Causes of the financial crisis of 2007–2009
Encyclopedia
Many factors directly and indirectly caused the ongoing Financial crisis of 2007–10 (which started with the US subprime mortgage crisis
), with experts placing different weights upon particular causes. The complexity and interdependence of many of the causes, as well as competing political, economic and organizational interests, have resulted in a variety of narratives describing the crisis. One category of causes created a vulnerable or fragile financial system, including complex financial securities, a dependence on short-term funding markets, and international trade imbalances. Other causes increased the stress on this fragile system, such as high corporate and consumer debt levels. Still others represent shocks to that system, such as the ongoing foreclosure crisis and the failures of key financial institutions. Regulatory and market-based controls did not effectively protect this system or measure the buildup of risk. Some causes relate to particular markets, such as the stock market or housing market, while others relate to the global economy more broadly.
The U.S. Financial Crisis Inquiry Commission
reported its findings in January 2011. It concluded that "the crisis was avoidable and was caused by: Widespread failures in financial regulation, including the Federal Reserve’s failure to stem the tide of toxic mortgages; Dramatic breakdowns in corporate governance including too many financial firms acting recklessly and taking on too much risk; An explosive mix of excessive borrowing and risk by households and Wall Street that put the financial system on a collision course with crisis; Key policy makers ill prepared for the crisis, lacking a full understanding of the financial system they oversaw; and systemic breaches in accountability and ethics at all levels.“
s secured by the price appreciation.
By September 2008, average U.S. housing prices had declined by over 20% from their mid-2006 peak. Easy credit, and a belief that house prices would continue to appreciate, had encouraged many subprime borrowers to obtain adjustable-rate mortgages. These mortgages enticed borrowers with a below market interest rate for some predetermined period, followed by market interest rates for the remainder of the mortgage's term. Borrowers who could not make the higher payments once the initial grace period ended would try to refinance their mortgages. Refinancing became more difficult, once house prices began to decline in many parts of the USA. Borrowers who found themselves unable to escape higher monthly payments by refinancing began to default. During 2007, lenders had begun foreclosure proceedings on nearly 1.3 million properties, a 79% increase over 2006. This increased to 2.3 million in 2008, an 81% increase vs. 2007. As of August 2008, 9.2% of all mortgages outstanding were either delinquent or in foreclosure.
The Economist
described the issue this way: "No part of the financial crisis has received so much attention, with so little to show for it, as the tidal wave of home foreclosures sweeping over America. Government programmes have been ineffectual, and private efforts not much better." Up to 9 million homes may enter foreclosure over the 2009-2011 period, versus one million in a typical year. At roughly U.S. $50,000 per foreclosure according to a 2006 study by the Chicago Federal Reserve Bank, 9 million foreclosures represents $450 billion in losses.
In addition to easy credit conditions, there is evidence that both government and competitive pressures contributed to an increase in the amount of subprime lending during the years preceding the crisis. Major U.S. investment banks and government sponsored enterprises like Fannie Mae played an important role in the expansion of higher-risk lending.
The term subprime refers to the credit quality of particular borrowers, who have weakened credit histories and a greater risk of loan default than prime borrowers. The value of U.S. subprime mortgages was estimated at $1.3 trillion as of March 2007, with over 7.5 million first-lien
subprime mortgages outstanding.
Subprime mortgages remained below 10% of all mortgage originations until 2004, when they spiked to nearly 20% and remained there through the 2005-2006 peak of the United States housing bubble
. A proximate event to this increase was the April 2004 decision by the U.S. Securities and Exchange Commission (SEC) to relax the net capital rule
, which encouraged the largest five investment banks to dramatically increase their financial leverage and aggressively expand their issuance of mortgage-backed securities. Subprime mortgage payment delinquency rates remained in the 10-15% range from 1998 to 2006, then began to increase rapidly, rising to 25% by early 2008.
Mortgage underwriting standards declined gradually during the boom period, particularly form 2004 to 2007. The use of automated loan approvals allowed loans to be made without appropriate review and documentation. In 2007, 40% of all subprime loans resulted from automated underwriting. The chairman of the Mortgage Bankers Association claimed that mortgage brokers, while profiting from the home loan boom, did not do enough to examine whether borrowers could repay. Mortgage fraud
by lenders and borrowers increased enormously.
A study by analysts at the Federal Reserve Bank of Cleveland found that the average difference between subprime and prime mortgage interest rates (the "subprime markup") declined significantly between 2001 and 2007. The quality of loans originated also worsened gradually during that period. The combination of declining risk premia and credit standards is common to boom and bust credit cycle
s. The authors also concluded that the decline in underwriting standards did not directly trigger the crisis, because the gradual changes in standards did not statistically account for the large difference in default rates for subprime mortgages issued between 2001-2005 (which had a 10% default rate within one year of origination) and 2006-2007 (which had a 20% rate). In other words, standards gradually declined but defaults suddenly jumped. Further, the authors argued that the trend in worsening loan quality was harder to detect with rising housing prices, as more refinancing options were available, keeping the default rate lower.
warned of an "epidemic" in mortgage fraud, an important credit risk of nonprime mortgage lending, which, they said, could lead to "a problem that could have as much impact as the S&L crisis".
refers to the cash paid to the lender for the home and represents the initial homeowners equity or financial interest in the home. A low down payment means that a home represents a highly leveraged investment for the homeowner, with little equity relative to debt. In such circumstances, only small declines in the value of the home result in negative equity
, a situation in which the value of the home is less than the mortgage amount owed. In 2005, the median down payment for first-time home buyers was 2%, with 43% of those buyers making no down payment whatsoever. By comparison, China has down payment requirements that exceed 20%, with higher amounts for non-primary residences.
Economist Nouriel Roubini
wrote in Forbes in July 2009: "Home prices have already fallen from their peak by about 30%. Based on my analysis, they are going to fall by at least 40% from their peak, and more likely 45%, before they bottom out. They are still falling at an annualized rate of over 18%. That fall of at least 40%-45% percent of home prices from their peak is going to imply that about half of all households that have a mortgage—about 25 million of the 51 million that have mortgages—are going to be underwater with negative equity
and will have a significant incentive to walk away from their homes."
Economist Stan Leibowitz argued in the Wall Street Journal that the extent of equity in the home was the key factor in foreclosure, rather than the type of loan, credit worthiness of the borrower, or ability to pay. Although only 12% of homes had negative equity (meaning the property was worth less than the mortgage obligation), they comprised 47% of foreclosures during the second half of 2008. Homeowners with negative equity have less financial incentive to stay in the home.
The L.A. Times reported the results of a study that found homeowners with high credit scores at the time of entering the mortgage are 50% more likely to "strategically default
" -- abruptly and intentionally pull the plug and abandon the mortgage—compared with lower-scoring borrowers. Such strategic defaults were heavily concentrated in markets with the highest price declines. An estimated 588,000 strategic defaults occurred nationwide during 2008, more than double the total in 2007. They represented 18% of all serious delinquencies that extended for more than 60 days in the fourth quarter of 2008.
, which the credit consumer might not notice until long after the loan transaction had been consummated.
Countrywide, sued by California Attorney General Jerry Brown
for "Unfair Business Practices" and "False Advertising" was making high cost mortgages "to homeowners with weak credit, adjustable rate mortgages (ARMs) that allowed homeowners to make interest-only payments.". When housing prices decreased, homeowners in ARMs then had little incentive to pay their monthly payments, since their home equity had disappeared. This caused Countrywide's financial condition to deteriorate, ultimately resulting in a decision by the Office of Thrift Supervision to seize the lender.
Countrywide, according to Republican Lawmakers, had involved itself in making low-cost loans to politicians, for purposes of gaining political favors.
Former employees from Ameriquest
, which was United States's leading wholesale lender, described a system in which they were pushed to falsify mortgage documents and then sell the mortgages to Wall Street banks eager to make fast profits. There is growing evidence that such mortgage fraud
s may be a cause of the crisis.
argued that a "culture of irresponsibility" was an important cause of the crisis. He criticized executive compensation that "rewarded recklessness rather than responsibility" and Americans who bought homes "without accepting the responsibilities." He continued that there "was far too much debt and not nearly enough capital in the system. And a growing economy bred complacency."
A key theme of the crisis is that many large financial institutions did not have a sufficient financial cushion to absorb the losses they sustained or to support the commitments made to others. Using technical terms, these firms were highly leveraged
(i.e., they maintained a high ratio of debt to equity) or had insufficient capital
to post as collateral
for their borrowing. A key to a stable financial system is that firms have the financial capacity to support their commitments. Michael Lewis
and David Einhorn argued: "The most critical role for regulation is to make sure that the sellers of risk have the capital to support their bets."
's chief economist at the time, stated that the 2006 decline in investment buying was expected: "Speculators left the market in 2006, which caused investment sales to fall much faster than the primary market."
