The Crisis [with Comments and Discussion] Author(s): ALAN GREENSPAN, N. GREGORY MANKIW, JEREMY C.

STEIN Reviewed work(s): Source: Brookings Papers on Economic Activity, (SPRING 2010), pp. 201-261 Published by: The Brookings Institution Stable URL: http://www.jstor.org/stable/40930484 . Accessed: 02/03/2012 07:37
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ALAN GREENSPAN
Associates Greenspan

TheCrisis
ABSTRACT Geopoliticalchanges followingthe end of the Cold War in induced worldwide a declinein reallong-term interest rates that, turn, proit ducedhomepricebubblesacrossmorethana dozen countries. However, from was theheavysecuritization theU.S. subprime of market 2003 mortgage to 2006 that the the spawned toxicassetsthat triggered disruptive collapseof risk theglobalbubblein 2007-08. Private and counterparty management official regulation failedto set levels of capitaland liquidity thatwould have thwarted financial and of contagion assuagedtheimpact thecrisis.This woefulrecord energized has reform also suggests regulations but that regulatory that to a forecast likely fail.Instead, primary are the has require imperative to be increased andcollateral for regulatory capital, liquidity, requirements banks and shadowbanksalike.Policiesthat that are presume someinstitutions "too be a big to fail"cannot allowedto stand. Finally, rangeof evidencesuggests that monetary policywas notthesourceofthebubble.

I. Preamble ThebankruptcyLehman in of Brothers September precipitated 2008 what, inretrospect, is likely bejudgedthemost to virulent financial crisis global ever.To be sure, contraction economic in the that in activity followed its wakehas fallen short thedepression the1930s.Buta precedent far of of for virtual the on a short-term withdrawal, so global scale,ofprivate credit, theleading offinancial is notreadily in evident ourfinancial crisis, edge The of credit fine-tuned history. collapse private counterparty surveillance, overso many the of decades, alongwith failure theglobalregulatory syscallsfor thorough the review governments private manand risk tem, by nowunder agers way.
CopyrightAlanGreenspan 201

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in The central theme thispaperis that theyearsleading to the of up of on a financial intermediation tofunction toothin layer capital, tried crisis, in of embedded ever-more-complex to of degree risk owing a misreadingthe II reviews causes the financial andmarkets. Section ofthepaper products In intermediation is probed. In III nature financial of ofthe crisis. section the address shortcomings the IV is section a setofreformsproposed I trust, that, In V role ofthe structure.section the ofmonetary policy existing regulatory in VI. I inthecrisis examined.offer someconclusions section is

II. Causesofthe Crisis

Crisis and ILA. The GlobalBondMarket theHousing Arbitraged toxic of The globalproliferationsecuritized, U.S. subprime mortgages reach of But ofthecrisis. theorigins thecrisis was theimmediate trigger War.1 fallofthe The of I to as back, best canjudge, theaftermaththeCold bloc'secoruin the Wallexposed economic produced theSoviet Berlin by disbutrapidly, markets In response, nomic quietly, competitive system. in so prevalent theSoviet central thediscredited of planning placedmuch Third World. blocandthethen Third A large of erstwhile World China, nations, especially segment the model theso-called of economic thesuccessful export-oriented replicated SouthKorea,andTaiwan):fairly AsianTigers (HongKong,Singapore, world technollow-cost welleducated, workforces, with developedjoined to rule adherence the oflaw, andprotected increasingly widespread by ogy Fund The economic unleashed Monetary growth.2 International explosive members the of that (IMF) estimated in 2005 morethan800 million and inexport-orientedtherefore were force world's labor competengaged Wall.3 sincethefalloftheBerlin of an itive markets, increase 500 million to domestic becamesubject of hundreds millions Additional competitive between As Union. a consequence, Soviet in forces, especially theformer was world rate 2000 and 2007 therealGDP growth of thedeveloping world. that double ofthedeveloped almost restrained culture in however, world, by Consumption thedeveloping couldnotkeepup withthesurgeof consumer and inadequate finance, world soared rate the and income, consequently saving ofthedeveloping outGDP in 1999to 34 percent 2007,far of 24 from percent nominal by
see 1. For a moredetailedexplanation Greenspan(2007, chapter 20). from1980 to 1990, in 2. Foreigndirectinvestment China, forexample,rose gradually butthenrose 39-foldby 2007. 3. IMF, WorldEconomicOutlook, 5, April2007, chapter p. 162.

ALAN GREENSPAN Debt, Averagefor15 Countries, Figure 1. NominalYields on 10-YearGovernment 1999-201 0a

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sources. Source:Variouscountry the are a. The countries Austria, Finland, France, Canada,Denmark, Germany, Italy, Netherlands, Belgium, the and States. Switzerland, United Kingdom, theUnited Norway, Spain,Sweden,

in slow rate. investment elsewhere theworld its stripping investment With was fall 2000to2005in totake theslack, result a pronounced from the up nominal interest both rates, 1) (figure andreal. globallong-term in interest indicated, necessity, rates of that the Although decline global to intentions chronically were exceeding globalsaving globalintentions ex and rates were invest, postglobalsaving investment in 2007,overall, in that thanin 1999,suggesting theuptrend the onlymodestly higher intentions developing of economies investment saving tempered declining in world.4 course, Of it intentions thedeveloped whether was a glutof intended or of the is intentions, conclusion saving a shortfall investment thesame:reallong-term interest hadtofall. rates Inflation long-term and interest inall developed rates economies the and I economies by 2006 converged singledigits, had to majordeveloping believe thefirst ever. path the for time The of convergenceevident the is in variance interest on 10-year of rates debt unweighted average sovereign of 15countries: average that declined from 2).5 markedly 2000to2005(figure
4. Thatweakened was determinantthedecline global in of globalinvestment a major reallong-term interest wasalsothe rates conclusion a March of 2007BankofCanadastudy and (Desroches Francis 2007). 5. Thevariance the of logarithmsthe15long-term of interest exhibits rates similar trends.

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Year Government Debt in 15 Countries, Rates: 10Figure 2. Varianceof Interest 1999-201 0a

0.10 0.05 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
sources. Source:Various country in 1. for a. Unweighted average the15 countries figure i | | | | | | | | | |_

lower rates and inevitably arbitraged capitalization were Equity realestate realinterest Asset rates. particularly prices, bythefallingloballong-term moved home dramatically higher. accordingly prices, of the document remarkable The Economist's convergence surveys the homepricerisesduring pastdecade.6 nations' 20 individual nearly weretheonly and reasons) (for Germany, Switzerland differing Japan, at U.S. home peak,wereno more price gains, their exceptions. important led events In the than globalpeakaverage.7 short, ultimately geopolitical inturn with lag,to a interest that rates toa fallinlong-term led, mortgage the boominhome globally. prices The II.B. SecuritizationSubprimes: Crisis Story Unfolds of inthe1990swasa small market developed that Thesubprime mortgage It fixed-rate of market largely successful but mortgages.serviced generally the meet down who homeowners couldnot those payment mainly potential a to handle butstillhad income of a prime loan, adequate requirement but beensecuritized, with amount had fixed-rate Only mortgage.8 a modest
"Finance and Economics: Houses Builton Sand," Sep6. For example,The Economist, tember 2007, p. 104. 15, 7. IMF, WorldEconomicOutlook, 3, April2008, chapter p. 113. of accountedfor7 percent totaloriginations. as 8. As recently 2002, subprime mortgages

ALANGREENSPAN Figure 3. MonthlyChanges in Home Prices,1976-201 0a

205

Source:Author's calculations basedon datafrom LoanPerformance Standard Poor's, and & a. Bothseriesare seasonally adjusted.

home risen a quickening since1997(figure subat prices having 3), pace was to prime lending seenas increasingly profitableinvestors. drawn thismarket, to financial in firms, Belatedly starting late2003, toaccelerate pooling packaging subprime the and of into began mortgages securities had 4). (figure Thefirms clearly found receptive buyers. Heavy demand from in of collaterEurope,9 theform subprime mortgage-backed alizeddebt wasfostered attractive anda foreclosure obligations, by yields rate theunderlying on that for mortgages hadbeenindecline 2 years. An evenheavier demand was driven theneedof FannieMae and by Freddie Mac, themajorU.S. government-sponsored (GSEs), enterprises of and pressedby the Department Housingand UrbanDevelopment
9. Thatmany theinvestors European confirmed therecent of were was losses by heavy on U.S. mortgages investors. Euro-area for exhibit a banks, example, reported European by securities write-downs theresidential to veryhighratioof residential mortgage-backed loansthey hold(IMF, GlobalFinancial October mortgage 2009,p. 10). Stability Report, The size of thebuildup subprime of securities abroad the is holdings during bubble years unclear. U.S. Treasury's The annual that forForeign Holdings Survey reports bymid-2006, held of issuedU.S. mortgage-backed some eigninvestors $341 billion privately securities, ofwhich were commercial securities. lessdetailed The mid-2002 mortgage-backed survey a for securities $169billion, of with in reportedtotal all asset-backed compared $594billion mid-2006.

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4. of 1995-20103 Securities, Figure Issuance Subprime Mortgage-Backed

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to "affordable Given sizeof the Congress meet housing goals."10 expanded to theGSEs' expanded commitments fundlow- and moderate-income in but wholesale, subprime housing, had fewalternatives to invest, they 42 of securities. GSEs accounted an estimated and49 percent all The for securities all (almost at adjustable newly mortgage purchased subprime interest retained investors' on balance sheets 2003and2004, rates) during their estimated share That more was than times five (table respectively I).11 in2002. the demand the against limited supIncreasingly, extraordinary pressed this borrowers. reach To ofqualified beyond limited potential subprime ply to securitizers originators mortgage unwisely prodded subprime population, lower offer (ARMs)with monthly payinitially mortgages adjustable-rate
the a 10. In October2000 HUD finalized rule"significantly increasing GSEs' affordable housinggoals" foreach year from2001 to 2003. In November2004 the annual housing (Officeof Policy Developmentand goals for 2005 and beyond were raised still further Research2001). to il. reaerai HousingMnance Agency,uuo Annualtteport congress (jevisea;, nistoricalData Tables 5b, Part 2, and 14b, Part 2 (originallypublishedMay 18, 2009, and effective reclassification September3, 2009). Before the updatedto include a significant Data newlyreclassified FannieMae I the revision, estimated shareat less than30 percent. by accountforalmostall therevision.

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ARMs soared deteriorated ments. loanunderwriting As standards rapidly, tonearly percent first-mortgage 62 of by subprime originations thesecond had of mortgage originations By subprime quarter 2007.12 2005and2006,13 of swelled a bubbly percent all U.S. homemortgage to 20 originations, in almost their triple share 2002. all of mortgage originaBy thefirst quarter 2007,virtually subprime 14 in with than half 2000, and less werebeingsecuritized, tions compared than totaled more securities $800 billion, outstanding subprime mortgage levelat theendof 2001.The securitizers, almost seventimes their profandarmed into newsource paper of this mortgage pools itably packaging inflated credit to with whatturned in retrospect, be grossly out, ratings, into of securities what amounts these unlimited were abletosellseemingly to globalmarket. appeared be a vastandreceptive
BubbleTakesHold U.C. A ClassicEuphoric

the for taking the of As a measure howfar appetite risk beyond securiwere debt had market gone,long-sacrosanct covenants tizedmortgage bubbletookhold.15 2007, yield eased as a classic euphoric By global was where there had to overall narrowed a point in spreads debtmarkets of measure credit ofrisk. broadest Our for little room further underpricing and 10-year rated CCC or lower of the risk, yieldspread bonds Treasury in thespring 2007,although of low record fell notes, to a probable only of all so 5). participants myacquainmarginally (figure Almost market that but tancewereawareof thegrowing risks, also cognizant riskhad of the I hadraised specter "irrational for remained often underpriced years. the over exuberance" a decadebefore 1996),onlyto watch (Greenspan for continue inflate 4 more to a dot-com stumble, boom,after one-day in fedof increase 350basispoints the unrestraineda cumulative by years, in to2000.Similarly 2002,1 expressed conrate 1994 eralfunds from my ". Committee the cerns before Federal (FOMC) that . . our OpenMarket

the 12. Data are from MortgageBankersAssociation(Haver Analytics). of 13. We at the Federal Reserve were aware earlierm the decade of incidents some we But regrettably, viewed it as underwriting practices. mortgage subprime irregular highly of not a localized problemsubjectto standard oversight, theprecursor thesecuriprudential bubblethatwas to arise severalyearslater. tizedsubprime mortgage 14. Inside Mortgage Finance Publications,The 2009 Mortgage Market Statistical Annual,vol. I, p. 4, and vol. II, p. 13. for are 15. These covenants restrictions on a borrower a lenderthatmight, examby put the other capital,or debtservicecover. borrowings, level of working ple, restrict

ALANGREENSPAN

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Figure 5. Yield Spread of Bonds Rated CCC and Lowerover 10-YearTreasuryNotes, 1988-201 0a

Percent

1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009

Source:BankofAmerica Merrill FederalReserve. Lynch, a. Averageyieldon Bankof America Merrill cash CCC and lowerminus Lynchhigh-yield pay bondsrated notesat constant yieldon 10-year Treasury maturity.

boom. . . financed very in increases mortextraordinary housing by large 16 cannot continue Itlasted until 2006. debt, gage indefinitely." in with financial were firms fearful that Clearly, suchexperiences mind, should retrench soon, too would almost lose share, they they surely market Their were inCitigroup chairperhaps irretrievably. fears given expression manandCEO Charles Prince's in now-famous remark 2007,justbefore theonset thecrisis: of "When music the in of stops, terms liquidity, things willbe complicated. as longas themusic playing, But is you'vegottoget We'restill up anddance. dancing."17 Thefinancial firms the that would unable anticbe to accepted risk they in of to that however, ipatetheonset crisis time retrench. believed, They theseemingly insatiable demand their for of financial array exotic products would enable them selllarge to of without They loss. parts their portfolios
16. The failureto anticipatethe lengthand depthof the emerging bubble should not have come as a surprise. and otherwise, Althoughwe like to pretend policymakers, indeed forecasters general,are doing exceptionally in well if we can get market essenprojections 70 of of tiallyright percent thetime.But thatmeanswe getthemwrong30 percent thetime. In 18/2 had yearsat theFederalReserve,I certainly myshareof thelatter. 1 /. Michiyo JNakamoto David Wighton, CitigroupChief Stays Bullish on Buyand Outs,"Financial Times,July 2007. 9,

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of that weremistaken. Theyfailedto recognize theconversion balance of of a demand largely function thedegree is sheet to liquidity effective of itself manifests in periods euphoria That riskaversion.18 process (risk averand trendless belowitslong-term, aversion (risk average) fear falling aversion ofrisk A in aboveitsaverage). lessening theintensity sionrising in bid-asked narrow creates spreads, volume theconvenincreasingly from as of tional definitionmarket, distinct balance sheet, liquidity. risk of I as In thiscontext define bubble a protracted a period falling below rates into that aversion translates capitalization falling measurably ratesin turn trendless their Fallingcapitalization averages.19 long-term, burst levels.All bubbles to assetprices unsustainable one propel ormore that its reaches irreducible when riskaversion minimum, is, whencredit of deflation the at success timing onset the zero, although approach spreads hasproved elusive. economic severe burst without Somebubbles consequences thedotof in of comboomandtherapid prices thespring 1987,for run-up stock That with burst severe Others consequences. classof deflationary example. Reinhart Kenneth and as Carmen (2009) demonstrate, bubbles, Rogoff
economicdefinition, herethanthestandard risk 18. I am defining aversionmorebroadly outcomes.Risk aversion,as I use theterm, of over different whichstatesit in terms utility actions.Most to that encompassesall factors governindividuals'willingness engagein risky towardrisk,but also theirperceptions it notably, encompassesnot only theirpreferences of risk. humantraitthatgovernsthe pricingof income-earning Risk aversion is the primary assets. When people become uncertainor fearful, they disengage fromperceived risk. Risk aversion,by definiWhen their declines,theytake on new commitments. uncertainty zero to full. tion,rangesfrom of of The extremes zero and fullriskaversion, course,are outsideall humanexperience. actions Zero riskaversion thatis, theabsence of anyaversionat all to engagingin risky among, objective implies thatan individualdoes not care about, or cannot discriminate statesof riskto lifeand limb. Such individualscannot(or do notchoose to) recognizelifeevents. threatening to contributors liferequiresaction,that and To acquirefood,shelter, theother necessary is, the takingof risks,eitherby an individualor by otherson the individual's behalf. withlife. Thus fullriskaversion,like zero Eschewing all objective riskis not consistent statethatis neverobservedin practice. riskaversion,is a hypothetical Day-by-dayexistenceoccurs well withinthese outerboundariesof risk aversionand measured by credit risk spreads. Credit spreads that very can be very approximately Primerailtrend. trackchangingriskaversionexhibitlittleto no long-term approximately road bonds of theimmediate spreadsover U.S. Treasuriesthat post-Civil War yearsreflect are similarto thepost-WorldWar II experience. a rates,are essen19. Yields on long-term Treasuries, proxyforrisklesscapitalization Real yields in recentyears are not far fromthe nominalTreasurybond tially trendless. wereeffecinflation (underthegold standard) expectations yieldsof 1900, whenlong-term tivelyzero.

