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Why the Crisis?

Wednesday, February 20, 2008

The roots of the subprime meltdown are found in the financial industry’s compensation system and in the Basel Accords.

Mortgage feature.jpgPredictably, Congress and much of the media are looking for convenient villains to explain why the subprime mortgage market brought on a financial crisis. Just as predictably, they will find some bad apples and dubious practices and will offer new legislation designed to prevent another meltdown. They will also do their best to smear the reputations of those responsible for policy earlier in this decade.

Finding scapegoats and passing new legislation may satisfy the public, but it will do nothing to prevent a similar crisis a few years from now. The right question to ask is: what incentives encouraged traders and firms to buy and sell subprime mortgages?

Ironically, most of the buyers and sellers were graduates of elite business schools. Better than most, they should have known enough to avoid making loans with no down payments to borrowers who had few assets and poor credit records. The reason they didn’t is that their incentive structure encouraged them to ignore the quality of what they sold and bought.

The financial industry pays enormous bonuses for 'performance.' When the profits for subprime traders were great, bonuses were large and, for many, irresistible.

The financial industry pays enormous bonuses for “performance.” For several years, the profits for subprime traders were great and the bonuses were large (and, for many, irresistible). Their supervisors had the same incentives. The main incentive was to increase the size of one’s bonus by increasing the firm’s bottom line. Failure to play the game could cost you not only your bonus, but also your job. The financial industry’s compensation system created these incentives. By the time the crisis came, the people who fueled it had sold their subprime assets to someone else, along with assurances from the rating agencies.

So where were the financial regulators in all of this? The Basel Accords required banks to increase capital if they held these subprime securities. Instead of holding the assets in a monitored financial system, the mortgages and claims went…well, goodness knows where. We find out only when the holders are in distress. In light of the many shortcomings of past bank regulation and supervision, the Basel Accords had created incentives to hide risky assets off the banks’ balance sheets. This was a big mistake.

More regulation is not the answer. Decades of regulation to protect the savings and loan industry ended with a massive bill footed by U.S. taxpayers and the collapse of the entire industry. The 2002 Sarbanes-Oxley Act has had harmful, unintended consequences. More than 50 years passed before Congress repealed the disincentives imposed by the 1933 Glass-Steagall Act and interest rate regulation. Regulation creates incentives that are not foreseen. Interest rate regulation led to the creation of money market funds, just as the Basel Accords created incentives for avoidance of capital requirements. There are many other examples.

As long as the current incentives remain, financial problems will come again in a different form. The financial industry must be encouraged to revise its compensation system to reduce the incentives that reward socially costly behavior and ultimately trigger financial crises. To be sure, that’s not what the Bush administration and the Federal Reserve have done, and that’s not what Congress is likely to do. Instead, they have sought to protect people who made bad decisions by changing the terms of the contracts. There is no surer way to create future crises than to push the subprime losses onto taxpayers.

Capitalism without failure is like religion without sin—it just doesn’t work.

Allan H. Meltzer is a professor of political economy at Carnegie Mellon University and a visiting scholar at the American Enterprise Institute.

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