Housing prices nearly doubled between 2000 and 2006, a vastly different trend from the historical appreciation at roughly the rate of inflation. While homes had not traditionally been treated as investments subject to speculation, this behavior changed during the housing boom. Media widely reported condominiums being purchased while under construction, then being "flipped" (sold) for a profit without the seller ever having lived in them. Some mortgage companies identified risks inherent in this activity as early as 2005, after identifying investors assuming highly leveraged positions in multiple properties.
Nicole Gelinas of the Manhattan Institute
described the negative consequences of not adjusting tax and mortgage policies to the shifting treatment of a home from conservative inflation hedge to speculative investment. Economist Robert Shiller
argued that speculative bubbles are fueled by "contagious optimism, seemingly impervious to facts, that often takes hold when prices are rising. Bubbles are primarily social phenomena; until we understand and address the psychology that fuels them, they're going to keep forming."
described how speculative borrowing contributed to rising debt and an eventual collapse of asset values.
Economist Paul McCulley
described how Minsky's hypothesis translates to the current crisis, using Minsky's words: "...from time to time, capitalist economies exhibit inflations and debt deflations which seem to have the potential to spin out of control. In such processes, the economic system's reactions to a movement of the economy amplify the movement--inflation feeds upon inflation and debt-deflation feeds upon debt deflation." In other words, people are momentum investors by nature, not value investors. People naturally take actions that expand the apex and nadir of cycles. One implication for policymakers and regulators is the implementation of counter-cyclical policies, such as contingent capital requirements for banks that increase during boom periods and are reduced during busts.
The former CEO of Citigroup
Charles O. Prince said in November 2007: "As long as the music is playing, you've got to get up and dance." This metaphor summarized how financial institutions took advantage of easy credit conditions, by borrowing and investing large sums of money, a practice called leveraged lending. Debt taken on by financial institutions increased from 63.8% of U.S. gross domestic product
in 1997 to 113.8% in 2007.
A 2004 SEC decision related to the net capital rule
allowed USA investment banks to issue substantially more debt, which was then used to help fund the housing bubble through purchases of mortgage-backed securities. From 2004-07, the top five U.S. investment banks each significantly increased their financial leverage (see diagram), which increased their vulnerability to a financial shock. These five institutions reported over $4.1 trillion in debt for fiscal year 2007, about 30% of USA nominal GDP for 2007. Lehman Brothers
was liquidated, Bear Stearns
and Merrill Lynch
were sold at fire-sale prices, and Goldman Sachs
and Morgan Stanley
became commercial banks, subjecting themselves to more stringent regulation. With the exception of Lehman, these companies required or received government support.
Fannie Mae and Freddie Mac, two U.S. Government sponsored enterprises, owned or guaranteed nearly $5 trillion in mortgage obligations at the time they were placed into conservatorship
by the U.S. government in September 2008.
These seven entities were highly leveraged and had $9 trillion in debt or guarantee obligations, an enormous concentration of risk, yet were not subject to the same regulation as depository banks.
In a May 2008 speech, Ben Bernanke
quoted Walter Bagehot
: "A good banker will have accumulated in ordinary times the reserve he is to make use of in extraordinary times." However, this advice was not heeded by these institutions, which had used the boom times to increase their leverage ratio instead.
In laissez-faire
capitalism, financial institutions would be risk-averse because failure would result in liquidation
. But the Federal Reserve's 1984 rescue of Continental Illinois and the 1998 rescue of the Long-Term Capital Management
hedge fund
, among others, showed that institutions which failed to exercise due diligence
could reasonably expect to be protected from the consequences of their mistakes. The belief that they could not be allowed to fail
created a moral hazard
which was a contributing factor to the late-2000s recession.
cited the following causes related to features of the modern financial markets:
The term financial innovation
refers to the ongoing development of financial products designed to achieve particular client objectives, such as offsetting a particular risk exposure (such as the default of a borrower) or to assist with obtaining financing. Examples pertinent to this crisis included: the adjustable-rate mortgage; the bundling of subprime mortgages into mortgage-backed securities (MBS) or collateralized debt obligations (CDO) for sale to investors, a type of securitization
; and a form of credit insurance called credit default swaps(CDS). The usage of these products expanded dramatically in the years leading up to the crisis. These products vary in complexity and the ease with which they can be valued on the books of financial institutions.
The CDO in particular enabled financial institutions to obtain investor funds to finance subprime and other lending, extending or increasing the housing bubble and generating large fees. Approximately $1.6 trillion in CDO's were originated between 2003-2007. A CDO essentially places cash payments from multiple mortgages or other debt obligations into a single pool, from which the cash is allocated to specific securities in a priority sequence. Those securities obtaining cash first received investment-grade ratings from rating agencies. Lower priority securities received cash thereafter, with lower credit ratings but theoretically a higher rate of return on the amount invested. A sample of 735 CDO deals originated between 1999 and 2007 showed that subprime and other less-than-prime mortgages represented an increasing percentage of CDO assets, rising from 5% in 2000 to 36% in 2007.
For a variety of reasons, market participants did not accurately measure the risk inherent with this innovation or understand its impact on the overall stability of the financial system. For example, the pricing model for CDOs clearly did not reflect the level of risk they introduced into the system. The average recovery rate for "high quality" CDOs has been approximately 32 cents on the dollar, while the recovery rate for mezzanine CDO's has been approximately five cents for every dollar. These massive, practically unthinkable, losses have dramatically impacted the balance sheets of banks across the globe, leaving them with very little capital to continue operations.
Others have pointed out that there were not enough of these loans made to cause a crisis of this magnitude. In an article in Portfolio Magazine, Michael Lewis
spoke with one trader who noted that "There weren’t enough Americans with [bad] credit taking out [bad loans] to satisfy investors’ appetite for the end product." Essentially, investment banks and hedge funds used financial innovation
to synthesize more loans using derivatives
. "They were creating [loans] out of whole cloth. One hundred times over! That’s why the losses are so much greater than the loans."
Princeton professor Harold James wrote that one of the byproducts of this innovation was that MBS and other financial assets were "repackaged so thoroughly and resold so often that it became impossible to clearly connect the thing being traded to its underlying value." He called this a "...profound flaw at the core of the U.S. financial system..."
Another example relates to AIG
, which insured obligations of various financial institutions through the usage of credit default swaps. The basic CDS transaction involved AIG receiving a premium in exchange for a promise to pay money to party A in the event party B defaulted. However, AIG did not have the financial strength to support its many CDS commitments as the crisis progressed and was taken over by the government in September 2008. U.S. taxpayers provided over $180 billion in government support to AIG during 2008 and early 2009, through which the money flowed to various counterparties to CDS transactions, including many large global financial institutions.
Author Michael Lewis
wrote that CDS enabled speculators to stack bets on the same mortgage bonds and CDO's. This is analogous to allowing many persons to buy insurance on the same house. Speculators that bought CDS insurance were betting that significant defaults would occur, while the sellers (such as AIG
) bet they would not. In addition, Chicago Public Radio and the Huffington Post reported in April 2010 that market participants, including a hedge fund called Magnetar Capital
, encouraged the creation of CDO's containing low quality mortgages, so they could bet against them using CDS. NPR reported that Magnetar encouraged investors to purchase CDO's while simultaneously betting against them, without disclosing the latter bet.
Credit rating agencies are now under scrutiny for having given investment-grade ratings to MBS
s based on risky subprime mortgage loans. These high ratings enabled these MBS to be sold to investors, thereby financing the housing boom. These ratings were believed justified because of risk reducing practices, such as credit default insurance and equity investors willing to bear the first losses. However, there are also indications that some involved in rating subprime-related securities knew at the time that the rating process was faulty.
An estimated $3.2 trillion in loans were made to homeowners with bad credit and undocumented incomes (e.g., subprime or Alt-A
mortgages) between 2002 and 2007. Economist Joseph Stiglitz stated: "I view the rating agencies as one of the key culprits...They were the party that performed the alchemy that converted the securities from F-rated to A-rated. The banks could not have done what they did without the complicity of the rating agencies." Without the AAA ratings, demand for these securities would have been considerably less. Bank writedowns and losses on these investments totaled $523 billion as of September 2008.
The ratings of these securities was a lucrative business for the rating agencies, accounting for just under half of Moody's
total ratings revenue in 2007. Through 2007, ratings companies enjoyed record revenue, profits and share prices. The rating companies earned as much as three times more for grading these complex products than corporate bonds, their traditional business. Rating agencies also competed with each other to rate particular MBS and CDO securities issued by investment banks, which critics argued contributed to lower rating standards. Interviews with rating agency senior managers indicate the competitive pressure to rate the CDO's favorably was strong within the firms. This rating business was their "golden goose" (which laid the proverbial golden egg or wealth) in the words of one manager. Author Upton Sinclair
(1878–1968) famously stated: "It is difficult to get a man to understand something when his job depends on not understanding it." From 2000-2006, structured finance (which includes CDO's) accounted for 40% of the revenues of the credit rating agencies. During that time, one major rating agency had its stock increase six-fold and its earnings grew by 900%.
