# Engineering the Financial Crisis ## Metadata * Author: [Jeffrey Friedman and Wladimir Kraus](https://www.amazon.comundefined) * ASIN: B00C3K67QQ * Reference: https://www.amazon.com/dp/B00C3K67QQ * [Kindle link](kindle://book?action=open&asin=B00C3K67QQ) ## Highlights the crisis was a regulatory failure in which the prime culprit was none of the usually targeted factors, but was, instead, the set of regulations governing banks’ capital levels known as the Basel rules. — location: [218](kindle://book?action=open&asin=B00C3K67QQ&location=218) ^ref-58046 --- Very soon, however, politicians and political ideologues began to treat the hypotheses that confirmed their predilections as if they were established facts, and these theories eventually formed the conventional wisdom. Thus, conservatives were eager to blame the crisis on the government by means of hypotheses 1, 2, and 5, while liberals were eager to blame the crisis on capitalism by means of hypotheses 3, 4, and 6. — location: [226](kindle://book?action=open&asin=B00C3K67QQ&location=226) ^ref-21308 --- (1) Why did the new money injected into the U.S. economy, as reflected in low interest rates, cause a bubble in housing, rather than, for example, a bubble in the price of cars, food, airplanes, computers, or clothing? And (2) why did this housing bubble cause a financial crisis—which is to say, a banking crisis—when it popped? — location: [290](kindle://book?action=open&asin=B00C3K67QQ&location=290) ^ref-55071 why housing and not another sector? --- Thus, in 1997, Fannie Mae began to repurchase mortgages with a mere 3 percent down payment, and by 2001, as part of its commitment to an “ownership society,” the Bush administration made the Clinton policy its own. Thereafter, Fannie and Freddie began repurchasing mortgages with no down payment at all (Wallison 2011a). The reduction in down payments made homeownership more affordable to the poor. Millions of people who could not afford down payments were now able to buy houses because of the GSEs’ willingness to assume the risk by repurchasing these loans from the mortgage originators. This had to have had the effect of driving up the price of housing. — location: [384](kindle://book?action=open&asin=B00C3K67QQ&location=384) ^ref-56341 --- Even without the GSEs, the subprime portion of the bubble, although smaller, would have been largely sustained by the PLMBS purchases of private investors. — location: [392](kindle://book?action=open&asin=B00C3K67QQ&location=392) ^ref-60655 --- To the extent that the GSEs helped pump up house prices, they bear that amount of responsibility for the severity of the burst housing bubble, and especially for the high delinquency and default rates among subprime borrowers when the price bubble burst—even though the GSEs did not make subprime loans directly. On the other hand, it is important to keep in mind that the housing bubble is not the same thing as the financial crisis or the recession that followed. — location: [400](kindle://book?action=open&asin=B00C3K67QQ&location=400) ^ref-27771 --- The investment banks, like commercial banks and most OBSEs, were regulated by the Basel accords, named after the location of the Bank for International Settlements, a central banking secretariat that includes the Basel Committee on Banking Supervision (BCBS). The BCBS negotiates agreements among member nations to adhere to sets of banking regulations that have become known as Basel I (1988), Basel II (2005), and Basel III (2010); these regulations are then adopted by most world governments. That said, the regulations imposed on the shadow banking system were in various respects lighter than those covering commercial banks. — location: [428](kindle://book?action=open&asin=B00C3K67QQ&location=428) ^ref-35396 --- Ever since 1975, SEC regulations had conferred an effective oligopoly on the three rating agencies—Moody’s, S&P, and Fitch; and older regulations, at both the state and federal level, compelled two of the three largest classes of institutional investors—pension funds and insurance companies—to buy only highly rated securities. — location: [518](kindle://book?action=open&asin=B00C3K67QQ&location=518) ^ref-2580 --- The two attention-getting events were the March 16, 2008, bailout of Bear Stearns and the September 15, 2008, bankruptcy of Lehman Brothers. These two investment banks were dragged under by the decline in the market value of their holdings of subprime mortgages and PLMBS—held in