Where did we go wrong?

The financial crisis that has developed around subprime mortgages is so so astounding in so many different ways that, like many others I suppose, I am still having difficulty getting my mind around it.  The whole thing is a big surprise for me.  I would have been pretty ready to assert, as late as 6 months ago, that financial crises of this magnitude had become solely a developing-country phenomenon and that rich countries had developed the regulatory and other mechanisms that would prevent them from getting into such a mess.  Yes, there would be smaller scale hiccups, such as the S&Ls or LTCM, but you certainly couldn't have a meltdown a la East Asia 1997-98 or Mexico 1994 in an economy such as the U.S.

Now we know that I would have been wrong.  What is happening in the U.S. is no different from what took place in Thailand in 1997 or in Argentina in 1999, with the entire financial sector going belly-up.  The only thing that remains to be seen is whether the costs to the real economy will be as high too.  The rough rule of thumb for emerging markets is that banking crises are associated with an output loss of around 10% (see here for example).  The best estimate we have at present is that U.S. real GDP will take a hit of something like 3.6% over the next couple of years.  This is a fraction of the loss experienced in a typical emerging market crash--but of course this particular estimate may also prove to be wildly optimistic.

But here is what I would love to know.  What is the single thing that, had it not happened or happened differently, would have prevented this crisis from turning into the meltdown it has?  In other words, what is it that has allowed a regular credit cycle to metamorpose into a systemic crash?   Here are some of the culprits we regularly see mentioned:

1. A bubble in the housing market
2. The originate-to-distribute model of mortgage lending
3. Lack of transparency in structured finance and mortgage-backed securities
4. Lack of regulation of derivatives
5. Poor credit-rating practices
6. Fannie Mae and Freddie Mac straying from their original mandates
7. Implicit government guarantees for Fannie and Freddie
8. Lack of regulation of hedge funds and private equity
9. Inadequate capital requirements for financial intermediaries
10. The too rapid or generous extension of Fed credit to non-banks
11. The rescue of Bear Stearns
12. The failure to rescue Lehman

I am sure you can add a few more to the list.

What I am asking is this: which one of these items--individually or taken in groups--was both necessary and sufficient to bring us to our current impasse, where the government has little choice but to take over all mortgage-related assets off the books of private financial institutions? If you answer "all of the above," you are not being helpful at all. 

Comments

[Jon]

I think Arnold Kling has hit on one important point - low down payment mortgages.

In general, people default on mortgages when then have negative equity. Forcing people to start with 20% equity would have gone a long way to (a) preventing some of the overheating in the housing market and (b) preventing some of the situations where it is economically "best" to walk away.

[Lord]

I would add 13, the crackdown on Fannie and Freddie diverting mortgages into the hands of those who didn't know how to make them.

I would take 1, or more specifically, allowing the decoupling of income and housing prices through not verifying incomes and failing to qualify people on fully adjusted market rates. A bubble cannot be established and supported without this decoupling. All other housing and lending measures, such as credit, downs, adjustables, etc. are minor in comparison to letting incomes and prices detach.

[Harvey]

I am not financial guru - just an ordinary white collar marketing mba - but my perspective is (and i can't seem to find anyone who will simplify this with me) that the whole mess is a result of the fed policies of greenspan - who i used to think of as a real guru. Basically his policy created a pyramid scheme where the "end user" became a vehicle for sustained growth. People were encouraged to buy homes (take all the risk) so middle men could pass ever growing piles of debt on to the next man - and the risk became so diluted with each layer that the normalization of risk/reward became a non-factor. Anyone that has ever applied the simple theory of relativity know that "what comes up, must come down" and the higher up you go, the higher down you'll fall. By allowing the housing marketing to go "up up up" we basically just made the requisite adjustment "that much bigger". The question on my mind now is "where is the gov't bailout money going to come from"? If it comes from my generation (Gen X), how the hell is that going to pan out once we deal with the retirement costs of the baby boom. Macro economically we've got such a small generation now burdened with 2 major "bailouts" which, IMO means whatever fix we put in place now is going to have its own effect some time in the future.

[rogue]

We have an abundance of globally inter-linked institutions. Because they are too inter-connected to fail, they are all prime candidates for a government bailout should any of them end up with unlucky trades. Theoretically, we could have an endless line of institutions who can “privatize profits but socialize failure”.

