5EN552

Milan Zmtko

The Global Financial Crisis of 2007-9 by Allan H. Meltzer

Introduction
This article, written by Allan Meltzer, wants to discuss sources of the financial crisis of 200709. Allan Meltzer is an American economist and a professor of Political Economy at Carnegie Mellon University. His main field of interest is monetary policy, its development and application. Article starts with examining some important features of the last global financial crisis. Then Meltzer briefly discusses behavior of the FED and its unprecedented steps which it did. After that, six main causes are discussed that contribute to the crisis or made crisis much more severe. The global financial crisis started in 2007 as housing and then mortgage crisis in the US markets. Then it spreads to other developed countries, especially to Europe, and transforms to financial crisis and credit market crisis. There was threat to global financial system as a credit crunch appeared in 2008. This situation forced the FED into unprecedented steps, which anyone can hardly anticipate at the days prior to the crisis. Events of summer 2007 opened a new chapter in the FED history. Never before the FED expanded its balance sheet by such enormous quantity of illiquid assets over so short period of time. Hoping that one time they will become again valuable. In 2008 the FED increased its balance sheet from $800 billion to more than $2.2 trillion. Also the Treasury does not keep away and established TARP program to help and protect most threaten banks and firms. Program helped more than 200 banks and bailout several firms and banks like AIG or GM. Meltzer also points out that this crisis show possible answers on some frequently discussed topics. One of them is a conflict between proponents of discretionary monetary policy and rules for monetary policy. The crisis shows how discretionary monetary policy breaks down. The lesson is that monetary policy should be based more on rules but whit short term adjustment. Many people blaming financial deregulation and financial globalization as source of the current problems. Politicians from over the world readily and willingly started work on that new and stronger financial regulation. Next section discusses six problems that trigger or contribute to make the crisis much more severe and long-lasting.

Congress and administration

Reason why government intervened in housing and mortgage markets was a belief that homeownership is a source of social stability and kind of public good that might be encourage by politicians of the both parties. And so did. Government interventions has several forms: it included legal acts often supported by various measures of economic policy. It was tax code that encourages homeowners by tax deductible mortgage interest payments. Then it was Community Reinvestment Act which increases pressure to the banks to increase lending to lower income groups. Government ranks the banks which itself depends on the mortgage outstanding to low income and often no-income individuals. The ratings influenced decisions to permit mergers and branches. In 1995, the congress strengthened the Community

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Milan Zmtko

Reinvestment Act enacting The American Dream Downpayment Act which subsidizes credit for low income groups. This helped to introduce other subsidize as zero dawn payment loans or no credit check loans. To promote homeownership the government established various agencies such Fanne Mae, Freddie Mac or Ginnie Mae. Main purpose of these federal agencies, some of them became private, were to increase liquidity of mortgage market by buying mortgages, guarantees mortgage securities backed by loans issued by the government agencies or to subsidize mortgages by lowering interest rates on those mortgages. They act unanticipated good. The amount of mortgages connected with this tree government agencies rise from 200 billion in 1980 to 4 trillion in 2007. This means 36% compound growth rate. Despite some warnings there was only few people concerning about the future. This behavior was further encouraged by strong lobby which housing sector had in the congress. Through the time Fanne Mae and Fraddie Mac get under receivership and under the government control. Their future is not happy and they should be liquidated and terminated. Another failure of the congress and the government was a policy of "too big to fail". This policy encourages gigantism of banks even more and the result was enormous moral hazard.

Role of the FED

Meltzer points out that many politicians, economists and other people blamed the crisis on the FED. Their claims stay on the fact that between 2003 to 2005 the FED hold the federal fund rate at 1%. This condition on money market allows further credit expansion much of which terminated in the mortgage market. This big money inflow was one of the reasons which yield to the housing and then mortgage crisis. But he also claims that the FED did not force any bankers or other individuals to buy mortgage debt. It was a decision of investment bankers and fund managers to invest in theses risky assets. But there is another plausible explanation of this behavior. It's so called "Greenspan put" in which was believed that the FED would prevent large losses especially for those banks which are considered as too big to fail. These believes gave bankers feeling of safety and let them go into large leverage positions especially in mortgage backed securities and other structure finance instruments. Obviously it is a problem of moral hazard. But these positions are without "Greenspan put" very risky and inappropriate to their risk management. The problem was that the FED never announce its lender of last resort policy. This led to an inconsistency in the decisions and uncertainty rose. There is no clear policy that one can recognize, moreover, there was strong believe that the FED will never let fail big banks. The absence of this policy has important consequences in the means of increasing uncertainty. One of proposed reforms gives the FED also responsibility for maintaining financial market stability but this reform isnt enacted yet. Critics say that the FED can hardly maintain price stability and, moreover, the financial stability is beyond its strength.

