Engineering the Financial Crisis This page intentionally left blank Engineering the Financial Crisis Systemic Risk and the Failure of Regulation Jeffrey Friedman and Wladimir Kraus U N I V E R S I T Y O F P E N N S Y LVA N I A P R E S S PHILADELPHIA Copyright ᭧ 2011 Jeffrey Friedman and Wladimir Kraus All rights reserved Except for brief quotations used for purposes of review or scholarly citation, none of this book may be reproduced in any form by any means without written permission from the publisher Published by University of Pennsylvania Press Philadelphia, Pennsylvania 19104-4112 www.upenn.edu/pennpress Printed in the United States of America on acid-free paper 10 Library of Congress Cataloging-in-Publication Data Friedman, Jeffrey, 1959– Engineering the financial crisis : systemic risk and the failure of regulation / Jeffrey Friedman and Wladimir Kraus — 1st ed p cm ISBN 978-0-8122-4357-4 (hardcover : alk paper) Includes bibliographical references and index Basel Accord (1988) Basel II (2004) Global Financial Crisis, 2008–2009 Bank capital—Law and legislation Banks and banking—Risk management Economics—Political aspects Financial crises—United States—History—21st century I Title II Kraus, Wladimir HB3717 2008.F75 2011 330.9Ј0511—pcc 2011024456 CONTENTS List of Figures and Tables vii Glossary of Abbreviations and Acronyms ix Introduction 1 Bonuses, Irrationality, and Too-Bigness: The Conventional Wisdom About the Financial Crisis and Its Theoretical Implications Capital Adequacy Regulations and the Financial Crisis: Bankers' and Regulators' Errors 57 The Interaction of Regulations and the Great Recession: Fetishizing Market Prices 86 Capitalism and Regulation: Ignorance, Heterogeneity, and Systemic Risk 112 Conclusion 144 Appendix I Scholarship About the Corporate-Compensation Hypothesis 157 Appendix II The Basel Rules off the Balance Sheet 163 Notes 175 References 189 Index 201 Acknowledgments 211 This page intentionally left blank FIGURES AND TABLES Figures 1.1 Fed funds rate, mortgage interest rates, house prices 1.2 Business lending, investment, unemployment 1.3 Decline in bank lending to businesses 1.4 Growth of subprime bond bubble 1.5 Bubble bursts: house prices and delinquency 2.1 Rise of private-label MBS 2.2 Rise of asset-backed securities 2.3 Rise (and fall) of asset-backed commercial paper 2.4 Steady bank leverage before crisis 2.5 Largest banks shift into low-risk-weighted assets 3.1 Falling ``price'' of mortgage bonds 3.2 Accounting and capital-adequacy regulations II.1 Rise and fall of U.S asset-backed commercial paper 12 14 48 49 69 71 72 80 82 96 99 170 Tables 1.1 Distribution of mortgage bonds 1.2 Securities exposures of banks 1.3 Bankers' preference for safety 2.1 Risk weights under Basel regimes 2.2 U.S bankers' search for capital relief 2.3 Overconcentration of private-label MBS 13 34 42 74 77 79 This page intentionally left blank GLOSSARY ABCP ABS ABX AIG ARM BCBS BHC BIS CCF CDO CDS CFTC Fannie Mae FDIC Fed FAS FASB Freddie Mac GDP Ginnie Mae GLBA GSE HELOC HUD IFRS IMF IRB LIBOR LTCM asset-backed commercial paper (short-term funding issued by OBSEs) asset-backed securities (such as an MBS) a source of price indices for MBS insurance via CDS American International Group adjustable-rate mortgage Basel Committee on Banking Supervision bank holding company Bank for International Settlements (located in Basel, Switzerland) credit conversion factor collateralized debt obligation (derivative that tranches pools of MBS) credit-default swap (insurance against default) Commodities Futures Trading Commission Federal National Mortgage Association Federal Deposit Insurance Corporation Federal Reserve Bank Financial Accounting Standards Financial Accounting Standards Board Federal Home Loan Mortgage Corporation gross domestic product Government National Mortgage Association Gramm-Leach-Bliley Act government-sponsored enterprise (e.g., Fannie Mae, Freddie Mac) home-equity lines of credit Department of Housing and Urban Development International Financial Reporting Standards International Monetary Fund internal ratings-based option of Basel II London Interbank Offered Rate Long-Term Capital Management 198 References Poszar, Zoltan, Tobias Adrian, Adam Ashcraft, and Hayley Boesky 2010 ‘‘Shadow Banking.’’ Federal Reserve Bank of New York Staff Report 458, July Rajan, Raghuram 2006 ‘‘Has Financial Development Made the World Riskier?’’ European Financial Management 12: 313–64 ——— 2008 ‘‘Bankers’ Pay Is Deeply Flawed.’’ Financial Times, January ——— 2010 Fault Lines: How Hidden Fractures Still Threaten the World Economy Princeton, N.J.: Princeton University Press Rieker, Matthias 2010 ‘‘At J P Morgan, Eye on Consumer Banking.’’ Wall Street Journal, January 15 RiskMetrics 2008 ‘‘On the White Board.’’ December http://www.riskmetrics.com/ on_the_whiteboard/20081215 Rochet, Jean-Charles 2010 ‘‘The Future of Banking Regulation.’’ In Dewatripont et al 2010 Rodriguez, Robert L 2007 ‘‘Absence of Fear.’’ Speech, CFA Society of Chicago, June 28 Roubini, Nouriel, and Stephen Mihm 2010 Crisis Economics: A Crash Course in the Future of Finance New York: Penguin Ryon, Sandra L 1969 ‘‘History of Bank Capital Adequacy Analysis.’’ FDIC Working Paper 69–4 Washington, D.C.: FDIC Division of Economic Research Salmon, Felix 2007 ‘‘The Weakness of Marking Subprime Bonds to Market.’’ Seeking Alpha (blog), December Samuelson, Paul 1973 Economics 9th ed New York: McGraw-Hill Schuler, Kurt 1992 ‘‘The World History of Free Banking: An Overview.’’ In Dowd 1992a SEC (Securities and Exchange Commission) 2008 ‘‘Report and Recommendations Pursuant to Section 133 of the Emergency Economic Stabilization Act of 2008: Study on Mark-to- Market Accounting.’’ Washington, D.C.: Office of the Chief Accountant, Division of Corporate Finance, December Segal, David 2010 ‘‘The X Factor of Economics.’’ New York Times, October 17 Selgin, George A 1988 The Theory of Free Banking Totowa, N.J.: Rowman and Littlefield ——— 1994 ‘‘Are Banking Crises Free-Market Phenomena?’’ Critical Review (4): 591–608 Sen, Amartya K 1979 ‘‘Equality of What?’’ In The Tanner Lectures on Human Values, vol 1, ed Steling McMurrin Salt Lake City: University of Utah Press Sender, Henry 2010 ‘‘Fed Makes ‘a Killing’ on AIG Contracts.’’ Financial Times, January 20 Senior Supervisors Group 2008 ‘‘Observations on Risk Management Practices During the Recent Market Turbulence.’’ Basel, March Shiller, Robert J 2000 Irrational Exuberance Princeton, N.J.: Princeton University Press ——— 2005 Irrational Exuberance 2nd ed New York: Broadway ——— 2008 The Subprime Solution: How Today’s Global Financial Crisis Happened, and What to Do About It Princeton, N.J.: Princeton University Press References 199 Simon, Herbert A 1985 ‘‘Human Nature in Politics: The Dialogue of Psychology with Political Science.’’ American Political Science Review 79:293–304 Slater, John 2009 ‘‘How Much Risk Is the Treasury Really Assuming from Financial Institutions?’’ Seeking Alpha, April http://mergers.com/toughtimes/2009/howmuch-risk-is-the-treasury-really-assuming-from-the-financial-institutions/ Smick, David M 2010 ‘‘A Never-Ending Economic Crisis?’’ Commentary, January Smith, Joseph A., Jr 2002 ‘‘The Federal Banking Agencies’ Guidance on Subprime Lending: Regulation with a Divided Mind.’’ North Carolina Banking Institute 6: 73–263 Smith, Elliot Blair 2008a ‘‘Bringing Down Wall Street as Ratings Let Loose Subprime Scourge.’’ Bloomberg.com, 24 September ——— 2008b ‘‘ ‘Race to Bottom’ at Moody’s, S&P Secured Subprime’s Boom, Bust.’’ Bloomberg.com, 25 September Stanton, Richard, and Nancy E Wallace 2008 ‘‘ABX.HE Indexed Credit Default Swaps and the Valuation of Subprime MBS.’’ University of California, Berkeley, Fisher Center for Real Estate and Urban Economics, working paper 312stantonwallace 15 February Stiglitz, Joseph E 2009 ‘‘The Anatomy of a Murder: Who Killed America’s Economy?’’ Critical Review 21 (2–3): 329–40 ——— 2010a Freefall: America, Free Markets, and the Sinking of the World Economy New York: Norton ——— 2010b ‘‘The Non-Existent Hand.’’ London Review of Books, April 22: 17–18 ——— 2011 ‘‘The Anatomy of a Murder: Who Killed the American Economy?’’ In Friedman 2011 Stiglitz, Joseph E., and Andrew Weiss 1981 ‘‘Credit Rationing in Markets with Imperfect Information.’’ American Economic Review 71: 393–410 Story, Louise, and Gretchen Morgenson 2010 ‘‘A Rift at the Fed over the Bailout of AIG.’’ New York Times, January 23 Taleb, Nassim N 2005 Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets New York: Random House ——— 2007 The Black Swan: The Impact of the Highly Improbable New York: Random House Tarullo, Daniel K 2008 Banking on Basel: The Future of International Financial Regulation Washington, D.C.: Peterson Institute for International Economics Taylor, John B 2009 ‘‘Economic Policy and the Financial Crisis.’’ Critical Review 21 (2–3): 341–64 Taylor, John B 2011 ‘‘Monetary Policy, Economic 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Princeton, N.J.: Princeton University Press Tett, Gillian 2009a Fool’s Gold: How the Bold Dream of a Small Tribe at J.P Morgan Was Corrupted by Wall Street Greed and Unleashed a Catastrophe New York: Free Press 200 References ——— 2009b ‘‘Genesis of the Debt Disaster.’’ Financial Times, May Thanassoulis, John 2009 ‘‘This Is the Right Time to Regulate Bankers’ Pay.’’ Economists’ Voice, April Timiraos, Nick 2010 ‘‘Mortgage Delinquencies Decline.’’ Wall Street Journal, November 19 UBS 2008 ‘‘Shareholder Report on UBS’s Write-Downs.’’ April 18 Varghese, Romy 2010 ‘‘Analyst Whitney Plans to Start Credit-Rating Firm.’’ Wall Street Journal, November 19 Volcker, Paul 2010 ‘‘ ‘The Time We Have Is Growing Short.’ ’’ New York Review of Books, June 24 Wallison, Peter J 2009a ‘‘Cause and Effect: Government Policies and the Financial Crisis.’’ Critical Review 21 (2–3): 365–76 ——— 2009b ‘‘Deregulation and the Financial Crisis: Another Urban Myth.’’ Financial Services Outlook Washington, D.C.: American Enterprise Institute for Public Policy ——— 2011a ‘‘Housing Initiatives and Other Policy Factors.’’ In Friedman 2011 ——— 2011b ‘‘Credit-Default Swaps and the Crisis.’’ In Friedman 2011 Weber, Max [1918] 1946 ‘‘Science as a Vocation.’’ In From Max Weber: Essays in Sociology, ed H H Gerth and C Wright Mills New York: Oxford University Press ——— [1968] 1978 Economy and Society, vol Ed Guenther Roth and Claus Wittich Berkeley: University of California Press ——— [1920–21] 1958 The Protestant Ethic and the Spirit of Capitalism New York: Charles Scribner’s Sons Wesbury, Brian S 2010 It’s Not as Bad as You Think Hoboken, N.J.: John Wiley WRCM (Western Reserve Capital Management) 2009 ‘‘Negative Feedback Loop.’’ February White, Lawrence J 2011 ‘‘The Credit-Rating Agencies and the Subprime Debacle.’’ In Friedman 2011 Winston, Clifford 2006 Government Failure vs Market Failure Washington, D.C.: AEI- Brookings Joint Center for Regulatory Studies Zandi, Mark 2008 Financial Shock: A 360-Degree Look at the Subprime Mortgage Implosion, and How to Avoid the Next Financial Crisis Upper Saddle River, N.J.: FT Press INDEX ABCP See asset-backed commercial paper ABX index, 96, 99, 101, 102, 176n7 Accounting regulations: FAS 107 (1991), 92, 182n6; FAS 114 (1993), 92, 182n7; FAS 115 (1993), 91, 92, 108, 125, 181n1, 182n8; FAS 157 (2006), 95, 101, 108, 125, 181n3, 182n9; FIN 46, 167–69; FIN 46-R, 168, 169 See also FASB; mark-to-market accounting Acemoglu, Daron, 105, 125 Acharya, Viral V., 71, 72, 82, 97, 161, 165, 166, 169, 170, 180n12, 185n1 Adelson, Mark, 127 Adequately capitalized banks, 59, 67, 70, 83, 103, 147, 178n19, 181n16 Adrian, Tobias, 95, 166, 187n3 Agency (GSE) mortgage-backed securities, 13, 47, 64–66, 68, 70, 73–74, 78, 108, 175n1, 178n21; commercial banks’ holdings of, 13, 42, 77, 177n12; commercial banks’ preference for, 41–43, 49, 75, 77, 81, 84, 144, 146; government guarantee of, 15, 19; interest rate on, 10–11; relative safety of, 41–42, 49, 75–76; role in financial crisis, 17 See also Basel I; Basel II; Recourse Rule AIG, 33, 100–101, 140, 176nn10–11 Akerlof, George A., 7, 53–55, 121, 150, 177–79 Alchian, Armen A., 137, 184n14 Animal spirits, 53–55, 150, 179n25 Ariely, Dan, 132–33 Aristotle, 179n25 Ashcraft, Adam B., 20–22, 76, 95, 166, 187n4 Asset-backed commercial paper (ABCP), 18, 71–73, 97–99, 163–74, 187n4; issuance of, in Europe, 72; issuance of, in United States, 72, 170 Asset-backed securities (ABS), 21, 59, 70–75, 79, 86, 97, 102, 104–5, 117, 124, 135, 136, 138, 165, 166, 170–74, 180nn6, 13, 183nn14, 15, 187n1 See also collateralized debt obligations; private-label mortgagebacked securities Asset bubbles, 10, 16, 24, 26, 48, 53, 55, 147, 179n25 See also housing bubble Asymmetrical information, 121, 125, 151, 175n1, 177n16 Atkinson, Paul, 75, 170, 180n14 Bailouts, 17, 23, 33, 43, 44, 46, 99, 143, 179n22; of GSEs, 11–12, 15 See also AIG; Bear Stearns; government-sponsored entities; Lehman Brothers; Too Big to Fail Bair, Sheila C., 112, 118–21 Baker, Dean, 44 Balachandran, Sudhakar, 36 BancOne Capital Markets, 187n8 Bank failures: in Canada, 115; in Germany, 62; in United States, 114–15; of Bear Stearns, 126; of Lehman Brothers, 11, 33 Bank for International Settlements (BIS), 18, 62, 105, 106, 123–24, 183n15, 185n15 Bank holding companies (BHCs), 13, 18, 24, 35, 38 Bank of America, 13, 15, 41, 45, 82, 160, 162 Bank runs, 60, 66; threat of, 114; policies designed to prevent, 115, 121, 143 Banking Act of 1933, 60, 61 See also GlassSteagall Act Barnett-Hart, Anna Katherine, 21, 103 Barth, James, 9, 14–16, 40, 41, 45, 82, 103 Basel Committee on Banking Supervision (BCBS), 18, 62–64, 67–70, 73, 74, 85, 105, 116, 127, 167, 168 Basel rules, 6, 56, 66, 86, 116, 129, 136, 174 See also Basel I; Basel II; Basel III; capital; Recourse Rule 202 Index Basel I, 18, 59, 70, 97, 114, 119, 147, 166; encouraged investing in agency MBS, 63, 64, 66, 73, 77–79, 108, 145, 163, 175n3; encouraged mortgage lending, 2, 63, 66, 68, 72, 98, 116–17, 138, 155–56; rationale for, 62–64, 114; risk weights and credit conversion factors under, 62–65, 68, 72, 74, 98, 115–16, 122–23, 131, 146, 155, 167–69, 171–74; Tier capital, 40, 80, 83, 91, 93, 94, 134, 174, 180n4; Tier capital, 80, 83, 134, 180n4 See also Basel II; Basel III; business lending; leverage; Recourse Rule Basel II, 18, 62, 70, 71, 78, 79, 180n14; encouraged investing in PLMBS, 2, 73–75, 86, 117, 135, 155, 163; encouraged mortgage lending, 73, 155; implementation, in Britain, 170; rationale for, 68, 114, 131; risk weights and credit conversion factors under, 68–70, 73–75, 77, 86, 117, 131, 155, 168–74; role in European sovereign debt crisis, 117; use of external ratings under, 3, 68–69, 73, 74, 86, 104–5, 116–17, 123–24, 131 See also Basel I; Basel III; business lending; leverage; Recourse Rule Basel III, 18, 62, 114, 115, 117 Bass, J Kyle, 21 BB&T Bank, 135 Beal, D Andrew, 135, 136 Beal Bank, 135 Bear Stearns, 14, 18, 23, 24, 34, 126, 129–31, 157–62, 178n22 Bebchuk, Lucian A., 157–61, 177n15, 186nn1–4 Bennett, Stephen Earl, 184n12 Benston, George J., 163, 165 Bernanke, Ben, 8, 51, 130, Bhattacharya, Sudipto, 114 BlackRock, 126, 131 Blundell-Wignall, Adrian, 75, 170, 180n14 Boesky, Hayley, 95, 166, 187n4 Boettke, Peter J., 120 Bolton, Patrick, 177n15 Bonuses See corporate compensation Boot, Arnoud W A., 114 Bordo, Michael, 114 Born, Brooksley, 32–33 Brem, Lisa, 101 Brereton, Natasha, 117 Britain: ABCP issuance, 170; Basel II implementation in, 75 Burton, Edwin T., 87, 182n8 Bush, George W., administration of, 16, 23, 26 Business lending: contraction in, 2, 10–15, 17, 19, 35, 147, 174, 176nn3, 11; discouraged by capital-adequacy regulations, 66, 68, 72, 92–99, 116–17, 138, 147, 148, 151, 173 Caballero, Ricardo J., 90, 111 Calomiris, Charles W., 115 Campaign contributions, 31 Canada: bond rating agency, 183n14; deposit insurance in, 62, 115; lack of banking panics in, 115 Capital: cushions before Depression, 61; definition of, 57–59; legal vs usable cushion of, 82–85, 98–99, 134–35, 137, 145–46, 181n16; ratios, 40–41, 62, 67, 80–83, 134, 174; relief, 71, 75–77, 80, 97, 146, 150, 152, 169–74, 181n15 See also Basel I; Basel II; Basel III; Recourse Rule Capital-adequacy regulation, as tax on banks, 136 See also Basel I; Basel II; Basel III; Recourse Rule Capital arbitrage See regulatory arbitrage Capitalism, 62, 113, 120–21, 129, 155; financial crisis and, 1, 6, 28, 78, 152–53; experimentation under, 132–33; heterogeneity under, 82, 133–43, 154; homogeneity under, 139; systemic risk under, 4, 139–41, 153–54 See also competition; economism; regulation