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To: ManyMoose who wrote (91275)	10/21/2008 9:12:45 PM
From: TimF	Respond to of 541284

More Government Induced Crisis Mike Rappaport Arnold Kling, who has taught me more about this crisis than anyone else, writes: An FDIC document on the risk weights of different bank assets. The higher the weight, the more capital the bank has to hold against that asset. As I read table 1 and table 3, if you originate a loan with a down payment of 20 to 40 percent, the risk weight is 35. But if you buy a AA-rated security, the risk weight is only 20. So if a junk mortgage originator can pool loans with down payments of less than 5 percent, carve them into tranches, and get a rating agency to rate some of the tranches as AA or higher, it can make those more attractive to a bank than originating a relatively safe loan. If you want to know why securitization dominated the mortgage market, this explains it. Regulatory arbitrage, pure and simple. In other words, the regulatory system promoted securitization rather than larger down payments. And since larger down payments are probably the most important ingredient of safe mortgages, we have a significant incentive towards securitization. I had suggested something like this previously when talking about the rating agencies, but this is more specific. The government failure story here just keeps on growing and growing. Update: Dan Simon challenges this post in the comments. Well, Dan, I appreciate the attention and the challenges. They help me get clearer on the financial crisis. That said, I don’t agree with you. Before getting into the narrow issue of these capital requirements, let me briefly note two wider aspects of the subject. First, I have previously argued, and won’t repeat here, how Fannie and Freddie were an important cause of the problem. This post here helps to explain why the securitization expanded beyond mortgages securitized by Fannie and Freddie – an issue you previously raised in your comments. Now, to address your main point. You write: The banks, bond dealers and bond rating agencies essentially colluded to exploit a subtle loophole in the regulations, allowing them to mask risky investments as safe ones so that they could dodge the reserve requirements and invest more heavily in high-risk, high-return securities. The risky investments went sour, and some banks became insolvent. The obvious conclusion is not that ill-advised regulation led the banks astray ("regulatory failure", as you put it), but rather that an insufficiently stringent regulation regime allowed the banks to circumvent it, with disastrous results. I believe your point is mistaken in a couple of ways. First, regulatory failure does not mean that the best response is to eliminate a regulation. It means that a bad regulation led to a problem, which is what happened here. Second, you write that the “banks, bond dealers and bond rating agencies essentially colluded to exploit a subtle loophole.” Well, not exactly. The banks were responding to a capital requirement that made it advantageous to buy securitized loans. It is not clear whether the banks understood that the securities were risky. But even if they did, they would have been responding to a regulatory environment where deposit insurance gives them a significantly reduced incentive to avoid risk. The capital requirements were set up to address that incentive, but they appear to have been badly written. Why the regulators made that mistake, and why they rely on the rating agencies which have been long known to be problematic (see my colleague Frank Partnoy’s work on this), I don’t know. The bottom line is not that the regulations “led the banks astray,” but instead that the regulations set up poor incentives and those incentives led to bad results. rightcoast.typepad.com

To: ManyMoose who wrote (91275)	10/21/2008 9:19:17 PM
From: Cogito	Read Replies (1) \| Respond to of 541284

>>They get public money. They try to influence the outcome.<< MM - There is an offshoot of ACORN that gets public money. It is no longer part of the organization that, among many other things, registers people to vote. - Allen