ALAN GREENSPAN

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in of to of sector, appears be a function thedegree leverage thefinancial of is the of when maturitydebt lessthan maturitytheassets the particularly itfunds. assetsfunded equity beensignificantly Had theshareof financial by in September that of 2008, it seemsunlikely thedeflation asset higher ifatall,beyond that would havefostereddefault a much, contagion prices in that of boom.It is instructivethis ofthedot-com regard sincethestart no has on the crisis, unaffiliated fund defaulted itsdebt, despite very hedge lossesthat often forced fund liquidation. large II.D. Why theBoomReach SuchHeights? Did I reachcentury-rare The Whydid the2007 bubble euphoria? answer, which burst very with little lieswith dot-com the believe, bubble, footprint in in United the recession onglobal GDP and, the States, produced mildest The in thepost-World II period. previous War U.S. recession, 1990-91, the the was thesecondmostshallow. Coupledwith factthat 1987 stock market crash novisible left on led Federal impact GDP,this experience the Reserve many sophisticated and a investor believethat to future contractions also prove worse no than typical a would recession. postwar Theneedfor bank buffers less large capital appeared increasingly pressof As Moderation. lateas April2007,theIMF ingin thisperiod Great notedthat"globaleconomic risks[have]declined since. . . September 2006.. . . Theoverall is U.S. economy holding well. . . [and]thesigns up elsewhere veryencouraging" are in The (emphasis original).20 banking under did a regulations adopted internationally theBasel Accords induce modest in increase capital to thecrisis. Butthe requirements leading up in debates Basel overthepending accordthat as globalcapital emerged Basel II werelargely overwhether keep bankcapitalrequirements to ortoreduce them. ballooned. unchanged Leverage accordingly It is in suchcircumstances we depend ourhighly that on sophisticated of risk to market breakdowns. global system financial managementcontain Howcouldithavefailed so broad scale?Theparadigm spawned on a that severalNobel Prize winners economics Harry in Robert Markowitz, and Myron Scholes(and Fischer had he lived) was so Merton, Black, embraced academia, central and that banks, regulators by thoroughly by 2006 ithadbecome coreoftheglobalregulatory the standards embodied in Basel II. Manyquantitative investment whosenumber firms crunching to exposeprofitable market weresuccessful so sought trading principles
20. IMF,World Economic Outlook, 2007,p. xii. April

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aversion it of time). moved (which didmuch the longas risk incrementally Butcrunching that data did yield a covered thelast2 or3 decades not only model couldanticipatecrisis. that a Mathematical modelsthatcalibrate are better risk,however, surely ofa half to risk than "ruleofthumb" the guides management judgments with conceptual the frameto fault century To this itis hard find ago. day work ourmodels, faras they BlackandScholes'elegant of as option go. than decadeago. The risk a is managepricing proof no less validtoday ment nonetheless harboredfatal a flaw. paradigm In the growing riskmanagers, Federal the stateof higheuphoria, theunderlying failed fully to and other Reserve, comprehend regulators tail of outand of size,length, impact thenegative ofthedistributionrisk crisis out. comesthat about be revealed thepost-Lehman played was to as in had with to Fordecades, little no data,mostanalysts, myexperience, wasthe limited risk. tail Thisassumption, a far more arguably, conjectured failures. risk source thecritical management of system major less was Only modestly ofa problem thevastand,insomecases,virtuof ofthe products spectrum financial allyindecipherable complexity broad mathematical of with andmarkets developed theadvent sophisticated that In subconrisk.21 despair, investment to managers techniques evaluate risk of task tracted inordinately part their tothe"safeharbor" desan large was No of judgment required rating agencies. further ignations thecredit held officers believed were who ofinvestment by effectively harmless they But thejudgments thesegovernment-sanctioned organizations. of rating at the decadesofexperience, analysts thecredit their rating agendespite than investthe the of at ciesproved more no adept anticipating onset crisis at ment communitylarge. models risk of the Evenwith breakdown oursophisticated management would thefinancial of andthefailures thecredit system rating agencies, - ourregulatory crisis bulwark had haveheldtogether thethird against it crisispressure, too failed. But effectively. under system functioned to failed of with vastmajority market the regulators participants, Along onset crisis. of the anticipate was Services U.K. Financial The heavily Authority unableto praised one threatened of that the and thusto prevent, bankrunthat anticipate, credit Rock.Thevenerated Northern commercial banks, country's largest
had thatbecause of thiscomplexity, 21.1 oftenmaintained policymakers to relyon an markets. high The to "invisiblehand"to bring international equilibrium suchundecipherable was working. that to level of market appeared,erroneously, confirm thesystem liquidity

ALAN GREENSPAN

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future smooth sailbestowed that ratings implied triple-A rating agencies on The Basel Committee toxicderivative for a highly product. ing many authorities theworld's from representing regulatory Banking Supervision, failed to a rulesthat majorfinancial systems, promulgatedsetof capital for foresee needthat the aroseattheheight thecrisis much of larger capihad buffers. Federal The talandliquidity Corporation DepositInsurance than percent all of as of "more 99 noted recently thesummer 2006that as institutions orexceeded requirementsthehighest met the of insured regubanks extenare standards."22 commercial savings U.S. and latory capital our and for banking sively regulated, eventhough years 10 to 15 largest to institutions had permanently have on-site examiners oversee assigned assets banks were still abletotake toxic on daily many operations, ofthese that them their to knees. brought III. Financial Intermediation

IIIA. The Purpose Finance of

in The ultimate ofa financial and goal system itsregulation a market is to direct nation's the borrowed from economy saving, plusanysaving abroad(thecurrent account in plant, toward investments deficit), equipand that offer greatest the in increases thenation's ment, human capital hour. Nonfinancial on rises output worker per output hour, average, per when obsolescent low output hour)arereplaced facilities with (with per facilities embody that (withhighoutput cutting-edge technologies per Thisprocess standards living a nation a of for as hour). improves average In whole. theUnited the successoffinance thedecades in States, evident before crisisin directing the scarcesavings intorealproductive capital investments to the that appears explain generous compensation nonfinancial market had to participants beenwilling paytothedomestic producers offinancial services. Theshare U.S. gross of domestic as to product accruing income finance andinsurance, to of rose according theBureau Economic Analysis, fairly from percent 1947to 7.9 percent 2006 (figure Many in 2.3 in 6). steadily other financial centers exhibit similar trends.23 a small of global Only part theriseintheUnited States an in demand represented increase netforeign
23. Increased, lesspronouncedly financial but shares evident the are in United so, Kingthe and others. world's The most dom, Netherlands, Korea, Australia, Japan, among rapidly a (and China, market-oriented) expanding increasingly economy, reports risein financial intermediaries' ofGDP from percent 1980to5.4 percent 2008. share 1.6 in in
22. FDIC Quarterly 2nd Quarter 2006, p. 3. BankingProfile,

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Figure 6. Share of the FinancialSectorin GDP, 1960-2008 Percent 8 " Percent 14

7
6 and insurance Shareof finance GDP (left innominal scale)y /

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Source:BureauofEconomic Analysis, a. Three-year averages. moving

The services.24 declinein theshareto and forU.S. financial insurance to of write-offssavings in 2008 reflects 7.4 percent presumed previously be productively employed.25 did of breakdown thelast 2 years, nonfinancial Giventhehistoric of the overthedecadesmisread efficiency finance market participants The of this smallsegment oureconomy? andinappropriately compensate failures financial so, of suggests for certainly product prevalence so many to it thedecadeleading tothecrisis. Nonetheless,is difficult makethe up for s rise in faceofthe same fairly persistent offinance'share judgment the in of share growth nominal finance's half theprevious century. Moreover, about10 percent since1990,averaging trendless GDP has beenlargely 6). (figure and for accounted byfinance of The proportion nonfarm employment theshareof grossincome since 1947 has risenfarless than insurance of a in sector, upgrading theskills implying significant originating that and A recent and to attracted finance their (Philippon study compensation. of riseinthesalaries those finds markedly a Reshef above-average 2009)
but serviceshas grownsignificantly has demandforU.S. financial 24. The netforeign services. of offset netimports insurance been largely by m 25. The share of national income originating a somewhatbroadenedmeasure oi 2008. was little finance changedin 2009 from

ALAN GREENSPAN

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skills in since1980,presumably the reflecting greater employed finance of of to in 2007 a quarter all graduates the drawn finance recent years. By were finance.26 venerable California Institute Technology entering of and Whatare we to makeof theseextraordinarily persistent stable is of accidental? Arethey all, (After there no evidence wholly uptrends? in the sucha trend theprewar It is notthat valueof assetsto be years.) to to The has managed beenpersistently relative GDP.27 answer this rising a deal. mattersgreat question issue thatmustbe In the context financial of the reform, critical was addressed whether growing is the share financial of services happenwas or that share financial of services required stance, evidence a growing division labor.I raisetheissue of to intermediate evermore an complex would becausemany recent policyrecommendations lowertheshareof income GDP. Wouldsuchpolicies in the financial services affect growth ofU.S. nonfinancial and of Moreimporproductivity ourstandards living? failures riskmanagement regulation, of and would tant, giventherecent time or increased increased financial atthis thwart (through staregulation enhance economic We of bility) growth? needa far deeper understanding in theroleof financial intermediationpromoting to answer that growth in How finance evolves thepostcrisis should question. years bring clarity tomany today's of uncertainties.
III.B. Risky FinancialIntermediation

As I noted the of earlier, shapeofthedistributiontheextreme negative tailrisk unknown was before default Lehman. the of in Sincetailrisk, prinatleast, open-ended,28 willalways some that is there be risk bank ciple capitalcannot and evenmany, will banks fail. But cover, hence some, perhaps that neednotbecomea systemic if problem equity capitaland liquidity are and requirements raised substantially a significant ofanintermedipart s takes form mandated the of bonds section (see ary' debt contingent capital will there alwaysbe thepossibility, however of remote, the IV.F). Still, financial credit private intermediary system faltering, requiring sovereign tokeepvital intermediation functioning.
26. TheEconomist, "Number-Crunchers Crunched," 13, February 2010,p. 568. 27. Household worth be taken a proxy the worth the net can as for net of economy be to at of net to income was largely managed a fee.The ratio that worth disposable personal between 1952and 1996.Sincethen has beenvolatile, it with recent unchanged quarters to returningthelong-term average. 28. Tail risk would to aversion were become to an absolute, converge zeroonlyifrisk iflife (see impossibility is tobe sustained note18).

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for of Central bankers havelongbeenaware thepotential a breakdown as in Statesas recently in private financial markets. Indeed, theUnited and of of 1991,incontemplationtheunthinkable attheurging theFederal Act Federal Reserve was Section 13-3ofthe Reserve BoardofGovernors, as revised The section reconsidered amended Congress. and grants by and to unlimited authority theBoardtolendin "unusual exigent virtually circumstances." Flood IlI.C TheHundred-Year I A decadeago,addressing issue, noted, that
confront that bankers of Thereis a ... difficult every problem riskmanagement central risk it we acknowledge or not:How muchoftheunderlying in a day,whether explicitly financialsystemshouldbe shouldered [solely] by banks and otherfinancialinstituto if tions?. . . [Central banks]have all chosenimplicitly, notin a moreovertfashion, for set our capital and otherreservestandards banksto guardagainstoutcomesthat of threaten stability ourdomesthe crisesthat excludethoseonce or twicein a century financial tic and international systems. But makesthiscalculation. we havechobankexplicitly I do notbelieveanycentral cannotprotect of that sen capitalstandards by any stretch the imagination againstall in in Thereis implicit thisexercisetheadmission adverseloss outcomes. that, potential when banksand otherfinancial at certain institutions, episodes,problems commercial banks. the At will their by systems proveinadequate, be handled central risk-management we that setthisbar very on sametime, high.Hundredsociety thewholeshouldrequire shouldexpectto hundred come onlyonce every years.Financialinstitutions yearfloods rare bankonlyin extremely situations. lookto thecentral 2000a) (Greenspan

a the At issue is whether crisisthatarrived fewyearslateris that observations results At flood." best, yield once-in-a-century "hundred-year what that evidence But robust. recent that scarcely are happened suggests severe the is inthewakeoftheLehman globalfinancollapse likely most the of cial crisisever.In theGreat Depression, course, collapsein ecofar and andtherisein unemployment destitution exceeded nomic output state future oftheglobal thecurrent intheviewofmost, and, prospective reduced bank the And markedly economy. ofcourse, widespread failures continued markets financial But credit short-term availability. short-term tofunction. first to are crises characterized a progressive Financial inability float by debt and overnight as well. short-term debt long-term and eventually than risk and greater near-term uncertainty therefore arealways Long-term of with maturity the increase almost and risk, henceriskspreads always crisisis of The in instrumentquestion.29 depth a financial thefinancial
risklessratesif tight can 29. Yields on risklesslongermaturities fall below short-term will inflation be less. that moneypersuadesinvestors future