CapitalOne, 135 Caplan, Bryan, 178n17, 186n2 Carlson, Mark, 115 Case-Shiller index, 9, 49 Cash hoarding (by banks), 11 Cash-out refinancing, 47, 179n23 Cass, Dwight, 135 Cassidy, John, 131 Cayne, James E., 157, 158, 160, 186nn2–3 CDS See credit-default swap CDO See collateralized debt obligation Central banks See European Central Bank; Federal Reserve Cheng, Ing-Haw, 38 Chicago school of economics, 120–21, 177n16 Index Cioffi, Ralph, 129–31 Citigroup, 13, 15, 18, 40, 42, 45, 82, 134, 157, 160–61, 180n14; SIVs of, 165, 171–72, 174 Clinton, Bill, 32; administration, 15–16, 23, 26 Code of Federal Regulations, 107 Cognitive hazard, 142 Cohan, William D., 126, 130, 131, 160 Cohen, Alma, 157–61, 186nn1–4 Cohen, Richard, 157 Colander, David, 38, 90, 111, 125, 177n16 Collateralized debt obligations (CDOs), 13, 21, 43, 49, 76, 96, 102, 104, 144, 135, 166, 172, 178n21, 183n15, 187n1; CDOs squared, 21; senior tranches of, 13, 41–43, 46, 75–78, 79, 84, 100–101, 103, 131, 134, 144–45, 152, 164–65, 185n1, 186n5; subprime, 130, 172; synthetic CDOs, 21 See also private-label mortgage-backed securities Commercial banks See adequately capitalized banks; agency mortgage-backed securities; Basel I; Basel II; Basel III; deregulation; investment banks; private-label mortgage-backed securities; Recourse Rule; well-capitalized banks Commercial paper See asset-backed commercial paper Commodity Futures Trading Commission (CFTC), 32, 33 Community Reinvestment Act, 26 Competition, 106, 120, 133, 184nn8, 14; reduces cognitive burden, 106, 133, 137–38, 153, 184n8; regulation and, 154 See also capitalism; regulation Complexity, 4, 27–29, 54–55, 106–11, 117–18, 126, 131–33, 136–43, 147–48 See also regulatory interactions Conduits, 18, 97, 166–69, 187n1 See also asset-backed commercial paper; structured investment vehicles Conflicts of interest, 124 Condon, Bernard, 135 Conglomerates, 161 Congress, U.S., 9, 23, 26, 127, 175n1 Conspiracy theories, Consumer confidence, 52 Consumers, 181n2; as competitive filter of markets, 89, 139, 154–55, 184n14; lending to, 2, 11, 13–14, 34, 66, 97, 146 See also capitalism; competition 203 Consumption goods, 181n4 Continental Illinois Bank, 43–44 Converse, Philip E., 113, 124 Core, John E., 159, 177n15 Corporate bonds, 13, 15, 34, 44, 45, 58–59, 63, 74, 78, 79 Corporate compensation, 1, 4, 5, 30, 36–43, 46, 49, 55, 61, 67, 76, 138, 157–62, 177n15, 186n2 Cotter, Richard V., 61 Counterparty risk, 33 See also AIG; creditdefault swap Countrywide Financial Corporation, 13, 14, 18 Coval, Joshua, 127 Cox, Rob, 135 Credit-conversion factor (CCF), 166–69 Credit-default swaps (CDS), 18, 30, 32–34, 58, 95–96, 100, 101, 130, 135, 176n7, 176n10, 177n11 See also AIG; Summers, Lawrence Credit-rating agencies See rating agencies Crews, Clyde Wayne, Jr., 107–8 Dash, Eric, 140 DeCanio, Samuel, 183n21 Deflation, Democracy See modern democracy; pragmatic democracy Democratic fundamentalism, 91 Department of Housing and Urban Development (HUD), 16, 77, 108, 175n1 Deposit insurance, 13, 23, 66–67, 118, 149, 178n19, 185n16; in Canada, 62, 115; capital regulations devised in response to, 35, 61–62, 64, 114–15, 125; unintended consequences of, 60, 115, 121, 143 See also FDIC Depository Institutions Deregulation and Monetary Control Act, 25 Deregulation, 2, 5, 18, 22–26, 30–32, 34–35, 55, 78, 116, 127–28, 153 See also creditdefault swaps; Gramm-Leach-Bliley Act; rating agencies; regulation Derivatives, 18, 21, 24, 30, 32–34, 176n10, 183n22 See also credit-default swaps Deutsche Bank, 134–35, 165 Dewatripont, Mathias, 39, 60 Dimon, Jamie, 134, 136 Dizard, John, 184n11 Dowd, Kevin, 115 204 Index Economic theory, 105, 110, 150, 175n1, 177n16, 184n12; assumption of perfect information and perfect markets, 3, 36, 38, 50, 55, 120–21, 125, 129; faulty models, 3, 7, 38, 116, 119, 132; game theory, 38 See also Akerlof, George; Chicago school of economics; economism; efficient-market hypothesis; ideology; imperfect information; incentives narratives; omniscience assumption; price fetishism; radical ignorance; Shiller, Robert; Stiglitz, Joseph Economism, 119–26, 142, 148–50 See also economic theory; ideology; price fetishism Efficient-market hypothesis, 90, 139, 177n16 See also economic theory Enron, 167 Error See ideology; ignorance European banks, 34, 87, 117, 170, 173, 187n8 European Central Bank (ECB), European Union (EU), Evans, Anthony, 121, 128, 175n1, 177n16, 186n4 Evolution, 137–38, 151, 184n14 Executive compensation, 158, 159 See also corporate compensation Exit (vs voice), 154–55 Experimentation See capitalism Experts See ideology; ignorance Fahlenbrach, Rudiger, 157, 186n1 ă Fair-value accounting See mark-to-market accounting Fannie Mae (Federal National Mortgage Association) See government-sponsored entities FAS 107 See accounting regulations FAS 114 See accounting regulations FAS 115 See accounting regulations FAS 157 See accounting regulations FASB See Financial Accounting Standards Board Federal Deposit Insurance Corporation (FDIC), 3, 8, 50, 61, 69, 83, 93, 108, 110, 112, 115, 118, 119, 168, 176n8, 178n20, 180n4, 185n1 See also deposit insurance Federal funds rate, 8–9 Federal Home Loan Bank (FHLB), 13 Federal Home Loan Mortgage Corporation (Freddie Mac) See government-sponsored entities Federal Housing Administration (FHA), 10, 175n1 Federal Reserve, 8, 12, 14, 25–26, 40, 69, 96, 98, 101, 108, 110–11, 119, 131, 140, 176n8, 179n22; 185n1 Federal Reserve Act, 177n13 Ferri, Fabrizio, 101 FIN 46 See accounting regulations FIN 46-R See