A forgotten financial failure

The regulatory responses to the global financial crisis have for the most part been conditioned on a false narrative about the causes and consequences of the crisis. In the US, this has seen a complete re-regulation of financial institutions and retail consumer finance. In Australia, the regulatory responses have been more limited, but still reflect a mistaken view of the underlying causes of the crisis.

Perhaps the most pernicious myth about the crisis is that it was the failure of the US government to rescue Lehman Brothers that precipitated these events. Indeed, it has become common practice to date the crisis from 15 September 2008 when Lehman Brothers was allowed to fail. Yet trouble had been brewing in credit markets for more than 12 months before.

The failure of Lehman Brothers was a trivial event compared to a much bigger but largely ignored financial failure that took place one week before when the two US mortgage giants Freddie Mac and Fannie Mae were put into conservatorship by the US government. These Congressionally-mandated, government-sponsored enterprises (GSEs) either owned or guaranteed two-thirds of the bad mortgages in the US financial system. They were far more highly leveraged than the private US or European investment banks. They will also ultimately cost US taxpayers more than all the other bail-outs of private financial institutions combined.

The two GSEs were the financial arms of US government housing policy, which from 1992 explicitly sought to extend mortgage finance to low income borrowers and those with impaired credit histories previously denied housing finance. The dominant predatory lender in the US was none other than the US government itself. This explains how the two GSEs came to dominate US housing finance. The Congressional Budget Office estimates that the failure of these institutions will cost US taxpayers $389 billion, the equivalent of 300 Nic Leesons (the rogue trader who brought down Barings Bank in the 1990s).

In the aftermath of the financial crisis, the failure of these two institutions has been largely ignored, not least by the US Financial Crisis Inquiry Commission that was charged with investigating the crisis. Those who want to understand the real causes of the financial crisis should read the excellent dissenting report by Peter Wallison, a member of the Commission and one of the few people to have warned about the risks posed by the GSEs as far back as 1999.

It is likely there will never be a public inquiry or investigation into the failure of the two GSEs, not least because the US Congress is not about to incriminate itself in relation to one of the worst financial crises in human history. The failure to acknowledge the real cause of the financial crisis and the false narrative built around the failure of the Lehman Brothers is designed to disguise the culpability of US politicians and regulators for the crisis and to scapegoat financial markets.

This false narrative now dominates discussion of the regulatory responses to the crisis. At the Reserve Bank of Australia's 50th anniversary symposium last year, United Kingdom economist Charles Goodhart gave this analysis of the implications of the failure of Lehman Brothers:

"the outcome was regarded as so awful that in virtually every major economy the authorities have effectively taken a vow that they will not allow any similar really large, interconnected systemic institution to be closed."

This view implies an absurd and barely considered counter-factual, that if Lehman Brothers had been rescued, then the crisis might have been prevented or would not have been as severe. The failure of Lehman Brothers was merely a symptom rather than a cause of the crisis and the unwillingness of the US authorities to rescue Lehman was perhaps the one good US policy decision made through this episode. Federal Reserve Chairman Ben Bernanke conceded as much recently, when he tried to defend the decision as a necessary one, but then undercut his own argument by maintaining that the decision also had disastrous consequences. What Bernanke should have argued was that the winding up of Lehman Brothers was fairly orderly as far as these things go and not a source of major systemic problems in the financial system.

The systemic problems that emerged in the wake of the failure to rescue Lehman were partly due to the decision being inconsistent with earlier actions, but also due to Bernanke and then US President George Bush going public in the following week to argue that unless Congress passed the Troubled Asset Relief Program (TARP), which gave the Bush Administration a blank cheque to fund further bail-outs, the world would come to an end. As Booth School of Business economist John Cochrane has noted, 'on what planet do stock markets not crash after that?'

Peter Wallison has refuted the dominant post-crisis narrative by noting that 'there is no example in all of US history in which the failure of an unregulated financial entity – securities firm, hedge fund, insurance company, finance company or private equity fund – caused a systemic breakdown.' That history includes Lehman Brothers. Ordinary bankruptcy laws provide an orderly process for the winding-up of failed financial institutions, a process that provides considerable certainty compared to the massive uncertainty that accompanies discretionary government bail-outs. It ensures that the burden of failure falls on the owners and managers of these institutions and not taxpayers.

The assets of failed financial institutions were not worthless and typically enjoyed positive cash flows that would have found ready buyers at the right price. Unfortunately, those prices were not consistent with the continued solvency of these institutions, which should have been allowed to fail, making way for new entrants. Unfortunately, US policymakers and their counterparts around the world acted mainly for the benefit of incumbents. Taxpayers are justifiably outraged at government support for financial institutions, but this outrage needs to be directed at politicians and not bankers.

The principal regulatory response to the crisis in the US has been the 2,300 page Dodd-Frank Act. The Act is meant to prevent 'too big to fail' but effectively institutionalises it by extending bank-like regulation and supervision by the Federal Reserve to any financial firm that might be deemed to 'pose a threat to the financial stability of the United States.' US financial institutions can be designated systemically important at the whim of regulators. They don't even have to be a source of actual financial instability, the mere threat instability is sufficient.

Once so designated, the Fed can effectively control anything and everything about the activities of that firm. The effect of the Act will be that every major financial institution in the US will now have to do the government's bidding, whether it is designated systemically important or not. In return, the US government offers protection from failure, which is the logical conclusion of the false view about the causes of the crisis expressed by Charles Goodhart at the RBA's symposium. It will reward those institutions that curry favour and are well-connected with Washington at the expense of new entrants who would otherwise pose a competitive threat to incumbents. Dodd-Frank is completely silent on the elephant in the room, the two government-owned enterprises that continue to account for 92% of new mortgages in the US.

In Australia, the financial crisis had a relatively modest impact, not least because Australia did not have government policies that sought to extend housing finance to those who could afford to repay a standard mortgage. The quality of the Australian banks' mortgage books is consequently very high and household borrowing is mostly undertaken by high income households who can readily afford to service their debts.

The Australian government has guaranteed retail deposits and the wholesale borrowing of major banks. During the crisis, Australia had little choice but to follow the rest of the world in this regard, as internationally mobile capital fled to the most secure and highly regulated jurisdictions. We will never know how important these guarantees were in providing for the stability of the Australian financial system, but they will have unfortunate long-term consequences. The government has established that it will not allow a major financial institution to fail, removing a significant market-based discipline on the behaviour of these institutions. In the absence of such market discipline, the Australian government, like governments around the world, will have to substitute increasingly heavy-handed and proscriptive regulation, but this is likely to stifle innovation and competition in financial services. It will make life particularly difficult for potential new entrants into the financial services industry. As RBA Governor Glenn Stevens has noted, the main effect of these regulatory actions will be to increase the cost of financial services to wholesale and retail borrowers, but with very uncertain benefits for the stability of the financial system.

The 'twin peaks' system of regulation put in place after the 1997 Wallis Inquiry served Australia well through the crisis. This system assigns the prudential regulation of financial institutions to the Australian Prudential Regulation Authority (APRA), while financial markets are supervised under a disclosure regime administered by the Australian Securities and Investments Commission (ASIC).

That said, the Wallis inquiry recommended that the regulation of financial markets and institutions should be reviewed after 10 years. We are past the 'best by' date on the Wallis reforms and another inquiry that draws on the lessons of the financial crisis is warranted. However, such an inquiry needs to be based on a factually correct narrative of the causes and consequences of the crisis and not the false narrative that has been designed to let US politicians off the hook for their role in causing one of the worst financial crises in human history.