ALANGREENSPAN

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of of measured thedegree collapsein theavailability shortby properly term credit. hours credits within of of Theevaporation theglobalsupply short-term A without historical failure I believe, ordaysoftheLehman is, precedent. to heretofore mutual market runon money funds, perceived be close to of hours theannouncement Lehman's of was riskless, under waywithin of set withdrawal trade of credit offa spiral Within default.30 days,the Reserve tomovequickly had and Federal economic contraction, the global sacroEven thealmost market. commercial to support failing the paper severe market encountered collateralized sanct, agreement repurchase fully difficulties. andunprecedented to financial One has to dig very history uncover deep intopeacetime the Themarket call money, keyshort-term for similar financing episodes. "when downat thepeakofthe1907panic, vehicle a century shut of ago, rosefrom one was at no call money offered all for dayandthe[bid]rate of 1 to 125%"(Homer Sylla1991, 340).Evenatthe and height the1929 p. annual thecall money market stockmarket functioned, crisis, although In financial of interest didsoarto20 percent. lesser rates crises, availability and shortin butovernight other funds thelong-term market disappeared, to term markets continued function. at of financial The withdrawal overnight money represents stringency will to before feel itsmaximum. Investors be willing lendovernight they and to out more distant, by capital reach for sufficiently protected adequate hence maturities. riskier, in The evaporation September credits global was 2008 of short-term But and all encompassing. it was thesame processwe had previously observed a more at micro level.31 IV. RegulatoryReform IVA. Principles Reform of Giventhisapparently of unprecedented period turmoil, whatstanby dardshould for reform official of andregulation be proposals supervision I know no form economic of of basedon a division judged? organization
30. Hugo Bnziger, Market FundsNeed New GlobalStandards," Financial "Money November 2009.Bnziger chief officer Deutsche was risk at Bankatthe time. Times, 5, 31. As thecredit NewYorkCity, example, of for became in the suspect themid-1970s, first of failure issuance evident long-term was in followed failures in bonds, municipal by shorter until markets started crumble. similar A to maturities, evenovernight progressively led Mexican financial of 1994-95. crisis progression uptothe

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on Papers Economic Activity, 201 Spring 0 Brookings

that oflabor, from to central unfettered laissez-faire oppressive planning, in has succeeded achieving maximum both sustainable economic growth andpermanent and Central failed, I strongly certainly stability. planning in that doubt stabilityachievable capitalist that is economies, given alwaysbut are turbulent markets continuously toward, beingdrawn competitive it this that never (and quite achieving, equilibrium that is precisely process leadstoeconomic growth). cannot productive be forethought exceptby People actingwithout a of innovation ofnecessity, rational chance.Identification effective is, whenit can be irrational behavior act. Hence,regulation, inhibiting by But as has can identified, be stabilizing, recent history demonstrated. in and of there an inevitable ofregulation terms economic is cost growth of when imposes it restraints standards living beyond containing unproductive behavior. markets. The restraints competitive on Regulation itsnature by imposes beena has and elusive of growth stability always point balancebetween to when comes financial it ofcontention, regulation. especially point in with exception the the States, years theUnited Throughout postwar Illinoisin 1984,for number bankbailouts of of a limited (Continental all to covervirtually proviadequate private capitalproved example), was a there never definitive losses.As a consequence, sionsfor lending that conventional constituted test what of then wisdom, namely, an equity that the on ratio precapital-to-assets of6 to 10 percent average, range the to vailedbetween 1946and2003,was adequate support U.S. banking system. tail of Riskmanagers' assumption thesize ofthenegative ofthedistriof and rate bution credit interest riskwas,as I noted of earlier, necessity had to testthoseconjectures. we and forgenerations never conjectural, docrisk ofperceived wasthoroughly of distribution Mostoftheshape the and financial crises euphoas in umented theprecrisis years, "moderate" financial But relevant ofthecurve. sincemodern out riastraced their parts flood"that had a "hundred-year we had never datacompilation began, tail of the intensity negative risk. exposed full an in decadesthat assumption knew earlier of Riskmanagers, course, but of in of normality thedistribution riskwas unrealistic, as a first it facilitated thatgreatly calculation, prevailed.The approximation but mathematics by tailswas also wellunderstood, ournumimplied fat calcuthe of fell bercrunching capabilities farshort making required cost. Thatis no longer at prohibitive lationsto guideactions, except thecase.

ALANGREENSPAN

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what experienced the we in weeks the default Clearly following Lehman is exactly type market the of seizure tailrisk that was supposed conjecture tocapture, didnot. and risk will Lehman, managers be Having experienced - atleast a while. far more in cautious evaluating future risk for investment areconstructing firms distributions ofoutMany probability comesemploying, thenegative databasedon theexperience the as of tail, last2 years. Monte Carlosimulations other or Using techniques, have they not that crisisas severe theone as concluded, unexpectedly, a financial that followed Lehman the default wouldhavebeenpredicted occur to far more often indicated models which is distributed than in risk by normally. Suchevidence the flood"somewhat suggests onsetof a "hundred-year more often than onceina century. theaftermaththe of Lehman crisis traced a startlingly out Indeed, larger tail had At negative thanalmost anybody earlier imagined. leastpartly of to underresponsible havebeenthefailure riskmanagers fully may stand impact theemergence shadow the of of a development that banking, increased financial innovation as a result, increased levelof also the but, risk. addedrisk notcompensated higher The was by capital. When premiums lowovera protracted risk are as for were, period, they from 1993to 1998andfrom 2003to2007,investors' example, willingness tobidfor types financial all of the tranches of assets, especially high-risk collateralized obligations, debt creates illusion permanent an of market that latest turned tobe intoxicating. several out Itled liquidity inthe episode investment toattempt weather financial banks to the storm only with major a thin veneer tangible of capital. Themost in judgment, the in aftermaththe of crisis reform, my pressing is to fixthelevelofregulatory and risk-adjusted capital, liquidity, collateralstandards Private market are required counterparties. by participants nowrequiring economic and sheet wellinexcess capital balance liquidity of theyet-to-be-amended II requirements. shadow Basel The banksthat survived crisisare nowhaving meetsignificantly the to market tighter with to and thanexisted standards, respect capital, liquidity, collateral, before crisis. the Thesearemajor that in changes needtobe reflected the new set of regulatory and standards requirements currently undergoing review. global One major fallout thecrisis a marked in thedegree moral of is rise of hazard(see note41), which that intermediaries be requires all financial tomaximum ratios. Theseratios, with risk-adjusted as all subject leverage need realistic adjustrisk measures, tobe basedon more capital adequacy ment factors to assets onthe and of liabilities applied their proportiontheir

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on Papers Economic Activity, 201 Brookings Spring 0

funded overnight other with or short-term Precrisis debt. regulatory capital basedon decadesofexperience, clearly were too requirements, although lax: forexample, they erroneously designated pools of self-amortizing home as the of instruments. a surprisAnd mortgages among safest private of decisions andunfortunately proportion investment ingly large portfolio status they if adhered thecredit to "safeharbor" were, law,accorded by risk ofthecredit (orrather, judgments misjudgments) rating agencies. To ensure thatfinancial intermediaries adequatecash to meet have in in commitments theeventof a shutdown external funding, ongoing international liquidity bank should match tightening the already regulation on evident private management in risk Committee Bank(Basel paradigms itself to has 2009). Collateral shown particularly subject ingSupervision in Bear had $20 liquid rapid recapture. Stearns nearly billion pledgeable trillost than half a funds week a it before collapsed. Morgan Stanley more In theheight thecrisis. the of collateral liondollars pledgeable of during of on broker," amount custhe to the of United States, lower risk a "run the that be held tomer assets (collateral) bybroker-dealers cannot commingled the Thatwoulddecrease withtheir own assetsneedsto be increased. must measured be suchaction of that amount funds can "run." However, to with andcoordinated other arbitrage globalregulators avoidregulatory French others and (see forthcoming). a the haveweathered crisis as extremerealUnaffiliated funds hedge - without assistance as I lifestress as one can construct test or, taxpayer are funds onlylightly noted default. earlier, regulated, hedge Although moreheavilyregulated comesfrom muchof their funding leveraged funds "Mosthedge as banks. Moreover, Sebastian (2010) writes, Mallaby their extremes toward ratioand make awayfrom money driving by prices to much-needed nal level."In so doing, liquidity financial theysupply that havewithdrawn. other markets when Regulations inhibit competitors are suchservices counterproductive. funds supply to theability hedge of all almost of in address and liquidity, collateral, myexperience, Capital, of theonset the structure the financial by shortcomings exposed regulatory that In there crisis. retrospect, hastobe a levelofcapital wouldhavepreBrothers. and BearStearns Lehman vented failure for the (If of, example, has 40 think percent.) not10 percent, Moreover, capital theregugeneric financial which to of having forecast prodparticular advantage not latory the did investors notforesee future toxic. to uctsareabout turn Certainly other broken or of subprime securities themyriad Adequate products. in the eliminates needforan unachievable specificity regulatory capital fine tuning.

ALANGREENSPAN

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in overthedecades that structure hasevolved Thejerry-built regulatory to failed too States becomemuch complex. has theUnited Policymakers in that to legislation led the resulting a badly recognize, during debates Act needed (the competition Gramm-Leach-Bliley opening offinancial up shadow increased of 1999),that banking, through competition, especially necessiAndincreased tail tail also increased negative risk negative risk. tates higher capital requirements. Revisions BankEconomic IV.B. Upward of Capital of institutions is Howmuch by being capital currently required financial in the revisions regwill influence upcoming their counterparties strongly But Itis answers. ulatory capital requirements. toosoontohavedefinitive forU.S. commercial bankscan be inferred veryrough approximations of default from response bank the of credit swaps(CDSs), a measure bank in Movements theCDS market events.32 risk,to postcrisis insolvency is into should also giveus somedirect insight whenthebanking system the fear to insolvency perceived haveovercome market's ofwidespread will markets that andbeyond towhen that, perceive banks feelsufficiently to of secure return thefree to lending theprecrisis years. in 2008 andaccelerating thefirst late into of Starting quarter 2009,the its U.S. Treasury, AssetRelief (TARP),added through Troubled Program 2 perto the of $250billion bank equity, equivalent adding approximately to theequity ratio. impact imporIts was centage points capital-to-assets tant immediate. and As thefinancial crisis took holdanddeepened, unweighted the average of 5-year CDSs of six majorU.S. banks Bank of America, JP price Goldman and Sachs,WellsFargo, Morgan Morgan, Citigroup, Stanley rosefrom basispoints early 17 in 2007 (for the contracts, average 5-year annual was of amount the of priceofinsurance 0. 17 percent thenotional to 170basispoints before Lehman the underlying instruments) swap just default September 2008. In response theLehman on to the 15, default, CDS average rosetomore than basispoints October 400 8. 5-year price by On theday theTARP was announced thepricefell to (October14), 200 or 7). approximately basispoints, essentially half(figure Thata by addition thebanks' book equitycapital-to-assets to 2-percentage-point

32. The sellerof a CDS insurestheholderof a particular debtinstrument againstloss in theeventof default. Pricesof CDSs are thusthemostsensitive measureof theprobability of bankdefault.

222

201 Activity, Spring 0 Paperson Economic Brookings

CreditDefault Swaps3 Figure 7. Priceof Five-Year Basis pointsb

400 -

350 300250

.
J 'f y'y
i

loo50-

VV 'A
K fl V^
i 1

l| jyyi

2007

2008

2009

2010

Source:Author's calculations; Bloomberg. GoldmanSachs,JPMorgan, a. Unweighted Citigroup, averagepricesof CDSs issuedby Bank of America, and WellsFargo, Morgan Stanley. valueoftheunderlying contract. of of b. Hundredths a percent thenotional swap

CDSs in half reversed ratio roughly thecrisissurge thepriceof 5-year in 10 rise(from percent additional an overall 4-percentage-point implies market cushion in to mid-2007 14 percent) theequity by required capital linear assumes of of the to That, course, participantsfund liabilities banks. herculean an and, preassumption, of course, extrapolation, admittedly was default de the of the that probability a TARP before Lehman sumes to reaction theTARP announceof The minimis. abruptness themarket however. such to ment appears confirm a presumption, The 14 ratios bookequity-to-assets arestillfarfrom percent. Current banks(as reported theFederal for ratio commercial Deposit by average on 31, Insurance FDIC) was 10.9percent March 2010,comCorporation, loan But in paredwith10.1 percent mid-2007. unacknowledged losses are wereestimated theIMF lastOctober (they nowless) to be in the by are in Trends relevant of of hundreds billions dollars. liquidity lessreadily incapital. to but measured areassumed parallel changes to still That banks havemore by capital addis also indicated the equity over of CDS price March 2010(andsince)remains that fact the5-year 31, to relative the17 basispoints elevated still 100basispoints, significantly in thatprevailed early2007, when10 percent capitalwas apparently

ALANGREENSPAN Ratios at FDIC-lnsuredCommercialBanks,2004-09 Figure 8. Equity-to-Assets Percent 20 -

223

18 ^ 16 14 -

Atmarket value^---^^ ^-^ ^ ^^^^ '

'.

10
T i

Atbook value

^-A '"" /
i i i

'

/- ~""

2005

2006

2007

2008

2009

Source:FederalDepositInsurance Corporation. a. Averages constructed Bloomberg on thebookandmarket from data valueof24 leading banks. equity

to eliminate threat default induce the of and loanofficers enough virtually tolendfreely. There little is doubt theTARP's cashinjection that reduced markedly thefear bankdefault of to through 2009.Moredifficultjudgeis the early on increase bankequity market in at impact bankCDS s of thedramatic valuerelative bank to assets market at value. That ratio 4.5 percentage rose from endofMarch the 2009 totheendofDecember, from per7.4 points cent 11.9percent to can doubt this matethat has 8). (figure There be little increased solvency banks, the of less rially although apparently effectively, dollar dollar, themore for than inbook-value permanent change equity.33 Muchoftherepayment TARPinvestmentstheU.S. Treasury of to was doubtless financed newequity madepossible a more than issuance, by by one-half-trillion increase U.S. commercial equity market dollar in bank at andbyborrowings much made easier the value, (andcheaper) by increased buffer bank The equity engendered gains in market-valued equity. by of contributions TARPandofcapital ofthe to parceling relative gains bank and to not cleareveninretrospect. solvency willingness lendmay be fully
33. Between endofMarch theendofDecember the and CDS price 2009,theaverage fell from to 104basispoints, 369 while ratio themarket the of valueofequity themarket to valueofassets rose450 basispoints.

