As a fan of the philosopher Karl Popper, I feel compelled to ask myself the following question: “What further empirical evidence might cause you to question – or might even falsify — your conclusions?”
Most importantly, the aggregate financial data I employ for European banks are data I assembled myself from publicly available sources, mainly Bloomberg. I am confident that they mirror reality reasonably well, but they are not precise. The BIS has a database that could presumably help confirm or refute my arguments. Unfortunately, I found this database impenetrable. I would be most grateful to anyone who could help me access the BIS data or supply the relevant data.
Also, I would question my conclusions if someone were to identify a sufficiently large alternative source for the immense credit flows that flooded into the mortgage market and other credit markets from 2000 to 2007. To me, Basel-driven leveraging is the most obvious and simplest answer. But, admittedly, I could be missing something. One possibility is “excess savings” from foreign countries – the famous “savings glut” invoked by Ben Bernanke. But I don’t think any such glut was nearly large enough to account for the credit bubble. As noted above, Basel-related leveraging dwarfed our payments imbalance with China. Ben may have single-handedly saved western civilization, but I think that his “savings glut” hypothesis is unlikely.
A related nagging question about my analysis is that I still can’t reconcile how trillions of dollars in credit could be created out of whole cloth with so little impact on the real economy. That is, one would think that the pre-crisis credit deluge would have been accompanied by big increases in monetary aggregates or bank reserves, or upward pressure on inflation or interest rates, or OECD economic growth greater than the mediocre 3-4% that was achieved. Yet we see essentially nothing except heightened construction activity in the US, Spain, Ireland, and European periphery nations. Could it really have been the case that vast bulk of the credit created prior to 2007 was simply conjured by (mostly European and shadow) banks and swapped among themselves in a great pyramid – repos funding reverse repos; derivatives written and bought and laid off to third parties ad infinitum? I have difficulty getting my mind around that.
As I pointed out above, derivatives account for much of the asset growth for European banks from 2000 to 2007. Unfortunately, derivative accounting was, then as now, a fraught discipline. When we see UBS’ derivatives book spike from E26 billion in 2000 to E450 billion in 2007, it is not necessarily the case that there has been a commensurate increase in risk to the UBS balance sheet. Of course, it is also possible that the underlying risk was greater, perhaps much greater, than the balance sheet reflects. Valuations were hazy and largely a function of management discretion. Given the euphoria that characterized the mid 2000’s and the license that Basel provided in valuing derivatives, I think it is unlikely that the actual risk was less than that presented on the balance sheet.
By the time the crisis hit, quants and traders were — effectively — running the banks: the inmates were running the asylum. Everyone deferred to them because anyone with the temerity to argue with their math got laughed out of the room. There are innumerable examples of risk managers being fired for questioning the growing exposures. Management, too, was intimidated and, in any case, the quants were making so much money for everyone that management could not afford to reign them in; no one could afford to kill the golden goose. That doesn’t absolve senior management — quite the contrary — but it does help explain how it all came about.
There is a fascinating post-mortem authored by the Swiss bank regulator concerning the immense losses at UBS. It goes into some depth describing the groupthink that contributed to management’s capitulation to the traders.
Ironically, but not surprisingly, the elaborate mathematical models spewed out by the quants during the good times turned out to be as bogus as the BIS “risk ratings” that caused the whole mess. I remember attending a bank analyst conference in November, 2007 when one of the presenters tried to explain CDO’s squared. Everyone’s jaws just dropped. Few in the audience had ever heard about them and no one could imagine anything so stupid. Also, I remember being astounded to discover that the principal risk models employed by many banks were just reconstituted “Value at Risk’ models. I had thought that VAR had been consigned to the dustbin of history after the collapse of Long Term Capital in 1998.
Partly, the ascendancy of quants and their models was due to the length of the “great moderation” that preceded the crash. Everyone was lulled into a sense of false security by the stability of the markets. Of course, if everyone had read their Minsky, they would have known that an extended period of stability is just a rubber band waiting to snap. (See Bob Barbera’s excellent book The Cost of Capitalism.) Things might not have gotten so out of hand absent the then prevailing devotion to free market Gospel. In his superb book How Markets Fail, John Cassidy details how “efficient market theory” (CAPM) came to dominate finance. CAPM reinforced the myth that no asset –derivatives included — could possibly be riskier than it was priced to be. It was the premise underlying the Basel standards. Anyone who disputed this orthodoxy was dismissed as a crank (eg Minsky and Benoit Mandelbrot.)
Remember too, that this didn’t all happen suddenly. It’s not as if one day all these managements decided to bet their banks on sub prime real estate derivatives. It was an incremental process. Quarter by quarter, management was under pressure to produce the revenue and profits to beat prior quarters. They kept taking on more leverage and increasingly esoteric derivatives because they were just repeating what had worked in the past. The incremental risk was pretty much invisible to them, and, anyway, it had all been blessed by the regulators. This, too, is vintage Minsky.
The advent of the Euro in 2000 also contributed to the credit bubble, especially within the Eurozone. (On this one issue I agree with Yanis Varoufakis.) Prior to 2000, a German bank that wanted to lend to a Greek importer not only had to consider the credit of the borrower, but had to consider how easily that borrower could obtain Deutsche Marks in the future in exchange for her Drachma, a much less liquid currency. The Euro eliminated this constraint, opening the floodgates to credit to the periphery. Because of the leveraging allowed by Basel, a credit tsunami washed into Spain, Greece, Ireland, and the Baltics — countries that were growing much faster than more established economies like Germany. (Of course, it occurred to precisely no one that the only reason for this fast growth was the credit inflows.) For a long time, interest rates for loans to the periphery were significantly lower than they were in Germany and France; for periphery countries borrowing seemed eminently rational.
Federal housing policy played a key role in the crisis. In pursuit of greater fairness and the “ownership society,” Congress prior to 2007 significantly raised the targets for Fannie and Freddie’s portfolio of low income mortgages, consisting both of whole loans and private MBS. Thus, these firms helped create the sub-prime market. Peter Wallison’s book Hidden in Plain Sightdetails these trends. While I disagree that Fannie and Freddie were the primary cause of the crisis, it is impossible to imagine the sub-prime market becoming as immense as it did without them driving it.
It is not clear to me how significant an influence Basel II had on bank risk profiles and banker behavior, but it certainly heightened risk-taking. Basel II was not officially promulgated until 2004 and was not adopted by many European banks until 2008. It was never officially adopted by US banks. Yet the broad outlines of Basel II had been apparent since at least 1999. So banks had been adjusting their business models in anticipation of Basel II for at least 5 years. For instance, US adoption of the “Recourse Rule” mentioned above, was motivated partly by the expected Basel II guidelines.
Driven by “efficient market” dogma, the centerpiece of Basel II was the A-IRB (Advanced Internal Ratings Based) approach, which relied on the banks themselves to provide risk models for their own portfolios. As a quid pro quo for bringing banks on board, it was widely recognized that bank capital ratios would be allowed to drop (see Dan Tarullo’s 2008 book Banking on Basel. Judging strictly from this book, one could not have predicted Tarullo’s future role as Dodd Frank’s Torquemada.)