http://econlog.econlib.org/archives/2008/12/my_planned_oral.html

by Arnold Kling

Chairman Waxman, Ranking Member Davis, and Distinguished Members of
the Committee:

It is a privilege to be asked to testify in this forum today regarding
the collapse of Fannie Mae and Freddie Mac and the ongoing financial
crisis. My name is Arnold Kling. My training is in economics, and in
the late 1980's and early 1990's I worked at Freddie Mac, where I was
present at the creation of several quantitative risk management tools
that paved the way for innovations in mortgage finance.

Speaking as a former financial engineer, I have many regrets about the
role played by modern financial methods in this crisis. Rather than
speak defensively about financial innovation, I want to offer
constructive suggestions for public policy going forward.

I emphatically disagree with the extreme partisan narratives for this
crisis. To blame the Community Reinvestment Act for what happened is
wrong, To blame financial deregulation for what happened is wrong. The
narrative I present in my written testimony describes a combination of
government failure and market failure.

I want to focus on how both industry executives and regulators were
fooled about the risks in the system. In particular, perverse
incentives in bank capital requirements encouraged unsound lending
practices and promoted excessive securitization.

When a bank originates a low-risk mortgage, why would the bank pay
Freddie Mac a fee to guarantee that mortgage against default? Freddie
Mac has no intrinsic comparative advantage in bearing the credit risk.
However, in practice, the bank was able to reduce its capital
requirements by exchanging its loans for securities. For bearing the
exact same credit risk, Freddie Mac was allowed by its regulator to
hold less capital than the bank.

By requiring Freddie Mac and Fannie Mae to hold less capital than
banks, our regulatory system encouraged Freddie Mac and Fannie Mae to
grow at the expense of traditional depository institutions. That
turned out to be dangerous.

The perverse regulatory incentives were even more striking with
high-risk loans. If a bank originates a high-risk loan, you would
think that there is no way to avoid high capital requirements. But it
turns out that when a high-risk loan has been laundered by Wall
Street, it can come back into the banking system in the form of a
AAA-rated security tranche. This means that from the standpoint of
capital requirements, bank regulators close their eyes and pretend
that the risk has disappeared..

My reading of the history of the secondary mortgage market suggests
the following lessons.

1. Capital requirements matter. Details that are easily overlooked by
regulators can turn out to cause major distortions.

2. Securitization is not necessary for mortgage lending. On a level
regulatory playing field, traditional mortgage lending by depository
institutions probably would prevail over securitized lending. Rather
than try to revive Freddie Mac and Fannie Mae, I would recommend that
Congress encourage a mortgage lending system based on 30-year
mortgages originated and held by old-fashioned banks and savings and
loans. This would require instructing the regulators of Freddie Mac,
Fannie Mae, banks, and savings and loans to all use the same capital
standard for mortgages, one that is based on a stress test
methodology.

3. Subsidized mortgage credit is an inefficient tool for promoting
home ownership. Unless what you want is home buyers who are buried in
debt and speculating on house price appreciation, I recommend that
Congress not try to create cheap mortgages and instead use other means
to encourage home ownership.

4. Recent financial innovations, particularly credit default swaps,
have changed our financial system in ways that current policymakers
fail to recognize. Bailouts and rescues are counterproductive in
today's financial crisis. Within the financial sector, de-leveraging
needs to slow down and the process of shutting down failed
institutions needs to speed up. Relative to these necessities,
handouts from the taxpayers are a hindrance, not a help.
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