What Caused the Crisis?

I have wanted to write this article for some time, but decided to sit on it in order to consider the matter more closely. What caused the financial crisis of 2008?

In my writings at RealMoney, I anticipated much of the crisis, though not all of it, and certainly not the severity of it. The prime cause of the financial crisis was a buildup of private debt encouraged by the tax code and the Federal Reserve. But let me go through the causes of the financial crisis one by one:

Causes

One) During the Greenspan era, recessions were not allowed to do their job of reducing bad debts. Recessions ended early, and expansions went on too long. This encouraged firms and individuals to borrow too much, and foolishly went under the moniker of the “Great Moderation.”  Monetary policy was too loose 1986-2005.

Two) China wanted to build its industries through exporting. To do that they had to keep their currency cheap. To keep their currency cheap, they had to buy financial claims from the US, so they bought our bonds. This kept our interest rates low, and allowed people to buy houses with low monthly payments, putting them into a larger house than they could afford, should the economy turn down.

Three) Partly because of monetary policy, a risk culture developed for economic actors took more and more risk because they thought that the Fed would rescue them in a crisis. During that era, I saw all manner of unorthodox ways that took a lot of risk to earn excess returns. Examples: leveraged non-prime commercial paper, selling short term at the money volatility, and taking exotic bets on the long side with subprime residential mortgage-backed securities, to name a few.

Four) This probably generates the most controversy, but the crisis was partially driven by total return or yield hogs. Having been a bond manager, I learned that the easiest error to fall into is to always add yield. In the short run, adding yield boosts your performance. The time before the crisis offered many opportunities for bond managers to add yield in structured securities that were rated AAA. Many economic players, especially European banks did so. These yield hogs were the enablers of the investment banks who structured some really crummy deals. Without the yield hogs, those deals could never have been done.

What’s that you say? The yield hogs were duped? I say no. Excluding AIG, most US-based insurance companies avoided those yield hogs securities. Conservative investing kept the insurance industry away from the areas that were going to get killed. If you are an institutional investor, it is incumbent on you to do the due diligence necessary, and not simply trust what the rating agencies say, nor what the underwriters say.

Five) Lenders lent too much against residential real estate. Borrowers borrowed too much. The two go together. Lending terms became too loose as far as underwriting goes. At the same time, loans were made to subprime borrowers who could only afford the “teaser rate,” and not the ultimate rate they would pay.

If you look at graphs that show the amount of equity underlying homes with mortgages, it should have been obvious by 2004 that we were in a bubble. We had never seen this level of indebtedness on housing Italy since the Great Depression or maybe the Panic of 1871.

Six) The GSEs helped facilitate this growth in debt. They charged a low amount to guarantee residential mortgage debt. They did not think it was low, but like the actuary of legend, they were driving looking through the rear view mirror. Past is prologue, and they decided that the future would be like the past, only more so.

Someone with real modeling capability would have developed a dynamic model that would’ve looked at debt service coverage under a variety of real estate pricing scenarios. When I was mortgage bond manager I did that for CMBS, from 1998 through 2001.

The GSEs were under-reserved if housing prices started to fall. We knew that at the hedge fund that I worked for, and waited for housing prices to fall.

Seven) Because banks originated mortgages in order to securitize them, underwriting quality went down. When you originate a loan to hold it, you are far more careful about credit quality.

Eight) Banking regulators were unwilling to regulate. Further, we allowed depository institutions to choose their regulator. Regulators had enough power to shut down sloppy underwriting if they had wanted to. The new laws that have been put into place are superfluous. If regulators will not use the powers granted to them, how will granting them greater powers make them do their job?

Allowing depository institutions to choose their regulator enabled them to choose weak regulators. What could be dumber policy? Far better that a depository institution is assigned a regulator by the government.

Nine) Though deposit insurance avoids runs on the bank, the repo market allowed for new sort of run on bank. By financing securities short term through the repo market, those financing securities left themselves open to the risk that lending terms change against them. As the crisis progressed, those financing in the repo market were forced to put up more capital against their positions, until they ran out of capital, and defaulted. The same was true for portfolio margining requirements. As financial companies were downgraded by the rating agencies, it created a “cliff” for the financial companies, which made their decline more precipitous.  As more capital was needed for margin requirements, less free capital was available, leading to further ratings downgrades, and eventual insolvency.

Ten) In general, capital regulations for banks were too loose. Banks probably needed to have twice the level of capital going into the crisis than they did. Also, rather than trusting banks’ internal models of risk for regulatory purposes, it would have been better to have a series of dumb rules that would limit the ability of banks to deal in areas where risk exposures are unclear.

Eleven) Derivatives are regulated wrong. They should be regulated like insurance. They should be regulated by the states. The doctrine of insurable interest should be enforced. In short, those who need to hedge may initiate trades; speculators may not initiate trades.

If rules like this had been in place, the derivative market would never have gotten so big, and only economically necessary trades would’ve been done.

Twelve) We need to move investment banks back to what they used to be: partnerships. That will reduce the amount of risk they take, as senior partners see their retirements in jeopardy if too much risk is taken. The same is true of commercial banks, where the doctrine of double liability should be reinstituted, and managers of banks could lose their personal wealth if the bank takes significant losses.

Thirteen) If we want to end “too big to fail,” we need to end interstate branching of banks. Make it uneconomic for banks to be big. And, let the states regulate banks. State regulation is good regulation. It is far harder to co-opt 50 state regulators than a single federal regulator, much less several federal regulators that the banks can choose.

Let me put it this way, echoing Francois Mitterand on Germany: “Don’t get me wrong, I like Bank of America.  In fact, I like Bank of America so much; I think there should be 50 of them, one for each state.”  That will end “too big to fail.”

This is a bigger factor in the crisis than the repeal of Glass-Steagall, which was a small factor in the crisis.  But if you make the commercial banks smaller, they will not be able to have large investment banks attached to them.

Fourteen) Securitization, aside from warping loan origination incentives, created opaque assets that were difficult to rate and price.  This hindered the recognition of losses as conditions deteriorated, and led to securities that were either “money good” or a “zonk” in the midst of the crisis, with a thin tipping point in-between.

Fifteen) The crisis would have happened regardless of what the government would have done with Lehman.  Note that all of the major institutions that were bailed out, bought out, or failed had large exposures to residential mortgages: Bear, Fannie, Freddie, AIG, Merrill, Washington Mutual, Wachovia and Lehman.

What was not part of the Crisis

One) The rating agencies, much as they profited from it, were forced to rate structured finance, because the regulators needed the ratings to calculate capital charges.  They didn’t do well at it, because the rating agencies always do badly with a new asset class – they don’t have any data to work with.  Don’t blame the rating agencies, blame the regulators that allow their firms to invest in unseasoned securities.

Two) The net capital rule was not a part of the crisis, as I documented here.

Three) Money market funds were not a part of the crisis, as I documented here.

Attitudes

I have often said that “free money brings out the worst in people.” (Please send the memo to Ben Bernanke, who creates free money.)  Everyone in the crisis points the finger at others, but not at themselves.

The sad truth is that the financial crisis resulted from people speculating on increases in housing prices, and commercial and investment banks that did the same thing, and ignored common sense, which sadly, is not common.