With the stock market regularly surpassing record highs, housing prices surging 13.6 percent in 2013 alone, and unemployment down to 6.7 percent, it is easy to forget just how dire the economic outlook appeared just five years ago. It is also tempting to assume that we have figured out what went wrong and have made the changes necessary to address the fragilities the crisis revealed. After all, academics, policymakers, and other commentators have produced seemingly endless articles and books about the crisis. Congress also passed the Dodd-Frank Act, the most sweeping financial reform bill since the 1930s. A closer look at the progress made, however, reveals a much bleaker picture. We remain a long way from understanding, much less addressing, the causes of the crisis and the moral hazard engendered by the government’s response to it.
One challenge is that many of the early narratives about the causes of the crisis were woefully incomplete, raising significant doubts about the advisability of reforms based on them. Many, for example, viewed the crisis as an inevitable by-product of securitization. Proponents of this view claimed that securitization gave rise to rampant moral hazard. Banks that originated mortgages had no reason to care about their subsequent performance, we were told, when they could sell those mortgages to a securitization vehicle rather than holding them to maturity. The Dodd-Frank Act sought to counter this moral hazard by requiring banks to retain a direct interest in the performance of mortgages that they originate and sell for securitization.
Yet, subsequent analysis has cast doubt on both the narrative and the response. It turns out that the investors buying mortgage-backed securities were not dupes. Investors understood well the moral hazard that could result when banks originated loans for distribution. Investors had addressed this issue by requiring banks to make extensive representations and warranties about the quality of the loans they were selling and the procedures they had undertaken in connection with originating the loans. These representations and warranties became more lax in the overheated market of the mid-2000s, but they were still sufficiently robust that investors and others have collected billions of dollars in damages from banks that sold subpar mortgages. The banks, it turns out, had skin in the game all along. The reforms similarly overlooked a range of other tools, including privately imposed retention requirements, that had been used to counter the well-recognized moral hazard.
Securitization, to be sure, contributed to the crisis we just experienced. By slicing, dicing, and redistributing economic interests in a home loan among numerous investors, securitization made it more difficult to renegotiate underwater mortgages, fueling the wave of foreclosures and further depressing home values. It also contributed to massive uncertainty about the distribution of exposures to subprime and other mortgages, setting the stage for panic when investors realized that those mortgages were worth less than previously believed. Securitization also gave rise to a host of agency costs, many of which probably contributed to the declining quality of the mortgages issued and the dramatic rise of subprime lending. The problem is that early accounts purported to provide a diagnosis and treatment without a comprehensive understanding of the ailment. In this light, it becomes far less surprising that recent work suggests the retention requirement may actually increase, rather than reduce, systemic risk.
A related challenge is that we still lack a complete picture of what actually happened before and during the crisis. For example, the Federal Reserve is widely viewed as the lender of last resort in the United States. Accordingly, when Congress sought to enhance transparency with respect to when and how the government provides financial institutions liquidity support, it exclusively targeted the Fed. Yet recent analyses of where banks actually sought liquidity when market sources of liquidity dried up during the early stages of the crisis paint a very different picture.
In lieu of going to the Fed’s discount window, banks increased their reliance on two other forms of government-backed liquidity. First, banks dramatically increased their use of secured loans from the Federal Home Loan Bank system, a little-known government-sponsored enterprise that ballooned in size to more than $1 trillion during the crisis. Second, when banks got into trouble, they used the lure of exceptionally high interest rates to retain and attract new insured deposits. As a result, it was not until after Bear Stearns failed and the Fed implemented a number of emergency lending programs that the Fed surpassed the Federal Home Loan Banks in terms of crisis-related lending, and, even then, the Federal Home Loan Banks remained the primary liquidity facility for U.S. depository institutions.
Perhaps we should not be surprised that there is so much that we still do not understand about the recent crisis. After all, three decades passed between the Depression and the publication of Milton Friedman and Anna Schwartz’s influential analysis of its causes. Even then, the unearthed lessons remained sufficiently plentiful for Ben Bernanke, as a young scholar in the 1980s, to earn tenure and a national reputation by helping us to better understand how bank failures contributed to that crisis. Nonetheless, there is little indication that the recent crisis has led to widespread risk aversion of the type that followed the Depression. Given the incredible pace of modern finance, we would be well served to remain diligent in our efforts to understand, and address, the lessons the recent crisis could teach.
Kathryn Judge is an Associate Professor of Law at Columbia Law School. This post was adapted from an article published in the Columbia Law School Magazine, which is available here.