224

201 Paperson Economic Activity, Brookings Spring 0

Table 2. CDS and LIBOR-OIS Spreads at Various Maturities, September2009 and March 2010 Basis points Maturity CDS 10 years 5 years 3 years 1 year LIBOR-OIS 3 months 1 month 15, September 2009 129 125 129 123 12 7 March 31, 2010 111 107 88 61 11 8

and Sources: British Bankers' Association, Reuters, Haver Bloomberg, Analytics.

market but The TARP notonlyinserted particicapital also induced that would,at leastfora while,stand pantsto infer theU.S. Treasury the This the of behind liabilities thebanking system. mayexplain divershort-term and 3-month) 2009 sincemid-September between (1gence meato as LIBOR-OIS spreads alternative CDS spreads a short-term (an CDS spreads. and of sureof thelikelihood bankdefault) 5- and 10-year level to had LIBOR-OISspreads returned their Short-term precrisis bythe back are CDS endofSeptember 2009.Long-maturity prices only partway either fallsin between. LIBOR-OIS spread (table2). The 1-year Clearly, value5 cushion market at bank some markets discounting ofthe are capital and/or of and 10 years hence, they prices, owingto thevolatility stock after of or the willingness, ability, theU.S. government, question political bank to another bailout.34 to markets return normal, initiate and set Giventheforegoing of fragile (and assumptions conclusions that I areall we have), would capital requireequity regulatory judge they the from 10 percent ments theendwillbe seento haverisen in precrisis of level(in terms bookvalue)to 13 or 14 percent 2012,andliquidity by willtoughen andcollateral commensurately. requirements
Can Do IV.C. WhatRegulation

can and in experience, What, my supervision examination do as a backis surveillance promulgate and to capitalrequirements counterparty up
in debtcrisismounted thespring from Europeansovereign the 34. As fearof contagion of 2010, CDS and LIBOR-OIS spreadsrose markedly.

ALANGREENSPAN

225

an and rulesthat preventative do notrequire are anticipating uncertain future. Supervision - canaudit enforce and and requirements35 capital liquidity - can require issue some debt thatwill thatfinancial institutions become should become IV.F) (see impaired section equity equity capital - can,andhas,putlimits prohibitions certain on of concenor types trated banklending - can prohibit affiliate subsidiary and structures whosesole complex is taxavoidance regulatory or arbitrage purpose - caninhibit reconsolidation sold the ofaffiliates previously toinvestors, structured investment vehicles (SIVs)36 especially - canrequire wills"inwhich financial intermediaries indicate, "living howthey be liquidated can with on an ongoing basis, expeditiously minimum on and impact counterparties markets. IV.D. SomeLessons Regulatory of Capital History In thelate 19th U.S. of century, banks required equity capital 30 perthe to centofassetsto attract liabilities their assets.In the required fund Warperiod, figure that 50 9). pre-Civil topped percent (figure Giventhe nature 19th-century of and rudimentary payment systems thepoorgeoin distributionreserves what of was then agricultural an econgraphical forbankcredit was largely local. It enablednational omy,competition bankson average obtain to returns income) their on assetsof well (net over200 basispoints thelate1880s, probably in and more than basis 300 in with a later). points the1870s(compared 70 basispoints century of intermediation, toconsolidation Increasing efficiencyfinancial owing of reserves improvementspayment and in exerted systems, competitive on to and ratios pressure profit spreads narrow allowed capital-to-assets to In decline. marked the netincome ofreturn rate contrast, annual average onequity amazingly was outside range 5 to 10pera of stable, rarely falling measured the from cent, 10). annually, during century 1869to 1966(figure Thatmeant netincome a percentage assetsand thedegree that as of of were that leverage approximately inversely proportional during century.
35. Increased can capital requirements go a longwaytoward containing compenlarge sation The will to the packages. recent higher profits be needed fulfill capital requirements, if have especially global competitors similar capital requirements. 36. When, the suchassetsappeared about fail, to during crisis, sponsoring companies, fearful reputation (a newinsight?), of risk reabsorbed detached affiliates subseat legally loss. quent great

226

on Activity, 201 Papers Economic Spring 0 Brookings

Figure 9. Ratio of EquityCapital to Assetsin the BankingSector,1834-2009

Percent hj' State banks

30 20 10 -

i A/^'f^

'

National banks

'A-''

' ' V.^

vj N^ H'*-. t,

V'

All commercial banks

,.<--

1840

1860

1880

1900

1920

1940

1960

1980

2000

of of and Source:Federal Corporation Office theComptroller theCurrency. DepositInsurance

Figure 10. Ratio of Net Income to Equityin the BankingSector,1869-2007

Percent

15 -

> i

10'.

National banks h

~ 1 i

/Vv/'V^"'

"'!', >'

'

banks A// commercial '

-10 1870 1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000
of of and Source:Federal Corporation Office theComptroller theCurrency. DepositInsurance

ALAN GREENSPAN

227

Ratesofreturn assets equity on and in the that (despite decline leverage resulted from Basel capital movedmodestly rising requirements) higher 1966-82owingto a rapidexpansion noninterest in for income, during from service and and activities, example fiduciary charges fees, securitizations from intoinvestment andbrokerage). (andlater expansion banking Noninterest income rosesignificantly between 1982and2006,increasing netincome nearly percent equity, a consequence a marked to 15 of as of increasein the scope of bankpowers.Thatincreasein partreflected theemergence April1987 of court-sanctioned FederalReservein and "Section investment 20" affiliates bank of comregulated banking holding The of is visible theacceleration in panies.37 transfer suchbusiness clearly of grossincomeoriginating commercial in relative thatin to banking investment in2000 (Bureau Economic of banking starting Analysis).38 I tentatively conclude thehistorical that relative of net stability average ratios backto thepost-Civil Waryears reflects income-to-equity dating an underlying ante ex market-determined return intermediation. rate of on In summary, crisiswill leave in its wake a significantly the higher ratio both and regulatory, that capital-to-assets requirement, economic must reached intermediation be restored the if be is to to point where banks andother financial institutions confident havea sufficiently are secure they cushion lendfreely. to capital IV.E. Limits Regulatory to Capital Requirements Ifwe accept a benchmark remarkable as the of ratio bank of stability the netincome equity to between and 15 percent) has 5 that capital (ranging with exceptions, theendoftheCivilWar(figure since prevailed, rare 10), we can infer highest the ratio capital assetsthat banking of to a average can before significant a number banksare required of to system tolerate raise their orshrink size,orboth. assume 5 percent their I a annual margin,

37. Thisdevelopment meant therepeal, that under Gramm-Leach-Bliley ofthe the Act, 1933Glass-Steagall which separated had commercial investment and Act, banking, changed little. From enactment Gramm-Leach-Bliley the of in 1999to theFederal Reserve's very of SachsandMorgan as services acceptance Goldman Stanley financial holding companies at theheight thecrisis, applications employ greater of no to the were powers forthcoming. Thatforbearance reflected a desire stay to clearoftheFederal Reserve's apparently regulaembrace. tory 38. Ratesofreturn crashed the half declines matched an during first of2009,with (on annual in a basis)onlyby those thedepression years1932-34.Bothcases reflectedrare breakout from historical the from on sharp range, resulting mostly largewrite-offs previextended loans. ously

228

on Activity, 201 Papers Economic Spring 0 Brookings

for as limit therange) a proxy thefull of rate (the average ofreturn lower wouldmakeup theaverage. of distribution thethousands banksthat of as it for exercise is employed theex antecompetitively this Accordingly, I assumeas a first return intermediation. on minimum average required Ifso,thehighest of ratio are that approximation all variables independent. and can that to system tolerate stillsupply capital assets theU.S. banking can service financial withadequate sector thenonfinancial capacity be inferred thefollowing from identity:

~c~~x~c'
If assets. n/C= and C where is netincome, is equity n capital, A is total 0.05,then = 20 x -. A A that = -rp- k)w+ n-e-a, where is therate Itcanbe shown n/A (rr rr rate from received ofinterest assets, is theinterest paidonearnearning rp of w ratio earning of ratio lossestoearning k assets, is the ingassets, is the e to income assets, is the of n is theratio noninterest assets total to assets, of anda is theratio taxesand tototal ratio noninterest of assets, expense table3, virtuAs assets. canbe seenfrom to minor other adjustmentstotal since1982is as U.S. banks a group and all oftheriseinn/A n/Cfor ally income. rise duetothemarked innoninterest nIA the before onsetof thecrisis, averaged In theyears immediately maximum the capital, 0.012, and therefore inferred averageregulatory than was 0.24. A ratehigher 0.24,all else as a first C/A, approximation, belowthecritical on rate wouldputtheaverage ofreturn equity equal,39 for back to its average 1950-75 wereto revert level.If n/A 5 percent abovethe12to 14percent then = 0.15,marginally CIA presumed (0.0074), banksto lend that market-determined requirement wouldinduce capital freely. all in model which varia assume static as Thesecalculations, I noted, on rate the But ables are independent. clearly required of return equity ratio. of be cannot independent the capital-to-assets Increased capital

K_n

39. I do notdenythatall else is notequal, and hence such conclusionsare moreillusA trative thanexplanatory. dynamicmodel is beyondthe scope of thispaper. Net interest income arguably income has enough of a historyto effectively model, but noninterest does not.

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will investors the of balance sheet hence attract and reduces risk the equity rise that to a rate This despite lower ofreturn. implies owing therecent in exceedthestacan thus Til theactualregulatory Ay readily ceiling capital increased tic ceilingof CIA = 0.24. In anyevent, capitalrequirements in that decades will surely the reduce marginal lending occurred recent fund risk. tail Muchofthat to to marginal lending owing thefailure fully That becamefully subsidized taxpayers. subsidy was in effect being by in the funded 2008bysovereign credit. through higher Removing subsidy balshrink financial will, intermediary capitalrequirements of course, and its was ance sheets. Muchof thislending evidently nonproductive, level for loss is notapttobe a problem ourcomplex economy's required ofintermediation. IV.F. TooBigtoFail is increased capitalrequirementsthenecessity Beyondsignificantly "toobigtofail" firms of ofaddressing problem somefinancial the being to "too or,moreappropriately, interconnected be liquidated quickly." scarcesavingis threatened of The productive employment thenation's with are firms theedgeof failure supported taxpayer at whenfinancial I agreewith institutions. as funds designated systemically and important Bankof MintheFederalReserve of the president GaryStern, former to will "creditors continue underprice whohas longheldthat neapolis, and overfund of financial therisk-taking these them, failto institutions, are that too low,syseffective market Facingprices discipline. provide risk" firms 2009,p. 56). (Stern temically important willtakeontoomuch in needto be invested cuttingthat absorbscarcesavings Thesefirms are of and ifoutput hour standards living to conper edgetechnologies, tinue rise. to "toobigto for of in After wallowing thebackwaters economics years, It to visiblethreat economic as fail"has arisen a major, growth. finally Mac were whenFannieMae and Freddie becamean urgent problem U.S. polon then, 7, conservatorshipSeptember 2008.Before placedinto Fannieand to couldpoint thefactthat crossed) (with fingers icymakers of and werenotbackedby the"fullfaith credit the Freddie, statute, by did Market U.S. government." however, not believe the participants a and Fannie Freddie specialcredit afforded and denial, they consistently and 7, Sherlund, Burgess 2005).On September 2008, (Passmore, subsidy vindicated. werefinally market participants Mac needto be split intosmaller Mae andFreddie Fannie compaup into reconstructed stand"toobig to fail,"and then nies,noneof them

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alone securitizers. Theirfuture of (and thethreat contagion) solvency that these GSEs be prohibited accumulating portfolios from requires large of assetsthat add no useful to or backing theprocessof securitization themortgage markets more Thoseportfolios' purpose sole is generally. to profit from subsidy market the that to theseGSEs participants grant 2004b). (Greenspan One highly of that disturbing consequence thetoo-big-to-fail problem hasemerged since September federal the of 2008 takeover Fannie Mae and will Freddie Mac is that market that players nowbelieve every significant financial should occasionarise, subject beingbailed the is to institution, outwith funds. is goingto be very It difficult legislators for to taxpayer future investors otherwise. persuade Businesses aresubject being that to bailedouthavecompetitive market andcost-of-capital but advantages, notnecessarily efficiency advantages, overfirms thought be systemically not to Foryears Federal the important. Reserve concerned was the about ever-growing ofourlargest size financial institutions. Federal Reserve research beenunable find had to economies of scale in banking a size (Berger Humphrey and 1994, beyond modest A decadeago,citing suchevidence, noted I 7; see also Berger 1994). p. that and are "megabanks beingformed growth consolidation increasby entities create potential unusually that the for ingly complex largesystemic risksin thenational international and shouldthey fail" economy we didlittle address problem. to the 1999).Regrettably, (Greenspan How to deal withsystemically institutionsamongthe is threatening for there no good solutions. are major regulatory problems which Early resolution bankproblems of under Federal the Insurance Deposit Corporation Act to Improvement of 1991 (FDICIA) appeared have worked with smaller banksduring of But periods general prosperity. thenotion that risks be identified a sufficiently can in manner enablethe to timely of a largefailing bankwith minimum proved loss untenable liquidation thiscrisis,and I suspectwill proveuntenable future in crises during as well.40 The solution in judgment, at leasta reasonable has chance of that, my theextraordinarily "moral hazard" hasarisen that overthe reversing large

40. TheFDIC hasexperienced lossesinthe valueofassets taken inresolution over large the during last2 years.

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is banksandpossibly financial all interpastyearandmore41 to require mediaries issue contingent to capitalbonds,thatis, debtthatis autoconverted equity to whenequity matically capitalfallsbelowa certain threshold. debt Such ofcourse, more be on than simwill, costly issuance ple debentures. should bonds we However, insufficient,should contingent capital prove allowlargeinstitutionsfailand,ifassessedbyregulators toointerto as connected liquidate to be into quickly, taken a special bankruptcy facility, the wouldbe granted access to taxpayer funds for whereupon regulator of thefailedinstitution. creditors Its "debtor-in-possession financing" is to defined (when out)wouldbe subject statutorily equity wholly wiped of from ("haircuts"), theinstitution and would principles discounts par then required split into be to noneofwhich should of be units, separate up a sizethat toobigtofail. is Thewhole would administered a be by process in panelofjudgesexpert finance. I assume someofthe created firms would and that survive, others newly a short no the fail.If,after fixed of time, viableexitfrom bankperiod
is 41. Moral hazard,in an economiccontext, ariseswhenan institution notdebitedwith to will thefullcosts of its actionsand therefore tend,in partat least,to act contrary how it of where the externalities would act were it pressuredsolely by unfettered competition, The institution accordingly by potentialbailout costs are fullyinternalized competitors. other some of thecosts of itsactions. requires partiesto suffer the An interesting speculationis whether crisis thatemergedin August2007 fromthe extraordinary leverage(as muchas 20 to 30 timestangiblecapital) takenon by U.S. investthat remainedthepartnerships theywere mentbanks would have occurredhad thesefirms and to thatallowed broker-dealers incorporate century ago. The 1970 ruling up to a quarter as Lehman gain permanent capital seemed sensibleat thetime.Nonetheless, partnerships, Brothers and Bear Stearnsalmost surelywould not have departedfromtheirhistorically fearful thejoint and several liabilityto whichgenof low leverage.Beforeincorporation, eral partnerships subject,those entitiesshied away fromvirtually are any risktheycould of avoid. Theircore underwriting new issues rarely exposed themformorethana fewdays. of lost hundreds of To be sure,the seniorofficers Bear Stearnsand Lehman Brothers millionsof dollarsfromthecollapse of theirstocks.But none,to myknowledge,has filed muchof their wealthallows themto maintain and forpersonalbankruptcy, their remaining of previousstandard living. feasiblein of shouldbe a goal whenever structure partnerships the Replicating incentive structure Thatgoal will doubtlessnotbe always metgiventhatthecorporate future reform. is seen as requiredto raise capital on a scale perceivedas necessaryin today's global market.To eliminatemoralhazard,it shouldnotbe necessaryto followHugh McCulloch, our in first of Comptroller theCurrency 1863, who wentsomewhatover theedge in proposing thattheNationalBank Act "be so amendedthatthe failureof a nationalbank be declared such underwhose administration and and primafacie fraudulent, thattheofficers directors, liable forthedebtsof thebank,and be punished shall occur,be made personally insolvency adminiswerehonestly that unless it shall appear,upon investigation, itsaffairs criminally, moralhazard surelywould notexist. tered."Undersuch a regime,

