about 69% in the early 2000's. But we did it, of course, by providing financing to people who could never have raised the funds to buy a home before, and probably should have been renters all along. But that's the issue that I think we all have to look at very carefully now because those loans, which are failing at unprecedented rates are part of the reason that we have a financial crisis today.
Is the government more or less involved in the housing market since the financial crisis?
Peter Wallison: Well, much more involved now. All of the things I have talked about before that is Fannie Mae, FAH, CRA, they existed long before I started looking at the housing market and exists, of course, today. But today the governmentis actually involved in the housing market in ways that are exceedingly important because things had gotten so bad there. So, the Federal Reserve is buying the mortgage-backed securities of Fannie Mae and Freddie Mac in order to keep their interest rates low so that they canprovide financing to banks, which in turn will be able to provide financing to homeowners. We're trying desperately to keep a market in homes going in this country. We also have the government attempting, through many programs of various kinds, to get banks and services to negotiate with homeowners that haven't been able to meet their mortgage obligations. Those are all involvements by the government in the housing market that didn't exist ten years ago because they didn't have to exist.
Today, because of what Frannie and Freddie did, because, I think, of government policy, we have had a catastrophe in our housing system and now, the only way to address that catastrophe is to have the government take even a bigger hand. But what I hope will happen, when all of this is over, is the government will completely withdraw from the housing finance system, turn it over to the private sector and we will not have these disasters in the future.
Is more or less regulated than it was in eighties?
Peter Wallison: There is slightly less regulation, but it had nothing to do with the financial crisis. The only really significant deregulation that occurred in the financial industry was the Gramm-Leach-Bliley Act of 1999. And the only thing of significant that that did was it allowed banks, commercial banks, to be affiliated through holding companies with firms that are engaged in other financial activities, such as securities, underwriting, and dealing. Many people say that the Glass-Steagall Act was repealed by the Gramm-Leach-Bliley Act. Not true. The Glass-Steagall Act still applies to banks. They are still forbidden by that Act to buy -- to actually underwrite and deal in securities.
However, what they Gramm-Leach-Bliley Act permitted is for banks to be affiliated with companies that underwrite and deal in securites. That has been blamed for the problems that were encountered by the large investment banks; Goldman Sachs, Merrill Lynch, Lehman Brothers, and Bear Sterns, and so forth. But in fact, had nothing to do with those investment banks. They were never bound by Glass-Steagle and they have never become involved with banks. They are not bank holding companies, they are not engaged in activities that were forbidden to them before the Glass-Steagall Act was amended by the Gramm-Leach-Bliley Act. So, there really is no deregulation has has occurred in our country since, oh, since I've become involved certainly, but even since the '30's and '40's that has had any effect on how the financial market functions today.
Have we gone too far in deregulating finance?
Peter Wallison: No. I think that the opposite is true. We should be deregulating finance even more than we have. One of the problems of banks is that they have lost out in the business of becoming the financial sources for large public companies or even small public companies. If you look at the data of banks, you will find that in 1965 they made about, a little bit less than 25% of their loans were made to the real estate business. That would be commercial and residential real estate. By 2008, that number is 55%. I other words, they are making more and more of their loans to a very risky and cyclical area of our economy and that is real estate, either commercial real estate, or residential. Why are they doing that? The reason they're doing that is that they have lost out in compeition with securities firms for financing public companies; public companies being IBM and many other companies that sell their shares in the public markets and are listed on the securities exchanges.
And why did that happen? It happened because it's far more efficient for securities firms to finance these public companies and for banks to do so. Banks have to hold the debt of these firms on the balance sheets for extended periods of time. It's very costly in terms of capital, whereas, securities firm simply sell the securities of these companies to investors and make a commission, or in some cases, make a spread. But in any event, they don't have to hold large amounts of the debts of these companies on their balance sheets for any length of time and they don't have to hold capital to support those holdings.
