Did deregulation cause the economic crisis?

[ServiceSoon]

It isn't a lie - you have still not provided any evidence that shows that banks were forced to make bad loans.

You seem to have got this a bit back to front, it's your claim that banks were forced to make bad loans not mine so it's up to you to provide evidence to show that they were in fact forced to make bad loans.

Until you do your claim is unsubstantiated and is at best just your opinion.

Banks were "compelled" to issue these loans.

While the regulations placed the greatest emphasis on lending, they encouraged innovative approaches to addressing community development credit needs.

Third, access to credit in lower-income communities is obviously much greater today than when the CRA was enacted.

The CRA was created to help ensure lower-income communities have access to credit and financial services.

Securitization of affordable housing loans expanded, as did the secondary market for these loans, in part reflecting a 1992 law that required the government-sponsored enterprises, Fannie Mae and Freddie Mac, to devote a large percentage of their activities to meeting affordable housing goals. Source

Enthusiastic Fanne Mae Foundation singled out Countrywide, who agreed to be the leader in subprime mortgages.

Countrywide's chief executive bragged that, to approve minority applications that would otherwise be rejected "lenders have had to stretch the rules a bit."

Banks that got poor (CRA) reviews were punished; some saw their merger plans frustrated; others faced direct legal challenges by the Justice Department.Source

 

[Darat]

Neither of those links support the claim that banks were forced to make bad loans - indeed one shows that some banks knew they were breaking the "rules" to make bad loans and sounds like they did it quite willingly - that is hardly being forced to make bad loans. (Plus they are scondary sources.)

 

[roger]

Neither of those links support the claim that banks were forced to make bad loans - indeed one shows that some banks knew they were breaking the "rules" to make bad loans and sounds like they did it quite willingly - that is hardly being forced to make bad loans. (Plus they are scondary sources.)

You clearly did not read either the quote or link. First we have "Banks that got poor (CRA) reviews were punished; some saw their merger plans frustrated; others faced direct legal challenges by the Justice Department" from the post above yours. Then we have

But bank regulators required the loosened underwriting standards, with approval by politicians and the chattering class. A 1995 strengthening of the Community Reinvestment Act required banks to find ways to provide mortgages to their poorer communities.

from the link provided in that post.

How is this not forcing the banks to make the loans? The acts required it, and banks were pursued with legal action by the justice department if they didn't make them.

 

[Darat]

You clearly did not read either the quote or link. ...snip...

I did and it is not the first time that these links have been provided.

How is this not forcing the banks to make the loans? The acts required it, and banks were pursued with legal action by the justice department if they didn't make them.

No here is there any indication in any of these links to any regulations, legislative acts etc. that forced banks to make bad loans. The word "force" is the crucial part of this claim - I doubt anyone is arguing that bad loans were not made and have contributed to this crises. It is whether the banks were forced to make those loans and that has not been established. Forcing a bank or other lending institutions to treat all it's customer base fairly and in the same manner is not the same as forcing them to make bad loans.

 

[Meadmaker]

I think I figured out the "subordinated debt as capital" issue. I'll summarize it as best I can:

War is Peace
Freedom is Slavery
Debt is Capital

It all seems to have to do with the doctrine of "market discipline". The theory is that if you force financial institutions to sell junk bonds (subordinated debt) the market will sprinkle free market pixie dust onto the junk bonds, and those junk bonds will be automatically fairly priced by the free market. The fair pricing of the bonds will then be a strong indicator of the financial institution's risk of default.

This appears to be the theory behind Senator Gramm's insistence that credit default swaps be unregulated. They were another mechanism to provide "market discipline". High prices on the credit default swaps would be far more effective at keeping banks in line than nasty old regulators telling the banks they had to keep real money on hand to cover loan defaults.

I'm guessing that academics are currently rushing a new generation of papers out that question the role of "market discipline", and suggesting that it might prove to be less effective than previous analysis had indicated.

 

[SaulOhio]

I am not surprised that attempts to answer Meadmaker's basic question have been very weak.

"If there was "de" regulation, then some regulations that had been in force must no longer be in force. Which ones were those? Does anyone know of any? "

There was mention of the Glass-Steagal act, and some nebulous references to failures to regulate. But how removing a barrier between two sectors of the banking industry helped cause the crisis is rather vague. If anything, it may have helped put off the crisis b y allowing banks to handle risk a bit better. Or it may have made the crisis worse by making banks thing they could handle risk a bit better. I am not sure.

