tv House Financial Services Committee Chair Hensarling on 2008 Financial Crisis CSPAN September 14, 2018 9:58am-12:43pm EDT
host: but in florida. hurricane season's not over. caller: as far as florida goes. i think the government's very prepared. we learn more and do bert every time. it seems like as far as preparedness i think florida's pretty much at the top of the list for the country. host: ok. steve in hudson, florida. a few -- minute or two left here . actually i think we can go now to the american enterprise institute. actually having a discussion in washington today at the american enterprise institute about the 2008 nngs crisis. jeb financial chair hensarling, a republican of texas, will be talking about what happened 10 years ago.
live coverage here on c-span. [captions copyright national cable satellite corp. 2018] [captioning performed by the national captioning institute, which is responsible for its caption content and accuracy. visit ncicap.org] >> i am a' a senior fellow here at the american enterprise institute. e have a full day ahead of us. including lunch talk with jeb hensarling, chairman jeb hensarling of the house financial services committee. i'll be interviewing him for that. the causes of the 2008 financial crisis, which has been called the worst financial crisis since the depression, are still controversial. at its 10th anniversary. insufficient regulation of the financial system and wall street, the feds' monetary policies, and the government's housing policies have all been blamed. the depression itself was like this, actually. no one really had any idea what
caused it. and so many of the policy that , works projects to put people back to work, hundreds of new agentcy, new laws, securities regulations to address what happened on wall street, and the strangest of all, efforts to reduce competition and keep prices high because low prices were thought to cause business failures and thus unemployment. most historians agree that all of these efforts did little to relay the hardships of the depression which finally ended when the nation geared up for world war ii. it was only in the mid 1960's when friedman and schwartz advanced the theory that the fed had made money too tight, that the economics profession seemed to have found a
plausible cause for what happened 30 years earlier. and still this theory is controversial, with many economists arguing that the fed actually was too open-handed, preventing liquidation of bad investments and that prolonged the depression. if 75 years later the causes of the depression are still being debated, we're going to have to wait a long time for any consensus about the events of 2008. we'll you will be around, of course. moreover, the issue of what caused the 2008 crisis and the remedies chosen to prevent a recurrence have now become embedded in our highly polarized politics, right and left have very different ideas about the causes and the remediation measures. this will make it that much harder for scholars in the future to untangle these issues.
bill's paper shows that a great majority of commentators who have written books discussing the 2008 crisis have apparently not dug much deeper than contemporaneous media assessments. nevertheless, what we can do is create a record of what scholars who experienced the crisis or who were actually government officials before, during, after the government crisis thought were the causes and the most appropriate responses. the presentations today will reflect this purpose. in the morning, we have a panel of scholars who will outline the three major views that the crisis was caused by insufficient regulation of the financial system, by the fed's monetary policies, or by the government's housing policies. in the afternoon, observers of the crisis will focus on the remedies, what was done at the
treasury as the crisis unfolded over two administrations, whether the policies followed by the fed and the treasury helped or hindered the recovery, and what finally can be said about government housing policies, which have largely been left unaffected. so this conference today will be a kind of initiation for future analysts, we hope. we will look at the prevailing theories today of why we had a crisis and then what was done or not done to prevent it. scholars in the future will be able to judge who, if anyone, had it right. we'll proceed as follows -- in both the morning and the afternoon sessions, each panelist will have 25 minutes for his presentation. with 10 minutes following that presentation for commentary by others on the panel or audience questions. so have your questions ready as you hear the panelists talking.
one reminder -- chairman hensarling will be joining us for lunch and we hope you will all be able to stay and listen to what he has to say. ow, for the panelists' time, i will be following colic rules. i will follow them for alex pollack when he's up there. and that is when you're getting two minutes from the end of your presentation, your 20 nutes, you'll hear this -- [ding] when you get to the end of the presentation and you have to quit [ding, ding] it's discreet. it's better than a bell or a drum, but that's how we'll handle it. ok. so we're ready to start. and we'll begin with aaron kline. you're up first, aaron. aaron: thank you very much,
peter. peter: before we start i will introduce you because people will not understand how significant your presence is. aaron kline is a fellow and economic studies and serves as policy director of the center of -- on regulation and markets at the brookings institution. he was the director of the bipartisan policy center where he also directed the first bipartisan comprehensive review of the post-crisis financial regulation. on the outset of the crisis, kline served as chief economist of the senate banking, housing, urban affairs committee with dodd.an chris in 2009 he was appointed to the treasury department, working as deputy assistant secretary for economic policy where he spent the first term of the obama administration working on financial regulatory reform issues, including developing the white papers for financial
regulation, housing, and housing finance reform, crafting and helping to secure passage of the dodd-frank wall street reform act. and implementing the tarp program. he's a graduate of dartmouth college and woodrow wilson school for public affairs at princeton. ow you can talk. mr. kline: thanks for having me. it's a privilege coming next door to a.i. look forward to the conversation with my fellow panelist. i want to start by laying a little of common ground for any financial crisis. i think peter has given us an impressive and important charge of creating a record and i think whereas i'll probably fall onto the mainstream, you
know, left of center analysis about the causes and problems associated with the cause of the crisis, i want to step back and talk about a financial crisis and you need two increed yents. you need the fundamental mispricing of an asset and leverage. one of these ingredients is not sufficient. this is extremely important to understand what the difference is between a bubble and a crisis. so i picked two of the most recent bubbles that i experienced. first is the dot-com bubble where you can see the price of equity markets fell. you had the fundamental mispricing of an asset. what was a click worth? what was a view on a homepage worth? amazon was worth $8, then $100, then $8 again. what is the true value of amazon stock? i don't know it now. i know if you bought at the peak of the dot-com bubble and never sold you're rich. at one moment you were pretty poor. but why didn't we have a financial crisis? we didn't have a financial crisis because we didn't have leverage. people were buying and selling dot-com stocks. mispricing an asset with their
own money. you have to have borrowed money and somebody else's money. why didn't we have leverage? i don't think it's because during the height of the dot-com mania people wouldn't have levered if they could have but we have strong s.e.c. margin requirements that cap leverage for retail stock investors as a little bit of a cultural hang-up about borrowing stocks on leverage but we got regulation in place correct after the depression which there were huge amounts of margin in the stock market and the stock market crashed. the second is enron, world come, tyco. that's the confidence -- worldcomm, tyco. that's the confidence. they had borrowed against things that didn't seem that levered at the time but apparently enron had no assets or capital or their earnings were mispriced and you also have a lack of trust. people often talk about the moment of a financial crisis as when people lose trust in their counterparty.
you didn't really have the fundamental mispricing of an asset class. i didn't know what enron was worth. there was large questions about what the worth was of any stock, right? if worldcomm was lying on their books, how do we know about anything else? you can see the dow fell sharply. almost as much as in the financial crisis. what the chart doesn't show but you can pull up, there was no corresponding run of fear of creditors in the debt market. you never had a transmission channel of leverage. consequently, nor did you have a deep misunderstanding of an entire asset class. once the accounting scandals and reforms were put in place that trust was developed within the pricing of the system and the reality that the vast majority of companies were honestly accounting for their materials, you saw the society and the economy bounce back and really a recession that really wasn't a recession is the result of the accounting scandals. so in this crisis there was a
mispricing of an asset, home values. neil called it mass delusion or hysteria earlier this week at a brookings institute. he was subject to it when he bought his house in 2005. i bought a condo in 2006. it's still not what it was in silver spring, maryland. but condo prices were doubling every six months. if you didn't get in now, there becomes a little bit -- hysteria is the wrong word. we kind of didn't get it. then there was leverage. and this is really where i think the financial system and the magnitude of the crisis came in. you see the quote from marty, former now, now vice chair of the fdic, and the huge runup in repo or overnight short-term lending within banks that go, you know, the left access, don't be fooled by one and two. those are in trillions of dollars. you see the giant runup. this is leverage in the
financial system. when that leverage is pulled and pulled suddenly is when a crisis occurs. where was that leverage? that leverage was in mortgage debt. this ties in kind of peter's point. you see there the huge runup in mortgage debt as a percent unsupported by income. there is a percent of disposable income so you can imagine debt if debt were supported by income rises. one thing i want to flag on this chart, which i -- everybody should more fully understand. in 1986, if you look right in 1985, you'll begin to see a change in the tread line on the accumulation of mortgage debt. this is because of tax policy changes. pre-1986, a lot of consumer debt was tax deductible, including automobile debt. if you look at a person's primary source of debt it's home, auto and then student loan. although not back then. college tuition was somehow affordable and we produced
college graduates. i am not sure what happened to tuition since then. that was a tax policy change. the second flip of that was markets catch up with taxes and ash trauge occurs efficiently. part of the rationale in 1986 was we wanted to support homeownership and home equity and home credit was for mortgage. when you make one time of interest tax preferred versus another and you give people time and you have the development of sophistication, lo and behold, don't get an auto loan, get a home equity loan to buy your car. what you find is a lot of that consumer debt that stayed what appears to be more constant, you see the financing of home equity and home assets being used to finance consumer expenditures. this is also consistent with what you saw in the 2000's in the decline of u.s. savings rates, in the growth of the economy without the growth of wages. this is supported by taking debt from homes for a variety
of factors. one is their tax preference. two is the ease of technology. three is the liquid secondary market. four is the mispricing of the asset to allow people to be willing to lend against this asset class. now, i want to turn to our failure of regulation. it is a common misperception -- there are two common misperceptions going into the financial crisis. one is that policymakers and regulators were unaware of the problem and, two, they lacked the authority to deal with the problem. both are false. this is a quote from former treasury assistant secretary for financial institutions in the early 2000's and then fdic chair under president bush, sheila. as she points out, the rules that could be put in place were not crazy rules limiting lending. they would have the effect of limited crazy lending but some,
you have a document customer's income. you have to make sure they have the ability to repay the loan. conservative things about loan underwriting. and the proper role of government is not necessarily in guessing what the price of the asset ought to be but dealing with the amount of leverage in the system. her position is that small rules like that instituted in the beginning time period would have made a big difference. there's a second common misperception that congress wasn't paying attention. i served under senator paul sarbanes who was the head democrat on the senate banking committee for 12 years. of the 12 years he spent 18 months as chairman. that's it. 10 1/2 years he was in the minority as those of us who worked in the hill know, the majority gets to set the agenda and the minority gets to contribute to the agenda. during his period, he held two hearings on subprime mortgages and problems and predatory
practices in subprime in 2001 and 2002 highlighting individual cases and aggregate cases, one of the first hearings chairman dodd held was on the same topic when he came back in 2007. by 2007 the story is way too late. by 2001 and 2002 it would have made a big difference as sheila bair argues and i agree with her. but we didn't do it. now, the second part of my argument was people knew about it, people were talking about it but did the government have the authority? under the homeownership and equity protection act of 1994, the federal reserve has the authority to designate high cost subprime mortgages. and under general bank holding company authority, they had the authority to regulate bank holding companies and subsidiaries. by the way, for those of us who worked in legislation, there is a huge fight on one word in law when it pertains to regulation which is "may" versus "shall."
