When discussing regulatory reform of the financial sector, I have emphasized the need to separate the factors that caused the crisis from those that magnified the effects of the crisis once it began. For example, I think of regulatory failures as part of the causes of the crisis. But factors such as high leverage ratios, while not causative, had the effect of substantially magnifying the effects of the financial sector shock once it hit.
I am not sure we can ever plug all the holes in the system and ensure that another crisis never happens, there are many, many ways to cause a crisis, some of which have not been dreamed up yet by imaginative financial engineers. We should still try, of course, and prevent what we can. But we also need to make sure that the effects of the next financial crisis are as muted as can be, and that requires regulation on the magnifying factors such as leverage.
Barry Ritholtz uses a similar distinction to sort the causes of the crisis (the "but fors") from the magnifiers (exacerbators in his terms), and uses this to ask whether Fannie-Mae is a primary casual factor, or whether its role was limited to contributing to the severity of the crisis once it began:
The usual crowd of ne’er-do-wells are seeking to divert attention from their own roles in the crisis, and shift blame elsewhere. These people make up a big chunk of the Its All Fannie’s Fault! crew. By muddying the waters, they hope to avoid retribution for their own roles in what occurred. As the mid-term election approaches, we should expect to hear more from this crowd.
The reality of crisis causation is far more complex and nuanced. Looking at the many factors that independently contributed to the collapse, and prioritizing them by degree of causation is not easy. A sophisticated approach is required to separate the prime and secondary factors.
Rather, than just repeat my list of factors what were the causal factors, today I want to try a different approach. Let’s do a “Causation Analysis” of the biggest factors to see if we can determine not just the various elements that contributed to the credit collapse, but which factors actually caused it to occur and what merely exacerbated the collapse, making it worse.
Understand that this is a theoretical discussion based on counter-factuals — what is likely to have occurred if various elements leading up to the crisis were different. We are trying to discern the differences between primary and secondary factors, separating the causes from the exacerbators.
Whenever someone asserts as a cause an event or force relative to a particular outcome, you should always ask: “Is this a “BUT FOR cause of that outcome?” In terms of a specific result or outcome, “But for” this factor, how would the outcome have changed? Would the result have been the same or different?
My top 3 list of crisis “BUT FORs” are:
1) Ultra low rates;
2) Unregulated, non bank, subprime lenders;
3) Ratings agencies slapping AAA on junk paper.
Why are these “But Fors?” But for these things occurring, the crisis would not have happened..., there is no boom and bust, no crisis and collapse. ... That is these are the big 3 — why I label them the prime cause of the crisis.
There is a secondary list of things that might or might not be prime causal factors; at the very least, they made the crisis significantly worse:
1) The Commodity Futures Modernization Act of 2000
2) Net Cap Rule Change of 2004 (aka Bear Stearns exemption)
3) Repeal of Glass Steagall (1998)
...Here’s the kicker — when I do the ... BUT FOR analysis on Fannie/Freddie, I get different results.
-Were they an accounting fraud run by weasels? Yes.
-Did they securitze mortgages? Yes, for decades.
-What about securitizing sub-prime mortgages? Primarily after late 2005. By then, the die had been cast.
So are Fannie & Freddie a “BUT FOR” ?
I don’t see how. Wall Street had been securitizing most of the sub-prime mortgages for years without the GSEs — Fannie and Freddie jumped in very late because they were losing market share. Their timing was perfect they started doing nonconforming mortgages just as the market peaked.
And if Fannie & Freddie didn’t exist, mortgage securitization would have happened anyway, the way it did in areas where their were no GSEs — securitized credit card receivables, auto loans, small biz loans, etc. took place without GSEs. I assume there would likely have been a private sector version for conforming loans, the way there was a private sector securitizing response to the demand for non-conforming (sub-prime) loans.
That’s how I end up saying they were not a prime cause of the crisis.
Of course, they certainly made things worse — but so did a lot of other entities. But the key question for the blame Fannie/Freddie crowd is “Would the crisis has happened without them?” The answer is yes — FRE/FNM were not BUT FORs, because all of this was happening anyway, prior to their participation in subprimes late 2005.