The treatment, the intermediate outcome, and the ultimate outcome: Leverage and the financial crisis

Gur Huberman points to an article on the financial crisis by Bethany McLean, who writes:

lthough our understanding of what instigated the 2008 global financial crisis remains at best incomplete, there are a few widely agreed upon contributing factors. One of them is a 2004 rule change by the U.S. Securities and Exchange Commission that allowed investment banks to load up on leverage.

This disastrous decision has been cited by a host of prominent economists, including Princeton professor and former Federal Reserve Vice-Chairman Alan Blinder and Nobel laureate Joseph Stiglitz. It has even been immortalized in Hollywood, figuring into the dark financial narrative that propelled the Academy Award-winning film Inside Job. . . .

Here’s just one problem with this story line: It’s not true. Nor is it hard to prove that. Look at the historical leverage of the big five investment banks — Bear Stearns, Lehman Brothers, Merrill Lynch, Goldman Sachs and Morgan Stanley. The Government Accountability Office did just this in a July 2009 report and noted that three of the five firms had leverage ratios of 28 to 1 or greater at fiscal year-end 1998, which not only is a lot higher than 12 to 1 but also was higher than their leverage ratios at the end of 2006. So if leverage was higher before the rule change than it ever was afterward, how could the 2004 rule change have resulted in previously impermissible leverage? . . .

On Jan. 3, 2009, at the annual meeting of the American Economic Association, Susan Woodward, a former SEC chief economist, highlighted the rule change in a presentation, a slide for which read: “2004 — SEC eliminated capital rules for investment banks” and “Average I-bank ratios of capital to assets: before 2004: 1 to 12. After 2004: 1 to 33.”

A number of prominent academics who were there went on to repeat a version of Woodward’s claim. They include Robert Hall, who was then the incoming president of the American Economic Association, Ken Rogoff, and Alan Blinder. . . . Thus did the “fact” become part of the conventional wisdom about the crisis. . . .

The funny thing is that this is a mistake that no one has corrected. Although Erik Sirri, who was then the director of the SEC’s division of trading and markets, rebutted the claim in 2009, the New York Times didn’t cover it. Lockner says he wrote to a handful of economists; only Niall Ferguson responded and was chagrined to find out he was wrong. Of the people I cited earlier, only Blinder, Johnson, Kwak and Susan Woodward responded to my calls or emails. Blinder now says: “It’s true that very high leverage was a big source of the problem, but the net capital rule does not appear to have changed that much.” . . .

More recently, Andrew Lo, the director of MIT’s Laboratory for Financial Engineering, wrote a paper analyzing 21 books on the financial crisis. In his paper, he pointed out the fallacy of blaming increased leverage on the 2004 rule change. Although Lo’s paper was picked up by the Economist, even that didn’t spur any of the academics who made the mistake to correct it. . . .

I know nothing about the substance here; setting that aside, this story interests me for two reasons. First, as Gur writes, it’s a story of “a posterior formed from a prior without letting the facts get in the way” and as such related to our discussions about communication difficulties and confirmation bias. Second, from a formal causal inference perspective, it’s a story of an “instrument” or treatment (a change in the leverage rule), followed by an “mediator” or intermediate outcome (the actual changes in leverage) and then an ultimate outcome (the financial crash). The claim is that the initial treatment had no effect because there was no change in the mediator. There would seem to be other possibilities (for example, perhaps the rule change, which allow the possibility of actual changes, was enough to motivate various dangerous outcomes), but I don’t know enough about the context to say anything more.

12 thoughts on “The treatment, the intermediate outcome, and the ultimate outcome: Leverage and the financial crisis

  1. “Facts are facts, and those who supposedly traffic in them should have respect for them.” It was good to see (reading the whole article) that Johnson and Kwak (whom I’ve let explain the crisis to me, more or less) do seem to have such respect.

  2. They’re making this more complicated than it has to be. I think we know:

    * Banks didn’t have enough capital to ride out the crisis without help. Whether leverage rose or not isn’t the question.

    * We saw similar events all over the world, so it’s unlikely some specific US policy was the key factor.

    * These things are system failures. As much fun as it is to blame some specific human error, it’s a temptation we should probably resist. Here’s a nice statement of a similar comment in a different context (see point 7, via John cook): http://www.ctlab.org/documents/How%20Complex%20Systems%20Fail.pdf

    • “We saw similar events all over the world, so it’s unlikely some specific US policy was the key factor.” this is only a convincing argument if the rest of the world was not also affected by U.S. policy.

      In other words, this is not a convincing argument.