may congress empowering a regulator but giving the regulator an ultimate authority to act. shall is congress requiring the regulator. under hopa, the fed shall promulgate regulation on subprime mortgages. this was passed in 1994. the authority was proposed by hen-fed governor gramlick in this early time period with sheila bair, that they put out examiners, flagging high-cost loans. hoepa was not a restrictive requirement. it was putting what we call a red star, a signal to the market that these are riskier products. there should be a risk-return tradeoff if you want to make them, fine, but these are risky products. and chairman greenspan rejected the idea. flatly saying it's not the government's job, the market will take care of itself and despite congress requiring the federal reserve to promulgate these regulations in 1994, does anybody want to know when the
egulations were promulgated? 2006. the final rule comes out in 2007, yes, january, 2007. comes out at the end of 2006. by that point it's too late. the game's over. under chairman greenspan's watch they just never did it. one thing that's not fully appreciated is how weak congress is relative to the financial regulators when the regulators ignore the law of congress. so part of the rationale for this regulatory paradigm of the 2000's was the desire not to interfere with the private market allocation of credit no matter on what term those credits are even when they include things like liar loans. so what's so contrasting to this -- and i hope as our colleagues talk about monetary policy and the fed's monetary policy is this philosophy in monetary policy captured by chairman eckles, it's the fed's
job to lean against the wind, when things are going a little bit too good. famous quote on the punch bowl. but on regulatory policy, the fed completely ignored this fundamental tenant of monetary policy. instead, you see people being very concerned about not spiking the punch enough. not taking the punch bowl away enough. these quotes from 2007 are actually at that point the private market is almost on its last legs. and so this was one of the big failures of regulatory will. i'm going to pause for a moment and move to what i think is the forgotten canary in the coal mines and it's another mistake of regulation and it involves something called structured investment vehicles, or siv's. it's something what regulation failed going into the crisis. and the first crisis response
also didn't work and is also not well understood. these have become footnotes in history that i think deserve a lot more attention. a structured investment vehicle was supposed to be an off balance sheet asset in which the bank did not have to hold capital because it was a tuss toadian of the asset, -- it was a custodian of the asset, not an owner. the s.i.v.'s set off balance sheet and were a bit of a search for yenald invested in, you know, the classic subprime c.d.o., the asset that was fundamentally mispriced. the regulator gave that treatment because the entity said we have no risk. this is our premiere client's asset. as late as october, 2017, i'm trying to use contemporaneous media accounts because history is written in real time and 1. forgotten at t-plus
no equity exposure. when you see these ratios of bank capital what's often misunderstood in this huge quick decline in capital was that assets were being taken on the books that had never really left the books but had been granted temporary treatment to leave the books. i pick a little on citi but you can run this on the other major financial institutions as well which is they were a little bit the largest and easiest to find the quotes. three months later, $50 billion are taken onto the balance sheet to preserve reputational risk. right? a strategic decision is made to bring these deeply troubled assets. now, in between that three months and even before in october, there had been a rescue proposal floated by the treasury department. the super s.i.v., was this industry based kind of group, not too dissimilar from the very first concept of
purchasing troubled assets but instead of the government, the industry was going to put this up and pool their assets together and ultimately there was no take-up. phil, who will be a commentator in this everyone's panel, wrote the following -- that in the end, banks preferred to take the s.i.v. back on their balance sheet in which showing that the government's response want as good from the bank's perspective as eating the loss on its own. and pointing out the tenuous nature of off balance sheet treatment in the first place which was a regulatory decision , granted that made regulatory capital look stronger than it ultimately was. -- [laughter] so other regulators involved --
bear stearns, 30-1 levered. deep concentration of mortgage-backed securities but the s.e.c. ignored it. they were part of their c.s.c., voluntary regulatory regime. there was an event held at brookings earlier this week with bernanke, paulson, geithner, the three architects of the crisis response. what one of the things that was stunning was that no point during this two-hour conversation did anybody ask, where was chris cox? where was the securities and exchange commission? in my mind i thought if there had been a crisis in the 1990's there would have been arthur levity. if investment banks had been predominant area of panel, the s.e.c. would have been there. the s.e.c. was just nowhere to be found and it was in fact s.e.c. regulated institutions. this gets to one point i want to make which is two of the common narratives about the failure i think that are deeply
lawed go back to gramlich- bliley debate which glass-steagall was repealed in 1990-2000, and the thing in gramlich-bliley, embraced by president trump and the republican party platform is that somehow the repeal of glass-steagall allowed these giant co-mingled investment banks and it was that commingling of activities. ar stearns, lehman brothers, yeah, citi first and foremost, jpmorgan less so. goldman sachs less so on both sides. there is no note that commingling was the source. the stand-alone banks were ultimately first levered and first dominoes to fall as well as some of the major banks and thrifts that had no investment banking.
i think that argument is false. the other thing is if they had redid the community investment bank which was originally in the legislation passed by the senate, 55-35, was the sticking point that was removed to get president clinton's signature in a law that passed 90-10, nothing passed in the c.r.a. there is no less powerful regulator in washington than housing and urban development office. most of the entities like bear stearns were not subject to c.r.a. requirement. those that were were lagging. that i think is false as the narrative of the commingling. so let me end -- that's my two minutes -- two quick points i'll go with. one is wachovia buying goldman west. regulators were allowing the purchase of large banks gobbling up big subprime lenders. take at the look at the zero chargeoffs in eight years lending to low-priced homes.
this is indicative there is a problem. the largest time we didn't go without a bank failure 2004-2007. instead it was sitting around congratulationses. i will skip my home bank slide which is the funding allowed the crisis to continue for the last six months after the market backed off. there was a government support of funding. it came from the home loan bank system. by the way, take a look -- it's just worth pointing some of the huge increase. i'm going to close with one final point and this is a point i don't think is fully appreciated. economists, market makers have fallen in love with the statistical tool called linear aggression and they deeply mis -- regression and they deeply misunderstand the math. it's the math and be a i willcation of statistical modeling tools that led in part to this giant false confidence. i was a math major before i became an economist. when you derive ordinary linear
regression, you use the five basic assumptions which i put on the board. these are five simple assumptions. they're the logic behind the computer model. you put numbers in the computer and you get a regression out. you get an r squared. i can do it. conference, who wins the super bowl, a.f.c., n.f.c., and the performance of the stock market and you get a giant r squared over that 20-year period. garbage in, garbage out. look at number three. no or little between the x values. that gets translated if my house price changes it has no impact on yours. that was the fundamental thesis in securitization of mortgages that was mistaken, that there couldn't be national implications of home vafment that lack of multicollinearity was in a vast number of regressions that they viewed as fundamentally mathematically sound. there are other math errors
made frequently and the other will be behind the next crisis. mr. wallison: thank you very much, aaron. let me ask one question to sort of start off. mispricing of homes. house prices. why? why was there a mispricing of house prices? mr. kline -- mr. klein: that's a good question. why tokyo real estate? in different crises you see a different asset. what was different about housing during this time one, there was a long period of sustainability. and so there was little room to run. two was, it was easy source of credit that had a tax preference relative to other source of consumer debt. three is consumers wanted to
increase their spending with relatively stagnant wages. you know, that's where the market decided to dance. i think if there will be other intellectual capabilities and enough of a deep liquid market and enough leverage found in the system you could have seen it on dot-com prices 10 years earlier. mr. wallison: any comments from the panel? yes, bill. bill: i want to take you on, head on the question of fed authority. and to do so i will describe an incident that goes way back on one of the older -- i'm one of the older people in this room and i remember it. after president nixon was elected, the democrats in control of congress gave the president the authority to control wages and prices. and they did that under the assumption that nixon would, as a conservative, would never use
it. that was the political calculus. democrats controlled the congress and in fact, they passed this bill over nixon's veto. surprise. nixon went ahead and used this authority. so the issue here is a political issue. it is not just a matter of what is written into the legislation. and i'll talk a bit more about that. mr. klein: so i guess i've done that. i've done political delegation authority and you say "may" and you say the regulator may do this and then you hope in the regulator's judgment they don't. one could argue that within dodd-frank, the franken amendment to the s.e.c. on credit rating was some of that and said, it actually said you shall do this unless you think otherwise. which is is kind of a creative way to say may and you'll notice that the s.e.c. has always found a way to think otherwise. whether you agree or disagree with franken, congress kind of set up that structure to allow the s.e.c. to avoid it.
read hoepa. the fed shall promulgate rules. they didn't. mr. wallison: any other comments from the panel? go ahead steve. steve: so i was a fed staffer at the time that the crisis was building and then broke. working on economic forecast. i had as much access to the data on what was happening in the pousing and mortgage markets as anybody i think at the fed. i don't think it's correct to say that the fed understood what was going on and deliberately decided not to regulate. i think we were operating with much, much less information in real time about what was really going on. i mean, otherwise it would have been impossible for bernanke to go up to the hill, i believe in february, 2017, and say that he believed that subprime
mortgages were really no big deal. the risks would be contained. i mean, looking back, that was obviously a false judgment but it was a judgment based on incomplete information. mr. wallison: so in 2007. mr. klein: i guess i will say two things on that. i don't believe the regulators' job is to weigh in when an asset -- is to weigh in on the asset side of the factors i put in. i don't think the regulator ought to know what the true value of the asset is. particularly i think too much is asked of the federal reserve, chairman greenspan's irrational exyou shall rance remark about the nasdaq. if you bought then your money would have doubled before the thing eventually collapsed. the question is on the point of the buildup of the leverage in the system. and this is the catch 22 i was trying to get to the back of which is, the entities leveraged looked good because they had been provided off
balance sheet treatment. the regulatory decision to allow them to gobble up all of these thrifts, which had been engaged in this risky subprime mortgage activity was a bank holding company authority, the fed -- that merger was approved, right? and what was allowing was this buildup in concentration of risk. what i didn't put on the slide was goldman west was at a 15% share premium and the regulators in real time were looking at the market feedback of no bank failure, zero chargeoffs in eight years, lendings targeted to low-price homes and saying, look, this is evidence of a stable market. and it's the flip side. the lack of failure, the lack of chargeoffs ought to be setting off an alarm bell. if i showed you a baseball player batting 1.000 you would be skeptical of him, right? if i show you someone making loans and have no chargeoffs
you ought to be extremely skeptical what's going on as opposed to -- but i don't disagree with the fact that the data looked like they had zero chargeoffs. mr. wallison: ok. questions from the audience. all right. we have some. ok. that hand went up first. es, sir. [inaudible] >> this is a very interesting presentation. is the mic on? shall i try now? mr. wallison: it works. just put it up. >> i was going to talk my loudest and see what happens. mr. wallison: we have another mic that doesn't work. [laughter] >> there we go. want to highlight two things. connected to the last question. one is you noted a runup to repo. i want to highlight and see
where your reaction is the connection between -- short-term assets leads to more trading in general, particular interest of mine, i think that's worth highlighting. second part of this -- and i'm glad you mentioned at the very end, stagnant wages. it's the backdrop of all this, you got the leverage in the system. you noted leverage in the households. you have the overall collapse in the middle class and the middle class squeeze, etc. as the vulnerability of this and led, the recession following was as much the financial crisis as it was the underlying weakness of the middle class. and then i'm particularly curious of your thoughts and i've seen this argument and i haven't reached my own conclusion. between investment banks and commercial banks, not that gram leach bliley -- graham leach buyly were mixing.
