Dallas Fed Research Director Harvey Rosenblum discusses the stability of the U.S. economy's Great Moderation and how it set the stage for the financial turmoil that has gripped the nation since August 2007.Economic conditions - United States ; Recessions ; Mortgage loans

Harvey Rosenblum

English

Research Papers in Economics

OnTheRecord
SouthwestEconomy FEDERAL RESERVE BANK OF DALLAS • MARCH/APRIL 2008 8
that fed on laziness and overconfidence. As 
a result, financial market participants’ incen-
tives became perverse, misplaced and mis-
guided. But financial markets and the econ-
omy  remained  calm,  so  the  complacency 
didn’t raise as many red flags as it should 
have. Regulation and market discipline were 
always one or two steps behind events.
Q. How did this complacency manifest itself?
A. Through what I call the three corollar-
ies of complacency—complexity, confidence 
and compensation. The first of these con-
cepts gets at whether managers can figure 
out what’s going on within their own orga-
nizations. 
Take the obvious example of a bank, 
which we have to remember is a regulated 
entity. Can the CEOs describe their organiza-
tions’ structure and investment risks to their 
12-year-old  grandchildren?  Are  objectives 
other than safety, soundness and shareholder 
value being pursued? Or is the complexity of 
Q. Would you explain the term Great 
Moderation?
A. Economists use it to describe the marked 
decline in the frequency of recessions over 
the past 25 years. A less volatile macroeco-
nomic performance was accompanied by big 
reductions in inflation and inflation volatil-
ity. This environment changed expectations. 
Inflation and inflation expectations are the 
keys to economic stability because they’re 
the  primary  drivers  of  changes  in  interest 
rates over long periods. 
One  way  this  relationship  affects  the 
average American is through its impact on 
mortgage rates, which also rise and fall based 
on  inflation  and  inflation  expectations.  As 
interest rate volatility nearly disappeared in 
recent times, home mortgage rates declined 
appreciably, making the American Dream of 
homeownership more affordable.
Q. So far, this sounds positive. How did we 
get from there to the irrational behavior we’ve 
heard about in the housing and mortgage 
markets?
A. We have to realize that some of the irra-
tionality that characterized the years leading 
up to the credit crisis was a by-product of 
the economic tranquility being experienced. 
The Great Moderation induced a feeling of 
minimal  risk,  but  the  feeling  did  have  an 
aura of rationality to it. 
Indeed, it may have been quite rational 
to  have  faith  in  positive  outcomes,  to  be-
come a bit complacent, given the economy’s 
increased and prolonged stability. The real 
question is, how do you draw the line be-
tween rational complacency and misplaced 
confidence?
Q. And the answer to that question is…?
A. At a certain point, complacency began to 
feed on itself; it became a psychological state 
the corporate structure a way to hide things 
from top management and shareholders? If 
so, there should be a rating penalty; every 
effort at obfuscation must be “taxed.” It’s fine 
to have a far-flung empire. It’s not fine for it 
to be subsidized by shareholders, investors 
or, perhaps eventually, by taxpayers.
Q. And the second C: confidence? 
A. I think of confidence as a component of 
liquidity, which isn’t one of those things you 
can easily measure. We’ve quickly learned 
that it’s more like a switch that’s either on 
or off. The crux of liquidity is whether you 
can sell something quickly for cash at a price 
close to the last trade. If you can, then an 
asset is liquid. But when market confidence 
starts disappearing, it takes liquidity with it, 
especially  during  turbulent  times,  when  a 
flight to quality is almost certain. 
I would be remiss if I failed to mention 
a separate aspect of liquidity that crept back 
in  the  recent  complacency:  a  classic  mis-
match of long-term assets funded by short-
term liabilities. In the current crisis, it has 
shown up in bank off-balance-sheet entities 
funded with very short-term commercial pa-
per backed by long-term assets of question-
able quality. 
Commercial  paper  has  traditionally 
traded at rates very close to similarly short-
term Treasury rates. The underlying assump-
tion behind every asset–liability mismatch is 
that you can indefinitely fund your liabilities 
at  something  close  to  short-term  Treasury 
rates. What banks discovered the hard way 
is that no market can provide a perfect sub-
stitute for the U.S. Treasury market.
Q. Does it bother regulators that they’re once 
again dealing with the repercussions of off-
balance-sheet financing? 
A. Not necessarily. A little background on the 
workings of commercial banks helps here. 
The sustainable competitive advantage com-
mercial banks have over their nonbanking 
competitors is the safety net that encompass-
es the Fed’s discount window and federal 
deposit insurance. Commercial banks volun-
tarily “pay dues” to be among the financial 
Dallas Fed Research Director Harvey Rosenblum discusses the stability of the U.S. 
economy’s Great Moderation and how it set the stage for the financial turmoil that has 
gripped the nation since August 2007. 
The Dangers of Complacency About Risk
A Conversation with Harvey RosenblumFEDERAL RESERVE BANK OF DALLAS • MARCH/APRIL 2008 SouthwestEconomy 9
“The Fed is using every tool at its disposal and creating 
new ones to mitigate the damage this storm is inflicting 
on the economy.” 
institutions that are more closely regulated. 
The advantage of membership in this club is 