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the should as available, financial ruptcy appears intermediary be liquidated as feasible. expeditiously IV.G. Regulations a Fail EmbodyingForecast with Regularity Thecrisis demonstrated neither regulators anyone has that bank nor else can consistently accurately and forecast forexample, whether, subprime will or a toxic,or to whatdegree, whether particular mortgages turn tranche a collateralized obligation default, evenwhether of debt will or the financial as a whole willseizeup.A large of fraction suchdifficult system forecasts invariably proved will be can wrong. Regulators readily identify risk of but underpriced and theexistence bubbles, mostimportant, they time onset crisis.42 should the of This cannot, chance, by except effectively notcomeas a surprise. A financial crisis defined anabrupt sharp is as and in price decline the of induced a dramatic in thedisassets, income-producing usually by spike count rateon expected income flows market as from participants swing to in is it euphoria fear. Implicit anysharp pricechange that is unanticifor the pated themassofmarket by participants, wereitotherwise, price imbalances would havebeenarbitraged away. for that Indeed, years 2007,itwaswidely leading toAugust up expected the event crisis would a sharp inthedolbe fall precipitating ofthe"next" account in dralar,as theU.S. current deficit, starting 2002,hadincreased Thedollar cameunder The matically. accordingly heavy selling pressure. risein theeuro-dollar rate around 1.10 in thespring of exchange from 2003to 1.30 attheendof2004appears havegradually to arbitraged away thepresumed dollar of crisis. U.S. current The account trigger the"next" deficit notplaya prominent roleinthetiming the2007crisis, did direct of because that, mayinthenext. of it although In theyears will forecasters readily risks are ahead, identify that under- or at leastpricedat less thantheir historical priced average.But in instance instance, I noted after as risk for earlier, hasremained underpriced Forecasters a group as willalmost misstheonsetof the years. certainly next financial as haveso often thepast, I presume in and crisis, they any willalso. newly designated "systemic regulator" that is A Many analysts argue forecastingnot required. systemic regulafine-tune and liquidity tor,they hold,couldeffectively capital require42. There beenconfusion theissue, which may has on to I havebeena party. With rare it to the at a will but exceptionshasproved impossible identify point which bubble burst, its and are in emergence development visible credit spreads.

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ments match stageofthebusiness to the such calibrated, cycle.Properly could in But imbalances. requirements presumably be effective assuaging In are uniform. realtime, where areinthe we is cycles not cycle a forecast, andcycles For the rate vary. example, lowofthe unemployment atcyclical Bureau Economic of since Research) peaks(as identified theNational by between and7.2 percent. 2.6 Wouldwe havejudgeda 1948has ranged in turn thebusiness for the rate cyclewhen, example, unemployment rose in In to 5.8 percent April1995,up from percent March? theevent, in 5.4 the unemployment soon reversed rate itself and continued fall for to 5 more years. It is besttofix the and carry regulatory parameters letmonetary policy willtighten it observes if load. Reserve rising discretionary The Federal that (as inflationary pressures itdidinFebruary euphoria signals mounting fall 1994andJune 2004)orifrisk premiums inordinately. that rules Moreover, regulatory wouldraiseuncertainties discretionary of environment couldundesirably investment. curb Thus,in thecurrent - and I see no readyalternative significantly to increasing complexity, and and up capital requirements liquidity beefing indifixing regulatory risk vidual banks'counterparty surveillance. of for about ability the has The Federal Reserve beenconcerned years that to andexaminers foresee emerging problems regulatory supervisors I auditors. and bankauditing haveeludedinternal systems independent "In Bankers in the remarked 2000 before American Association, recent much of to obsolete has begun render technology changing years rapidly Bankregulain decades. established earlier thebankexamination regime on and to are tors perforce increasingly greater more being pressed depend form of thestillmosteffective market discipline, private sophisticated the of reinforce truth a keylesson these Indeed, developments regulation. remains our from banking supervision counterparty private historythat that defense" thefirst ofregulatory line 2000b).Regrettably, (Greenspan failed. first ofdefense line loansandjudge individual couldappraise A century examiners ago, how intoday's But their soundness.43 environment, doesa globallending U.S. bankexaminer of, quality say,a loanto a Russian judgethecredit would of bank?Thatin turn and henceof theloan portfolio that bank,
with who had more thana passing relationship 43. In 1903, O. Henry(W. S. Porter), bank examinerfromthe wrotein "A Call Loan" about a fictional bankingshenanigans, who was obsessed withthe collateralbackinga of Officeof theComptroller the Currency banks. rarein today's larger is $10,000 loan. Such detailedscrutiny exceptionally

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and the vetting Russianbank'scounterparties thosecounterparrequire transof financial all ties'counterparties,tojudgethesoundness a single andneither a credit can In a action. short, bankexaminer cannot, rating for is of How deep intothemyriad layers examination enough agency. certification? in in of The complexity our financial spawns, any system operation in never crises that, theevent, week, happen, many alleged pending given each To of misconduct. examine and innumerable allegations financial conclutoreach atthe levelofdetail such meaningful necessary possibility than force an sions would multiples larger those require examination many at nowinplaceinanyofourbanking agencies. Arguably, such regulatory risk and soundbanklending itsnecessary taking levelsof examination, be would impeded. The FederalReserveand other were,and are, therefore regulators or of to of problems allegarequired guesswhich theassertions pending a regulatory workbe to of should subject full tions misconduct scrutiny by But thisdilemma limited examination forcewithnecessarily capacity. of we means intheaftermathan actual that crisis, willfind highly compeReserve a Madoff. Federal tent examiners to havespotted Bernie failing is evenconsidering failthe and supervision evaluation as goodas itgets, Banksstill havelittle choicebutto rely uresofpastyears. uponcounterfirst defense.44 surveillance their lineofcrisis as party V. The Role of MonetaryPolicy
VA. Monetary Policyand Home PriceBubbles

Theglobalhome bubble thelastdecadewas a consequence of of price lowerinterest but interest ratesthatgalvanized rates, it was long-term rates home assetprices, theovernight ofcentral not as banks, hasbecome In theseeming conventional wisdom. theUnited thebubblewas States, driven thedeclinein interest rateson fixed-rate by long-term mortgage to relative their mid-2000 6 before FOMC began the loans,45 peak, months the funds inJanuary rate 2001. easing federal

44. Having served JPMorgan's on board a decade before joining Federal for the just my I into effectiveness company's ofthat surReserve,hadanextended insight the counterparty veillance Citicorp, of BankofAmerica, WellsFargo, others, and relative theregulatory to surveillance Federal Reserve banks. by 45. Their is than years 26 Finance (Federal average maturitymore Housing Agency).

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Between 2002 and2005,themonthly fixed-rate rate mortgage closely in tracked earlier measured (as changes U.S. homeprices11 months by R2 the home with adjusted onthe an S&P/Case-Shiller price index), 20-city of of regression 0.500 and a f-statistic -6.93. Thuslong-term mortgage rates were far a better indicator home of than federal the funds rate: prices R2 an a regressionhome of on latter exhibits adjusted of0.205and prices the on a -statistic of-3.62 with an8-month lead.46 home only Regressing prices an 11-month andthe federal funds both fixed-rate the lead) (with mortgage -statistic the for rate(with 8-month an lead) yieldsa highly significant -statistic thefederal for funds rate -5.20,butan insignificant of mortgage rate -0.51. of of Thisshould comeas a surprise. not After theprices long-lived all, the of assets havealways beendetermined discounting flow income (or by of No interest onassets comparable rates services) maturity. imputed using interest - suchas thefedrates one,tomyknowledge, employs overnight whether rate rate the eralfunds - todetermine capitalization ofrealestate, rent itbe thecashflows an office of or theimputed ofa singlebuilding residence. family have federal funds would rate Itis understandable before 2002,the why, that indicator many of statistics in factare as beenperceived a leading between federal the interest rates. The correlation driven longer-term by loansfrom 1983to2002,for rate fixed-rate on funds andthe rate mortgage those had 0.86.47 during years, regresAccordingly, example, beena tight wouldhaveseemingly variable as sionswith homeprices thedependent rates rates wellwith either worked long-term or overnight as the equally variable. explanatory
46. Both regressions, however,especially thatusing the fundsrate,exhibitsignificant are that serialcorrelation, suggesting ther-statistics likelytoo high. 47. As a consequence,theFederal Reserveassumed thattheterm (the differpremium variable.The ence betweenlong-and short-term stable,independent rates)was a relatively rise in the fundsrateto carrythe yield on failurein 2004 and 2005 of the 325-basis-point it the 10-yearTreasurynote along with it (as historically almost invariablyhad) was That episode has dramatically deemed a "conundrum." changed the long-heldview that if rates were significantly interest U.S. long-term influenced, not largelydetermined, by monetary policy. rateshas largelydelinkedU.S. longThe emergenceof globally arbitraged long-term from ratesfrom Federal Reservepolicy. It has accordingly term changedthe"conundrum" failedto respondto changesin thefunds noteyieldunexpectedly Treasury whythe 10-year the was ratetermstructure so stablethrough latter ratein 2004, to whytheinterest partof the 20thcentury. being a fundaAny notionthatthe Federal Reserve had of thatstability of was dashed withtheemergence globallyarbitraged of mentalcharacteristic U.S. finance rates. long-term

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But thefixed-rate delinked from federal the funds mortgage clearly in rate theearly ofthis Thecorrelation between them to fell part century. an insignificant during 0.10 2002-05,theperiodwhenthebubblewas most and the rate if intense, as a consequence, funds exhibited little, any, influence homeprices. on Thefunds waslowered rate from percent early in 6/2 2001to VA percent inlate2001,andthen in to a that eventually 1 percent mid-2003, rate held for year. Federal a The Reserve viewed lowering 1 percent an act the to as ofinsurance thefalling ofinflation 2003,which charrate in had against acteristics similar theJapanese to deflation the1990s.We thought of the of but it should occur, dansmall, theconsequences, probability deflation On other we that rate hand, recognized a funds heldtoolowfor gerous. the toolongmight I thought thetime inflation. at that product encourage price therate decrease nonetheless reflected appropriate an I of balancing risks. still do. To myknowledge, lowering thefederal that of funds ratenearly a decade ago was not considered key factor the housingbubble. a in as the Indeed, lateas January 2006,Milton Friedman, historically Federal Reserve's severest from 1987to 2005, critic, evaluating monetary policy "There noother is of in the wrote, period comparable length which Federal Reserve has so of System performed well. It is morethana difference itapproachesdifferencekind."48 a of degree; Itthus cameas somewhat a surprise of in when, August 2007,Stanford John whom rarely I that (with University's Taylor disagree) argued FederalReserve in of bubble was theprinpolicy theaftermath thedot-com of bubble. to cipalcause of theemergence theU.S. housing According had thefunds followed eponymous housing rate his (2007), rule, Taylor starts wouldhavebeensignificantly andtheU.S. economy lower would haveavoided "much thehousing of boom"andprice bubble. concluHis often and I to closetoconsion, seems, fear, havebecome copied repeated, ventional wisdom.49 As evidence, the inverse correlation, Taylornotesfirst "significant" with lag,from 1959tomid-2007 a midbetween federal the funds and rate
" 48. Milton 'The Greenspan 'He Friedman, Story: Has Set a Standard,' WallStreet Journal 31, January 2006. 49. Forexample, recent a Journal Hilsenrath, "Bernanke (Jon survey theWallStreet by on that of 14, Challenged Rates'RoleinBust," January 2010)found 78 percent WallStreet andbusiness economists and of economists surveyed 48 percent academic surveyed thought, in half causea bubble house in "Excessively Fed policy thefirst ofthedecadehelped easy prices."

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starts argues according hisrule(a useful approxiand that to first housing mation a central to bank'smonetary the Reserve policystance), Federal 50 had setan inappropriately funds during low rate 2002-05. As a consehe starts to . quence, claims, "housing jumped a 25-year high. . . Thesurge inhousing inhousing demand toa surge led inflation. jumpin [The] price in then the for housing priceinflation accelerated demand housing an 2007). upward (Taylor spiral" as of starts theprimary driver homeprices. Taylor postulates housing The evidence, that that and however, suggests itis notstarts drive prices initiate "upward the buttheother around 11). Home spiral," way (figure with for lead, price changes, a 6-month havesignificant explanatory power R2 starts midsingle-family from 1976to2009:the adjusted is 0.36,andthe -statistic15.0.American is homebuilders, myexperience, in to respond funds how homepricechanges, thefederal not to rate, determine many "homes sale"they for start. thehome And as earlier, price change, I noted is a function lagged of rates. long-term mortgage in should extraneous Taylor's be to starts, anyevent, explanaHousing because Taylor byitself structhe rule is tion the of bubble. is employed It funds rateto balancethe trade-off tured indicate proper to a federal Thereare no assetpriceinputs, between inflation unemployment. and in rule.Homeprices cannot calledfor theTaylor home especially prices, for consumer the index(CPI) or thecore be substituted price willy-nilly in index theTaylor (PCE) price paraconsumption expenditures personal if for The CPI couldstand a proxy homeprices thecorrelation as digm. between But it is not.The correlation between twowerevery the high. in and and assetprices general and home prices, between prices consumer The and is small negligible, onoccasion to negative. Taylor product prices, when to cannot applied asset be rule benign prodespecially prices, clearly condition an incomefor a necessary is uctpriceinflation almost surely price producing-asset bubble.51 of The correct interpretationa Taylorruleas appliedto theperiod funds is toolowis that rate that federal the 2002-05that product stipulates
rate the in to rule 50. TheTaylor indicated, (2007),that funds according a chart Taylor with of havebeensetatan average 3.7 percent should 2002-05, compared an actual during index the as the calculations rate price employ consumer Taylor's average of 1.8 percent. the the inflation variable. price expenditures index, consumption Employing corepersonal the narrows gapsignificantly. Reserve's Federal measure, preferred were behind either orproduct inflation missasset the 5 1. Moreover, usualculprits price was for in of stock, example, wellbehaved during ing.Growth theM2 measure themoney 2002-05.