-- gramm-leach-bliley were mixing. the commercial banks were able to make more loans to tie with the investment banking activities, the investment banking were able to -- swaps, other things. curious was that chasing something you could push back to gramm-leach-bliley? mr. klein: the maturity transformation is exactly right. it's on my sheet. i probably overlooked it which is the mismatch of classic long-term, short-term -- peter asked the question, why housing? i different way to say that is it's particularly problematic when you're using overnight short-term funding to fund a long-term asset like a house. other things like, say, commercial real estate, which has usually a five-year period as opposed to a seven to 30-year period has a much -- the crises would have unfolded a little bit differently and that pressure in the financial system whose goal is maturity transformation is exacerbated
by that. that i think will also tie into some of the low nominal yield and low real yield environment questions in the chase for yield that will go there. mr. wallison: if you want to finish up quickly on this because -- mr. klein: a good paper that ben bernanke put out yesterday that points out the panic side. he argues the panic side was the reason why the crisis was so bad. kind of takes on the milan argument on the household debt side. it's a growing debate. and the chasing thing, i forget which bankers said when the music's on we have to dance. so i think everybody is chasing everybody. i do think there was a regulatory system if you look at who's failing the most, the thrifts and the commercial banks and investment banks is a little different than the commercial banks. mr. wallison: sorry. i got to do this. we have a very packed schedule. incidentally, if there are any panelists from the second group, the afternoon group who are sitting other than at that
reserved table, please move because we have -- we don't have enough seats for everyone who might want to come in the door and that reserve table shouldn't be empty. ok. thank you, guys. all right. our next speaker is hal scott. hal is the emeritus professor of the international financial systems at harvard law school where he taught from 1975 to 2018. that's the end of my iphone. he is currently an adjunct professor of public policy at the harvard kennedy school of government where he teaches capital market regulation. he has a b.a. from princeton university and m.a. from the stanford university in political science and a j.d. from the university of chicago law school in 1972. in 1974 to 1975, before joining
harvard, he clerked for justice byron white. his books include "connected" and "contagion" published by m.i.t. and "the global financial crisis" published by foundation press in 2009. he's also a member -- well, we won't go into all that. he's a member of lots of things. hal scott, the floor is yours. mr. scott: thank you, peter. so in my view, the causeation of the 2008 u.s. financial crisis came in two parts. part one dealt with many of the things aaron was discussing. what the fundamental causes were. plunging housing prices, overly risky mortgages, securitization, a lot of the stuff you discussed. part two, though, is my focus which was the run on the financial system that was in part caused by these fundamental problems. this contagion was successfully stemmed by three government
responses. by the way, my remarks will overlap kind of what caused and what we don't know about it so i apologize for that. the three government responses were resort powers at the fed, liability guarantees from the fdic and the treasury and capital injections through the tarp program created by congress in 2008. post-crisis, all of these u.s. eapons had been limited or eliminated primarily by the dodd-frank act of 2010 as undesirable bailouts. now, dodd-frank purports to solve the contagion problem with heightened capital and new liquidity requirements and new resolution procedures. it is questionable how effective this policies have been or will be to decrease the risk of contagion and what their cost is to the economy. but even if they are effective and cost justified, you don't abolish the fire department just because you believe you
have more fire resistant buildings. in the u.s., we need to restore and strengthen these three powers. most recently today, glen hubbard in "the wall street journal," and i believe last week paulson, bernanke, geithner in "the new york times" made this point. it's a fundamental thesis of my book and i totally agree with it. but the chances of doing this in an anti-bailout environment, which by the way is fueled by both the left and the right. the left doesn't like who's getting the money and the right doesn't like who's giving it. in this environment, reform is, i think, very unlikely. so that's kind of a pessimistic outlook on my part. the main concern of financial system regulation is to prevent systemic risk of which there are three varieties, what i call the three c's -- correlation, conductiveness, contagion. correlation refers to the situation where the same
external event creates losses for a large number of important financial institutions. such as the 2008 housing price collapse. connectedness comes in two flavors. asset connectedness where the loss of one financial institution causes the loss of another. or liability connectedness where the failure of one financial institution endangers the funding of others. the third c is contagion where the actual failure or fear of failure of a financial institution or other -- or some other external causes causes short-term creditor investors to withdraw and withhold funding for financial institutions generally, and this may be out of the lack of information or rational panic or combination of both. these three c's are not mutually exclusive but they are conceptually distinct. correlated losses due to the falling housing prices did set
the scene for part two of the crisis of 2008. contagion. but that by itself did not lead to a financial panic. contagion, not asset or connectedness was in my view the primary driver of part two of our crisis. we -- some large banks did experience deposit runs but these withdraws were not widespread and did not affect the largest banks. however, the liaman brothers insolvency -- leahman brothers insolvency put contagion in overdrive in the nonbank sector. reserved primary fund broke the buck and it spread quickly across the money market fund industry including two institutions with no significant exposure to leahman and then rapidly spread more widely to all short-term financial liabilities including those at most financial institutions and even the commercial paper issued by
nonfinancial institutions. now, many believe that asset connectedness, not contagion, was the major problem during the crisis. my book examines this claim in detail with respect to the leahman failure. investors in the leahman connected primary fund did lose money. not much. less than a penny on the dollar. but no financial institutions connected to leahman failed to result of the failure of leahman. moreover, no institution exposed to a.i.g., in my view, would have failed if a.i.g. had een permitted to fail. for example, goldman sachs would have 18% of loss of capital. that's less than the conventional 25% loan loss limit on secured lending for banks and this loss does not take account of the credit default swaps goldman had on a.i.g. so i think goldman would have survived the collapse of a.i.g.
many of the g-20 reforms post-crisis had been focused on connectedness, not contagion. primary rationale for sievi designation was are the -- sifi designation was the concern that asset management company, broker-dealer could lead to the failure of their counterparties. central clearing of over-the-counter derivatives was also motivated by the chain reaction of failure of scenario. the idea was to mutualize this risk. bilateral credit limits are also premised on the chain reaction of counterparty but it is risk 101 to not put all your credit exposure in one basket. so financial institutions for many years have placed their own limits on counterparty exposure and these generally held up pretty well during the crisis. in thinking about our ability to deal with contagion, keep in mind that panics can be set off by causes that have little or nothing to do with financial
institution failures. in june, 2006, we briefly flirted with possible panic when the unexpected vote in favor of brexit was announced. just yesterday, carney, head of the bank of england, alluded the possible panic over a no-deal brexit. what does this have to do with the safety and soundness of financial institutions? major terrorist events, the threats of war or natural disasters could also set off panics. the point here is limiting contagion weapons across the board out of concern for moral hazard in the financial system is a bit myopic. let me turn to the role of the fed in the crisis as lender of last resort to nonbanks. the fed was created in 1913 to stop financial panic, latest which had been in 1907. interestingly, the 1907 u.s. panic started in the nonbank sector of nicker bacher trust
company. -- knickerbocker trust company. so even the failure of a nonbank was a concern. uring the 2008 crisis, the fed amply discharged this to override means. lower penalty rate, lower access for primary dealers, securities, the term option facility were major changes in the discount window. and a multitude of new facilities were created for nonbanks. this apply of liquidity to the financial sector doubled the fed's balance sheet to $2 trillion by 2009. supplying liquidity to the nonbank system provided nonbanks with $930.6 billion in loans in addition to general market liquidity. even more importantly, the very ability of these facilities, in my judgment, helped stop the run. as many observed, the fed in turn the taxpayer actually benefited from this new
lending. balance sheet expansion generated fed profits and thus remits to treasury for treat, the remittance was over $40 billion. now, i estimate that today there is about $10 trillion in net uninsured short-term funding in the u.s. financial system with about 60% in nonbanks, primarily money market funds and broker dealers. the ability to lend to nonbanks in a crisis is essential. i expect this percentage actually to increase as lending in capital market activities with short-term funding are increasingly driven out of the intensely regulated banking system. now, the legal authority in the u.s. for lending to nonbanks during the crisis was then quite broad section 133 of the federal reserve act. it provided that, in quote, unusual -- in unusual and exigent circumstances, unquote,
the board could authorize a reserve bank to make loans to a nonbank where loans were cleared to the satisfaction of the federal reserve bank, unquote. this authority to loan to nonbanks is quite separate from the 10-b discount window authority to lend to banks. interestingly, other major countries do not divide authority between lending to banks and nonbanks. rather, they divide the world into normal and emergency lending. after the crisis, lender of last resort authority was, and it continues to be widely attacked as bailing out wall street. this is despite the fact that taxpayers benefited from these loans due to additional federal remittances but much more importantly, the country avoided what would have been a much more serious crisis. but this counterfactual is always difficult to conclusively prove. what would have happened if you didn't do it? now, legitimate moral hazard concerns have been raised about this lending.
but the beneficiary of -- beneficiaries of this lending were largely victims of a panic. without panic, withdraws from these institutions they would have been solvent. clearest exception, however, to this is probably a.i.g. the anti-bailout concern triggered radical changes in 133 lending authority under dodd-frank for banks. interestingly, lending to banks were moral hazard concerns should be raised were left largely untouched. what were these 13-3 restrictions? first, the federal reserve can lend to nonbank without approval of the secretary under procedures adopted in consultation with the treasury. now, one can argue that this isn't very important. it is clearly taking independent authority away from the fed and away not applicable to banks. some point correctly to the fact that paulson was generally bernanke's cheerleader during the crisis. as always been reported in the
ball paper -- i think this is very important -- that paulson refused to let the fed lend to leahman in september, 2008, because he did not want to be known as mr. bailout. even though leahman, according to the ball paper, had adequate collateral. secretaries of the treasury are by nature political and may again deny funding in the future to avoid political criticism, particularly when their approval is now formally required as it was not then. and the market will know that fed support may not be assured because of this which itself could trigger or accelerate a run. and they could not make one off loans when they did in 2008 to a.i.g. it must instead do so under a broad program. a fed regulation implementing
this must provide five institutions must be, quote, eligible, unquote, for any fed program. if this means eligible at the time the fed provides the first loan, it may make it harder to nit the contagious run in the butt. they would have to wait for five institutions to be under attack. if it means ever eligible then it is not much of a restriction at all. who knows if it could ever occur. its use could cause congressional cute knee. third, dodd-frank says all loans must be challenge ralized and -- before they could, you know -- make lending -- felt assured the loan was protected. this new requirement would preclude lending to unsecured commercial paper issuers because they aren't secured. and that's a major thing the fed did in the crisis. now, the fed can only loan to
nonsolvent institutions. the solvency requirement is a requirement in baggio -- i never -- i would have to do some historical research on pronunciation -- is a cardinal principle in the 19th century formulation of the appropriate role of the lender of last resort. but as we all know, judging solvency or insolvency in a crisis is extremely difficult. should assets be valued at market value? something that reflects sales crieses caused by a panic or values they might revert to after the fed actually makes a loan? an underlying argument for solvency requirement is the funding to an inol vent institution should be a fiss -- insolvent institution should be a fiscal issue. congress should play a role to guaranteeing fed losses or off -- which is the bank of england and the treasury -- the
treasury guarantees the bank of england under such circumstances, or the congress could authorize the treasury to do appropriations like they did with tarp. i wholeheartedly agree with this concern but we should then establish an ex-anti-framework to make this possible. charlie and i wrote about that. if that's what you think, then you have an obligation to put something in place to make it happen. a fifth provision. all loans to nonbanks must be reported within seven days to the chairman of the house and senate financial institution committees and then must be disclosed to the public within a year. and the banking side, i'll discount to loans must be publicly reported within two years. the concern with disclosure requirements is that the prospect of disclosure, certainly within seven days, and even perhaps within two years, will discourage borrowers concerned with the
stigma of this fact being known from seeking needed support, thus worsening the problem. indeed, in the crisis, banks in need of funding, avoid the discount window out of fear that their borrowing might be leaked or uncovered by analysts thus leading fed to create the term option facility where all banks could obtain cheap funding. sixth, dodd-frank provides the banks can no longer pass on discount when the loans to their nonbank affiliates such as broker dealers without being subject to the normal section 23-a limits on lending which is 10% of capital. this means that substantial borrowing by bank affiliated brokers in the future would have to occur under 13-3 and not be able to go through discount window with the bank lending onto the affiliate. so that's what happened to lender of last resort. how about guarantees and capital injections?
guarantees. in october, 2008, the fdic removed any limits on deposit insurance for transaction accounts, which is key to the payment system, increased the insurance limit on other accounts from $100,000 to $250,000, and guaranteed certain senior debt offerings. while dodd-frank permanently increased deposit insurance limits to $250,000, it removed the existing authority of the fdic to raise any limits in the future or guarantee senior debts -- senior debt during crisis. in addition, in september, 2008, following the breakout of the run on the money market funds, the treasury used or misused, according to one's view, its exchange stapplization fund authority to guarantee the money market funds. this had a major impact on stopping the runs on the funds. this power was taken away actually before dodd-frank by the tarp legislation in 2008. now we have tarp. so we have lender last resort. you have guarantees, tarp. right on cue.
the final tool to combat contagion was tarp which authorized the injection of up $700 billion in solvent banks. as most of you know, actually government made money on tarp. also, unlike the e.u. and japan which has standing authority for capital injections -- this goes back to something we were talking about before -- if the u.s. needs such injections in the future, authority would have to be obtained in the midst of the crisis itself as it was in 2008. we all remember the famous one-page paulson sheet and what appened as a result of that. in conclusion, we need a strong lender of last resort, even stronger than 2008. we need to enhance disclosure of financial institutions. i haven't talked much about that to reduce uncertainty while recognizing such disclosures will always be out of date in real time and somewhat incomplete. we need to have a coordinated
fiscal government, lending fed approach clearly established which we don't have. we also need the fed to clearly set forth its emergency lending policies. not only is ambiguity not constructive, it is positively harmful. finally, last sentence -- to reduce moral hazard and to respond to political criticism, emergency borrowers should pay a penalty. whether it be in the form of a penalty rate -- problematic because people might not borrow -- increase supervision or replacement of management. there needs to be a penalty, i think, to deal with moral hazard and to deal with the political consequences of not imposing penalties on people who borrow. thank you. mr. wallison: ok. well, the penalty for speaking er the limit is -- fewer questions. fewer questions. mr. scott: did i get the binge,
binge? mr. wallison: you got the bing, the bing and another bing. let me start off with one question. one thing you said, really, is quite interesting in terms of what actually happened in the financial crisis. d that is you said that no other company failed as well as of lehman's failure. that is not a fact that most people know. so my question comes out of that and i'd like you to speculate a little bit about this and that is -- what if bear stearns had been allowed to fail? if there was no reaction, serious reaction in terms of he ability of firms to survive after lehman, what would have happened if bear stearns, which was smaller than lehman, been allowed to fail?
