What Caused the Financial Crisis?

An article in the NY Times, "Pressured to Take on Risk, Fannie Hit a Tipping Point," is causing many people to wonder if Fannie and Freddie caused the financial crisis.

First, let me clarify the question. We are asking what caused the housing bubble, and, by definition, the cause cannot be explained by changes in an underlying market fundamental. I don't mean that we can't point to, say, a rumor that led to a rapid increase in the price of some good as speculators rush in, just that bubbles - by definition - are divorced from market fundamentals.

I think a more interesting question is what sets the stage for a bubble to emerge - what allows the rumor, irrational exuberance, etc., to express itself as a bubble? One thing that is needed is liquidity and credit, some way of substantially increasing demand. This is the air that inflates the bubble. Even if all the other conditions for a bubble to emerge are present, if there is no way to inflate the bubble - no way for speculators to rush in and drive up the price - then it won't inflate.

We already know that there was enough available liquidity to inflate a housing bubble. So something went wrong in these markets that allowed the bubble to emerge and then pop, and this is causing us immense problems right now, but what was it?

I think the most important factors are agency problems, the mis-pricing of risk, and the failure of securitization to distribute risks across the financial system.

With respect to the agency issues, there is a long chain between the home buyer, the mortgage broker, and, ultimately, the sliced and diced complex securities that nobody fully understands. Let's take one step in the chain, that of a a bank or mortgage broker, either one. Suppose they are paid a fee, i.e. by the number of mortgages that pass through their hands each month (as, essentially, they were). The more mortgages they can push through, the higher their income. They are required to meet certain guidelines as they do this, but so long as their income depends upon the number of mortgages passing through their hands and not what happens to the mortgages later on - so long as it is a fee-based system - they have every incentive to push the guidelines as hard as they can and to find a way around them whenever possible.

If mortgage brokers had done their job and only made loans to people who could pay them back (i.e. with "reasonable" levels of default), we wouldn't have a financial crisis. So right away, in nearly the first step of the chain, we have to ask what went wrong, why they were willing to take so many questionable loans. The problem is what economists call an agency issue. The brokers had no stake in the outcome once the mortgages left their hands. The same with banks, all they had to do was process the mortgages, package them up, then sell them and collect their fee.

Think about the incentives here. Suppose you are a mortgage broker and you begin to suspect that the bubble will pop soon, that all this lucrative business might end. To protect the business, should you get worried and start checking mortgages more carefully to make sure that things don't get further out of hand? No, you should accelerate what you are doing, write even more mortgages - nothing you can do can stop the bubble from popping, you are just one of many, many brokers far down the chain - so why not collect as many fees as possible before the gravy train ends? What if everyone thinks this way, and they all rush to sell as many of these things as they can? Mania.

A solution to this is to give each person in the chain a stake in the future outcome of the mortgage. If mortgage brokers' income had been connected to a financial instrument that pays off according to the future performance of the mortgages they write, would they have behaved differently? Probably. (What about homeowners, why didn't they say no? Don't they have a stake in the future price of the home? Homeowners in non-recourse states - and more generally - were basically granted cheap options on their homes. The downside was protected and they had no reason to effectively monitor risk. If prices fell, they could just walk away and know that their other assets remained safe and that their credit reputations could be restored with time. Of course, if everyone walks away other assets such as retirement savings don't remain safe, but that doesn't change the incentive on an individual level.)

Ah, you say, but as you go up the chain why didn't people refuse to take the financial paper, why didn't they conclude it was too risky? The risky mortgages don't have to be stopped at the bottom, this is a linked chain, so why weren't they stopped higher up in the chain where the stakes are higher? Isn't that where Fannie, Freddie, and moral hazard rear their ugly heads? Did they encourage and allow this risky paper to pass through the system?

The mis-pricing and mal-distribution of risk played a key role here (along with poor management decisions in cases where alarms were raised). The agency issues above, and the consequences of the failure to predict and distribute risk are much more important than any moral hazard issues arising from the implicit government guarantee granted to Fannie and Freddie.

Institutions in the shadow banking sector were willing to take large volumes of risky loans as they came up through the system. Why?

The people at the top of this complex chain did not fully understand the risks the were assuming when they took on the subprime business, or, rather, when they took on the complex securities derived from the subprime business. When the bubble popped, it shouldn't have been a big problem if the risk assessment models they relied upon had been correct, and if securitization had distributed the risk as promised. As Brad DeLong notes:

• There is $11T if U.S. mortgages
• There is $60T of global financial assets
• Even if we had $2T of losses on mortgage-backed securities that shouldn't pose a big problem for Wall Street--actually 48th and Park Avenue

So if the risks had been distributed fairly evenly, it's much less likely that we'd be in this mess (the losses of 2T - an intentionally high-balled number - are only 1/30th of global financial assets). It wasn't the misprediction of the level of risk that was the biggest problem, the losses could have been absorbed, it was the (unintended) concentration of risk through the failure of securitization that was the most problematic.

Fundamentally, then, it was the agency problems and the failure of risk prediction and distribution models that allowed the bubble to inflate and then cause big problems after it popped. But back to Fannie and Freddie. The willingness of the non-traditional banking sector - the shadow banking system - to take on these risky assets and still pay investors a relatively high return put tremendous pressure on Fannie and Freddie to follow suit. And their response was unwise - Fannie and Freddie followed the shadow banking sector downward. There is lots to fault in the behavior of Fannie and Freddie and in government oversight of them - the decisions of management, the lobbying efforts that were funded by their ability to extract a premium from the implicit government guarantee - all of this was a big problem. The bubble, and later the financial crisis expressed itself in these institutions, and they may have also contributed to it to some extent as they took on more risky securities when their business began to go elsewhere. But the agency issues and the failures of risk models and securitization would have created problems in the largely unregulated shadow banking sector even if these two institutions had taken on nothing but the safest of mortgages. The bubble still would have inflated in the shadow banking system - maybe it's a little smaller, I don't know - but it still would have been large enough to cause big problems when it burst. The best behavior of Fannie and Freddie would not have been enough to stop the bubble from inflating in other parts of the financial sector, and then turning into a full fledged financial crisis as housing prices plunged.

The problems we are having were caused when lots of available liquidity rushed past the checks and balances that proper agency provides in pursuit of promises that risk models and complex securities did not deliver. The unexpected losses alone might not have caused a crisis had the losses been widely distributed, but, the losses were concentrated and hidden in ways that created widespread fear and threatened the entire system. Getting rid of that fear is not going to be easy.

[Update: Given some of the responses elsewhere to this post and others like it, let me add one more thing. Asking the question "what caused the financial crisis," thinking about it, and then arguing that Fannie and Freddie were not the primary driving forces behind the financial meltdown (though they could have affected the size of the problem as noted above) is not the same as defending Fannie and Freddie. Whether are not Fannie and Freddie are performing a useful function, and if they are performing a useful function how they should be structured going forward is not a question I've fully resolved. The market failure they are addressing is not entirely evident to me, and until I understand how they improve the efficiency of these markets, I won't take a position. They certainly should not operate as private entities with an implicit government guarantee as before - that's what set up the situation where the implicit guarantee could be exploited profitably and used to fund lobbyists and ad campaigns to make sure the golden goose kept laying eggs. However, I have posted arguments from other people arguing for their existence, and I am thinking about those as well as arguments against their continuation. In any case, something to guard against, I think, is to inappropriately blame Fannie and Freddie for the financial crisis and then use that as a reason to shut them down irrespective of any useful function they might serve. So when I see those with an agenda against government intervention trying to do just that - arguing honestly in some cases and dishonestly in others that Fannie and Freddie were a big factor in the crisis so they can use them as an example of government intervention gone awry and also shut them down - a double bonus in their eyes - I have tried to present evidence and arguments that the cause lies elsewhere. But as I said, that is not the same as defending their existence. My interest is in understanding the true cause of the financial crisis and in stopping it from happening again - and to avoid getting stuck on wrong arguments along the way - not in using the crisis to argue about whether Fannie and Freddie ought to continue as government supported institutions. That can wait for another day.]

Comments

[Highgamma]

In reference to your second paragraph, isn't the availability of subsidized credit a "market fundamental"? Can't the existence of subsidized credit (in the form of Fannie and Freddie's behavior) "cause" a market bubble (though it will need the 'irrationally exuberant' to set the match to the powder keg)?

[Bruce Wilder]

It is interesting to me to contrast the economist, casting around for an ideal incentive, and Tanta of Calculated Risk, the bureaucrat, casting around for the ideal rule or policy.

Incentives and rules. Personally, I doubt you can ever get the incentives to line up properly. And, the rules rule, so to speak, in the end. But, both operate.

[ken melvin]

"If mortgage brokers had done their job and only made loans to people who could pay them back (i.e. with "reasonable" levels of default), we wouldn't have a financial crisis.

When we have a fire, there are always those who seek to find the ‘culprit’ that started the fire. Most times, the fire was a fire waiting to happen. And would’ve.

The people who couldn't pay for mortgages for many times what the homes were worth were the problem? Don’t think so. I say: speculation caused the bubble; as always, there were those caught up who bit off more than they could chew; and, this time, there were scam artist who peddled sub-prime mortgages as get rich quick schemes much as those scammers before peddle gold mine shares, etc.

Beginning with its formation, this housing bubble itself was at least a part of the current financial crisis. Part and parcel? It appears to me that the bursting of the bubble exposed more very serious underlying problems. Even if the bubble is solely responsible, the sub-prime mortgages, though they partially fueled a part of the later expansion, did not cause the bubble, and the bubble that simply had to break; it only a matter of when.

[bakho]

Dean Baker blames the housing bubble and I think he nails it.

http://www.prospect.org/csnc/blogs/beat_the_press_archive?month=10&year=2008&base_name=fannies_demise_it_was_the_coll

It occurs to me that sorting the good from the bad mortgages will be problematic until the housing bubble hits true bottom.

Is there a way to pull out the low risk assets (mortgages with sufficient equity from non-bubble areas) to at least make those assets tradable? High risk category for mortgages in housing bubble areas and junk for those that have defaulted? Would it be worth it to the shadow system to pay agents (loan originators?) to re-evaluate mortgages? It is hard to believe that is not being done.

[bakho]

In order to guard against a problem, one has to first recognize the problem. It seems like many of the administration functionaries along with the Greenspan Fed were denying the existence of a bubble.

