A Personal FAQ on the Financial Crisis of 2008

Editor’s Note: This post is by Ivo Welch of Brown University.

In “A Personal FAQ on the Financial Crisis of 2008“, I muse about the magnitude of the mortgage losses, some of the problems that caused the current financial mess, and some potential remedies.

First, the financial crisis is not caused just by bad mortgages, although the crisis started with them. Reasonable estimes of the potential losses due to bad mortgages are on the magnitude of perhaps “only” about $300 billion. By now, the financial crisis has moved much beyond the subprime and alt-A mortgages. Moreover, even economists often forget that value is unique only in a perfect market. If the market for assets is not liquid (as is the case now), their values are a range, not a point. Thus, lamenting over the low values of bad bank assets right now is misleading: when the market for mortgage loans will return to normal liquidity, these assets will be worth more than a firesale right now would bring.

Second, there are multiple layers of causality of the crisis. Most economists have focused on shallow and middle layers, such as the fact that banks are not lending, that markets are illiquid and values are tough to come by, or (deeper) that real-estate prices have fallen and mortgages are defaulting. They have made many good suggestions on how to deal with these problems, especially when it comes to schemes to recapitalize banks and renegotiate loans with homeowners.

However, there are much deeper causes, and they need to be fixed after the immediate crisis is over. In order of importance:

Governance: Punishing bank shareholders, now or in the future, will not impose a market discipline that will prevent similar crises in the future. The fact is that shareholders have no real oversight over management, including their risk-taking activities. The Chairmen of the Boards did not see it in their interests to learn how much risks CEOs were really taking on, and firing CEOs that took on too much. After all, the CEOs were themselves these Chairman. The main culprits of the current crises will all walk away very rich, even though it is the shareholders that will ultimately be the losers.

Sidenote: It also makes no sense to limit the executive compensation of incoming CEOs. It punishes the wrong party. It is not future CEOs and bankers who have caused the crisis, but past ones. For discipline to be effective, it must punish those that are responsible for creating a mess, not those who are put in charge for cleaning it up.

Tax Code: Our tax code continues to encourage levered ownership over equity ownership.

Bankruptcy code: Our bankruptcy code is not equipped to deal with systemic financial institution failure. As a result, financial liquidity crises become self-fulfilling prophesies.

Rating agencies and mortgage qualification: Like banks, these are rife with agency conflicts. The agencies made bundles of derivative securities appear safer than the underlying mortgages—and earned more in fees by doing so.

Related causes, such as mortgage buyer stupidity, are not easy to fix. Intelligent buyers of mortgage securities could have understood the conflicts of the rating industry. (This does not absolve the rating agencies.)

Third, it is naive to argue for or against regulation. Zero or infinite regulations are inferior to an intermediate amount of regulation. We need good, efficient, and effective regulation—and not too much and not too little. We know from experience that good government regulation is not an easy thing to come by. On the one hand, over-hasty regulation right now may only lead to more bad choices, as it did in the case of SOX. On the other hand, waiting too long may allow the lobbyists in Washington to torpedo good and meaningful governance reforms.

In my judgment, we should execute two corporate governance reforms:

[1] We should establish a “Corporate Governance Standards Board” (similar to FASB) in charge of “Generally Acceptable Corporate Governance Standards” (similar to GAAP). This board should be endorsed by the SEC, with additional safe-harbor provisions for firms following these standards and fewer protections for CEOs not following these standards.

[2] We should appoint a (legal) economist as head of the SEC, rather than a politician or pure lawyer. The SEC focus needs to tilt away from its traditional focus on enforcement and pure rule-based thinking and more towards effective economic regulation.

Clearly, reforms of the tax and bankruptcy codes are similarly important. However, I am less optimistic that our political system can manage these.

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  1. Jeff Williams
    Posted Sunday, November 2, 2008 at 8:45 pm | Permalink

    I like your list. I would add that, governance standards or not, there needs to be some way to make it meaningful to hold boards accountable, and then do so. The entire discussion around these governance failures focuses on CEOs, and has been silent on the role of boards. But, check the Lehman Bros or Bear Stearns websites — each is replete with lofty and detailed descriptions of board governance structures — risk management committees etc included. So codes of practice alone won’t cut it. Directors should be paid in stock with a lock up extending beyond their terms on the board.

  2. Walter Gangl
    Posted Monday, November 3, 2008 at 12:00 pm | Permalink

    We already have a de facto “Corporate Governance Standards Board.” It’s called ISS (now RMG). It has proven no more able to prescribe good corp gov than its counterparts in the debt rating world were able to rate the risk of CMOs.
    The last thing the world needs is a government-sanctioned body to make it worse with one-size-fits-all standards. The only advantage I can see in that is that it probably would be free of the conflicts that ISS labors under.
    I agree with your comments on Goldilocks regulation, but also don’t know the magic formula to get it “just right.”
    The SEC has to implement what Congress tells them to, and (apart from a few successes like our logical and efficient tax code and Congress’ visionary energy policy that had the foresight to position our country to compete in the global economy) too often they get it wrong.
    It might be useful if our political governance institutions, particularly Congress, did an honest, candid, annual self-evaluation like corporate boards are doing with the simple focus of “How can we together do our job better?”
    For that matter, adopting Conflicts and Ethics policies like those in place at companies might help them find the Goldilocks standard for regulation. It might improve public faith in that political institution. At least it couldn’t hurt.
    Walt Gangl

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