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.

[Lord]

It doesn't take rising prices to separate incomes from prices; falling incomes can do that just as well which was what typically happened in places like Ohio. Most of the innovations in lending were designed to accomplish this. Stated income loans to eliminate qualifying. Adjustables, option arms, and interest only loans to qualify borrowers on teaser rates. Resale, repackaging, and ratings to hide the low quality of lending. Liquidity and leverage to amplify the results. The finance industry relies on this opacity as it is not very profitable in the short term without it, nor very profitable in the long term with it.

One can't blame Greenspan for the poorly designed Bush tax cuts that necessitated his behavior, though one can fault him for not reacting to the result of it.

[Doc at the Radar Station]

I believe that the greatest contributor to the problem by far is "The originate-to-distribute model of mortgage lending". I've got a manufacturing background, not economics, but it makes a good analogy. If you use a lot of flawed components in an assembly, and then that assembly goes into another, you keep adding more value to something that will blow up later with the bad components. It all boils down to the initial mistakes. If the people doing the origination of the loans had to hold part of the risk, they wouldn't have made the bad loans, and the prices wouldn't have unrealistically inflated in the first place.

A close second would be "Lack of regulation of derivatives". This could be analogous to the company that manufactures expensive and complex equipment becoming lax in the quality oversight of their supply-chain by paying somebody else to insure them against warranty claims when their equipment catches fire due to bad components. The solution here is to return to spending more of their own money to validate the integrity of their supplied components.

[Bill C]

I'd go with some combination of 3, 4 & 9. The key difference between the US and the EM's seems to be that the rest of the world wants to buy our government bonds, and, so far, it seems like the crisis is making them want to buy them more, not less. Which is fortunate, since it looks like we'll be issuing about another $1 trillion or so...

[Per Kurowski]

The fact that a professor like Dani Rodrik includes “5. Poor credit-rating practices”, is exactly part of what brought us here, because the truth is that the better the credit-rating practices the more we risk following the practitioners into the wilderness.

This I say because credit-rating, just as the minimum capital requirements for banks based on risks, is introducing an formal risk adversion againts “risks of default” that only set us up to all other type of much more dangerous risks.

Is there anyone out there who dares to tell me that avoiding default risks is all financing is about?

From now on are the bailouts we going to see only to be the result of faultily measured risks and not of those risks that society incurs to move it forward?

Currently our biggest problem is that most have completely bought the silly one track-mind agenda of our financial regulators… the Basel wimps!

Financial regulation is much to serious to be left in the hands of the members of the mutual admiration club of financial regulators.

If we are going to waste taxpayer’s money let us at least assure the crisis has been worth it. Never have I seen such a useless crisis than the current one that has only produced millions of people to move in into their homes only to be evicted a couple of months and many tears later.

[Per Kurowski]

There is very little to show for, having followed the wimps of Basel.

Including as Dani Rodrik does “5. poor credit-rating practices” as a factor that have brought on the current crisis is part of what brought us here, because the fact is that the better the credit-rating practices, the more we will risk following the practitioners into the wilderness.

The dotcom explosion at least propelled that sector forward much faster than what would otherwise have been the case, but the current crisis, what does it have to show for itself? … overextended consumers and millions of people who moved in into their homes only to be evicted a couple of months and many tear later…not much.

And all this was the results of the extreme risk adverseness of the financial regulatory wimps of Basel; that thought their only mission in life was to drive out the risks of default in the financial system; and arrogantly thought themselves capable to do so; and to that effect created minimum bank capital requirements based on risks measured by their outsourced risk kommissars, the credit rating agencies.

And the credit rating agencies gave AAAs to securities backed by transparent an easily understood plain lousy mortgages to the subprime sector; and the markets followed those signs… and here we are.

No friends, financial regulation is much too serious to be left in the hands of the members of the mutual admiration club of financial regulators. If we are going to waste taxpayer’s money let us at least assure that the crisis we pay for are worth it.

[Per Kurowski]

There is very little to show for, having followed the wimps of Basel.

Including as Dani Rodrik does “5. poor credit-rating practices” as a factor that have brought on the current crisis is part of what brought us here, because the fact is that the better the credit-rating practices, the more we will risk following the practitioners into the wilderness.

The dotcom explosion at least propelled that sector forward much faster than what would otherwise have been the case, but the current crisis, what does it have to show for itself? … overextended consumers and millions of people who moved in into their homes only to be evicted a couple of months and many tear later…not much.

