Eric S Rosengren: The role of "financial myths" in financial crises
Remarks by Mr Eric S Rosengren, President and Chief Executive Officer of the Federal
Reserve Bank of Boston, at the Boston University conference on "The State of Financial
Reform" (panel on Lessons Learned from the Global Financial Meltdown), Boston,
Massachusetts, 28 February 2011.
* * *
Good morning. I'd like to thank Boston University and all the conference organizers,
particularly Larry Kotlikoff, for the opportunity to be here to discuss lessons learned from the
global financial meltdown.1
Everyone knows that the past three years have been a particularly difficult period for global
financial market stability and for the global economy. The financial crisis clearly showed the
dramatic impact that financial problems can have on the real economy. And in spite of a fair
amount of focus on financial stability prior to the crisis, events highlighted that the private and
public sectors both here and abroad were not fully prepared for the kinds of financial shocks
we experienced.
Today I'd like to discuss the role of what I call "financial myths" in creating financial crises. By
financial myths I mean the beliefs, held by most market participants and by regulators, that
certain outcomes are so unlikely to occur that they can basically be ignored - essentially that
low probability events, based on historical experience, can be reclassified as zero probability
events. When these sorts of widespread assumptions - these financial myths - turn out to be
wrong, most financial-market participants find themselves poorly positioned for the resulting
shocks. The result is insolvency of groups of firms and substantial uncertainty - uncertainty
about the exposure of many firms to direct losses, or to indirect losses created by their
counterparty exposure to other firms that suffer direct losses.
These so-called financial myths are not unique to this time period, or to this country. I would
like to briefly mention two among the numerous examples from recent history - examples
where financial myths were important in helping to create a potential crisis. The first example
involves the assumption of many in Japan that real estate prices could not fall in the late
1980s. The second involves the assumption, in the late 1990s, that the Internet had
completely changed how we should think about company valuation.
I will then briefly mention four financial myths that played critical roles in the recent financial
crisis. These include the following assumptions:

that a diversified portfolio of US real estate had little risk of falling in value;

that Triple-A rated securities based on mortgages were so well protected by the
structure of the securitization that they posed little risk even if real estate prices did
fall;

that the evolution of many financial institutions to an "originate to distribute" model of
lending and securitization meant there was little risk exposure to declining real
estate prices; and,

