Financial Crisis
Content
Causes of Financial Crisis Imprudent Mortgage Lending Against a backdrop of abundant credit, low interest rates, and rising house prices, lending standards were relaxed to the point that many people were able to buy houses they couldn’t afford. When prices began to fall and loans started going bad, there was a severe shock to the financial system.
Housing Bubble With its easy money policies, the Federal Reserve allowed housing prices to rise to unsustainable levels. The crisis was triggered by the bubble bursting, as it was bound to do.
Global Imbalances Global financial flows have been characterized in recent years by an unsustainable pattern: some countries (China, Japan, and Germany) run large surpluses every year, while others (like the U.S and UK) run deficits. The U.S. external deficits have been mirrored by internal deficits in the household and government sectors. U.S. borrowing cannot continue indefinitely; the resulting stress underlies current financial disruptions.
Securitization Securitization fostered the “originate-to-distribute” model, which reduced lenders’ incentives to be prudent, especially in the face of vast investor demand for subprime loans packaged as AAA bonds. Ownership of mortgage-backed securities was widely dispersed, causing repercussions throughout the global system when subprime loans went bad in 2007.
Lack of Transparency and Accountability in Mortgage Finance Throughout the housing finance value chain, many participants contributed to the creation of bad mortgages and the selling of bad securities, apparently feeling secure that they would not be held accountable for their actions. A lender could sell exotic mortgages to home-owners, apparently without fear of repercussions if those mortgages failed. Similarly, a trader could sell toxic securities to investors, apparently without fear of personal responsibility if those
contracts failed. And so it was for brokers, realtors, individuals in rating agencies, and other market participants, each maximizing his or her own gain and passing problems on down the line until the system itself collapsed. Because of the lack of participant accountability, the originate-todistribute model of mortgage finance, with its once great promise of managing risk, became itself a massive generator of risk.
Rating Agencies The credit rating agencies gave AAA ratings to numerous issues of subprime mortgage-backed securities, many of which were subsequently downgraded to junk status. Critics cite poor economic models, conflicts of interest, and lack of effective regulation as reasons for the rating agencies’ failure. Another factor is the market’s excessive reliance on ratings, which has been reinforced by numerous laws and regulations that use ratings as a criterion for permissible investments or as a factor in required capital levels.
Mark-to-market Accounting FASB standards require institutions to report the fair (or current market) value of securities they hold. Critics of the rule argue that this forces banks to recognize losses based on “fire sale” prices that prevail in distressed markets, prices believed to be below long-term fundamental values. Those losses undermine market confidence and exacerbate banking system problems. Some propose suspending mark-to-market; EESA requires a study of its impact.
Deregulatory Legislation Laws such as the Gramm-Leach-Bliley Act (GLBA) and the Commodity Futures Modernization Act (CFMA) permitted financial institutions to engage in unregulated risky transactions on a vast scale. The laws were driven by an excessive faith in the robustness of market discipline, or self-regulation.
Shadow Banking System Risky financial activities once confined to regulated banks (use of leverage, borrowing short-term to lend long, etc.) migrated outside the explicit government safety net provided by deposit insurance and safety and soundness regulation. Mortgage lending, in particular, moved out of banks into unregulated
institutions. This unsupervised risk-taking amounted to a financial house of cards.
Non-Bank Runs As institutions outside the banking system built up financial positions built on borrowing short and lending long, they became vulnerable to liquidity risk in the form of non-bank runs. That is, they could fail if markets lost confidence and refused to extend or roll over short-term credit, as happened to Bear Stearns and others.
Off-Balance Sheet Finance Many banks established off-the-books special purpose entities (including structured investment vehicles, or SIVs) to engage in risky speculative investments. This allowed banks to make more loans during the expansion, but also created contingent liabilities that, with the onset of the crisis, reduced market confidence in the banks’ creditworthiness. At the same time, they had allowed banks to hold less capital against potential losses. Investors had little ability to understand banks’ true financial positions.
Government- Mandated Subprime Lending Federal mandates to help low-income borrowers (e.g., the Community Reinvestment Act (CRA) and Fannie Mae and Freddie Mac’s affordable housing goals) forced banks to engage in imprudent mortgage lending.
Failure of Risk Management Systems Some firms separated analysis of market risk and credit risk. This division did not work for complex structured products, where those risks were indistinguishable. Collective common sense suffered as a result.
Financial Innovation New instruments in structured finance developed so rapidly that market infrastructure and systems were not prepared when those instruments came under stress. Some propose that markets in new instruments should be given time to mature before they are permitted to attain a systemically significant
size. This means giving accountants, settlement systems time to catch up.
regulators,
ratings
agencies,
and
Complexity The complexity of certain financial instruments at the heart of the crisis had three effects: (1) investors were unable to make independent judgments on the merits of investments, (2) risks of market transactions were obscured, and (3) regulators were baffled.
Human Frailty Behavioral finance posits that investors do not always make optimal choices: they suffer from “bounded rationality” and limited self-control. Regulators ought to help people manage complexity through better disclosure and by reinforcing financial prudence.
Bad Computer Models Expectations of the performance of complex structured products linked to mortgages were based on only a few decades worth of data. In the case of subprime loans, only a few years of data were available. “[C]omplex systems are not confined to historical experience. Events of any size are possible, and limited only by the scale of the system itself.”
Excessive Leverage In the post-2000 period of low interest rates and abundant capital, fixed income yields were low. To compensate, many investors used borrowed funds to boost the return on their capital. Excessive leverage magnified the impact of the housing downturn, and deleveraging caused the interbank credit market to tighten.
