Sunday, July 13, 2008

What Caused The Credit Crisis?

I have been following and writing about the credit crises for some time. Watching the stock prices of the financial companies plummet over the past few months has been painful if you own any of them. As I wrote in March I have been expecting this decline, but its acceleration in recent weeks has been breathtaking.

I have been reading a lot of commentary about what caused the credit crisis. Most recently I read the first section of “The First Global Financial Crisis of the 21st Century” published by VoxEU.org. This is a collection of articles written by renowned economists addressing the credit crisis, and part one deals with the causes. Unless otherwise noted my references in this article to other writers refers to their article in this collection. There is a rather long list of suspects, but in my opinion the cause of the credit crisis was a failure of the regulators of the financial system to adequately protect it from systemic risks that they should have seen at the time. Determining why they failed under such circumstances should be the primary path of inquiry. This involves uncovering the reasons why, in the face of compelling evidence of a major financial storm in the making, financial regulators did nothing. The same can be said for Congress.

I believe there is plenty of blame to go around and there were many bad actors involved in generating loans that should never have been made. In one of my early articles I pointed the finger at many of these actors. But it is the job of regulators to monitor the financial system and prevent excessive, systemic credit problems and they failed to do so. When banks are lending people 100% of the value of a home, waiving income verification, and basing the borrowers ability to pay on a loan payment that is based on a temporary teaser rate there is abject foolishness in the market. This condition existed for at least two years while bank regulators and Congress looked on and did nothing. As if this wasn’t enough, at the same time there was obvious chicanery in the credit markets relating to housing we experienced a housing bubble of massive proportions. Regulators and Congress still did nothing, except that Congress and the President began to brag about home ownership rates.

Some commentators (see Tito Boeri and Luigi Guiso, pg 37) (see also Theodore Forstmann, “The Credit Crisis Is Going To Get Worse”, The Wall Street Journal Online Edition, July 5 2008) argue it was classic supply-push in the credit markets caused by excessive monetary easing from 2001 – 2004 that caused the stupidity that led to this crisis. I tend to agree that monetary policy has been too accommodative and is one of the root causes of the current crisis. However, we have always known that monetary policy easing increases risk taking so to blame this as the cause of the crisis misses the point.

Some argue that new innovations, such as CDOs, where not fully understood (see Guido Tabellini, pg 45). I find humor in this though I am not happy with the result. If we take a lot of crappy assets and put them together, will the resulting “diversified” pool of crappy assets have less risk? Well, when all the assets are correlated to the housing market and are the most sensitive to any price changes (subprime) then obviously all you have done is made a bigger pool of crap. Add to this the fact that history exists in the subprime lending world and it is not good. Where the assumptions came from underlying the ratings on CDOs is a mystery to anyone who has seen subprime lenders crash and burn. To say this was a failure of the statistical models is a nice way of saying the assumptions were wrong and upon further inspection this should have been obvious. Statistical complexity aside, what happened to common sense? Isn’t this where the regulators are supposed to come in? When the market is doing things that are clearly high risk and in large magnitude? Where were they?

Some argue it was the rating agency conflicts that enabled this debacle to occur. I agree this was a contributing factor, but Congress and the regulators knew this problem existed since, at the latest, 2002 when it was presented to Congress in testimony relating to the Enron bankruptcy by Frank Partnoy (see part II. D). There were very clear and explicit warnings that this type of crisis was waiting to happen yet Congress and the regulators turned a blind eye.

Some argue that it is the over reliance on statistical modeling that led to this crisis (see Jon Danielsson pg. 13). The lack of backtesting data for those once in 100 years events meant that the science was flawed. In addition, the correlations are all wrong when everyone acts the same way at the same time (the heard). I buy this argument, but what I don’t buy is the argument that the regulators were fooled by all of this. This was clearly a movement to allow financial institutions to self regulate using their own internally developed models. Whether this was politically driven or truly a belief among regulators that this was a better way I do not know, but it takes a lot of the burden off regulators to monitor and regulate! Now regulators are calling for additional powers. I ask, where were they when this crisis developed?


