Andrew Lo reviews 21 books on the financial crisis

The paper and abstract are here:

The recent financial crisis has generated many distinct perspectives from various quarters. In this article, I review a diverse set of 21 books on the crisis, 11 written by academics, and 10 written by journalists and one former Treasury Secretary. No single narrative emerges from this broad and often contradictory collection of interpretations, but the sheer variety of conclusions is informative, and underscores the desperate need for the economics profession to establish a single set of facts from which more accurate inferences and narratives can be constructed.

It is an instructive look at how bad we are at discovering the truth and talking about it.  Here is part of his beginning:

To illustrate just how complicated it can get, consider the following “facts” that have become part of the folk wisdom of the crisis:

1. The devotion to the Efficient Markets Hypothesis led investors astray, causing them to ignore the possibility that securitized debt2 was mispriced and that the real-estate bubble could burst.

2. Wall Street compensation contracts were too focused on short-term trading profits rather than longer-term incentives. Also, there was excessive risk-taking because these CEOs were betting with other people’s money, not their own.

3. Investment banks greatly increased their leverage in the years leading up to the crisis, thanks to a rule change by the U.S. Securities and Exchange Commission (SEC).

While each of these claims seems perfectly plausible, especially in light of the events of 2007–2009, the empirical evidence isn’t as clear.

Starting on p.35, you can find a new take on the myth of the 2004 SEC change to Rule 15c3–1 (though see the first comment), relating to the supposed increase in leverage requirements from 12-1 to 33-1:

…it turns out that the 2004 SEC amendment to Rule 15c3–1 did nothing to change the leverage restrictions of these financial institutions. In a speech given by the SEC’s director of the Division of Markets and Trading on April 9, 2009 (Sirri, 2009), Dr. Erik Sirri stated clearly and unequivocally that “First, and most importantly, the Commission did not undo any leverage restrictions in 2004”. He cites several documented and verifiable facts to support this surprising conclusion, and this correction was reiterated in a letter from Michael Macchiaroli, Associate Director of the SEC’s Division of Markets and Trading to the General Accountability Office (GAO) on July 17, 2009, and reproduced in the GAO Report GAO–09–739 (2009, p. 117).

It is also shown that the higher leverage was common in the late 1990s.  There is more to the discussion, but it is time to reconsider this point.


The 2004 SEC amendment to Rule 15c3–1 was for broker-dealers that are part of CSEs (Consolidated Supervised Entities).
In late 2003, the SEC set up ad hoc regulations for 5 investment banks with european operations in order for these to avoid supervision by european regulators w.r.t Basel II related capital rules.
These investment banks were re-branded by the SEC as "Consolidated Supervised Entities". The CSEs were allowed to use their own risk-models based on Basel II, and compute their own capital requirements based on these models (allegedly approved by the SEC).
The rest is history: leverage at the CSE level went trough the roof and none of these banks has survived as an investment bank (neither has the SEC's Consolidated Supervised Entities Program which ended shortly after Lehman went bust) , they were either bust, sold or converted to bank holding companies.

+1 Kudos for jck.

This is why vetting on the internet is sooooh good.

Absolutely devastating takedown on the myth of the myth.

Bill, why do you think jck is right and Lo is wrong? Jck just made an unsubstantiated statement. Who knows if he is right or not? I tend to think he is wrong because from what I know about Basel II it applies only to commercial banks, not investment banks.

"Under rules proposed in late 2003, five large, independent U.S. securities houses - including Merrill Lynch, Goldman Sachs and Bear Stearns - now also will be subject to Basel II under the SEC's Consolidated Supervised Entities (CSE) regime."
Basel II: Coming to America
"...all of the firms are applying Basel II and its advanced approach to credit risk exposure. Each CSE has undertaken to maintain a ratio of regulatory capital to risk-weighted assets of at least 10 percent, the Federal Reserve's standard for a well-capitalized institution."

So it wasn't the 2004 amendment but the 2003 ad hoc regulations? And only for 5 investment banks, which subsequently increased their leverage and went bust?

How many of the 5 were too big to fail? Received TARP assistance? Probably all.

Lehman Brothers failed and has been liquidated.

Bear Stearns was forced into a fire sale to JP Morgan.

Merrill Lynch was forced into a fire sale to Bank of America.

Morgan Stanley chose the evil of "crushing government regulation" to obtain more than a hundred billions in Fed credit as a regulated and fee paying bank holding company.