Relaxed Regulation of Leverage The SEC liberalized its net capital rule in 2004, allowing investment bank holding companies to attain very high leverage ratios. Its Consolidated Supervised Entities program, which applied to the largest investment banks, was voluntary and ineffective.
Credit Default Swaps (CDS) An interesting paradox arose, however, as credit derivatives instruments, developed initially for risk management, continued to grow and become more sophisticated with the help of financial engineering, the tail began wagging the dog. In becoming a medium for speculative transactions, credit derivatives increased, rather than alleviated, risk.”
Over-the-Counter Derivatives Because OTC derivatives (including credit swaps) are largely unregulated, limited information about risk exposures is available to regulators and market participants. This helps explain the Bear Stearns and AIG interventions: in addition to substantial losses to counterparties, a dealer default could trigger panic because of uncertainty about the extent and distribution of those losses.
Fragmented Regulation U.S. financial regulation is dispersed among many agencies, each with responsibility for a particular class of financial institution. As a result, no agency is well positioned to monitor emerging systemwide problems.
No Systemic Risk Regulator No regulator had comprehensive jurisdiction over all systemically important financial institutions. (The Fed had the role of systemic risk regulator by default, but lacked authority to oversee investment banks, hedge funds, nonbank derivatives dealers, etc.)
Short-term Incentives Since traders and managers at many financial institutions receive a large part of their compensation in the form of an annual bonus, they lack incentives to avoid risky strategies liable to fail spectacularly every 5 or 10 years. Some propose to link pay to a rolling average of firm profits or to put bonuses into escrow for a certain period, or to impose higher capital charges on banks that maintain current annual bonus practices.
Tail Risk Many investors and risk managers sought to boost their returns by providing insurance or writing options against low-probability financial events. (Credit default swaps are a good example, but by no means the only one.) These strategies generate a stream of small gains under normal market conditions, but cause large losses during crises. When market participants know that many such potential losses are distributed throughout the system (but do not know exactly where, or how large), uncertainty and fear are exacerbated when markets come under stress.
Black Swan Theory This crisis is a once-in-a-century event, caused by a confluence of factors so rare that it is impractical to think of erecting regulatory barriers against recurrences. According to Alan Greenspan, such regulation would be “so onerous as to basically suppress the growth rate of the economy and ... [U.S.] standards of living.” Testimony before the House Oversight and Government Reform Committee, Oct. 23, 2008.
Stages that lead to financial crisis The events leading up to the financial crisis can be divided into four stages. First was the housing bubble, which occurred over the last 10 years or so, inflating the value of real estate around the country to unsustainable levels. The second stage began when the bubble burst, resulting in fast dropping home values and many foreclosures. The third part was the ensuing 'credit crisis', in which banks, saddled with uncertain mortgages and mortgage-backed assets, stopped lending to businesses and individuals. The entire economy was under grave threat, and so the Treasury had to step in (the fourth and final stage) and loan $1 trillion to commercial banks, investment banks, AIG, and other companies to clean up the toxic assets to keep the economy afloat.
The Housing Bubble The housing bubble was caused by government policies that funneled too much money into the housing market, increasing prices, speculation, and risk, and creating a huge and unsustainable market in real estate. The worst part was that
much of the money was government insured, meaning that any fall in value would be borne by the taxpayer.
The first culprit is the long-standing mortgage interest tax deduction, which encourages people to buy instead of rent. So many people who perhaps should have rented a property were encouraged to buy a new one. Without the deduction, certainly fewer bad mortgages would have been sold. National Association of Realtors lobbies for the deduction, claiming that home values could fall as much as 15% in some areas. Clearly it was a significant contributor to the bubble.
Just as importantly, Freddie Mac and Fannie May (and the Community Reinvestment Act) created huge markets for bad loans. Under pressure from Congress (Barney Frank in particular), they gladly bought up poor quality mortgages in the name of the public good - getting more people to own homes. Currently they own or guarantee about half of the total national $14 trillion mortgage market. By purchasing the mortgages they added fuel to the fire putting more money back in the hands of the banks to make more loans. Freddie and Fannie funded their operations by selling AAA loans to the public, which carried an implicit government guarantee that was part of the basis for their high rating.
The big investment houses - JP Morgan, Lehman Brothers, and Bear Stearns also got in on the game. For the 'non-conforming' mortgages that the public sector would not take (either because they were too big or the buyer had insufficient equity), the big boys bought them up, diced and sliced them, insured them internally or though AIG(FP), put on a 'AAA' sticker, and sold them to pension funds and foreign banks, and often right back to the banks that originated them. Although taking on a huge liability, they made lots of money from fees, perhaps believing that government would bail them out in the event of failure. And it did - at least for Lehman Brothers. (Bear Stearns was allowed to fail.)
Another big contributor to the housing bubble and subsequent mortgage crisis was the Federal Home Loan Bank (FHLB), a little-known but huge mortgage lender, funneling money through its network of member banks. Its assets of $1.3 trillion make it the largest borrower in the country, second only to the Federal Government. (It borrows money by selling tax exempt bonds to the general
public.) This represents almost 10% of the total $14 trillion national mortgage market.
Why would FHLB (which is considered at-risk in many parts of the country) continue to make such bad loans? And why would investors buy their bonds to fund the loans? The reason is that the bonds are tax exempt, both federally and locally. Also they sport an implicit government guarantee. Even though the FHLB denies this, it's the basis of their AAA rating (according to Moody's), and furthermore the Treasury has opened a line of credit for them (though they have not yet used it). The average investor buys FHLB bonds not because of an interest in the mortgage market, but because they are considered safe and tax exempt. However this money can be used only for buying homes. Thus they unwittingly provided the leverage the banks needed to put themselves out of business. When WaMu failed, by far its largest creditor was FHLB, with $83 billion in loans.