Critics allege that the rating agencies suffered from conflicts of interest, as they were paid by investment banks and other firms that organize and sell structured securities to investors. On 11 June 2008, the SEC proposed rules designed to mitigate perceived conflicts of interest between rating agencies and issuers of structured securities. On 3 December 2008, the SEC approved measures to strengthen oversight of credit rating agencies, following a ten-month investigation that found "significant weaknesses in ratings practices," including conflicts of interest.
Between Q3 2007 and Q2 2008, rating agencies lowered the credit ratings on $1.9 trillion in mortgage backed securities. Financial institutions felt they had to lower the value of their MBS and acquire additional capital so as to maintain capital ratios. If this involved the sale of new shares of stock, the value of the existing shares was reduced. Thus ratings downgrades lowered the stock prices of many financial firms.
's Gaussian copula formula assumed that the price of CDS was correlated with and could predict the correct price of mortgage backed securities. Because it was highly tractable, it rapidly came to be used by a huge percentage of CDO and CDS investors, issuers, and rating agencies. According to one wired.com article: "Then the model fell apart. Cracks started appearing early on, when financial markets began behaving in ways that users of Li's formula hadn't expected. The cracks became full-fledged canyons in 2008—when ruptures in the financial system's foundation swallowed up trillions of dollars and put the survival of the global banking system in serious peril... Li's Gaussian copula formula will go down in history as instrumental in causing the unfathomable losses that brought the world financial system to its knees."
As financial assets became more complex, less transparent, and harder and harder to value, investors were reassured by the fact that both the international bond rating agencies and bank regulators, who came to rely on them, accepted as valid some complex mathematical models which theoretically showed the risks were much smaller than they actually proved to be in practice. George Soros
commented that "The super-boom got out of hand when the new products became so complicated that the authorities could no longer calculate the risks and started relying on the risk management methods of the banks themselves. Similarly, the rating agencies relied on the information provided by the originators of synthetic products. It was a shocking abdication of responsibility."
. They were then able to lend anew, earning additional fees. Author Robin Blackburn
explained how they worked: Off balance sheet financing also made firms look less leveraged and enabled them to borrow at cheaper rates.
Banks had established automatic lines of credit to these SIV and conduits. When the cash flow into the SIV's began to decline as subprime defaults mounted, banks were contractually obligated to provide cash to these structures and their investors. This "conduit-related balance sheet pressure" placed strain on the banks' ability to lend, both raising interbank lending rates and reducing the availability of funds.
In the years leading up to the crisis, the top four U.S. depository banks moved an estimated $5.2 trillion in assets and liabilities off-balance sheet into these SIV's and conduits. This enabled them to essentially bypass existing regulations regarding minimum capital ratios, thereby increasing leverage and profits during the boom but increasing losses during the crisis. Accounting guidance was changed in 2009 that will require them to put some of these assets back onto their books, which will significantly reduce their capital ratios. One news agency estimated this amount to be between $500 billion and $1 trillion. This effect was considered as part of the stress tests performed by the government during 2009.
During March 2010, the bankruptcy court examiner released a report on Lehman Brothers
, which had failed spectacularly in September 2008. The report indicated that up to $50 billion was moved off-balance sheet in a questionable manner by management during 2008, with the effect of making its debt level (leverage ratio) appear smaller. Analysis by the Federal Reserve Bank of New York indicated big banks mask their risk levels just prior to reporting data quarterly to the public.
wrote in June 2009: "...an enormous part of what banks did in the early part of this decade – the off-balance-sheet vehicles, the derivatives and the 'shadow banking system' itself – was to find a way round regulation."
wrote that the financial sector became increasingly concentrated in the years leading up to the crisis, which made the stability of the financial system more reliant on just a few firms, which were also highly leveraged:
By contrast, some scholars have argued that fragmentation in the mortgage securitization market led to increased risk taking and a deterioration in underwriting standards.
From 2000 to 2003, the Federal Reserve lowered the federal funds rate
target from 6.5% to 1.0%. This was done to soften the effects of the collapse of the dot-com bubble
and of the September 2001 terrorist attacks, and to combat the perceived risk of deflation.
The Fed then raised the Fed funds rate significantly between July 2004 and July 2006. This contributed to an increase in 1-year and 5-year adjustable-rate mortgage (ARM) rates, making ARM interest rate resets more expensive for homeowners. This may have also contributed to the deflating of the housing bubble, as asset prices generally move inversely to interest rates and it became riskier to speculate in housing.
This globalization can be measured in growing trade deficits in developed countries such as the U.S. and Europe. In 2005, Ben Bernanke
addressed the implications of the USA's high and rising current account
deficit, resulting from USA imports exceeding its exports. Between 1996 and 2004, the USA current account deficit increased by $650 billion, from 1.5% to 5.8% of GDP. Financing these deficits required the USA to borrow large sums from abroad, much of it from countries running trade surpluses, mainly the emerging economies in Asia and oil-exporting nations. The balance of payments
identity
requires that a country (such as the USA) running a current account
deficit also have a capital account
(investment) surplus of the same amount. Hence large and growing amounts of foreign funds (capital) flowed into the USA to finance its imports. This created demand for various types of financial assets, raising the prices of those assets while lowering interest rates. Foreign investors had these funds to lend, either because they had very high personal savings rates (as high as 40% in China), or because of high oil prices. Bernanke referred to this as a "saving glut." A "flood" of funds (capital
or liquidity) reached the USA financial markets. Foreign governments supplied funds by purchasing USA Treasury bonds and thus avoided much of the direct impact of the crisis. USA households, on the other hand, used funds borrowed from foreigners to finance consumption or to bid up the prices of housing and financial assets. Financial institutions invested foreign funds in mortgage-backed securities. USA housing and financial assets dramatically declined in value after the housing bubble burst.
has argued that "inordinately mercantilist
currency policies" were a significant cause of the U.S. trade deficit, indirectly driving a flood of money into the U.S. as described above. In his view, China maintained an artificially weak currency to make Chinese goods relatively cheaper for foreign countries to purchase, thereby keeping its vast workforce occupied and encouraging exports to the U.S. One byproduct was a large accumulation of U.S. dollars by the Chinese government, which were then invested in U.S. government securities and those of Fannie Mae and Freddie Mac, providing additional funds for lending that contributed to the housing bubble.
Economist Paul Krugman
also wrote similar comments during October 2009, further arguing that China's currency should have appreciated relative to the U.S. dollar beginning around 2001. Various U.S. officials have also indicated concerns with Chinese exchange rate policies, which have not allowed its currency to appreciate significantly relative to the dollar despite large trade surpluses. In January 2009, Timothy Geithner wrote: "Obama -- backed by the conclusions of a broad range of economists -- believes that China is manipulating its currency...the question is how and when to broach the subject in order to do more good than harm."
and in long economic waves based on technological revolutions. Daniel Šmihula
believes that this crisis and stagnation are a result of the end of the long economic cycle originally initiated by the Information and telecommunications technological revolution in 1985-2000.
The market has been already saturated by new “technical wonders” (e.g. everybody has his own mobile phone) and – what is more important - in the developed countries the economy reached limits of productivity
in conditions of existing technologies. A new economic revival can come only with a new technological revolution (a hypothetical Post-informational technological revolution). Šmihula expects that it will happen in about 2014-15.
winning program, NPR correspondents argued that a "Giant Pool of Money" (represented by $70 trillion in worldwide fixed income investments) sought higher yields than those offered by U.S. Treasury bonds early in the decade, which were low due to low interest rates and trade deficits discussed above. Further, this pool of money had roughly doubled in size from 2000 to 2007, yet the supply of relatively safe, income generating investments had not grown as fast. Investment banks on Wall Street answered this demand with the mortgage-backed security
(MBS) and collateralized debt obligation
(CDO), which were assigned safe ratings by the credit rating agencies. In effect, Wall Street connected this pool of money to the mortgage market in the U.S., with enormous fees accruing to those throughout the mortgage supply chain, from the mortgage broker selling the loans, to small banks that funded the brokers, to the giant investment banks behind them. By approximately 2003, the supply of mortgages originated at traditional lending standards had been exhausted. However, continued strong demand for MBS and CDO began to drive down lending standards, as long as mortgages could still be sold along the supply chain. Eventually, this speculative bubble proved unsustainable.
. These entities became critical to the credit markets underpinning the financial system, but were not subject to the same regulatory controls. Further, these entities were vulnerable because they borrowed short-term in liquid markets to purchase long-term, illiquid and risky assets. This meant that disruptions in credit markets would make them subject to rapid deleveraging, selling their long-term assets at depressed prices. He described the significance of these entities: "In early 2007, asset-backed commercial paper conduits, in structured investment vehicles, in auction-rate preferred securities, tender option bonds and variable rate demand notes, had a combined asset size of roughly $2.2 trillion. Assets financed overnight in triparty repo grew to $2.5 trillion. Assets held in hedge funds grew to roughly $1.8 trillion. The combined balance sheets of the then five major investment banks totaled $4 trillion. In comparison, the total assets of the top five bank holding companies in the United States at that point were just over $6 trillion, and total assets of the entire banking system were about $10 trillion." He stated that the "combined effect of these factors was a financial system vulnerable to self-reinforcing asset price and credit cycles."
described the run on the shadow banking system as the "core of what happened" to cause the crisis. "As the shadow banking system expanded to rival or even surpass conventional banking in importance, politicians and government officials should have realized that they were re-creating the kind of financial vulnerability that made the Great Depression possible—and they should have responded by extending regulations and the financial safety net to cover these new institutions. Influential figures should have proclaimed a simple rule: anything that does what a bank does, anything that has to be rescued in crises the way banks are, should be regulated like a bank." He referred to this lack of controls as "malign neglect." Some researchers have suggested that competition between GSEs and the shadow banking system led to a deterioration in underwriting standards.