Goldman Sachs chose the evil of "crushing government regulation" to obtain Fed credit as a regulated and fee paying bank holding company.

Share holders in every one of these five suffered huge losses as a direct result of the mismanagement that followed their gaining exemptions from important financial regulation that we were told was completely unnecessary and that hindered banks promoting sustained economic growth.

Only if you think shareholders are irrelevant to corporations can you argue these firms were bailed out by the government. But that implies that both tax payers and shareholders are transferring their wealth to corporate CEOs to squander and keep for themselves, in a complete corruption of both public and private democracy. How can the free market democracy of corporate governance fail so badly as it did for these five firms?

1) Institutional investors who controlled the majority of shares were blind/didnt care about corporate governance, which led to
2) boards that were fully on autopilot, staffed with old zombies who are there to collect the 6 figure salaries without actually having to work because,
3) Del Chancellery decisions in the last 10 years absolved boards of almost any responsibility, and insurance for boards against lawsuits by shareholders did the rest

Yes, everything would have turned out for the best if the big investment banks had been regulated by European bank regulators. In retrospect, it's clear that the European bank regulatory regime was much better, which is why no European banks failed, and even now no European banks are in distress.

No, they chose NOT to run real stress tests, so as to expose their deficiancies, and to include convertible stock as assets. They are now suffering for their competition to the bottom.

I think Thomas's tongue is in his cheek.

Regarding the three "facts" that are now "part of the folk wisdom:"

All the statements make multiple claims, some claims are true, others questionable, and the implied relationships between the claims are interesting at best.

E.g. #1:

"Devotion to the EMH." Huh? Devotion to EMH was the first idea to go in the bubble - by 2005 or so, investment banks were scrambling to exchange traded real-estate indexed products, a clear sign of pent-up pricing imbalances.

"Ignoring the possibility that debt was mispriced?" Um, so credit default swaps never caught on?

How are these two "facts" related?

These are all just strawman arguments about a mythical "folk wisdom."

I think that the other relevant literature here would be that written on major accidents. What is found when they are studied, is that there is almost always a chain of events that had to go wrong in order to create a catastrophe. Rarely is there a single event. People like the simplicity of singe cause arguments, and it is a good way to substantiate one's bias, but single cause arguments are usually wrong.


No Econned, no 'How Markets Fail', no 'Crisis Economics'.

I mean, TDID is barely even about the current crisis.

Page 7 out of 41:
"Roubini and Mihm, 2010, Crisis Economics: A Crash Course in the Future of Finance.
Penguin Press"
Your mention of TDID (the book which appears right before Roubini's) indicates your read that page. So I'm mystified at your claim they didn't review Crisis Economics.

I think the simple explanation is that I'm an inattentive idiot.

Tyler, how can you post about the causes of the current recession, without (as usual) at least mentioning Scott Sumner in passing? :-)

If I were to attempt to channel Sumner, he would probably say: all of those "causes" may indeed have happened, but NONE of them necessarily led to any multi-year recession. At best, they were individual matches that provided the first spark. But the "cause" of the recession's wildfire was the professional firefighters (aka the US Fed) that sat back and allowed the initial small flames to catch and then burn out of control.

The "cause" of the recession, is the Fed allowing NGDP to plummet. Everything else you mention is in the noise. Even if true.

...that is, if the Fed is able to control NGDP.

Lo's paper does not even mention fed policy.

Sumner needs to write a book and Lo can write an addendum.

There was one central cause: The belief on the part of everyone - from home buyers to investment bankers - that home prices would not go down on average nationally. "Not since the depression"
The three "facts" are corollaries to that one fact or things that wouldn't have been such a problem (in this crisis) without that one fact. EMH is wrong for many reasons, but in this case houses were mispriced. The short term trades fattening Wall Street bets were based on sub-prime mortgage securities, which were created with the assumption house prices wouldn't fall. And the leverage that brought down the investment banks was used to horde these MBS's (or derivatives based on them).

One "fact" to rule them all. Of course everyone learned from that and it will never happen again.

