Fault Lines: How Hidden Fractures Still Threaten the World Economy (44 page)

9
I thank Rakesh Mohan, former deputy governor at the Reserve Bank of India, for pointing out this trend to me.

10
P. Gourinchas and H. Rey, “From World Banker to World Venture Capitalist: US External Adjustment and the Exorbitant Privilege,” NBER Working Paper 11563, National Bureau of Economic Research, Cambridge, MA, 2005.

11
B. Bernanke, M. Gertler, and S. Gilchrist, “The Financial Accelerator and the Flight to Quality,”
Review of Economics and Statistics
78, no. 1 (February 1996): 1–15.

12
Studies using detailed banking data now show that low interest rates cause riskier lending. See G. Jimenez, S. Ongenga, J. Peydro, and J. Saurina, “Hazardous Times for Monetary Policy: What Do Twenty-Three Million Bank Loans Say about the Effects of Monetary Policy on Credit Risk?” CEPR Discussion Paper No. 6514, Center for Economic Policy Research, London, 2007; V. Ionnadou, S. Ongenga, and J. Peydro, “Monetary Policy, Risk Taking and Pricing: Evidence from a Quasi-Natural Experiment,” paper presented at IMF Annual Research Conference, Washington, DC, November 2008.

13
See Raghuram G. Rajan, “Investment Restraint, the Liquidity Glut, and Global Imbalances,” remarks presented at the Conference on Global Imbalances, Bali, Indonesia, November 16, 2006.

14
See. A. Shleifer and R. Vishny, “The Limits of Arbitrage,”
Journal of Finance
52, no. 1 (1997): 35–55, for a theory as to why arbitrageurs may find it difficult to bring asset prices back in line even without short-sales constraints.

15
See Claudio Borio and Philip Lowe, “Asset Prices, Financial and Monetary Stability: Exploring the Nexus,” BIS Working Paper 114, Bank for International Settlements, Basel, July 2002.

16
See, for example, Bernanke, “Asset Price Bubbles and Monetary Policy.”

17
Alan Greenspan, speech at the American Enterprise Institute, December, 5, 1996.

18
Alan Greenspan,
The Age of Turbulence: Adventures in a New World
(New York: Penguin Press, 2007), 176–78

19
Alan Greenspan, “Opening Remarks,” Federal Reserve Bank of Kansas City symposium, Jackson Hole, WY, August 2002.

20
Ben Bernanke, “Monetary Policy and the Housing Bubble,” speech delivered at the annual meeting of the American Economic Association, January 3, 2010.

21
Marek Jarocinski and Frank Smets, “House Prices and the Stance of Monetary Policy,”
Federal Reserve Bank of St. Louis Review
90, no. 4 (July–August 2008): 319–65.

22
However, studies have identified a clear relationship between the level of interest rates and the level of house prices across countries.

1
This example relies on Peter Hoffman, Gilles Postel-Vinay, and Jean-Laurent Rosenthal,
Surviving Large Losses: Financial Crises, the Middle Class, and the Development of Capital Markets
(Cambridge, MA: Belknap Press, 2007), 149–51.

2
Adam Smith,
An Inquiry into the Causes of the Wealth of Nations
(Chicago: University of Chicago Press, 1976), 18.

3
Dan Ariely, Emir Kamenica, and Dražen Prelec, “Man’s Search for Meaning: The Case of Legos,”
Journal of Economic Behavior and Organization
67, no. 3 (September 2008): 671–77.

4
See James Chanos, “Prepared Statement: U.S. Securities and Exchange Commission Roundtable on Hedge Funds,” U.S. Securities and Exchange Commission,
www.sec.gov/spotlight/hedgefunds/hedge-chanos.htm
, accessed March 10, 2010.

5
Jill Riepenhoff and Doug Haddox, “Risky Refinancings Deepen Financial Hole,”
Columbus Dispatch,
June 2, 2008.

6
See Allen Frankel, “The Risk of Relying on Reputational Capital: A Case Study of the 2007 Failure of New Century Financial,” BIS Working Paper 294, Bank for International Settlements, Basel, 2009.