And all this was the results of the extreme risk adverseness of the financial regulatory wimps of Basel; that thought their only mission in life was to drive out the risks of default in the financial system; and arrogantly thought themselves capable to do so; and to that effect created minimum bank capital requirements based on risks measured by their outsourced risk kommissars, the credit rating agencies.

And the credit rating agencies gave AAAs to securities backed by transparent an easily understood plain lousy mortgages to the subprime sector; and the markets followed those signs… and here we are.

No friends, financial regulation is much too serious to be left in the hands of the members of the mutual admiration club of financial regulators. If we are going to waste taxpayer’s money let us at least assure that the crisis we pay for are worth it.

[David]

I'm not an accounting expert, but I have been reading a little about the recently introduced accounting regulation FAS 157, which came into effect early '08. Most of the results on google seem to warn about the effects on "Level 3" (including CDOs) evaluation and some major institutions are mentioned that may get in trouble because of it: Lehmann Brothers, Bear Stearns, Goldmann Sachs, JP Morgan Chase, AIG. Almost reads like an obituary less than a year later.

It is my understanding that papers like CDOs now have to be accounted for using mark-to-market. If there is currently nobody buying a paper like the one you have, it needs to be valued at $0 - even if there is a return (payments) coming in and the value, rather obviously, isn't nothing. The effect this has on the balance sheet must be devastating. Could this have set off the landslide?

As investors retreated to more secure papers, the market value of the riskier stuff dropped below the modeled value, hence nobody would be willing to sell them unless they had no other choice.

[BMH]

@ Peter | September 19, 2008 at 07:01 PM

I think Peter pretty much nailed it in his #1 point.

This topic is covered on Brad Setser blog "follow the money" just in case there are still economobloggers who don^t know him.
Best BMH

[bg]

Minsky would say long periods of prosperity will cause weak control of lending which leads to bubbles. Bubbles lead to asset deflation which leads to bank failures.

So it is all #1 and #2. Everything else is a symptom.

[Andy McLennan]

You're focusing on the trees, and overlooking the forest.

Modern finance is about handing large sums of money to total strangers in exchange for a promise to return it with interest or profit. If you think about it for a minute, this is an utterly amazing thing that we shouldn't take for granted, but we do. There is potential moral hazard at every link of the chain between the saver and the person who puts the money to work, and a conservative (stodgy, if you like) regulatory environment would err on the side of preventing abuse. The current regime largely exempts hedge funds and investment houses, the reasoning being that their counterparties are "big boys" who can take care of themselves, and it imposes only minimal supervision on mortgage origination, based on similar reasoning. But there are lots of fools out there, some of them quite rich, and others who perhaps aren't so foolish, but who put their trust in doing the "normal thing," what their friends and neighbors are doing. There are also people managing large amounts of money who have no practical way of telling when a AAA rating isn't "really" AAA. In an environment where these people can be robbed, they will be. Your list presumes that some small tinkering with the system might have made all the difference, but to me it seems that these particulars are incidental.

[Etienne Calame]

The shock in western economies after the subprimes crisis may well be translated by figures very modest compared to Argentina or Turkey’s outcomes. Generally entrepreneurs in such countries work with higher margin than their colleagues of more mature markets, this make them able to absorb higher shocks than the western industries would be able. I think the same remark is valid for households, the incompressible part of the income is more important in a western income making families in growing economies able to absorb significant hits a home owner in the west will not.
Think about an earthquake of 6 in Tokyo, and 6 in rural Iran, the consequence are not comparable even if the scale is the same. It would be necessary to measure the losses in economy growth and the gains in inflation with a pondering factor reflecting their consecutive damages.
By the way the necessity for local investors to work with higher margin makes them personally rich but reinforce the power of importers of western goods that put at risk only their stocks plus some trade investments, but not the heavy structure of a modern industry. Think to make an industrial dairy in Africa, calculating the difficulties to collect milk from thousands of remote villagers, the difficulties to keep it cool, and the energy shortage, not talking about bribery, ransoming, riots and the rest. Imported milk products are naturally cheap and contribute to the imbalance of these economies.

