What Was the Financial Crisis?

Mike from Rortybomb writes,

Your local shadow bank took in money in the repo market as deposits, and used senior tranches of debt as the collateral. Now what happens when it needs liquidity? There is no market maker of last resort who the system as a whole could turn to. Repeat that again. It exists in the shadows, there is nowhere to turn to for emergency liquidity. There is no regulation/liquidity tradeoff here. This is what is meant by being unregulated - not that there weren't any government agents in sight.

As such it was only a matter of time before a bank run of epic proportions happened.

There is a fundamental divide over whether the financial crisis was a liquidity crisis or a solvency crisis. Mike is putting himself, along with Gary Gorton, in the liquidity crisis camp. In this view, there was a bank run that took place outside the banking system.

I think of the crisis as primarily a solvency crisis.

People made mortgage loans that only were good in an environment of continual house price appreciation. House prices stopped rising. The loans turned out to be bad. The holders of those loans turned out to be extremely highly leveraged, meaning that they had insufficient capital to survive in the event that loans turned out to be bad.

The liquidity crisis fits with the "shadow banking" story. That story in turn facilitates blaming the crisis on regulators being out of position with respect to the problem.

For the solvency crisis story, the institutions that held mortgages and mortgage credit risk were at the center of the story. That means banks, which were regulated. That means Freddie Mac and Fannie Mae, which were regulated by the Office of Federal Housing Enterprise Oversight (although I believe that Congress tampered with OFHEO to make it fairly ineffective).

This issue of which type of crisis we faced is very important going forward. The Obama Administration is basing its policies on the liquidity crisis story. They think we should go back to the same financial structure, but with more regulatory players. See Felix Salmon's summary.

Those of us who see the financial crisis as a solvency crisis have doubts about securitization. We worry about the incentives of banks to create leverage and take excessive risk. We have a different diagnosis and we propose different cures.

Presented by

Arnold Kling

Arnold Kling earned his Ph.D in economics at MIT. He was an economist on the staff of the Federal Reserve Board. From 1986-1994 he worked at Freddie Mac. He started Homefair.com in 1994 and sold it in 1999. His fourth book, From Poverty to Prosperity, co-authored with Nick Schulz, is due out in April of 2009. He blogs regularly at Econlog.

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