For example, investment bank Bear Stearns
was required to replenish much of its funding in overnight markets, making the firm vulnerable to credit market disruptions. When concerns arose regarding its financial strength, its ability to secure funds in these short-term markets was compromised, leading to the equivalent of a bank run. Over four days, its available cash declined from $18 billion to $3 billion as investors pulled funding from the firm. It collapsed and was sold at a fire-sale price to bank JP Morgan Chase March 16, 2008.
American homeowners, consumers, and corporations owed roughly $25 trillion during 2008. American banks retained about $8 trillion of that total directly as traditional mortgage loans. Bondholders and other traditional lenders provided another $7 trillion. The remaining $10 trillion came from the securitization markets, meaning the parallel banking system. The securitization markets started to close down in the spring of 2007 and nearly shut-down in the fall of 2008. More than a third of the private credit markets thus became unavailable as a source of funds. In February 2009, Ben Bernanke
stated that securitization markets remained effectively shut, with the exception of conforming mortgages, which could be sold to Fannie Mae and Freddie Mac.
The Economist
reported in March 2010: "Bear Stearns and Lehman Brothers were non-banks that were crippled by a silent run among panicky overnight "repo
" lenders, many of them money market funds uncertain about the quality of securitized collateral they were holding. Mass redemptions from these funds after Lehman's failure froze short-term funding for big firms."
was passed from mortgage originators to investors using various types of financial innovation
. This became known as the "originate to distribute" model, as opposed to the traditional model where the bank originating the mortgage retained the credit risk. In effect, the mortgage originators were left with nothing which was at risk, giving rise to moral hazard
in which behavior and consequence were separated.
Economist Mark Zandi
described moral hazard
as a root cause of the subprime mortgage crisis
. He wrote: "...the risks inherent in mortgage lending became so widely dispersed that no one was forced to worry about the quality of any single loan. As shaky mortgages were combined, diluting any problems into a larger pool, the incentive for responsibility was undermined." He also wrote: "Finance companies weren't subject to the same regulatory oversight as banks. Taxpayers weren't on the hook if they went belly up [pre-crisis], only their shareholders and other creditors were. Finance companies thus had little to discourage them from growing as aggressively as possible, even if that meant lowering or winking at traditional lending standards."
The New York State Comptroller's Office has said that in 2006, Wall Street executives took home bonuses totaling $23.9 billion. "Wall Street traders were thinking of the bonus at the end of the year, not the long-term health of their firm. The whole system—from mortgage brokers to Wall Street risk managers—seemed tilted toward taking short-term risks while ignoring long-term obligations. The most damning evidence is that most of the people at the top of the banks didn't really understand how those [investments] worked."
Investment banker incentive compensation was focused on fees generated from assembling financial products, rather than the performance of those products and profits generated over time. Their bonuses were heavily skewed towards cash rather than stock and not subject to "claw-back" (recovery of the bonus from the employee by the firm) in the event the MBS or CDO created did not perform. In addition, the increased risk (in the form of financial leverage) taken by the major investment banks was not adequately factored into the compensation of senior executives.
Bank CEO Jamie Dimon
argued: "Rewards have to track real, sustained, risk-adjusted performance. Golden parachutes, special contracts, and unreasonable perks must disappear. There must be a relentless focus on risk management that starts at the top of the organization and permeates down to the entire firm. This should be business-as-usual, but at too many places, it wasn't."
, such as the increasing importance of the shadow banking system
, derivatives
and off-balance sheet financing. In other cases, laws were changed or enforcement weakened in parts of the financial system. Several critics have argued that the most critical role for regulation is to make sure that financial institutions have the ability or capital to deliver on their commitments. Critics have also noted de facto deregulation through a shift in market share toward the least regulated portions of the mortgage market.
Key examples of regulatory failures include:
Author Roger Lowenstein
summarized some of the regulatory problems that caused the crisis in November 2009: "1) Mortgage regulation was too lax and in some cases nonexistent; 2) Capital requirements for banks were too low; 3) Trading in derivatives such as credit default swaps posed giant, unseen risks; 4) Credit ratings on structured securities such as collateralized-debt obligations were deeply flawed; 5) Bankers were moved to take on risk by excessive pay packages; 6) The government’s response to the crash also created, or exacerbated, moral hazard. Markets now expect that big banks won’t be allowed to fail, weakening the incentives of investors to discipline big banks and keep them from piling up too many risky assets again."
have been argued as contributing to this crisis:
Banks in the U.S. lobby politicians extensively. A November 2009 report from economists of the International Monetary Fund
(IMF) writing independently of that organization indicated that:
The study concluded that: "the prevention of future crises might require weakening political influence of the financial industry or closer monitoring of lobbying activities to understand better the incentives behind it."
The Boston Globe reported during that during January–June 2009, the largest four U.S. banks spent these amounts ($ millions) on lobbying, despite receiving taxpayer bailouts: Citigroup $3.1; JP Morgan Chase $3.1; Bank of America $1.5; and Wells Fargo $1.4.
The New York Times reported in April 2010: "An analysis by Public Citizen found that at least 70 former members of Congress were lobbying for Wall Street and the financial services sector last year, including two former Senate majority leaders (Trent Lott and Bob Dole), two former House majority leaders (Richard A. Gephardt and Dick Armey) and a former House speaker (J. Dennis Hastert). In addition to the lawmakers, data from the Center for Responsive Politics counted 56 former Congressional aides on the Senate or House banking committees who went on to use their expertise to lobby for the financial sector."
The Financial Crisis Inquiry Commission
reported in January 2011 that "...from 1998 to 2008, the financial sector expended $2.7 billion in reported federal lobbying expenses; individuals and political action committees in the sector made more than $1 billion in campaign contributions."
magazine claims that economists mostly failed to predict the worst international economic crisis since the Great Depression
of 1930s. The Wharton School of the University of Pennsylvania
online business journal examines why economists failed to predict a major global financial crisis. An article in the New York Times informs that economist Nouriel Roubini
warned of such crisis as early as September 2006, and the article goes on to state that the profession of economics is bad at predicting recessions. According to The Guardian
, Roubini was ridiculed for predicting a collapse of the housing market and worldwide recession, while The New York Times labelled him "Dr. Doom". However, there are examples of other experts who gave indications of a financial crisis.
concluded that the crisis was: (1) caused by excess monetary expansion; (2) prolonged by an inability to evaluate counter-party risk due to opaque financial statements; and (3) worsened by the unpredictable nature of government's response to the crisis.
, where lenders that had provided the funds using the MBS as collateral had contractual rights to get their money back. The combination of losses and margin calls resulted in further forced sales of MBS and emergency efforts to obtain cash (liquidity). Markdowns may also reduce the value of bank regulatory capital, requiring additional capital raising and creating uncertainty regarding the health of the bank. In other words, writing down the assets presented both liquidity and solvency challenges. Advocates argued that the rule enabled the most accurate estimate of the financial health of the banks.
explanation, is that the financial crisis is merely a symptom of another, deeper crisis, which is a systemic crisis of capitalism
itself. According to Samir Amin
, an Egyptian economist, the constant decrease in GDP
growth
rates in Western countries
since the early 1970s created a growing surplus of capital which did not have sufficient profitable investment outlets in the real economy
. The alternative was to place this surplus into the financial market, which became more profitable than productive capital
investment
, especially with subsequent deregulation. According to Samir Amin, this phenomenon has led to recurrent financial bubbles
(such as the internet bubble) and is the deep cause of the financial crisis of 2007-2009.
John Bellamy Foster
, a political economy analyst and editor of the Monthly Review
, believes that the decrease in GDP
growth
rates since the early 1970s is due to increasing market saturation
.
John C. Bogle wrote during 2005 that a series of unresolved challenges face capitalism that have contributed to past financial crises and have not been sufficiently addressed: "Corporate America went astray largely because the power of managers went virtually unchecked by our gatekeepers for far too long...They failed to 'keep an eye on these geniuses' to whom they had entrusted the responsibility of the management of America's great corporations." He cites particular issues, including:
One of the unique features of this crisis is the linkage of global investors and financial institutions to the price of U.S. housing, through financial innovations such as MBS, CDO, and CDS described above. As borrowers stop paying their mortgages (due to the inability to refinance, negative equity, or loss of employment), foreclosures and the supply of homes for sale increases. This places downward pressure on housing prices, which further lowers homeowners' equity. The decline in mortgage payments also reduces the value of mortgage-backed securities, which erodes the net worth and financial health of banks. This reduces the amount of lending that banks can support, which slows down business investment. When consumers do not spend, business earnings are impacted, which increases unemployment. This vicious cycle or self-reinforcing loop is at the heart of the crisis.