accounting regulations Financial Accounting Standards Board (FASB), 87, 90, 95, 106, 110, 142, 167, 168, 181nn1, 3, 182nn6–9 See also accounting regulations; mark-to-market accounting Financial Crisis Inquiry Commission (FCIC), 118 First Pacific Advisors, 104–105 Fischhoff, Baruch, 51 Fitch Ratings, 2, 22, 68, 86, 104–6, 126, 128, 148, 182n13, 183n15, 187n3 Foreclosures: on prime mortgages, 10, 25, 100; on subprime ARMs, 9, 25, 100 Fortis Investments, 126 Foucault, Michel, 155 Fox, Justin, 184n14 Freddie Mac See government-sponsored entities Freeman, Gaylord A., Jr., 61 Free-market ideology See market fundamentalism Friedman, Benjamin, 54 Friedman, Jeffrey, 37, 121, 128, 175n1, 177n16, 180n12, 184nn12, 14, 186nn3, 4, Friedman, Milton, 115 Friedman, Paul, 131 Frydman, Roman, 90 Fuld, Richard, 157–58, 160, 186n2 Game theory See economic theory Garn-St Germain Act, 25 Gaussian copula, 127 Geanakoplos, John, 92 Geithner, Timothy, 112, 114, 119–20, 139–40 Gigerenzer, Gerd, 179n25 Giglio, Stefano, 178n22 Gilliam, Lee, 57, 168 Gjerstad, Steven, 32, 103, 135 Glass-Steagall Act, 18, 23–24, 30–31, 34–35 See also Banking Act of 1933; GrammLeach-Bliley Act Index Goldberg, Michael D., 38, 90, 111, 125, 177n16 Goldman Sachs, 18, 100–101, 135, 140, 176n7, 185n1 Gorton, Gary, 90, 114–15, 182n12, 183n1, 187n2 Government Accountability Office (GAO), 16, 181n16 Government-sponsored entities (GSEs), 5, 41, 47, 55, 63, 66; bailout of, 12, 33; debt of, 13, 15, 17, 45, 63, 65, 86, 175n1; Fannie Mae, 1, 5, 10–13, 15–16, 23, 33, 45–46, 55, 64–65, 86, 175n1, 176n11, 178n22; Freddie Mac, 1, 5, 10–13, 15–16, 23, 33, 45–46, 55, 64–65, 86, 175n1, 176n11, 178n22; Ginnie Mae, 13, 175n1; securitization by, 64, 176n5, 176n7; government guarantee of, 10–11, 15, 17, 19, 46, 175n1; role in housing bubble, 1, 5, 10, 16–17, 55, 78 See also agency mortgage-backed securities Graham, Jed, 114 Gramm, Phil, 26, 176n8 Gramm-Leach-Bliley Act (GLBA), 23–24, 26, 30, 34–35, 176n8, 178n21 See also GlassSteagall Act Great Depression, 60–61, 86, 108, 114–15 175n1 Great Recession, 2, 4, 17, 19, 25–26, 55, 94, 98, 103, 139; cause of, 11–17, 35, 55–56, 106, 108, 111, 141, 147, 155–56, 172, 174; predictions of, 183n22; timing of, 11–13 Greed, 141, 177n16 See also corporate compensation Greenlaw, David, 27, 172, 185n1 Greenspan, Alan, 8, 51–52, 54, 130, 179n25 Gross Domestic Product (GDP), 17 Grossman, Sanford J., 121 Grundfest, Joseph, 186n1 GSE See government-sponsored entities Guay, Wayne R., 159, 177n15 Gugliada, Richard, 104 Haas, Armin, 38, 90, 111, 125, 177n16 Hanson, Samuel, 83 Harnal, Hitesh, 36 Harrington, Shannon D., 172, 174 Hart, Oliver, 44 Hartgraves, Al L., 163, 165 Hatzius, Jan, 27, 172, 176n7, 185n1 205 He, Zhiguo, 97 Hedge funds, 13, 14, 43, 77, 126, 129–31, 183n22, 185n1 Hellwig, Martin, 83 Herd behavior, 135, 139, 154 Hester, Elizabeth, 172, 174 Heterogeneity See capitalism Hindsight bias, 29–30, 49–52, 127, 179n25 Hirschman, Albert O., 155 Hoffman, Damien, 183n22 Home-equity lines of credit (HELOC), 47, 179n23 Home-equity loans, 47, 71, 179n23 Home Ownership and Equity Protection Act, 25 Homeownership: initiative to expand, 15–16, 23, 26, 29; rate of, 16 See also Community Reinvestment Act Homogeneity See regulation Hong, Harrison, 38 House flipping, 47, 52 Housing bubble, 1, 5, 10, 15–17, 26, 48–49, 50–52, 69, 110–11, 119, 130; bursting of, 9, 10, 17, 24, 49, 55, 78, 79, 147, 176n3; misinterpretation as boom, 15, 22, 50–52, 54–55, 130; regulations that encouraged, 5, 8, 55, 73, 86, 110, 152, 155–56, 175n3 HUD See Department of Housing and Urban Development Ideology, 177n16; of bankers, 130, 137; of capitalists, 133, 153; error due to, 32, 120; function of, 124–25, 153–54, 184n9; of regulators, 31–32, 120–26, 142, 148, 149, 153; social science theories as, 125 See also economism; price fetishism Ignorance: bankers’, 3, 36, 39, 41, 67, 79, 128–32, 152, 157, 160–62, 186n3; citizens’, 109, 141; economic actors’, 3–4, 29, 52, 88, 91–93, 101–3, 106, 111, 126, 128, 153, 177n16; experts’, 4, 54, 111, 116–18, 120; ignorance of, 141, 152; impossibility of modeling, 3, 38, 128, 178n18; inadvertent, 36, 39, 41, 175n1; inevitability of, 124, 133, 137, 142; vs irrationality, 52–53, 55, 178n17; nonrandom, 178n18; overconfidence as, 53; rating agencies’, 105, 124; regulators’, 3, 32, 86, 105–11, 113–15, 118–20, 124, 128–29, 138, 139, 141–43, 147–48, 151–53; state autonomy due to, 206 Index Ignorance (continued) 183n21; trivializing, 1, 29, 31–32, 55, 88, 91, 106, 121, 175n1; ubiquity of, 125–28, 142 See also incentives narratives; ignorance hypothesis; irrationality; omniscience assumption; radical ignorance; unintended consequences Ignorance hypothesis, regarding bank executives, 157–60 Ikeda, Sanford, 128 Imperfect information See information Imperfect markets, 30, 119 Incentives narratives, 3, 6, 7, 29–31, 36–39, 43, 46, 88, 111, 116, 121–22, 124–25, 128–33, 141, 148, 149–51, 153–54, 159, 161, 177n14 See also corporate compensation; moral hazard; omniscience assumption; Too Big to Fail IndyMac, 18 Inflation, 179n25 Information: nonrandom, 178n18; overabundant, 109, 143; perfect, 3, 55, 120, 121, 125, 129; relevant, 87–91, 109, 122, 124, 181n2 See also ignorance; interpretation; radical ignorance Innovation, 181n2 Insurance companies, 13, 22, 33, 58, 104, 176n11, 183n14, 185n1 See also AIG Interaction of regulations See regulatory interaction Interbank lending, 11 Interest rates, 5, 8–11, 14, 15, 25, 51, 55, 65, 72, 73, 78, 90, 138, 156 Internal Revenue Code, 184n13 International