that there was little risk of a "run" on organizations like investment banks that relied
on short-term, collateralized borrowing.
Then to conclude I'd like to briefly mention what we can and must do to reduce the risks
resulting from these sorts of financial myths, going forward. I believe that financial stability
will, in the future, be better served as we implement some of the protections afforded by the
Dodd-Frank Act; but I also suspect that doing better at protecting against various financial
myths ultimately requires a cultural change. As a discipline, risk management has been too
willing to accept that historical statistical relationships will be stable. Ideally, risk management
practices would lead us to ask things like "What will happen if the historical relationship
breaks down?" and "What assumptions would need to change for them to break down?"
Also, I will touch on the fact that challenging assumptions and understanding the risk
inherent in relying solely on historical experience should not be the responsibility of the risk
manager alone. These things also need to be better ingrained in CEOs, members of boards
of directors, and regulators. I believe we need to do a much better job of using so-called
stress tests to challenge commonly held views, so that boards of directors and regulators of
firms better understand the fundamental drivers of risks in organizations and in the financial
system.
Financial myths in recent history
Let me look back to the time period before the most recent crisis and share two examples of
financial myths - and, unfortunately, their messy demise. And I would emphasize that these
are just two of many examples of the phenomenon.
First, I'll note that during the late 1980s, New England began to experience substantial
declines in residential and commercial real estate prices. My research at that time at the
Boston Fed was focused on how problems at financial institutions could disrupt credit
availability. Interestingly, in 1989 I was visited by a variety of Japanese academics and
government officials. They wanted to understand how we had missed the signs of an
overheating real estate market.
As Figure 1 indicates, it was shall we say an interesting time for researchers from Japan to
ask such a question. However, when I inquired about the rapid increase in real estate prices
in their country, I always received the same answer - Japan is an island nation and had
limited buildable lots, and that prevented real estate prices from declining. This view was
very widely held. However, as you can see in Figure 2, that widely held financial myth was
soon shattered. Unfortunately, the result of this belief was eventually the crippling of some of
the world's largest financial institutions, a long period of subpar economic growth in Japan,
and eventually a problematic deflation that Japan struggles with to this day.
A second example is provided by the growth of the Internet, and in particular the growth in
"dot-com" stock valuations, in the late 1990s. As shows, there was a substantial
Figure 3
run-up in stock valuations during this period. At the time I had conversations with a variety of
financial professionals in Boston who made the argument that traditional valuation measures
no longer applied. The view assumed by many was that valuation of firms should be based
on clicks of a computer mouse rather than earnings, either current or expected in the future.
As Figure 4 shows, such enthusiasm for a new way of valuing companies was short-lived.
But importantly, the substantial decline in Internet-related stocks did not create a financial
crisis. Many of the positions were equity financed - so, while significant wealth was lost,
financial institutions and financial markets did not suffer severe repercussions. That loss in
wealth helped ignite the 2001 recession, but it was a much more mild downturn than the one
we have experienced of late. With the financial infrastructure not significantly damaged, the
impact was much less severe than if individuals and firms had taken highly leveraged
positions.
Financial myths in the recent crisis
Now I'd like to describe, and present some charts that illustrate, four financial myths that
played a role in the recent crisis.
Myth 1 - Diversification eliminated the risk of declines in residential real estate
holdings
Despite the experience of Japan's real estate in the 1990s, and substantial declines in real
estate prices in many regions of the United States throughout history, many commentators
argued that a significant, widespread housing-price decline in a country as large and varied
as the United States had not happened historically and was very unlikely to occur.
That logic was based on what you see in Figure 5, which highlights that there had been
significant declines in some regions of the country - but the declines were coincident with
increases elsewhere. As Figure 6 shows, there had not been recent, sustained declines in
national real estate prices. This observation, combined with the increased securitization of
real estate into diversified national portfolios, gave buyers - and those rating the
securitizations - confidence that the "real estate cycle risk" was substantially mitigated
through diversification.
But, as Figure 7 shows, the assumption that a geographically diversified portfolio of real
estate assets would avoid price declines proved wrong. While prices nationally had not
experienced a substantial decline in the past, for three years the U.S. has experienced
substantial and sustained declines in prices.
Some of my colleagues point out, probably appropriately, that given the historical data the
failure to anticipate nationwide house prices falling is largely understandable. It was certainly
very widespread. What may be more surprising is that in the 2005 timeframe, when many
were expecting house prices to slow down or flatten, there was not much by way of risk
mitigation undertaken.
Myth 2 - Triple-A mortgage securities carried little risk
The securitization market - that is, the market for securities based on various slices of
pooled mortgages - grew dramatically over the past decade. One reason for the growth in
securitization was investor interest in, and demand for, securities with little credit risk but
returns above those of Treasuries.
Many buyers of such securities felt sure of two things. First, that national real estate prices
were quite unlikely to fall - in other words, our Myth 1. Second, that even in the highly
unlikely event that the price of a national portfolio did fall, they would be protected by the
structure of the securitization. Securitizations were structured so that any losses were first
borne by lower-rated securities built from the pool of underlying mortgages. Given the
structure, the assumption was that lower-valued securities would take all potential losses if
borrowers defaulted. Many - but not all, of course2 - assumed that home-price declines and
related defaults would have to be very extreme before the highest rated, Triple-A securities
were impacted. Under this assumption these securities fully deserved the Triple-A rating
given by the rating agencies.
I should note that making this assumption about Triple-A rated mortgage backed securities
(MBSs) proved less problematic than making this assumption about the recombined lower
tranches of mortgage-backed securities that were billed as Triple-A rated collateralized debt
obligations (CDOs).3 But many investors focused not on the security's underlying
components, merely on the ratings.
Figure 8 shows that Triple-A securities remained at par values as the securitization boom
