Ten years ago last month, the collapse of Lehman Brothers abruptly turned what was already a housing and mortgage bust into a global financial crisis the worst since the Great Depression. After gigantic bailouts for banks and major corporations, as well as unprecedented efforts by the Federal Reserve, the United States slowly but painfully clawed its way back.
Did we learn anything? Is the banking system safer and better capitalized? Are we any better at seeing the warning signs of a new financial crisis? Will we be any better at responding?
We sat down with two experts at Stanford Graduate School of Business who have both spent much of the past decade analyzing the crisis but from very different perspectives.
Darrell Duffie, the Dean Witter Distinguished Professor of Finance, has advised top policymakers in the U.S. and abroad on what went wrong with the “plumbing” and oversight of the financial system.
Amit Seru, the Steven and Roberta Denning Professor of Finance, has focused on how banks and regulators fueled the crisis and how policies fell short in limiting the damage for homeowners and Main Street.
Design the Right Tools
“The big-picture lesson for me is that it is very difficult to know where the next crisis will come from,” says Seru. “This is especially the case if banks have private incentives to keep taking dangerous risks until, as Citigroup’s CEO famously said, the music stops, even to the point of perpetuating fraud. And regulators with their own conflicts and incentives look the other way or are a step slower.
“Rather than believe we can fix the whole system such that there are no crises in the future, we should acknowledge that there are many pieces to this puzzle. One simple solution, such as requiring banks to keep bigger equity capital buffers so they can better withstand bad shocks, might be the easiest way to prevent future financial meltdowns.”
Still, Seru emphasizes, the consequences of the crisis could have been much less severe if banks and policymakers had handled things differently beforehand. Seru argues, for example, that market design could have allowed specialized “SWAT team-like” institutions to take control and provide debt relief to households if an economic crisis arose. That kind of mechanisms exists in some sectors like commercial real estate and would have transmitted federal relief during the crisis quickly and effectively.
Another potentially valuable tool for the next crisis, Seru says, would be a mortgage contract that includes semi-automatic relief mechanisms. Such “state-contingent” mortgage contracts would automatically index a borrower’s interest rate to vary with local economic conditions. If an area’s unemployment rate suddenly spikes and home prices sink, for instance, the mortgage could automatically adjust to a lower rate for borrowers in that neighborhood. By reducing foreclosures and leaving families with more money to spend, Seru suggests, state-contingent mortgages could act like automatic stabilizers and be a net plus for the entire economy.
Don’t Trust “Market Discipline”
“Almost by definition, a financial crisis means that people borrowed more than they could pay back,” Duffie notes. “That is not the time to get moralistic about forcing people to pay their debts. It’s a time to restructure those debts.”
That said, Duffie argues that poor financial regulation played a key role in the crisis. “A reasonably well-supervised financial system would have been much more resilient to this and other types of severe shocks,” he recently argued in “Prone to Fail,” a paper for the National Bureau of Economic Research.
The most basic failure, he contends, was that regulators assumed that “market discipline” would prevent banks from taking reckless risks. But the banks’ creditors which provided banks with trillions of dollars a day in overnight financing believed that the big banks were “too big to fail” and that the government would bail them out if necessary. That allowed the Big Five investment banks Goldman Sachs, Morgan Stanley, Bear Stearns, Merrill Lynch, and Lehman Brothers to borrow at spectacularly low interest rates and to drastically ratchet up their reliance on debt. The Big Five became, in Duffie’s words, “the greatest danger to the functionality of the core of the financial system.”
One key lesson, Duffie notes, is that every financial regulator’s statutory responsibilities should include a mandate to protect financial stability. This mandate, proposed by former Federal Reserve Vice-Chair Donald Kohn, would confront all regulators with the risk of being called on the carpet by Congress for the sorts of failures to safeguard the financial system that they made before the crisis.