mr. scott: i haven't done that research. you have to look at the exposure of bear stearns which is what i did with lehman. but my suspicion is when the fed -- i did look at it with goldman sachs assuming a.i.g. had not been bailed out. as i said, i didn't see any big hit there. there would have been a hit but they could have survived. mr. wallison: ok. we have one other -- one time for one other question. madam. >> thank you very much for your remarks. professor scott, i appreciate your distinction of the fed being the lender of last resort to solvent institutions that are in liquidity challenges and institutions that need to go to fiscal majorities. what do you think of the -- there's -- there have been some proposals out there of transforming the fed's open market operations into what has been called a flexible open market operating system that
would operate more like the task did back in the crisis which is open to pretty much any participant. they could put up any -- and through an auction process would be able to get the funds they need and opening it up to more parties than just the primary dealers would enable that system to be a system for liquidity in good times but also one in bad times without the fed having to make any change to any of its policies and basically not even needing a 13-3 authority that that facility could be available at whatever time and only solvent institutions would be able to get that funding because they would bid the highest for it, what would be a penalty rate because they would need that money? mr. wallison: ok. one minute to answer that question. . mr. scott: there are two parts to the question. mr. wallison: a minute for each part, please. mr. scott: can we go from basically loans to single banks
to kind of term auction facility. i think that has a lot of plausibility, particularly because banks are unwilling to go to single loans because of stigma. the second part is expand this program to nonbanks, that's the issue. 13-3 restricted that. you basically would get into an argument, should we expand the majority of the pend to be the lender of last resort? you are bailing out wall street and all through that again. i think it's very unlikely. it's a backdoor solution to the restrictions on 13-3. mr. wallison: thanks very much. noshert.speaker is he's the director of the heritage foundation's center of data analysis where he specializes in financial markets and monetary policy.
before joining heritage in 2013, he was a tenured professor of nicholson state university in the college of miss. he holds a doctoral degree in financial economics from the university of new orleans. we received a bachelor of business degree in finance from loyola university. the floor is yours. mr. michel: thank you, peter. good morning. peter asked me to talk about specifically how monetary policy might have contributed to the crisis. i make a distinction between pure monetary policy and feds' regulatory policy and emergency pend lending pol -- lendingpolicy. i'm not commenting on -- lending policy. i'm not commenting on that part. one is the fed's policy stands was too loose leading up to the -- stance was too loose leading
up to the crisis. and the flip side is it was too tight as the crisis unfolded thus worsening the crisis and prolonging the recession. there are many, many different stories i could talk about here, ut i only have 20 minutes. i'll try to cover it all. i'm going by the alex rule. for the most part i'm just going to sort of report on these. tell you what those stories are without giving touch too much about my opinion which might be correct oirn correct t makes sense for me to put these chronologically. i'm going to start with the boom period. in the interest of time i'm going to start with two stories at once because they are kind of aw versions of the same story. -two versions of the same story. the first is they attempted to inflate equity markets to avoid the deflation problem that was the big fear in the early 2000s. the second spergs of that is
that greenspan deliberately to inflate housing prices to avoid the problem. that was a big fear after the dot-com bust. in both cases the fed needed to boost equity prices. and rely on some kind of wealth effect to boost the economy. they cut rates to initiate some kind of boom. what kind of evidence do we have for this? we know they cut the heck out of rates. the fed funds' rate target in january of 2001 was 6.5% and they started cutting it and took it all the way to 1% by june of 2003 and that's where it stayed until june of 2004. either version of this story says those rate reductions helped investors borrow funds more cheaply and that those funneled unds got somehow into securities markets. fueling the boom in equity prices. in one version, it was mostly in real estate securities, thus leading to the funneled somehow housing price
boom or the real estate boom. either way, wealth goes up. that leads to more spending, that's your wealth effect, you get more inflationary pressure to combat the deflationary fear. if we look for evidence in the way of direct statements where greenspan or somebody else in the somc specifically says, yes, we cut rates because we wanted a wealth effect in, for example, the housing market to combat -- you have a really, really hard time finding that. what you do find are more indirect statements in the sense that the fed and the fomc knew there was -- thought there might be this wealth effect. they were measuring it, looking at it. new housing prices were going up. new equity prices were going up. they didn't want to stop it. that's there. so that's pretty much the exfent they think of what you can do with those stories. the next one, my third one, the fed kept the federal funds rate
at that low based on what the taylor rule says they should have kept the funds rate at or what their trget should have been. according to this story, monetary policy starting alt way back in the 1980's contributed to a great moderation specifically of the housing cyclele. bay closely following a -- cycle. by closely following the taylor ruling description. from 2002 to 2005 things changed, the feds changed their approach and that's what inflated the bubble. they kept the short inflation rate path below what the taylor rule said it should have been. my specific part of this is here is relying heavily on john taylor's paper from december of 2007 where he says, deviating manner, rule in this and i quote, may, aaron you'll appreciate that word, may have been a cause of the boom and bust in housing starts and inflation. that's what he said.
what sort of evidence does he present? he uses quarterly data from 1959 to 2007 to show a strong link between the fed funds rate and housing starts, and then once he establishes that link, he does a counter factual simulation. this is from figure win of his paper, on page five of his paper, solid line, the dash line is the counter factual simulation. and as this shows, the actual and alternative paths departed in the second quarter of 2002 and they didn't come back together until late in 2006. based on this the feds one rate was low as 1% where it should have been as high as 4%. that's a large difference and that's the argument. that this is what creates the extra leverage. fuels the leverage. we should keep in mind exactly what the taylor rule is and is not. it is not strictly speaking a
measure of the natural or equilibrium rate. it's a response function. it tells us that the fed should change the industry rate target based on deviation from two things. its inflation target and potential output. it weights both of those deviations with specific weights, different weights on each deviation, specifically so that the fed can respond heavily or not as heavily to either one of those deviations. that's what it does. what taylor is saying here the fed actively responded differently to inflation and output gap than it had in the past. based on the taylor rule. to be fair, he acknowledged there were multiple ways of doing this analysis, calculating it, he points to similarities in his results to a few others. one is even a bill poole paper. then what we find is that in 2015 ben bernanke publishes a blog post at brookings and says
hold on a minute, if you use the core p.c.e. instead, because taylor used the c.p.i. in the paper, and if you use a weight on the gap of one instead of .5, which is what taylor used, then the federal funds rate was actually above where the taylor rule says it should have been. there is a controversy there and no wonder that bernappingy would have been prickley at the suggestion because it does say the feds it chose to do something different than what it had been doing. i'm not going to be able to solve that problem. that's the argument. that's what it is. next storery, fourth story, is a little different. it is at productivity surged late into 2001, she had a boost in productivity, the defense kept the fed funds rate target too low relative to the natural rate of interest. that's a little different than the taylor rule. the natural rate should have
been thought of as an equilibrium rate wrt supply and demand of funds is in balance. consistent with full employment and stable prices and a growing economy. in that sense it's the optimal rate f you push interests rates below that rate, that's when you cause people to borrow more money, invest more money, expand their business, so on. that destabilizes the economy. that leads to the boom. that's the argument here. aside from the fact that the fed can't just make interest rates whatever they want them to be, a major problem here for policymakers and determining whether the story is accurate or not, is that the true natural rate is unobservable. it can only be estimated and you can estimate it using different methods. this is why it's great to be an economist. i'm going to rely on one paper, one 2015 paper for my
presentation. it's a paper in the journal of policy modeling. the reason i like this one is that it addresses specifically in the paper, it addresses why the fed may have done this. in other words, even if we think that the fed did do this, we still have to credibly address why it might have done this, in my mind that's much stronger. what did the authors do? they start with the -- just a macroestimate of what the natural rate is and rely no the fact can you do a good job of estimating that, it seems, with just the productivity growth rate. achieving a neutral monetary policy, would consist of, before the crisis, adjusting the feds fund rate target in response to changes in productivity. or expected changes. they proxied the natural rate with a measure of total factor productivity and they plot that against the actual fed funds
ate from 1970 to 2006. this one is different, the dotted line is the actual, the solid line is the proxy. when the actual rate is above the policy stance is too tight . when it's below the stance is too loose. it's a little hard to see what they do then is they say ok, that difference is the productivity gap and we're going to just plot the productivity gap itself. so when you are below the zero line here, you are too loose. you look at this and you'll see in the 1970's, of course, policy was too loose. 1980's when the fed was clamping down on inflation, it was probably too tight. in the 1990's, a little bit of looseness and tightness, but not as dramatic. and then in the early 2000s, it is loose and more dramatically so than even in the 1970's. with regard to the entire
series, the loosest, most expansionary period here based on this measure is the early 2000's. that's what they show here. again by their measure. they also show that during this sample period a positive total factor productivity shot does lead to a lower inflation rate and moderately higher unemployment rate. to which the fed tended to respond to by lowering its fed funds rate target. that's as would normally be expected if the fed is trying to monitor both inflation and unemployment. the problem is it's the opposite response that you should make if , in you -- if you want to maintain a neutral stance in the face of a productivity shock. positive productivity shock. the fed should raise its target rate as you get the positive productivity shock.
if they don't, they dot opposite, that's what gives rise o this productivity gap. they chose to be overly accommodated with their policy stance and then we have to ask, ok, what is the evidence of this? that's actually the fun part because there is lots of evidence that they did this and they knew this. there is direct evidence of this. there are statements by greenspan. there are statements by others in the federal local market committee meetings, and there is even a speech by greenspan in 2004 where he admits they did this. and there is actually even a great article-dirble' leave that out. you can go -- article -- i'll leave that out. you can go through-dirble' mention one quickly. there is a december, 2003 federal market committee meeting. an exchange between tom and david stockton and they
specifically say we realize we're holding rates below the equilibrium level and we're going to keep doing that. we think we can get away with that. that's what they did. the paper also cites some additional evidence of this nature. and there are others that have come out after that. there is at least one paper that the richmond said, there's lots of other corroborating evidence, if you will. my fifth and final story is at the end of the -- at the end of that period. where we get to the crisis. the fed policy stance was excessively tight when the crisis hit. i still get crazy looks from people when i try to tell this story. i typically get stuff what are you talking about? it couldn't have been too tight. they cut rates. the crisis hit, they cut rates down to nothing. they injected trillions of dollars in the economy with q.e. there's no way policy was too tight. that doesn't make sense. that's a very common way of thinking. it shows up all over the place. nd it's wrong.
see the evidence for this and what the story is about, first thing you have to do is wave to let go of our sort of stubborn fascination with interest rates. nominally they can't tell us if policy is too loose or too tight. whether the fed cut their target alone could not tell us whether this stance is too loose or too tight. and even if you look at the change in a monetary aggregate by itself, you still can't tell whether policy is too loose or too tight. rates depend on both supply and demand for credit and real assets. monetary aggregates can grow too slowly or too quickly based on the growth or depending on growth of the demand for various types of assets. so you have to look at the public's demand. multiple ways of doing that, one simple way to look at a measure, would be total nominal spending or close proxy. nominal g.d.p. growth. prior to the crisis this is something ben bernanke talked
about. . also aside from the interest rate issue, the big picture is it is to prevent an economic collapse, it's supposed to prevent a deep recession. that's what it's supposed to do. it's supposed to prevent a collapse in aggregate demand. in those slowdowns we know that they coincide with people holding larger money balances. that's the liquidity shortage for the rest of the economy and that's what the fed is supposed to do. it's supposed to provide systemwide liquidity. that's it's job. whether it does or doesn't do that will determine whether the policy stance is too loose or too tight. it did this. i think even aaron mentioned one at the beginning. where milton freedom said we'll never do it again. it's ironic, here we're, that's what happens. that's what they do.