7
James R. Hagerty, Ruth Simon, Michael Corkery, and Gregory Zuckerman, “Home Stretch: At a Mortgage Lender, Rapid Rise, Faster Fall,”
Wall Street Journal,
March 12, 2007.

8
Riepenhoff and Haddox, “Risky Refinancings.”

9
For arguments and evidence along these lines, see U. Rajan, A. Seru, and V. Vig, “The Failure of Models That Predict Failure: Distance, Incentives and Defaults,” University of Chicago working paper, 2009.

10
Even the credit score of a borrower could be “managed,” with arrangements sometimes being made for a borrower to piggyback, for a fee, on the loan of a stranger with higher credit quality. See Frankel, “The Risk of Relying on Reputational Capital”; David Streitfield, “In Appraisal Shift, Lenders Gain Power and Critics,”
New York Times,
August 19, 2009.

11
Riepenhoff and Haddox, “Risky Refinancings.”

12
Bradley Keoun and Steven Church, “New Century, Biggest Subprime Casualty, Goes Bankrupt,”
Bloomberg.com
,
www.bloomberg.com/apps/news?pid=20601087& refer=home&sid=aXHDSbOcAChc
, accessed March 10, 2010.

13
See Atif Mian and Amir Sufi, “The Consequences of Mortgage Credit Expansion: Evidence from the U.S. Mortgage Default Crisis,”
Quarterly Journal of Economics
124, no. 4 (November 2009): 1449–96.

14
For a model of how volume can swamp incentives, see Andrei Shleifer and Robert Vishny, “Unstable Banking,” NBER Working Paper 14943, National Bureau of Economic Research, Cambridge, MA, 2009.

15
See Frankel, “The Risk of Relying on Reputational Capital.”

16
Peter Wallison, “Barney Frank: Predatory Lender,”
Wall Street Journal,
October 16, 2009.

1
This example borrows from Joshua Coval, Jakub Jurek, and Erik Stafford, “The Economics of Structured Finance,” Harvard Business School Working Paper 09–060, Cambridge, MA, 2008.

2
Tim Rayment, “The Man with the Trillion Dollar Price on His Head,”
Sunday Times,
May 17, 2009.

3
Ibid.

4
Shareholder Report on UBS’s Writedowns,
UBS, Zurich, April 18, 2008.

5
See the colorful account in Lawrence McDonald and Patrick Robinson,
A Colossal Failure of Common Sense
(New York: Crown Business, 2009).

6
Eric Dash and Julie Creswell, “The Rush to Riches that Undid Citigroup: Banking Giant’s Management Failed to Monitor the Risks Tied to Its Deals,”
International Herald Tribune,
November 24, 2008.

7
Andrew Ellul and Vijay Yerramilli, “Stronger Risk Controls, Lower Risk: Evidence from U.S. Bank Holding Companies,” Indiana University working paper, Bloomington, 2010. Available at Social Science Research Network,
http://ssrn.com/abstract=1550361
.

8
Rudiger Fahlenbrach and Rene Stulz, “Bank CEO Incentives and the Credit Crisis,” NBER Working Paper 15212, National Bureau of Economic Research, Cambridge, MA, July 2009.

9
McDonald and Robinson,
Colossal Failure
.

10
Calvin Trillin, “Wall Street Smarts,”
New York Times,
October 14, 2009.

11
Ibid.

12
Thomas Philippon and Ariell Reshef, “Wages and Human Capital in the U.S. Financial Industry: 1909–2006,” NBER Working Paper 14644, National Bureau of Economic Research, Cambridge, MA, 2009.

13
See R. Rajan, “Why Bank Credit Policies Fluctuate: A Theory and Some Evidence,”
Quarterly Journal of Economics
109, no. 2 (May 1994): 399–441.

14
Andrew Ross Sorkin,
Too Big to Fail
(New York: Viking, 2009), 145.

15
Michiyo Nakamoto and David Wighton, “Citigroup Chief Stays Bullish on Buyouts,”
Financial Times,
July 9, 2007.

16
Gillian Tett,
Fool’s Gold
(New York: Free Press, 2009), 144–45.

17
Ibid., 112–13.

18
I. Cheng, H. Hong, and J. Scheinkman, “Yesterday’s Heroes: Compensation and Creative Risk Taking,” working paper, Princeton University, 2009.