While there is nothing wrong with leverage in principle, it should be done with private funds, not government-guaranteed funds. Regulation that fails to take this into account cannot work.
With so much extra money in the housing market, banks had to put it somewhere. As opportunities for prime mortgages ran out, they had no choice but to consider qualified subprime borrowers, and after those ran out, there was no choice but to fudge the applications. Banks also turned to independent mortgage companies, more often than not unscrupulous and aggressive 'predatory lenders'. These lenders sold high interest mortgages to people who couldn't afford them (so-called "Liar's Loans", because the buyers were encouraged to lie about their income, job, and assets). They also offered risky low-down-payment loans, among other types of dubious practices. But the banks didn't care because they could easily sell the mortgages to others. However, the supply of even poor quality borrowers was not limitless.
By selling off their mortgages to Freddie, Fannie, and the big investment banks, mortgage lenders had no 'skin in the game'. They had nothing to worry about. If the investment failed, no problem - the taxpayer would be on the hook for repayment. And that's exactly what happened. The lenders' only mistake was not getting rid of the mortgages fast enough. When the mortgage crisis hit, some banks still had sufficient toxic assets on their books to take them down.
For example, WaMu had sold off hundreds of billions in mortgages, but still had about $20 billion in bad assets when it failed.
Of course lenders were not forced to lend, but the environment created such a great opportunity. Should they have given the money back? Of course they should. But they didn't. Certainly this behavior was illegal, but the incentive was irresistible.
The additional funding also fueled speculation, as investors got cheap money for second properties (both for rental and for flipping). This inflated the market still further, making mortgages even more unaffordable and risky.
In this way, government's pro-homeownership policies contributed greatly to the real estate market bubble. Furthermore, if the government didn't guarantee the mortgages, then at least the taxpayer would not have had to pay for the damage from the collapse.
The Bubble Bursts In this fragile market in 2007, defaults became more commonplace. The loss of a job or an unexpected expense, and a payment was missed. The foreclosures started. The supply of even unqualified borrowers to support the market had run low. Housing prices starting falling, and many homeowners dropped underwater (i.e. the mortgage was greater than the value of the home). They chose just to walk away. The wave of foreclosures grew.
If instead these people had rented a property, and either the rent increased or they lost their job, the situation would be much more fluid. They could move to another cheaper property, or move to where the jobs are. Rental prices would also go down as they do in a poor economy, making rentals more affordable. Instead, many homeowners were trapped in a sinking ship. The unintended consequences of well-intentioned government policy.
As real estate prices fell, banks could sell foreclosed homes only at a loss, causing a significant drop in mortgage bond values. If not for the artificially induced bubble, many of these homes could be re-sold, thereby retaining the
value of the bond, and thus not presenting such a risk to the banks and funds that owned them.
To make matters worse, many foreclosed homes sat empty while waiting for a new buyer. In additional to the loss of potential income on the asset, this increased neighborhood blight and inflated local rental prices - making the situation even worse. This is because FDIC regulations discourage banks from renting out their property, as it is outside their customary line of business.
Grade Inflation: AAA Junk Bonds The ensuing credit crisis resulted from the fact that the AAA rated bonds were now of dubious value, threatening the solvency of banks and pension funds across the country and around the world (due to FDIC and other regulations). How did these bonds get AAA rating in the first place? Fannie Mae and Freddie Mac bonds get AAA rating because as Government Regulated Entities (GREs), they get an implicit government guarantee. The rating agencies believe that the mission of these agencies (increasing homeownership) is so important, that the federal government will step in and bail them out if they fail. Of course that's exactly what happened. It's the same for FHLB. Although the FHLB web site denies that the bonds are backed by the government, the agency still receives AAA from Moody's, despite the fact that 6 of its 12 banks are considered to be at-risk, because as a GRE there is an implicit government guarantee. In fact, the Treasury in 2008 opened a $1 trillion line of credit to FHLB, although this credit has not yet been tapped.
The story behind the AAA ratings for investment bank Mortgage Backed Obligations (MBOs) is a bit more complicated. The reason is that the ratings agencies make lots of money from the companies and instruments that they rate. It's a fundamental conflict of interest. (This is not the case with stocks, where the investor buys the ratings recommendations from an independent rater such as Morningstar. In the case of bonds, investors get ratings for free. There is no recourse if the ratings are bad.) How did this conflict of interest occur? Surprisingly it is also due to government regulation. In the 60's, after investors got burned by poor quality ungraded bonds, the government chartered a monopoly for the 3 agencies - Moody's, S&P, and Fitch, requiring that all bonds must get rated. So now the agencies could charge companies for the right to get their bonds on the market. These agencies all started in the early 1900's as investor-subscription services, and were originally accountable only to investors. But after this new regulation, their business model changed, and they started
charging fees to bond issuers. Abuses started to occur, such as shopping around for the best rating, and paying for a higher rating. One can imagine the huge incentive to make the huge market of poor quality mortgage-backed investments appear to sparkle with a triple-A rating. This is what happened with CDOs and MBSs. This is also what happened with AIG. In fact the ratings agencies never even investigated the loan files. When they finally did, according to Fitch, "There was the appearance of fraud or misrepresentation in almost every file."