[Etienne Calame]

The shock in western economies after the subprimes crisis may well be translated by figures very modest compared to Argentina or Turkey’s outcomes. Generally entrepreneurs in such countries work with higher margin than their colleagues of more mature markets, this make them able to absorb higher shocks than the western industries would be able. I think the same remark is valid for households, the incompressible part of the income is more important in a western income making families in growing economies able to absorb significant hits a home owner in the west will not.
Think about an earthquake of 6 in Tokyo, and 6 in rural Iran, the consequence are not comparable even if the scale is the same. It would be necessary to measure the losses in economy growth and the gains in inflation with a pondering factor reflecting their consecutive damages.
By the way the necessity for local investors to work with higher margin makes them personally rich but reinforce the power of importers of western goods that put at risk only their stocks plus some trade investments, but not the heavy structure of a modern industry. Think to make an industrial dairy in Africa, calculating the difficulties to collect milk from thousands of remote villagers, the difficulties to keep it cool, and the energy shortage, not talking about bribery, ransoming, riots and the rest. Imported milk products are naturally cheap and contribute to the imbalance of these economies.

[robertdfeinman]

Insufficient margin requirements (similar to #9).

The "proximate cause" of 1929 was the huge amount of stock bought at 10% down. A 1% drop in price caused a 10% drop in asset value and triggered a margin call.

This time we have had many cases of a 3% investment so that a 1% drop in value leads to a 33% drop in value.

It may be that the drop in value started in the housing market, but this has amount to, perhaps, a 10% drop in the overall value of homes being financed. Without the high leverage this could easily have been worked through.

Margin brought down the US in 1929 and it's doing it again in 2008.

After 1929 the SEC put in a higher margin requirement (now at 50%) that people wouldn't see that this type of requirement was needed in the hedge fund area was deliberately ignoring the lessons of history.

Of course three card Monte players also find new suckers, but they aren't elected officials.

[acc]

Blissex, I checked out your signal lake article. I think your point would be made more clearly if you used the term "shadow banking system." You're entirely correct that the growth of the uncapitalized shadow banking system is a huge part of the problem.

As for causes of the banking crisis, allowing financial firms to raise money on commercial paper markets seems to be a huge error. When commercial paper was first developed, issuance by a financial firm was considered corrupt.

[Richard]

#9. If reserves are truly adequate, the provisioning and the rates charged will be adequate as well.

[Aaron]

I'll try to re-hash the points.

1. A bubble in the housing market - information distortion whose symptom is an overvaluation of assets.

2. The originate-to-distribute model of mortgage lending - the complexity and sophistication of financial derivatives allowed lending institutions to innovate their way past lending requirements.

3. Lack of transparency in structured finance and mortgage-backed securities - Asymmetry of information

4. Lack of regulation of derivatives - Level of regulation, denoted X is less than a, where a is the market equilibrium, the inverse is true.

8. Inadequate capital requirements for financial intermediaries - similar to above.

9. The too rapid or generous extension of Fed credit to non-banks - similar to (7).

10. The rescue of Bear Stearns - moral hazard.

11. The failure to rescue Lehman - political move?

The common theme here seems to be regulation that can't keep pace with financial innovation. As financial innovation evolves its way around regulation, its complexity increases.

I agree with Black Swan baby's reference to Taleb.

In some situations, you can be extremely wrong and be fine, in others you can be slightly wrong and explode. If you are leveraged, errors blow you up; if you are not, you can enjoy life.

[J.S.]

#9 by far is the most important- with higher capital requirements the investment banks would never have been able to leverage so much and thereby fall so far....

[Walt French]

My #13 is the lack of transparency about risks -- especially counterparty risks -- in the CDS and OTC derivatives markets. See Akerlof about how junk products drive out the good when only the seller knows how good the goods are. (Spoze you could have ignorant sellers and informed buyers, in which case maybe there'd be no problem; the dogs would just go for lower prices.)

Another -- #14? -- might be the lack of familiarity with Basel II, leading banks to implement shoddy models, or to ignore their sensible warnings because the bank managers hadn't established comfort with them.

[Kramladen]

Two points:

1) A lot of capital was there that searched for profitable investments - but there was none, no new hot product that promised huge profits (like the internet, or the railway etc.).

2) huge inequality in the US combined with the political necessity to keep employment up: low interest rates and deregulated financial markets allowed lots of credit for people who where not able to consume sufficiently out of their meagre and declining wages. Employment and growth was credit financed - consumer demand driven by borrowed money.

Solution: More regulation, more redistribution through higher taxation of wealth = real consumer demand, higher saving rate, less dominance of the financial markets.

[Justin Rietz]

I concur with Charles, but would point out several details:

1. Excessive leverage is a result of a fractional reserve banking system run amuck

2. The "linkage" is loose monetary policy.

Unnaturally low interest rates(i.e. interest rates held below the market clearing rate) result in low levels of savings, excessively large investments in risky projects and investment vehicles, and inflation. I think that pretty well sums up our current economic woes.