that it provides a solid means of funding in 
both good times and bad.
What we’re grappling with today is that 
some banks have effectively bent the rules 
under which they’ve agreed to be regulated 
by creating these off-balance-sheet entities 
that are very difficult to track. Why they did 
this leads us to the subject of incentives, or 
the last of my three C’s of complacency—
compensation. 
Before the current crisis hit, it appeared 
the incentive systems were operating as they 
were  meant  to,  as  a  guide  for  people  to 
maximize company profit and shareholder 
value.  But  in  retrospect,  these  incentives 
seem  perverse.  They  encouraged  increas-
ingly risky lending by compensating people 
for the number of transactions and not for 
the long-run return on investment financed 
by these transactions.
Q. Can you give us an example?
A. The most obvious one comes out of the 
mortgage banking industry. For starters, the 
entire industry really changed when savings 
and loans became less of a factor in mort-
gage lending. The S&L decline in the 1980s 
resulted in a critical shift away from a busi-
ness  model  that  might  be  deemed  quaint 
these  days:  A  lender  specializing  in  mort-
gage loans knew it would hold them to ma-
turity. As a result, the incentive was to lend 
to borrowers who had the means to repay, 
with  the  loans  collateralized  by  property 
that wouldn’t decline in value. The risk was 
that you funded these assets with deposits, 
liabilities whose maturity was much shorter 
than the assets’. 
The  S&Ls’  fall  opened  the  door  to  a 
cottage  industry  that  made  mortgage  loans 
on behalf of a wide range of investors who 
wanted to hold mortgage debt. In this new 
business model, you originated loans with the 
intent of selling them to investors rather than 
holding them. You got paid for making loans. 
Looked at differently, every loan denied was 
time and income forgone. So the incentive 
was to get investors to be flexible about what 
long-term assets they were willing to hold.
In a relatively short time, the 
industry went from a platform of 
homogenous,  plain  vanilla  mort-
gages that may not have met all 
borrowers’ needs to an amalgam 
of customized mortgages with ad-
justable rates, zero or low down 
payments,  interest-only  payments 
and looser standards for documen-
tation of income.
Q. How does that tie into our recent troubles?
A. The Great Depression taught us mortgag-
es could be risky products. House prices fell 
when unemployment rose. For many years 
after the Depression, national banks weren’t 
allowed  to  hold  mortgages  because  they 
were viewed as too risky. Fifty years of home 
mortgages being much less risky changed all 
that, abetted by the Great Moderation.
Q. I doubt many people today would describe 
mortgages as “less risky.”
A. It doesn’t help that the housing indus-
try has been hit by what has been described 
as the equivalent of a 100-year storm. But 
unlike an uncontrollable event in nature, I 
think the storm in the housing market might 
have been prevented. 
Homes  have  always  been  depreciable 
assets.  They  appreciated  only  if  you  kept 
blowing money into them, kept improving 
and modernizing them. But at some point, 
the public began to believe that homeown-
ership was a party you had to attend, that 
house  prices  could  go  in  only  one  direc-
tion—up.
Feeding  this  perception  was  that  cot-
tage industry of mortgage lenders and in-
vestors grafted onto the existing mortgage 
industry structure. We saw a tremendous ex-
pansion of lending. Money flowed in from 
all over the world to support it. The perva-
sive complacency, however, meant many in-
vestors didn’t adequately consider the risks 
involved, particularly when it came to the 
innovations in the subprime segment of the 
mortgage market.
Not all of this financial innovation was 
bad,  mind  you.  The  positive  spillover  is 
that many Americans have better access to 
mortgage  credit  and  homeownership  rates 
have risen sharply. And much of that money 
flowed  to  responsible  borrowers  who  are 
fully  discharging  their  repayment  obliga-
tions. Many of them wouldn’t have had ac-
cess to mortgage credit under the “quaint” 
business model of the late 20th century. The 
democratization of the mortgage market—
and  other  segments  of  the  credit  markets 
as well—is something that, on balance, we 
should celebrate.
Q. So how do we navigate, and presumably 
escape, this perfect storm’s path?
A. Until we have a sense that house prices 
have stopped falling, it’s hard to say how 
long the current turmoil will last. But let’s 
not lose sight of the fact that there will be 
a bottom to this market. And it’s probably 
not all that far away. The Fed is using every 
tool at its disposal and creating new ones to 
mitigate the damage this storm is inflicting 
on the economy. The Fed has been rewriting 
the textbook on economics and finance. The 
Fed is clear about its mission, and I believe 
we’re succeeding.
Editor’s note: Two Dallas Fed Economic Letter 
articles offer background on the issues discussed 
here. See “The ‘Great Moderation’ in Output and 
Employment Volatility: An Update,” by Evan F. 
Koenig and Nicole Ball, September 2007, and 
“From Complacency to Crisis: Financial Risk 
Taking in the Early 21st Century,” by Danielle 
DiMartino, John V. Duca and Harvey Rosenblum, 
December 2007.

On the record: the dangers of complacency about risk: a conversation with Harvey Rosenblum

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On the record: the dangers of complacency about risk: a conversation with Harvey Rosenblum

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