I actually know part of the answer to my last question. One thing the regulators were working on was providing the financial system with large amounts of leverage that would ultimately be at the root of the liquidity part of this crisis. In 2004 regulators codified banks’ use of off balance sheet entities, those SIVs and asset-backed commercial paper conduits that leapt onto the front pages last Fall, with minimal regulatory capital requirements. At the same time there were regulatory changes for the investment banks that have been referred to as the “Bear Stearns Future Insolvency Act of 2004”. With respect to the banks, the result is easily discernible from the graph above. Asset-backed commercial paper outstanding skyrocketed as banks utilized their newly codified leverage structure to take on the CDOs and other securities where the true risk of all this absurd lending was being hidden. Especially notable here is the absence of the SEC. These securities that were being rated and issued were, apparently, not understood by anyone. By extension, they were not understood by the SEC – isn’t that part of its job? Unfortunately, when investors discovered that there was excessive risk in these vehicles they stopped purchasing the commercial paper that funded them. The result was a severe liquidity crisis as the banks had to honor lines of credit they provided to these entities securing the repayment of commercial paper under just these circumstances. The Federal Reserve has received great admiration for its creative tonics when this crisis broke out, but I believe that is like honoring a firefighter for extinguishing a very dangerous fire that the firefighter ignited in the first place. I can’t finish this part of my rant without pointing out a couple of issues here. First, a crisis in the commercial paper market would certainly present a systemic risk to the financial system if all the banks had credit lines backing their $1.2 trillion in asset-backed commercial paper. Given this fact, together with the knowledge from Enron that off balance sheet treatment does not eliminate risk but increases risk taking, how did the bank regulators determine that is was 10 times safer to fund assets this way than the traditional method of holding them on a bank’s balance sheet? This seems like an extraordinary conclusion, extraordinarily wrong headed.

Of course the current crisis is well beyond a mere liquidity event. The off balance sheet leverage combined with excessive monetary easing provided much too much liquidity to the markets, and the resulting stupidity in the credit world will ultimately cost institutions their solvency. As of this writing Bear Stearns no longer exists (although the taxpayers now own $29 billion (and falling) of mortgage-backed securities that Chase didn’t want while the shareholders walked with cash) and the FDIC has seized IndyMac, a large bank with extensive mortgage operations. I don’t believe this will be the last, and taxpayers will be paying for this debacle for years to come.

So what caused this crisis? Those responsible for ensuring a sound financial system failed, plain and simple. Regulators and Congress are to blame as they were well aware of the risks of rating agency conflicts, off balance sheet financing and excessive leverage yet they turned a blind eye when it came to the financial sector. The fact that rating agency conflicts and other abuses by Wall Street and others played a role does not change the fact that those responsible for regulating these activities failed. In fact, these issues should have made the regulators even more watchful in light of the fact that they were warned of rating agency conflicts that go to the heart of the regulatory system they set up.

In hindsight all of this looks obvious, and what is obvious in hindsight is not always so clear at the time. Perhaps it was not so obvious to regulators or Congress at the time. But why didn’t they figure it out? These are the best and brightest in the field and it is their job to figure this out and monitor and protect the financial system. What forces were at play such that this set of events could be set in motion and play out without any reaction from the Fed or Congress? Perhaps there is something structurally wrong with having the Fed involved in bank regulation at the same time it is responsible for monetary policy. Perhaps there is an issue with the appointment of regulators such that a given administration’s policies become too pervasive. Perhaps too many key people in the regulatory authorities come from the very institutions they are there to regulate or get jobs at those institutions when they leave. Perhaps the financial industry has too much influence in Congress and it is the broken political system where money buys influence that caused the credit crisis. In my opinion these are the fundamental issues raised by the credit crisis and I believe they should get more attention than they are getting now. I also believe that these very same regulators should not be setting the agenda for the new regulatory regime that will follow this crisis, but as of now they are.

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11 comments:

Anonymous said...

Great piece. Thanks I learned a lot.
I think your last paragraph of guesses about what caused the fix we is quite comprehensive.

A somewhat simplistic summary:
-Greed
-Unfettered free market ideology which the holders of couldn't stay with when the going got tough.

Ayn Rand and Uncle Miltie are turning over in their graves as W's economics profs at Harvard are the ones smirking now.

Palermo's Blog said...