[Gegner]

You need to take the 'long view' here Dani.

If wages had kept up with consumption, we wouldn't be here.

Our current plight is the direct result of imbalances in our economic structure.

The bottom of the economic pyramid is dust...and castles in the sky don't stand, and, thanks to gravity, they don't 'float' either.

You can't hollow out your economy and pretend to be shocked when it collapses.

[Doug K]

in my oversimplification:
2 producing 1, aided and abetted by those who should have known better - Mr Greenspan, suggesting that we get ARMs:
http://www.usatoday.com/money/economy/fed/2004-02-23-greenspan-debt_x.htm

The bubble was then leveraged into disaster by 3. 4, 8 and 9 contributed to 3, but that was the basic flaw.

[bsetser]

i would throw in "excessive exchange rate management and reserve growth, which financed the us deficits (fiscal and external) at low rates for too long -- and contributed to both the large surpluses in the emerging world and the offsetting deficit in the us household sector" to the list of causes.

[Sam]

Economics is all about incentives. The incentives in the originate and hold model were in sync, it was in the best interest for everyone that the loan did well. In the originate to distribute model, no one cared as the bag holder was the only one that cared how the loan performed. The securitization model, while introducing many wonderful efficiencies, was not aligned with the incentives in the market where everyone was paid on churning not performance. Sam

[Dude]

I'm voting for #5. Once the credit agencies gave the securities a AAA rating, few investors looked to see what junk their sausage consisted of. In fact, many plugged these into their risk models as AAA Treasuries. Of course, everything else contributed, too. But if the credit agencies had downgraded these investments around 2006 (when Goldman noticed these notes were junk and hedged their positions), everyone would have been forced to protect their positions.

[buermann]

Approximately:

recession -> greenspan's negative real interest rates -> safe money pours into real estate for the return they no longer get from t-bills -> it's 2003 and there's no one left to lend to, the smartest guy in the room asks "Did anybody notice we are completely unregulated?" -> liar loans and ARM boiler room hustles -> ad infinitum -> real estate hyperinflation peaks in 2006 when the liar loan defaults begin -> then ARM reset defaults begin -> then negative equity defaults begin -> rolling financial crisis -> recession.

Mix in, at every stage, powerful institutionalized vectors of the conventional wisdom shouting out "real estate never goes down!" or misdirecting with "real estate markets are local, so there can't be a bubble" and "a few isolated real estate markets are a little frothy".

[Pedro Forquesato]

The real cause of the breakdown is the Shadow Financial System.

Of course if you go deeper, you will see that the monetary system based on flexible dolar might have a lot to do with it too.

[CWD]

This fiasco required the failure of multiple systems and resolution of any one of the following contributing causes might have prevented the full scale meltdown: (1) the exponential growth of Fan and Fred fueled by (a) Congressional pressure to provide higher and higher levels of "affordable housing" through risky lending and (b) ridiculous executive rewards for taking huge risks with taxpayer dollars, (2) the absolutely absurd lowering of lending standards across the mortgage industry, (3) the rating agencies twisted computer models, obssessive pursuit of market share, and lack of real accountability for monstrous errors, (4) revocation of the net capital rule for the five big investment banks and widespread overleveraging, (5) mark to market accounting, (6) low interest rates, (7) an antiquated and ineffective regulatory system, (8) the explosion of the opaque and unregulated "shadow" banking system, (9) Congress members who are willing to suspend sound judgment for votes or campaign contributions, and (10) political gamesmanship that prevented McCain and Obama from suspending the first debate and remaining in DC for an all out effort to get Congressional Republicans and the Democratic Black Caucus on board to pass the market stabilization bill immediately, instead of letting public confidence plunge while credit markets remained frozen and precious time slipped away.

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I agree with the low down or no down payment issue. I lived in a community that I put a 20% down payment on. All of a sudden you could buy a home for zero down.

Sure the realtors closed a lot of deals, builders built a lot of homes and mortgage people closed their deals but in the end what happened to my neighborhood?

People that never should have been approved to own a home took over the neighborhood. They didn't have any "skin" in the game so they didn't care.

They treated their homes like just another apartment they were renting. Lawns were not cut. Trash everywhere. Deferred maintenance.

How easy it was to walk away from a home they invested nothing in. Little did I know it was a foregleam of what was happening all over the country and has resulted in the mess we have today.

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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

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