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Did European Banks Cause the Mortgage Bubble?

Conventional wisdom has it that deteriorating standards in the U.S. mortgage market, and in the market for mortgage derivatives, greatly contributed to the globalization of the financial crisis.

You can see this view reflected in the Securities and Exchange Commission’s complaint against Goldman Sachs. According to the narrative of the regulators, Goldman bankers — corrupted by a malfeasant bonus compensation system — duped European customers into buying its mortgage-related securities, convincing them that toxic bonds were practically risk-free.

Another version of this narrative places blame on the ratings agencies. In this version, the agencies were corrupted by their own compensation system — in which issuers paid for ratings — into supplying rosy ratings for toxic mortgage-backed securities. These rosy ratings seduced the innocent Europeans into buying mortgage-backed securities , collateralized debt obligations , structured investment vehicle commercial paper, and every other deadly product of the mortgage boom.

I’ve long argued that this theory was too simplistic. It puts all the blame on the suppliers rather than the consumers of the financial products of the mortgage bubble. It also poses some false hopes for averting another crisis by supporting claims that restrictions on the supply side — tighter regulation on securities issuers and ratings agencies — will go far enough.

The truth is that there was a strong demand for top ratings from the buyers of financial products. The higher the ratings givento the most volume of financial products, the more the balance sheets could expand at financial institutions faced with risk-weighted capital requirements.

What’s more, we know for a fact that the German bank on the other end of the Goldman Sachs trade, IKB Deutsche Industriebank, was actively pushing U.S. investment banks to supply more highly rated CDOs, while largely turning a blind eye to the underlying risks. As long as it was rated highly and paid a high yield relative to other triple-A rated bonds, the German bank didn’t care what went into it. (You can read all about this in the series that I wrote, in part with Teri Buhl, here: Part 1, Part 2, Part 3, Part 4.)

Now, this view of the world has been formalized by a Princeton economist named Hyun Song Shin. In a recent paper titled “Global Banking Glut and Loan Risk Premium,” Shin argues that the culprit for easy credit conditions was a “global banking glut” spurred, in part, by the ability of European banks to expand their balance sheets.

The paper is more suggestive. It was delivered as a lecture, but it raises key questions that are largely ignored by many financial commentators eager to demonize the U.S. banking system. Most importantly, it points out that it was European banks that most expanded the intermediation between U.S. borrowers and U.S. savers. To put it differently, it was European banks that most readily transformed access to U.S. savings via money-market fund lending into providing credit to the U.S. housing market.

Why did European banks play such a prominent role in this? Shin suggests that it was likely the Basel II capital regulations. This is very likely right, in my opinion. (I’ve written endlessly on the role of capital regulations and the damage they do. Here’s one piece.)

It’s not likely to be a popular position with partisan financial commentators. It neither supports the favored Republican narrative blaming Fannie Mae and Freddie Mac (or the Community Reinvestment Act), nor the favored Democratic narrative blaming greedy bankers running wild.

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