my last chart is you can see -- i should have done another one, you can see the nominal spending does collapse. nominal g.d.p. does fall. growth slowed in 2007 and went negative in 2008. what we know is that the fed was worried about hitting a federal funds rate target and hitting an inflation target instead of worrying about that collapse. how do we know this? again it's all over transcripts. it's all over the mini meet -- meeting minutes. it's in ben bernanke's book, the courage to act. he explains it clearly. there is a great article -- there is a great article in "the atlantic" that details this. it talks about rosen green and frederick who were the only two pushing back against this idea of worrying about inflation. what happened? everything started out fine. everything started out fine in august of 2007. some of the earlest signs of the crisis the fed made net purchases of treasuries.
injecting liquidity into the system. that's what they should have been doing. then for whatever reason they decided all the way through september of 2008 when they had made hundreds of billions of dollars in emergency loans that they needed to sterilize everything. dollar for dollar for everything that they injected, they took something out. that's what they did. they sold treasuries, taking reserves out of the system. it's in detail on pages 236 to 2386 ben's book. -- 236 to 238 through ben's book. they did all the way past this period as well. they ran out of treasuries, this is also in the book, they ran out of treasuries to sell so they had could come -- to come up with something new. that's what we got interest on excess reserves. in 2003 they started the firts round of q.e. by the end of 2014 they injected $5 trillion into the system. while it seems like that was great idea on the surface, they actually also at the same time started paying above market
interest rates, above market interest rates on those reserves so that they would stay put. whether you believe that's a good idea or not, i don't know, but it's useless -- it's objectively useless in terms of fighting a recession and preventing a collapse in total demand. in that sense the policy stance was certainly too tight. mr. wallison: good work. do we have any comments, any questions? comments from the panel? bill? >> two aspects of the discussion here that i think are missing. i went to every fomc meeting for 10 years. my last one was january of 2008. so i didn't get to observe the eally exciting part of the crisis.
mr. poole: the two points i would emphasize always the ambiguity of the real-time data. you work with data today, but it is very helpful to go back and see what we saw at the time we were making the decisions. that's critical for understanding the decisions. second point, expectations. the decisions have to be -- a framework that helps the market to understand what the central bank is doing in a consistent way. i'm going to talk about that in my a framework presentation. >> it makes no sense to know what the heck they are doing. for the public to not see what is going on and what they are doing. i know that there is a real time data problem. mr. michel: i'm just reading through what's in the transcripts. mr. pinto: the transcripts emphasize -- mr. poole: the transcripts
emphasize that. mr. michel: it may also show there is a clear preoccupation with the inflation rate, keeping it up, and with keeping the target for the federal fund rate. mr. poole: my peernl experience in the fomc as i say ended in january of 2008. so i'm much more speaking about the greenspan feds than the bernanke fed. mr. michel: ok. mr. wallison: questions from the audience. >> i'd like to go back to greenspan keeping the interest rates too low. you have talked in terms of economic data. i want to talk a little bit about the collapse of enron and worldcom. the sarbanes-oxley bill. because it seems to me that the real worry was the loss of trust in all the accounts that the
companies were producing. i happened to be on the board of scandia insurance international based in stockholm. we were watching the stock markets between the collapse of these companies until about 2003 off c.e.o.'s had to sign for their accounts. what was one of our concerns, the impact of the loss of confidence on the equity markets. and it occurred to me that that might have been one of the reasons that greenspan kept the interest rates low during that period. mr. michel: it could be. when we went through looking through all the transcripts and meetings, i wasn't looking for that. i copt say for sure -- i couldn't say for sure, but it makes sense. >> i have read the transcripts from that era also.
again i think like you what strikes you is how little an understanding there was of what was really happening. so my question is this. what happens when we run into the next crisis and we see more and more talk about the next crisis, not if, but when? how is it going to be any different next time? better the fomc have insight of what was going on than the case in the last crisis? or are we going to go through the same thing again where after the fact people say the fed should have seen this, this, or this. mr. michel: i think that might be a better question for somebody -- >> i gave the question to you. mr. michel: i think it will be a disaster. that's what i think. >> be more diverse. at one point of the 12 regional
bank presidents, 11 came through the federal reserve system. have more diverse outside opinions that are more -- that may represent different viewpoints or constituencies. the purpose of having 12 regional banks was to try to get geographic diversity. mr. klein: we can go through each region and ask what the president knows about that region. can you go through the same thing and say how much is this person of the federal reserve system or from a different vantage point, and there's a loft consistency they are from the federal reserve. >> if coy respond quickly. i was struck when i read the transcripts as to how out of tune. so fed bank presidents were about what was happening in their own particular district. i won't mention names, but there's one in particular who didn't have a clue as to what was going on in that person's district. i don't see why it's going to be any different next time. mr. michel: i agree. even if you look at -- still
good on time. even if you look at this as having the right people in place with the right diverse opinions. you have at the time of the crisis unfolding, you have two of the foremost experts in the world on this on the board saying, no. short term. forget about inflation. forget about the fed funds target. everything's collapsing. they still did it. thecies tome we have, framework we have, i don't see how you avoid this problem again. >> that's wonderful. mr. wallison: in the back. mr. michel: should have asked somebody else. >> i love your presentation. i wonder if you could illuminate more about 2003 because i remember that moment when my wife and i bought a house here in washington and i said, honey, interest rates will never be this low again. and -- it was baffling, too, as an economist to see the fed cut rates in that summer when it
went down to 1%. and so it just seemed like all the evidence is saying the economy may be overheating and they were still cutting. mr. michel: this is part of why i tried to just sort of tell these stories and not give too much of my opinion because i'm a little bit unconventional on this in some respect. i think that the fed tends to follow rates down. i don't think that it's accurate that they took those rates down that low in that direction for that long just because they wanted to. i think they had to. based on the targeting system they have. >> it was coming in month after month after month was the ontinuing decline of nonemployment. that was critical. mr. michel: it was there. mr. wallison: any other questions? we'll proceed to -- one more in he back.
at the klein mentioned beginning of the conference that there are two items that you need for a widespread crisis. that is a fundamental mispricing f the assets and leverage. according to some congressional committees, the rating nirms were at the heart of that -- firms were at the heart of that. how might it be different? how can we prevent that from happening in the future? mr. klein: two things, right? the rating agencys aren't providing the leverage, they are providing an opinion, which is important because the people who provide the leverage can choose to lose that opinion or not. third party to price the asset can choose to do that. there is a nice chart on the value of subprime triple b which goes from basically par to zero. it's kind of one of these little
functions. two questions comes on that. one is, the outsourcing of due diligence to third parties. versus the insourcing of due diligence. the second is the legal regulatory regime that promotes or discourages that. and so there you get into i think some difficult questions, i think former fed governor jeremy stein has written this term and used to use it a lot before he went to the treshry. the wall of dumb money, which is a tremendous global and growing global amount of money that wants to invest in safe assets with very little due diligence on their own. as that wall grows in size, potentially the ability for the two ingredients to form to create a crisis, the mispricing of an asset and leverage, grow in size as well because of the
lack of due diligence on investment. one solution is to encourage -- this is where people may get to a moral hazard and i take and agree with large parts of house presentation. if you are so -- hal's presentation. if you are so allowing into a system i'm investing with some sofert expectation of not -- getting a higher yield with lower risk and somebody else has blessed that, it grows in problem. >> you have the incentive that is issue pay versus investor pay. is that right or not? in other words the ratings for the most part are paid by the issuer. does that create a fundamental conflict? >> whoever pays has a self interest. they are going to buy the results, what the issuer pays --er or the receiver. they want a different result thefment want to say it's 250
low. somebody has to finance this. mr. scott: i don't think there is an easy way out of this. people should speculate we should have a government agency. i think that would be a total isaster. mr. klein: the government figuring out what the right price of the asset is a mistake. the government looking at when leverage is built up in the system is the better of the two regulatory solutions. mr. wallison: ok. i think we have exhausted this topic. we're going to go on now to bill poole's presentation. let me just say a few words about bill. he's the distinguished senior scholar at the nice institute and distinguished scholar also and in residence at the university of delaware. he retired as president and c.e.o. of the federal reserve bank of st. louis in march, 2008.
in that position in which he had 1998, he served on the federal reserve's main monetary policy body, the federal open market committee. before joining the st. louis fed, he was herbert h. goldberg professor of economics at brown university. he was a senior economist at the federal reserve. and a member of the counsel of economic advisors in the first reagan administration. he received his b.a. from swarth more -- swartmore, and m.b.a. and ph.d. degrees from the university of chicago in 1963 and 1966. bill. go ahead. mr. pool: -- party, thank you for inviting me to speak at this event.
it is terribly important that everyone understand better what happened to create the financial crisis that broke wide open 10 years ago. i agree with your analysis expressed carefully and with extensive supporting evidence in both your dissent to the report of the financial crisis inquiry commission, and your book "hidden in plain sight." i put great emphasis on understand better because the standard view of the crisis is mostly wrong. mostly wrong. investment and commercial banks participated in the crisis and made it worse, but they were not the fundamental cause of the risis. too many observers are guilty of the hopepolicy. let me put the matter more strongly. we need a confrontation on this issue. we need to get to the bottom of it.
of who or what was primary-u responsible -- primarily responsible for the crisis. on one side, one view, wall street and inadequate federal reserve regulation. or the affordable housing policy with privileges for the g.s.e.'s on the other side. i'm going to do the best can i to provide that confrontation. the fact that market turmoil became dramatically worse after lehman failed does not mean that the lehman failure and the mistakes of other banks caused the crisis. a few paragraphs from now i will consider a counter factual in wit investment and commercial banks had enough capital that they did not fail. absent the government's affordable housing policy, this crisis would not have occurred. absent the mistakes of the banks, the banks made, but with the affordable housing policy, a
severe recession would have occurred and those holding the toxic paper would have suffered large losses. if we're going to commit the post hope fallacy, would it not make more sense to begin with the g.s.e.'s, fannie mae and freddie mac? why? based on size alone, in early september, 2008, before lehman failed, fannie and freddie had total assets and guaranteed mortgage-backed securities utstanding of roughly $4.5 trillion. where can as lehman assets were 0.6 trillion. that is the g.s.e.'s were 7 1/2 times the size of lehman. no one doubts the g.s.e.'s would have defaulted if they had not been taken into federal conservativeship in september of
2008. think about what kind of crisis that would have been. 4.5 trillion of assets in default that everyone thought had been de facto guaranteed by the united states government. in this mode of reasoning makes you -- if this mode of reasoning makes you uncomfort and, it should. we need to look at much more than size. so my first slide shows a chart lifted from wallison's dissent. in the good old days a prime mortgage meant, among other things, that a home buyer put up at least a 20% down payment. when buying a home. as the chart shows, before 1990, the g.s.e.'s financed very few rtgages with superlow down payments. by 2008, 40% of fannie mae
purchase volume involved mortgages for which the borrower was contributing a negligible a capital, 3% or less. second mortgage on top of a first mortgage could mean a combined loan to value ratio of 120%. over the past few years i have read many books. some i picked up in response to interesting reviews. others in connection with various writing projects. i reviewed many books on my kindle with the authors say something about the financial crisis. my list for this presentation includes 53 books. that gives the first page of my list. i have a color coding system. so by the beginning of 2012 there was a substantial amount of work available on the crisis. besides wallison's dissent,
there were several other contributions where authors had reached the same conclusion. the crisis was fundamentally due to the federal government's affordable housing policy. that policy included goals forcing the g.s.e.'s to purchase mortgages from households with below median income. only through purchasing subprime and other weak mortgages could fannie and freddie mete the goals set by h.u.d. the department of housing and urban development. for the next few slides i will assume that you can multitask. you can consider some of the books with your eyes, i'm hoping it's readable up there, and listen to me with your ears. i have included only books where the author says something about the crisis. henry kissinger's on china is a wonderful book, but he seems not to have done any real research on the financial crisis. a brief mention.