Past performance is no guarantee of future results.

Past failure of homeowner defaults is no guarantee of future lack of defaults if the new homeowners have financial issues.

[ken melvin]

Controlled burns in the future?

[Lord]

For bubble formation, prices must be divorced from values. In credit, this is accomplished by separating borrowing from the capacity to repay, separating borrowing from the income to pay for it by failing to qualify borrowers on market rates and failing to verify incomes. This allows for credit creation independent of underlying value, as lenders print money. I hesitate to call this an agency problem because the agents were only acting in accordance with the design of the program. I don't think one can view bubbles as a failure of finance, but rather as the intention of finance. It allows the separation of fools from their money and is a fundamental purpose of finance.

[robertdfeinman]

Perhaps this is the same thing, but not expressed in economics speak.

The home buyers (even the wise guys) bought variable mortgages which means that their future risk is unknowable. Many had increases based upon external factors like some national interest rate. In earlier times home owners had predictable mortgage payments and the only risks were loss of income due to things like unemployment, illness or divorce. The levels of these risks is well known. The discount rate five years hence is not. So unknown risk was put on people who couldn't evaluate it even if conscientious buyers.

In addition the SEC fell down on its job (see the NY Times earlier this week) and permitted investment banks to decrease their reserves to 3%. The hedge funds and others did the same since they don't even have nominal regulation.

A modest drop in housing (prices or ability to pay) got quickly leveraged by 33:1. Capitalist enterprises, by their nature, are forced to take on increasing risks to out do their competition. It is up to the regulatory agencies to limit this. These risks aren't always financial, as we see in the recent product safety disasters they can involve quality and safety as well. The same goes for the safety of the workplace.

Letting inveterate gamblers gamble to excess is the fault of government. In this case a 40 year deliberate policy of gutting of existing laws and regulations. Jay Gould would feel right at home.

All the proposals (Mark Thoma's included) aim at restoring some role for government, they only differ in the details. Even the classic free marketeers now see things have gotten out of hand. They, of course, prefer to blame it on bad actors rather than on their ideology.

[bakho]

"They, of course, prefer to blame it on bad actors rather than on their ideology."

Indeed

[Anonymous]

Having spent quite a bit of time reading Tanta, I think that part of the problem was that investors were counting on the fact that loan originators are required to take back a loan that doesn't meet criteria or that goes into default too fast. With the result that undercapitalized firms (basically designed to go belly up) were originating the worst loans.

This seems to be how our economic system works these days: protect profits by making sure the liability lies with someone who can't afford to pay.

[donna]

I still think the problem was in the risk modeling failing to account for the "fat tail" of many, many mortgage failures at the same time. It's the way we measure risk that is the main problem, and the other problem is the way we measure success of corporations and individuals strictly in terms of income.

We have to look at the risks of allowing inequality and economic conditions to lead to economic conditions such that many people are not able to pay their mortgages all at once. Wall Street bankers can't make billions for years loaning money to people who can't afford the homes they buy, and then be surprised when it all falls apart.

[Ciphernerd]

"If mortgage brokers had done their job and only made loans to people who could pay them back (i.e. with "reasonable" levels of default), we wouldn't have a financial crisis."

not necessarily. I think all the actors here could have behaved rationally and still caused the bubble to form.

Imagine person A taking out a mortgage to buy a loan. He works as a home builder and can pay back the loan because B and C both borrow money to purchase homes from him. B and C also work as home builders and pay back their loans from D, E, F, and G, and so on.

Every individual actor is rational, but the system is unsustainable.

The race to the bottom could have resulted from other borrowers maxing out their credit.

[Ciphernerd]

A solution is to forgive all debt every seven years.

[Matt]

If the government overshot the goal of home ownership, it is the responsibility of the investment houses to realize that, just as they realize any other risk in the economy.

Neither Bear Sterns, nor Goldman Sachs, nor Morgan Stanley were required to support sub prime.

[me]

NPR today summed up by pointing out that the total of credit default swaps is enormously more than the total money in the world -- and that people were taking out credit default "insurance" on bonds they did not own, as a way of gambling.
It sounds exactly like "selling" a stock hoping it will go down.

And NPR said some bonds might have ten different credit "insurance" deals on them so if they fail, ten times as much money as the value would supposedly have to be handed over to the people who bought the "insurance."

And NPR said that these are secret, none are registered, there is no money set aside to cover them -- because values 'could only go up' so it seemed like free money with almost no risk.

And they said repeatedly, these were really , really smart people.

Any of that true?

Why not just require all these financial instruments to be publicly disclosed -- register them, book them. After a deadline (say, January 9th?) any that are not public are invalid.

Then -- everyone will know where the risk is.

Problem solved?

$$Profit$@)#(%$&|#@U)$?

[dWj]

The housing bubble did not have to cause a financial crisis; without the irresponsible lending, the housing bubble may have been less dramatic, but I think it's likely it would have still happened. The financial crisis would be much less severe.

Also, I disagree that the fact that $2T in bad debt caused this much trouble is evidence that the securitization didn't effectively spread the risk. Much of the credit crisis is higher-order, knock-on credit problems; there has now been a lot more loss of value of other assets, partly because some of them, ultimately, are backed by the MBS -- when we counted both the value of a Lehman bond and the value of an MBS that Lehman held as assets, we're on some level double counting -- and partly because uncertainty is disvalued. The problem isn't so much that securitization didn't spread risk, it's that it created so much more of it, not least through the agency problems you mention.

(Long term, I can imagine a solution involving mortgage originators developing a valuable brand among buyers of securities, but that could take a long time to develop; concern for "brand" or the like certainly doesn't seem to have played any braking role in the last five years.)

Clearly the GSEs were misregulated, and many other financial institutions, though perhaps less egregiously. Securitization, including the credit tranching of mortgages, seems to me like it has a useful role to play in our economy -- just as canals and the internet do -- but it's obviously going to have to be done with a little more circumspection the next time around.

[dWj]

The comment just before my previous one strikes me as awfully tendentious in a couple ways.

Credit default swaps are partly "secret" for the same reason my bagel purchases are "secret". To be sure, I know that hedge funds try to prevent the disclosure of their strategies, as that disclosure would seriously erode the value of the research that has gone into them, but it's hardly as though this is some terribly cloak-and-dagger conspiracy stuff -- nobody's standing in a dark alley asking, "hey, buddy, you wanna buy a CDS?"

Second, one doesn't short either stock or credit primarily because one "hopes" for it to go down -- though the converse may be true -- but because one "expects" it to go down, or even "fears". Credit default swaps are used by companies with a counterparty or other creditor-type relationship to hedge risks that aren't directly related to their holding bonds issued by that creditor; these people are hedging risks. For every buyer of a CDS, there is, of course, a seller; these are the actual sources of today's troubles.

Finally, note that it has been quite a while -- maybe a year -- since we've heard of a hedge fund blowing up, and then it was on energy trades. The systemic problem seems nicely to be avoiding the least regulated part of the industry.

[Lord]

The first hedge funds to blow up were Bears.

[Ciphernerd]

"The housing bubble did not have to cause a financial crisis; without the irresponsible lending, the housing bubble may have been less dramatic, but I think it's likely it would have still happened. The financial crisis would be much less severe."

Is there any theory about exactly how far bubbles can go while the actors are still behaving rationally? The definition of an "irresponsible" loan can change dramatically if a bubble starts to pop and affects the economy.

[me]

http://www.thisamericanlife.org/Radio_Episode.aspx?episode=365

10.03.2008
365: Another Frightening Show About the Economy

Alex Blumberg and NPR's Adam Davidson—the two guys who reported our Giant Pool of Money episode—are back, in collaboration with the Planet Money podcast. They'll explain what happened this week, including what regulators could've done to prevent this financial crisis from happening in the first place. You can learn more about the daily ins and outs on the Planet Money blog.

http://www.npr.org/blogs/money/

But How Will It Affect Me?

We just heard the This American Life story Alex and I did with Ira, about the financial crisis.

As soon as it was over, my dad and my uncle called to say they liked it a lot but still had a crucial question: you say it's scary, but how is it scary to me? How does the crisis affect regular people?

I do think I could have done a better job of laying this out.

We will be focusing on this question intensely over the coming weeks. The truth is, the crisis is still somewhat contained to big banks and large corporations. It is harder for people to get a loan, but it's far from impossible.

It's hard to do good narrative journalism about a thing that might happen. It's always easier to tell good, juicy stories about things that have happened, already, to real people.

Here's what I'm afraid of, why I said I'm scared:

Continue reading "But How Will It Affect Me?" (go to their blog, obviously ...)

-- Adam Davidson

[evagrius]

Amazing that the most important purchase for a family could have ended up being a casino chip in a roulette game.

[ken melvin]

They all, sub-primers included, bought because they believed the prices would continue to go up.

[Winslow R.]

" As Brad DeLong notes:

There is $11T if U.S. mortgages
There is $60T of global financial assets
Even if we had $2T of losses on mortgage-backed securities that shouldn't pose a big problem for Wall Street--actually 48th and Park Avenue
So if the risks had been distributed fairly evenly, it's much less likely that we'd be in this mess (the losses of 2T - an intentionally high-balled number - are only 1/30th of global financial assets)."

What is Brad (and Mark?) thinking?

Haven't you heard the leverage was more than 30x?

What does Brad not understand that when 60 trillion in assets falls by more than 3% the 2 trillion in capital supporting it is GONE and deleveraging ensues! We have asset values falling by 30%! This is what the Treasury is replacing. In addition, if government lowers leverage limits by turning the financial sector into commercial banks (with leverage of 10x) then the Treasury will have to recapitalize to the tune of 6 trillion!

Brad doesn't understand his need for surpluses in the late 90's created this problem. Let me explain. The economy needs financial capital that comes from the Treasury. With Brad's willingness to run surpluses from 1997 to 2001. Check out the Z1. He instigated the removal of some 420 billion of capital in the economy when it should have grown by some 600 billion.
http://www.federalreserve.gov/releases/z1/Current/

Brad Delong removed 1 trillion in capital from the economy. Leveraged a conservative 15x and that is some 15 trillion in private sector loans that were not going to be made. Does everyone forget the crisis Greenspan was in in 2002 with thoughts of the Great Depression and the zero bound?