19
Steve Fishman, “Burning Down His House: Is Lehman CEO Dick Fuld the True Villain in the Wall Street Collapse?”
New York
magazine, November 30, 2008,
nymag.com/news/business/52603/index3.html#ixzz0XFCXEyhZ
.

20
Sorkin,
Too Big to Fail,
273.

21
Andrea Beltratti and Rene Stulz, “Why Did Some Banks Perform Better during the Credit Crisis? A Cross-Country Study of the Impact of Governance and Regulation,” NBER Working Paper 15180, National Bureau of Economic Research, Cambridge, MA, July 2009.

22
See editorial, “‘No Line Responsibilities’: What Robert Rubin Did for His $115 Million,”
Wall Street Journal,
December 3, 2008,
http://online.wsj.com/article/SB1228266 32081174473.html
.

23
See Viral V. Acharya, Thomas Cooley, Matthew Richardson, and Ingo Walter, “Manufacturing Tail Risk: A Perspective on the Financial Crisis of 2007–09,” working paper, New York University Stern School of Business, 2009.

24
Caroline Baum, “Fed Should Read Its Own Memo on Rising-Rate Risk,”
Bloomberg.com
, January 19, 2010,
www.bloomberg.com/apps/news?pid=20601039&sid=aygo_Qm9sZ9I
.

25
See Tom Braithwaite, “Banks Face Probe over Trading in Tarp Frenzy,”
Financial Times,
February 1, 2010.

26
Ibid.

27
Henry Paulson,
On the Brink: Inside the Race to Stop the Collapse of the Global Financial System
(New York: Business Plus, 2009), 293.

28
D. Diamond and R. Rajan, “Fear of Firesales and Credit Freezes,” NBER Working Paper 14925, National Bureau of Economic Research, Cambridge, MA, 2009.

1
Matt Taibbi, “Inside the Great American Bubble Machine,”
Rolling Stone,
July 2, 2009.

2
See the discussion in Donncha Marron,
Consumer Credit in the United States: A Sociological Perspective from the 19th Century to the Present
(New York: Palgrave Macmillan, 2009), 3–5.

3
Benjamin Franklin,
The Way to Wealth,
Wealth Reader,
wealthreader.com/book/the_way_to_wealth/1
, accessed March 10, 2010 (italics in original).

4
See Robert Higgs,
Crisis and Leviathan: Critical Episodes in the Growth of American Government
(Oxford: Oxford University Press, 1987), 179.

5
For an excellent paper on tail risk, see Viral V. Acharya, Thomas Cooley, Matthew Richardson, and Ingo Walter, “Manufacturing Tail Risk: A Perspective on the Financial Crisis of 2007–09,” working paper, New York University Stern School of Business, 2009.

6
Raghuram Rajan, “Bankers’ Pay Is Deeply Flawed,”
Financial Times,
January 9, 2008.

7
Dennis Berman, “Where Was Lehman’s Board?”
Wall Street Journal,
September 15, 2008,
blogs.wsj.com/deals/2008/09/15/where-was-lehmans-board
/.

8
The ideas on disclosure are based on a working paper by the Squam Lake Working Group on Financial Regulation, “A New Information Structure for Financial Markets,” Council on Foreign Relations,
www.cfr.org/publication/18568/new_information _infrastructure_for_financial_markets.html
, February 2009.

9
See Andrew Ross Sorkin,
Too Big to Fail
(New York: Viking, 2009), 304.

10
See D. Diamond and R. Rajan, “Illiquidity and Interest Rate Policy,” NBER Working Paper 15197, National Bureau of Economic Research, Cambridge, MA, 2009.

11
This is a proposal made by the Squam Lake Group in its forthcoming report, to be published by Princeton University Press.

12
Banks should benefit by committing to their clients that they will not trade using their information or against their interests. Some boutique investment banks use the fact they have no conflicts of interest as a selling point. Perhaps this trend will catch on, in which case regulation will be unnecessary.

13
For a detailed explanation of why equity capital is costly in banks, those familiar with the Modigliani-Miller theorem can consult D. Diamond and R. Rajan, “A Theory of Bank Capital,”
Journal of Finance
55, no. 6 (December 2000): 2431–65.