But Steven Horwitz cites a long list of regulations that were in force, and even imposed in very recent years that economic theory would predict would cause exactly this kind of crisis. Did anyone actually read his "An Open Letter to my Friends on the Left"?

One of the biggest confusions in the current mess is the claim that it is the result of greed. The problem with that explanation is that greed is always a feature of human interaction. It always has been. Why, all of a sudden, has greed produced so much harm? And why only in one sector of the economy? After all, isn't there plenty of greed elsewhere? ...snip...


...snip...

Edited by Darat: 

Breach of Rule 4 removed.

The current mess is thus clearly shot through and through with government meddling with free markets, from the Fed-provided fuel to the CRA and land-use regulations to Fannie and Freddie creating an artificial market for risky mortgages in order to meet Congress's demands for more home-ownership opportunities for low-income families. Thanks to that intervention, many of those families have not only lost their homes, but also the savings they could have held onto for a few more years and perhaps used to acquire a less risky mortgage on a cheaper house. All of these interventions into the market created the incentive and the means for banks to profit by originating loans that never would have taken place in a genuinely free market.

On one side, you have the repeal of Glass-Steagal and some handwaving about failure to regulate, and on the other side, you have all that from the above quote of Horwitz's article. Which side wins the debate?

P.S.: I like Horwitz' comparison of greed to gravity. Interventionists always blame greed for the failures of their policies. Its like NASA blaming gravity for the failure of a rocket launch. Its always there. You didn't take it into account?

 

[not_so_new]

I am no economist by any means, just an interested citizen but…..

P.S.: I like Horwitz' comparison of greed to gravity. Interventionists always blame greed for the failures of their policies. Its like NASA blaming gravity for the failure of a rocket launch. Its always there. You didn't take it into account?

To combat the effects of gravity NASA uses multiple systems and redundancy to help ensure that the rocket will keep going upwards and protect the crew from a catastrophic plummet. If greed is always there shouldn't we have multiple systems and redundancy to help ensure that the market does not have a catastrophic plummet? I don't know… something like more regulation?

 

[SaulOhio]

I am no economist by any means, just an interested citizen but…..

To combat the effects of gravity NASA uses multiple systems and redundancy to help ensure that the rocket will keep going upwards and protect the crew from a catastrophic plummet. If greed is always there shouldn't we have multiple systems and redundancy to help ensure that the market does not have a catastrophic plummet? I don't know… something like more regulation?

It is regulation that Horwitz is blaming for creating these unintended consequences, perverse incentives which motivate businessmen to do all sorts of risky things, like offer loans without a down payment.

How my previous post was edited, supposedly for copyright violation, was very interesting. All the meat was taken out of the argument, leaving just the conclusions. Why leave specifically the conclusions without the evidence?

Anyway, I don't think the essay is copyrighted. It is, after all, an "open letter".

And a further anyway: I got the author's permission:

Please feel free to post it in its entirety. All I ask is that you
mention me and my university by name and include a link to the original.

Thanks for your kind words.

SH

[e-mail address removed] wrote:
> I recently read your essay "An Open Letter to my Friends on the Left", and
found it excellent. You have summed up all that is wrong with the economy today.
>
> Do I have to treat your essay as copyrighted material, or can I post it in its
entirely on internet forums?
>
> [Full name removed]
>

--
Steven Horwitz
Charles A. Dana Professor of Economics
Department of Economics
Hepburn Hall
St. Lawrence University
Canton, NY 13617
Tel 315 229 5731
Fax 315 229 5819
Web http://myslu.stlawu.edu/~shorwitz

So here is the meat of the argument removed before, the entire litany of government regulations that caused this mess:

To call the housing and credit crisis a failure of the free market or the product of unregulated greed is to overlook the myriad government regulations, policies, and political pronouncements that have both reduced the "freedom" of this market and channeled self-interest in ways that have produced disastrous consequences, both intended and unintended. Let me briefly recap goverment's starring role in our little drama.