i have awarded him a gentleman's c. my color coding should be clear enough that you can spot my summary opinion of each book. these authors generally blame wall street for creating the substandard mortgages and the federal reserve for inadequate regulation. my full paper includes a few quotes from these books. that provide the flavor of the author's use. and if you think i have mischaracterized the book, please send me an email. many of these books exhibit what malpractice with regard to understanding the financial crisis. a he 53 books, i give 36 grade of red, five a grade of yellow, and 12 a grade of green. and the red group, by the way,
includes mervin king, former governor of the bank of england, ben bernanke, former fed chairman, bill emmett, long-time economist magazine editor in chief. i had a little space left over on the final slide. i better keep working to get down there. on the final slide and used it to quote an author. i'm going to have to skip here to get there. you can probably catch those as hey come by. ok. the final book, it's a very cent book, by professor adam twos, a quote from the book. fannie mae and freddie mac set
high minimum standards for the quality of the loans they would buy. the g.s.e.'s didn't support the kind of low quality subprime loans that were beginning to fail in droves in 2005. and 2006. end quote. this sentence is totally out of touch with reality. how could fannie and freddie be described this way when they required a federal bailout costing perhaps $200 billion? i feel a bit guilty picking on him because there are similar sentences in many of these other books. however, in my defense i suppose i note that he's on the faculty of columbia university and the department of history. we expect historians to conduct careful research to support their factual findings and he didn't. and i hope he publishes a revised edition and i'll buy it. if you form opinions on a topic based in part on the political
persuasion of the author, you are out of luck on this topic. the authors of green coded books stretch across the political spectrum. let's change to a different topic. consider this counter factual. investment in commercial banks had sufficient capital that they did not end up on the rocks. when weak mortgages began to default. available evidence supports the proposition that 10 years ago the g.s.e.'s held or guaranteed a vast stockpile of nontraditional mortgages, perhaps about 76% of all such mortgages. counter factual then is that those holding the other 24% had enough capital to stay afloat. the federal reserve staff puts
together briefing documents ahead of every fomc meeting. green book part one covers the outlook and green book part two is a compendium of prevent data. -- recent data. the documents for the meeting that took place just after lehman failed were put together the prior week. that is before lehman failed. the staff outlook for the economy recognized that we were in a recession. however the staff thought that unemployment in the most pessimistic as the alternative projections would peak at just over 7%. green book part two showed a sharp increase in mortgage delinquencies. as you can see on this slide. data available to the staff ran -- the key ling
womency rate for prime mortgages had also risen slig. data for september were available for the december fomc meeting. in september, as lehman was going under, the delinquency rate for subprime mortgages was about 23%. brime motorsports had doubled -- prime mortgages had dubblingd to about 2%. serious recession was baked into the cake before lehman failed. as mortgagings -- mortgages failed and house price were falling, it was inevitable that home construction would decline. it was also inevitable that consumption would decline. many households had been using cash out refinancing to support prior consumption. that game was over at this point no matter what happened to lehman. remember the counter factual we're considering. same actual for the g.s.e.'s,
but strong enough investment banks. keep in mind that the federal government rescued fannie and freddie before lehman. that meant that the mortgage backed securities guaranteed by the g.s.e.'s now depended enthrire on the federal government. now -- entirely on the federal government. now would be the federal government foreclosing on the thousands of homeowners. the messy politics had nothing to do whatsoever with lehman. the crisis commission majority, inquiry commission, blamed the federal reserve for inadequate regulation. that conclusion contains a hidden counter factual. that the fed had the political clout to stop subprime mortgage origination. in my paper i list several findings that are inconsistent with that argument. that the fed could have stopped
excessive subprime origination. for example, quote, congress created the supervisor for the without legal powers comparable to those of bank and thrift supervisors. in enforcement, capital requirements, funding, and with receivership. cracking down on the thrifts while not on the g.s.e.'s was no accident. the g.s.e.'s had shown their immense political power during the drafting of the 1992 law. end quote. the affordable housing goals were the policy of congress and two successive presidents. i can assure you that substantial abuse would have been heaped on the fed if it had had -- slowed or stopped subprime origination. fed critics would have complained that the fed was damaging prospects for
minorities and inconsistent with presidential policy. in fact, for all i know greenspan attempted to warn president bush and bush hold him -- this is made up. alan, i need you to stay out of the way on this one. bug off. so the bottom line was this. the enormous amount of capital the g.s.e.'s pumped into the residential mortgage market, pumped up the subprime mortgage origination, pumped up house price, degraded the quality of mortgage credit in the economy. as the crisis deepened, fed policy was nonstandard. hard to predict, and confusing. timothy geithner had this to say in his book, "stress test." quote, still our constant zig-zags look ridiculous. we were lurching all over the place and no one had any idea what to expect next. hank said he wouldn't need to
inject capital into fannie and freddie. then did what had to be done and injected $200 billion. collectively we helped prevent bear's failure. seemed to suggest we let lehman fail on purpose and turned around and saved a.i.g. from collapse. now we had announced an unannounced merger, end quote. these are geithner's words, not mine. keep in mind that geithner was one of the key players in managing the crisis. first as president of the new york fed and later as treasury secretary. in 2009, john taylor published a fine book, getting off track. he argued unpredictable policy had much to do with the crisis. based on the market's fear gauge, the spread between libel and overnight index swap rate taylor's evidence shows fear and confusion did not build to truly
alarming levels until treasury secretary paulson announced the iday after lehman that there would be a target program. the market understood from the beginning that the plan to take troubled assets off bank balance sheets was infeasible. because there was no satisfactory way to determine the price at which the treasury would buy the assets. how could the treasury and the fed given six months of it elapse since the bear stearns bailout? be so unprepared as to announce an infeasible program. in my full paper i explain that the confusion had roots going back to august of 2007. at the conclusion of its meeting of august 7, the fomc issued a policy statement that contained a hint that the federal funds
rate might increase. no one on the fomc was thinking of a rate increase. on august 16, the federal reserve board cut the discount rate by 50 basis points. bernanke did not want to cut the fed funds rate. most banks had access to the fed funds market at 5 1/4. which was the fomc's target rate. why would they want to borrow from the fed's discount rate at 5 3/4? it made no sense. banks did not borrow. more importantly, for years the discount rate and the fed funds rate had been adjusted together. the discount rate, 100 basis points above the funds rate. the irregular -- irregular policy action of cutting the spread between the two rates to 50 basis points accomplished nothing other than to make experienced market participants wonder what was going on.
in my paper i discussed several other irregular policy actions. none of which i argued made any olicy sense. studiedears or nor they -- more they followed the case for -- there was no paper to look at the advantage or accidental creation of policy uncertainty. robert lucas, later awarded the nobel prize, really did spark a new direction in economic research. policy predictibility was one of my constant themes while i was president of the st. louis fed. i talked about it in fomc meetings and speeches. so i leave you and especially the journalists in the audience with some homework. before saying any more about the financial crisis, make sure you understand two things. first, the central role of affordable housing policy.
and second, the importance of predictibility government -- predictable government policy. i think i made it. mr. wallison: are you right on time. didn't even need to ding you. i would like to point out one thing that's come up again and again here. that is on the question of what the fed could have done about subprime mortgages. why there were subprime mortgages we haven't resolved. the fact that they were in the market in such numbers has led many people afterward why didn't the fed do something about it? they had the power whether it was may or shall, they had the power. and the answer is that there were very few defaults going on among these subprime mortgages. and if you are -- not only that, the housing rate, the home ownership rate in the united states was going up substantially. it had risen from about 6 a 5%
almost 70% -- 65% to almost 70% by 2004. if the fed had approached congress and said we want to limit these subprime loans, i'm afraid the answer would have been show us the data. if there's something wrong with these subprime loans, we should see a lot of defaults. and they didn't. the reason of course is that housing crisis was going up and you were able to refinance if you couldn't meet your obligations, you could easily refinance the home and stretch out the obligations. it was impossible for the fed to have done that. that's my little intervention here on this because i do have to support the fed on that one. although i don't on a lot of other things. questions from the audience or the panel. start with the panel then get to he audience.
>> i appreciate taking the time head-on. you point to a lot of fair criticisms of the g.s.e.'s structural >> weakness, political power. what was missed is the growth of from nearly nothing to $1 trillion a year p.l.s. market. mr. klein: what is missed is the fact most of these subprime mortgages started out as refis not renewal originations. most were about equity stripping. and the political climate argument, read the transcripts of the 2001 and 2002 hearings. yes, there were not defaults because mostly equity stripping. there were huge yield spread premiums. huge fees being charged outside. tremendous amounts of consumer abuses including a product single credit premium life insurance, which is a ghastly product only offered on subprime mortgages. essentially eliminated when major players gone terribly
agreed to stop purchasing it. all of these were elements of parts of congress asking the fed to step in and do something. supporting governor gram lick -- gramlick who noted these problems and wanted to aggressively do this. even greenspan in his own book acknadges -- acknowledges he turned down his request. i think this kind of looking back and saying, even if the fed had noticed this, and there were people in the fed who were noticing this, congress with some -- had you a hypothetical conversation with bush. that was i understood totally hypothetical. i'm thinking about the actual conversations in which members of congress were screaming about abuses overwhelm impacting the subprime mortgage. and the corresponding response, which was peter's response is, the market seems to be doing fine. why are there any problems in these mortgages? there were no defaults? they have had zero charge offs. how do you respond to that kind
-based on of the fact history? mr. poole: it's not too hard to respond to it because congress can talk out of both sides of its mouth, and often does. read the book by usian wharton gates. -- susan wharton gates. she explains she was a 19-year employee of freddie mac. and she explains the strategy that freddie back used and undercut the predatory lending laws in georgia and north carolina. they went after and they were successful. because they needed those subprime mortgages. that was written by an employee who was very familiar with the situation. she also talks about how the chief risk manager at freddie mac, expressing his concerns about what they were doing. hey fired him.
i believe these incidents are correctly reported. i also point out there were merous efforts to reform the g.s.e. situation. congressman baker was working on that. i gave a speech in washington, i think it was 2003, where i criticized the g.s.e.'s. i got a call on my cell phone a national airport from congressman baker. he aid, i want to warn you, plays rough. you should be prepared for fannie to go after the directors, the st. louis fed directors. that's what might happen. i don't know whether that ever happened or not. that was the way fannie ran the business. and there are lots of such
incidents reported. i have a few in my paper. but there are lots of those reported in. so books on my green list and also a couple earlier ones, particularly the book by morganson and rouser in -- rousner is full of the politics of what was going on. i am convinced that the federal reserve did not have the political power and what would have happened is it would have been embroiled, it would have been embroiled in these debates about social policy. green bay testified, testified before the senate banking committee. he said that we're worried. i think he said we. it probably was fair to say we. a lot of us were worried. we believe that the systemic crisis is likely, if we do not have reform. greenspan was very much out there. and congress absolutely refused
to accept any reform. keep in mind, this was complicated also because president bush's h.u.d. kept pushing up the goals. this was president bush. and president bush kept talking about the ownership society. he kept celebrating the home ownership rate. it was not just the democrats. it was republicans as well. greenspan wanted to protect the federal reserve -- freedom is not quite the right word, i'll use it anyway. freedom to conduct a monetarypolicy. he tried to keep monetary policy out of politics. and i can assure you -- coy even name some of the democrats in congress -- i could even name some of the democrats in congress who would have attacked him. that's the answer.
mr. wallison: i think we ought give >> i think we ought to give the audience a chance to ask some questions. yes, sir. questioner: the points that been made that the problem with the subprime loans was the very low down payments compared to the 20% down payments. and yet v.a. loans also have a very low down payment. and i've never heard that they were a significant problem. and the only thing i can think of is that a veteran would only be able to get a v.a. loan if they had an honorable discharge. so they weed out all the people with less than honorable discharge who arguably are among the more dysfunctional and if they were dysfunctional during their service they might not be the best person to lend money
to. >> i think that peter talks about the v.a. and the f.h.a. along with the g.s.e.'s. but the g.s.e.'s were absolutely dom nant in terms of the size -- dominant in terms of the size. you can answer that better than i can. mr. poole: as a member of the audience here who will be on the panel this afternoon, he can talk also about the v.a. and other organizations in addition to the g.s.e.'s and i'd rather wait for him to address that subject this afternoon. >> if you look up the urban institute, there's a monthly housing indicator, they have a great chart here. the f.h.a.-v.a. market share went to almost nil. during the crisis. because you got better deals from the private label security. so even if you're a veteran, you're getting a better deal from one of these mortgage brokers who then is selling to an investment bank whose originating. so the desire from the market
and the compensation down the ballot, down the stream, was to get knew one of these subprime loans because it would make more money through the securitization regime, because of this fundamental mispricing within the market. but there just were very few v.a. loans and f.h.a. loans made in the 2004, 2005, 2006 vintage. >> but the mortgage brokers were putting together packages to sell to the g.s.e.'s as well. not just to the private market. >> that's right. but the explosion in 2003, 2004, 2005 is in the private label security and it cannibalizes oth g.s.e. and v.a. share. >> i think we've come to a point where we can address that too. the next speaker is steve. steve is the state farm-dames q. wilson scholar at the american enterprise institute. nd he's also the co-founder of a.e.i.'s center on housing,
markets and finance. he currently serves as a senior advisor in the center. he's also a senior fellow at the center for real estate at the university of california-los angeles. before joining a.e.i. in 2012, steve worked for more than 25 years at the federal reserve board as a research economist and a member of the senior management team. he has a ph.d. and an m.s. in economics from the university of wisconsin and received his b.a. in economics from the university of virginia. steve. the floor is yours. >> thank you, peter. i'm really pleased to have the opportunity today to present some new results on the evolution of mortgage risk in the decade and a half leading up to the financial crisis. this is joint research with morris davis from rutgers, will arson at fhfa and benjy smith, who is a colleague at a.e.i.
