Lessons from the Financial Crisis

It is often claimed that “free, deregulated markets failed,” bringing about the housing collapse and financial crisis. In fact, the free, relatively deregulated equities market absorbed mas- sive losses this time, as last time, with relatively little turmoil. It was the regulated, supervised part of the market that failed.

Chicago economist John Cochrane examines the why and the what-we-learned (PDF). John offers up a lot to ponder:

Why did Lehman fail — along with Fannie Mae, Freddie Mac, aig, Wamu, and ver y nearly Citigroup and Bank of America?…

…in 2007 most commentators and the Fed (who, remember, is going to be regulating all this the next time around) were saying that the problems in housing finance were “contained.” Most estimates put subprime losses around $400 billion. The stock market absorbs losses like that in days. But it turned out that housing risks are spread very differently from stock market risks.

The difference is that mortgages were held in very fragile financial structures. An extreme example: many mortgages were pooled into securities, and the securities were held in special purpose vehicles (spvs), funded by rolling over short- term commercial paper with an off-the-books credit guar- antee from a large bank. Less extreme: when Bear Stearns failed, it was holding a large portfolio of mortgage-backed securities (mbss) funded at 30-to-1 leverage by overnight debt. In both cases, when the mortgages lose value, the debt- holders refuse to renew their loans and the whole thing blows up. In contrast, when your (and my) pension account loses value, we cannot run for the exits and tr y to make someone else hold the losses.

These structures attempt to take risky assets — mort- gages — and turn them into risk-free assets in the form of short-term debt. But we all know you cannot do that; you can slice and dice risk, but you cannot get rid of it.

Here is what this financial structure does instead: First, it tur ns a “smooth” risk, like equities, which are repr iced routinely, into “earthquake” risk that either pays a steady stream or fails catastrophically and unpre- dictably.

Second, it turns a “non- systemic” risk into a very “sys- temic” one. For the funda- mental investors to lose any money, we need to see a default or a bankr uptcy, which is always expensive and chaotic. The losses can drag down brokerage, derivatives, market-making, and other “systemic” businesses having nothing to do with simply sitting on credit risk.

(…) P O L I C Y

Given my diagnosis of the central problem, it should be no surprise that I think much of the thrust of current policy- making is misguided.(…)

…The only way to limit expectations of a bailout is for the government to give up the legal authority to do it. Lehman is actually a great example: it went to bankruptcy because the government could not save it. We need more of that. If everybody had known that ahead of time, rather than have it emerge from the usual weekend conclave in Washington, there likely would have been no panic because Lehman’s failure would not have signaled anything about the government’s commitments to Citigroup.

Please continue reading. And note that John’s proffered policy foces upon making the incentives driving the politicians healthy — in particular by removing the legal bailout authority.