For starters, Fannie Mae and Freddie Mac are "government sponsored enterprises". Though technically privately owned, they have particular privileges granted by the government, they are overseen by Congress, and, most importantly, they have operated with a clear promise that if they failed, they would be bailed out. Hardly a "free market." All the players in the mortgage market knew this from early on. In the early 1990s, Congress eased Fannie and Freddie's lending requirements (to 1/4th the capital required by regular commercial banks) so as to increase their ability to lend to poor areas. Congress also created a regulatory agency to oversee them, but this agency also had to reapply to Congress for its budget each year (no other financial regulator must do so), assuring that it would tell Congress exactly what it wanted to hear: "things are fine." In 1995, Fannie and Freddie were given permission to enter the subprime market and regulators began to crack down on banks who were not lending enough to distressed areas. Several attempts were made to rein in Fannie and Freddie, but Congress didn't have the votes to do so, especially with both organizations making significant campaign contributions to members of both parties. Even the New York Times as far back as 1999 saw exactly what might happen thanks to this very unfree market, warning of a need to bailout Fannie and Freddie if the housing market dropped.

Complicating matters further was the 1994 renewal/revision of the Community Reinvestment Act of 1977. The CRA requires banks to to make a certain percentage of their loans within their local communities, especially when those communities are economically disadvantaged. In addition, Congress explicitly directed Fannie and Freddie to expand their lending to borrowers with marginal credit as a way of expanding homeownership. What all of these did together was to create an enormous profit and political incentives for banks and Fannie and Freddie to lend more to riskier low-income borrowers. However well-intentioned the attempts were to extend homeownership to more Americans, forcing banks to do so and artificially lowering the costs of doing so are a huge part of the problem we now find ourselves in.

At the same time, home prices were rising making those who had taken on large mortgages with small down payments feel as though they could handle them and inspiring a whole variety of new mortagage instruments. What's interesting is that the rise in prices affected most strongly cities with stricter land-use regulations, which also explains the fact that not every city was affected to the same degree by the rising home values. These regulations prevented certain kinds of land from being used for homes, pushing the rising demand for housing (fueled by the considerations above) into a slowly responding supply of land. The result was rapidly rising prices. In those areas with less stringent land-use regulations, the housing price boom's effect was much smaller. Again, it was regulation, not free markets, that drove the search for profits and was a key contributor to the rising home prices that fueled the lending spree.

While all of this was happpening, the Federal Reserve, nominally private but granted enormous monopoly privileges by government, was pumping in the credit and driving interest rates lower and lower. This influx of credit further fueled the borrowing binge. With plenty of funds available, thanks to your friendly monopoly central bank (hardly the free market at work), banks could afford to continue to lend riskier and riskier.

The final chapter of the story is that in 2004 and 2005, following the accounting scandals at Freddie, both Freddie and Fannie paid penance to Congress by agreeing to expand their lending to low-income customers. Both agreed to acquire greater amounts of subprime and Alt-A loans, sending the green light to banks to originate them. From 2004 to 2006, the percentage of loans in those riskier categories grew from 8% to 20% of all US mortgage originations. And the quality of these loans were dropping too: downpayments were getting progressively smaller and more and more loans carried low starter interest rates that would adjust upward later on. The banks were taking on riskier borrowers, but knew they had a guaranteed buyer for those loans in Fannie and Freddie, back, of course, by us taxpayers. Yes, banks were "greedy" for new customers and riskier loans, but they were responding to incentives created by well-intentioned but misguided government interventions. It is these interventions that are ultimately responsible for the risky loans gone bad that are at the center of the current crisis, not the "free market."

An Open Letter to my Friends on the Left
Steven Horwitz
Department of Economics
St. Lawrence University
sghorwitz@stlawu.edu
September 28, 2008

 

[Meadmaker]

One of the problems with trying to understand this mess is that tracking down the actual regulations and/or legislation involved is very tough. Frequently, we have to deal with opinion pieces that make arm waving references to regulations or deregulation, without actually citing the actual regulations or laws. Such is the case of the letter by Horowitz. Although the letter is quite lengthy, the actual list of regulations is, in fact, quite short.

I'll analyze it below, by citing actual instances where he mentions regulations.

the ethanol mandate

This was by way of analogy, although I think it did actually contribute to our current problems. By raising food prices, it made us unable to pay for our outrageous mortgages.

In the early 1990s, Congress eased Fannie and Freddie's lending requirements

Sounds a bit like deregulation to me.

Congress also created a regulatory agency to oversee them,

Whereas before they had been overseen by a different regulatory agency. No new regulations there.

both Freddie and Fannie paid penance to Congress by agreeing to expand their lending to low-income customers.

Hmmm....they agreed to do this. So, was there a mandate to do this? Was this regulation? Or was it acting to avoid regulation.? From what I've read, it seems like Fannie and Freddie may have done stupid things under pressure from Congress, but it isn't the same thing as regulation, is it? And of course, I say “stupid” things, but the people who actually made the decisions made out like bandits.