Any other company that committed such a mistake would be out of business by now. Although it's likely that the malefactors will be prosecuted, the business are too important for the government to be dismantled. As a result, it is unlikely that any lessons will be learned, except that they can survive after committing fraud.
Credit Default Swaps were an integral part of the process. A new and little known financial instrument in 2000, by 2005 they had become the 'special sauce' for subprime loans, making them palatable to banks and pension funds. Basically they are insurance on bonds, purchased for a fee, and in this case turned low-rated securities into AAA (the insured bonds inherit the rating of their AAA insurer - in this case AIG). They became a huge part of the bond market. Common sense would suggest that such a product is a bad idea. You can't insure an entire market, because if the market goes down all at once, then there's a huge hit. For example, most insurance companies don't cover flooding, because floods tend to affect a large number of customers all at once. This presents a huge liability, potentially crippling the company. On the other hand, car accidents are much more predictable and easy to insure. You don't know where an accident will happen, but you have a pretty good sense of frequency based on historical data. So CDS should not exist on a large scale, but they did, because they turned junk into gold. AIG remained a AAA rated company despite their huge liability.
As CDS became more popular, AIG realized that the entire financial system was in fact dependent on them. They could sell more and more, secure in the knowledge that even if the market turned, the government would have to bail out the company to avoid financial catastrophe. As Obama said on Letterman (9/22), "People were taking wild risks, expecting that maybe taxpayers would come back and bail them out after the fact because we couldn’t afford to let the whole financial system to go under."
Thus bonds were cleaned by this financial laundry service. The fundamental market principle of 'risk/reward' was decoupled. These were seemingly very low risk investments with high interest rates. They basically sold themselves. Banks and pension funds bought them up like candy.
The Credit Crisis In the face of obvious trouble, the rating agencies finally started to downgrade bonds. People began to realize that the "Emperor has no clothes." The bond market froze up because no one knew how much the troubled assets were worth.
As a bank's assets falls below AAA, its capital reserve requirements increase. If it cannot meet these requirements the bank is deemed insolvent by the FDIC. The agency would have to step in and resolve the situation, either by orchestrating a merger, or selling off the bank's assets (into a troubled market) and restoring it's depositors. As a result the credit markets froze up, since banks didn't know if their assets would fall below AAA, and if they did, whether they would be able to sell them into a troubled market to raise capital.
The credit markets are essential to the daily function of industry big and small, as well as consumer spending. Having frozen up, the economy was brought to the brink. There was a level of crisis and fear not experienced since the Great Depression.
Ironically it was the FDIC reserve requirements that caused the problem -- ironic because the FDIC was created to prevent public panic. Without the regulations, banks could continue to lend, and the problem would not have been nearly so bad. Furthermore, the crisis created panic in Washington. Something had to be done, and fast.
The Bailout The federal government, fearing economic collapse and bank runs on a wide scale, decided it had no choice but to maintain the AAA ratings of bonds at all costs. If it didn't, then the banks would fail, and the FDIC would have to resolve
bank failures on a scale never before seen. They would have to sell their assets in a depressed market AND make their depositors whole. It would have been an impossible task. FDIC insurance fund is far to small to take on such a huge problem.
The additional irony is the utter powerlessness of the FDIC. The very organization that is supposed to rescue banks in times of crisis itself had to be rescued. Pension funds were in a similar situation. Lower bond ratings would require costly state intervention.
So in addition to bailing out Freddie Mac and Fannie Mae, the government also had to bail out AIG and other Wall Street investment banks to maintain their high credit ratings and the ratings of the bonds they insured.
Without the FDIC regulations, AIG could have been allowed to fail, and banks could continue to service their customers. Perhaps it would be necessary to limit withdrawals temporarily until the bond market resumed functioning. Worst case if bankrupt, the bank could slowly wind down and distribute the proceeds to its customers. Losses from troubled assets were generally only a fraction of total deposits, so depositors would receive most of their funds.
It was not only the FDIC, but other government regulations which contributed to the crisis. The insurance companies in New York State are themselves selfinsured. By state regulation, if any insurance company fails, then all other companies have to bail it out and restore their customers. Thus, AIG could not be allowed to fail. If it did, all the other insurance companies would have to bear the cost. With a company as big as AIG, this could destroy them. So for their own survival, business in NYS supported the bailout of AIG. Despite the bailout, the problem is far from resolved. Banks are still holding onto assets of dubious value and could still face a future crisis.
As well, now that subprime lenders are gone, the FHA (Federal Housing Agency) has stepped in to insure the riskiest mortgages. Because the FHA has very low standards with regard to approval, it is now supporting about 30% of loan applications. The worst part, of course, is that if the borrower defaults, the American taxpayer must pay the bill. It is estimated that the cost could be half a
trillion dollars. Thus the housing market remains artificially inflated, and when it falls again, another crisis will ensue.
References Adrian Blundell-Wignall and Paul Atkinson (2008), “The Subprime Crisis: Causal Distortions and Regulatory Reform”, in: Paul Bloxham and Christopher Kent, Lessons from the Financial Turmoil of 2007 and 2008, Proceedings of a Conference held at the H.C. Coombs Centre for Financial Studies, Kirribilli, on 1415 July 2008; Reserve Bank of Australia; available at http://www.rba.gov.au/PublicationsAndResearch/Conferences/2008/BlundellWign all_Atkinson.pdf.
Blundell-Wignall, A and P. Atkinson (2008), “The Sub-prime Crisis: Causal Distortions and Regulatory Reform”, in Paul Bloxham and Christopher Kent, eds., Lessons from the Financial Turmoil of 2007 and 2008, Reserve Bank of Australia. This full paper published paper was circulated to the OECD Committee on Financial Markets meeting in November 2008.