As a result, they can operate much, much more efficiently and public companies have found that they can raise money far more easily through selling their debt, selling bonds, selling notes, selling commercial paper in the markets rather than borrowing from banks.
So, we really have a problem with banks and that is that they are so restricted in what they are permitted to do that they are increasingly involving themselves with the more risky kinds of lending. Not only the housing, not only to commercial real estate, but also to small business and in some cases consumer loans, all of which involve far higher levels of risk than lending to public companies.
Have less-regulated firms like hedge funds fared better than those that were monitored?
Peter Wallison: We don't have the full data yet. I'm sure that will come out. The data I have seen has to do with hedge funds. Hedge Funds lost about 19% in value during the time of the financial crisis, banks, which are regulated heavily lost about 30%-40% in value. So, the suggestion there is that unregulated institutions did better than regulated institutions and that does not surprise me at all. Regulated institutions are looked at by people in the market as though the government is protecting investors against risk, that's called moral hazard, wheres investors in hedge funds know that they have no protection fromt he government. They have to protect themselves and they are much more careful in their lending of their financing of hedge funds.
So, I'm not surprised if there's a difference. And it ought to teach us something. And what it ought to teach us is that as soon as we have some sort of problem, the answer is not always to get the government involved in regulating financial institutions. We ought to think before we do that because marekt discipline has shown that hedge funds can be far more effective than government regulation.
Should the government have done nothing in repsonse to the crisis?
Peter Wallison: Certaintly not nothing because I think the financial crisis was probably caused by government policy and housing. Government policy created, or caused the creation of 26 million sub prime loans. A huge number of sub prime and alt A, that is highly risky loans. And that's almost 50% of all loans in our financial system. And when it's those loans started to fail that we went into the financial crisis. It's a very simple argument. Very clear.
So, the answer is not to regulate the rest of the financial industry the way the administration wants. They want to regulate the hedge funds and the securities firms and insurance companies and financial companies and so forth. The answer is to get the government out of the housing business. If we are successful in doing that, we will not create the kind of weakness in financial institutions that is what we call thefinancial crisis.
Which of the administration’s plans concern you most?
Peter Wallison: Well, the most damaging, I think, are two of the administrations proposals. The first, was to give the Federal Reserve the authority to regulate all, what they called, systemicly significant companies. What did that mean? What they were trying project by that idea is the notion that one can identify a very large company as dangerous in terms of creating a systemic collapse of some kind if it fails. Frankly, impossible. We have no idea what a systemicly significantly company is. We have no idea which companies would create a financial crisis if they failed. And so, the whole idea that identifying these companies in advance would be a mistake. But if we did it, if we actually named them, we would be creating Fannie's and Freddie's in every sector of our economy. Fannie Mae and Freddie Mac came to dominate the housing sector simply because they were viewed by the market as too big to fail, and backed by the government. And if we designate these other companies, whether they are hedge funds, insurance companies, bank holding companies, securities firms, whatever they might be, as systemically significant, we will be signaling to the market that they are backed by the government and will be protected by the government because, if they fail, the government believes they will cause some sort of systemic collapse.
So, if we were to actually identify these companies, we would be creating Fannies and Freddies throughout our economy and they would have serious adverse competitive effects on all other companies that are not so designated.
So, that idea was a disasterously bad idea. An unimaginably, ill-thought through by the government. I can't imagine how sophisticated people who know anything about finance and about competition could have come forward with such an idea.
Another idea that came forth from the administration was the notion that the FDIC ought to be given the authority to bail out or unwind these very large systemically significant companies. Now, even if we don't name the systemically significant companies, but just give the FDIC the authority to take them over when it believes they are failing, or might fail, we don't name them in advance, we just give themthe authority to take over these large companies when they want, we'll be doing almost exactly the same thing as if we named the companies in advance because the market will look at the very largest institutions and they will assume that the very largest insitutions are the ones that will be taken over. And since we don't know the difference between a firm that will actually cause the systemic breakdown and one that will just cause some sort of disruption, we will always be in the situaiton we have been in recently with say, General Motors. Where no one ever said that General Motors was a systemically significant company, but the government decided to rescue it using TARP funds.