Complicating matters further was the 1994 renewal/revision of the Community Reinvestment Act of 1977.

We've been over this a great deal. I won't try at this time to convince anyone that this was at most a minor factor. I'll simply say that Sarah Yellen et all have convinced me that the CRA was not a significant factor.

In addition, Congress explicitly directed Fannie and Freddie to expand their lending to borrowers with marginal credit as a way of expanding homeownership.

Now this, if true, would be a smoking gun. Is it true? There was no citation of evidence. There was no legislation cited. As far as I know, that's the only way for Congress to “explicitly” do anything. I would be very interested to find out what Congress actually did in this regard.

stricter land-use regulations,

This was the least convincing part of the letter. I have no doubt that there was a correlation between housing inflation and land use regulation, but that's because land use regulations are generally passed in areas where fast growth is changing the quality of life in the neighborhood. The fast growth aggravates the housing bubble, and the fast growth brings calls for regulation of land use.

At any rate, during my research, I read a few papers talking about the appearance of new slums in the distant suburbs. Basically, land on the fringes of urban territory was build up with houses, but when the bubble burst, there was no one to buy them, leaving a lot of vacant homes. I see that a great deal here in the metro Detroit area, so perhaps I am biased to believe that our experience is typical, undermining the Cato Institutes claims to the contrary.

pumping in the credit and driving interest rates lower and lower.

Certainly that had an impact, but it isn't regulation, is it?


So, the “long list of regulations” was actually a short list, with a bunch of other things thrown in. I have been persuaded that the CRA did not cause the problem. I am confident that zoning laws and “slow growth” initiatives did not cause the problem. The other things cited weren't regulations.

The one exception was the assertion that Congress explicitly directed the GSEs to loan to uncreditworthy customers. If someone could cite their explicit statement to do so, I would have to concede that Congress bore the brunt of the blame. Of course, the GOP was in charge of Congress, but if the initiatives were supported primarily by Democrats, I would acknowledge that that party should be held responsible.

 

[not_so_new]

It is regulation that Horwitz is blaming for creating these unintended consequences, perverse incentives which motivate businessmen to do all sorts of risky things, like offer loans without a down payment.

Meadmaker responded to the points in the letter already (and they are valid points at that).

I just want to respond to the concept that you are presenting here.

You are saying that....

1) Greed is inherent in humans (I agree completely)

2) We need to factor in greed when dealing with the market (again, I agree completely)

3) We should have less oversight in the markets because greedy people will be less inclined to practice greedy tactics if no one is watching over them?



Because to me it is pretty simple. If you want to prevent businessmen from entering into risky loans, like offering loans without a down payment, you create regulation that stipulates that businessmen can't accept loans without a down payment or that businessmen can only accept a small percentage of loans without a down payment or that businessmen need to keep a percentage of liquid capital on hand in relation to the amount of loans they have outstanding that were secured without a down payment or.....

If Horwitz wants to argue that these specific regulations that lead us to this crisis were bad, I would disagree (see Meadmakers post) BUT for sake of argument let's say that this is true.

Does that make ALL "regulation" bad or just this series of regulation steps bad. Don't throw the baby out with the bathwater. Just because some oversight may or may not have been poorly implemented in the past does not negate the fact that oversight of admittedly greedy people is important.

Let's not mince words here. No one is asking for BAD regulation. We are asking for intelligent regulation that prevents greed from trumping common sense... common sense that would clearly show a house that was worth $250,000 in one year was not worth $2,000,000 the a few years later.

 

[not_so_new]

You know... another thing that yanks my bobber here.

Again, I am not an economist so I freely admit I may be completely missing something here.

It really seems like people are tying to throw lower income folks under the bus.

So let's say for sake of argument that Congress DID "explicitly directed Fannie and Freddie to expand their lending to borrowers with marginal credit as a way of expanding homeownership."

If that were the case and the evil Liburals led the charge they would have been doing it for low income folks right? The GOP stance is that it's the Democrats fault for trying to get low income people into housing with the CRA.

Before the fall there were houses all over the lower income parts of my town for $20,000 or $30,000. Say that these low income loans were on a $30,000 house, it would take 66 foreclosures to equal ONE $2,000,000 high income foreclosure.