Housing Bubble With its easy money policies, the Federal Reserve allowed housing prices to rise to unsustainable levels. The crisis was triggered by the bubble bursting, as it was bound to do.
Global Imbalances Global financial flows have been characterized in recent years by an unsustainable pattern: some countries (China, Japan, and Germany) run large surpluses every year, while others (like the U.S and UK) run deficits. The U.S. external deficits have been mirrored by internal deficits in the household and government sectors. U.S. borrowing cannot continue indefinitely; the resulting stress underlies current financial disruptions.
Securitization Securitization fostered the “originate-to-distribute” model, which reduced lenders’ incentives to be prudent, especially in the face of vast investor demand for subprime loans packaged as AAA bonds. Ownership of mortgage-backed securities was widely dispersed, causing repercussions throughout the global system when subprime loans went bad in 2007.
Lack of Transparency and Accountability in Mortgage Finance Throughout the housing finance value chain, many participants contributed to the creation of bad mortgages and the selling of bad securities, apparently feeling secure that they would not be held accountable for their actions. A lender could sell exotic mortgages to home-owners, apparently without fear of repercussions if those mortgages failed. Similarly, a trader could sell toxic securities to investors, apparently without fear of personal responsibility if those
contracts failed. And so it was for brokers, realtors, individuals in rating agencies, and other market participants, each maximizing his or her own gain and passing problems on down the line until the system itself collapsed. Because of the lack of participant accountability, the originate-todistribute model of mortgage finance, with its once great promise of managing risk, became itself a massive generator of risk.
Rating Agencies The credit rating agencies gave AAA ratings to numerous issues of subprime mortgage-backed securities, many of which were subsequently downgraded to junk status. Critics cite poor economic models, conflicts of interest, and lack of effective regulation as reasons for the rating agencies’ failure. Another factor is the market’s excessive reliance on ratings, which has been reinforced by numerous laws and regulations that use ratings as a criterion for permissible investments or as a factor in required capital levels.
Mark-to-market Accounting FASB standards require institutions to report the fair (or current market) value of securities they hold. Critics of the rule argue that this forces banks to recognize losses based on “fire sale” prices that prevail in distressed markets, prices believed to be below long-term fundamental values. Those losses undermine market confidence and exacerbate banking system problems. Some propose suspending mark-to-market; EESA requires a study of its impact.
Deregulatory Legislation Laws such as the Gramm-Leach-Bliley Act (GLBA) and the Commodity Futures Modernization Act (CFMA) permitted financial institutions to engage in unregulated risky transactions on a vast scale. The laws were driven by an excessive faith in the robustness of market discipline, or self-regulation.
Shadow Banking System Risky financial activities once confined to regulated banks (use of leverage, borrowing short-term to lend long, etc.) migrated outside the explicit government safety net provided by deposit insurance and safety and soundness regulation. Mortgage lending, in particular, moved out of banks into unregulated
institutions. This unsupervised risk-taking amounted to a financial house of cards.
Non-Bank Runs As institutions outside the banking system built up financial positions built on borrowing short and lending long, they became vulnerable to liquidity risk in the form of non-bank runs. That is, they could fail if markets lost confidence and refused to extend or roll over short-term credit, as happened to Bear Stearns and others.
Off-Balance Sheet Finance Many banks established off-the-books special purpose entities (including structured investment vehicles, or SIVs) to engage in risky speculative investments. This allowed banks to make more loans during the expansion, but also created contingent liabilities that, with the onset of the crisis, reduced market confidence in the banks’ creditworthiness. At the same time, they had allowed banks to hold less capital against potential losses. Investors had little ability to understand banks’ true financial positions.
Government- Mandated Subprime Lending Federal mandates to help low-income borrowers (e.g., the Community Reinvestment Act (CRA) and Fannie Mae and Freddie Mac’s affordable housing goals) forced banks to engage in imprudent mortgage lending.
Failure of Risk Management Systems Some firms separated analysis of market risk and credit risk. This division did not work for complex structured products, where those risks were indistinguishable. Collective common sense suffered as a result.
Financial Innovation New instruments in structured finance developed so rapidly that market infrastructure and systems were not prepared when those instruments came under stress. Some propose that markets in new instruments should be given time to mature before they are permitted to attain a systemically significant
size. This means giving accountants, settlement systems time to catch up.
regulators,
ratings
agencies,
and
Complexity The complexity of certain financial instruments at the heart of the crisis had three effects: (1) investors were unable to make independent judgments on the merits of investments, (2) risks of market transactions were obscured, and (3) regulators were baffled.
Human Frailty Behavioral finance posits that investors do not always make optimal choices: they suffer from “bounded rationality” and limited self-control. Regulators ought to help people manage complexity through better disclosure and by reinforcing financial prudence.
Bad Computer Models Expectations of the performance of complex structured products linked to mortgages were based on only a few decades worth of data. In the case of subprime loans, only a few years of data were available. “[C]omplex systems are not confined to historical experience. Events of any size are possible, and limited only by the scale of the system itself.”
Excessive Leverage In the post-2000 period of low interest rates and abundant capital, fixed income yields were low. To compensate, many investors used borrowed funds to boost the return on their capital. Excessive leverage magnified the impact of the housing downturn, and deleveraging caused the interbank credit market to tighten.
