System Failure

How to think about financial regulation in an era of systemic risk.

Our collective economic tragedy leaves at least two beneficiaries in its wake: expert financial writers and financially literate readers. Readers do not lack for abundant material to digest on the financial crisis of 2008 and its origins. Some of the volumes are already legendary. They include Michael Lewis’s evocative The Big Short, Simon Johnson and James Kwak’s metaphorical 13 Bankers, Paul Krugman’s sobering The Return of Depression Economics, Kenneth Rogoff and Carmen Reinhart’s centuries-spanning This Time Is Different, Andrew Ross Sorkin’s Too Big to Fail, Robert J. Shiller’s The Subprime Solution, and George Soros’s rather ethereal The Crash of 2008 and What It Means.

One reason for perusing all of these books is that doing so offers a lesson in cultural anthropology. It exposes the reader to a bewildering indeterminacy, with manifold readings of the same facts. There are as many glosses on the crisis as there are chapters in these tomes. Their culprits range widely: from the conspiratorially political impulse to deregulate to the contingently historical structure of modern finance; from the inescapable psychological limits of human learning and ignorance of “black swan” events to the profoundly cultural obsession with trading and selling volume, and with housing, finance, and profit itself.

This emergent literature on the crisis has worrisome limits. One is the tendency of authors to exploit the crisis to reaffirm pre-existing views, neglecting the opportunity to scrutinize models of regulation that have been newly legitimized by our collective tragedy. Would an intact Glass-Steagall law, the New Deal-era legislation regulating banks that was repealed in 1999, really have prevented the catastrophe, or was stronger medicine necessary? Would relatively coordinated state attorneys general, unencumbered by pre-emption, truly have fixed on the perils of subprime lending in California, Florida, and Nevada?

A deeper failure lies in the insularity of so many of the accounts, focusing on the world of systemic finance while barely glancing at the household finances undergirding that realm. Systemic financial risk comprises, roughly, institutions lending to and investing in other institutions, whether publicly (the stock market) or privately (private equity, over-the-counter derivatives). The realm of consumer finance involves those debt instruments in which households invest (mortgages, auto loans, credit cards, and other consumer loans). Unlike so many past financial crises, the crisis of 2008 was rooted in a spectacular, global decline in the price of a single commodity: housing. This fact is clear in all of the recent books, and yet its recognition only takes us so far. Market and regulatory failure in real estate cannot provide all of the explanation for the crisis. Real estate bubbles come and go, after all. No nationwide, one-way price escalator for land has ever prevailed for long in America. Serious crises have afflicted local and regional housing markets (Florida in the late 1920s and 1930s), commercial real estate (New York in the postwar era), and agricultural tracts (the 1890s, the 1920s, and the 1980s). So why did this real estate bubble take down Wall Street with it? And what can we learn from the carnage?

The critical and oft-neglected fact of the crisis rests in the deep connections between the worlds of consumer risk and systemic risk. These connections are both the central metaphor and the driving analytic framework for a perceptive new book by legal scholars Kathleen Engel and Patricia McCoy. As its title suggests, The Subprime Virus describes the infectious spread of bad credit, which vaulted from the consumer realm to the systemic realm. It traveled from places like Florida, Cleveland, and Las Vegas to governments and banks in Iceland and Charlotte, North Carolina, and on Wall Street.

Engel and McCoy are uniquely situated to provide this analysis. Engel is a bankruptcy law scholar who recently moved from Cleveland-Marshall College of Law (where she documented the housing downturn in Cleveland with ethnographic insight) to Suffolk University. McCoy is a professor of finance law at the University of Connecticut and now assistant director for home equity and mortgage markets at the new Consumer Financial Protection Bureau. They combine legal understanding of the really significant changes (and non-changes) in federal law with a shrewd grasp of the individual narratives and aggregate statistics of the housing crisis. (I will placehold, for another time and another essay, the fact that the most enlightening and underappreciated analysis in the years before and after the crisis seems to have been done by women, both as policy-makers—Sheila Bair, Brooksley Born, Elizabeth Warren—and as authors—Engel and McCoy, Susan Wachter, Warren again.)

Engel and McCoy open and close their volume on the gritty streets of Cleveland. The late 1990s offered some hope for Ohio’s most populous city, as they did for other rusting industrial centers. Long-stilled factories began to hum again and, in that more equitable boom of the Clinton years, real money began to line the pockets of the working class. But just as Cleveland’s working families surfaced for air, so too did a slew of predatory loans emerge, with mortgage brokers going door to door to lure homeowners into refinancing on unsustainable terms. “We could not fathom,” write Engel and McCoy, “why lenders would make loans that borrowers could not afford to repay. Foreclosures yield about fifty cents on the dollar. So why would lenders do business when the endgame was foreclosure?”

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