inventory to be sold to investors (such as commercial banks). The fact that Bear Stearns and Lehman Brothers were investment banks strongly influenced the frenzied search for explanations of the crisis after September 15, so financial deregulation immediately presented itself as a plausible cause; — location: [529](kindle://book?action=open&asin=B00C3K67QQ&location=529) ^ref-59974 --- Leonhardt’s rebuttal to the GLBA trope was to point out that Bear Stearns and Lehman Brothers were unaffected by the legislation, since they remained stand-alone investment banks, not subsidiaries of BHCs. However, Leonhardt kept the “repeal of Glass-Steagall” story alive by speculating that an investment bank that was part of a BHC could give the commercial bank under the same BHC umbrella “more capital to invest” in subprime housing (which is true, but begs the question of why the commercial bank would want to invest capital in subprime housing—the question of demand). — location: [546](kindle://book?action=open&asin=B00C3K67QQ&location=546) ^ref-22132 --- The tussle over the Community Reinvestment Act was emblematic of the larger political objective of the Clinton and, later, the Bush administration: expanding the middle class by offering homeownership opportunities to the poor. There was no way to accomplish this objective other than by making subprime loans and securitizing them, since securitization was perceived to reduce the risk inherent in subprime lending. It does not seem realistic to lay blame for the crisis on the absence of a ban on the very practices that would achieve the homeownership objectives of powerful political forces. — location: [588](kindle://book?action=open&asin=B00C3K67QQ&location=588) ^ref-35681 --- modern democratic culture diminishes the desire to analyze the causes of complex social problems. Such analysis tends to stop as soon as one reaches a cause of a problem that could have been prevented by a law or regulation—no matter how unrealistic such a law or regulation would have been at the time, given the political forces then in play; and given the difficulty of predicting the future effects of legal and regulatory remedies under modern conditions. Thus, even as social complexity grows, our understanding of society shrinks, because our interest in the empirics of social and economic problems becomes secondary to thinking up policy solutions for them. — location: [617](kindle://book?action=open&asin=B00C3K67QQ&location=617) ^ref-53823 --- However, if the housing bubble had burst before those mortgages had been converted into private-label mortgage-backed securities, and if commercial banks had not acquired nearly $500 billion of these securities, there probably would not have been a financial crisis and recession. Low interest rates, GSEs, deregulation, banks’ compensation systems, the notion that large banks were too big to be allowed to fail, and irrational exuberance do not explain why nonprime mortgages were privately securitized or, more importantly, why such a substantial sum of these assets found their way into the investment portfolios of commercial banks. Our interpretation of why this happened, and how it caused the Great Recession, will be given in the next two chapters respectively. We begin with the Basel rules on bank capital, which governed not only the level but the type of assets that commercial banks acquired during the years preceding the crisis. — location: [1154](kindle://book?action=open&asin=B00C3K67QQ&location=1154) ^ref-23071 --- The Great Depression prompted an unprecedented wave of bank runs in the United States, to which one response was a provision of the Banking Act of 1933 that instituted deposit insurance for commercial banks and savings and loans. This would prevent future bank runs by reassuring depositors that they would be bailed out if their bank became insolvent. Because of deposit insurance, commercial banks and savings and loans were immediately subjected to legal capital minima by the federal government. What are now called “capital adequacy requirements” were designed to ensure against the “moral hazard” that, because of deposit insurance, bankers would gamble depositors’ money on reckless loans or investments. — location: [1219](kindle://book?action=open&asin=B00C3K67QQ&location=1219) ^ref-58058 Changes to bank capital regulation in light of the great depression were similar to the Basel regulations implanted throughout the 2000's. Could this be the reason why