Thomas Friedman
summarized some of this interaction in November 2008:
Former Fed Chair Paul Volcker
summarized several other assumptions:
Subprime mortgage crisis
The U.S. subprime mortgage crisis was one of the first indicators of the late-2000s financial crisis, characterized by a rise in subprime mortgage delinquencies and foreclosures, and the resulting decline of securities backed by said mortgages....
), with experts placing different weights upon particular causes. The complexity and interdependence of many of the causes, as well as competing political, economic and organizational interests, have resulted in a variety of narratives describing the crisis. One category of causes created a vulnerable or fragile financial system, including complex financial securities, a dependence on short-term funding markets, and international trade imbalances. Other causes increased the stress on this fragile system, such as high corporate and consumer debt levels. Still others represent shocks to that system, such as the ongoing foreclosure crisis and the failures of key financial institutions. Regulatory and market-based controls did not effectively protect this system or measure the buildup of risk. Some causes relate to particular markets, such as the stock market or housing market, while others relate to the global economy more broadly.
The U.S. Financial Crisis Inquiry Commission
Financial Crisis Inquiry Commission
The Commission reported its findings in January 2011. It concluded that "the crisis was avoidable and was caused by: Widespread failures in financial regulation, including the Federal Reserve’s failure to stem the...
reported its findings in January 2011. It concluded that "the crisis was avoidable and was caused by: Widespread failures in financial regulation, including the Federal Reserve’s failure to stem the tide of toxic mortgages; Dramatic breakdowns in corporate governance including too many financial firms acting recklessly and taking on too much risk; An explosive mix of excessive borrowing and risk by households and Wall Street that put the financial system on a collision course with crisis; Key policy makers ill prepared for the crisis, lacking a full understanding of the financial system they oversaw; and systemic breaches in accountability and ethics at all levels.“
The U.S. housing bubble and foreclosures
Between 1997 and 2006, the price of the typical American house increased by 124%. During the two decades ending in 2001, the national median home price ranged from 2.9 to 3.1 times median household income. This ratio rose to 4.0 in 2004, and 4.6 in 2006. This housing bubble resulted in quite a few homeowners refinancing their homes at lower interest rates, or financing consumer spending by taking out second mortgageSecond mortgage
A second mortgage typically refers to a secured loan that is subordinate to another loan against the same property.In real estate, a property can have multiple loans or liens against it. The loan which is registered with county or city registry first is called the first mortgage or first position...
s secured by the price appreciation.
By September 2008, average U.S. housing prices had declined by over 20% from their mid-2006 peak. Easy credit, and a belief that house prices would continue to appreciate, had encouraged many subprime borrowers to obtain adjustable-rate mortgages. These mortgages enticed borrowers with a below market interest rate for some predetermined period, followed by market interest rates for the remainder of the mortgage's term. Borrowers who could not make the higher payments once the initial grace period ended would try to refinance their mortgages. Refinancing became more difficult, once house prices began to decline in many parts of the USA. Borrowers who found themselves unable to escape higher monthly payments by refinancing began to default. During 2007, lenders had begun foreclosure proceedings on nearly 1.3 million properties, a 79% increase over 2006. This increased to 2.3 million in 2008, an 81% increase vs. 2007. As of August 2008, 9.2% of all mortgages outstanding were either delinquent or in foreclosure.
The Economist
The Economist
The Economist is an English-language weekly news and international affairs publication owned by The Economist Newspaper Ltd. and edited in offices in the City of Westminster, London, England. Continuous publication began under founder James Wilson in September 1843...
described the issue this way: "No part of the financial crisis has received so much attention, with so little to show for it, as the tidal wave of home foreclosures sweeping over America. Government programmes have been ineffectual, and private efforts not much better." Up to 9 million homes may enter foreclosure over the 2009-2011 period, versus one million in a typical year. At roughly U.S. $50,000 per foreclosure according to a 2006 study by the Chicago Federal Reserve Bank, 9 million foreclosures represents $450 billion in losses.
Sub-prime lending
The term subprime refers to the credit quality of particular borrowers, who have weakened credit histories and a greater risk of loan default than prime borrowers. The value of U.S. subprime mortgages was estimated at $1.3 trillion as of March 2007, with over 7.5 million first-lien
Lien
In law, a lien is a form of security interest granted over an item of property to secure the payment of a debt or performance of some other obligation...
subprime mortgages outstanding.
Subprime mortgages remained below 10% of all mortgage originations until 2004, when they spiked to nearly 20% and remained there through the 2005-2006 peak of the United States housing bubble
United States housing bubble
The United States housing bubble is an economic bubble affecting many parts of the United States housing market in over half of American states. Housing prices peaked in early 2006, started to decline in 2006 and 2007, and may not yet have hit bottom as of 2011. On December 30, 2008 the...
. A proximate event to this increase was the April 2004 decision by the U.S. Securities and Exchange Commission (SEC) to relax the net capital rule
Net capital rule
The uniform net capital rule is a rule created by the U.S. Securities and Exchange Commission in 1975 to regulate directly the ability of broker-dealers to meet their financial obligations to customers and other creditors...
, which encouraged the largest five investment banks to dramatically increase their financial leverage and aggressively expand their issuance of mortgage-backed securities. Subprime mortgage payment delinquency rates remained in the 10-15% range from 1998 to 2006, then began to increase rapidly, rising to 25% by early 2008.
Mortgage underwriting
In addition to considering higher-risk borrowers, lenders offered increasingly risky loan options and borrowing incentives.Mortgage underwriting standards declined gradually during the boom period, particularly form 2004 to 2007. The use of automated loan approvals allowed loans to be made without appropriate review and documentation. In 2007, 40% of all subprime loans resulted from automated underwriting. The chairman of the Mortgage Bankers Association claimed that mortgage brokers, while profiting from the home loan boom, did not do enough to examine whether borrowers could repay. Mortgage fraud
Mortgage fraud
Mortgage fraud is crime in which the intent is to materially misrepresent or omit information on a mortgage loan application to obtain a loan or to obtain a larger loan than would have been obtained had the lender or borrower known the truth....
by lenders and borrowers increased enormously.
A study by analysts at the Federal Reserve Bank of Cleveland found that the average difference between subprime and prime mortgage interest rates (the "subprime markup") declined significantly between 2001 and 2007. The quality of loans originated also worsened gradually during that period. The combination of declining risk premia and credit standards is common to boom and bust credit cycle
Credit cycle
The credit cycle is the expansion and contraction of access to credit over the course of the business cycle. Some economists, including Barry Eichengreen, Hyman Minsky, and other Post-Keynesian economists, and some members of the Austrian school, regard credit cycles as the fundamental process...
s. The authors also concluded that the decline in underwriting standards did not directly trigger the crisis, because the gradual changes in standards did not statistically account for the large difference in default rates for subprime mortgages issued between 2001-2005 (which had a 10% default rate within one year of origination) and 2006-2007 (which had a 20% rate). In other words, standards gradually declined but defaults suddenly jumped. Further, the authors argued that the trend in worsening loan quality was harder to detect with rising housing prices, as more refinancing options were available, keeping the default rate lower.
Mortgage fraud
In 2004, the Federal Bureau of InvestigationFederal Bureau of Investigation
The Federal Bureau of Investigation is an agency of the United States Department of Justice that serves as both a federal criminal investigative body and an internal intelligence agency . The FBI has investigative jurisdiction over violations of more than 200 categories of federal crime...
warned of an "epidemic" in mortgage fraud, an important credit risk of nonprime mortgage lending, which, they said, could lead to "a problem that could have as much impact as the S&L crisis".
Down payments and negative equity
A down paymentDown payment
Down payment is a payment used in the context of the purchase of expensive items such as a car and a house, whereby the payment is the initial upfront portion of the total amount due and it is usually given in cash at the time of finalizing the transaction.A loan is then required to make the full...
refers to the cash paid to the lender for the home and represents the initial homeowners equity or financial interest in the home. A low down payment means that a home represents a highly leveraged investment for the homeowner, with little equity relative to debt. In such circumstances, only small declines in the value of the home result in negative equity
Negative equity
Negative equity occurs when the value of an asset used to secure a loan is less than the outstanding balance on the loan. In the United States, assets with negative equity are often referred to as being "underwater", and loans and borrowers with negative equity are said to be "upside down".People...
, a situation in which the value of the home is less than the mortgage amount owed. In 2005, the median down payment for first-time home buyers was 2%, with 43% of those buyers making no down payment whatsoever. By comparison, China has down payment requirements that exceed 20%, with higher amounts for non-primary residences.