  3. I just love it when people cite Stiglitz as an authority on the Financial Crisis.

    Let us recall his track record: In 2002 he wrote: “the risk to the government from a potential default on GSE [Fannie Mae] debt is effectively zero…the expected cost to the government of providing an explicit government guarantee on $1 trillion in GSE debt is just $2 million.” [“Implications of the New Fannie Mae and Freddie Mac Risk-based Capital Standard,” by Joseph E. Stiglitz, Jonathan M. Orszag and Peter R. Orszag. It’s listed in Fannie Mae Papers, Volume 1, Issue 2, March 2002.]

    Question for those who cite Stiglitz as an authority on the Financial Crisis: by how many HUNDREDS OF BILLIONS of dollars was his estimate off?

  4. Repeal of Glass-Steagall and the refusal to regulate derivatives (both of which happened under Clinton with Summers as Treasury Secretary) were probably bigger problems then “leverage”. After all, leverage of 1 is excessive when the underlying asset you are borrowing against loses half or more of its value (as many of the real estate tranches did). The shadow banking system was basically isomorphic to the world-wide banking system in 1929–unregulated and undercapitalized.

    The key is understanding why the financial crisis happened. The main cause is the distortions in the market caused by preferential treatment of gains from investment. This leads to an oversupply of capital and diminishing returns for this capital. On the other hand, the owners of capital want the same return on their money as they did before the preferential tax treatment (if you go back through the financial literature of the early-to-mid aughts, it is full of complaints about lack of return). When someone wants something, someone will provide it, whether the Florida land boom in the 20’s or the real-estate derivatives (COO’s) of the aught’s. Since those providing it take a percent, the trust-worthiness of the underlying asset is immaterial (the incentives of those owning a nuclear power plant are much different than those downwind from it).

    Now, the problem becomes this is a self-perpetrating cycle, as the increased amount of capital (even though the return is not as great, the concentration of capital continues to increase) leads to the ability to manipulate public opinion and political campaigns. Ordinarily cartels don’t work, but OPEC worked because Saudi Arabia could act unilaterally and lower or raise oil output sufficiently to set prices. Similarly, a single individual can now change a political campaign in a demonstrable manner (look at Gingrich’s campaign). Given the institutional constraints in the American political system (primarily the ascendency of economic over political freedom on the current Supreme Court), this will not end well.

    • There was a host of contributing factors. Some of these are quite subtle. For example inflation statistics tend to be measured in a way that understates the effect of asset bubbles. For much of the last decade, we saw spectacular increases in housing prices in North America and elsewhere. These increases were made possible by extraordinarily low interest rates and lax lending standards, which in turn were facilitated by financial engineering – the buyers of the supposedly AAA financial instruments didn’t realize what they were actually buying. If the housing bubble were reflected in the inflation statistics, the central banks would have been obliged to respond by increasing interest rates and restraining speculative investments in housing. This did not happen with the result that the inevitable crash that followed led to massive financial dislocations. And while the housing bubble was expanding, the political leaders were only too happy to enjoy the illusion of prosperity.

      • These increases were made possible by extraordinarily low interest rates.

        Interest rates were low because there was insufficient purchasing power amount all but the very well off throughout the decade of the aughts. This allowed the use of borrowing to maintain living standards. It also kept the economy out of a recession, which was Greenspan’s main motivation.

        What I find interesting is that we have twice in the last 80 years had a huge increase in income inequality and both times this has been followed by a terrible economic downturn, and people don’t make a connection. We now have automatic stablizers that cushion the blow so we aren’t in a situation like the 30’s, but it’s still very bad. I don’t think what happened is subtle at all. How it played out was subtle and unique, just like snowflakes. But the theory behind them is relatively simple.

  5. Everybody likes to grasp at straws because nobody wants to think very hard about the single most obvious factor — the subprime bubble in the Sand States of the U.S. If we did, we might actually learn something, and we can’t have that.

    • Thanks Steve. You’re my hero! I wish I were brave like that. Other than those three years in the worst part of the Sunni triangle, I’m a complete coward. Deep down I know I was taking those Quantum Field Theory courses simply to avoid doing the hard thinking about mortgages in the sand states. That’s how us cowards roll; we take the path of least resistance. Special people like you who make the opposite choice are the ones who are going to save us from all this. Remember Steve, only you can save us. Only you!

      • 60 years from now, Steve Sailer will be hailed as the single most important economic scholar of the 21st century; his book “The Stands States of the US” will be a best-seller and be mandatory reading for ECN101 students.

  6. Don’t forget the books were cooked to look less leveraged than they were, ala rule 151. I don’t know how this changed over time, but the financial statements probably shouldn’t be taken at face value.

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