The claim housing/real estate prices never went down nationally is "true" only if one rewrite the history of the Reagan era. Which has occurred to make Reagan a hero of conservative economic policy because the economy suffered twice while Reagan was president, just as it suffered twice while GW Bush was president. A mild early 80s recession was made much worse by Reagan's fiscal policies (Volcker Fed policies caused a recession in 79 from even tighter monetary policy than in 81-83) and then the real estate and stock market bubbles popping in 87-88. The recovery in the early 00s was the worst since WWII (until the tax cut stimulus policies since 2007 created an even worse recovery) followed by real estate and stock market bubbles popping in 2007-08.

Perhaps I am one of the few to remember real estate prices falling steeply and sharply because I moved at the peak of the housing bubble in 86 and told everyone that housing was over priced so I was making a huge down payment and not buying a bigger house or getting highly leveraged because prices would probably fall by 10%. Two years later prices had fallen by 30-40%. Texas was bulldozing large housing tracts that had gone the middle of construction and been abandoned. HW Bush signed a controversial TARP law.

History does repeat. The pattern threatened in the 90s, but Clinton's economic team were perhaps still remembering the mess that was the 80s in both domestic and international banking, and by "rule of men" steered away from bubble markets harming the economy. The 90s NASDAQ bubble popping was basically harmless. The 90s Asian real estate bubbles popping had little impact in the US. The national debt crisis wave of the 90s was handled deftly to prevent global economic contagion. So the 90s were not that different from the 80s or 00s, except for the skill and luck of the human policy making to manage the problems.

Between the 30s and 80s, similar problems were largely prevented by far more intrusive government regulation, and government intervention in the markets by forcing debt restructuring. It was the government restrictions on speculation and government forced hair cuts on sovereign debt from the 30s to 80s that led to the policies since 70s and 80s based on the free lunch that getting the government out of the way would result in greater growth and greater stability.

Oh the curse of being old enough in the 60s to follow the debates over credit, banking, regulation, stock markets: None of the promised benefits made by the likes of Milton Friedman have materialized and all of the problems predicted by the opponents of deregulation have come true over the past three decades multiple times.


In the late 80's, I was attending a mortgage backed securities conference in Toronto. The S&L crisis was unfolding, but its depths were not clear.

None of the risk models had any room for signals of criminality - the ability of the bad guys to mimic good paper. (It is a very bad sign for your credit system when fake credit can be literally manufactured by bad guys.)

Of course, we know that the S&L crisis was rampant with criminal enterprises masquerading as banks; Bill Black is an excellent source on this.

This is the area, which should be of interest to game theorists, that is missing, from Lo's review and perhaps the literature: discussions about signals from criminal or grey enterprises.

@Max Rockbin: Read Don Geddis's post. That is precisely what is dispute. A housing bubble can lead to a crash (just like a stock market crash or the end of the internet bubble) without necessarily triggering a worldwide macro recession. The claim of monetarists like Sumner is that allowing NGDP to fall by being insufficiently expansive on monetary policy is the true "cause" of the crisis.

This may or may not be true, but it certainly shows that NOT everyone agrees that the housing bubble was a sufficient cause.

Being generous, we can conclude that Lo ignored the monetary perspective on the recession favored by Sumner and other Market Monetarists because it hasn't yet been presented in book form, instead appearing in many articles and blog posts. This will be remedied by the appearance in a few months of this important book by Robert Hetzel of the Richmond Fed --

I, for one, appreciate that he used Rashomon to illustrate the movie concept of 'limits of the known' rather than Pulp Fiction (What's in the briefcase?) or Reservoir Dogs (What happens to Mr. Pink?)

Sorry I am late to this but Dr. Erik Sirri is a brazen liar. When he says:

…it turns out that the 2004 SEC amendment to Rule 15c3–1 did nothing to change the leverage restrictions of these financial institutions. In a speech given by the SEC’s director of the Division of Markets and Trading on April 9, 2009 (Sirri, 2009), Dr. Erik Sirri stated clearly and unequivocally that “First, and most importantly, the Commission did not undo any leverage restrictions in 2004”.

He is lying.

See this link.

The article includes a link to the tape of the SEC committee hearing approving the rule.

In the tape the staff says "to expect capital requirements to be reduced"

The first question from the commissioners was how much capital requirements to be reduced. The woman who ahd been introducing the rule turned to another and asked how much they capital would be reduced and the second staff member mumbled something, I think the answer was 30% but the tape is unclear. Staff then went on to say it would be hard to say because so much would be judgemental. Staff really had no idea what the capital requirement reduction would be though they seemed to think it would be less than 50%.

If you don't believe me listen to the tape.

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