Economist Nouriel Roubini
Nouriel Roubini
Nouriel Roubini is an American economist. He claims to have predicted both the collapse of the United States housing market and the worldwide recession which started in 2008. He teaches at New York University's Stern School of Business and is the chairman of Roubini Global Economics, an economic...
wrote in Forbes in July 2009: "Home prices have already fallen from their peak by about 30%. Based on my analysis, they are going to fall by at least 40% from their peak, and more likely 45%, before they bottom out. They are still falling at an annualized rate of over 18%. That fall of at least 40%-45% percent of home prices from their peak is going to imply that about half of all households that have a mortgage—about 25 million of the 51 million that have mortgages—are going to be underwater with negative equity
Negative equity
Negative equity occurs when the value of an asset used to secure a loan is less than the outstanding balance on the loan. In the United States, assets with negative equity are often referred to as being "underwater", and loans and borrowers with negative equity are said to be "upside down".People...
and will have a significant incentive to walk away from their homes."
Economist Stan Leibowitz argued in the Wall Street Journal that the extent of equity in the home was the key factor in foreclosure, rather than the type of loan, credit worthiness of the borrower, or ability to pay. Although only 12% of homes had negative equity (meaning the property was worth less than the mortgage obligation), they comprised 47% of foreclosures during the second half of 2008. Homeowners with negative equity have less financial incentive to stay in the home.
The L.A. Times reported the results of a study that found homeowners with high credit scores at the time of entering the mortgage are 50% more likely to "strategically default
Strategic default
A strategic default is the decision by a borrower to stop making payments on a debt despite having the financial ability to make the payments....
" -- abruptly and intentionally pull the plug and abandon the mortgage—compared with lower-scoring borrowers. Such strategic defaults were heavily concentrated in markets with the highest price declines. An estimated 588,000 strategic defaults occurred nationwide during 2008, more than double the total in 2007. They represented 18% of all serious delinquencies that extended for more than 60 days in the fourth quarter of 2008.
Predatory lending
Predatory lending refers to the practice of unscrupulous lenders, to enter into "unsafe" or "unsound" secured loans for inappropriate purposes. A classic bait-and-switch method was used by Countrywide, advertising low interest rates for home refinancing. Such loans were written into mind-numbingly detailed contracts, and swapped for more expensive loan products on the day of closing. Whereas the advertisement might state that 1% or 1.5% interest would be charged, the consumer would be put into an adjustable rate mortgage (ARM) in which the interest charged would be greater than the amount of interest paid. This created negative amortizationNegative amortization
In finance, negative amortization, also known as NegAm, deferred interest or graduated payment mortgage, occurs whenever the loan payment for any period is less than the interest charged over that period so that the outstanding balance of the loan increases...
, which the credit consumer might not notice until long after the loan transaction had been consummated.
Countrywide, sued by California Attorney General Jerry Brown
Jerry Brown
Edmund Gerald "Jerry" Brown, Jr. is an American politician. Brown served as the 34th Governor of California , and is currently serving as the 39th California Governor...
for "Unfair Business Practices" and "False Advertising" was making high cost mortgages "to homeowners with weak credit, adjustable rate mortgages (ARMs) that allowed homeowners to make interest-only payments.". When housing prices decreased, homeowners in ARMs then had little incentive to pay their monthly payments, since their home equity had disappeared. This caused Countrywide's financial condition to deteriorate, ultimately resulting in a decision by the Office of Thrift Supervision to seize the lender.
Countrywide, according to Republican Lawmakers, had involved itself in making low-cost loans to politicians, for purposes of gaining political favors.
Former employees from Ameriquest
Ameriquest
ACC Capital Holdings was a national mortgage lender based in Orange, California. The company is the largest privately held retail mortgage lender in the United States and the largest subprime lender by volume...
, which was United States's leading wholesale lender, described a system in which they were pushed to falsify mortgage documents and then sell the mortgages to Wall Street banks eager to make fast profits. There is growing evidence that such mortgage fraud
Mortgage fraud
Mortgage fraud is crime in which the intent is to materially misrepresent or omit information on a mortgage loan application to obtain a loan or to obtain a larger loan than would have been obtained had the lender or borrower known the truth....
s may be a cause of the crisis.
Risk-taking behavior
In a June 2009 speech, U.S. President Barack ObamaBarack Obama
Barack Hussein Obama II is the 44th and current President of the United States. He is the first African American to hold the office. Obama previously served as a United States Senator from Illinois, from January 2005 until he resigned following his victory in the 2008 presidential election.Born in...
argued that a "culture of irresponsibility" was an important cause of the crisis. He criticized executive compensation that "rewarded recklessness rather than responsibility" and Americans who bought homes "without accepting the responsibilities." He continued that there "was far too much debt and not nearly enough capital in the system. And a growing economy bred complacency."
A key theme of the crisis is that many large financial institutions did not have a sufficient financial cushion to absorb the losses they sustained or to support the commitments made to others. Using technical terms, these firms were highly leveraged
Leverage (finance)
In finance, leverage is a general term for any technique to multiply gains and losses. Common ways to attain leverage are borrowing money, buying fixed assets and using derivatives. Important examples are:* A public corporation may leverage its equity by borrowing money...
(i.e., they maintained a high ratio of debt to equity) or had insufficient capital
Financial capital
Financial capital can refer to money used by entrepreneurs and businesses to buy what they need to make their products or provide their services or to that sector of the economy based on its operation, i.e. retail, corporate, investment banking, etc....
to post as collateral
Collateral (finance)
In lending agreements, collateral is a borrower's pledge of specific property to a lender, to secure repayment of a loan.The collateral serves as protection for a lender against a borrower's default - that is, any borrower failing to pay the principal and interest under the terms of a loan obligation...
for their borrowing. A key to a stable financial system is that firms have the financial capacity to support their commitments. Michael Lewis
Michael Lewis (author)
Michael Lewis is an American non-fiction author and financial journalist. His bestselling books include The Big Short: Inside the Doomsday Machine, Liar's Poker, The New New Thing, Moneyball: The Art of Winning an Unfair Game, The Blind Side: Evolution of a Game, Panic and Home Game: An...
and David Einhorn argued: "The most critical role for regulation is to make sure that the sellers of risk have the capital to support their bets."
Consumer and household borrowing
U.S. households and financial institutions became increasingly indebted or overleveraged during the years preceding the crisis. This increased their vulnerability to the collapse of the housing bubble and worsened the ensuing economic downturn.- USA household debt as a percentage of annual disposable personal income was 127% at the end of 2007, versus 77% in 1990.
- U.S. home mortgage debt relative to gross domestic productGross domestic productGross domestic product refers to the market value of all final goods and services produced within a country in a given period. GDP per capita is often considered an indicator of a country's standard of living....
(GDP) increased from an average of 46% during the 1990s to 73% during 2008, reaching $10.5 trillion. - In 1981, U.S. private debt was 123% of GDP; by the third quarter of 2008, it was 290%.
Home equity extraction
This refers to homeowners borrowing and spending against the value of their homes, typically via a home equity loan or when selling the home. Free cash used by consumers from home equity extraction doubled from $627 billion in 2001 to $1,428 billion in 2005 as the housing bubble built, a total of nearly $5 trillion dollars over the period, contributing to economic growth worldwide. U.S. home mortgage debt relative to GDP increased from an average of 46% during the 1990s to 73% during 2008, reaching $10.5 trillion.Housing speculation
Speculative borrowing in residential real estate has been cited as a contributing factor to the subprime mortgage crisis. During 2006, 22% of homes purchased (1.65 million units) were for investment purposes, with an additional 14% (1.07 million units) purchased as vacation homes. During 2005, these figures were 28% and 12%, respectively. In other words, a record level of nearly 40% of homes purchases were not intended as primary residences. David Lereah, NARNational Association of Realtors
The National Association of Realtors , whose members are known as Realtors, is North America's largest trade association. representing over 1.2 million members , including NAR's institutes, societies, and councils, involved in all aspects of the residential and commercial real estate industries...
's chief economist at the time, stated that the 2006 decline in investment buying was expected: "Speculators left the market in 2006, which caused investment sales to fall much faster than the primary market."
Housing prices nearly doubled between 2000 and 2006, a vastly different trend from the historical appreciation at roughly the rate of inflation. While homes had not traditionally been treated as investments subject to speculation, this behavior changed during the housing boom. Media widely reported condominiums being purchased while under construction, then being "flipped" (sold) for a profit without the seller ever having lived in them. Some mortgage companies identified risks inherent in this activity as early as 2005, after identifying investors assuming highly leveraged positions in multiple properties.
Nicole Gelinas of the Manhattan Institute
Manhattan Institute
The Manhattan Institute for Policy Research is a conservative, market-oriented think tank established in New York City in 1978 by Antony Fisher and William J...
described the negative consequences of not adjusting tax and mortgage policies to the shifting treatment of a home from conservative inflation hedge to speculative investment. Economist Robert Shiller
Robert Shiller
Robert James "Bob" Shiller is an American economist, academic, and best-selling author. He currently serves as the Arthur M. Okun Professor of Economics at Yale University and is a Fellow at the Yale International Center for Finance, Yale School of Management...
argued that speculative bubbles are fueled by "contagious optimism, seemingly impervious to facts, that often takes hold when prices are rising. Bubbles are primarily social phenomena; until we understand and address the psychology that fuels them, they're going to keep forming."
