The mortgage-backed security crisis: What went wrong?

1/20/2010 - Scott Shay ’80 believes that government intervention isn’t dampening the flames of the crisis in the mortgage-backed securities market — it’s merely adding fuel to the fire.

Scott Shay '80

In a Jan. 13 talk sponsored by the Kellogg School’s Zell Center for Risk Research, the Signature Bank founder and board chairman explained how the once-useful tool has become “the security that ate the American economy.” What’s worse, he noted, government policies intended to end the crisis are just extending it.

“Fannie Mae and Freddie Mac have now effectively been nationalized. There’s no longer an implicit government guarantee — there’s a full faith and credit government guarantee,” he said. “We’re not addressing the root issues (of the crisis). The mortgage-backed securities market is a symptom, it’s not the disease. And I think what we’re doing right now from a public policy perspective is exacerbating our problem.”

While government interference is warranted, it’s been implemented the wrong way, Shay asserted.

“More regulation is needed, but price signals would have been a far better solution,” he said. “Fannie and Freddie technically remain private companies with unlimited access now to debt at the government interest-free rate, and are actually being encouraged to buy all sorts of securities and make transactions they otherwise wouldn’t be (buying), and then have 80 percent of their securities purchased by the Federal Reserve Board. How’s that going to give us a price signal?”

But the most worrying aspect of the situation is a more basic one, Shay said.

“We got the finance wrong,” he said. “We haven’t done the basic finance; there is no theoretical framework for the folks in Washington to work with. When you have an economy or a theoretical construct that depends upon appropriate pricing for debt and you throw that out the window, you get a misallocation of capital. When you then expand that to fully private actors, you’re going to get rampant misallocations of capital throughout the economy.”


This realization led him to develop a maxim he calls Shay’s Theorem, which asserts that when the government contributes to the creation of a bubble, the bubble tends to grow and persist.

“If you go back in history and look at bubbles where there wasn’t fraud, they were due to a mispricing of the applicable costs of capital,” he explained. “In instances where it was the government who did it, those bubbles got bigger and lasted longer.”

Shay sees that happening again — and urged Kellogg students and others in the audience to study and learn the lessons from the current crisis.

“We’re creating new misallocations of capital,” he said. “It’s there — it’s in plain sight. We have to identify that or I think we’re going to continue to be a bubble-prone economy from the time of the [savings and loan] crisis to today. MBS is a symptom of this greater misallocation of capital, and I think as a business community, we have to fill the underlying framework to make that clear.”