the only really important thing on this first slide is the stuff you probably can't read because the precipitation is too small. -- because the print is too small. we're very grateful for many helpful conversations with edmund pinto on these topics and the analysis and conclusions are ours alone and do not represent official views of any of the institutions we're affiliated with. so with, that let me get to the substance of the talk. we're now 10 years after the financial crisis and you would think there would by now be a comprehensive account what have actually happened to mortgage risk year by year leading up to the financial crisis. but the fact is that account does not exist. and that's because the data that you need to do it are hard to get. the project that we're working on, which is now in its second year, and probably will have another year to run, is to dig out that data, to provide that comprehensive account that
completes the picture. so what are we trying to do? first, we're going to cover the entire mortgage market. the g.s.e.'s of course are important. but all of the other sectors of the mortgage market are as well. we're going to provide history back to 1990, paying close attention to it the need to do a lot of data imputations the further back you go in time. because the data become more spotty. that's taken a lot of the effort that we're doing. importantly, because of our collaboration with fhfa, we have data on the full book of g.s.e. loans. loan level data on the full book. this has never been used before in research that has gotten out of fanny and freddie or fhfa. and we use all this information to track the important risk factors that built up over time. and to measure a combined impact.
so today's presentation is a progress report. i'm going to present results for the g.s.e.'s and for loans that were packaged into private label securities. we've talked about this a bit already. the rest of the market is turning away and probably will be forthcoming by the end of the year. i'm also going to talk about home purchase loans only. we're working on revised but those results are not yet ready. nonetheless, there's a lot to chew on here. so to begin, let me just characterize how much of the market we're really covering in the results i'm going to present. for the purchase loan market, the g.s.e.'s represented between 40% and 60% of the market in every year from 1990 to 2007. the private label securities were very small as a share of the market, up through the mid 1990's. they grew some over the second half of the 1990's, and then as
we've heard from a couple of the other speakers, really exploded as you went into the mid 2000's. at its peak, the p.l.s. loans constitute 3d1% of the purchase loan market. but fannie mae and freddie mac were still bigger. even at the peak of the p.l.s. market. the rest of the market that really would be represented in the gray area at the top are portfolio loans held on the books of banks and f.h.a., v.a. and rural housing loans which we've talked about a bit, and as aaron said, the v.a. and f.h.a. loans are very small part of the market. once you get to the cusp of the risis. one thing to point out is that the entire analysis is about loans, acquisitions of whole loans. it is not about the purchases of securities. so fannie and freddie became in the 2000's very large purchasers of private label securities. this was a lot of the risk they
ultimately bore. we're not covering any of that here because this is about their direct acquisitions. but it's important to keep in mind that the actual credit exposure that fannie and freddie had was significantly greater than what i'll be showing here. and i know that ed in his comments this afternoon will touch on those purchases by fannie and freddie. so the data are for first leans to purchase one to four unit homes from 1990 to 2007. we used the fhfa data for the g.s.e. loans and we used core logic data for the private label security loans. the core logic data are the standard source for information on this part of the market. importantly, as i mentioned, we have the full g.s.e. book and the core logic data are pretty close to a full universe of the
p.l.s. loans. so we have very high market coverage. the final clean data sets that we're using are large. they're about 36 million fannie and freddie loans in this data set through 2007. and about nine million private label security loans. so let me touch for a second on methodology. i mentioned that we construct an index, a risk index that measures how loans would perform under severe stress. i need say a few words about what that is because we're going to be looking at the results for those -- that index throughout the presentation. so we use the financial crisis as the stress event. we calculate the actual default rates of loans that were originated in 2006 and 2007 on e cusp of the crisis, with various characteristics. and then we put those default rates into structured tables that have all of the key risk factors, to stratify the default
rates. debt to income ratios, loan to value ratios, credit scores. these are what we call periodic tables. then we assign loans from other origination years to the appropriate cells on the periodic table and take that as the estimate of how those loans would perform if they had been experiencing the financial crisis. so that's how we construct a stress default rate for years -- for loans that originated in any year that we're looking at. so these periodic tables, there are a lot of them. eight in total for g.s.e. loans because you really do need to take strict account of the factors that generate default risk. so we have a table for -- of defaults for 30-year primary fixed rate mortgages. for those we separate out plain vanilla loans, fully documented,
with no risky payment features with regard to interest only, then those that are not fully documented, then those that have some of the risky payment features, and then those that have both. we do the same thing for a.r.m.'s. that's a total of eight tables. and we do the same thing for private label security loans. each one of those tables there are 320 combinations of credit scores, loan to value ratios and debt to income ratios. and in all of them the definition of default is any instance of a 180-day delinquency or an involuntary termination. then we run all the loans from every other origination year through these tables and calculate the implied stress default rates with adjustments for a few factors we didn't take account of in the tables. principally terms that differ from 30 years and whether the loan is for a second home or an
investor. so before we get to results, just to make this a little more concrete, what i've done is i pulled a slice out of each of two of these periodic tables. the top one, table one, is for fixed rate loans that are fully documented and fully amortized. no interest or negative amer toization. these are the actual default rates for loans that had credit scores between 720 and 769. and the full range of possible d.t.i.'s and the full range of possible cltv's. we use shading to indicate low default rates with green, orange for middle and red for high. what you can see is that there's a very predictable and strong relationship between risk factors and defaults. so in the northwest, default rates are very low for loans that have low debt to income ratios and low loan to value ratios. as you go down to the southeast, all those rates rise. the table right below it has
exactly the same structure but these are for low or no dock loans. while comparing cell to cell, you can see the effect of low dock or no dock per se. and it raises risk a lot. so this is an example of the tables that were running loans -- through. so let's actually get the results. starting with the left panel. all of the charts that i'm going to be giving from here on out use red for private label securities loans and blue for g.s.e. loans. what you can see from the left panel is that systemically throughout the entire period, private label security loans were riskier. they would have had higher stress default rates than the g.s.e. loans. risk was rising for both of them. both sectors. and it's not evident from the left panel, but in the right panel, all we do is rescale the scales to be ratio scales so
that the slope of those lines represent the rate at which risk is rising. and what you can see is that the rate of risk increase was basically the same in the p.l.s. market and the g.s.e. market. but the level of risk in the g.s.e. market was lower. perhaps the most important finding on this slide is in the area with the gray shading marked 2001 to 2003. the most commentators take the position that those years were years of normal lending standards and that is what we should be aiming for as we think about what is the right kind of equilibrium level of risk in the mortgage market. but what you can see is that those aren't normal in any sense. risk had already been rising for roughly a decade before we got to that point. we're really in the middle of a boom at the point of 2001 to 2003. so we need to look back into the 1990's to think about anything
that can be considered normal. another indicator that 2001 and 2003 are not normal is just looking at house prices. so this is the rate of increase n house prices from a standard fhfa house price index that's just on their website. and what you can see is that house price increases were already rapid. 2003. we got to 2001 or the increases averaged about 6% per year starting in 1998, running through 2000. the ac -- they accelerated to about 7% a year in 2001 to 2003. they rose further and then of course crashed. so the bottom line here is that i think 2001 to 2003 are really consistent with viewing that as the middle of the boom. you need to go back a lot further, that's why we're doing the history.
'm not good at this. so now let's look at the actual characteristics of the loans that generated those results i showed before on the stress defaults. so here on the left panel, we're looking at the average debt to income ratio for the g.s.e. loans and the private label security loans. you can see that they were rising throughout the period. particularly so for the g.s.e. loans. the d.p.i.'s rot a lot -- d.t.i.'s rose a lot. it rose from 29% in 1990 just about 40% in 2007. there were periods in which the rise -- it rise fast than others but they correlate well with changes in the affordable housing goals. then in the right panel, we showed the same type of chart for the combined loan deval --
loan to value ratio. this includes second lean as the the time of origination, as well as the first lean. private label securities loans, it's pretty much a straight upward line. for the g.s.e.'s it's interesting that cltv's rose basically in two periods. there was a little bit of increase between them, but the early 1990's and then 2006 and 2007. the early 1990's i think are really a period in which the g.s.e.'s were getting -- were jumping the gun. on the affordable care act -- on the affordable housing standards. they wanted to get political kudos for being ahead of the game and in their own documents they indicate that they really increased the share of high ltvl -- l.t.v. loans a lot during that period. we can see that in the data. then in 2006 and 2007 i think the increase was because they had really been relying on meeting the goals by using purchases of private label securities. but that market had started to dry up.
so they then had to go back to the whole loan acquisition to really double down on risks there to meet the goals. and i think that's what we're seeing here. i skipped one. sorry. so credit scores. one of the things that we learned from this work is that credit scores were really not the margin that got pushed to increase risk. there wasn't a major change in the purchase loan market in the average credit score. for the g.s.e.'s, the credit scores drifted up a bit, for the private label loans they were volatile year to year. but you wouldn't say that there wa any trend there. what did end up pushing credit scores down a bit for the market as a whole is that there was a shift in market share toward the p.l.s. loans, which had lower average credit scores. so that mix shift, as you can see on the right-hand panel,
caused there to be a very mild downward drift in kerd credit scores. but this wasn't nearly as important as just the plain vanilla increase in leverage that we saw in the prior slide. the other piece of the puzzle is what happened to the use of low dock and no dock loans and loans that had a payment reducing feature. in the left hand panel you can ee the results for the low doc/no doc. there was a sharp decline from 1990 to 1991 in the use of low doc/no doc. it had been high in the late 1980's and there was a lot of documentation at the time about using these loans because they were thought to be relatively ow risk. then they started to pull back in 1990 and 1991. you can see that here. then the use of low doc/no doc was basically flat until we get
to about 2000 and it zoomed. again, this is more common in the p.l.s. market than the g.s.e. market but even so, by the time we get to 2006, something like 18% of the g.s.e. purchase loans were low doc/no doc. so there was a very large -- they had a very large presence in the market by that point. in the right-hand panel, the payment reducing features, they weren't used much at all until prices had risen so much that there was just a search for other ways to continue to afford homes where prices had risen a lot and making your payment smaller through either an interest-only loan or a negative amer toization loan was a way to do that -- amorization loan was way to do that. i think it's important to recognize that these risky features contributed to risk but i think their role can be easily overstated and this slide
attempts to try to quantify how much plain vanilla leverage, just rising cltv's, rising d.t.i.'s, little down drift in credit scores, would have raised risk had there been no use of these risky product features at all. so to do that, the red line is just the risk index for private label securities that we've seen in prior slides. the dash line, the nonsolid line, is a counterfactual calculation of risk. if all the loans had had one of those risky product features, were instead assigned to the default tables that were plain vanilla, as if this -- if they didn't have that feature. what you can see is that more than half of the increase in risk, 18 percentage points out of 32, was attributable in the p.l.s. market, just a plain vanilla leverage. another 14 percent an points was due to the risky product features. for the g.s.e.'s we don't have a
picture yet to correspondent to this. but we know that the importance of plain vanilla leverage was greater than in the p.l.s. market because on the prior slides you can see that use of negative amorityization, low doc, etc., wasn't as important. so i think when we're all said and done, we're going to find something like 2/3 of the rise in risk, my guess, was due to just plain vanilla leverage. the next one tries to get at some notion of how the developments in the g.s.e. market might have been impacting other related markets. so what we've done here is to break the p.l.s. market into two parts. the left panel shows the risk index for the conforming part of the p.l.s. market. these are loan amounts that had small amounts where they could have been involved with the g.s.e.'s and so these are markets that compete with one
another. on the right we show the p.l.s. market for jumbo loans which were not eligible for purchase. what you can see in the left panel is that the rise in risk in g.s.e. loans from 1992, when the safety and sound effect went into place, through 1998 was basically paralleled by what was happening in conforming p.l.s. loans. so that competition induced transmission, i believe, of the looser g.s.e. standards to the broader market. in the right panel, the jumbo p.l.s. risk index didn't move at all. so it suggests that markets that were not directly competing with the g.s.e.'s didn't have that kind of transmission. so let me wrap up. some key takeaways from the presentation. it's really important to not think that history of the mortgage markets started in 2000.