Gore lost the election, because we went into recession in 2001, remember?

Bush reversed the surplus with huge tax cuts and a war in Iraq, remember?

Get the story straight!

Please.

[me]

So after listening to that, and going back and listening to THIS:

http://marketplace.publicradio.org/display/web/2008/04/01/credit_default_swaps_q/

Why isn't this business of buying "credit default" "insurance" simply actionable as illegal gambling, for people who don't own the actual bond that's being insured?

They're betting that a particular bond someone _else_ owns will default -- and like a horse race, a dozen different people can all bet against the same bond.

It's more like wagering than like short selling even.
Because (is it safe to assume?) people can't short-sell more stock than actually exists. But people can _each_ "insure" the total face amount of a bond and hope it fails.

And maybe, er, nudge it a little?

Hell, it's _Internet_ gambling. Illegal under the Port Safety Act of a couple of years ago!

[me]

Oh, wait, I was wrong about short selling:
http://economistsview.typepad.com/economistsview/2008/10/hal-varian-on-s.html

"... At one point, the number of Palm shares borrowed to sell short was 147 percent of the shares outstanding. (The number could exceed 100 percent since shares could be borrowed only to be lent out again.) ..."

[me]

http://www.thisamericanlife.org/Radio_Episode.aspx?episode=365

10.03.2008
365: Another Frightening Show About the Economy

Alex Blumberg and NPR's Adam Davidson—the two guys who reported our Giant Pool of Money episode—are back, in collaboration with the Planet Money podcast. They'll explain what happened this week, including what regulators could've done to prevent this financial crisis from happening in the first place. You can learn more about the daily ins and outs on the Planet Money blog.

http://www.npr.org/blogs/money/

But How Will It Affect Me?

We just heard the This American Life story Alex and I did with Ira, about the financial crisis.

As soon as it was over, my dad and my uncle called to say they liked it a lot but still had a crucial question: you say it's scary, but how is it scary to me? How does the crisis affect regular people?

I do think I could have done a better job of laying this out.

We will be focusing on this question intensely over the coming weeks. The truth is, the crisis is still somewhat contained to big banks and large corporations. It is harder for people to get a loan, but it's far from impossible.

It's hard to do good narrative journalism about a thing that might happen. It's always easier to tell good, juicy stories about things that have happened, already, to real people.

Here's what I'm afraid of, why I said I'm scared:

Continue reading "But How Will It Affect Me?" (go to their blog, obviously ...)

-- Adam Davidson

[BJ Feng]

Securitization did spread the risks around, but there is a lag effect. The big players, Lehman, WaMu, Countrywide, etc., were caught holding a huge amount of mortgages that were in the process of being securitized. When the MBS market broke down last year, they were unable to unload what was already in their pipeline, and became more exposed than they wanted to be. Because it can take months for mortgages to go through the process, a huge load of mortgages all had to be absorbed onto the institutions' balance sheet. Many stopped their loan programs as soon as the market broke down, but it was already too late, billions upon billions were already in the pipeline.

I think the lag effect was overlooked, or perhaps not taken seriously enough. For years and years the securitization process flowed like water, then all of a sudden it seized up. Some thought they would have more time, clearly this issue will not be overlooked again, not for a long while.

The ratings agencies were a big part of the process and deserve a lot of blame. They never made clear (though most participants knew) that AAA ratings across different product lines were not equivalent. That is a municipal bond AAA does not have the same likelihood of default as an AAA rated CMO tranche. The municipal bond is less likely to default as are AAA corporate bonds. AAA rated derivatives always traded at a higher yield than AAA corporate bonds, the market prices reflected the fact that the two were not equal, but some institutions treated the two as equal. They thought they were getting a great deal when all they were doing was buying lower quality stuff.

The ratings agencies have a huge amount of power and are often too slow to realize and correct their mistakes. These derivatives were too new for the ratings agencies to have a firm understanding of how they would behave in a down market situation. However the agencies continued to give AAA ratings even after the first warning signs popped up. They then downgraded months after the market effectively downgraded the mislabeled AAA bonds for them through higher yields.

I don't blame them for being slow to downgrade AIG or Lehman at the end. They could have destroyed those companies with a downgrade, and everyone already knew the truth by then. None of AIG's or Lehman's bonds were trading at investment grade levels, there was no need to force a bankruptcy, might as well continue to give them an A rating until they go bust.

The trick is to lower ratings as soon as possible when doing so will not destroy the company, but will stop the company from taking on more risk. That's what the rating agencies should have done, but didn't. Agencies downgrade when the institution takes on too much risk, regardless of the current market environment. The market sentiment can change on a dime. Yet too often the agencies change only after the market climate changes and by that time it is already too late. The firms are forced to deleverage and stop by the market, not by the agencies.

[gc]

Without some good descriptive evidence of what was going on with leverage (not limited to hedge funds) and credit default swaps, trying to identify the cause of the financial crisis seems more like a game of pin the tail on a donkey than like a serious discussion leading to policy proposals.

[Winslow R.]

'Financial innovation' was created to deal with a lack of sufficient capital (lack of sufficient deficit spending).

It really is that simple.

Why is it important to understand?

So we understand that with our current fiat currency system, it is very important to maintain a sufficient deficit or else financial collapse and war await us (which will then create 'sufficient deficits') .

says...

The question 'what caused the bubble' is not the sames is 'what made the pop a systemic crises'. In the latter category leverage and CDSs in particular, I think, play a big part but they didn't cause the bubble.

Where there was supply there was also demand. One part of the puzzle might be the American emotional & cultural attachment to home ownership. Especially low income and minorities who are typically excluded from the party. When faced with apparent economic enfranchisement lost all ability to act rationally.

[Jim Harrison]

A modest (and perhaps ignorant) question: what would the American economy have looked like in the Bush years if the housing bubble had not taken place? The recovery after the recession was mighty anemic as it was. Without some sort of con game to keep the ball in the air, maybe the crash would have come sooner. To put the question another way: was the root problem unnecessary financial tomfoolery or was the expansion of credit a form of unwise self medication?

[Sandman]

what would the American economy have looked like in the Bush years if the housing bubble had not taken place?

First, the economy looked close to re-entering recession in the fall of 2002 winter 2003 when the Iraq war was formulated and the economy bounced back out of it post-intial conflict. No surprise the more substainable recovery got going in the fall of 2003. The "unsubstainable" part of the housing boom cycle was 2nd half 2003 through the first half of 2006. That was when the bulk of the damage was done.

If you take away the war and the credit blowoff, the 2000's would have been like the 73-83 period, except the embedded deflation crisis would have been clearly seen earlier from a J6P point of view.

That was a huge reason why Bush "made up" the Iraq war and moved to burn the last energy of the credit expansion via Greenspan post 9-11. Notice the best it did was cause a recovery.

Maybe in another time, There is no boom and the housing cycle doesn't boom, but stays steady. Having to deal with the recession of 2003 wouldn't have been much help either.

Probably another recession in 2006-07 once the financial cycle ended and another one in 2010. A bunch of minor/moderate recessions themselves aren't bad, but put them together and they start to really hurt. I think we see the same now, except the intial one will hurt more than it could have. We wasted to many resources to prevent anything else. The bad side of war.

The US also IMO is close to ending the "war on terror" line. They have gone about as far as they can go against them. They have purged them from the international scene and now they have regrouped in their native homelands on the Asian continent. We can't beat them there and we know it. Now we hope nothing else gets through and it fades from history.

If Obama is elected that is a clear sign the power elite want to liquidate the Bush era military which will provide more budget flex, but hurt the general economy in the short term.

[Patrick]

In addition to Sandman's comment - the Bush admin/Republican Congress used monetary policy as their primary policy tool to deal with the dot bomb recession. The other option was: instead of $2 trillion (according to Stiglitz) for death and destruction in Iraq, spend the money on productive infrastructure projects at home (rail, energy, schools, hospitals, and all the other usual suspects). Alas, it was not to be.

[Bruce Wilder]

Jim Harrison:
A modest (and perhaps ignorant) question: what would the American economy have looked like in the Bush years if the housing bubble had not taken place? The recovery after the recession was mighty anemic as it was. Without some sort of con game to keep the ball in the air, maybe the crash would have come sooner. To put the question another way: was the root problem unnecessary financial tomfoolery or was the expansion of credit a form of unwise self medication?

It's a bad question. The economy is not the weather. The housing bubble did not just "happen". It was a choice. Like squandering the surplus on tax cuts for the wealthy was a choice. Like the invasion and occupation of Iraq was a choice.

As Patrick says, there were other choices available. We could have spent $2 trillion on worthwhile projects and investments, instead of Iraq. We could have stopped pretending that the suburban 1950's dream could on forever, and begun dealing with peak oil and global warming with a $5 trillion national debt instead of a $10 trillion national debt.

It's always a choice. 45% of the American People evidently think a woman, who cannot name a newspaper, a Supreme Court decision or even an historical V-P, would make a great Vice-President of the United States. You betcha! President. Also.

Bad policy has bad consequences. Surprise!

[a]

"I think the most important factors are agency problems, the mis-pricing of risk, and the failure of securitization to distribute risks across the financial system."

I'd vote for:
1/ Hubris, in Wall Street, Washington, and academia
2/ A culture gone made, which mistook debt for wealth

[Jim Harrison]

Over the last thirty years or so, we've been treated to a whole series of bubbles from the Savings and Loan disaster to the current train wreck. I quite agree that these events were not inevitable and that better policies could have prevented or mitigated them. But maybe that's in principle only. I don't think what the financial and political powers in fact decided to do was simply a case of greed and black mischief, however, even if a tremendous amount of sheer criminality was involved in every instance. Reckless deregulation and hasty privatization have a certain logic and appeal to the normal human tendency to kick the can down the road instead of trying to do something very difficult and painful. Promoting or simply allowing financial bubbles was an understandable response to the deep structural problems with the American economy that began to surface with the original oil shock and more generally with the end of the post WWII expansion of the real economy. As the failure of Carter's attempts to honestly address our problems proved, at least to the satisfaction of succeeding politicians, facing the facts is just too much of a shock for the public; and even Carter swallowed quite a bit of the neoliberal Koolaid. Maybe a Galactic Mule of a politician could have brought people around. Unfortunately, he or she didn't turn up--Clinton turned out to be another Grover Cleveland instead of another FDR. For everybody, the easier thing was to hope that the magic of the unregulated market would solve all problems.