we get a slow or stagnant recovery? --- The intuitive solution to this problem is to allow federal bank examiners the discretion to be flexible—say, by making exceptions for banks primarily invested in what the supervisor considers to be ultrasafe loans or securities, or by excluding from the asset number “assets classified as worthless or of doubtful value” (FDIC 1984, 116). However, the discretion required to make exceptions or to determine which assets are indeed worthless or of doubtful value amounts to the power to supersede the bank’s own judgments about the riskiness of various assets. If federal regulators are thought to have better judgment about risk than the bankers themselves (due to the bankers’ presumed moral-hazard problems), then there is really no reason to allow private banking to continue. The only ostensible purpose of private banking (or any other private economic activity) is the possibility that, at least overall, private parties will somehow have better judgment than government employees. — location: [1248](kindle://book?action=open&asin=B00C3K67QQ&location=1248) ^ref-17316 --- There was a clear logic to these categories—the 0 percent and 20 percent categories relied on the relatively riskless nature of “sovereign debt” and semisovereign debt (BCBS 1988, para. 38), at least at that time. As for the 50 percent bucket, “loans fully secured by mortgage on occupied residential property have a very low record of loss in most countries” (ibid., para. 41).3 Yet obviously the round numbers—0 percent, 20 percent, 50 percent, 100 percent—continued the practice of lumping together disparate risks, both generically and individually. — location: [1278](kindle://book?action=open&asin=B00C3K67QQ&location=1278) ^ref-26029 Clearly need to start by reading the old Bl s documents to understand this further. --- Bankers’ judgments about risk, like all human judgments, are themselves subjective and somewhat arbitrary. By substituting its own judgment for that of bankers, the BCBS was inevitably going to be subjective and somewhat arbitrary, too. — location: [1296](kindle://book?action=open&asin=B00C3K67QQ&location=1296) ^ref-62939 --- The establishment of different risk buckets, however, allowed bankers to engage in what economists call “regulatory arbitrage” in order to reduce the amount of scarce capital that they needed. — location: [1307](kindle://book?action=open&asin=B00C3K67QQ&location=1307) ^ref-21968 --- One lesson of this exercise is that as the regulators intended, the Basel rules created incentives for bankers to engage in certain types of lending rather than others. The rules encouraged mortgage lending by requiring twice as much capital for business and consumer loans as for home loans, and they encouraged mortgage securitization by requiring five times as much capital for business and consumer loans as for agency bond purchases. The “encouragement” of mortgage lending and GSE securitization can also be seen as a penalty for other types of lending. — location: [1334](kindle://book?action=open&asin=B00C3K67QQ&location=1334) ^ref-31763 --- by virtue of the perceived need to impose leverage maxima on bankers (in the form of capital minima), the regulators were put into the position of determining in advance, and from afar, the riskiness of business loans, mortgage loans, securitized mortgages, and sovereign debt—without having any idea of how risky (or “uncertain”) a particular bank’s loans and investments in these categories might really be. The mechanism through which this was accomplished was to impose heavier “capital charges” on assets in the risk buckets that were deemed riskiest by regulators than on assets in risk buckets they deemed safest. Thus, to the extent that a banker in a particular place and time was optimistic enough about general economic conditions to want to increase leverage, Basel ensured that the most economical way to do so would be to reduce business and individual loans relative to mortgages, agency MBS, and sovereign debt. The Basel Accord was criticized on precisely these grounds. “In particular, Basel I was accused of prompting a contraction of credit extended to individuals and firms” (Rochet 2010, 80), causing a “credit crunch” for businesses and individuals. — location: [1373](kindle://book?action=open&asin=B00C3K67QQ&location=1373) ^ref-26484 Bank regulations embed assumptions about the future. I should investigate the criticism at the time of implementation. --- For