[Al Chang]

small causes (simple incentives), inevitable large effects.

http://www.derivativesstrategy.com/magazine/archive/1999/0899qa.asp

I'm sure you've seen this already, but Martin Mayer's *1999* column on his three laws of derivatives applied to decentralized swaps and securitization taken to their logical conclusion lead to "many of the above" not as a primary cause, but as symptomatic outcomes of the lack of centralized visibility and the incentive structure of the industry. It's a straight shot from 1999 to here.

http://news.bbc.co.uk/2/hi/business/2817995.stm

Buffett says pretty much the same thing in 2003.

Help me if this isn't the right characterization, I'm not a finance guy, but the analogy in my head.

I buy car insurance from the cheapest source that's a brand I don't think will go under. Even though underneath it's about the eventual solvency of the companies in their ability to pay, they look equivalent to me a consumer. If you put an implicit government guarantee under this car insurance, they literally are equivalent to me.

Assuming little regulation, if an individual insurance agent's commission income is based on monthly (short-term) sales. They're going to misprice the risk (long-term), write me cheaper and cheaper (riskier and risker) policy to capture my premium and I'm going to buy it because I know it's safe and backed by the government guarantee.

We all win. Agents get their bonus, the company gets the revenue, and i get my insurance cheaply, and we can pretend we're all geniuses until some super multi-car pileup exposes the lack of capital to back those future claims. Maybe house insurance would be a better example.

It doesn't strain the brain at all to see that the companies themselves will play the same game in the large in writing aggregated "insurance" (swaps) policies to each other.

Substitute opaque mortgage,interest-rate, credit default swaps,etc for the simplified consumer auto insurance model above and you'll follow Mayer's third rule straight into hell: "Risk-shifting instruments will tend over time to shift risks to those less able to bear them, because 'them as got want to keep and hedge, and them as ain’t got want to get and speculate.'" Witness those absolutely bizarre stories about fund managers having no idea what's in the paper they're holding.

Without the transparency of a swaps exchange= no way of seeing the overall risk+ removal default risk to originators + remove non-payment risk from the buyers+ ratings agencies enabling unique counterparty risks to be abstracted into a single historical class default rate line item on the balance sheet (swaps as solid as rock minus a historical "loss provision"), If we didn't have the specific causes you listed above, different ones would have been invented to perform the same function until we got to the paradoxically "inevitable" black swan event.

What was it Buffett compared it to? Keg of freaking dynamite?

It doesn't seem particularly different to the structural components of a garden variety ponzi scheme, though applied to hyper large sources of capital. Near as I can tell, we're still feeding the game with money, with the assumption that underneath it all there's enough money to pay all the "claims" and unwind this mess, which given the size of the united states is probably true. But from down here it looks cronyism, patronage and socialism, nay fascism of the worst order. At least in socialism, someone claims at least theoretically to be looking after assets of the state as owned by and on behalf of the people.

I'm not a finance guy, just a guy off the street. I'd love feedback on this. Thanks

[Sven]

For me it's #3. Becoming aware of the lack of transparency is what made Libor rates soar about one year ago (meaning: Banks don't trust each other anymore). Without trust any financial system is probably bound to collapse as all financial institutions are using some kind of leverage.

[Henri Tournyol du Clos, Paris]

Come on, Dani, this is far too circumstancial a list and you are forgetting all three main culprits :

1 - the growth in central bank reserves since the start of this century/millenium/whatever, which drove risk-free savings out of Treasuries and into riskier assets, while giving the (wrong) impression that cheap funding was now structural;

2 - profit-addiction : a 20 year natural bull run for the financial industry, thanks to falling yields, had to be replaced creatively when it ended;

3 - Glass Steagall et alii : the US has less than 100% of GDP on its banks' balance sheets, vs 300% on average over here in Europe. This makes for a highly unstable financial sector, especially with the whole of the planet using the dollar market as the borrower of last resort.

Also, I fear you are mixing up the FannyFreddy mishap with the wider issue : should it be government policy to foster home ownership? We all thought we knew the arguments for and against that, but the sheer scale of the current fiasco does call for some sort of a rethink, I would say.

[bunbury]

Not including asset prices in inflation measures and targets.