gathered steam. However, Figure 9 shows that when the severity of the decline in house
prices manifested itself, even the Triple-A rated mortgage securities collapsed in value. The
combination of illiquidity, growing concerns with the real estate market, and ebbing
confidence in the ratings resulted in dramatic declines in the pricing of Triple-A securities as
the financial crisis worsened.4
Myth 3 - The "originate to distribute" model limited the balance-sheet risk of banks
Over the decade preceding the crisis, large commercial and investment banks had become
increasingly involved in securitizing mortgage assets. They argued that this provided a
steady stream of fee income but generated little risk for the bank. While they packaged
mortgages, they were not retaining the risk in their own portfolio - instead, the risk was taken
by those that purchased the mortgage securities, particularly the lower-rated mortgage
securities.
What was frequently ignored by many was the rapid growth of Triple-A mortgage securities
holdings elsewhere within the banks, as well as in off balance sheet structures. While these
off balance sheet structures were considered separate entities, banks found the potential
reputational risk of not supporting their sponsored off balance sheet risk sufficiently great that
many ended up supporting these off balance sheet structures. In a sense, "originate to
distribute" was, in practice, something more like "originate to hold, loosely, somewhat off to
the side."5
In addition, risk managers, bank management, and regulators were sufficiently lulled by
Myths 1 and 2 to develop their faith in Myth 3. The unfortunate result was that these banks
were not as protected from falling housing prices as many had assumed, and this contributed
to the substantial decline in stock prices and the need for government support for many of
these large financial intermediaries.
Myth 4 - Investment banks were not subject to runs, because their liabilities were
collateralized
There has long been an understanding, and indeed a regulatory presumption, that banks
could be subject to "runs," resulting in a need for both deposit insurance and a heavily
regulated environment to reduce that risk. At the same time, it had largely been presumed
that investment banks were better protected against such runs. While the balance sheets of
investment banks had substantial short-term liabilities, many of them were collateralized.
Investment banks would buy longer-term securities but finance them with short-term
borrowing (using repurchase agreements). It was assumed that because there was collateral
backing up the loans, borrowers were protected and would not run.
Financing securities with short-term borrowing allowed investment banks to substantially
expand their balance sheets, as shown in Figure 10. However, the lenders in this market
were other banks, money-market funds, and hedge funds. As questions about the value of
the collateral became more prominent, and the solvency and liquidity of investment banks
became a greater concern, many short-term lenders abandoned the market. Figure 11
shows the dramatic change that occurred. The inability to finance large securities holdings
made the traditional model of investment banking unsustainable, and this contributed to the
failure of investment banks and the merger under duress, or conversion to bank holding
companies, of others.
What can we do about financial myths, going forward?
We plumb this history to help us understand what we can do about financial myths, going
forward, and how we can avoid their damaging impact.
As the previous slides have shown, taking too much confidence in historical data repeating in
the future can be dangerous - to the financial health of institutions and the financial system.
That said, we are probably not likely to see a sea-change in the tendency for overconfidence
in and reliance on recent statistical regularities.
However, there are a variety of market participants that could better protect their own
interests - and the financial system - if they spend more time understanding the key
assumptions being made in financial modeling, and have a clearer understanding of what
could happen if those assumptions were invalid. Properly done, stress testing should provide
valuable information to organizations on key risk drivers. This needs to be more than feeding
a handful of macroeconomic assumptions into a model. It requires an understanding of the
events that could lead to that macroeconomic outcome, and what other indirect effects might
be likely to occur.
Who should be responsible for regular, thoughtful stress testing? Risk managers, CEOs, and
boards of directors should all understand key risk drivers - and should consider whether a
stress scenario is sufficiently severe, and whether the direct and indirect effects are
reasonably captured. Rating agencies and stock analysts should be increasingly demanding
better quality stress tests, and that the results be made available to them. Finally, regulators
should be able to compare and contrast the quality of stress tests across organizations and
hold accountable those organizations that are not keeping up with their peers.
As I mentioned at the outset, challenging assumptions and understanding risks should not
only be the responsibility of the risk manager. These things also need to be better ingrained
in CEOs, members of boards of directors, and regulators.
Operationalizing this point is not going to be easy, but it is critical. At a fundamental level,
debunking a myth requires individuals to go against strongly and widely held beliefs, to
convince decision-makers, and to build consensus. For this to happen we may need
significant changes in the governance of risk management at banks and other parties in the
financial system. Put more plainly, we need to think about an environment where those in the
position of most influence have the incentive to "poke holes" in myths via robust stress tests,
and not the incentives to override their risk managers when the stress-test implications are
not to their liking, or risk a near-term loss of clients or market share.
Concluding observations
New financial myths are regularly created. In closing, I will just speculate on where some
may exist that interested parties should be exploring, now.

Potential Myth 1 - Sovereign debt problems will not be disruptive to the world
economy. Not long ago, the sovereign debt problems were viewed as manageable
and confined to one country. However, as interest rate spreads have widened - as
shown in Figure 12 - investors are highlighting that problems in many countries
have yet to be resolved. While I believe the most likely outcome is that there are no
serious disruptions, interested parties should diligently consider scenarios that could
be disruptive, involving various countries.

Potential Myth 2 - State and local financing problems will not be disruptive to
the national economy. While much attention has been given to problems in state
and local finances, it is generally assumed that the capacity exists to resolve these
problems. While I expect these issues will be resolved without widespread or
cascading problems, we should consider what scenarios could emerge if political
impasses result in more disruptive outcomes.
These are just two of many potential scenarios that are worth exploring. However, I would
unlikely
add that the recent financial crisis highlighted that events can happen, and when
they do, the outcomes can be quite costly for everyone. So the need for better risk
management is clear. Fortunately, the opportunity is there as well.
Thank you.
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