Relaxed Regulation of Leverage The SEC liberalized its net capital rule in 2004, allowing investment bank holding companies to attain very high leverage ratios. Its Consolidated Supervised Entities program, which applied to the largest investment banks, was voluntary and ineffective.
Credit Default Swaps (CDS) An interesting paradox arose, however, as credit derivatives instruments, developed initially for risk management, continued to grow and become more sophisticated with the help of financial engineering, the tail began wagging the dog. In becoming a medium for speculative transactions, credit derivatives increased, rather than alleviated, risk.”
Over-the-Counter Derivatives Because OTC derivatives (including credit swaps) are largely unregulated, limited information about risk exposures is available to regulators and market participants. This helps explain the Bear Stearns and AIG interventions: in addition to substantial losses to counterparties, a dealer default could trigger panic because of uncertainty about the extent and distribution of those losses.
Fragmented Regulation U.S. financial regulation is dispersed among many agencies, each with responsibility for a particular class of financial institution. As a result, no agency is well positioned to monitor emerging systemwide problems.
No Systemic Risk Regulator No regulator had comprehensive jurisdiction over all systemically important financial institutions. (The Fed had the role of systemic risk regulator by default, but lacked authority to oversee investment banks, hedge funds, nonbank derivatives dealers, etc.)
Short-term Incentives Since traders and managers at many financial institutions receive a large part of their compensation in the form of an annual bonus, they lack incentives to avoid risky strategies liable to fail spectacularly every 5 or 10 years. Some propose to link pay to a rolling average of firm profits or to put bonuses into escrow for a certain period, or to impose higher capital charges on banks that maintain current annual bonus practices.
Tail Risk Many investors and risk managers sought to boost their returns by providing insurance or writing options against low-probability financial events. (Credit default swaps are a good example, but by no means the only one.) These strategies generate a stream of small gains under normal market conditions, but cause large losses during crises. When market participants know that many such potential losses are distributed throughout the system (but do not know exactly where, or how large), uncertainty and fear are exacerbated when markets come under stress.
Black Swan Theory This crisis is a once-in-a-century event, caused by a confluence of factors so rare that it is impractical to think of erecting regulatory barriers against recurrences. According to Alan Greenspan, such regulation would be “so onerous as to basically suppress the growth rate of the economy and ... [U.S.] standards of living.” Testimony before the House Oversight and Government Reform Committee, Oct. 23, 2008.
Stages that lead to financial crisis The events leading up to the financial crisis can be divided into four stages. First was the housing bubble, which occurred over the last 10 years or so, inflating the value of real estate around the country to unsustainable levels. The second stage began when the bubble burst, resulting in fast dropping home values and many foreclosures. The third part was the ensuing 'credit crisis', in which banks, saddled with uncertain mortgages and mortgage-backed assets, stopped lending to businesses and individuals. The entire economy was under grave threat, and so the Treasury had to step in (the fourth and final stage) and loan $1 trillion to commercial banks, investment banks, AIG, and other companies to clean up the toxic assets to keep the economy afloat.
The Housing Bubble The housing bubble was caused by government policies that funneled too much money into the housing market, increasing prices, speculation, and risk, and creating a huge and unsustainable market in real estate. The worst part was that
much of the money was government insured, meaning that any fall in value would be borne by the taxpayer.
The first culprit is the long-standing mortgage interest tax deduction, which encourages people to buy instead of rent. So many people who perhaps should have rented a property were encouraged to buy a new one. Without the deduction, certainly fewer bad mortgages would have been sold. National Association of Realtors lobbies for the deduction, claiming that home values could fall as much as 15% in some areas. Clearly it was a significant contributor to the bubble.
Just as importantly, Freddie Mac and Fannie May (and the Community Reinvestment Act) created huge markets for bad loans. Under pressure from Congress (Barney Frank in particular), they gladly bought up poor quality mortgages in the name of the public good - getting more people to own homes. Currently they own or guarantee about half of the total national $14 trillion mortgage market. By purchasing the mortgages they added fuel to the fire putting more money back in the hands of the banks to make more loans. Freddie and Fannie funded their operations by selling AAA loans to the public, which carried an implicit government guarantee that was part of the basis for their high rating.
The big investment houses - JP Morgan, Lehman Brothers, and Bear Stearns also got in on the game. For the 'non-conforming' mortgages that the public sector would not take (either because they were too big or the buyer had insufficient equity), the big boys bought them up, diced and sliced them, insured them internally or though AIG(FP), put on a 'AAA' sticker, and sold them to pension funds and foreign banks, and often right back to the banks that originated them. Although taking on a huge liability, they made lots of money from fees, perhaps believing that government would bail them out in the event of failure. And it did - at least for Lehman Brothers. (Bear Stearns was allowed to fail.)
Another big contributor to the housing bubble and subsequent mortgage crisis was the Federal Home Loan Bank (FHLB), a little-known but huge mortgage lender, funneling money through its network of member banks. Its assets of $1.3 trillion make it the largest borrower in the country, second only to the Federal Government. (It borrows money by selling tax exempt bonds to the general
public.) This represents almost 10% of the total $14 trillion national mortgage market.
Why would FHLB (which is considered at-risk in many parts of the country) continue to make such bad loans? And why would investors buy their bonds to fund the loans? The reason is that the bonds are tax exempt, both federally and locally. Also they sport an implicit government guarantee. Even though the FHLB denies this, it's the basis of their AAA rating (according to Moody's), and furthermore the Treasury has opened a line of credit for them (though they have not yet used it). The average investor buys FHLB bonds not because of an interest in the mortgage market, but because they are considered safe and tax exempt. However this money can be used only for buying homes. Thus they unwittingly provided the leverage the banks needed to put themselves out of business. When WaMu failed, by far its largest creditor was FHLB, with $83 billion in loans.