That 66 : 1 ratio says a lot about where the problem was to me and even if that ratio were 40 : 1 to account for inflated home prices there is still a huge gap between the low income risk footprint and the upper middle class footprint.

In my eyes it was the middle, upper middle and upper class folks reaching beyond their income bracket that put the most hurt on lenders.

 

[not_so_new]

I think this is pretty telling....

Second, it is hard to blame CRA for the mortgage meltdown when CRA doesn't even apply to most of the loans that are behind it. As the University of Michigan's Michael Barr points out, half of sub-prime loans came from those mortgage companies beyond the reach of CRA. A further 25 to 30 percent came from bank subsidiaries and affiliates, which come under CRA to varying degrees but not as fully as banks themselves. (With affiliates, banks can choose whether to count the loans.) Perhaps one in four sub-prime loans were made by the institutions fully governed by CRA.

Most important, the lenders subject to CRA have engaged in less, not more, of the most dangerous lending. Janet Yellen, president of the San Francisco Federal Reserve, offers the killer statistic: Independent mortgage companies, which are not covered by CRA, made high-priced loans at more than twice the rate of the banks and thrifts. With this in mind, Yellen specifically rejects the "tendency to conflate the current problems in the sub-prime market with CRA-motivated lending.? CRA, Yellen says, "has increased the volume of responsible lending to low- and moderate-income households."

http://www.prospect.org/cs/articles?article=did_liberals_cause_the_subprime_crisis

 

[SaulOhio]

MeadMaker: Fannie Mae and Freddie Mac are Government Sponsored Enterprises, founded by an act of government, supported by special privelidges from the government, and given its mandates by the government. When government "regulates" them, it is simply trying to controll its own Frankenstein mosters. Creating them was an act of regulation in and of itself. When congress eased its lending requirements, that was also regulation, in that it was telling its own creation what it could and could not do.

Did you miss reading the first part of the second paragraph?
"For starters, Fannie Mae and Freddie Mac are 'government sponsored enterprises'. Though technically privately owned, they have particular privileges granted by the government, they are overseen by Congress, and, most importantly, they have operated with a clear promise that if they failed, they would be bailed out."

It may be true that CRA loans themselves have a lower rate of default than the rest of the economy, but it is also true that the CRA, and the expansion of its role under Clinton, opened the door to these "creative" financing techniques.

In addition, Congress explicitly directed Fannie and Freddie to expand their lending to borrowers with marginal credit as a way of expanding homeownership.

Now this, if true, would be a smoking gun. Is it true? There was no citation of evidence. There was no legislation cited. As far as I know, that's the only way for Congress to “explicitly” do anything. I would be very interested to find out what Congress actually did in this regard.

Fannie Mae Eases Credit To Aid Mortgage Lending
By STEVEN A. HOLMES
Published: September 30, 1999

In a move that could help increase home ownership rates among minorities and low-income consumers, the Fannie Mae Corporation is easing the credit requirements on loans that it will purchase from banks and other lenders.

The action, which will begin as a pilot program involving 24 banks in 15 markets -- including the New York metropolitan region -- will encourage those banks to extend home mortgages to individuals whose credit is generally not good enough to qualify for conventional loans. Fannie Mae officials say they hope to make it a nationwide program by next spring.

Fannie Mae, the nation's biggest underwriter of home mortgages, has been under increasing pressure from the Clinton Administration to expand mortgage loans among low and moderate income people and felt pressure from stock holders to maintain its phenomenal growth in profits.

How can the stricter land use regulations be so unconvincing as a regulation causing the problem? These were "open space" laws, motivated not by attempts to deal with human problems caused by economic and population growth, but by environmentalist ideology.

And you think that the Fed controlling interest rates is not regulation? How do you define regulation? The Fed is also a government created entity, instituted for the express purpose of regulating the economy. How can that not be regulation???

Not so new: You point number 3), "We should have less oversight in the markets because greedy people will be less inclined to practice greedy tactics if no one is watching over them?" is a strawman. I do not say there should be oversight, even from the government. There should be alws against force and fraud. And also, government isn't the only entity capable of overseeing the market. The market has internal checks and balances, feedback mechanisms that allow it to regulate itself. The rising and falling of prices, businesses making profits or taking losses, the judgment of individual people as customers, employees, and businessmen. It is often regulation, government action above and beyond its role of protecting people from force and fraud, that actually interferes with these checks and balances.