ALAN GREENSPAN Figure 11. Home Pricesand Housing Starts,1976-2009 Percent 30 Changein home prices'" scale) (left

239

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NHousingstarts* scale) (right

V Nyl' T"U ' I

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1982

1986

1990

1994

1998

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Source:Standard Poor's,LoanPerformance, BureauoftheCensus. & and a. Three-month data. BeforeDecember1999,LoanPerformoving averageof seasonally adjusted monthly manceSingle-Family Combined HomePriceIndex;from December 1999onward, S&P/Case-Shiller Composite Index. 20-City b. Starts single-family of data. homes, seasonally adjusted monthly

PCE deflator theFederalReserve's in (the priceinflation core implicit is threatening, ratehikesto meet areindicated. inflation and it But case) didnot threaten. corePCE averaged modest a annual inflation rate Indeed, ofonly1.9 percent that Thusnotonlywas theTaylor rule during period. for it inappropriate assessingthecauses of assetpriceincreases; also for to the gavea falsesignal policy stabilize corePCE price. Thebelievers Federal in Reserve as root the of "easymoney" policy the bubble note a funds (at only1 perrate housing correctly that lowfederal centbetween mid-2003 mid-2004) and lowered interest forARMs. rates inturn, claim, increased demand homes for financed ARMs That, they by andhence an important was contributor emergence the tothe of bubble. Butinretrospect, itappears thedecision buya home that to most likely the decision howtofinance purchase.suspect cannot of the I (but preceded that of a definitively prove)that during period euphoria, largemajority ofhomebuyers endedup financing ARMs wouldhaveinstead who with funded their withfixed-rate had purchases mortgages ARMs notbeen available. How else canoneexplain peaking originations ARMs the of of 2 years thepeakinhome Market demand obvibefore 12)? prices (figure to homeprices the ouslydidnotneedARM financing elevate during last 2 years theexpanding of bubble.

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of 2000-093 Figure 12. Home Pricesand Originations Adjustable-Rate Mortgages, Billionsofdollars (left Originations scale) A Jan. 2000 = 100 Index,

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2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
Bankers Association Standard Poor's, and & Source:Mortgage a. Bothseries quarterly seasonally are data, adjusted.

bubble was that with (2009),confronted evidence thehousing Taylor in of to alludes a seemingly relationship a number European tight global, rule from Taylor andthesize the of countries between degree deviation the staff But a recent of thebubble. (Dokkoand study FederalReserve by deviations notesthat of countries, a broader others 2009),using sample in with the ruledo notseemto be correlated changes home from Taylor is the conclude 31) that relationship"statistically insignifThey (p. prices. terms well)." as weak icant (andrelatively ineconomic does notbuytheglobalsaving-investment Moreover, explanaTaylor he rates interest (which foreshortens in tionofthedecline reallong-term He bubble. sucof as into "saving the housing glut") thetrigger theglobal states, cinctly
rates in 2002-4 were caused by global factorsbeyond the Some argue thatthe low interest decisions by the monetary controlof the monetaryauthorities.If so, then the interest-rate authoritieswere not the major factorcausing the boom. This explanation- appealing at rates remained low for a while afterthe short-term first glance because long-terminterest federal fundsrate began increasing focuses on global saving. It argues thattherewas an excess of world saving- a global saving glut that pushed interestrates down in the United States and othercountries.The main problem with this explanation is thatthereis no actual evidence of a global saving glut. On the contrary... the global saving rate world saving as a fractionof world GDP - was low in the 2002-4 period, especially when compared withthe 1970s and 1980s. (Taylor 2009, p. 6)

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HereTaylor employing postdatatorefute is ex basedon ex ante analysis ILA above),an argument and investment intentions section (see saving most economists should puzzling. find V.B. CouldtheBreakdown BeenPrevented? Have that markets have Couldthebreakdown so devastated globalfinancial low beenprevented? Giveninappropriately financial intermediary capital andtwoprevious decadesof virtually unreis, (that excessive leverage) I very low inflation, low long-term and interest rates, lenting prosperity, much doubt Thoseeconomic it. conditions the are necessary, likely and the in for of conditions theemergence a bubble income-producing sufficient, bankmonetary has assets.To be sure, central to tightening thecapacity cash breakthebackof anyprospective flowthat asset supports bubbly but at contraction economic of surely thecostof a severe prices, almost with indeterminate Thedownside that of is trade-off consequences. output, open-ended.52 But whynottighten Thereare no examples, my to incrementally? of incremental of that prosknowledge, a successful defusing a bubble left intact. Successful incremental banks graduto perity tightening central by defuse bubble a a short-term feedback But ally requires response.53 policy affects economy longandvariable ofas much 1 to2 years.54 an with as lags How does theFOMC, forexample, knowin real time itsincremental if is affecting economy a pace thepolicyrequires? the at How tightening much advance in willithaveto tighten defuse bubble to the without disthe But unless incremental relevant, abling economy? more tightening sigraises aversion long-term interest or the (and rates) disables nificantly risk

52. Tight on down regulations mortgage lending for example, payment requirements of30 percent more, removal themortgage or the of interest deduction, elimination tax or of homemortgage nonrecourse enthusiasm for provisionswouldsurely severely dampen But would limit also tothe unless homeownership. they homeownership affluent, ownership households fully were subsidized government. JanSince bylow-andmoderate-income by 2008 thesubprime market virtually has How uary mortgage origination disappeared. will HUD' s affordable in future? housing goals(see note10)be achieved the 53. Some econometric modelsimply suchcapability assetpricesin general for and home in this a term of structure, which, prices particular. achieve byassuming stable They a between federal the funds andlong-term The rate rates. necessity, yields tight relationship is latter then to a of services thecase in employed capitalize flow income (imputed housing ofhomes). 54. See,for AlanS. Blinder, "TheCase for on Wall example, Optimism theEconomy," Street December 2009. Journal 16,

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that the asset to the economy enough undercut cashflow supports relevant I of prices, see little prospect success. In failed. TheFederal Reserve's attempt incremental one at tightening toconfront what 1994we embarked a 300-basis-point on early tightening It we perceived thetime growing at as inflationary pressures. was a policy as that couldhavebeenjustas easilyreadbythemarket an incremental dot-com bubble. to the tighteningdefuse then-incipient market bubble was that We notonlyfailed defuse nascent to the stock it. of in but enhanced Theability theeconomy evident late1993, arguably in 1994inadvertently demonto withstandsevere a tightening monetary than had that boomwas stronger markets anticipated strated theemerging level of theDow Jones raisedtheequilibrium and,as a consequence, far than This that Industrial Average.55 suggested a tightening greater the to in havebeenrequired quash or 1994episode thetightening2000would that than a rate higher the6/2 thebubble. percent was Certainlyfunds far in would havebeenrequired. reached mid-2000 If percent not is can Atsome rate, any monetary policy crush bubble. 6/4 of But for matter. thestate prosor 20 percent, 50 percent that enough, try In victim.56 2005 we at theFederalReserve will perity be an inevitable bubble of resolution thehousing aboutthepossible didharbor concerns has notdealt In thenation. 2005 I noted, that "History euphoria gripped of of withtheaftermath protracted periods low riskpremiums" kindly 2005,p. 7). (Greenspan had a sufficiently never we However, at theFederalReserve strong we the that conviction about risks couldlie ahead.As I noted earlier, had beenlulledintoa stateof complacency theonlymodestly negative by of market crash 1987andthedot-com of economic aftermathsthestock we bust.Giventhathistory, believedthatanydeclinein homeprices to werenotperceived debtproblems be gradual. would Destabilizing those conditions. ariseunder to we Forguidance, lookedto thepolicy response theunprecedented and bust stock-bubble ofOctober 1987, the2000bearmarket. 19, one-day Reserve of to liquidity large experience, injections Federal Contrary prior

55. For detailssee Greenspan (2004a). the 56. Such actionswould obviouslyprovokean extreme politicalresponse.Although decisions of the FOMC are not subject to legal reversal,the range of monetary policy wisdomin acadeconventional to constrained whatconstitutes choices has been politically is the mia. As recentevidencereaffirms, Federal Reserve's degreeof policy independence or and fixedby statute, it can be altered eliminated statute. by

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had such the did apparently helpstabilize economy previously crashes retrenchment. ledtoeconomic and markets leveris choice abandon to Unless there a societal dynamic will I bubbles that someform central of planning,fear preventing age for their aftermath seemsthe in theendturn to be infeasible. out Assuaging and should focuson bothprivate public, bestwe can hopefor. Policies, and causedbydeflationary the of ameliorating extent deprivation hardship in increases capital, to But than crises. ifaneffective other substantial way, a on defuse bubbleswithout majorimpact economic growth leveraged in our it be werediscovered, would a major stepforward organizing marketeconomies. VI. In Summary In this I the economic forces that to paper haveendeavored trace powerful and inthe aftermaththe of ColdWarandledtoa dramatic decline emerged rates. Thatin turn of globalreallong-term interest engenconvergence home bubble dered, a dramatic first, global price heavily leveraged debt, by andsecond, delinking monetary a of from interest rates.57 policy long-term The globalbubblewas exacerbated thewidespread of by packaging U.S. subprime alt- mortgages securities, and A into which found willing at the buyers home(especially GSEs) andabroad, many encouraged by inflated credit Morethan decadeofvirtually a unrivaled grossly ratings. low and interest reduced rates globalprosperity, inflation, low long-term aversion historically to unsustainable levels. globalrisk Thebubble started unravel thesummer 2007.Butunlike the to in of in "debt-lite" deflation followed earlier that the dot-com leverboom, heavy set serial in is to as defaults, aging off culminating what likely be viewed themostvirulent financial crisisever.The majorfailure bothprivate of risk credit and management (including rating agencies) official regulation was to significantly the size of thetail risksthatwerelater misjudge in of default. capital liquidity Had and exposed theaftermaththeLehman to lossesbeensignificantly going into crisis, the provisions absorb higher defaults would havebeenfar less. contagious surely Thispaperhas argued that accordingly theprimary imperative going forward to be increased has and regulatory capital, liquidity, collateral

57. Whether latter continue a lessarbitrageable the will with international market bond remains be seen. to

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a of I banks. havealso noted number for and requirements banks shadow be initiatives may useful. that lessimportant reform of as Butthenotion an effective of "systemic regulator" part a regulaforeof The sad is ill advised. chronic state economic reform tory package on that issue.Standard should models, pause casting givegovernments couldnotanticipate when by except heavily adjusted ad hocjudgments, let thecurrent Indeed,modelsrarely crisis, alone its depth. anticipate forced themodel into is therecession artificially recessions, unless, again, structure. crisis is lessonofthis that In closing, mereiterate thefundamental let of of of thecomplexity thedivision laborrequired modern that, given to financial innovative we systems ensure globaleconomies, needhighly most But economies. although, ofthose the fortunately, functioning proper in much not.Andit is notpossible is is innovation successful, financial successof eachinnovation. adequate the advance discern future to Only If is can this and then, capital collateral resolve dilemma. capital adequate, will will and institution default serial no definition, financial contagion by should levelofrisk-adjusted theproper be thwarted. capital Determining forward. of focus reform be thecentral going assetsthat on We can legislate prohibitions thekindsof securitized alt-A But for crisis. markets newly thecurrent originated and aggravated debt collateralized obligasynthetic mortgages, subprime adjustable-rate vehicles investment structured and tions, many highly popular previously to no have investors shown inclination revive exist. Andprivate no longer new of a exhibit plethora innovative willno doubt The crisis them. next that characteristics no toxic willhaveunintended someof which assets, are But if capitaland collateral adequate, in one can forecast advance. who shareholders seekabnormal to losseswillbe restricted those equity losses.Taxpayto but returns intheprocess exposethemselves abnormal not ersshould be atrisk. and to editors to ACKNOWLEDGMENTS I wish express gratitudethe my most contheir for Brainard toGregory Stein, Mankiw, Jeremy andWilliam of of paper, course, The and comments suggestions. conclusions this structive own. aremy

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References
Framework for Basel Committee Banking on 2009. "International Supervision. - Consultative Risk Standards Monitoring and DocuLiquidity Measurement, ment." Basel:Bankfor International Settlements (December). in AllenN. 1994."TheRelationship between and Berger, Capital Earnings Bank94-17.Wharton Financial Institutions Center ing." (February). Working Paper Allen N., and David B. Humphrey. 1994. "Bank Scale Economies, Berger, and The Concentration, Efficiency: U.S. Experience." Mergers, Working Financial Institutions Center (June.) Paper94-25.Wharton and 2007. "World Real Interest Rates:A Desroches, Brigitte, MichaelFrancis. GlobalSavings Investment and Bank Perspective." ofCanadaWorking Paper 2007-16. Ottawa (March). Brian T. and 2009."Monetary Dokko, Jane, Doyle,Michael Kiley, others. Policy andthe Bubble." Finance Economics and Discussion Series. Housing Washington: Federal Reserve Board(December 22). Kenneth Martin Baily, Neil John Campbell, others. Y. and 2010. The French, R., the Princeton Press. SquamLakeReport: Fixing Financial System. University Alan.1996."TheChallenge Central of ina Democratic SociGreenspan, Banking American for Institute PublicPolicy ety."Francis BoyerLecture, Enterprise Research, (December 5). Washington . 1999."TheEvolution BankSupervision." of before American the Speech Bankers Phoenix Association, (October 11). . 2000a."Technology Financial and Services." the Speechbefore Journal ofFinancial Services Research theAmerican and Institute ConferEnterprise enceinHonor AnnaSchwartz, of 14). Washington (April . 2000b. "Banking the Bankers Supervision." Speechbefore American Association, 18). Washington (September . 2004a."RiskandUncertaintyMonetary in Policy." Speechat theMeetoftheAmerican Economic San Association, Diego(January 3). ings . 2004b. "Government-Sponsored beforethe Enterprises." Testimony Committee Banking, on andUrban U.S. Senate, Affairs, Housing, Washington 24). (February . 2005. "Reflections Central on Banking." Speechat a symposium sponsoredby the FederalReserveBank of Kansas City,Jackson Hole, Wyo. 26). (August . 2007. TheAge of Turbulence: Adventures a New World. in New York: Penguin. and 3rd Homer, Rates, ed. RutSidney, Richard Sylla.1991.A History Interest of Press. gers University Sebastian. 2010.MoreMoney ThanGod: HedgeFunds and the Mallaby, Making ofa NewElite.London: Bloomsbury. Office PolicyDevelopment Research, of and of and Department Housing Urban 2001. "HUD' s Affordable Goals forFannie Mae and Development. Lending Freddie Mac." IssueBrief 5. Washington no. (January).

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ShaneM. Sherlund, Gillian and 2005."TheEffect of Passmore, Wayne, Burgess. on Rates." Real Estate Housing Government-Sponsored Enterprises Mortgage Economics no.3: 427-63. 33, and Reshef. 2009. "WagesandHuman Thomas, Ariell Philippon, Capitalin the U.S. FinancialIndustry: 1909-2006."Working Paper 14644. Cambridge, Mass.:National Bureau Economic of Research (January). Is Carmen andKenneth 2009. ThisTime Different: Reinhart, M., Eight Rogoff. Press. Centuries Financial Princeton Folly. of University Statement before H. the Stern, Gary 2009."Addressing Too BigtoFailProblem." and U.S. WashtheCommittee Banking, on Affairs, Senate, Housing, Urban ington (May6). John 2007. "Housing Monetary M. and Policy." Speechat a symposium Taylor, Reserve Bankof KansasCity, Jackson Hole,Wyo. sponsored theFederal by (August). Actions and Interventions . 2009. Getting Track:How Government off Calif.: and Worsened FinancialCrisis.Stanford, the Caused,Prolonged, Hoover Press.