many years before the June 2004 conclusion of this process, it was clear that the BCBS6 was determined to use “external credit ratings” (i.e., from Moody’s, S&P, and Fitch) to refine the risk-sensitivity of its capital-adequacy standards. — location: [1385](kindle://book?action=open&asin=B00C3K67QQ&location=1385) ^ref-23532 --- Because of the financial crisis, Basel II was never implemented in the United States. But the process leading to Basel II had an important effect on the United States at the very moment that the housing bubble, the subprime bubble, and the growth in PLMBS issuance all began: 2001. — location: [1395](kindle://book?action=open&asin=B00C3K67QQ&location=1395) ^ref-23932 --- We believe that the timing of the growth spurt in 2001 and subsequent years may be due, in part, to the so-called Recourse Rule,7 a regulation governing capital requirements for asset securitization and sale by U.S. banks that was first proposed in 1994,8 refined in 1997 and 2000,9 and finalized on November 29, 2001. The Recourse Rule, issued by the FDIC, the Federal Reserve, the Office of Thrift Supervision, and the Office of the Comptroller of the Currency, applied the developing Basel II ratings-based approach to privately issued securitized assets to U.S. commercial banks and “thrifts,” or savings and loans. — location: [1398](kindle://book?action=open&asin=B00C3K67QQ&location=1398) ^ref-33212 --- These risk weights were exactly the ones that had been proposed in the 1999 BCBS consultative paper for Basel II, except that the BCBS document had proposed dollar-for-dollar capital reductions, instead of a 200 percent risk weight, for B-rated tranches. The net effect was to dramatically raise the capital requirement for the riskiest parts of a securitization, the equity tranche and the B tranche, but to reduce the capital requirement by 80 percent for the top-rated tranches. By the same token, the Recourse Rule penalized banks that did not invest in top-rated ABS by requiring them to devote 400 percent more capital to business or commercial loans than to double- or triple-A ABS, and 150 percent more capital to whole mortgages than to such ABS. We believe that this may be the primary explanation for the overconcentration of securitized mortgage risk in the commercial banks.12 — location: [1418](kindle://book?action=open&asin=B00C3K67QQ&location=1418) ^ref-55550 --- One of the most interesting aspects of the figure is that it shows a second spike in the creation of ABCP, primarily but not exclusively among European issuers, beginning in 2005, when the final version of Basel II was introduced. — location: [1438](kindle://book?action=open&asin=B00C3K67QQ&location=1438) ^ref-4307 --- we suggest that the 50 percent risk weight applied across most of the world by Basel I may contribute to the explanation of both the housing booms that occurred in many countries and the boom in the mortgage variety of ABS. Basel II made matters worse: it reduced the risk weight for mortgages from 50 to 35 percent. — location: [1449](kindle://book?action=open&asin=B00C3K67QQ&location=1449) ^ref-7872 --- On the other hand, as Adrian Blundell-Wignall and Paul Atkinson (2008) have pointed out, in some countries, including Germany and Britain, banks were extended Basel II capital treatment by their countries’ financial regulators in advance of the country’s official implementation date, and in other countries banks may have begun to shift their portfolio composition in anticipation of Basel II once they knew their countries’ regulators’ intentions as to the final form the Accord would take in law.14 Therefore, the effects of Basel II might have been felt, in a given country, as early as 2004. Our approach will be to follow Blundell-Wignall and Atkinson in allowing that the implementation and anticipation of Basel II may have helped to lay the groundwork for the financial crisis outside the United States, but to use the demonstrable U.S. effects of the Recourse Rule, whose risk weights for ABS were essentially the same as those of Basel II, as a template for what might have been happening in other countries in 2004–7 because of Basel II. Future research will have to determine whether this template is appropriate. — location: [1473](kindle://book?action=open&asin=B00C3K67QQ&location=1473) ^ref-60879 --- Thus, we can rule out the possibility that bankers preferred yield to safety, or yield to capital relief. Their preference for triple-A bonds suggests that