[Jon Eddison]

I used to be a corporate transactional lawyer for twenty five years. I did subprime deals. I would say that the "but for" causes are "2" plus the wave of securitization (not listed) plus "8". What your list omits is "fee lust". No one in the subprime mortgage origination through securitization cared about the risk of nonpayment because (a) they got their fees paid up front and (b) the risk was passed on - they did not bear it. Fee lust becomes bonus lust as you move up the ranks of banks, investment banks and brokerage firms. No analysis of this period can stand that does not weigh the tremendous fees, bonus and salaries of the control groups at the afore-mentioned institutions over the last decade.

[Greg Ransom]

You list a lot of proximate causes. You leave out these ultimate causes:

1. Interest rates set below the natural rate, generating the artificial boom and inevitable bust as described by Friedrich Hayek and Roger Garrison (let me recommend Garrisons articles on this available at his U. of Auburn web site).

2. The intellectual bankruptcy of modern macroeconomics, which has no room for anything but what Hayek identified as pseudo-science. This whole crisis wouldn't have happened without the participation of the economics profession in such institutions as the Fed.

[Peter]

I vote for two, not exactly on the list.

1. The willingness of the US to exploit its reserve currency status to run unsustainable current account deficits for a decade or more is the background enabling factor. After the dot.com bust private external financing melted away, requiring an increasing infusion of official support. This money literally chased assets, directly and indirectly fueling the housing bubble. (Even when China, the Gulf etc. bought Treasuries, they financed domestic US portfolio shifts toward bubble assets.) As I've argued elsewhere, from a global finance perspective, the Fed/Treasury bailout is a device to filter out risk as much as possible to the benefit of official capital inflows. (They buy distressed assets, many from foreign holders, financed by a new issuance of Treasuries that will largely be purchased by these same foreign holders.) The deep cause at work is a condition of global imbalance that has persisted much longer than it could have for any other country, due to the status of the dollar.

2. Obviously many failures of regulation can be pointed to as having exacerbated the crisis, but I would single out the failure to contain leverage. This was crucial for two reasons. First, it had direct effects on financial fragility. Second, it fueled an arms race in the complexity of trading instruments and programs. With enormous leverage, very small margins earn big profits. Physics PhD's were hired to invent strategies that, if all was correctly modeled, would permit traders to take slightly more profitable positions slightly faster. But of course the modeling was never perfect (especially wrt risk), and when the programs and instruments interacted the system's complexity became unfathomable. This in turn fed into the panic of market participants when losses (magnified by that same leverage) started showing up.

[BR]

Not verifying this:
Can the borrower pay for his home with documented income and assets using a 30-year fixed mortgage.

[BR]

OK, Lord already covered it.

[bob2]

repeal of glass-stegall?

[dissent]

I am wondering about the complexity and interconnectedness of the international global order. It seems to be an ideal transmission medium for financial instability.

In computer science in the 80's encapsulation and interfaces became de rigeur and computer languages were designed to eliminate 'transparency'. Barriers were designed into complex systems on purpose, to prevent the contamnination from bad data, bad configuration, security breaches and the like, from spreading throughout the system.

Curiously, the financial system seems to be designed to address the problems of contagion with greater transparency. Designing for transparency may be a fundamental flaw. (I hope I'm wrong.) It means the system is without circuit breakers.

By my view, the Glass-Segeall (sp?) law may be exactly the sort of thing that is effective in limiting contagion.

[Black Swan Baby]

Here is Nassim Taleb's view on the current crisis:

http://www.edge.org/3rd_culture/taleb08/taleb08_index.html

[happyjuggler0]

It is worth pointing out that "the housing bubble" was/is a local phenomenon in a very small number of states. The vast bulk of the country (geographically anyway) had no bubble.

The question is why was there a bubble in some places, and not in others? My vote goes for land use restrictions, which distorted the price rule. Demand went up for a limited supply, prices went up. But at that point you are supposed to get more supply, but in several areas, some densely populated, others with plenty of space but with "open space" set asides. Some with both.

Thus there was/is a huge lag between the price signal of increased demand and the markets ability to respond to those price increases.

In other words it is a classic case of government failure.

This is not to say that there weren't all kinds of other accomplices in the crime of the century, but there are good reasons why Texans quickly built houses after increased demand while Californians dilly-dallied. Texas has no housing bubble crisis despite a rapidly increasing population, while CA is the epicenter of the problem.

[Mario]

My story is that high investment from places like China and the economic slowdown in the early part of the decade brought interest rates to 40 year lows. People responded by buying more mortgages, which depleted the housing stock. This, plus the excess number of buyers, drove up prices faster than ever, encouraging more people, primarily speculators, to get into the market. Banks loosened their standards to get their piece of the new business, assuming that they could package up the bad mortgages and sell them off before anyone knew which were no good. Housing prices fell, the market dried up, and some companies were left holding the bag.