And why did they do that? Not because it was systemically significant, but because it would cause some kind of disruption and it was politically powerful and the labor unions and others involved with GM were politically powerful. And so by giving the government the kinds of authority throught he FDIC that the administration wants, we would be creating moral hazard by signalling to the market that very large financial institutions will be taken over, will be treated differently from the smaller ones, will not go to bankruptcy, will not involve the same risks as the smaller ones, and we will involve ourselves with a lot of political decisions, not economic decisions aboutwho to rescue and who not. It will do grave damage to our economy again.
So those are the two things that the administration has proposed, which I think are disasterously bad and I am quite hopeful that Congress, in working through the various proposals that it has before it will drop both of those.
Should policy itself be considered a systemic risk?
Peter Wallison: Sure. It is. And we always have to balance these things. We have to look at our regulation, not only for the good that it might do when we are facing a question of moral hazard, or risk by companies that the government is backing, say banks; we have to also realize that anytime we impose regulation, we are creating moral hazard becaue the people assume that whenthe government is regulating a company, that company is gong to be taking fewer risks. So, anytime the government gets involved with private sector activity, with economic activity, there is going to be a distortion of the market that can cause a problem. And so, public policy can be the source of enormous problems and that's why I suggested earlier, that the only thing we really have to do to provent another financial crisis of the kind we have just gone through is to get the government out of the housing business. Because the government there was following a public policy which was to increase homeownership. It's a good idea to increase homeownership, but not by distoring the financial system in order to achieve it. And by creating Fannie Mae and Freddie Mac, by giving them an obligation to increase homeownership, they were obviously distoring the financial system.
How is a consumer protection agency elitist?
Peter Wallison: Yeah well, it's elitist -- it was elitist as the administration proposed it. It is not elitist anymore because Congress has dropped the most significant elements of the administration's proposal that were elitist. But just to outline just what they were and why they were elitist, it had to do with something called a "plain vanilla product." The case of the "plain vanilla product," or what the administration was proposing was that every one that was offering any kind of financial product to the consumers had to have a "plain vanilla product" that went along with it.
What they were essentially saying is, a lot of people who buy financial products are too stupid to understand the complexities and the trouble that those products can cause them. So, there's no amount of disclosure that is going to be satisfactory for those people. We really have to make sure that they are offered products that can't get them into any trouble. All right, well fine, and that's an elitist point of view about people that they really aren't smart enough to understand things that they are told, but if you think about it from the standpoint of the providers, what does the provider do? There's someone sitting across the desk from him and he's talking about a mortgage. Well, can you offer him a plain vanilla mortgage, or can you offer him another kind of mortgage, a more complex one? Is he capable of understanding those things. And since there would be terrific enforcement problems and risks associatied with selling a complex product to someone who couldn't understand it, the providers are always going to offer to the person across the desk, if he's not well-educated, if he doesn't have a financial background, he's going to be offered the plain vanilla product even though many such people who didn't happen to go to college can perfectly well understand the risks if they're properly disclosed in any kind of product.
But what it would do is, the providers, trying to protect themselves, would have denied to people who were perfectly capable of understanding these things, products that they believe these people cannot understand. And there's no way to know whether a person understands a product or not.
So, I was very worried about this when it came out because it looked to me as though they were then dividing the country between people who were educated and elite, and people who were not because the elites, the ones who went to college, the ones who have financial background would get the complex, useful, valuable, products, whereas the people who were not clearly of that level in the eyes of the provider would not. And that is a very bad idea to start with in our democracy. So, I was very disturbed about it. I wrote a lot about it, and fortunately, Congress dropped that idea.
Recorded on December 21, 2009