Fault Lines: How Hidden Fractures Still Threaten the World Economy Read Online Free PDF Page A

where fiscal and monetary stimulus created enormous additional demand for goods and services, especially in home construction. Foreign investors looked for safety. Their money flowed into securities issued by government-sponsored mortgage agencies like Fannie Mae and Freddie Mac, thus furthering the U.S. government’s low-income housing goals. The investors, many from developing countries, implicitly assumed that the U.S. government would back these agencies, much as industrial-country investors had assumed that developing-country governments would back them before the crises in those countries. Even though Fannie and Freddie were taking enormous risks, they were no longer subject to the discipline of the market.
    Other funds, from the foreign private sector, flowed into highly rated subprime mortgage-backed securities. Here, the unsuspecting foreign investors relied a little too naively on the institutions of the arm’s-length system. They believed in the ratings and the market prices produced by the system, not realizing that the huge quantity of money flowing into subprime lending, both from the agencies and from other foreign investors, had corrupted the institutions. For one of the weaknesses of the arm’s-length system, as I explain in Chapter 6 , is that it relies on prices being accurate: but when a flood of money from unquestioning investors has to be absorbed, prices can be significantly distorted. Here again, the contact between the two different financial systems created fragilities.
    However, the central cause for the financial panic was not so much that the banks packaged and distributed low-quality subprime mortgage-backed securities but that they held on to substantial quantities themselves, either on or off their balance sheets, financing these holdings with short-term debt. This brings us full circle to the theme of my Jackson Hole speech. What went wrong? Why did so many banks in the United States hold on to so much of the risk?
    The problem, as I describe in Chapter 7 , has to do with the special character of these risks. The substantial amount of money pouring in from unquestioning investors to finance subprime lending, as well as the significant government involvement in housing, suggested that matters could go on for some time without homeowners defaulting. Similarly, the Fed’s willingness to maintain easy conditions for a sustained period, given the persistent high level of unemployment, made the risk of a funding squeeze seem remote. Under such circumstances, the modern financial system tends to overdose on these risks.
    A bank that exposes itself to such risks tends to produce above-par profits most of the time. There is some probability that it will produce truly horrible losses. From society’s perspective, these risks should not be taken because of the enormous costs if the losses materialize. Unfortunately, the nature of the reward structure in the financial system, whether implicit or explicit, emphasizes short-term advantages and may predispose bankers to take these risks.
    Particularly detrimental, the actual or prospective intervention of the government or the central bank in certain markets to further political objectives, or to avoid political pain, creates an enormous force coordinating the numerous entities in the financial sector into taking the same risks. As they do so, they make the realization of losses much more likely. The financial sector is clearly centrally responsible for the risks it takes. Among its failings in the recent crisis include distorted incentives, hubris, envy, misplaced faith, and herd behavior. But the government helped make those risks look more attractive than they should have been and kept the market from exercising discipline, perhaps even making it applaud such behavior. Government interventions in the aftermath of the crisis have, unfortunately, fulfilled the beliefs of the financial sector. Political moral hazard came together with financial-sector