Comments Discussion and

COMMENT BY

N. GREGORY MAIMKIW Thisis a great It one paper. presents ofthe best narratives what about went over pastseveral the comprehensive wrong that If to students onepaper to years I haveread. youwant assign your only readabouttherecent financial this crisis, wouldbe a goodchoice.There aresomepiecesofthe about I which amskeptical. before get But I analysis tothat, meemphasize let several ofagreement. important points refers recent to events thehousing in market a "classic as Greenspan bubble." is certainly that He can from euphoric right assetmarkets depart in fundamentalswaysthat often are hard understand. has to This apparent and the before, it willhappen happened again.Whenthebubblebursts, aftershocks never are pleasant. then out the rather reducing than Greenspan points that political process, the risks associated the with bubble, contributed tothem. a footIn actually hepoints that October out in inthewaning note, 2000, daysoftheClinton the of and finaladministration,Department Housing Urban Development izedrules that theaffordable ofthegovernmentexpanded housing goals Mae andFreddie Mac. As a result, sponsored (GSEs) Fannie enterprises theGSEs increased their of holdings subprime mortgages substantially. neither nor that Although Greenspan I wouldsuggest thecrisiswas prithe of we believe these that marily result misguided housing policies, both served makea bad situation to worse.Thisfactis important to policies is than of to keepin mind notto assessblame;there more enough that in Rather, judginghow muchpolicycan accomplish go around. going one be of the forward, should mindful howimperfect political is. process When what future cando toreduce likelihood the considering regulation offuture that rules crises, Greenspan emphasizes whatever arepromulgated
247

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cannot premised policymakers' be on to an ability anticipate uncertain In wise. the future. myviewthisis particularly Somethink maincause to the of oftherecent crisis that is failed anticipate bursting policymakers If we bankers greater with the bubble. only hadcentral prescience, housing theargument goes,all thiscouldhavebeenavoided.In myview and, - this wishful in It is I believe, as thinking theextreme. Greenspan's well national econthe the indeed would niceifsomehow individuals be guiding In the our had to omy superhuman powers seeinto future. reality, economic in as the leaders mortals share samebiasesandflaws perception are who market participants. more can the What, then, be donetomake financial crash-proof? system First offers several obvious, capital goodsuggestions. andmost Greenspan it Thisis truer than haseverbeen.By now should raised. be requirements institution needed as well that financial out it, every major bailing almost of raisedtheexpectation as a fewthat not,thefederal did government in into financial the future bailouts, system, effect, a turning entire thereby will to creditors theseinstitutions view of GSEs. Goingforward, group in too The will as and them safe, so they lendtothem freely. institutions, to to low will to turn, be tempted respond their costofdebt leveraging by this are excess.Higher capital requirements neededto counteract newly moral hazard. expanded financial idea wills,"in which Second,I likeGreenspan's of "living to their ownplansto windthemselves intermediaries required offer are when future ideais that of fail.Theadvantage this downintheevent they willhavea gameplanin as they failures will,policymakers occur, surely to is willswillwork, financial hand. How wellthese however, hard living - the by maywell be contested "nextof kin" say. Like realwills,they willsto work, For transactions. living to theinstitution's counterparties them would needtobe madepublic say,byputting ona centralized they the after from the webpage to discourage counterparties complaining of in fact they that thought hadmore legalrights theevent liquidation they do. than they financial I like most and Third, perhaps important, theideaofrequiring when someregulainto debt will to firms issuecontingent that turn equity would this has deems thefirm insufficient that tor Essentially, debt capital. finanevent a future of inthe of a become form preplanned recapitalization would donewith be the crisis. most But cial priimportant, recapitalization firm Becausethefinancial wouldpaythe than vaterather publicmoney. it than rather enjoying costofthese subsidies, funds, taxpayer contingent for to loweritsriskprofile, instance wouldhavean incentive by today

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its The the it the the reducing leverage. less risky firm, less likely is that wouldbe triggered, thelowertheinterest thefirm and rate contingency would onthis debt. pay contingent I Thisbrings tothe conclusion the me one of paper with which disagree I The the or,atleast, wasnotsufficiently persuaded. issueconcerns importanceof leverage theviability a financial to of intermediary. Greenspan and but proposes raising capital requirements reducing leverage, he sugIf that are to is too he gests there limits this. leverage reduced much, argues, financial will intermediaries be notbe sufficiently to profitable remain viable.He offers someback-of-the-envelope calculations purport that to showhowmuch the needstostay afloat. leverage financial system WhenI readthispart thepaper, first of was,Whatabout my thought theModigliani-Miller theorem? Recall thatthisfamous theorem says that firm's a value as a business is of enterprise independent how it is financed. debt-equity determines therisky The ratio how cashflowfrom is divided creditors owners, itdoes notaffect and but operations among whether firm fundamentally as a going the is viable concern. seemsto It methat, leastas a first as the theorem should approximation, logicofthis to financial intermediarieswellas to other as ofbusiness. If apply types not? not, why I think is clear where,from Modigliani-Miller it the perspective, calculations awry. assumes He that rateofreturn the on Greenspan's go must at least5 percent. as he notes, number actually be But this is equity to degree leverage. a bank lessleveraged, equity If of is its endogenous the willbe safer, therequired ofreturn and rate should fall. one a with almost leverage all. Suppose no at Indeed, canimagine bank banks were tohold100percent reserves demand required against deposits, andthat bank all loanshadtobe financed percent bank 100 with A capital. bankwouldthen, essence, a marriage a super-safe in be of market money mutual fund with unleveraged an finance would (Sucha system company. be similar what sometimes to is called"narrow It banking.") seemstome that banking a under suchstrict couldwell system operating regulations the function financial of intermediation. No perform crucialeconomic would required. be leverage Such a system the transformation" would,however, forgo "maturity function thecurrent of financial in banksandother system, which many intermediaries borrow short lendlong. issueI amwrestling is and The with whether transformationcrucial is a feature a successful of finanmaturity cialsystem. resulting The mismatch seems be a central to element maturity ofbanking crises. The openquestion what is valueit panicsandfinancial

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has andwhether benefits today's the of financial highly leveraged system exceedtheall-too-obvious costs. To putthepointmostbroadly: The Modigliani-Miller theorem says and capitalstructure irrelevant, manybankers are would leverage yet claimthey central theprocess financial are to of intermediation. A surely on is out compelling question theresearch agenda to figure whois right, andwhy.
COMMENT BY

JEREMY C. STEIN

It is a pleasure comment this to on and important In AlanGreenspan. light thebreadth ground of of wide-ranging by paper I that covers, willhaveto focusmycomments justa coupleof the it on issuesthat struck as particularly me Thefirst these of concerns interesting. in anyattempt to thecentral of capitaland liquidity role requirements reform financial markets. thepaper As "Themost reform, states, pressing inmy in of is the judgment, theaftermaththecrisis to fix levelofregulastandards and required by tory risk-adjusted capital, liquidity, collateral I agreewith view.Moreover, this Chairman Greenspan counterparties." this to logmakes highly a welcome contributiontaking observation the by to the ical next he poses,andattempts answer, quantitative question step: Thisis a point on should raised. be ofjusthowhigh capital requirements silent. which most have far policymakers thus beenconspicuously to minimum ofbookequity assets ratio Thepaper for argues a regulatory a has in theneighborhood 14 percent. argument twoparts. The of First, the bankratio that 14percent would a calculation provide rough suggests a to with buffer a equalinmagniadequate see itthroughcrisis ingsector And another tude that the few to of last years. second, back-of-the-envelope minimum would that exercise the regulatory yields conclusion a 14percent it sensethat wouldnotprevent in notbe overly burdensome, thespecific in historical on from a banks averages. earning return equity linewith another I In thesamespirit simple of calibration,wouldliketo offer with associated raising the costs ofthe tothe second puzzle: piece approach is My points. analysis nothing by percentage requirements several capital cost of than application thestandard an more average ofcapital weighted toMBA students that everywhere, (WACC) machinery is routinely taught of totakeaccount the which (1958) augments Modigliani-Miller paradigm areraised that taxes. income requirements capital Suppose equity corporate - say, that Moreover, suppose at points. substantially by10percentage very debtin thecapital this themargin, additional long-term displaces equity

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the to banks. of structure theaffected According Modigliani-Miller, only on of neteffect thischange banks'WACC (and henceon theratethey the comesfrom lost for or for loans, example) charge corporate consumer is debt on taxdeductions thelong-term that eliminated. Thus,ifthedistax a then debtyielded, 7 percent, given 35 percent corporate say, placed raisethe would in tax reduction thedebt shield a 10-percentage-point rate, 25 or WACC by0.10 x 0.07 x 0.35 = 0.00245, about basispoints. Again, in increase theequity of this theimpact a very is ratio, equivcapital large all ratio 4 percent thewayup to the of a alent goingfrom low initial to of levelsuggested Greenspan 14percent. by and of a comeswith number caveats. this Of course, calculation First, the of be itshould thought as capturing long-run most important, perhaps on to costs steady-state of having holdmoreequity thebalancesheet, the with flow the whiledisregarding transitional costsassociated raising with associated selection Given adverse the newequity. problems required flow costsmaybe sigand issues(Myers Majluf1984),these newequity are if that higher This implies nificant. capitalrequirements phasedin - so thatbankshave to get there too abruptly through largeexternal retained than rather bygradually issues, accumulating earnings equity behavior on thetransitional maybe muchhigher lending impact their than 25-basis-point figure suggests. my taxesmaynotbe Another caveat that is evenina long-run state, steady conditions. violation theidealized of theonlyrelevant Modigliani-Miller and Metrick Gorton Andrew To takeoneexample, (2010) andStein Gary debt like short-term because that (2010)argue banks toissuecollateralized convenience basedon its a thisdebtcommands "money-like" premium If transactions services safeclaims that relative andthe provide. one safety on convenience to takes crude a bound this premium be 1 percent, upper have effect crowding suchshort-term of out andifcapital requirements the as to debtat themargin, opposed long-term this debt, wouldadd another for of 0.10 x 0.01 = 10basispoints theoverall to effect,1 a total 35 instead modifications also likely are of25. Thislogicsuggests other that sensible tohaveonly relatively effect. a small Allofthis would therefore toreinforcealbeit seem with quite a differ- the ent conclusions Greenspan's in that broad methodology namely, paper, with there undoubtedly associated are costs increases although significant in bankcapitalrequirements, a crudeestimate thesecostsdoes not of
1. Krishnamurthy Vissing-Jorgensen estimate convenience and the (2010) premium with associated Treasury securities be onthe to order 70 basispoints, of which that suggests a number probablyconservative bound. is my100-basis-point upper

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that are Said both and suggest they prohibitive. differently, his analysis minewouldappearto givesignificant comfort thosewhoworry to that will plausibly higher capitalrequirements makebankloansmuchmore expensive. Andyetthere wouldseemtobe an obvious tension Banksmanihere. care deal about their and structures, they festly a great optimizing capital In contrast, showa persistent to gravitate toward tendency high leverage. most nonfinancial of with lower firms, many which operate dramatically seldom to as drawn toward fixed leverage, appear be nearly strongly any structure. although Modigliani-Miller-plus-taxes So the target capital parasmallbenefits debt of for the digmmaybe adequate capturing relatively in different behavfor nonfinancial onewonders, light their of firms, very does leaveoutsomething first-order of whether sameparadigm not the ior, if when firms. simply: higher Put capital importance itcomesto financial on financial ratios haveonlya smallimpact theWACC for firms, do why - resist their nonfinancial them forcefully? so counterparts they unlike the this ownattempt reconciling tension as follows. at goes Perhaps My does in facthavethesamesmall substitution equity debtfinance of for firms financial nonfinancial - say,25 basis and effects theWACC for on ratio. Butwhatis for change points a lO-percentage-point in theequity of are different financial about firms thecompetitive implications a small firm An automanufacturera software is or disadvantage. cost-of-capital overa 25-basis-point to out cost-of-capital unlikely be driven ofbusiness of the ofitsproduct, loyalty other factors the so difference;many quality that canfail it more andso on areso much itscustomer base, important In survive. condimension still and on cost-of-capital tofully optimize the and is dominant for firm, trast, a financial cheapcapital thesingle input, it In cannot afford cede a 25-basis-point to itscompetitors. to edge simply like firms whata performanceis thissense,highleverage forfinancial to is elitesprinters: ifthedrug harmful health even enhancing is for drug with else all their from of andcutsonlya fewhundredthsa second times, it. not can not so closely matched, may feelthey afford totake they stricter much makes the Onthe hand, drug one regulation capital analogy form ifit a seemlikea no-brainer: canstop systemically unhealthy ofcomon with case,on the (in impact performance this petition onlya minimal then and costofloansto corporations households), itwouldseemhighly like much is The a desirable from socialperspective. hitch, however, that, for motive create powerful a forces the with drug testing, samecompetitive is for evasion migration channel this One the evading regulation. important to sector theless regulated from regulated the ofcredit creation banking

COMMENTS and DISCUSSION

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shadow sector. example, For instead keeping consumer on of a loan banking itsbalance tothe more a can sheet, rules, bank bunsubject stringent capital dletheloanwith similar loansinto security, a which winds say, other, up, intheportfolio a hedge of in which turn finances purchase the its of fund, with andonly very sliceofcapital. a thin security largely overnight repos suchmigration leave thebanksthemselves it safer, is Although may much clearthat leavesthefinancial less it in a system better shapeshould crisis occur. One ofthemost dramatic features thesubprime of crisis was thecomplete for securitiesandnot collapseofthemarket asset-backed thoserelated subprime to but just mortgages, also thosebased on auto credit receivables, card student and assets. Thismarket loans, loans, other which was arrested by theFederal Reserve's intervention collapse, only with Term the Asset-Backed Securities Loan Facility an (TALF), played role the crunch. important indeepening credit The bottom is that do notworry muchabouttheeffects I line too of on thecostofloansto households firms. and higher capital requirements Basedonthesorts calculations of sketched is above, bestestimate that my these effects be relatively will muted. thesametime, worry great At I a deal abouttheeffects howand bywhom on credit provided, the is and ofthese for overall potential implications changes systemic stability. To be clear, do notatall mean suggest capital I to that for requirements banks should be significantly not if to Indeed, forced picka number higher. for required the I well in ratio, might comeoutsomewhere thesame capital as Greenspan. the of to However, danger competition range leading evasion of thecapitalrequirement that not suggests thefocusshould be just on or institutions. an must banks, evenjuston all bank-like Rather, effort be made impose to similar standards acrossa given assetclass,nomatcapital ter whowinds holding asset.Thiswillnotbe an easytask, one the but up toolthat be is of might helpful broad-based (that regulation "haircuts" is, minimum on securities trade the that in margin requirements)asset-backed shadow market. to theprevious this banking Returning example, regulation that holds tranche a consumer secua of loan might stipulate whoever be a or ritization, it a hedgefund, pension fund, anybody else,wouldbe to haircut that The required posta minimum against tranche. valueofthe haircut would ontheseniority the of tranche, underlying the collatdepend If haircut are eral,and so forth. these requirements wellstructured, they couldgo a longwaytoward harmonization organizational across achieving in there would no obvious be basedon avoidance forms, that of advantage to moving consumer the loansoff balancesheets banks the of regulation andinto shadow the sector. banking

