Wall Street Didn’t Cause The Last Financial Crisis; Government Won’t Prevent The Next One

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We are approaching the tenth anniversary of the start of the 2008 economic crisis. While the causes of the dramatic global market downturn were numerous and complex – and remain subject to continuing debate to this day – the impact on financial institutions is clear. Some of the world’s largest financial institutions either went bankrupt (Lehman Brothers), were absorbed by commercial banks (Merrill Lynch and Bear Stearns), or were effectively nationalized (AIG, Fannie Mae and Freddie Mac).

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While no one should downplay the massive financial dislocation that occurred, I believe that some elected officials and regulators created a false narrative after the crisis and have promulgated it for nearly a decade. Their narrative holds that Wall Street and lax regulation, rather than bad government policy, “caused” the downturn.

The government-sponsored Financial Crisis Inquiry Commission report (2011, p. xviii) concluded:

“The sentries were not at their posts, in no small part due to the widely accepted faith in the self-correcting nature of markets and the ability of financial institutions to police themselves.” 

President George W. Bush made a similar point, albeit in more colorful imagery, in 2008:

“Wall Street got drunk…and now it’s got a hangover. The question is how long will it (take to) sober up and not try to do all these fancy financial instruments.”

Unfortunately, nearly ten years later, our financial institutions remain hobbled by regulations crafted by elected officials and unelected regulators who created this false narrative. This remains the case, despite measures Congress is now considering to lift some regulatory burdens imposed in the aftermath of the crisis associated with Dodd-Frank.

The fallout from this false narrative is more than excessive regulation. The credibility and reputations of financial institutions ranging from banks, asset managers, and brokerage firms still suffer from the public's impression that they were careless or even criminal.

If the diagnosis of the problem is wrong, so too will be the prescribed cure. Proper diagnosis requires one to differentiate between problems that occurred on Wall Street from problems with Wall Street. In other words, Wall Street may have been afflicted with a severe cold, but it does not mean that Wall Street created that cold or wanted to inflict the cold on itself.

Such a distinction is crucial and will enable us to realize that see the massive regulatory increases have saddled global financial institutions with enormous costs, hampered innovation, and reduced the capital available for investment in economic growth.

Taking stock ten years later, we know that mortgage-backed securities, collateralized debt obligations, credit default swaps and other complex instruments were heavily impacted by the downturn. But that does not mean we should attribute the economic crash to these instruments – or to the Wall Street institutions that created them. Even though problems were showing up in market values, private market governance was actually functioning effectively, even in highly complex markets associated with the financial crisis.

The reality is that during the 2008 economic downturn, the advanced financial instruments and contracts that many people point to as “causing” the financial crisis were simply reacting to changes in economic variables. Products such as collateralized debt obligations sliced up pools of debt into different “tranches” with varying levels of risk. They let risk averse investors such as pensions to essentially pay other investors to assume risk of problems with the pool first (the first loss investors) and the interest rates varied accordingly. Such products allow investors to assume different risks, depending on their desire for returns and risk appetites, but they were never intended to eliminate all risk. Many of the problems experienced with these products were due to large-scale fluctuations in the markets, with the largest losses taking place in the riskiest classes (which certain investors had sought out).

Similarly, with credit default swaps, such contracts were created so firms could hedge or get some insurance against others’ defaulting. When the economy weakened and credit events occurred, firms that had been “paid” to assume risks were obliged to do so. The situation was similar to an insurance company having to pay after storm. While many investors in collateralized debt obligations or credit default swaps did not fare as well as they had initially hoped, these instruments largely functioned as designed, and actually helped some parties mitigate risk. The fact that many firms’ portfolios were contractually intertwined, such that the problems of one firm affected the financial stability of another firm, does not signify a failure of Wall Street.

Of course, we should not make excuses for institutional failures of judgment or outright fraud. Many investors and firms certainly made imprudent investment choices based on unrealistic assumptions about housing appreciation, for example. On the other hand, those firms that chose to invest in the safest investment vehicles were exposed to fewer problems than those who willingly assumed more risk.

Not every firm will always exercise sound judgment, with the result that market and competitive forces will weed out poor-performing firms over time. The mistake made by government, based on the false narrative of an inept or malevolent Wall Street, is to create rules and regulations with little concern for the costs or growth constraints imposed by those rules.

Article By Edward Stringham, Ph.D., President, American Institute for Economic Research and Professor at Trinity College

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