I think I would blame the lenders for the bulk of the problems, since they should have held themselves and their customers to higher standards, although there is a persuasive case that government pressure and fear of charges of redlining contributed. I think the rest of the market acted in good faith.

[Blissex]

Well, I have been trying to post a summary of some data to answer the question, and it keeps getting rejected by the antispam filter, even if I put in correctly the captcha. I suspect that is because it contains several URLs to data sources and graphs.

bigpicture.typepad.com/comments/2007/10/margin-debt-gro.html
www.nowandfutures.com/key_stats.html

and this:

www.signallake.com/innovation/FedReserve1995.pdf
«The key event that happened around 1995 is that the fractional reserve ratio was not only lowered, it was effectively eliminated entirely. You read that right. The net result of changes during that period is that banks are not required to back assets which largely correspond to M3 or "broad
money'' with cash reserves. As a consequence, banks can effectively create money without limitation. I know that sounds hard to believe, but let's look at the facts.»

are the most striking.

[Blissex]

This is the text of my comments without the URLs, hoping it passes the spam filter:

Well, I have asked myself the same for a long time. The thing that I noticed over the past several years was that jut about any "financial" quantity changed trend in 1995. From a gently sloping trend of growth matching or being slightly higher than GDP, the trend changed to growth much faster than GDP; a set of "hockey sticks".

So something important happened in 1995. From the graphs it looks like that it was a gigantic expansion in the availability of "money", and in particular of short term credit.

The only plausible explanation that I found is amazingly from a gold bug (who was inspired by Luskin...):

www.signallake.com/innovation/FedReserve1995.pdf
«The key event that happened around 1995 is that the fractional reserve ratio was not only lowered, it was effectively eliminated entirely. You read that right. The net result of changes during that period is that banks are not required to back assets which largely correspond to M3 or "broad money'' with cash reserves. As a consequence, banks can effectively create money without limitation. I know that sounds hard to believe, but let's look at the facts.»

Once the rules were changed to allow for ever increasing leverage, the system was on a hockey-stick trajectory, and one that got helped, for example with other relaxations:

bigpicture.typepad.com/comments/2008/09/regulatory-exem.html

especially as the financial sector became an ever larger percentage of GDP, stock market valuation and corporate profits, fueled by the seemingly endless availability of credit at a very low cost.

If there is another explanation for the sudden boom in credit availability and thus zooming leverage that started in 1995 I'd like to know.

[Raul P. Murguia]

#4: "Lack of regulation of derivatives".

While relatively simple derivatives have valuable utility, complex derivatives, whose value is unknown and *unknowable* in a free market, were added on top of the regular market cycle.

How can a free market work when there is such a big "unknown" in the middle?

[Per Kurowski]

None of the above!

The number one culprit, by far, were the financial regulators who empowered the credit rating agencies to act as risks kommissars and which of course, sooner or later, had to take the world over a precipice.

In a letter to the Editor of the Financial Times published May 11, 2003 I said “Everyone knows that, sooner or later, the ratings issued by the credit agencies are just a new breed of systemic errors, about to be propagated at modern speeds". Unfortunately the reality was that those who really should know that, the financial regulators, didn’t, and perhaps did not even care about it.

[Per Kurowski]

Believe it or not, the Financial Times, in their editorial of September 19 titled “Central banks: a survival guide” September 19, blames it all on the “follies of a generation of irresponsible financiers”

http://teawithft.blogspot.com/2008/09/and-what-about-folly-of-generation-of.html

[Matías]

If you were surprised, you should read Dean Baker (Beat the Press) on a regular basis. He is one of the several heterodox economists that have been talking about the housing bubble and other elements of the crisis for years.

[Charles]

You had a situation where a diverse set of institutions had opaque and highly leveraged exposure to an overvalued asset class.

An easy way to break-it down is to seperate causes in the run-up of the crisis into those related to the housing boom and those related to the changes in financial institution structure (increased leverage and linkages.

A housing crisis alone wouldn't have done this; nor would the excessive risk-taking by Wall street have caused this without high, correlated exposure to the same assets. I have a dozen other factors to add to your list but the point is that it takes most of these to explain the effects you have been seeing. A brief way to summarize it however is linkages, leverage and liquidity.