In the case of what's happened in the last seven years, I don't see what alternative would have been politically possible. Even if Gore had taken office, he would hardly have been able to get a serious economic reform plan through Congress; and it would have been ideologically impossible for Bush. His base and his keepers wouldn’t have let him do it. It will be interesting to see what Obama will be able to do. Maybe the crisis is serious enough this time to enable a leader to actually accomplish something.

[a]

"My interest is in understanding the true cause of the financial crisis and in stopping it from happening again..."

How do you stop something which happens every 80 years or so? You can ban debt for a generation, but in 3 generation human beings, being what they are, will yet again think they understand everything and go back to the same mistakes and, to boot, think that the previous generations were to blame for their own problems because they were idiots.

I think the only solution is *time travel*. If time travel were possible, then members of our time could leap forward 60 or so years, and, seeing the idiocies of the future, jump up and down and warn the futurites of the errors of their ways. If there were a sufficient number of time travellers, this might just work.

But alas, time travel isn't possible. So the future will have to cope with human nature the best it can.

Everything we have done wrong, was already done wrong in the times leading up to the great depression. Only the names have changed. They had trusts, we have CDOs. It's not an exact repetition of history, but it rhymes pretty well.

says...

That's kind of a dumb argument if you think about it. We got 80 years of stability because we responded to the problems that were evident during and before the Great Depression (and it was only 50 years if you count S&Ls). It's time to reassess - things have been wobbly the last few decades - fix things as we can, and try to get that kind of stability again (and there are far more episodes to learn from if you look beyond US borders, so the once every 50 years thing isn't really correct in terms of learning about how to fix problems).

To argue otherwise seems, uhm, short-sighted.

[Hal]

It was obvious early on that a bubble was forming. Nothing was done to stop this because Greenspan and others did not believe in stopping or pricking bubbles in good time. I think this is the fundamental thing that needs to change. When a bubble, especially one in an area as vast as housing, begins to form the FED and the Treasury and all those with the weapons that can be used need to prick the bubble, need to act and do so in good time. Letting bubbles involving trillions of dollars of assets alone can't be part of future policy.

[Walt French]

I'd ask, "what institution had we set up to prevent the failure?"

To this observer, "free" markets by nature embody uncertainty about the fair value of assets, and the correlation between individual assets' values can sometimes be much higher than it appears possible/likely through naïve assumptions of efficiency. Then, you have occasional volatility in individual assets -- here, homes -- amplified by a whole set of slice-n-dice derivatives on those assets, some as simple as a mortgage with a free put; others, the as complex as an MBS tranche insured by somebody with totally inadequate capital. Some crazy instruments flew about that individually could actually make sense -- sorry I can't credit the writer who showed how I, as an iBank, could actually sell insurance that'd only pay off if I were to go into default -- and unable to pay -- and a knowing buyer would take it.

Since home prices are expected to vary, and since we write derivatives on them that can go ballistic, there is NO realistic amount of capital that can ALWAYS backstop a financial institution. I assert this as a simplistic generalization of Diamond & Dybvig; who will refute this?

Before the introduction of the FRB, the US had multiple currency crises caused by banks' ordinary pursuit of profitability. Today, the shadow banking system has created another because the full faith & credit of the US was not ultimately backstopping any of these instruments, and capital has been wiped out across the board. Since we had no structure in place that would've forestalled the crisis, the question was only, why did it happen now vs earlier or later?

[anon/portly]

Thanks to MT for his ongoing efforts in laying all this out, which has helped me understand some things a little bit better (if not well).

Having said that, paragraph 8 went way over my head. A condensed version:

"Think about the incentives here. Suppose you are a mortgage broker and you begin to suspect that the bubble will pop soon ... you should accelerate what you are doing, write even more mortgages ... everyone thinks this way.... Mania."

I'm having a hard time getting my head around the idea of mortgage brokers driving the "mania" train. I can understand the idea that a grocer has some cans of tuna that are going to go bad so he marks them down and then tuna "mania" breaks out.

What can mortgage brokers do, so they can write more mortgages? They could also offer lower interest rates, but it doesn't seem like the incentives to do that would be changed by an expectation that the bubble was going to pop. When "[mortgage brokers] accelerate what [they] are doing," I think this must mean that they accelerate the lowering of standards - they get further and further away from the ideal of "only [making] loans to people who could pay them back."

But isn't the lowering of standards tied to increases in housing prices? Increases in housing prices necessitate the lowering of standards (to keep writing mortgages as house prices increase faster than home buyers' incomes) and at the same time justify the lowering of standards (as long as house prices keep going up, defaults are not a worry and the upsteam buyers of mortgages keep on buying).

I don't see why mortgage brokers need to "suspect that the bubble will pop soon" to "accelerate what [they] are doing," it seems like the existence of the bubble itself provides this incentive. Agency problems seem more like artifacts of mania than cause.

[Zipf]

I think Mark gets it mostly right. Combined with the observation with Anonymous above,

"This seems to be how our economic system works these days: protect profits by making sure the liability lies with someone who can't afford to pay."

I think I had heard somewhere there was an economic reason for the explosion of CDS - trading in swaps was more liquid than the underlying and therefore allowed market mechanisms to price these instruments (instead of models). Can anyone comment on this?

Thanks for a clear exposition.

[hari]

Mark is implicitly (only) using the critical failure of the regulatory control regime both at state and federal levels which created this mortgage bubble, if that's what you want to seeriously analyse, you're fundamentally giving the free market system (again!) a free ride in this thread. Why?

The subprime bubble, under a fully regulated system, would never been allowed to run amock and creat this mahem in the financial sector world-wide, me thinks.

Reason why Fed/BB have reinstituted the mortgage regulatory regime with a vengence, after first letting it ride freely under Greenspan.

PS. It's high time academic economists come to grips with political economy, if at all intuitively possible, and deal with gritty nitty of policy making in the real world.

[hari]

F & F are part of the problem but, I agree, if one looks closely at their links with Congressional Reps it becomes obvious that F&F was not regulated, for its own benefit, let alone its supposed public benefit.

The bottomline, here, as on hi street, is that there are limits to laissez faire capitalism, greed, and fraudulent business practics given the nature of money making business.
We may never be able to get rid of all the inequities within the system, however, if there is a will and a way, we can establish regulatory oversight and control and literally stop system from getting suffocated by fraudulent business practices like the subprime mess.

[a]

"We got 80 years of stability because we responded to the problems that were evident during and before the Great Depression (and it was only 50 years if you count S&Ls). "

That's what history tells you. In the aftermath of the Great Depression there was great controversy what caused it and there only began to be a consensus much later - that it was the fault of the Fed and the U.S. government for not doing the right things.

On the contrary the cause of the Great Depression was too much debt, and the solution to the Depression turned out not to be all the new regulations and economic medicines, but simply that liquidation occurred to such an extent that people actually did live better and more virtuous lives - i.e. they paid their bills and refused to go into too much debt. For a while. Until they forgot. And the cycle repeats.

[ndd]

My interest is in understanding the true cause of the financial crisis and in stopping it from happening again -

One crucial part of why the crisis was allowed to happen is that, even though there were regulations on the books, a political party was in power which fundamentally did not believe in enforcing them -- and so they didn't. The Bush Administration pre-empted state laws on predatory bank lending, and the SEC may as well have ceased to exist. Meanwhile Alan Greenspan was deliberately turning a deaf ear to pleas from Lyle Gramlich to use existing powers to stop the lending spree. And here we have the natural consequences of the total lack of regulatory enforcement.

So regardless of whatever new rules or regulations economists or policymakers might dream up, the next time a cabal which does not believe in said rules and regulations comes to power, they too will not be enforced.

There is one solution to this problem, which I will continue to post until people finally get it. There is an old legal writ called "Mandamus", which is issued by a court to Order bureaucrats to do their jobs. Give states' attorneys general the standing to bring writs of Mandamus against Federal officials who are not enforcing their regulations, and you build in an important layer of protection against willful nonfeasance from happening again.

[RueTheDay]

What caused the financial crisis?

Same things that always do.

"All panics, manias and crises of a financial nature have their roots in an abuse of credit."
--Hyman Minsky

Leverage + Maturity Mismatch = Asset Price Bubble

The deflation of an asset bubble (the proximal event that pricks it is irrelevant) in the presence of leverage (debt) and maturity mismatch then creates the crisis.

This isn't rocket science.

Put down your general equilibrium texts and game theory texts and CAPM finance texts and read what Minsky wrote, assuming you want to have some chance at understanding what actually transpires in the REAL WORLD of economics and finance.

[Greg Bickley]

It seems to me that one of the problems here is that the "inventors" of these derivative instruments were guilty of believing they were DIVIDING risk when in fact they were MULTIPLYING risk.

I remember many physics and calculus problems I did in school where I simply applied the wrong operation on the formula. I had all the variables correct I just made a simple error in figuring out what to do with the variables.

If you think something is "distributing" rather than "accumulating" the effects are devastating.

[paine]

others may have made this point way up stream....

the risk of default is different on say a lear jet
or pick up truck
that has stable real secondary market value
based on replacement cost and depreciation
houses are okay because like boats they can be built anew

house lots ..like picasso prints no

house lots like gold
where the ratio of yearly production to existing stock is very low ....

like stock they need
to be controled in their total expansion rate
by margin laws
and income to debt ratios
at a minimum
regulations
that efectively pin the lot values value

do the rationing right and bubbles don't inflate

so how can you blame any one else

agents will be agents
who didn't understand agency catalytics going in

who didn't understand bubblenomics

this was policy induced deliberate and utterly culpable
as to moral hazard
blame the s and l and dot .com
" rectification" was inadequate ...eh ???

obviously either the hand slaps doled out
weren't hard enough or the scape goats
frightening enough last time
or as i believe
there is no stopping these agents
by risk of jail and shame and financial destruction

pre emption

there have to be no bubblenomic opportunities
in the first place

[paine]

as to spreading the risk
that was all about building an obviously faulty insurance system
don't tell me the risk wasn't calculated
this was a shell game
a fraud
a bright bunch of folks saw an opporutnity to loot
and took it
then zillions of followe ons
came in
who figured
as it grew into a full blown "market"
when ..not if..it collapsed
they had safety in numbers
and the comfort in knowlege that after the last two
looter waves
the purps landed back on their feet
not totally and forever destroyed

[paine]

my grand father used to say

"let em take all my winnings away
just so long as i got hope
someday some where selling so thing
i can get back into.... the great game"

[Bubble]

GSEs may have followed the recent bubble, rather than led it, but they contributed to the general price rise over the last few decades. A brand new home went from the CPI adj equivalent of about 65k to 180k. The recent bubble took it even higher. A decades long slow motion bubble, followed by the recent blow off. Bubbles enrich the first people in the chain, but impoverish the last ones in.

