Engineering the Financial Crisis: Systemic Risk and the Failure of Regulation [Hardcover]

Since the bursting of the real estate bubble in 2008, a slew of books have been published claiming to provide the definitive narrative of what caused the financial crisis and resulting economic malaise. Some blame irrational exuberance while others have attributed the blame to deregulation or poorly aligned economic incentives between bank executives and their principals. Given the irreducible complexity of our global economy, it is quite possible that we will never know the correct narrative - assuming that one exists - and that the whole debate is more ideological posturing than anything else.

Of the books that I have read, "Engineering the Financial Crisis" is the best so far, not because I think that Friedman and Kraus have necessarily identified the correct culprits, but rather they are able to see beyond the economic blinders that cause so many other authors to focus on incentives over information failures. In short, the authors are able to get to the heart of the crisis better than anyone else.

Friedman and Kraus argue that the following elements significantly contributed to the financial crisis by disabling important market information and providing the wrong incentives:

1. The SEC conferred monopoly status on three credit rating agencies, which severely disrupted competition and the dissemination of dissenting information related to the quality of mortgage-backed securities.

2. Bank capital requirements (e.g. the Recourse Rule), as promulgated by various regulatory agencies in the U.S., which provided a large capital subsidy for purchasing mortgage-backed securities over other securities.

3. Mark-to-market accounting, which caused massive asset write-downs during the height of the financial crisis and may not be the best valuation methodology for assessing asset impairments in illiquid markets.

4. HUD directives, starting in the mid 1990s, which paved the way to the relaxation of underwriting standards.

Although their arguments are well documented, we may never know if Friedman and Kraus have found the substance of the problem over the other competing narratives. I tend to disagree with some of them, in particular, the assertion that mark-to-market accounting, which was promulgated in the early 90s, played a large role in the crisis.

What sets this book apart from the others is the acknowledgement that information failures (i.e. ignorance and uncertainty) lay at the heart of the crisis. Neither the bankers nor the regulators adequately understood the nature or severity of the risks of low quality mortgage-backed securities flowing through the financial system. In hindsight, hardly anyone understood the risks or was willing to short the assertion that real estate values always rise.

But, the authors make an important Hayekian distinction: information failures work very differently among regulators and market participants. While there may be heterogeneous opinions among regulators as to the correct regulations, only one theory gets codified into law. In contrast, discordant theories between market participants lead to competition and a darwinian weeding out of erroneous strategies via profits and losses. Regulations, as codified by the SEC, the Federal Reserve and various other regulatory agencies worked in perverse ways to disable important information from reaching the market and led to unintended catastrophic consequences. In the meantime, bankers did what they always do - they maximized their incomes.

This is a spectacularly intelligent work about a systemic risk they aptly call "cognitive hazard", which manifested itself in several regulatory edicts that, the authors cogently demonstrate, "engineered the financial crisis. Specifically, those edicts included not only regulations designed to expand mortgage availability to persons at high risk of default, but more systemically, bank capital regulations that assigned lower risk capital weights to mortgages, mortgage - backed securities, and sovereign debt --- the very classes of debt that have been driving the financial crisis the past four years -- which incentivized such banks to hold and demand more of them (3X what the market in general was holding, according to the appendix). As well, they specify regulatory endorsement of rating agency output among the affirmative directives that steered commercial banks into the portfolio of loans that they held at the inception of the financial crisis, and how mark-to-market regulations, adopted toward the end of the pre-crisis period, acted as an accelerant to fuel the collapse of asset prices, thereby deepening the invasion of bank capital, and the need for central bank intervention.

This is an incisive counter to the MSM and political class's narrative of under-regulation, of regulators being captured and failing to do their job, which is defined to be being tough on greedy bankers. But it differs significantly from the simplistic myth that completely free markets, left alone, always produce optimal results. The authors posit instead that relative to the huge complexity of "the economy", any human or organization is likely to make mistakes, not just because of irrationality but because the complexity is such that error is going to occur even in decisions that emerge from processes thought to be entirely rational. It is a brilliant critique of what they call "economism", Hayek called "scientism" and others called "the planning fallacy" - the idea that with enough research and position papers, wise decisionmakers can create structures that eliminate problems systemically. There are several devastating sendups of exponents of the opposing camp, particularly Joseph Stiglitz, Robert Schiller and Lucian Bebchuk.