U.S. bankers’ aggregate preference was for either safety or capital relief first and yield last.15 In turn, their preference for implicitly guaranteed agency bonds suggests that the order of priority was safety first, then capital relief, then yield. — location: [1503](kindle://book?action=open&asin=B00C3K67QQ&location=1503) ^ref-34433 --- the preference for safety before yield undermines the leading theories of the cause of the crisis: the corporate-compensation thesis, the TBTF thesis, and the irrational-exuberance thesis. But if we are to defend the alternative thesis that the Recourse Rule was the chief culprit in the United States, we need to see whether the objective “incentive” that the Rule created for investing in highly rated PLMBS and CDOs actually had much of an effect on commercial bankers’ behavior. — location: [1508](kindle://book?action=open&asin=B00C3K67QQ&location=1508) ^ref-10738 --- the GSEs acquired PLMBS to help meet their HUD targets for affordable housing — location: [1523](kindle://book?action=open&asin=B00C3K67QQ&location=1523) ^ref-3027 --- In the absence of capital-adequacy regulations in general (i.e., in this context, Basel I), U.S. commercial banks would have been free to invest in whatever assets they chose, whether mortgages, business loans, corporate bonds, asset-backed bonds, or corporate equities. And in the absence of the Recourse Rule, U.S. commercial banks would have had no particular reason to favor PLMBS more than other investors did. Thus, it seems to us that Table 2.3 strongly suggests the following: Without the favorable treatment of highly rated PLMBS by the Recourse Rule, U.S. commercial banks might have acquired only a third of the exposure to PLMBS that they did, in fact, acquire. Thus, causal responsibility for the crisis should be attributed not so much to capitalism—which is to say, to the errors made by capitalist investors, including bankers—as to capital-adequacy regulations—which is to say, the errors made by the regulators of capitalism. — location: [1536](kindle://book?action=open&asin=B00C3K67QQ&location=1536) ^ref-52077 --- As Martin Hellwig (2010, 20) puts it, there has been little “consideration of the paradox that the buffer function of regulatory capital is limited because this capital is needed to satisfy the regulator.” Thus, a bank with an 8 or 10 percent capital buffer on the eve of the crisis could not use this capital to absorb losses, or else it would fall below the regulators’ legal minima. By contrast, if there were no legal capital requirements, a bank with a 10 percent buffer would be able to let it fall to 9, 7, 5, or 1 percent to absorb losses in times of trouble. When the financial crisis struck, however, this was not possible for U.S. banks wanting to retain the legal privileges associated with being a “well-capitalized” bank, capitalized at 10 percent; or for banks not wanting to be seized by the FDIC ninety days after they fell below the 8 percent “adequately capitalized” level.16 — location: [1605](kindle://book?action=open&asin=B00C3K67QQ&location=1605) ^ref-36318 --- Indeed, it is this very fact—the unpredictability of the future—that justifies capital cushions. It is a conceptual error of the first order, then, to tie capital cushions, let alone hard capital floors, to the fluctuating current prices of assets. Yet that is what MTM accounting did when it was imposed on all U.S. corporations, a subset of which were commercial banks covered by capital-adequacy regulations. — location: [1727](kindle://book?action=open&asin=B00C3K67QQ&location=1727) ^ref-31978 --- The reasonableness of MTM (in the words of one of its critics) “follows from the idea that if markets are efficient, that is, if prices aggregate the information and beliefs of market participants, then this is the best estimate of ‘value’ ” (Gorton 2008, 64). The key word is beliefs: FASB’s view of market prices effectively equates market participants’ beliefs (i.e., predictions) with knowledge. This is akin to assuming that all “information” possessed by market participants is accurate, representative, and germane to producing correct beliefs — location: [1733](kindle://book?action=open&asin=B00C3K67QQ&location=1733) ^ref-16044 --- Thus, in February 2010, John Geanakoplos (2010, 13) noted that in 2008, the market index of JPMorgan Chase prime mortgage bonds fell rapidly, plummeting from 100 to 60 by early 2009, even while “the cumulative losses on these prime loans even