FDICIA
Another reason why this crisis was so severe is an impossibility to apply the Federal Deposit Insurance Improvement Act (FDICA) to all financial firms. It can be applied only on banks. FDICIA gives the power to the regulators to intervene in solvent, however problematic, banks and assume control before banks capital disappear. This threat can avoid risky behavior of bankers and make them more prudent.

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Milan Zmtko

Regulation
Meltzer also sees the reason of severe crisis in inappropriate regulation. He claims that successful regulation takes account of the incentives it foster and avoid incentives to circumvent. As an example of bad regulation he mentioned The Basel Accord. It requires to hold more capital if they acquired more risk. Its idea seems plausible but the solution was not as they anticipate. Instead of increasing the capital banks move their risky assets to so called SPV. This procedure hold risky assets from their balance sheet but their liabilities and responsibilities remain. This shows that market can always circumvent costly regulation.

Compensation and incentives

Problem of compensation systems for bankers and traders and incentives it cause is frequently discussed topic. Meltzer sees the problem in short term goals. Banks often rewarded short term increases in revenue or earnings without connection to long term effects of this behavior. This compensation system encourage risk taking and urge traders to bigger and more risky positions. But on the other side, he is skeptical about government enforcement of salary schedule. He asserts that government cannot establish the rules avoiding any circumvention by the banks. Establishing compensation system is the responsibility of management. As Meltzer pointed out, in many cases these traders and bankers accept the credit ratings without investigating value of investment accuracy. Because often these ratings are incorrect investors frequently losses their money. One way how can be compensation system improved is somehow spread rewards over longer period of time to balance possible future losses.

Rating agencies
Role of rating agencies in the recent crisis is often discussed and stressed. Many politicians blame the crisis on the rating agencies. They argue that they incentives during rating processes are not clear. They also argue that there is existence of the conflict of interest. It stems from the fact that some kind of ratings, especially ratings of structured products, are demanded by clients. So, ratings agencies have incentives to satisfy clients desires. Meltzer says that possible solution can be modification and development of current compensation and incentive programs to more reward accuracy of rating achieve over time.

Transparency and risk

Another problem mentioned in the article, which contribute to the crisis, are incorrect risk models. These models work with specific assumptions which not always hold. Some of them are related to probability distributions of earnings. For example, they often presume normal probability distribution of earnings which very often doesnt hold. Probability distributions of earnings, especially of risky assets, are usually negatively skewed with fat tails. The incorrect assumptions lead to poor outcomes of these models. Another problem is that they make no distinction between permanent or persistent and transitory changes in risk spreads. Improving ability to judge persistence can improve results of these models. Last part of the article is devoted to recommendation of Issing committee appointed by G-20 and headed by professor Otmar Issing. Recommendations concern changes in policies, regulations, and supervision that would prevent financial system from future crisis. The Committee identified three reasons responsible for these incentive misalignment: structured finance, rating agencies and management compensation. This was supported by a massive inflow of liquidity and low interest rates. The Committee proposes higher supervision of credit rating agencies and more transparency in structured products. Increase in transparency

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Milan Zmtko

means enact new rules to disclose allocation of losses among tranches. This enable investors measure risk more precisely. Moreover, they suggest establish global credit register to uncover financial relationships between different counterparties.

Conclusion
There are several roots of the recent financial crisis. Both private and public sectors contribute to the crisis. In many cases their behavior make crisis much more severe. The crisis enforced aggressive intervention of the FED and Congress into markets to restore financial stability. There are several possible solutions how again to restore and maintain financial stability in the global markets. Societies have to reestablish individual responsibility and secure that individuals will bear the losses for their bad decisions. The FED should announce and maintain rule of lender of last resort, in order to decrease uncertainty. Other recommendation refers to the monetary policy: there should be less discretion and more rules. As Meltzer asserts, the only way to stabilize the markets is to improve the incentives.