It would have been better overall to just keep prices at the original CPI adj 67k. If subsidized easy credit is used to make housing more affordable, it must be coupled with rules that keep prices from rising (elastic supply). Otherwise, it is not more affordable, but rather an extended Ponzi scheme designed to enrich the first by impoverishing the last.

[capital influx]

Every major financial disaster in the U.S. from 1792 to 1930s involved

large foreign capital influx
unsound banking practices

Likewise in japan crisis, Sweden crisis, and emerging market crises of the 1990s.

Massive capital inflows and relaxed regulations always seem like a good idea at the time.

[Richard Boltuck]

First, Mark's essay (and several of the comments) contribute to an important post mortem. Without identifying the cause, how can we craft policies, and businesses adjust business models, to prevent a future recurrence?

Second, here's where I take issue with Mark's narrative. I think by pinning blame at the top of the investment chain solely on poor risk modeling and securitization execution ignores the significant role of moral hazard for large players such as Bear Stearns, Lehman, Countrywide, WaMu, Wachovia, IndyMac, First Nat of Nevada and others. The commercial banks, of course, relied on Federally insured deposits, and the investment banks benefited from implicit
Federal insurance of bondholders and derivatives counterparties based on the "too-big-to-fail" principle. (Moreover, if the risk models were so flawed, why did Goldman's and Morgan Stanley's implementation prevent those firms from suffering the fate of Bear Stearns and Lehman?)

Moral hazard, of course, leads to excessive risk taking, for well known reasons. This risk taking is rational behavior. In the current episode, it supported 30-1 leverage, and investment strategies that relied on continuation of what was widely suspected contemporaenously (by Shiller and many others) to be a significant housing bubble. Moreover, this strategy was highly profitable despite the eventual bankruptcies: if a company earned 500% on equity over 5 years (for example), the loss of 100% of equity in the sixth year when the strategy headed south is a tolerable price to pay.

I just learned that Australia is the only major country without deposit insurance. It would be interesting to examine how its banks are faring through the present global crisis, and the history of any past stresses on the banking system in that country.

Deposit insurance (and too-big-to-fail implicit insurance) is usually justified as required to prevent bank runs/panics, following reasoning formalized in the Diamond-Dybvig model. But the question of whether the stabilizing effect is greater than the destabilizing effect of the associated moral hazard/excessive risk taking/rotten assets problem ought to be an empirical, not theoretical, one.

Also, following the S&L crisis, and up until a few years ago, CATO produced a significant literature in its journals and publications studying the history of deposit insurance, which as I indicated, raises the same moral hazard concerns as implicit "too-big-to-fail" insurance. To see a list of this literature, do the following Google search:

http://www.google.com/search?hl=en&as_q=&as_epq=deposit+insurance&as_oq=&as_eq=&num=10&lr=&as_filetype=&ft=i&as_sitesearch=www.cato.org&as_qdr=all&as_rights=&as_occt=any&cr=&as_nlo=&as_nhi=&safe=images

[Zipf]

I had thought that the major problem - the cause of the bailout - was that counter-party risk was all but discounted in the CDS market. Once Lehman fell, this assumption was invalidated. Banks stopped lending to each other because exposure to CDS could cause a bankruptcy overnight, hence the tightening of credit.

The sub-prime mess caused Lehman to fail - however I would venture that sub-prime-initiated failure was not a necessary component of the credit tightening. For example, if bad bets on commodities had caused the failure instead, the CDS underwritten by Lehman would have been just as worthless, resulting in the same panic.

To those who critique that the current problems were failure of regulations, I would agree. However, it does seem that the best financial innovation does try to run ahead of regulation. Maybe that is the point of financial innovation?

I agree with the quote above:

"All panics, manias and crises of a financial nature have their roots in an abuse of credit."
--Hyman Minsky

I would also argue the abuse stems from the agency problem: through bankruptcy or bailout - organizations (and to a less extent people) don't own the mess that they create.

Finally, I wonder if the price of real innovation is a bubble? Would we have had Amazon, Firefox, Google, Ebay, Paypal, Craigslist, Wikipedia, and the Ipod without the Internet bubble? I start to wonder what derivative products will survive the subprime mess?

[Larry]

@Jim Harrison - "what would the American economy have looked like in the Bush years if the housing bubble had not taken place? "

Another answer is that capital not invested here gets invested there. It doesn't disappear. We'd have less consumer debt and therefore less stuff in our garages. But we'd have other assets paid for by that capital, and those assets, while lowering short-term growth, would have prevented/shrunk the crash we're now enduring.

'Reckless deregulation and hasty privatization have a certain logic and appeal'

Partly because they don't look reckless at the time. On balance, the US economy has done better than most developed economies over the period, with lower unemployment and faster economic growth. Our economy is somewhat less regulated than others, and we have had bigger swings, but our averages are still stronger.

@Bruce Wilder - "2 trillion on Iraq"

Even if that number is correct about the eventual costs, nowhere near that amount has gone into Iraq to date. Not that 600 billion is a small amount...

@hari - "giving the free market a free ride"

The housing market is heavily regulated. But regulators are subject to terrific pressures by lobbyist and politicians, and in this case the pressures were all in the wrong direction. The GSE's had the power to say no. Their regulators had the power to tell them no. Homebuyers had the power to say "this is nuts". Nobody did.

@ndd - "the Bush administration"

Bush gets a share of the blame, but so do Democrats - see the Frank remark above. It was an "if it ain't broke, don't fix it" moment.

"Lyle Gramlich"

At any given time, you can find some reputable person saying "do X" where X turns out to be the right thing, even when it is advocated by nobody else. But that's not how we do it. To be influential, you have to convince a lot of people, not just be right.

"Mandamus"

Any AG who went after the GSE regulator before the end would have been attacked as racist for trying to keep poor people from becoming homeowners. Not a great way to get elected.

@RueTheDay - "maturity mismatch"

The definition of a bank is borrow short and lend long. Do you know anybody who would give a bank their money for 30 years so the bank could make a 30-year mortgage? Pre-depression there were no 30 year mortgages. As a result, very few people owned their homes...

...

The housing bubble was a perfect souffle of error. Liberals endorsed it because it seemed to be helping low income people. Conservatives endorsed it - except for the GSE's - because it showed markets working. Consumers endorsed it because their living standards rose along with their mortgage balances. If you played your cards right you could buy a nice house and pay for it entirely out of your ever-expanding debt balance because the value of your place rose so fast. What was not to like?

The GSE's didn't cause the problem. It took a bunch of well-intentioned changes to do it. Another one: we expanded the capital gains exclusion on housing. When you lower the tax on something its value increases.

It's also true that the Fed hasn't figured out how to pop bubbles without tanking the entire economy. The levers to do things like telling the GSE's or the investment banks not to take the "bubble-wrap" were not in its hands, and obviously nobody else saw it as their mandate. Their political masters (my favorite line is Barney Frank's "roll the dice a little") were pushing them towards making the bubble ever bigger.

Many alternatives to market economies have been tried, and have been rejected around the world. Many variations of market economics are running now. These variations have not protected them against this crisis. Rather than imagining that we can prevent crises, we should acknowledge the limits on our wisdom and make sure we preserve our ability to get things back on track with relatively little pain. We'll learn from this crisis and prevent this kind of crisis from recurring. The next crisis (there will be one) will also catch us by surprise...

[NoeValleyJim]

On balance, the US economy has done better than most developed economies over the period, with lower unemployment and faster economic growth. Our economy is somewhat less regulated than others, and we have had bigger swings, but our averages are still stronger.

Unfortunately, this is not true. If you look at GDP/person, which is the most reasonable way to measure economic growth, northern European economies have equaled ours over any period. If you look at median GDP/capita growth, which also measure distribution effects, any northern European country outpaces the United States, and with less variation.

As to the "root cause" I think that when Phil Gramm pushed through a law explicitly outlawing the regulation of financial derivatives would be a good place to look.

[Infectious Greed]

Zipf wrote "... it does seem that the best financial innovation does try to run ahead of regulation. Maybe that is the point of financial innovation?"

AMEN BROTHER!

Thank you Mike Milken!

says...

@Larry "We'll learn from this crisis and prevent this kind of crisis from recurring. The next crisis (there will be one) will also catch us by surprise..."

Ha Ha Ha Ha...... Surprise? This was a precision executed robbery while everyone watched and commented.

Entrenched at the top are we? Have you received your check from Paulson in the mail?

says...

"All panics, manias and crises of a financial nature have their roots in an abuse of credit."
--Hyman Minsky

Leverage + Maturity Mismatch = Asset Price Bubble

Imagine if we learned to avoid leverage. That is a study no banker would fund.

[Steve Roth]

I agree with BJ Feng that the ratings agencies were central, and I'm surprised, yet again, that the econobloggers (notably Mark, here) are largely ignoring this point.

If the ratings agencies--who were paid by the issuers of the securities, and have acknowledged explicitly that they prepare(d) their ratings in collusion with those issuers--had done their job, this crisis might not have happened, and would certainly have been less severe.

If the MBSes had had lower ratings, they would have sold at lower prices and higher yields (and the cost of CDOs on those MBSes would have been higher), removing much of the money that corrupted the mortgage issuers back up the chain. With less incentive to issue any loan to any one, and more incentive to issue quality loans, mortgage issuers would have followed those incentives.

It was the very job of the ratings agencies to "understand" these securities, so their buyers didn't have to. They abdicated that responsibility, and cashed the issuers' checks.

If there's any place that tightly targeted, simple, and transparent regulation could create incentives resulting in a more transparent and efficient (and stable) market, it is here.

Make it illegal for ratings agencies to take money from the issuers of the securities that they are rating. Or at least, require a cigarette-style warning on each rating:

"The issuer of the security rated herein paid the rater to prepare this rating, and the rating was prepared in consultation with that issuer."