Financial Reporting Standards (IFRS), 87, 99 International Monetary Fund (IMF), 10, 20, 34, 48, 49, 69, 77, 79, 93, 95, 96, 98–100, 102, 165, 166, 172, 173, 182n12, 185n1 Interpretation, 29–32, 51–55, 58, 89, 109, 141, 143, 152–53, 178n18, 181n2; misinterpretation, 50, 52, 54–55, 58, 179n25 Investment banks, 13, 14, 16, 18–24, 34–35, 70, 77–79, 127, 131, 159–60, 126, 162, 164, 177n12, 178n21, 183n22, 185n1 Irrationality, 50–55, 86, 101, 125; vs error, 53, 150, 175n1, 178n17; vs incompetence, 179n25 Irrational exuberance, 1, 5, 7, 49, 51–53, 55, 76, 111, 150 Isaac, William M., 93, 100 Issuer-pays business model, 124, 183n15, 185n15 Ivashina, Victoria, 11, 12, 14, 98, 99, 175n2 Iyer, Madhuri, 185n1 Jabłecki, Juliusz, 48, 67, 171, 180n12 Japan, ABCP issuance, 72 Jarsulic, Marc, 12, 14, 22, 25, 26, 39 Johnson, Simon, 10, 16 Jones, Sam, 104, 127, 182n13, 184n11 JPMorgan Chase, 13, 15, 40, 45, 82, 92, 134–37, 178n22 Jumbo mortgages, 48, 176nn5, Jurek, Jakub, 127 Juselius, Katarina, 90, 111, 125, 177n17 Kahneman, Daniel, 179n25 Kashyap, Anil K., 27, 60, 83, 95, 172, 176n7, 185n1 Katz, Alan, 40 Kay, Ira, 157 Keller, James, 176n10 Keynes, John Maynard, 3, 31, 36, 57, 128 Khand, In Gu, 97 Kirman, Alan, 38, 90, 111, 125, 177n16 Kirzner, Israel, 177n16 Kling, Arnold, 90, 180n12 Knight, Frank, 176n9 Kogut, Bruce, 36 Kraus, Wladimir, 1, 37, 155 Krishnamurthy, Arvind, 97, 185n1 Kroll, Inc., 127 Kuritzkes, Andrew, 40, 41 Kwak, James, 10, 16 Labaton, Stephen, 26 Lace Financial, 127 Lachman, Desmond, 98 Landler, Mark, 23 Lane, Charles, 16 Lehman Brothers, 11, 13, 15, 18, 23–24, 33, 34, 42, 77, 79, 157–62, 176n7, 178n22, 182n12, 185n1 Leonhardt, David, 24, 30, 34–35, 112 Leverage of banks, 2, 5, 40, 42, 43, 59, 62, 64–68, 80–85, 95, 110, 114, 121, 134, 144–46, 149, 173; 180nn4, 5, 183n22; deleveraging, 66, 81–82 144, 183n22 See also regulatory arbitrage Index Levy, Ari, 135 Lewis, Michael, 21 Li, Tong, 14, 15 Liquidity, 69, 89, 93, 95, 97, 164–69, 171, 181n4 loan-to-value ratio (LTV), 47–48, 89 London Interbank Offered Rate (LIBOR) 14 Long-term capital management (LTCM), 43, 44 Lowenstein, Roger, 184n11 Lucchetti, Aaron, 127 Luce, Edward, 131 Lux, Thomas, 38, 90, 111, 125, 177n17 Mabel, Cynthia C., 180n10 Machaj, Mateusz, 48, 67, 171, 180n12 Madrick, Jeff, 18, 22 Mago, Akhil, 185n1 Maiden Lane III, 101, 140 Market fundamentalism, 120, 122–23, 149, 154 Market-price fetishism See price fetishism Mark-to-market (MTM) accounting, 86–102, 140, 156, 174, 182nn8, 11; rationale for, 87–88, 125, 167; unintended consequences of, 2, 90, 101, 103, 106, 108, 111, 126, 139, 142, 147–48, 172 See also regulatory interactions MBS See agency mortgage-backed securities; private-label mortgage-backed securities McArthur, Travis, 44 McDonald, Lawrence G., 76, 160 Measures of risk, 106, 122; mathematical models of, 127 Mehran, Hamid, 43, 177n15 Merrill Lynch, 18, 100, 131 Mildenberg, David, 40 Mill, John Stuart, 37 Mitchener, Kris James, 115 Modern democracy, 27–31, 34, 91, 132, 141, 151, 153 See also pragmatic democracy Moody’s, 2, 22, 68, 86, 104, 106, 117, 126–28, 148, 183n15, 187n3 Moral hazard, 23, 36, 43, 46, 60, 66–67, 114, 121–25, 141–45, 148, 149, 153, 158–59, 167, 183n15, 185n15 Morgan Stanley, 18 Morgenson, Gretchen, 101, 126, 184n11 Mortgages: adjustable-rate (ARM), 9, 10, 12, 22, 25–27, 29, 32, 55, 100, 102; Alt-A, 9, 207 16, 19, 21, 47, 48, 55; defaults on, 5, 12, 17, 22, 26–27, 47–49, 70, 100, 104, 130, 172; jumbo, 48, 176nn5, 7; nonprime, 47–48, 55; origination of, 5, 13, 16, 18, 23–25, 48, 64, 70, 156, 175n1, 176n6; prime, 5, 8–10, 15, 19, 24, 25, 93, 176n7; securitization of, 5, 16, 19, 23, 25–27, 29, 32, 55, 64, 66, 69–71, 73, 75, 116, 119, 131, 164, 176nn5, 7, 185n1; subprime, 2, 5, 9–10, 12, 14–32, 47, 55 102, 103, 118, 131, 164, 172 See also agency mortgage-backed securities; government-sponsored entities; home-equity loans; home equity lines of credit, private-label mortgage backed securities Mortgage-backed securities (MBS) See agency mortgage-backed securities; private-label MTM See mark-to-market accounting Murphy, Kevin, 186n1 Mutual funds, 77, 127 Narayanan, V G., 101 National Banking Act of 1863, 114, 118 National Bureau of Economic Research (NBER), 12 Nationally chartered banks, 25, 176n6 Nationally Recognized Statistical Rating Organization (NRSRO), 104–5, 108, 127–28, 138, 182n13, 183nn14, 15 Neumann, Jeanette, 127 New Deal, 115 New York State Banking Association, 61 Nisbett, Richard, 179n25 No-recourse laws, 48 Norris, Floyd, 184n11 Norton, Joseph J., 61 Obama, Barack, 32 Obama administration, 132 Off-balance-sheet entities (OBSEs), 18, 163, 166–67, 169, 178n20 Office of the Comptroller of the Currency (OCC), 40, 69, 92, 93, 108, 110, 119, 168 Office of Thrift Supervision (OTS), 18, 40, 69, 108, 110, 168 O’Neal, E Stanley, 131 Omniscience, assumption of, 3, 36, 44, 45, 50, 55, 88, 90–91, 99, 106, 109, 119, 138, 140, 148–49, 151, 177n16 208 Index Organization for Economic Co-operation and Development (OECD), 74 Over-the-counter markets for derivatives, 32 Pension funds, 22, 104, 109 Perfect information See information Performance bonuses See corporate compensation Phumiwasana, Triphon, 14, 15 Pimco, 126, 131 Pittman, Mark, 40 Plato, 179n25 Plender, John, 184n11 PLMBS See private-label mortgage-backed securities PNC Bank, 135 Policy mindset, 2, 7, 27–30, 32, 34, 38, 113, 115–18, 128, 132, 161, 186n4 Policy tunnel vision See policy mindset Ponzi scheme, 165 Popper, Karl R., 112, 132 Posner, Richard A., 36, 37, 177n14 Poszar, Zoltan, 95, 166, 187n4 