While there is nothing wrong with leverage in principle, it should be done with private funds, not government-guaranteed funds. Regulation that fails to take this into account cannot work.
With so much extra money in the housing market, banks had to put it somewhere. As opportunities for prime mortgages ran out, they had no choice but to consider qualified subprime borrowers, and after those ran out, there was no choice but to fudge the applications. Banks also turned to independent mortgage companies, more often than not unscrupulous and aggressive 'predatory lenders'. These lenders sold high interest mortgages to people who couldn't afford them (so-called "Liar's Loans", because the buyers were encouraged to lie about their income, job, and assets). They also offered risky low-down-payment loans, among other types of dubious practices. But the banks didn't care because they could easily sell the mortgages to others. However, the supply of even poor quality borrowers was not limitless.
By selling off their mortgages to Freddie, Fannie, and the big investment banks, mortgage lenders had no 'skin in the game'. They had nothing to worry about. If the investment failed, no problem - the taxpayer would be on the hook for repayment. And that's exactly what happened. The lenders' only mistake was not getting rid of the mortgages fast enough. When the mortgage crisis hit, some banks still had sufficient toxic assets on their books to take them down.
For example, WaMu had sold off hundreds of billions in mortgages, but still had about $20 billion in bad assets when it failed.
Of course lenders were not forced to lend, but the environment created such a great opportunity. Should they have given the money back? Of course they should. But they didn't. Certainly this behavior was illegal, but the incentive was irresistible.
The additional funding also fueled speculation, as investors got cheap money for second properties (both for rental and for flipping). This inflated the market still further, making mortgages even more unaffordable and risky.
In this way, government's pro-homeownership policies contributed greatly to the real estate market bubble. Furthermore, if the government didn't guarantee the mortgages, then at least the taxpayer would not have had to pay for the damage from the collapse.
The Bubble Bursts In this fragile market in 2007, defaults became more commonplace. The loss of a job or an unexpected expense, and a payment was missed. The foreclosures started. The supply of even unqualified borrowers to support the market had run low. Housing prices starting falling, and many homeowners dropped underwater (i.e. the mortgage was greater than the value of the home). They chose just to walk away. The wave of foreclosures grew.
If instead these people had rented a property, and either the rent increased or they lost their job, the situation would be much more fluid. They could move to another cheaper property, or move to where the jobs are. Rental prices would also go down as they do in a poor economy, making rentals more affordable. Instead, many homeowners were trapped in a sinking ship. The unintended consequences of well-intentioned government policy.
As real estate prices fell, banks could sell foreclosed homes only at a loss, causing a significant drop in mortgage bond values. If not for the artificially induced bubble, many of these homes could be re-sold, thereby retaining the
value of the bond, and thus not presenting such a risk to the banks and funds that owned them.
To make matters worse, many foreclosed homes sat empty while waiting for a new buyer. In additional to the loss of potential income on the asset, this increased neighborhood blight and inflated local rental prices - making the situation even worse. This is because FDIC regulations discourage banks from renting out their property, as it is outside their customary line of business.
Grade Inflation: AAA Junk Bonds The ensuing credit crisis resulted from the fact that the AAA rated bonds were now of dubious value, threatening the solvency of banks and pension funds across the country and around the world (due to FDIC and other regulations). How did these bonds get AAA rating in the first place? Fannie Mae and Freddie Mac bonds get AAA rating because as Government Regulated Entities (GREs), they get an implicit government guarantee. The rating agencies believe that the mission of these agencies (increasing homeownership) is so important, that the federal government will step in and bail them out if they fail. Of course that's exactly what happened. It's the same for FHLB. Although the FHLB web site denies that the bonds are backed by the government, the agency still receives AAA from Moody's, despite the fact that 6 of its 12 banks are considered to be at-risk, because as a GRE there is an implicit government guarantee. In fact, the Treasury in 2008 opened a $1 trillion line of credit to FHLB, although this credit has not yet been tapped.
The story behind the AAA ratings for investment bank Mortgage Backed Obligations (MBOs) is a bit more complicated. The reason is that the ratings agencies make lots of money from the companies and instruments that they rate. It's a fundamental conflict of interest. (This is not the case with stocks, where the investor buys the ratings recommendations from an independent rater such as Morningstar. In the case of bonds, investors get ratings for free. There is no recourse if the ratings are bad.) How did this conflict of interest occur? Surprisingly it is also due to government regulation. In the 60's, after investors got burned by poor quality ungraded bonds, the government chartered a monopoly for the 3 agencies - Moody's, S&P, and Fitch, requiring that all bonds must get rated. So now the agencies could charge companies for the right to get their bonds on the market. These agencies all started in the early 1900's as investor-subscription services, and were originally accountable only to investors. But after this new regulation, their business model changed, and they started
charging fees to bond issuers. Abuses started to occur, such as shopping around for the best rating, and paying for a higher rating. One can imagine the huge incentive to make the huge market of poor quality mortgage-backed investments appear to sparkle with a triple-A rating. This is what happened with CDOs and MBSs. This is also what happened with AIG. In fact the ratings agencies never even investigated the loan files. When they finally did, according to Fitch, "There was the appearance of fraud or misrepresentation in almost every file."
Any other company that committed such a mistake would be out of business by now. Although it's likely that the malefactors will be prosecuted, the business are too important for the government to be dismantled. As a result, it is unlikely that any lessons will be learned, except that they can survive after committing fraud.