Would this create a market for more objective ratings? It's true that ratings are currently free to the purchaser. But purchasers should be aware that they're getting exactly what they pay for.

[anne]

Mark Thoma:

"What Caused the Financial Crisis?"

Having carefully read and discussed the article on Fannie Mae, I am convinced that Fannie Mae and Freddie Mac have to be counted as among the most significant causes of the housing bubble and resulting financial crisis. Forgive the failure to agree, but the impossible, unethical way described in the article in which the management of Fannie Mae operated from at least 2000 and the financial power of the company make it impossible for me to excuse as a prime cause of the crisis.

[anne]

The New York Times account of a lack of responsibility and ethics of management of such a public-private company as Fannie Mae is astonishing, and the encouragement of irresponsible behavior by management by leading Congressional Democrats as late as 2006 is astonishing. Paul Krugman was discussing the problems in housing in 2005, while Democrats were encouraging Fannie Mae to inflate the housing bubble in 2006. There is something dreadfully wrong of which I was not before aware. Fannie Mae is no ordinary small company.

[anne]

October 5, 2008

Pressured to Take on Risk, Fannie Hit a Tipping Point
By CHARLES DUHIGG

Capitol Hill bore down on Mr. Mudd as well. The same year he took the top position, regulators sharply increased Fannie’s affordable-housing goals. Democratic lawmakers demanded that the company buy more loans that had been made to low-income and minority homebuyers.

“When homes are doubling in price in every six years and incomes are increasing by a mere one percent per year, Fannie’s mission is of paramount importance,” Senator Jack Reed, a Rhode Island Democrat, lectured Mr. Mudd at a Congressional hearing in 2006. “In fact, Fannie and Freddie can do more, a lot more.”

But Fannie’s computer systems could not fully analyze many of the risky loans that customers, investors and lawmakers wanted Mr. Mudd to buy. Many of them — like balloon-rate mortgages or mortgages that did not require paperwork — were so new that dangerous bets could not be identified, according to company executives.

Even so, Fannie began buying huge numbers of riskier loans....

[Not 2000, not 2001, not 2002, but 2006.]

[anne]

http://www.nytimes.com/2005/08/08/opinion/08krugman.html?ex=1281153600&en=5712579cabaf3faa&ei=5090&partner=rssuserland&emc=rss

August 8, 2005

That Hissing Sound
By PAUL KRUGMAN

This is the way the bubble ends: not with a pop, but with a hiss.

Housing prices move much more slowly than stock prices. There are no Black Mondays, when prices fall 23 percent in a day. In fact, prices often keep rising for a while even after a housing boom goes bust....

http://www.nytimes.com/2008/10/05/business/05fannie.html?hp&pagewanted=print

October 5, 2008

Pressured to Take on Risk, Fannie Hit a Tipping Point
By CHARLES DUHIGG

Capitol Hill bore down on Mr. Mudd as well. The same year he took the top position, regulators sharply increased Fannie’s affordable-housing goals. Democratic lawmakers demanded that the company buy more loans that had been made to low-income and minority homebuyers.

“When homes are doubling in price in every six years and incomes are increasing by a mere one percent per year, Fannie’s mission is of paramount importance,” Senator Jack Reed, a Rhode Island Democrat, lectured Mr. Mudd at a Congressional hearing in 2006. “In fact, Fannie and Freddie can do more, a lot more.” ...

[anne]

I will find precisely when in 2006 Senator Reed pressured Fannie Mae to act more irresponsibly and less ethically, but coming from a Senator in 2006 to a company with the public trust obligation of a Fannie Mae the comment is intolerable.

[Mark Thoma]

I am about to post another argument that Fannie and Freddie were not the main cause. Nobody's saying they didn't contribute, or that management was awful, etc., but as a primary cause? It just doesn't fit.

And, though I didn't ask this question, how did Fannie and Freddie cause problems (bubbles) in other countries?

[Winslow R.]

Steve Roth joins the game of whack a mole.

"I agree with BJ Feng that the ratings agencies were central"

[Winslow R.]

Anne wrote "Forgive the failure to agree, but the impossible, unethical way described in the article in which the management of Fannie Mae operated from at least 2000 and the financial power of the company make it impossible for me to excuse as a prime cause of the crisis."

Anne they are just the most regulated of all the actors. Peek under the hood of hedge funds, investment banks, and even commercial banks and you will find the real excessive leverage.

Most people, including many on this board, don't understand what leverage is and how it unwinds.

[anne]

Mark Thoma:

"And, though I didn't ask this question, how did Fannie and Freddie cause problems (bubbles) in other countries?"

The answer is that there were housing bubbles and deflatings in country on country from Hong Kong to the Netherlands to Australia, to South Africa, and on and on. Germany may have been the latest or last. None of these bubbles were caused by Fannie Mae. However these other bubbles and deflatings have been and would appear to be more easily contained absent mortgage lending abuse.

[anne]

"Having carefully read and discussed the article on Fannie Mae, I am convinced that Fannie Mae and Freddie Mac have to be counted as among the most significant causes of the housing bubble and resulting financial crisis."

Consider this wrong then, leave out housing bubble and modify the comment to leave financial crisis alone even though there were wholly private actors building risky mortgage positions and building the derivative positions that are more dangerous than I yet understand.

Mark Thoma is properly corrective.

[anne]

Winslow, I agree.

[Winslow R.]

Classic can't see the forest (systemic overleverage at more than 30x) for the trees (Fannie, Freddie, rating agencies, WaMu etc.)

[Steve Roth]

Winslow R.:
Steve Roth joins the game of whack a mole.
"I agree with BJ Feng that the ratings agencies were central"

1. Note that I did not say "the central." No single mole was at fault.

2. I point it out as a crucial, centralized leverage point, where a small number of actors exert(ed) inordinate negative influence.

3. I agree that the leveraging (which was greatly unleashed by a handful of SEC actors in a 2004 meeting covered two days ago in the NYT, driven by provisions in Gramm's Commodity Futures "Modernization" Act) also greatly leveraged the ill effects of the inaccurate ratings.

Regulating the ratings agencies won't create nirvana. But it is a crux, a strong leverage point, where those who believe in minimal, smart, targeted regulation can improve market efficiency with less risk of unintended consequences.

An unfettered, unregulated free market provides strong incentives for individual actors to make sure that information is *not* known--a very anathema to efficient markets. This is but one situation in which a visible hand can create individual incentives that result in a more efficient market.

[Roger Chittum]

This comment relates also to Mark’s video blog 10/3, Financial Intermediation and the Financial Crisis.

“Agency problems” and “spreading of risk” describe the same thing. Mark, you (and others) use different phrases because, on the one hand, you are against the bad effects of this thing, but on the other hand, you are for the good effects.

You say it is a problem that “the brokers [and bankers] had no stake in the outcome once the mortgages left their hands” and that “a solution to this is to give each person in the chain a stake in the future outcome of a mortgage” to correct a “mal-distribution of risk.” That is exactly the same thing as saying the risk was spread too much. If each of these players retained 100% of the risk, the agency problem would be gone, but so would the benefits of risk spreading. If each player retained 1% of the risk, their behavior would not change because 99% of the risk would be spread away from them.

Yet, you say in the same post that another major cause of the crisis was “failure of securitization to distribute risks across the financial system.” Well, which was it Mark—was risk not concentrated enough, or was risk too concentrated? And how in the future can we identify the Goldilocks spot in the risk concentration/spreading continuum?

Your video very well explains the benefits but not the dark side of risk spreading. Also on the dark side is the increasing cost and difficulty, and ultimately the complete inability, to work out problem loans. I’ll call it administrative impotence. When risk is spread thinly, there will be diversity of perceptions, tax positions, priorities, business strategies and judgments, inability to obtain consensus and lack of authority to make decisions without it, and lack of money to hire professionals, personal conflicts, etc. As a result, even minor problems cannot be worked out by restructuring defaulted loans, and every default implodes into the worst possible financial outcome. These are losses that flow directly from dispersion of risk and no doubt are not effectively priced in. Here are some illustrative examples.

1. If Borrower owes Bank A $50 million and can’t pay, Bank A will assign a workout team headed by a more senior banker and more senior lawyer than those who papered the transaction, and a restructuring of the loan will be quickly worked out if Borrower still has a business that can work. There may be a reduced principle with partial conversion to equity, accrual instead of payment of interest, and/or any number of other changes (as well as covenants that intrude deeply into Borrower’s business).

2. If Borrower owes $100 million spread among Bank A (40%), Bank B (30%), and Bank C (30%), and the banks are experienced and have other relationships with each other, a workout will probably get done. But each bank will have its own workout team, the transaction will take longer, and as a consequence the transactions costs are likely to be double what they would be if Bank A held 100% of the loan.

3. In this case, Borrower owes $500 million to a consortium of 10 banks. This workout may or may not happen, but if it does there will surely be a disproportionate increase in transaction costs. It would not be surprising for the holder of a small stake to be a big problem. You could have a guy in the room who is angry at some other banker(s) for getting him into the deal (which may be a black mark on his career), who has not read the intercreditor agreement or the draft workout plan, doesn’t have experienced counsel, has an uninformed or distorted view of what’s possible, and highly resents the fact that the negotiations may prevent him from playing in a big-deal golf tournament. As negotiations drag on, the best workout options may go away, and many billing meters will keep running. The more players there are, the greater the risk that a maverick will block or delay progress. If, agreement is not reached, or not reached seasonably, the Borrower may go into bankruptcy, where the transaction costs will get still bigger and the options poorer.

4. Now let’s take a case where risks are very broadly spread, say 200 investors with stakes of $100,000 to $300,000 each. If something goes wrong, their investment is probably doomed to the worst possible outcome. There may or may not be a general partner or manager with authority to negotiate a workout. If there is such a person, it may not have enough investor cash to engage the necessary professionals. Often a group of investors will try to organize something and raise a war chest, but that will usually fail because many investors won’t or can’t contribute, because there will be differences of opinion about what to do, and because there is no practical ability to make quick and binding decisions. This is where I suspect we are with MBSs. The SIV documents may or may not give a manager authority to renegotiate mortgages, and if it does there probably is not enough money to make a dent in such a huge labor-intensive task. If an insurer pays off on a defaulted loan, it doesn’t acquire all the rights it needs to administer individual mortgages efficiently. So, broad spreading of mortgage risk results in higher average costs for defaulted mortgages than if the mortgages were still held by the local bank that issued them.