today are still in the single digits; it is hard to imagine them ever reaching 40 percent,” as implied by the 40 percent decline in their market prices. Similarly, William M. Isaac (2009, 2), a former chairman of the FDIC, testified at a March 2009 congressional hearing about MTM that at the end of 2008, a bank that he portrayed as typical had been required to write down $913 million of a $3.65 billion PLMBS consisting of prime loans that the bank itself had originated, despite losses to date of only $1.8 million and projected losses over the lifetime of the PLMBS of $100 million. — location: [1782](kindle://book?action=open&asin=B00C3K67QQ&location=1782) ^ref-25939 --- Yet the legal enforcement of the crowd’s opinion through MTM may turn these otherwise-inaccurate market assessments into self-fulfilling prophecies, through the mechanism described in the Office of the Comptroller of the Currency’s summary. — location: [1793](kindle://book?action=open&asin=B00C3K67QQ&location=1793) ^ref-4149 --- When MTM accounting is combined with legal capital minima, banks may have to reduce lending into the real economy to preserve their capital cushions—inducing or exacerbating a recession, in line with the crowd’s macroeconomic prediction. — location: [1798](kindle://book?action=open&asin=B00C3K67QQ&location=1798) ^ref-21985 --- MTM and capital-adequacy regulations interact when MTM write-downs impinge, or threaten to impinge, on a bank’s regulatory capital “cushion.” Otherwise a bank could simply accept the MTM deductions from earnings without doing anything about it, confident that the current wave of bearish market opinion will pass. However, since MTM reductions in earnings reduce Tier 1 capital levels and thus threaten legal consequences, banks cannot afford to wait. They must take corrective action—at the expense of the real economy. — location: [1810](kindle://book?action=open&asin=B00C3K67QQ&location=1810) ^ref-11564 --- When bank A adjusts by liquidating assets—e.g., it may sell off some of its mortgage-backed securities—it imposes a cost on another bank B who [sic] holds the same assets: the mark-to-market price of B’s assets will be pushed down, putting pressure on B’s capital position and in turn forcing it to liquidate some of its positions. Thus selling by one bank begets selling by others, and so on, creating a vicious circle. — location: [1819](kindle://book?action=open&asin=B00C3K67QQ&location=1819) ^ref-11969 --- In a major liquidity crisis of the type experienced in 2007–2009, all securities become highly correlated as all investors and funded institutions are forced to sell high quality assets in order to generate liquidity. This is . . . a feature of any market-based financial system where financial institutions’ balance sheets are tied together with mark-to-market leverage constraints. — location: [1828](kindle://book?action=open&asin=B00C3K67QQ&location=1828) ^ref-26069 --- If there were no prices available for an identical asset because nobody was willing to buy it on that date, however, then banks would have to mark down the asset to “observable” prices for similar assets. Thus, the observable prices for CDS insurance on PLMBS were used to mark down the type of asset that they insured. Eighty-two percent of assets marked down by banks in an SEC study of MTM (SEC 2008, 62) were valued in this fashion, with only 11 percent marked against actual prices.11 — location: [1836](kindle://book?action=open&asin=B00C3K67QQ&location=1836) ^ref-42355 --- from the second quarter of 2007 through March 2008, U.S. banks had to write down about $250 billion on their $472 billion worth of mortgage-backed securities, representing an MTM decline in value of 53 percent.12 This reduced the paper value of banks’ total assets by about 2.2 percent, given the 4.3 percent of banks’ assets that was invested in mortgage bonds (Table 2.5 above). In principle, this 2.2 percent write-down could have interacted with the 10 percent capital minimum for well-capitalized banks to reduce U.S. banks’ lending capacity by 22 percent of total U.S. commercial bank assets, amounting to $2.5 trillion (Federal Reserve 2008, Table 1). — location: [1849](kindle://book?action=open&asin=B00C3K67QQ&location=1849) ^ref-17189 --- U.S. banks had to fulfill their liquidity commitments by bringing $245 billion or less in ABCP assets onto their balance sheets (Acharya and Schnabl 2009, 91). Since mortgages, risk weighted at 50 percent, may, using the most