Duffie lays particular blame on the Securities and Exchange Commission, an agency that has attracted relatively little attention in other post-mortems of the crisis. The SEC’s oversight failures were crucial, Duffie says, because the top five Wall Street investment banks all selected the SEC before the crisis to be their “consolidated financial supervisor.” Because the SEC’s primary mandate was to protect brokerage customers, however, the commission appeared to have little experience or interest in enforcing solvency and did essentially nothing to stop the Big Five from their reckless reliance on leverage, he adds. The failure of Lehman Brothers to meet its debts sparked a panic, and a giant house of cards came tumbling down.
Banking Reform Untested but Encouraging
Duffie says the United States has reduced the degree to which banks are “too big to fail,” via new procedures for an orderly restructuring of debts held by financial institutions heading toward solvency.
It remains unclear whether those plans will work in practice, but Duffie notes an encouraging sign.
“One important piece of evidence is that banks are much better capitalized today than they were before the crisis, yet the cost of credit to them is much higher,” he observes. “The only way to interpret that evidence is that creditors now believe they will be on the hook if something happens.”
However, Duffie warns the progress is less clear elsewhere in the world.
“‘Too big to fail’ remains a bigger problem outside the United States,” he says. “One sign of that is what happened in Italy in July 2017, when the Italian government bailed out two troubled banks with 17 billion euros. Meanwhile, China now has the four largest banks in the world, and the government has their backs.”
Not Fixed? The Housing Market
“The housing market where the crisis started is still a mess,” says Seru. “We were worried before that Fannie Mae and Freddie Mac [so-called “government-sponsored enterprises,” or GSEs, that buy and resell mortgages made by private lenders] were too big in the market. But the GSEs’ market share is now 95%, where it was only 75% at the peak of the housing bubble. So instead of lowering their influence, we have increased it. What we do not realize is that the risk is still very much in our system, being funded by taxpayer-funded ‘too big to fail’ entities.”
That’s not all, Seru says.
“Shadow banks (non-bank lenders that aren’t supervised by the traditional bank regulators) are even more important in the mortgage market now than they were before the crisis,” he says. “Quicken Loans is now the nation’s biggest mortgage lender. No one knows what their balance sheet looks like, but they are selling all their mortgages to Fannie Mae and Freddie Mac. It is worth remembering that two of the largest and most notorious non-bank lenders, New Century and AmeriQuest, went belly up first and helped trigger the last crisis.” Quicken Loans may well have better loan practices today, he says, but regulators can’t be sure because they don’t really know what the non-banks are doing. “Between this increased opacity and the increase in government support for the housing market, I think we are in a similar state or even worse than a decade ago.”
President Donald Trump recently signed a bill to roll back significant elements of the 2010 Dodd-Frank law, which imposed extensive new financial regulation. We should be worried about that, says Seru.
“This is not just about President Trump,” Seru says. “Historically, after a financial crisis, there is a wave of regulation and, as memory fades, a swing back to deregulation. It’s natural that regulations are getting watered down this time, too. Under the garb of deregulation, however, there is a concerted push to roll back everything. The banks are saying their equity capital requirements are now too high, but what’s interesting is that the banks are making record profits. One could make the case that banks should keep even higher equity capital, because it would make them safer and perhaps even more profitable.”
Duffie agrees. “The regulations going through Washington now are intended to cure parts of the initial regulations that were not perfectly aligned. But in almost every case, they’ve ended up going easier on the banks. For example, I myself agree that the Volcker Rule [which aimed at prohibiting banks from trading securities] was a bad idea. So why not take away the Volcker Rule but require banks to have more capital? Instead, they took away the rule and reduced capital requirements.”
Doomed to Repeat History?
Have we really learned enough from the financial crisis? Has it instilled the kind of “market discipline” that was lacking before the crisis? Duffie is skeptical.
“There are a lot of traders out there who weren’t active before the crisis, and who don’t have the searing memories of what happened. If you look at the median age of people making investment decisions in banks and hedge funds today, you can guess that many of them are not familiar with the nature and consequences of excessive risk taking.”