Change you can’t believe in: The unintended consequences of bad government policies

As we noted last time, Republican Congressman Jim Saxton, the ranking member of the Joint Economic Committee (JEC), recently issued a report outlining the policy blunders that have led to the “inflated and unsustainable housing bubble” and the ensuing crash and financial crisis.

Continuing with our posting of the report’s highlights, the JEC summarized the macroeconomic policy factors that have contributed to the current worldwide financial problem. (Emphasis added.)

During the last decade, the governments of the world’s major economies have pursued two different exchange rate policies: freely floating exchange rates and pegged exchange rates…

The exchange rate-induced price distortions influenced macroeconomic policy decision-making around the world. In the United States and other economies in the floating zone, central banks pursued, at least in retrospect, overly accommodative monetary policies that expanded the availability of credit at low interest rates. In turn, these policies inflated unsustainable housing price bubbles. In the PRC and some other economies in the pegging zone, macroeconomic policy errors caused price inflation in goods and services to surge.

After these housing bubbles popped, massive overinvestment (i.e., the accumulation of assets in excess of the demand for these assets) and malinvestment (i.e., the accumulation of the wrong types of assets) was revealed in the housing sectors of the United States and most of the other major economies in the floating zone. This triggered a global financial crisis that began on August 9, 2007.

Among the microeconomic policy factors, the JEC report noted the following:

During the last three decades, an alternative financial system has developed to the traditional bank-centric financial system. This alternative system is based on (1) the securitization of loans, leases, and receivables into structured credit products (e.g., residential mortgage-backed securities), and (2) the purchase of these structured credit products by highly leveraged non-depository financial institutions (e.g., investment banks, financial government-sponsored enterprises including Fannie Mae and Freddie Mac, hedge funds, and off-balance sheet entities).

The unintended consequences from financial regulations included the following (emphasis added):

Federal regulatory policies that addressed legitimate problems (i.e., inconsistent capital regulations for multinational banks, and inadequate accounting standards that allowed Enron to conceal its true financial condition before its collapse in 2001) had the unintended consequences of encouraging excessive leverage and risk-taking especially among these highly leveraged nondepository financial institutions. In particular, two policies encouraged financial institutions to behave pro-cyclically:

1. Promoting the use of value-at-risk models to determine the risk exposure in financial institutions without sufficient consideration of the inherent limitations in these models, especially the lack of sufficient historical data to draw statistically valid conclusions about (a) the credit performance of new products, and (b) institutional liquidity under rare episodes of financial stress; and

2. Requiring financial institutions to use fair value (also known as mark-to-market) accounting for illiquid financial assets that such institutions intend to hold.

Reliance on value-at-risk models caused both financial institutions and their regulators to underestimate the risk exposure at these institutions.

This underestimation encouraged aggressive lending and underwriting practices at financial institutions during upswings. Small changes in the price factors that econometric models use to estimate the fair value of illiquid financial assets can cause large drops in the recorded value of these assets during downturns, forcing financial institutions to take large writedowns.

There has been a lot of reporting on the unintended consequences caused by housing policies that promoted home ownership.

The shift from FHA-insured mortgage loans to subprime mortgage loans among low income households in the United States and the widespread issuance of subprime mortgage-backed securities by investment banks during the first half of this decade is, in large part, the unintended consequence of well-meaning, but poorly conceived federal policies to increase the home ownership rate  among low income households…

Responding to this regulatory-induced demand, mortgage banks greatly increased their extension of subprime mortgage loans, while investment banks placed these loans into subprime mortgage-backed securities.

Lastly, the JEC report noted “misaligned private incentives”:

Misaligned private incentives encouraged excessive risk-taking in financial institutions:

1. Unlike the originators of other loans, leases, or receivables, the originators of residential mortgage loans were not required to retain an equity interest, known as “skin in the game,” in (a) the loans which were sold or (b) the mortgage-backed securities into which these loans were placed. Thus, originators such as mortgage banks had no incentive to apply sound credit standards when underwriting residential mortgage loans.

2. The “issuer pays” business model of credit rating agencies made them financially dependent upon a few investment banks whose structured credit products the agencies were assessing. These agencies pressed their analysts to give favorable ratings to maintain or increase market share with these banks.

3. Banks had “up-front” incentive compensation packages for investment bankers that did not adjust their compensation for the long-term profitability of their deals for the banks or their customers.

The JEC’s conclusion:

Macroeconomic policy errors both here and abroad combined with regulatory policy deficiencies and misaligned private incentives to inflate unsustainable bubbles in housing prices in the United States and most of the other major economies in the floating zone. After these bubbles popped, the alternative financial system proved vulnerable to a modern version of 19th century bank runs. This sparked a global financial crisis that is ongoing.