Anonymous - thanks, great comment:-)

Steve D said...

The Fed and Gov do not deserve the benefit of doubt. The coming housing debacle has been predicted by many people, me included, since mid-2004. All one had to do was to walk around the neighborhood and look at sticker prices of the homes for sale and at the people who were buying them. I would literally freeze on the spot with my jaw open. The "regulators" knew!

I'm glad that more people are seeing the political connection. Because this is first a political crisis. Economics is only secondary and really is nothing new.
But, hey, what do you expect - for 95 years we have been using private debt money, backed by borrower's valuation of the asset he wants to buy? Chilling, isn't it.

Palermo's Blog said...

steve D - I agree, we need more discussion of the political issues and less of the economics. The candidates haven't even touched these issues as far as I can tell. More of the same in that regard. Very discouraging to me. I guess it has to get really bad before real change is forced on Washington.

dd said...

I am appalled by anonymous's comment and palermo's concurrence. The free market didn't create this problem - it was the lack thereof. First of all, if we all dealt in real money banks would be making damn sure of the loans they originate. Secondly, entities such as Fannie Mae and Freddie Mac "guaranteeing" loans and access thereto for all Americans exacerbated the situation - unnecessary governmental intrusion in the housing market. Not too mention the free and loose federal monetary policy that helped originate the excessive number of loans and values thereof. Oh sure, MORE regulation will fix this - my ass! The free market works fine only if its truly free and not manipulated by elements within the government for political purposes. To insinuate that W is a free marketeer is laughable - look at his maniac Keynesian Socialist appointee Bernanke. W's alma mater was Yale for all you know.

Palermo's Blog said...

Unregulated free markets in the financial sector that allocates capital resources in the economy is certain to result in failures and suffering. Take a look at the rate of bank failures and financial crises before the Federal Reserve (and the Depression when they were learning:-) ). I don't have a handy reference, but there were regular bank failures and periods of deflation and recession that were much more frequent than in modern history. This gets into a much longer discussion about banks and banking but unregulated financial markets is not on my agenda. When we remove the regulations greed takes over, leverage and risk taking accelerates, and failures become rampant. The failures then ripple through the economy and everyone suffers.

dd said...

There is *NO* incentive for a bank to seek failure in the free market...Regulators aren't "doing their job" anyway

Tim said...

dd, Palermo- It's much more complicated. Yes, you need to have regulation to keep wall street in check and letting the free market run hog wild can be a recipe for disaster. However, this current crisis is more the fault of those regulators who pushed for easier credit guidelines so that more people could own homes. The industry knew that they would be bailed out, so they had no reason to not take the excessive risks.

What's happened here is that we're not in a free market, or in a socialised system. It's a hybrid, freakish mutant creature where we privatize gains and socialize losses.

We are overdo for a massive bloodletting revolution. Then we can choose a sensible economic model that doesn't just benefit 12 people.

Palermo's Blog said...

tim - I prefer the peaceful revolution - here's a thought - keep voting for whoever is not the incumbent no matter what you think of their policies. In fact, the more they have to spend on a campaign the more they may be indebted to special interests, so pay no attention to the advertising crap you see. If enough people do this eventually politicians will get the message that they can't stay in office by raising lots of money to spend on campaigns!

Anonymous said...

We need better conflict of interest laws. A senators aide leaves for a lobbying job with the very industry they were regulating. Next thing you know they are writing the law for their friends left back in the halls of congress. Don't kid yourselves, that is how it works. Lobbyists write the text and the congressional staff package it into the legislation.

How about a five year ban between the time someone leaves a congressional post and joins K street?

Palermo's Blog said...

Anonymous - I'm with you on those points. Here is a recent comment I made on another blog:
How to fix the problem:

1. Pay politicians more money so that we attract better people and reduce the lure of corruption;
2. Reform campaign finance so the politicians are not indebted when they arrive and raising money the minute they start; and
3. Prohibit politicians from working in an industry they have had oversight of for at least three years after leaving office (and, if we need to pay them for those three years, I say we do it).

This should be the agenda for change IMO. Oh yes, add changes to the appointment process for key positions so that we don't get a "friends of the President" administration where everyone is covering everyone else's back.

I like your expansive view - include staffers, etc.