Pragmatic democracy, 107, 112–13 See also modern democracy Predatory lending, 25, 55 Price fetishism, 88–91, 140, 148, 149, 151 Private-label mortgage-backed securities (PLMBS), 11, 15–17, 24, 33, 35, 46, 55, 69–73, 75–76, 85, 93, 96, 97, 119, 127, 128, 134, 146, 149, 152, 163–65, 170–72, 174, 176n7, 177n12, 179n22, 181n15; appeal of, 19–21, 81, 84, 150; bankers’ preference for senior tranches of, 38, 41–43, 46, 49, 81, 84, 138, 144; commercial banks’ holdings of, 13, 42, 55, 77–79, 99, 145, 177n12, 185n1; downgrades of, 126; equity tranches of, 14, 19–22, 70, 100, 122, 123, 187n2; European issuance of, 169–70, 187n8; GSE purchases of, 16; mechanics of, 19–22; misratings of, 172; overcollateralization of, 20, 21, 25, 70, 100, 123, 145, 163–65; ratings downgrades of, 12, 103, 126; senior (AAA) tranches of, 13, 19–22, 41–43, 49, 53, 71, 76, 79, 81, 85, 96, 100–104, 140, 145, 164–65, 174, 178n21, 180n13, 185n1; subordination principle, 19–22, 100, 164–65; subprime, 12, 16, 19, 22, 23, 27, 48, 172; tranching of, 19–22, 41, 102, 164–66, 187n1 See also agency mortgage-backed securities; asset-backed securities; collateralized debt obligations Psychologism, 150 QE2, 132 Radical ignorance, 128–33, 141, 150, 152, 154 Raiter, Frank, 127 Rajan, Raghuram, 37, 60, 95, 110, 185n1 Rating agencies, 58; Canadian, 183n14; models used by, 22, 104, 127, 183n15, 185n15; protection from competition, 2–3, 22–23, 103–7, 119, 124, 126–28, 142, 148, 154, 182nn13, 15, 184n11; reliance on, by capital-adequacy regulations, 103–4, 118, 122–23, 180n6; trust in, 126, 129–31 See also Fitch; Moody’s; Standard & Poor’s Rational-choice theory, Rationality: definition of, 55; types of, 150, 178n17 Recourse Rule, 3, 68–81, 104–8, 110, 116, 118–20, 133, 147, 153, 155–56, 167–68, 171–73, 180nn12, 14, 182n8; encouraged overconcentration of PLMBS in commercial banks, 2, 68–70, 73–79, 81, 83–84, 97, 99, 135, 138, 145–46, 153; official name of, 180n7; rationale for, 69–70, 114, 122–23; risk weights under, 68–70, 74, 76, 86, 131, 173; treatment of PLMBS under, 70, 77–79, 86, 116–17, 135, 138, 145–46 See also Basel I; Basel II; Basel III; business lending Recklessness, 5, 6, 11, 23, 38–42, 44, 60, 61, 113, 121, 162, 177n16, 186n3 See also corporate compensation; greed; ignorance; incentives Refinancing, 25 See also cash-out refinancing Regulation, 4, 23, 107–8, 119–20; of branch banking and nationwide clearing houses, 114–15; crisis of, 6, 28; to correct moral hazard, 60, 121, 125, 148, 149, 151; epistemological burden of, 138–40; errors of, 90, 115, 138, 142–43, 151, 185n17; homogenization of capitalism by, 64, 136, 138–39, 141, 143, 154–55, 182n13; inadequate, 31–32; intellectual history and, 113; lack of, in derivates market, 24, 30, 32–34; lack of, in mortgage lending, 24; vs redistribution, 154; systemic risk under, 136, 138, Index 141–43, 153; theory of, 119, 136, 138, 141–42, 147–48; unintended consequences of, 30, 79, 86, 103, 107, 109, 111, 113, 142–43, 149, 152 See also Banking Act of 1933; Basel I; Basel II; Basel III; Community Reinvestment Act; deregulation; Glass-Steagall Act; ideology; ignorance; mark-to-market accounting; National Banking Act of 1863; Recourse Rule; regulatory interactions; unintended consequences Regulatory arbitrage, 64–65, 81–84, 99, 146, 174, 180n14, 181n16 Regulatory interactions, 86, 93–96, 98–99, 103, 106, 108–11, 139, 147, 148, 172, 182n8 See also unintended consequences Rieker, Matthias, 134 Richardson, Matthew, 71, 82, 161, 170, 180n12, 185n1 Risk: regulations designed to reduce, 115–17; underestimation of, 22; vs return, 21; vs safety, 129, 144–45; vs uncertainty, 31–32, 129, 152 RiskMetrics, 177n11 Robinson, Patrick, 76, 160 Rochet, Jean-Charles, 39, 41, 60, 68, 180n3 Rodriguez, Robert L.,105 Rogoff, Kenneth S., 23 Rosenberg, Joshua, 43, 177n15 Ross, Lee, 179n25 Roubini, Nouriel, 183n22 Ryon, Sandra L., 61 Sabarwal, Rahul, 185n1 Salmon, Felix, 101–2 Samuelson, Paul, 112, 119 Sarbanes-Oxley Act, 182n8 Scharfstein, David, 11, 12, 14, 98, 99, 175n2 Scheinkman, Jose A., 38 Schnabl, Philipp, 72, 97, 165, 166, 169, 187n8 Schuermann, Til, 20, 21, 22 Schuler, Kurt, 115 Schwartz, Anna Jacobson, 115 Scott, Hal, 40, 41 Securities and Exchange Commission (SEC), 2, 22, 87, 95, 104–5, 108–10, 124, 127–28, 148, 154, 167, 169, 182n8, 183n14, 184n11 Segal, David, 132 Self-interest, 3, 29, 38, 43, 121, 125, 141, 149, 175n1, 177n16 209 Selgin, George A., 114 Sen, Amartya, 185n14 Sender, Henry, 100, 101 Senior Supervisors Group, 137 Shadow banking system, 5, 18, 19 Shapiro, Joel, 177n15 Shiller, Robert J., 7, 51–55, 150, 178n17, 179n25 Shin, Hyun Song, 27, 172, 176n7, 185n1 Simon, Herbert, 38, 178n17, 179n25 SIVs See structured investment vehicles Skidelsky, Robert, 31, 36 Slater, John, 135 Sloth, Brigitte, 38, 90, 111, 125, 177n16 Slovic, Paul, 179n25 Smith, Elliot Blair, 127, 184n11 Smith, Joseph, 180n10 Smith, Vernon L., 32, 103, 135 Socie’te’ Ge’ne’rale, 100–101, 140 Solow, Robert, 132, 133 Souleles, Nicholas S., 187n2 Sovereign debt, 63, 68, 74, 117; French and German banks’ holdings of, 117 Spamann, Holger, 157–61, 177n15, 186nn1–4 Special-purpose entity (SPE), 163–64, 166, 187n2 Special-purpose vehicle (SPV), 163, 187n2 Stafford, Erik, 127 Standard & Poor’s (S&P), 2, 9, 22, 49, 68, 86, 104, 106, 126–28, 148, 183n15, 187n3 State-chartered banks, 25, 176n6 Stein, Jeremy C., 60, 83, 95, 185n1 Stigler, George, 120 Stiglitz, Joseph E., 6–7, 22, 30–32, 36, 37, 43, 46, 87–88, 90, 110–11, 116–17, 120–22, 124–25, 128–29, 178n21, 181n2, 183n2, 184n14 