generous estimates, have comprised as much as $228 billion of these assets (Acharya and Schnabl 2010, 12), their risk-weighted value would have been $114 billion; added to the other assets, risk weighted at 100 percent, this would have constituted a $131 billion expansion of banks’ balance sheets, requiring $13.1 billion of new capital and—in its absence—reducing banks’ lending capacity by $131 billion, on top of the $2.5 trillion that, in the previous section, we estimated as an upper bound on the loss produced by MTM write-downs on mortgage-backed bonds. — location: [1863](kindle://book?action=open&asin=B00C3K67QQ&location=1863) ^ref-27673 --- Banks took this dangerous route because otherwise, this type of lending would have been subjected to relatively high capital charges on their balance sheets. Once the ABCP market dried up, this type of lending had to stop, especially since the interaction of MTM with capital-adequacy regulations for on-balance-sheet assets had put banks in no position to extend new loans. — location: [1873](kindle://book?action=open&asin=B00C3K67QQ&location=1873) ^ref-39784 --- new business lending during this period fell by 67 percent. Business lending is more important to small businesses than to large ones, since the latter, unlike the former, can borrow money by issuing bonds instead of turning to bank loans. Bank loans to businesses are, of course, risk weighted at 100 percent under Basel I, such that these loans would be among the first things for banks to cut if their regulatory capital cushions were endangered. In that circumstance, it would be better to continue making loans to home buyers or to the federal government rather than to keep lending to small businesses, since mortgages were risk weighted at 50 percent and Treasuries at 0 percent. — location: [1887](kindle://book?action=open&asin=B00C3K67QQ&location=1887) ^ref-6976 --- triple-A CDO bonds from the 2007 vintage were, on average, downgraded to CCC + by 2008 (Barnett-Hart 2009, 23–24), producing a 4,900 percent increase in the capital required for these bonds. In this case, the capital required for $100 worth of bonds rose from $2 to $100 (i.e., a dollar-for-dollar capital expenditure; see Table 2.1), such that the bank would have had to raise $98 in new capital for every $100 in assets. Fifteen percent of all triple-A PLMBS bonds issued from 2005 through 2007 were eventually downgraded (Barth 2010, Table 5.3). Thus, even while MTM accounting was reducing banks’ capital levels based on actual or imputed market prices for similar bonds (and based on the lower prices of other assets being sold in “fire sales”), the rating agencies’ downgrades were raising the amount of capital that banks needed if they were to remain well-or even adequately capitalized. — location: [1972](kindle://book?action=open&asin=B00C3K67QQ&location=1972) ^ref-461 --- while the three rating firms could use whatever rating techniques they wished, their financial success did not depend on the ability of these techniques to produce accurate ratings. Instead, their profitability depended on government protection. If the rating agencies used inaccurate rating procedures, they would not suffer for it financially—let alone would they go out of business. It is hardly surprising that the rating agencies made mistakes, given that no competitor had been allowed to capitalize on such mistakes since 1975. — location: [1992](kindle://book?action=open&asin=B00C3K67QQ&location=1992) ^ref-62043 Allowing competitors to capitalize on mistakes is how old and stale businesses get pushed out. --- Why, in contrast to Rodriguez, did the American financial regulators who issued the Recourse Rule, as well as the BCBS in crafting Basel II, place so much reliance on ratings from these three companies? One possibility is that they were ignorant of the companies’ legally protected status. This hypothesis is supported by a BIS report issued in 2005, in which a team of staff economists analyzed whether, in light of the rise of “structured finance”—such as tranched, mortgage-backed securities—Basel II should continue on the path toward incorporating NRSRO ratings that had been established by the 1999 BCBS consultative paper discussed in Chapter 2. In advising that this was the proper course, the authors of the report appear to have been unaware of the fact that the rating agencies were shielded from competition by the SEC. — location: [2006](kindle://book?action=open&asin=B00C3K67QQ&location=2006) ^ref-44702 --- He writes, for instance, that “the banking system in the United States and many other countries did not focus on lending to small and medium-sized businesses, which are the basis of job creation in any economy, but instead concentrated on promoting securitization, especially in the mortgage market” (2010a, 6). He must be unaware that Basel I penalized lending to small and medium-sized businesses by requiring banks to invest twice as much capital in business loans as in mortgage loans; — location: [2237](kindle://book?action=open&asin=B00C3K67QQ&location=2237) ^ref-54372 --- On April 21, 2010, Moody’s downgraded Greek government bonds from A- to BBB +, suddenly requiring banks holding these bonds to raise 150 percent more capital for them and touching off a “minor” European financial crisis that, as we write, has yet to be fully resolved. French and German banks alone held $206 billion in Greek government bonds, as well as $244 billion in Portuguese government bonds and $727 billion in Spanish government bonds, all risk weighted at 0 percent due to their AA ratings (Brereton 2010). These large purchases of sovereign debt must have driven down the cost of funding it (the interest paid by these governments on their bonds), which may have encouraged them to borrow on such a large scale.3 — location: [2253](kindle://book?action=open&asin=B00C3K67QQ&location=2253) ^ref-28614 --- Economism has two components. First is the view that perfect markets represent a normative ideal against which to judge real-world capitalism. When capitalism displays the characteristics of perfect markets, it should be left alone; when it does not, it should be regulated. The Chicago end of the continuum consists of economists who see real-world capitalism as breathtakingly close to the normative ideal, while at Stiglitz’s end of the continuum, market failures appear to be so pervasive that “there [are] always some government interventions that could make everyone better off” (Stiglitz 2010a, 243). — location: [2319](kindle://book?action=open&asin=B00C3K67QQ&location=2319) ^ref-31013 --- an imperfect institutional parallel to controlled natural science experimentation can be found in the very capitalist economies that regulators, backed by social science, are trying to perfect. That institution is, as in natural science, experimentation, as embodied in “competition.” By competition we do not mean interpersonal rivalry. We mean the deployment by competing capitalist enterprises of various fallible hunches, heuristics, theories, even “ideologies” that address how, in a specific context, a company can make profits and avoid losses. We are not suggesting that “perfect competition” is necessary or even desirable, or that “market discipline” will somehow incentivize capitalists to overcome their radical ignorance. We are not pointing to the number of firms or the doggedness of entrepreneurs, but the heterogeneity of the ideas that they collectively put into play. — location: [2574](kindle://book?action=open&asin=B00C3K67QQ&location=2574) ^ref-15500 --- For the most part, the bankers did what the regulators wanted them to do. But since the regulations did not command anyone to take advantage of the low capital charges on low-risk-weight assets, it was still possible for bankers who disagreed to resist the herd, if they could absorb the competitive costs of doing so while other banks were being subsidized with low capital charges. In other words, there was enough leeway in the regulations that a determined banker who disagreed with the regulators’ view about which investments were prudent might be able to resist the tide for a period of time—if he or she happened to be sitting on a large enough pile of cash. — location: [2618](kindle://book?action=open&asin=B00C3K67QQ&location=2618) ^ref-50900 --- Society might therefore be well advised to diversify its asset portfolio by allowing capitalist competition to proceed unhindered, rather than by predicting that a single interpretation is best in advance and then imposing it on all capitalists’ behavior at once. — location: [2974](kindle://book?action=open&asin=B00C3K67QQ&location=2974) ^ref-33133 --- capitalist behavior is not always heterogeneous; “herd behavior” is common, and we suspect that it will grow more common as education and culture are increasingly homogenized on a global scale. — location: [2984](kindle://book?action=open&asin=B00C3K67QQ&location=2984) ^ref-60988 ---