most people do because that's when the easily available data begins. but you have to go back further because there were important things happening in the 1990's, if you're going to find the orins of the financial crisis. and credit standards had already loosened a lot by the time you get to the early 2000's. second, as i mentioned a moment ago, the results for the 1990's indicate that in competing with the g.s.e.'s, risk rose in the conforming p.l.s. markets that competed with the g.s.e.'s. and over the entire 17-year period that we're studying, p.l.s. loans had a higher level risk than g.s.e. loans but risk rose at the same rate for both. due to sharp increases in debt to income ratios, loan to value ratios, and actually not much changed in average credit scores. there was also a jump in the use of the risky product features later in the boom, particularly for the p.l.s. loans. but the last point, the one i'm going to make now, i think is really the most important takeaway for thinking about where the mortgage market is
today. and that is despite the jump in the use of these risky product features, plain vanilla leverage accounted for most of the rise in risk leading up to the financial crisis. which is an important message for today's mortgage market. because those forms of risk are rising it a lot and my colleague at pinto will have more to say about this in the afternoon. thank you. mr. wallison: thanks very much. we have a little bit of time for some questions and then i want to remind everybody that jeb hensarling will be here for lunch. right outside the door is a buffet. dishes and things to eat. and you can come back in and eat at the table. but as soon as we end this, you can start on the buffet line. ok? uestions from the panel. >> so you posit in the second bullet point that competition between the g.s.e.'s and private market was important.
how do you know that? how do you know they were competing with eemp and that accounts for this or some external factors accounts for the rise in both at the same time? >> i don't know. so this is an infor instance from the differing pat -- infor instance from the differing -- infonches -- infenches from the differing panels. this wouldn't have been the driver. if there was a driver, it would be the g.s.e. standards that were spilling over to affect what was happening in that other market. i don't know why, if there was some external third factor, i don't know why it spared the jumbo p.l.s. market from the same rise and risk. would you have thought if there was something that wasn't originating in the g.s.e.'s, that would you have seen all those lines rising at the same rate. you don't see anything happening in the jumbo market at that point.
>> great presentation, steve. really looking forward to the full fruit of your work on that. >> me too. >> i think it rhymes with some things we already know from some more microscopic forensic analysis and i want to sort of highlight that and get you to react. what i think is puzzling and this lynx up to some things aaron was saying. so, another way to look at the mistake of high leverage is that people underestimated the possibility of housing prices going down. so i want to now think about this from the perspective of the actual models that rating agencies and the private sector was using and i want to say that there were two key errors in those models. and i also want to say that those errors were known to be errors at the time. so the two key errors were, first, they underestimated the probability of a housing price
decline and the reason that this was happening was those models were based on the 2001 recession experience. ridiculous but still being used, i would say, with a wink and a nod as a private market justification for the crazy assumption. well, we only had one prior recession and that recession, prices didn't go down. the other thing that was -- which i think you referred to, there was in these models almost no discount for non-documentation. in other words, if you went off of the recession of 2001, housing prices declined, which was zero, in fact it went up, and you went off of the notion that fikeo scores by themselves, a-- fico scores by themselves, were all you needed to know. risk managers knew from the 1990's that that wasn't true. and in fact the freddie mac risk
manager spictly knew and commented to senior management that it wasn't true. i will address this puzz until my own comments but i'll -- puzzle in my own comments but i'll let you try. , y would the private market who i can prove to you knew better than either of those two assumptions, why would they be purchasing securities based on those assumptions that were known to be wrong and that were the basis for and in fact explain the entirety of the difference between actual loss and forecasted loss? ust those two assumptions. >> i'll offer a few comments. it sounds like you'll have the eab in the afternoon. i think on the house prices it was more than relying on what happened in 2001, which is -- wasn't a housing recession.
the consumer sector fell through. if you go back 20, 30, 40, 50 more years, all the way back to the great depression, there really wasn't a national large house price decline for the past 70 years before that. so i think it would have been easy to say, expecting a 35% national house price decline, that would have been outside the realm of most people's imaginations. on the second point about low doc/no doc, in retrospect, we know that many of these loans involved a significant degree of fraud. they had to. if you think about why would you use low doc/no doc legitimately, it's because you have irregular income. or hard to document income. if you're just a wage earner and you're getting a paycheck twofere weeks or every month, -- every two weeks or every month, your income is easy to document. people who were in that situation were doing low doc/no
doc loans. they had to be, given that nearly 20% of the g.s.e. loans were low doc/no doc and 60% of the p.l.s. loans. so a lot of regular wage earners were basically overstating their income. now, what i don't know is how readily apparent that was to savvy investors at the time or whether because there's been a lot of research after the crisis we now know that. but wouldn't have been -- wouldn't have known at that -- known that at point that it happened. mr. wallison: i think we have time for a couple of questions till to come in. >> i also am interested in going back to the issue of realistically, could anybody have known what was going on? i took your answer just now as you're refuting the idea that it was obvious or should have been known that there would be a financial crisis. i look at it from a securities industry perspective and think to where, you know, alan greenspan was constantly asked to raise margin levels, limit
leverage, when the securities market appeared to be too high. he declined to do that. said, if there is a collateral, that someone feels is good clad clathral for lending, the -- collateral for lending, the money will come in from other sources and you really cannot make a difference, you can't make a determination on how much leverage is too much leverage without making a determination on what's the actual value of the asset. and it's the market that's going to determine that ultimately. i do think we've learned some things in hindsight about the peculiarities of the housing market. anyway, here's the question. i took your remarks earlier in the day to be consistent with my understanding which is the fed was getting information that was not undulyy alarming as so the state of the market, given the fact there was an understanding that in a stable market, if there's a problem with the loan, the collateral will be sold, no big problem.
but in this remark you also said we're making the comment that chairman greenspan was concerned about there being a systemic crisis. i don't know how significant his concern was. could you color that a little bit and maybe put those remarks together? >> i'm just going to go back to my own experience at the fed. i was there from 1984 to 2011. doing forecasting a lot of the time. we just didn't dig deep enough to understand how bad the risk situation was. it could have been done. a few people did and they shorted this market and made a lot of money. but i guess i would just go back mindset, hadn't been any severe national housing bust for 70-some-odd years.
so that's kind of outside your framework of reference about what -- frame of reference of what normal risk is. when you analyze things it's within a narrower range of risk parameters. i'm not trying to exonerate what the fed and others failed to see, including myself, because i was on the forecasting staff. i'm just trying to give you perspective on why i think it might have happened. it was a failure of imagination. and a failure to dig as deeply and do forensics that i think should have been done. it would have been hard. i mean, it's not like this information was just sitting out there. peter's book is excellent in indicating that a lot of this information was deliberately with held. by the g.s.e.'s. so you have to be i think realistic about how much could have been dug out in realtime. >> [inaudible] >> ok. wife we have time for one more question -- mr. wallison: we have time for one more question. i'd like someone who hasn't asked a question.
right here. can we get a microphone over here? sorry, bert. you can ask a question this afternoon. >> this touches on comments made by several of the panelists. but i think professor scott pointed out the dichotomy between the solvency of banks at the market price and what the federal reserve thought they might be valued after or what their assets might be worth after various programs were instituted. if you look at -- if you think morgan stanley's marks on various subprime securities it had around november, 2008, the implied loss rate on those, quite late in november of 2008, turned out to be very close to the real-life losses that s&p
made it on very similar pools and securities around 2013. i guess the point i'm making is that it's really hard for anyone to make that judgment in the crisis and it was around that november when citi was falling into failure while posting record high levels of capital. d so could you, i guess, comment on the roll of -- role of accounting in all of this? it seems that -- it doesn't make sense to call something tier 1 capital while it's going up and the bank is failing. and everyone knows it's insolvent. >> so i guess the general question is how do you value a bank in the midst of a crisis? is that basically your zpwhe -- question? how do you value without them? i guess the response is it's very difficult. ok? [laughter]
because particularly for the fed, if you really believe that by lending to the banks you're going to stabilize the situation and these assets will revert back to their precrash level, their solvent in some sense, whereas if you believe that's not going to happen, they're insolvent. i think the correct way to handle this situation is any time the fed has doubts about there should be a collaborative response between fiscal authorities and the federal reserve about handling the rest of the world says emergency lending, normal lending. we don't. so if we're in a situation with emergency lending and if that's what we should be doing here, i think coordinated decisions should be made by the fed and the fiscal authorities as to how to handle.
it but we need to have the capacity of the fiscal authority to handle it in the event it's designated to be a fiscal problem. that's a long answer. i don't think there's an easy way to value and when there's doubt i think both authorities need to work together. >> i tried to address some of that with the vehicles as an example of how this eterioration occurred. i think somebody mentioned the sarbanes-oxley. you can go back and see a lot of these problems. >> we fixed that. we fixed the accounting rule. >> well, we fixed it in that way. the accounting was much later. we fixed that going forward.
but at some point in the future, i'm concerned about the human being rouse -- hubris of the model. i take your point. i think the two are somewhat brought together which was we assumed no -- [inaudible] -- between liar loans. we assume liar loans wouldn't behavior similarly because they're geographically dispersed. it turns out, if you have a liar loan, it behaviors like a liar loan. regardless -- behaves like a liar loan. regardless of where you lied. this is not somehow to me rocket science. but if you assume, then you can't do a model, then your linear progression breaks down. we don't want to do an alternative model so we make an assumption, even though it's inaccurate. and i think the best answer to your question is what i believe is the right answer on bank capital, which is what i call the chopsticks approach. you take risk-weighted capital
and take a simple leverage ratio. both are deeply flawed. but working together, like two chopsticks, you can eat elegantly. if you just have one chopstick you're poking at something. if you allow a simple leverage ratio to guide sometimes, then you don't have to worry. you can't gimmick a simple leverage ratio with accounting. on the other side, sometimes you let a risk-weighted system work because there's a problem with the simple leverage ratio. mr. wallison: steve, did you have anything you wanted to add at this point? >> just a final comment circling back to some of the questions that have come up before about, well, what should have been known before the crisis and will the feds the anticipate the next one? i'm deeply dubious that the fed will be able to anticipate the next one because it's going to take a form that's different than what we're protecting ourselves against. so to me the main message from that is just keep the level of
risk in the financial system more contained. there's no free lunch for offering high-risk mortgages to lots and lots of people. they're going to blow up at some point. you just don't know when. mr. wallison: ok. we're prepared to end for the second part of our conference this afternoon. so we'll start to have lunch now. i hope you'll all stay. we have a very interesting second section coming along. and bring your lunch in and have lunch here among us. thank you. [captioning performed by the national captioning institute, which is responsible for its caption content and accuracy. visit ncicap.org] [captions copyright national cable satellite corp. 2018]
>> forum on the 2008 financial crisis taking a break now for lunch. the forum will pick up again at 1:00 p.m. eastern with a speech from congressman jeb hensarling. he chairs the house financial services committee. that will be live here on c-span starting at 1:00 p.m. eastern. earlier today, officials with fema and other federal agencies provided an update on hurricane florence. we'll show you as much of this briefing from fema headquarters as we can before the american enterprise institute forum re-resumes. >> good morning. i work with noaa's national weather service. at around 7:15 this morning, the center of hurricane florence made landfall at wrightsville