Stimulus, 132 Stock market, 180n1 Stock options, 36 Stolberg, Sheryl Gay, 23 Story, Louise, 101 Structured investment vehicles (SIVs), 18, 134, 165–66, 171–74, 182n12 See also asset-backed commercial paper; Citigroup ´ Stulz, Rene M., 157, 186n1 Suarez, Gustavo, 165, 169 Summers, Lawrence, 32 Systemic risk, 109, 138, 140–41, 143, 155 See also capitalism; regulation 210 Index Taleb, Nassim, 127 Tannin, Matthew, 129–31 TARP See Troubled Asset Relief Program Tarullo, Daniel K., 83, 93–94, 129, 167, 180n2 Taylor, John B., 8, 11, 180n12 TED spread, 14 Tetlock, Philip E., 118 Tett, Gillian, 45, 134–35, 137 Thakor, Anjan V., 114 Thanassoulis, John, 37 Timiraos, Nick, 100 Tirole, Jean, 39, 60 Too Big to Fail, 1, 4, 5, 6, 15, 30, 43–46, 49, 55, 61, 67, 76, 149, 177n16, 178n22, 183n3 Traders, 36, 39, 41–42, 46, 158, 161 Treasury, U.S., 101, 140; bills, 14; bonds, 15, 21, 45; debt, 183n22 Troubled Asset Relief Program (TARP), 135 Truth in Lending Act, 25 Tversky, Amos, 179n25 UBS, 134, 161, 186n5 Uncertainty (vs risk), 31–32, 129 Underwriting, 35 Unemployment, 12, 17, 99 Unintended consequences, of regulation, 30, 81–82, 86, 93–96, 103–11, 113–15, 143 See also deposit insurance; deregulation; mark-to-market accounting; Recourse Rule; regulation; regulatory interactions U.S Bancorp, 135 Usury laws, 25, 26 Vanguard, 126, 131 Vardi, Nathan, 135 Varghese, Romy, 128 Volcker, Paul, 43, 114 Wall Street, 31 Wallison, Peter, 11, 16, 33, 35, 180n12 Weber, Max, 7, 55, 149–50, 178n17 Weill, Sanford, 157 Weiss, Andrew, 121 Well-capitalized banks, 40, 59, 65, 67, 70, 83, 84, 96, 147, 166, 168, 169, 173, 178n19, 180n4 Wells Fargo, 13, 135 Wesbury, Brian, 17 Western Reserve Capital Management (WRCM), 93 White, Lawrence J., 104, 124, 183n14 Whitney, Meredith, 127–28 Winston, Clifford, 185n17 Wisdom of crowds, 91–96, 100 World War II, 51 Zandi, Mark, 9, 47, 130, 179n23 Zingales, Luigi, 44 ACKNOWLEDGMENTS This volume would not have been possible without the help of many scholars and researchers At the top of the list are Viral V Acharya and Philipp Schnabl of the NYU Stern School of Business, who never failed to share their pioneering research on asset-backed commercial paper, without which we could not have begun to navigate the very difficult landscape of offbalance-sheet banking activities Moreover, Acharya’s paper with Matthew Richardson on capital arbitrage, which appeared in Critical Review’s 2009 special issue on the causes of the financial crisis, served as our first introduction to the Basel rules, and their importance was reinforced by Juliusz Jablecki and Mateusz Machaj’s paper in the same issue on the implications of the Basel rules off of banks’ balance sheets We thank all these scholars not only for opening our eyes to the path of research we would end up taking, but for their unstinting generosity in helping us to understand the many twists and turns we encountered In addition, we gained illumination, and often data, from John Allison of Wake Forest University; James H Barth and ‘‘Cindy’’ Tong Li of the Milken Institute; Juan Carlos Climent, Meg Donovan, Michael Gordy, and Andreas Lehnert of the Federal Reserve Board; Darrell Duffie of Stanford University; Donna Fisher of the American Bankers Association; Karen Frenza and Jan Hatzius of Goldman Sachs; Stefano Giglio, Victoria Ivashina, and David Scharfstein of Harvard University; Steven Gjerstad of Chapman University; William M Isaac, former director of the FDIC; Anil K Kashyap of the University of Chicago; Ira Kay of Pay Governance LLC; Jodi Scarlata of the IMF; Aaron Steelman of the Federal Reserve Bank of Richmond; and Katherine G Wyatt and Richard A Brown of the FDIC Rich Brown, in particular, was immensely helpful in guiding us to many of those listed here, and in never betraying annoyance in answering one ‘‘final’’ question, after another, after yet another, as we grew increasingly to understand that we needed to know even more Viral Acharya, Howard 212 Acknowledgments ´ Baetjer, Amar Bhide, David Bernstein, Peter J Boettke, Tyler Cowen, Steven Gjerstad, Juliusz Jablecki, Garett Jones, Jeffrey Rogers Hummel, Ashwin Parameswaran, Philipp Schnabl, and Hal Scott read chapters of this book or versions of Friedman’s introduction to What Caused the Financial Crisis, in which many of the ideas developed in this book were originally bruited The usual caveat applies, with great emphasis in some cases! Finally, we thank Erin Graham of the University of Pennsylvania Press for her faith in this project; Jeremy S Davis of Houston, Texas for a muchneeded research grant to one of us (Kraus) at a crucial moment; and our wives, Shterna Friedman and Oksana Budnyk, for their long-suffering patience Shterna also formatted the manuscript for publication and prepared the index, and engaged in much helpful parsing of the mysteries of leverage ratios and the hermeneutics of the Recourse Rule We are more grateful to all of you than we can say .. .Engineering the Financial Crisis This page intentionally left blank Engineering the Financial Crisis Systemic Risk and the Failure of Regulation Jeffrey Friedman and Wladimir Kraus U... Library of Congress Cataloging-in-Publication Data Friedman, Jeffrey, 1959– Engineering the financial crisis : systemic risk and the failure of regulation / Jeffrey Friedman and Wladimir Kraus —... concerned about the default risk of the banks as they were about the default risk of Fannie and Freddie As we discuss toward the end of the chapter (when we consider the ‘‘too big to fail’’ theory as