Wall Street History

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Wall Street History

03/06/2009

Martin Feldstein on the Origins of the Crash, Part II

Last week I noted some excerpts from an interview with Harvard economist Martin Feldstein for PBS’ Frontline program, “Inside the Meltdown.” Feldstein did the sit-down in December but I thought some of the topics he discussed were a good tutorial on the crisis…thus I present a bit more. 

[On the role of the regulators…and being seemingly asleep at the switch] 

Feldstein: How did it happen? They went in, and they looked at the assets, and they saw that these were highly-rated, AAA mortgage-backed securities. They asked themselves about the off-balance-sheet special-purpose vehicles. The banks could reply, “Well, under the international banking rules, the so-called Basel rules, those don’t have to have as much capital as ordinary on-balance-sheet obligations.” Mortgages are allowed to have half the capital of loans to AAA companies. So these are strange rules, but the supervisors didn’t make them up. 

And you can then say, well, why in the world did the international banking folk come up with these rules? I suppose they looked at history and said: “Well, mortgages have been very safe assets, while companies are not so safe. And we have to have rules that were in many countries, and so we can’t have different standards for a AAA U.S. company and a AAA German company, so that’s the way we do it.” 

These mortgage-backed securities that were rated AAA were a relatively recent invention of the financial engineers. They could take a group of low-quality mortgages and create out of that a series of bonds, of mortgage-backed securities – that’s a fancy way of saying bonds – some of which were considered very risky, but others were considered very safe. 

Yes, it’s a particular form of collateralized debt obligation. Let me describe a very simple way in which this might work. You take 1,000 subprime mortgages; each one of those is a risky security. But you know they’re not all going to fail, so you agree on the following thing: Somebody will get the payments on the first 100 to fail. So if none fail, he gets full interest on whatever the obligation is. But the first 100 to fail are his problem, that institution’s problem. So that’s very risky. He knows that. He says, “I’ll only buy that security if you give me a very high interest rate,” and that’s agreed. 

But the chance that there will be more than 100 failures is pretty small. So the next 100 to fail is considered a different security, and that security carries a lower interest rate…therefore the fellow who’s got the 201st mortgage, very low. So that’s already probably a AA or AAA security because it’s so unlikely based on history that it would fail. 

So you take these tranches – these slices – one after another, and by the time you get to the third or fourth slice, people would say: “Well, there’s no chance at all based on the history that we have examined that there will be any defaults there at all. That is better than a AAA bond; that is better than a U.S. government security.” And so those things were called super senior debt. 

So the idea was that they created these different-quality mortgage-backed securities out of a pool of otherwise look-alike, very poor-quality underlying mortgages. 

One of the problems was that when they did this, they based this rating, how likely or unlikely it is that these will default, on very recent history, last five years or so. Well, those were five wonderful years for the real estate market. House prices were going up, in some years at double-digit rates. So it was very unlikely that there would be defaults on individual mortgages, and therefore, things looked much better than [they] turned out to be. 

Once house prices peaked and started coming down, then we began to see very substantial defaults, and the thing that triggered the crisis in the middle of 2006 and on into 2007 was that there were many more defaults on subprime loans than anybody expected, because all of these ratings were based on a favorable period in which house prices were rising, and now we were in a unfavorable period in which house prices were falling. 

[So instead of going back 20 years and saying what’s the worst year, what’s the best year, and finding a good average that way?] 

Right. But the rating agencies, in their defense, would say the world is always changing, and so we look at the recent past because the distant past may be very different. Well, it turns out that the future may be very different from the recent past as well, and that’s where they got it wrong…. 

[The supervisors] were not asking the right question. They were looking at the fact that others more technical than themselves had evaluated these mortgage-backed securities and given them AAA ratings or super senior ratings. And so they, the supervisor on the ground in the banks, could say: “Well, we’re not supposed to dig down more deeply into these complex securities. Somebody else has done it for us, and we’ll take their word for it.” That was the mistake. 

There were also in these processes lots of people who say to us: “I’m at a party. The punch bowl is there; I’m not going to leave the party.”…. 

People get drunk doing that. [William] McChesney Martin was chairman of the Federal Reserve back a number of years ago, [from 1951 to 1970], who said the job of the Federal Reserve was to take away the punch bowl when the party is just getting good. He was talking about in terms not of individual securities but of an economy that could be overheating. And so it was the job of the Fed to slow the economy down to prevent inflation. But you could use that same analogy here and say the supervisors should have done something; perhaps even the Fed in its monetary policy should have done something to slow down this housing bubble. 

Feldstein: Moral hazard has nothing to do with morals or morality. It is that people will respond, institutions will respond, to incentives to take risks or to do other things that are inappropriate because of the incentive structure. 

So, what’s a good example of that? If people have very good insurance, they may be less careful about locking their car when they park it, because if it’s stolen, well, the insurance company will pay for it. An economist would say that’s an example of moral hazard. If they didn’t have that insurance, they’d have locked the car. 

So translating that into Wall Street, if you think you can take very big risks as a financial institution and in the end get saved by the Federal Reserve or the Treasury coming along, then you’re going to take very big risks. You’re not going to bother to lock the car. And so that’s the moral hazard that they worry about. 

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