Credit Default Swaps were an integral part of the process. A new and little known financial instrument in 2000, by 2005 they had become the 'special sauce' for subprime loans, making them palatable to banks and pension funds. Basically they are insurance on bonds, purchased for a fee, and in this case turned low-rated securities into AAA (the insured bonds inherit the rating of their AAA insurer - in this case AIG). They became a huge part of the bond market. Common sense would suggest that such a product is a bad idea. You can't insure an entire market, because if the market goes down all at once, then there's a huge hit. For example, most insurance companies don't cover flooding, because floods tend to affect a large number of customers all at once. This presents a huge liability, potentially crippling the company. On the other hand, car accidents are much more predictable and easy to insure. You don't know where an accident will happen, but you have a pretty good sense of frequency based on historical data. So CDS should not exist on a large scale, but they did, because they turned junk into gold. AIG remained a AAA rated company despite their huge liability.
As CDS became more popular, AIG realized that the entire financial system was in fact dependent on them. They could sell more and more, secure in the knowledge that even if the market turned, the government would have to bail out the company to avoid financial catastrophe. As Obama said on Letterman (9/22), "People were taking wild risks, expecting that maybe taxpayers would come back and bail them out after the fact because we couldn’t afford to let the whole financial system to go under."
Thus bonds were cleaned by this financial laundry service. The fundamental market principle of 'risk/reward' was decoupled. These were seemingly very low risk investments with high interest rates. They basically sold themselves. Banks and pension funds bought them up like candy.
The Credit Crisis In the face of obvious trouble, the rating agencies finally started to downgrade bonds. People began to realize that the "Emperor has no clothes." The bond market froze up because no one knew how much the troubled assets were worth.
As a bank's assets falls below AAA, its capital reserve requirements increase. If it cannot meet these requirements the bank is deemed insolvent by the FDIC. The agency would have to step in and resolve the situation, either by orchestrating a merger, or selling off the bank's assets (into a troubled market) and restoring it's depositors. As a result the credit markets froze up, since banks didn't know if their assets would fall below AAA, and if they did, whether they would be able to sell them into a troubled market to raise capital.
The credit markets are essential to the daily function of industry big and small, as well as consumer spending. Having frozen up, the economy was brought to the brink. There was a level of crisis and fear not experienced since the Great Depression.
Ironically it was the FDIC reserve requirements that caused the problem -- ironic because the FDIC was created to prevent public panic. Without the regulations, banks could continue to lend, and the problem would not have been nearly so bad. Furthermore, the crisis created panic in Washington. Something had to be done, and fast.
The Bailout The federal government, fearing economic collapse and bank runs on a wide scale, decided it had no choice but to maintain the AAA ratings of bonds at all costs. If it didn't, then the banks would fail, and the FDIC would have to resolve
bank failures on a scale never before seen. They would have to sell their assets in a depressed market AND make their depositors whole. It would have been an impossible task. FDIC insurance fund is far to small to take on such a huge problem.
The additional irony is the utter powerlessness of the FDIC. The very organization that is supposed to rescue banks in times of crisis itself had to be rescued. Pension funds were in a similar situation. Lower bond ratings would require costly state intervention.
So in addition to bailing out Freddie Mac and Fannie Mae, the government also had to bail out AIG and other Wall Street investment banks to maintain their high credit ratings and the ratings of the bonds they insured.
Without the FDIC regulations, AIG could have been allowed to fail, and banks could continue to service their customers. Perhaps it would be necessary to limit withdrawals temporarily until the bond market resumed functioning. Worst case if bankrupt, the bank could slowly wind down and distribute the proceeds to its customers. Losses from troubled assets were generally only a fraction of total deposits, so depositors would receive most of their funds.
It was not only the FDIC, but other government regulations which contributed to the crisis. The insurance companies in New York State are themselves selfinsured. By state regulation, if any insurance company fails, then all other companies have to bail it out and restore their customers. Thus, AIG could not be allowed to fail. If it did, all the other insurance companies would have to bear the cost. With a company as big as AIG, this could destroy them. So for their own survival, business in NYS supported the bailout of AIG. Despite the bailout, the problem is far from resolved. Banks are still holding onto assets of dubious value and could still face a future crisis.
As well, now that subprime lenders are gone, the FHA (Federal Housing Agency) has stepped in to insure the riskiest mortgages. Because the FHA has very low standards with regard to approval, it is now supporting about 30% of loan applications. The worst part, of course, is that if the borrower defaults, the American taxpayer must pay the bill. It is estimated that the cost could be half a
trillion dollars. Thus the housing market remains artificially inflated, and when it falls again, another crisis will ensue.
References Adrian Blundell-Wignall and Paul Atkinson (2008), “The Subprime Crisis: Causal Distortions and Regulatory Reform”, in: Paul Bloxham and Christopher Kent, Lessons from the Financial Turmoil of 2007 and 2008, Proceedings of a Conference held at the H.C. Coombs Centre for Financial Studies, Kirribilli, on 1415 July 2008; Reserve Bank of Australia; available at http://www.rba.gov.au/PublicationsAndResearch/Conferences/2008/BlundellWign all_Atkinson.pdf.
Blundell-Wignall, A and P. Atkinson (2008), “The Sub-prime Crisis: Causal Distortions and Regulatory Reform”, in Paul Bloxham and Christopher Kent, eds., Lessons from the Financial Turmoil of 2007 and 2008, Reserve Bank of Australia. This full paper published paper was circulated to the OECD Committee on Financial Markets meeting in November 2008.