Pro-cyclical human nature
Keynesian economist Hyman MinskyHyman Minsky
Hyman Philip Minsky was an American economist and professor of economics at Washington University in St. Louis. His research attempted to provide an understanding and explanation of the characteristics of financial crises...
described how speculative borrowing contributed to rising debt and an eventual collapse of asset values.
Economist Paul McCulley
Paul McCulley
Paul Allen McCulley is a former managing director at PIMCO. He coined the terms Minsky moment and Shadow banking system which became famous during the Financial crisis of 2007-2009....
described how Minsky's hypothesis translates to the current crisis, using Minsky's words: "...from time to time, capitalist economies exhibit inflations and debt deflations which seem to have the potential to spin out of control. In such processes, the economic system's reactions to a movement of the economy amplify the movement--inflation feeds upon inflation and debt-deflation feeds upon debt deflation." In other words, people are momentum investors by nature, not value investors. People naturally take actions that expand the apex and nadir of cycles. One implication for policymakers and regulators is the implementation of counter-cyclical policies, such as contingent capital requirements for banks that increase during boom periods and are reduced during busts.
Corporate risk-taking and leverage
Citigroup
Citigroup Inc. or Citi is an American multinational financial services corporation headquartered in Manhattan, New York City, New York, United States. Citigroup was formed from one of the world's largest mergers in history by combining the banking giant Citicorp and financial conglomerate...
Charles O. Prince said in November 2007: "As long as the music is playing, you've got to get up and dance." This metaphor summarized how financial institutions took advantage of easy credit conditions, by borrowing and investing large sums of money, a practice called leveraged lending. Debt taken on by financial institutions increased from 63.8% of U.S. gross domestic product
Gross domestic product
Gross domestic product refers to the market value of all final goods and services produced within a country in a given period. GDP per capita is often considered an indicator of a country's standard of living....
in 1997 to 113.8% in 2007.
A 2004 SEC decision related to the net capital rule
Net capital rule
The uniform net capital rule is a rule created by the U.S. Securities and Exchange Commission in 1975 to regulate directly the ability of broker-dealers to meet their financial obligations to customers and other creditors...
allowed USA investment banks to issue substantially more debt, which was then used to help fund the housing bubble through purchases of mortgage-backed securities. From 2004-07, the top five U.S. investment banks each significantly increased their financial leverage (see diagram), which increased their vulnerability to a financial shock. These five institutions reported over $4.1 trillion in debt for fiscal year 2007, about 30% of USA nominal GDP for 2007. Lehman Brothers
Lehman Brothers
Lehman Brothers Holdings Inc. was a global financial services firm. Before declaring bankruptcy in 2008, Lehman was the fourth largest investment bank in the USA , doing business in investment banking, equity and fixed-income sales and trading Lehman Brothers Holdings Inc. (former NYSE ticker...
was liquidated, Bear Stearns
Bear Stearns
The Bear Stearns Companies, Inc. based in New York City, was a global investment bank and securities trading and brokerage, until its sale to JPMorgan Chase in 2008 during the global financial crisis and recession...
and Merrill Lynch
Merrill Lynch
Merrill Lynch is the wealth management division of Bank of America. With over 15,000 financial advisors and $2.2 trillion in client assets it is the world's largest brokerage. Formerly known as Merrill Lynch & Co., Inc., prior to 2009 the firm was publicly owned and traded on the New York...
were sold at fire-sale prices, and Goldman Sachs
Goldman Sachs
The Goldman Sachs Group, Inc. is an American multinational bulge bracket investment banking and securities firm that engages in global investment banking, securities, investment management, and other financial services primarily with institutional clients...
and Morgan Stanley
Morgan Stanley
Morgan Stanley is a global financial services firm headquartered in New York City serving a diversified group of corporations, governments, financial institutions, and individuals. Morgan Stanley also operates in 36 countries around the world, with over 600 offices and a workforce of over 60,000....
became commercial banks, subjecting themselves to more stringent regulation. With the exception of Lehman, these companies required or received government support.
Fannie Mae and Freddie Mac, two U.S. Government sponsored enterprises, owned or guaranteed nearly $5 trillion in mortgage obligations at the time they were placed into conservatorship
Conservatorship
Conservatorship is a legal concept in the United States of America, where an entity or organization is subjected to the legal control of an external entity or organization, known as a conservator. Conservatorship is established either by court order or via a statutory or regulatory authority...
by the U.S. government in September 2008.
These seven entities were highly leveraged and had $9 trillion in debt or guarantee obligations, an enormous concentration of risk, yet were not subject to the same regulation as depository banks.
In a May 2008 speech, Ben Bernanke
Ben Bernanke
Ben Shalom Bernanke is an American economist, and the current Chairman of the Federal Reserve, the central bank of the United States. During his tenure as Chairman, Bernanke has overseen the response of the Federal Reserve to late-2000s financial crisis....
quoted Walter Bagehot
Walter Bagehot
Walter Bagehot was an English businessman, essayist, and journalist who wrote extensively about literature, government, and economic affairs.-Early years:...
: "A good banker will have accumulated in ordinary times the reserve he is to make use of in extraordinary times." However, this advice was not heeded by these institutions, which had used the boom times to increase their leverage ratio instead.
In laissez-faire
Laissez-faire
In economics, laissez-faire describes an environment in which transactions between private parties are free from state intervention, including restrictive regulations, taxes, tariffs and enforced monopolies....
capitalism, financial institutions would be risk-averse because failure would result in liquidation
Liquidation
In law, liquidation is the process by which a company is brought to an end, and the assets and property of the company redistributed. Liquidation is also sometimes referred to as winding-up or dissolution, although dissolution technically refers to the last stage of liquidation...
. But the Federal Reserve's 1984 rescue of Continental Illinois and the 1998 rescue of the Long-Term Capital Management
Long-Term Capital Management
Long-Term Capital Management L.P. was a speculative hedge fund based in Greenwich, Connecticut that utilized absolute-return trading strategies combined with high leverage...
hedge fund
Hedge fund
A hedge fund is a private pool of capital actively managed by an investment adviser. Hedge funds are only open for investment to a limited number of accredited or qualified investors who meet criteria set by regulators. These investors can be institutions, such as pension funds, university...
, among others, showed that institutions which failed to exercise due diligence
Due diligence
"Due diligence" is a term used for a number of concepts involving either an investigation of a business or person prior to signing a contract, or an act with a certain standard of care. It can be a legal obligation, but the term will more commonly apply to voluntary investigations...
could reasonably expect to be protected from the consequences of their mistakes. The belief that they could not be allowed to fail
Too Big to Fail
Too Big to Fail is a television drama film in the United States broadcast on HBO on May 23, 2011. It is based on the non-fiction book Too Big to Fail by Andrew Ross Sorkin. The TV film was directed by Curtis Hanson...
created a moral hazard
Moral hazard
In economic theory, moral hazard refers to a situation in which a party makes a decision about how much risk to take, while another party bears the costs if things go badly, and the party insulated from risk behaves differently from how it would if it were fully exposed to the risk.Moral hazard...
which was a contributing factor to the late-2000s recession.
Financial market factors
In its "Declaration of the Summit on Financial Markets and the World Economy," dated 15 November 2008, leaders of the Group of 20G-20 major economies
The Group of Twenty Finance Ministers and Central Bank Governors is a group of finance ministers and central bank governors from 20 major economies: 19 countries plus the European Union, which is represented by the President of the European Council and by the European Central Bank...
cited the following causes related to features of the modern financial markets:
Financial product innovation
Financial innovation
There are several interpretations of the phrase financial innovation. In general, it refers to the creating and marketing of new types of securities.- Why does financial innovation occur? :...
refers to the ongoing development of financial products designed to achieve particular client objectives, such as offsetting a particular risk exposure (such as the default of a borrower) or to assist with obtaining financing. Examples pertinent to this crisis included: the adjustable-rate mortgage; the bundling of subprime mortgages into mortgage-backed securities (MBS) or collateralized debt obligations (CDO) for sale to investors, a type of securitization
Securitization
Securitization is the financial practice of pooling various types of contractual debt such as residential mortgages, commercial mortgages, auto loans or credit card debt obligations and selling said consolidated debt as bonds, pass-through securities, or Collateralized mortgage obligation , to...
; and a form of credit insurance called credit default swaps(CDS). The usage of these products expanded dramatically in the years leading up to the crisis. These products vary in complexity and the ease with which they can be valued on the books of financial institutions.