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of he My reading Greenspan's paperis that is fundamentally sympathetic this to and that approach, indeed hehassomething much very along these linesin mind when refers theneedto "fix levelof... colhe to the If so, lateral standards other required counterparties." I hopethat by poliwillpaycareful attention hisadvice. to cymakers On a different I aminclined be more to of note, skeptical Greenspan's when downplays roleoflowshort-term he the interest inthe rates analysis initial ofthehousing boom.He writes, "Theglobalhome bubyears price ble ... was a consequence lowerinterest of but rates, it was long-term not rates interest that rates galvanized homeassetprices, theovernight of conventional wisdom" central as hasbecome seeming the banks, (emphasisinoriginal). ownsuspicion that is short-term didplayanimporrates My for tantindependent by reducing required the role, monthly payments are borrowers outadjustable-rate (ARMs),whoserates mortgages taking that This hypothesis tiedto short-term market rates. presumes someof their or so these borrowers either were constrained, that myopic liquidity - as opposed theexpected over to initial payments the monthly payment in this choice.Although presumption lifeoftheloan was decisive their of the of characterize behavior themajority borrowmaynotaccurately as it more true a descripersinnormal estate real markets, perhaps rings boom. tionoftherecent subprime evidence myhypothfor In anycase,althoughdo not I haveconclusive 1 for set one esis,I can offer suggestive ofplots. Figure plots, eachyear in mortof from 2001 through 2006,theshare fixed-rate mortgages total areas (MSAs) statistical initiated each of 269 metropolitan in gages index MSA. The affordability is index an against affordability forthat in income median and s from family Moody' Economy.com is basedonthe on a median-priced to an MSA relative themonthly mortgage payment fixed-rate a MSA (assuming conventional homein that loan). mortgage that to valuesoftheindexcorrespond greater affordability, is, to Higher to ratios incomes home of prices. higher the two keymessages. The figure First, throughout period, conveys conwhere inmore ARM use is more cities, liquidity expensive prevalent on to more are straints presumably likely be binding homebuyers. Second, 2002 and between more becomes thisrelationship strikingly pronounced out funds ratewas bottoming and homeprices 2004, whenthefederal with is effect consistent thekey This to risedramatically. latter began rate short-term that mechanism namely, the my underlying hypothesis, for to its works payments incomethrough ability reducethemonthly ARMs. with their who borrowers finance homes constrained

COMMENTS and DISCUSSION in Figure 1. Share of Fixed-Rate Mortgagesand Housing Affordability 269 MSAs, 2001-06

255

Source:Benjamin Harvard Business Federal Reserve BankofNew York, Iverson, School,andJames Vickery, and the Monthly Interest Rate Surveyfrom FederalHousing the usingdata fromMoody's Economy.com Finance Agency. a. Each observation for single is a MSA. The affordability is basedon theratio median index of income family in an MSA to themonthly on fixed-rate for homein that payment a conventional mortgage a median-priced MSA. Highervalues of theindexindicate ratioof medianincometo (that greater affordability is, a higher Linesarefitted lines. mortgage payment). regression

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this and work would required be is Again, evidence only suggestive, more I with of to support story havein mind the anyrealdegree confidence. I believe the ofshort-term inthe that role rates ata Nevertheless, minimum, recent bubble remains important question. an housing open
REFERENCES THESTEIN FOR COMMENT Metrick. 2010. "Securitized Gorton, Bankingand theRun on GaryB., and Andrew Mass.: NationalBureauofEconomic 15223. Cambridge, Repo." Working Paper Research. 2010. "The Aggregate Arvind,and AnnetteVissing-Jorgensen. Krishnamurthy, Demand forTreasury Debt." Working paper.Northwestern University. H. andMerton Miller.1958. "The Cost of Capital,Corporation Franco, Modigliani, EconomicReview48, no. 3: American Financeand theTheoryof Investment." 261-97. and Stewart andNicholasC. Majluf. 1984. "Corporate C, Financing InvestMyers, Do That Investors Not Have." mentDecisions When FirmsHave Information Journal Financial Economics13,no. 2: 187-221. of WorkC. Stein, Regulation." Policyas Financial-Stability Jeremy 2010. "Monetary University. ingpaper.Harvard

thanks Chairto GENERALDISCUSSION Several expressed panelists in that and his to nation for candor stating for service the his man Greenspan views. somelong-held to had the events the few of last years ledhim revise of Stein in presence taxes with Mankiw Jeremy that the Gregory agreed wellrespond banks to over for there a preference debt is may equity, which is the If that thecase, then policy is other firms. more than prescription for the the reform taxcodetoeliminate preference debt. clear: on consensus there an to whatseemed incipient AlanBlinder pointed what thismayoversimplify might of twotypes bubble, although being the includes tech which of Bubbles thefirst be type, really a continuum. and than rather leverage are of late stock bubble the 1990s, basedonequity are the include recent which thoseof thesecond, whereas crisis, credit, based on excessiveleverage.The Greenspan-Bernanke mop-up-after the to continues makesensefor first crises viewofhowtodealwith type has Reserve inforis the One reason that Federal the butnotfor second. If the in mational part. especially banking system, advantages thecredit riskregulator an weredesignated explicit Reserve theFederal systemic would thatinformational financial over the entire advantage system, evenlarger. become

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in that Blinder with equity capital thefinancial Greenspan more agreed of but institutions tobe part thesolution, he was has structure financial of There potentially intermediis an it unsure whether is thewholesolution. as between forced atecourse action of bankruptcy,inthecase ofLehman can and as Brothers, bailout, in thecase ofAIG. The government stepin fire and grabholdof thereins, management, outtheshareholders, wipe firm either into and takethefailed somelosseson creditors, then impose or to such Authority undertake resolutions receivership conservatorship. bubwillbe an important ofanyreformnotbecauseitwillprevent part and when butbecause willmitigate fallout thecosttotaxpayers it the bles, is more collateral behind Related this theneedto require to they happen. to ofover-the-counter derivativesthecapital markets analogue purchases bank Onecouldgo further more lessforce and or derivincreasing capital. a atives transactions organized onto exchanges, imposinghigher by capital for not on Reform should also requirement derivatives traded exchanges. include about go-for-broke the incentives were that ramdoing something in in markets therun-up thecrisis. to pant financial Friedman observed strengthening requirements that is Benjamin capital also aboutaccounting reform. is Often what matters notjustthespecific assets must backed equity, also thespecifibe but percentage which by by cation the of asset which percentage multiplied. examthat total For by gets in at was that were ple,thechief problem Citibank the$100 billion assets off balance the and which bank the heldzerocapisheet, therefore against tal. The comparable off-balance-sheet amount Lehman at Brothers was In reform notchoosing newpercentis a $50 billion. eachcase theneeded that be a more inclusive agebutrequiring capital heldagainst much specification thefirm's of assets. Friedman thought Modigliani-Miller also the which had perspective, beensuggested both was but discussants, interesting led to a troubling by conclusion. standard The theorem assumes onlyno not Modigliani-Miller butalso no bankruptcy. banking Ifthe as a wholeis operattaxes, system then is to ingat one levelofleverage, anyone bankthat forced makedo with leverage at a competitive less is If disadvantage. thebanking system someminimum amount leverage do business, implies of to this requires someprobability anybank(orevenall ofthem) of and in failing, this turn either publicsector a or of requires subsidy thepossibility a taxpayer If bailout. that so, itmeans is there cannot a banking be sector unless the banks havea leverage ratio toputthetaxpayer collectively high enough atrisk.

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Friedman for on choice between Finally, poseda question Greenspan the the and Before regulation publicinstitutions regulation creditors. by by had and that was crisis, Greenspan argued forcefully articulately thelatter The critical oneas ofthe of other. was however, as sharply superior. paper, of Friedman therefore wondered whether experience thecrisishad the on of changed thinking therelative advantages thetwo. Greenspan's matuOlivier Blanchard followed on Mankiw's remarks up regarding In the havea longer transformation. aggregate, savers most rity probably to Muchofthis is retirehorizon thefirms which lend. than they saving for has ment other or whereas much long-term physical capital a life purposes, of shortat themacro thetransformation of about10 years. Thus, level, does notseemthat term intolong-term investment yet important, saving in that institutions involved precisely process. are many of Martin amongnoneconomists Baily laid out two viewsprevalent whose it what causedthecrisis: is that was all about one bankers, greedy The is it of worst kind. other that was actions a failure the produced market either theregulators of housing of or a government failure, policy.For the is the was whothink culprit federal the those policy, answer tochange - togetthegovernment ofthewayandletthemarket work. For out policy the is was those whothink problem market the failure, answer tostrengthen market failure s crisis caused both was ButinBaily' viewthe by regulation. extent things tobe both have to andthereforesome andgovernment failure, in done somemixoflessgovernmentsomeareasandmore government inothers needed. is but doesnot cannot forecast be that precisely, that Bailyagreed bubbles one be that canorshould donewhen seesa bubble mean nothing forming. or whether when not Ifyouknow havehigh cholesterol, may know you you anti-cholesterol a but willhavea heart attack, itis still goodideatotake you and Whenpolicymakersbothfinancial medication. regulators mone- observe highly in increase assetprices, a authorities they leveraged tary in even should something, though risk do diagnosis. wrong their they being that of out It is worth against policy atleastleaning taking theinsurance Reserve to the wind.It wouldalso be a goodidea for Federal particular marto theability adjust it tool haveanother that presently lacks, namely, to of or example, set requirementsall kinds for ginrequirementscapital mortintheevent an incipient of for minimum down payments mortgages gagebubble. had hazard beencrethat to Bailyagreed, somedegree, a largemoral in debtors theheatofthecrisis, to weregoodreasons protect ated.There that regulabelieve the investors a butdoing alsocreated danger: so might

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tors willnotregulate nexttimeeither. theother the On the hand, moral hazard can be overstated. managers financial The of institutions problem havecertainly taken hit:almost theinstitutions gotintotrouble a all that havereplaced their Shareholders taken big hitas well. have a managers. Theproblem mainly thedebtors' is on side,anditneedsto be dealtwith the willsandother resolution mechanisms Greenspan that through living tomakesure thedebtors that cannot walkawayunscathed. mentioned, Carroll calledthePanel'sattention thefact to that Robert Christopher in 1996speech theFederal at had of Shiller, a December Reserve, warned a bubble inthestock andthat January in market, 2004,speaking emerging Shiller warned a bubble had of in Reserve, againattheFederal emerging thehousing market. whenRobert Shiller enters precincts the of Perhaps theFederalReserveBoard,he takeson supernatural powersthatgive himintuition thissubject others on that lack.Butifone or at leasta few economists strong have intuitions a bubble intheprocess that is respected of forming, does seeman appropriate forregulators think that time to about more becoming vigilant. Sims that sector Christopher citedthepaper'sobservation theprivate didnotseemtoprice risk wellleading tothecrisis. This systemic very up thepresence an externality: becauseprivate of do not suggests just agents take account the of risks impose thesystem not on does mean systhat they temic doesnot risk exist. That markets notseemtoreact this the did to risk inadvance raises question whether the of coulddo better. There regulators is somechance that right the kindof regulators coulddo better, through information collection examination accounting or of aggressive practices, for Thenthequestion becomes howtoavoidregulatory example. capture. In theyears to thecrisis, hadbecome it difficult to leading up politically Oneargument assigning for more suggest tighter regulation. responsibility forsystemic to thansome other regulation theFederalReserverather is the Reserve a dedicated has revenue source its and agency that Federal serve14-year terms. Thesethings a longwaytoward governors go making and them avoidcapture. to regulators independent allowing the Georgevon Furstenberg interpreted paper'smessageto private financial institutions"Go aheadand spillit we willmopit up." Yet as thispolicy, argued, already to enormous he has led of underpricingrisk andsubsequent socialization enormous of losses. Thiswasindeed oppothe siteofcentral In what words, planningitwascentral bungling. other producesa deviation from market models to let markets perceived is be as in an egregious itis important takeprecautions to failing way.Therefore, andbuffer system the the effects bubbles. bubbles of If against destructive

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on Papers Economic Activity, 201 Brookings Spring 0

arenotpreventable, much then are Some greater precautions necessary. in nowtheFederal ofthese haveabsurdly kicked after fact: the Housing Administration theGSEs have increased and their standards; lending nowfirms AIG aresubject specialmargin There like to requirements. are the of to that be donetoreduce vulnerabilitythesystem can many things if hailstorms but exist there must If youknowthat be. bubbles, bubbles There cannot havetostand outdoors bareheaded. them, do not predict you theonlycourseis notjust are waysto reduce your exposure. Certainly but that to mopup afterwarda strategy in thiscase has beenanything to and market and directed, has beenvery costly incomplete extremely thetaxpayer. that Richard CooperagreedwithGreenspan banks,at a minimum, finanand other should subject higher to be capital requirements, perhaps is as cial institutions should well.He wondered that why general point not - whynot, example, minimum for evenmore impose broadly applicable had The on downpayment requirements homebuyers? FederalReserve to such the itregulated impose full to requireauthorityrequire institutions such in of ments; thespirit Baily's anti-cholesterol metaphor, imposing the have prevented heart in 2003 and 2004 might attack, requirements at what known thetime. was given Friedman theneedfor on with reform, accounting Cooperalso agreed vehicles thelike and investment structured for and specifically bringing He balancesheets. was at leastas interested, ontobanks'consolidated and of the in principles however, the governing valuation assets liabilities, for do markets notexist(forventure whenregular capital, particularly counin as havefrozen, happened late2008.Inthis orwhen they example) National calledthe to rules body private try, accounting areleft anentirely that under principle all the which Standards Board, operates Accounting statements onto be information canconceivably brought thefinancial that ontothebalancesheetare and should Transparency bringing be. things for whether process the however. twodifferent Cooperwondered things, a or to in standards general ought be reviewed, whether accounting setting that tobe established would standards setofregulatory ought accounting on rather relying mark-tobe usedforsetting requirements, than capital have valuations tobe artificially when market market rules, particularly the transactions. from fewdistress a or simulated taken medanti-bubble that Martin Robert Hall noted Bailyhadprescribed But existed. the of medication that ifa best-selling as ication already type bank rate the was by paper'sargument that interest controlled thecentral to at anti-bubble is notan effective medication, leastwith respect real

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estate. investors the from pieceof a Prospective capitalizing valuestream realestate lookfar into future, thecentral the bank'sinfluence limis yet ited a relatively horizon. pointed that to short Hall out countries that many - andthegreat - also hadhugehousdidnothaveARMs do majority not The to interest as what rates ingbubbles. evidence points low long-term matter whenvaluinghousing, and therefore thatit was low suggests not rates, short-term that rates, causedwhatbecamea globallong-term worldwide bubble. Hallwent tonote the on that other anti-bubble medication, suggested by Richard involves frictions financial into markets Cooper, introducing by down or There nothing is regulating payments margins. intrinsically wrong ordangerous about that holdloans, making risky provided theinstitutions theloansarenothuge, andsystemically ing highly leveraged, important. a more robust financial is to Getting much system thesolution this probmedication. economy The rodethrough equity the lem,notanti-bubble bubble popped 2000without financial that in crisis. should ableto It be any ride a realestate bubble as well. through just Justin Wolfers noted that paperwas largely the silent theshadow on and of banking system hopedformorediscussion that topicin thefinal draft.