There’s another major blunder in the post. The only evidence offered for the idea that risk has been too concentrated is the suggestion that “only” 1/30 of global financial assets are threatened with evaporation and, intuitively, it seems the system should be able to absorb it. As Winslow R. pointed out, that would have zeroed out the capital of Lehman and others that were leveraged at 32:1 or 33:1 even if they had held only precisely their global shares of the bad stuff.

In sum, increased costs of agency problems and administrative impotence (and maybe other problems too) are caused by too much risk spreading. If by arguing that failure to do enough risk spreading was a cause of the current crisis you mean to suggest that we should want more risk spreading to make future markets safer, I dissent. Like a lot of other things in life, a moderate amount of risk spreading is undeniably good, but overdoing it is bad.

[Mark Thoma]

On the leverage point - I forgot to mention this, but part of the point in bringing up the 2T figure (which is likely an over estimate) is that we've had shocks this large in the past that were absorbed by the system without causing a major financial meltdown (and more than once). Firms were leveraged up then too, so the leverage alone can't be the problem. That tells you the answer is somewhere else, maybe in the structure - such as how the costs are distributed - it's not merely the size of the shock to the system and the subsequent deleveraging that is the problem (or it would have happened in the other cases).

[RueTheDay]

Larry wrote:

@RueTheDay - "maturity mismatch"

The definition of a bank is borrow short and lend long. Do you know anybody who would give a bank their money for 30 years so the bank could make a 30-year mortgage? Pre-depression there were no 30 year mortgages. As a result, very few people owned their homes...

Yes, I know quite well that the business of fractional reserve banking is maturity mismatch, or as they call it, "maturity transformation". Just as I know quite well that adding melamine to watered down dairy products makes them appear to be, well, not watered down. Just because something is, doesn't mean it ought to be.

I also recognize that it's not just banks, but the entire shadow banking system that is playing the game now.

Institutionalizing high degrees of leverage combined with maturity mismatch creates a structure that is extremely unstable along numerous dimensions and thus is susceptible to changes in liquidity preference, changes in the slope of the yield curve, changes in credit risk, and changes in the prices of underlying assets and liabilities. It creates a house of cards that has always fallen over, is falling over now, and always will fall over in the future. At some point you have to stop building houses from cards.

[anne]

Daniel Mudd as CEO of Fannie Mae testified before Congress on June 15, 2006. The executive was then urged to significantly expand mortgage lending because housing prices were rising faster than incomes, as though there were no sense of the easily apparent deflation of the housing bubble.

Paul Krugman had written in the New York Times on the deflating of the housing bubble on August 8, 2005 and would write again of housing getting ugly on August 25, 2006. Where was the Congressional or Administration or Regulatory Agency or investor attention?

[john c. halasz]

This wasn't a housing bubble; it was a massive credit/leveraged debt bubble, on a global scale. Housing was just the "asset class" used to draw in the wage-constrained household sector and loot it. For whatever reason, at the start of the naughties, there was a massive amount of liquidity injected into the global financial "economy", with Europe in the doldrums and the Euro tanking, Japanese ZIRP, Fed down to 1%, etc. With real productive investment constrained by disinflationary wage stagnation, and little corporate pricing power, real economy profitability was determined by cost-cutting, and the immense liquidity was directed into the build up of an immense pyramid of leveraged debt financing and recurrent asset inflation, (which is tantamount to falling profits in the real productive economy). And that in turn amounts to an enormous rent extraction scheme by the financial "economy", from the real economy, (rents here being defined as excess profits detached and displaced from underlying real costs of production and the productive capacity of the real economy). And, yes, the tax-deductibility of debt-interest plays a role in such schemes, together with asset-inflating reduction in taxes on unearned "investment" income. The result is an ever-growing build-up of the stock of fictitious capital, of which the inflation of housing-lot values far in excess of sustaining household incomes is only the most wide-spread example, which amount to ever-extending claims on the future revenues of the real productive economy, which ultimately can never be sustained, and must inevitably be destroyed in asset deflation/debt destruction.

But what has amazed me is how oblivious mainstream economics /economists have been over the last 6 years to the building up of the housing and other asset bubbles. I was well aware of the building of a housing bubble in 2002, correlating it with the mounting CA deficit and negative real interest rates, which I understood as a deliberate policy of reflating the asset-bubble economy of the '90's after its bust. If I "knew" that then, why was there such little notice off it and long denial, with a few honorable exceptions, by the pros? I suspect what is at work in mainstream neo-classical economics in abetting such blindness, is not any sort of Ayn Rand worship, but rather the theoretical fiction of "complete" markets, which don't and can't exist in reality,- (since future contingencies can not be foreseen, prices are not entirely determined at the margin by "perfect" competition, most industrial markets and many others are oligopolistic, and some, such as the labor "market", are institutional fictions, long-run illiquid fixed capital investment can not be readily, nor entirely converted into something liquid and readily exchangeable, and business firms compete with each other largely by attempting to exclude competition, else its difficult to explain their emergence and sustenance, which often involves their emergence from underlying technological developments into markets that are incomplete, by virtue of not yet existing, and which become "competitively" consolidated by virtue of economies of/increasing returns to scale, etc,),- but the mirror-image mirage of which can be imitated through the devices, operations and vehicles of the financial economy. The focus on "empirical" price formation, at the expense of the long-run dynamics of underlying value formation, renders, in turn, financial assets prices artificially continuous with real economy production prices, and fosters a perpetual presentism, whereby all prices are as they "must" be, until, "surprisingly", they aren't. The result is that neo-classical theory ends up looking less like a realistic science, and more like Babylonian astrology. (Perhaps the politico-economic institutional career incentive structures of the economics profession are in need of examination, given its recurrent tendencies to produce entirely inauthentic "knowledge").

One more comment. The concept of insurance for credit or other financial assets doesn't make basic logical/economic sense. Insurance depends on investing risk-adjusted premiums in financial assets to reserve against contingent liabilities as they arise, which contingencies must not be correlated with those of financial investments. But, of course, financial investments are correlated through tightly coupled financial markets with other such assets investments, and when the "insurance" is most needed during a financial crisis,- (which is not a 1 in 1000 year occurrence, but, in varying degrees, more like a 1 in 12 year event),- correlatively depreciating various asset classes, those very assets must be sold by the insurer to pay-off default claims, further adding to the downward pressure on asset prices and triggering still more defaults, thus amplifying rather than insuring against the problem. On the other hand, the illusion of such insurance generates moral hazard in the exact, proper use of the term, encouraging financial "players" to take on higher levels of risk, since it has been ostensibly laid off on other parties. (This is slightly different than the point about CDS's being not true swaps, like interest-rate or currency swaps, but actually, as everyone knows, unregulated insurance contracts thinly disguised as swaps, which, as everyone knows, is insanely dangerous).

Oh, and if dJw above actually believes that the hedge-fund sector is holding up well in this mega-crisis, he's seriously deluded. The real festivities will begin next Jan., when the withdrawal requests filed last Tues. come due, though there might be some nice anticipatory fire-works in the meantime.

[anne]

http://select.nytimes.com/2006/08/25/opinion/25krugman.html?hp&pagewanted=print

August 25, 2006

Housing Gets Ugly
By PAUL KRUGMAN

Bubble, bubble, Toll's in trouble. This week, Toll Brothers, the nation's premier builder of McMansions, announced that sales were way off, profits were down, and the company was walking away from already-purchased options on land for future development.

Toll's announcement was one of many indications that the long-feared housing bust has arrived. Home sales are down sharply; home prices, which rose 57 percent over the past five years (and much more than that along the coasts), are now falling in much of the country. The inventory of unsold existing homes is at a 13-year high; builders' confidence is at a 15-year low.

A year ago, Robert Toll, who runs Toll Brothers, was euphoric about the housing boom, declaring: "We've got the supply, and the market has got the demand. So it's a match made in heaven." In a New York Times profile of his company published last October, he dismissed worries about a possible bust. "Why can't real estate just have a boom like every other industry?" he asked. "Why do we have to have a bubble and then a pop?"

The current downturn, Mr. Toll now says, is unlike anything he's seen: sales are slumping despite the absence of any "macroeconomic nasty condition" taking housing down along with the rest of the economy. He suggests that unease about the direction of the country and the war in Iraq is undermining confidence. All I have to say is: pop!

Now what? Until recently most business economists were predicting a "soft landing" for housing. Even now, the majority opinion seems to be that we're looking at a cooling market, not a bust. But this complacency looks increasingly like denial, as hard data — which tend, for technical reasons, to lag what's actually going on in the market — start to confirm anecdotal evidence that it is, indeed, a bust.

Why the sudden crackup? When prices were rising rapidly, some people bought houses purely as investments, betting that prices would keep going up. Other people rushed to buy houses, or stretched themselves to buy houses they couldn't really afford, because they feared that prices would rise out of reach if they waited. And all this speculative demand pushed prices even higher. In other words, there was a market bubble.

But eventually prices reached a level beyond what even optimistic potential buyers were willing to pay, especially after interest rates rose a bit. (They're still low by historical standards.) As demand fell short of supply, double-digit price increases declined into the low single digits, then went negative everywhere except in the South.

And with prices falling in many areas, the speculative demand for houses has gone into reverse, as people try to get out with a profit while they still can. There's now a rapidly growing glut of unsold houses. This is a recipe for a major bust, not a soft landing.

Moreover, it could be both a deep and a prolonged bust. Since 2000, much of the nation has experienced a rise in home prices comparable to the boom in Southern California during the late 1980's. After that bubble popped, Los Angeles house prices began a slow, grinding deflation, eventually falling 20 percent (34 percent after adjusting for inflation). Prices didn't begin a sustained recovery until 1996, more than six years after the downturn began.

Now imagine the same thing happening across a large part of the United States....