The book is amazingly short - only 156 pages, and those contain an introduction and conclusion which set forth, respectively, what they are going to show and what they have shown. Appendices and endnotes add another 60 pages or so. I found it hard to go more than a few pages without dogearing one or having to pause to absorb and reflect on the insights that emerged.

If there is any flaw I see in the book, it is that it does not much address the non-commercial banks - Countrywide, Lehman, Bear Stearns and AIG - that failed or came close to failing in 2008. I would hope that the authors would do so at some point. One of the authors (Kraus) is researching the European regulatory framework and that seems quite timely and likely to lead to significant additional and similar insights (because Basel II and its implementing regulations in EU states, to my knowledge, perpetuated the bias in favor or sovereign debt and mortgage-backed debt, which have played a significant role in the crisis we see in Europe today).

Also, although this is not a criticism or shortcoming of the authors, the subject of bank regulation is not one with which every reader is going to have sufficient facility to appreciate fully the arguments made in this book. If the authors could figure out way to collaborate with the likes of Michael Lewis or Andrew Sorkin, they might garner the readership their impressive analysis deserves.

But if you have either some familiarity with the subject or are sufficiently intellectually gifted to jump in at a sophisticated level, you should definitely read this book.

In my opinion Engineering the Banking Crisis would have been a more descriptive title. It has little to say about the housing bubble and burst that led to the crisis at commercial banks. Absent knowing the authors' narrower meaning of "financial crisis", one would find the alternative explanations that they "find no evidence for" on page 1 very questionable. I haven't read What Caused the Financial Crisis, which was co-edited by Friedman, but it appears to be about the financial crisis with the wider, usual meaning.

I still thought the book covered the territory it did pretty well. The authors say the primary cause of the financial crisis -- reduced lending by commercial banks to non-financial companies or consumers in the "real economy" -- was Basel I and the Recourse Rule (an adoption in the U.S. of part of what later became Basel II), which specify capital requirements for commercial banks. These set low capital requirements for mortgage-backed securities compared to much higher capital requirements for loans to non-financial companies and consumers. A secondary cause is mark-to-market accounting, which affected capital adequacy. Another cause was the bond rating agencies. They make a strong case for these. I've read quite a bit about the financial crisis, and this was the first source that addressed the capital requirements and their effect.

A major thesis of the book is ignorance--of both regulators and bankers. Regulators acted lacking understanding of the full range of regulations that apply to the regulated and unintended consequences. It appeals to the difference between "uncertainty" and "risk" ala Frank Knight and Keynes. They don't do so mainly to cast blame, since they regard economic uncertainty as inevitable. The thesis is contrasted with that of economists who claim the everything can be explained by incentives. An oft-used example is Joseph Stiglitz, who fails to recognize the ex-post cures he advocates were a big part of the problem that led to the crisis.

I agree with their ignorance thesis. They also criticize causes of the crisis that others give. One is "deregulation." They debunk this claim, making a distinction between deregulation and nonregulation. They also criticize the common claims that compensation incentives, too-big-to-fail, irrational exuberance, and over-leveraging caused the crisis. However, their criticisms focus only on these with regard to the behavior of commercial banks, and they take a very narrow view of leverage. A bank can grow its mortgage or mortgage-backed assets ($) a lot not only via a higher leverage ratio, but adding a little capital while adding such assets (and liabilities). Have a look at Citigroup's or Bank of America's asset growth from 2001-07! For example, Bank of America's assets and liabilities grew about 175% (more than 18% annually) those years while its leverage ratio (assets to GAAP capital) decreased!

Two minor points:
1. I believe the authors are wrong on page 32 about Brooksley Born proposing in 1998 to study credit default swaps. When Born made the proposal credit default swaps (CDS) were in their infancy. Far more credible is that Born's target was interest rate swaps (much different from CDS) and maybe currency swaps.
2. On page 167 it says the FASB is an arm of the SEC. That is at least misleading. The SEC expects companies to conform to FASB rules. However, FASB is not a *part* of the SEC any more than Moody's or Standard & Poor are part of government.