And also, Not So New, helping the poor own their own homes is a noble goal, one I have nothing against. But that was simply the motive for all the government intervention. Its the intervention that I have a problem with. Good ends cannot be achived by evil means, and the government pointing its guns at people and telling them what to do is just such an evil means.

If you want to help poor people own their own homes, contribute to "Habitat for Humanity", or become an architect or developer with a mind towards creating affordable housing. Don't go pumping hundreds of billions of dollars into the housing industry. That will only inflate housing prices. Don't use government to encourage bankers to lend more money. Same thing.

I agree that the CRA's role was minor, but there is no evading the role of the GSE's, and the government's encouragements towards them and other banks to make so many shaky loans.

 

[SaulOhio]

I will be travelling for the next couple of days, so I won't be able to respond to anything till maybe late Sunday, or Monday.

 

[Caustic Logic]

I would say yes.
[...]
ETA: Most of this could have been avoided if the Glass-Steagall Act wasn't repealed in 1999.
The Glass-Steagall Act, passed in 1933, mandated the separation of commercial and investment banking in order to protect depositors from the hazards of risky investment and speculation.

Dang, that's a lot of useful there, thanks! Some good specifics to check up on, not that I am, right now, but...

 

[YoPopa]

...

Again, I am not an economist so I freely admit I may be completely missing something here.
.......

In my eyes it was the middle, upper middle and upper class folks reaching beyond their income bracket that put the most hurt on lenders.

I'm not an economist either but I know that Fannie & Freddie were backing some very large subprime loans. I consider $500,000.00 a lot of money for a subprime loan.

Even the lowest end subprime loans had a direct impact on this mess by contributing to trickle up. Is it greed to sell your small home in a bad neighborhood and move up to a nicer home in a better neighborhood with better schools?

The only reason many people were able to make that move up was because someone else was enabled by the CRA to move into that small home in the not so great neighborhood.

 

[mookid]

The causes of 'this situation' are far more likely to be regulation and market intervention than 'deregulation'.

Anybody looking for objective economic analysis, don't trust most of what you have read on this thread.

There's alot of political nonsense going on in America, and many are being mislead by the both campaigns.

I'd still vote for Obama even though he's complete wrong about this, he's a little bit less of an utterly pathetic excuse for a politician than McCain is.

I hate you America. Have fun imploding.

 

[69dodge]

I'm obviously in over my head, and google is not sufficient to help me out.

Can someone explain why subordinated debt is capital?

I'll give my understanding of what it means to issue subordinated debt, and perhaps someone can explain to me where capital comes out of it.

So, I own a bank. In order to get money to operate the bank, I issued 200 million dollars in bonds. Later, I issued 100 million dollars in other bonds which, in the event I was in financial trouble or was liquidated, would not be paid until after the first 200 million dollars was paid. That second 100 million dollars is "subordinated debt".

So, where's the capital? It seems to me like at the end of this process, I owe 300 million dollars. What are we calling capital in all this?

If you sold a bunch of shares in your bank for 100 million dollars instead of selling that second bunch of bonds, would things be so different? You'd still have an extra 100 million dollars to work with now, and the buyers would still have an iffy claim on you, which wouldn't get repaid if you later ended up with only enough money to repay the "real" creditors.

 

[DanishDynamite]

If you sold a bunch of shares in your bank for 100 million dollars instead of selling that second bunch of bonds, would things be so different? You'd still have an extra 100 million dollars to work with now, and the buyers would still have an iffy claim on you, which wouldn't get repaid if you later ended up with only enough money to repay the "real" creditors.

Of course deregulation caused the current crisis.

 

[Meadmaker]

If you sold a bunch of shares in your bank for 100 million dollars instead of selling that second bunch of bonds, would things be so different? You'd still have an extra 100 million dollars to work with now, and the buyers would still have an iffy claim on you, which wouldn't get repaid if you later ended up with only enough money to repay the "real" creditors.

Thanks. I eventually figured it out, I think. I realized at some point that they were talking about capital owned by shareholders, more like "market capitalization" than what I was thinking of. I was thinking of capital in the sense of capital investment, such as machinery needed to run factories.

By the way, it's still nuts. It trades on the market kind of like capital, in the manner that you explained. On the other hand, this only works if the investors are actually informed and rational. This may have been true back in the days before I could by bonds through E*Trade. However, today, it isn't.

Meanwhile, if I understood it right, if banks had a lot of subordinated debt, they could issue more loans. i.e. debt, which was renamed as capital, allowed you to take on more risks.

It's totally crazy.