[anne]

http://krugman.blogs.nytimes.com/2006/08/25/the-bubble-bursts/

August 25, 2006

The Bubble Bursts
By Paul Krugman

Just a wonkish note about how bad the macroeconomics of all this could be:

If you look at the most leading of the indicators on housing, stuff like new home sales and applications for permits, they're off more than 20 percent from a year ago. If that translates into an equivalent fall in residential investment, we're talking about a fall from 6 percent of the G.D.P. to 4.8 percent. And this may be only the beginning; I wouldn't be surprised to see housing investment drop below its pre-bubble norm of 4 percent of G.D.P., at least for a while.

Add to this the likely effect of a housing bust on consumer spending and you've got a direct hit to G.D.P. of, say, 2.5 percent or more. That's bigger than the slump in business investment that led to the 2001 recession. And the main reason the 2001 recession wasn't as deep as some feared was that the Fed was able to engineer... a housing boom. What will the Fed do this time?

Maybe rising business investment and a declining trade deficit will soften the blow. But it's remarkably easy, playing with the numbers, to come up with scenarios in which the unemployment rate rises above 6 percent by the end of 2007. That's not a prediction, but it's well within the range of possibility.

[anne]

http://krugman.blogs.nytimes.com/2006/08/25/the-bubble-bursts/

August 25, 2006

The Bubble Bursts
By Paul Krugman

Maybe rising business investment and a declining trade deficit will soften the blow. But it's remarkably easy, playing with the numbers, to come up with scenarios in which the unemployment rate rises above 6 percent by the end of 2007. That's not a prediction, but it's well within the range of possibility.

[The Krugman was a little too early for a time on employment losses gave some hope that a general recession could be just avoided, but the hope is gone for me now.]

[anne]

Mark Thoma:

"On the leverage point - I forgot to mention this, but part of the point in bringing up the 2T figure (which is likely an over estimate) is that we've had shocks this large in the past that were absorbed by the system without causing a major financial meltdown (and more than once). Firms were leveraged up then too, so the leverage alone can't be the problem. That tells you the answer is somewhere else, maybe in the structure - such as how the costs are distributed - it's not merely the size of the shock to the system and the subsequent deleveraging that is the problem (or it would have happened in the other cases)."

What then was the problem in which the entire bond market was supposed to be threated just by Long-Term Credit hedge fund in August 1998? I never took the threat seriously, but may never have understood the threat. This was a problem supposedly caused by a lone company.

[anne]

I have no idea why, and will ask a specialist, but Berkshire Hathaway took 3 years in a perfect market to unwind the derivatives that were found in the investment portfolio of General Re when the company was bought.

A $2 trillion increasingly questionable basic investment portfolio allowing for a layering of derivative positions, could mean how much in terms of leverage and what difficulty in unwinding to any extent in a wary and worse market?

[Mark Thoma]

That's the point - if you take those losses and distribute them throughout the system instead of concentrating them in a particular place, it isn't threatened. A 2T shock isn't that large - what matters is where the shock lands. One of the big selling points of these complex securities is that they were supposed to distribute the risks to people who could afford them without suffering a big crash (w/o destructive deleveraging - the promise of distributing risks throughout globally integrated markets). This wasn't supposed to happen for precisely that reason, these complex securities were supposed to distribute risks in ways that would avoid major problems like we had in the past. Instead, the risks were concentrated in ways that did, in fact, threaten the system (e.g. through obscure contract clauses nobody noticed that put a floor under the price of assets forcing banks to buy them back).

That's not to say a shock that large is harmless - the 9T losses just in the stock market after the tech bubble popped caused economic distress, but we didn't end up bailing out the financial system. Where the losses are distributed matters.

[anne]

Mark Thoma:

"This wasn't supposed to happen for precisely that reason, these complex securities were supposed to distribute risks in ways that would avoid major problems like we had in the past. Instead, the risks were concentrated in ways that did, in fact, threaten the system (e.g. through obscure contract clauses nobody noticed that put a floor under the price of assets forcing banks to buy them back)."

Got it, got it; thank you so much.

[Roger Chittum]

The agents had to buy back the securities. I did not know that. Agency problem solved.

[ken melvin]

Appears that our current financial structure cannot tolerate large scale deflation/bubble burstings. How best preclude? Prevent bubbles forming. Spotting rampant speculation, bubble formation, ... can't be that hard, can it?

[ken melvin]

In response to: Nick Rowe: What Caused the Financial Crisis? above, I had written:

Don't think that speculation in housing should be tolerated. Do not think that after the fact, including borrowers who could not make mortgage payments on houses worth much less than the mortgage, is the problem. The problem is/was the speculative bubble. From thence, how best preclude recurrence? This wanting to blame the borrower's by me. If the seller, the one who benefited most, hold the bag, the mortgage, had to take it back if it really wasn't worth umpteen thousand more than sold for ... OK, seller in partnership with a local bank, if you wish. Capital gainsing the dickens out of housing prices is another way. I’m not sure about the net positives of any and all forms of bubbles, tulips don’t bother me much, but some things, such as the price of housing and health care should be rendered immune from speculation.

[Winslow R.]

Mark wrote: "On the leverage point - I forgot to mention this, but part of the point in bringing up the 2T figure (which is likely an over estimate)."

If asset markets bounce back? Then I agree. In the short-term this is a gross underestimate.

If you don't expect asset markets to bounce back (as they have in the past) then you need a new framework :)

[Winslow R.]

"That's not to say a shock that large is harmless - the 9T losses just in the stock market after the tech bubble popped caused economic distress, but we didn't end up bailing out the financial system. Where the losses are distributed matters."

I don't think this is correct. Interest rates were lowered and leverage was increased. Add these two items together and you have a massive bailout of the financial sector (even if it was temporary).

Bank with 2% spread and 10x leverage = 20% return
Bank with 4% spread and 20x leverage = 80% return

[Larry]

@NoeValleyJim - "Unfortunately, this is not true. If you look at GDP/person, which is the most reasonable way to measure economic growth"

Yes, some countries did better than we did. You can't anoint one measure, though. Unemployment does matter. Differences in age profiles, population growth, immigration, mean that you have to look at multiple indicators. It's also worth noting that "Northern European countries" have been moving in our direction, e.g., by lowering tax rates and reducing regulation.

"As to the "root cause" I think that when Phil Gramm pushed through a law explicitly outlawing the regulation of financial derivatives would be a good place to look."

I'm sticking with the whack-a-mole guys. Basically everyone involved is guilty. I exempt those who were trying to draw attention to the issues, among whom are surprisingly, Krugman and the WSJ editorial page.

"This was a precision executed robbery while everyone watched and commented."

Most of them cheering wildly.

@anne - "Where was the Congressional or Administration or Regulatory Agency or investor attention?"

They were getting loaded with everybody else involved, including the media and everyone lined up on Main Street.

@john c. halasz - "This wasn't a housing bubble; it was a massive credit/leveraged debt bubble, on a global scale
"The concept of insurance for credit or other financial assets doesn't make basic logical/economic sense."

Mortgage insurance doesn't make sense then, either?

@anne - "What then was the problem in which the entire bond market was supposed to be threated just by Long-Term Credit hedge fund in August 1998? I never took the threat seriously, but may never have understood the threat. This was a problem supposedly caused by a lone company."

It was that too many others got tangled up with them. How pleasant it would be if we could figure out how to ensure that every innovation comes coupled with a manageable wind-down vehicle.

[WM]

The financial crisis is not the same thing as the mortgage bubble bursting. The mortgage bubble had been bursting for three years before the crisis hit hard and caused a rash of bankruptcies. Something important changed just prior to the bankruptcies to cause them.

What was that?

[Lord]

The speculative bubble is borrowers who cannot repay their loans. They are one and the same. If the income was there to repay, prices would never have reached this level because there was no bubble in incomes, and while some would default in any case, there would be others able to buy. At most one would have a normal business cycle in housing. An individual could speculate, but only up to their income then. Builders also speculate since their incomes vary a lot but construction loans often require presale before lending.

There was capital to cover expected losses, but once this became seriously depleted with no bottom to prices in sight, bankruptcies occurred or were anticipated.

[Peeka]

Interesting thread and comments. I really enjoyed reading it all.
Please see this artichle as well:
http://peekablog.net/2008/10/what-caused-the-financial-crisis/

[One FromOz]

Hello humbles, know alls, republicans, democrats, ……
Some already got the riches and laughing.
Some trying to make a (political) gain out of this.
Some still trying to make even more riches out of this.
and us, the majority, bewildered, talking nonsense.
the riches, the problem, the solution has absolutely got nothing to do with us, other than us being the meat on the bone between the teeth of “some”.

Think !!!! Who is biting and eating you?

Ask!!! Who prints the "green back"?

[John]

WHO IS TO BLAME FOR THIS MESS? WE ARE.

1. Lenders are making loans with little or no down payment with high interst rates

2. Borrowers are borrowing the maxuim amount they can borrow and and they agree these high interst rates

3. Appraisers bump the value of the property up 5-7%

4. Buying loans that have little or no equity so that if the is a foreclosure you wind up selling them at at a loss

If something unexpected happens in the borrowers life they can no longer make the mortgage payment

[Bill Parks]

it's the money!

All the money circulating in the economy, with the exception of coins, is created by private banks and the privately owned Federal reserve as debt, extended into the economy as loans and bonds which must be repaid with interest. Since these institutions create only the principal of the loans and no one creates the additional money to pay interest the banking system is doomed to fail.

If the interest is paid from the existing money supply, the principal, then there will not be sufficient money to repay the loans, resulting in an impossible contract when taken as a collective whole. For example if the money supply is $50 T and the interest rate is 6% the interest payment will be $3 T, deducting the $3 T interest payment from the $50 T money supply leaves just $47 T to pay a $50 T bill – impossible!

If the banks originate new loans to service the interest requirements of the old ones, they create an expanding pyramid of debt – a Ponzi Scheme.

The root cause of the crisis is the private banking and monetary system itself. The solution is to replace private money with government-issued public money. The government can lend money like the banks, create and spend money directly into the economy independent of taxation, and it can fine-tune the economy with appropriate taxation.

[andy]

Some excellent thoughts expressed in the article and comments. To me leverage and greed (poor risk management) were the key causes of the financial ciris, which has a way to go still.

[Jack Metcalf]

in 2006 real estate appraisers were threaten with the loss of their job if they didn't over value the appraisels as a result they did and people on the new found equity to borrow on. Banks loaned money on this false value. Then people found owed more than the value of their homes so they defaulted. I think it was a foreign power who did ths in order to destroy the U.S. economy.