The CDO in particular enabled financial institutions to obtain investor funds to finance subprime and other lending, extending or increasing the housing bubble and generating large fees. Approximately $1.6 trillion in CDO's were originated between 2003-2007. A CDO essentially places cash payments from multiple mortgages or other debt obligations into a single pool, from which the cash is allocated to specific securities in a priority sequence. Those securities obtaining cash first received investment-grade ratings from rating agencies. Lower priority securities received cash thereafter, with lower credit ratings but theoretically a higher rate of return on the amount invested. A sample of 735 CDO deals originated between 1999 and 2007 showed that subprime and other less-than-prime mortgages represented an increasing percentage of CDO assets, rising from 5% in 2000 to 36% in 2007.
For a variety of reasons, market participants did not accurately measure the risk inherent with this innovation or understand its impact on the overall stability of the financial system. For example, the pricing model for CDOs clearly did not reflect the level of risk they introduced into the system. The average recovery rate for "high quality" CDOs has been approximately 32 cents on the dollar, while the recovery rate for mezzanine CDO's has been approximately five cents for every dollar. These massive, practically unthinkable, losses have dramatically impacted the balance sheets of banks across the globe, leaving them with very little capital to continue operations.
Others have pointed out that there were not enough of these loans made to cause a crisis of this magnitude. In an article in Portfolio Magazine, Michael Lewis
Michael Lewis (author)
Michael Lewis is an American non-fiction author and financial journalist. His bestselling books include The Big Short: Inside the Doomsday Machine, Liar's Poker, The New New Thing, Moneyball: The Art of Winning an Unfair Game, The Blind Side: Evolution of a Game, Panic and Home Game: An...
spoke with one trader who noted that "There weren’t enough Americans with [bad] credit taking out [bad loans] to satisfy investors’ appetite for the end product." Essentially, investment banks and hedge funds used financial innovation
Financial innovation
There are several interpretations of the phrase financial innovation. In general, it refers to the creating and marketing of new types of securities.- Why does financial innovation occur? :...
to synthesize more loans using derivatives
Derivative (finance)
A derivative instrument is a contract between two parties that specifies conditions—in particular, dates and the resulting values of the underlying variables—under which payments, or payoffs, are to be made between the parties.Under U.S...
. "They were creating [loans] out of whole cloth. One hundred times over! That’s why the losses are so much greater than the loans."
Princeton professor Harold James wrote that one of the byproducts of this innovation was that MBS and other financial assets were "repackaged so thoroughly and resold so often that it became impossible to clearly connect the thing being traded to its underlying value." He called this a "...profound flaw at the core of the U.S. financial system..."
Another example relates to AIG
AIG
AIG is American International Group, a major American insurance corporation.AIG may also refer to:* And-inverter graph, a concept in computer theory* Answers in Genesis, a creationist organization in the U.S.* Arta Industrial Group in Iran...
, which insured obligations of various financial institutions through the usage of credit default swaps. The basic CDS transaction involved AIG receiving a premium in exchange for a promise to pay money to party A in the event party B defaulted. However, AIG did not have the financial strength to support its many CDS commitments as the crisis progressed and was taken over by the government in September 2008. U.S. taxpayers provided over $180 billion in government support to AIG during 2008 and early 2009, through which the money flowed to various counterparties to CDS transactions, including many large global financial institutions.
Author Michael Lewis
Michael Lewis (author)
Michael Lewis is an American non-fiction author and financial journalist. His bestselling books include The Big Short: Inside the Doomsday Machine, Liar's Poker, The New New Thing, Moneyball: The Art of Winning an Unfair Game, The Blind Side: Evolution of a Game, Panic and Home Game: An...
wrote that CDS enabled speculators to stack bets on the same mortgage bonds and CDO's. This is analogous to allowing many persons to buy insurance on the same house. Speculators that bought CDS insurance were betting that significant defaults would occur, while the sellers (such as AIG
AIG
AIG is American International Group, a major American insurance corporation.AIG may also refer to:* And-inverter graph, a concept in computer theory* Answers in Genesis, a creationist organization in the U.S.* Arta Industrial Group in Iran...
) bet they would not. In addition, Chicago Public Radio and the Huffington Post reported in April 2010 that market participants, including a hedge fund called Magnetar Capital
Magnetar Capital
Magnetar Capital is a hedge fund based in Evanston, Illinois. Among its many activities, the firm was actively involved in the collateralized debt obligation market during the 2006–2007 period...
, encouraged the creation of CDO's containing low quality mortgages, so they could bet against them using CDS. NPR reported that Magnetar encouraged investors to purchase CDO's while simultaneously betting against them, without disclosing the latter bet.
Inaccurate credit ratings
Mortgage-backed security
A mortgage-backed security is an asset-backed security that represents a claim on the cash flows from mortgage loans through a process known as securitization.-Securitization:...
s based on risky subprime mortgage loans. These high ratings enabled these MBS to be sold to investors, thereby financing the housing boom. These ratings were believed justified because of risk reducing practices, such as credit default insurance and equity investors willing to bear the first losses. However, there are also indications that some involved in rating subprime-related securities knew at the time that the rating process was faulty.
An estimated $3.2 trillion in loans were made to homeowners with bad credit and undocumented incomes (e.g., subprime or Alt-A
Alt-A
An Alt-A mortgage, short for Alternative A-paper, is a type of U.S. mortgage that, for various reasons, is considered riskier than A-paper, or "prime", and less risky than "subprime," the riskiest category. Alt-A interest rates, which are determined by credit risk, therefore tend to be between...
mortgages) between 2002 and 2007. Economist Joseph Stiglitz stated: "I view the rating agencies as one of the key culprits...They were the party that performed the alchemy that converted the securities from F-rated to A-rated. The banks could not have done what they did without the complicity of the rating agencies." Without the AAA ratings, demand for these securities would have been considerably less. Bank writedowns and losses on these investments totaled $523 billion as of September 2008.
The ratings of these securities was a lucrative business for the rating agencies, accounting for just under half of Moody's
Moody's
Moody's Corporation is the holding company for Moody's Analytics and Moody's Investors Service, a credit rating agency which performs international financial research and analysis on commercial and government entities. The company also ranks the credit-worthiness of borrowers using a standardized...
total ratings revenue in 2007. Through 2007, ratings companies enjoyed record revenue, profits and share prices. The rating companies earned as much as three times more for grading these complex products than corporate bonds, their traditional business. Rating agencies also competed with each other to rate particular MBS and CDO securities issued by investment banks, which critics argued contributed to lower rating standards. Interviews with rating agency senior managers indicate the competitive pressure to rate the CDO's favorably was strong within the firms. This rating business was their "golden goose" (which laid the proverbial golden egg or wealth) in the words of one manager. Author Upton Sinclair
Upton Sinclair
Upton Beall Sinclair Jr. , was an American author who wrote close to one hundred books in many genres. He achieved popularity in the first half of the twentieth century, acquiring particular fame for his classic muckraking novel, The Jungle . It exposed conditions in the U.S...
(1878–1968) famously stated: "It is difficult to get a man to understand something when his job depends on not understanding it." From 2000-2006, structured finance (which includes CDO's) accounted for 40% of the revenues of the credit rating agencies. During that time, one major rating agency had its stock increase six-fold and its earnings grew by 900%.
Critics allege that the rating agencies suffered from conflicts of interest, as they were paid by investment banks and other firms that organize and sell structured securities to investors. On 11 June 2008, the SEC proposed rules designed to mitigate perceived conflicts of interest between rating agencies and issuers of structured securities. On 3 December 2008, the SEC approved measures to strengthen oversight of credit rating agencies, following a ten-month investigation that found "significant weaknesses in ratings practices," including conflicts of interest.
Between Q3 2007 and Q2 2008, rating agencies lowered the credit ratings on $1.9 trillion in mortgage backed securities. Financial institutions felt they had to lower the value of their MBS and acquire additional capital so as to maintain capital ratios. If this involved the sale of new shares of stock, the value of the existing shares was reduced. Thus ratings downgrades lowered the stock prices of many financial firms.
Lack of Transparency and Independence in Financial Modeling
The limitations of many, widely-used financial models also were not properly understood (see for example ). LiDavid X. Li
David X. Li is a quantitative analyst and a qualified actuary who in the early 2000s pioneered the use of Gaussian copula models for the pricing of collateralized debt obligations...
's Gaussian copula formula assumed that the price of CDS was correlated with and could predict the correct price of mortgage backed securities. Because it was highly tractable, it rapidly came to be used by a huge percentage of CDO and CDS investors, issuers, and rating agencies. According to one wired.com article: "Then the model fell apart. Cracks started appearing early on, when financial markets began behaving in ways that users of Li's formula hadn't expected. The cracks became full-fledged canyons in 2008—when ruptures in the financial system's foundation swallowed up trillions of dollars and put the survival of the global banking system in serious peril... Li's Gaussian copula formula will go down in history as instrumental in causing the unfathomable losses that brought the world financial system to its knees."
As financial assets became more complex, less transparent, and harder and harder to value, investors were reassured by the fact that both the international bond rating agencies and bank regulators, who came to rely on them, accepted as valid some complex mathematical models which theoretically showed the risks were much smaller than they actually proved to be in practice. George Soros
George Soros
George Soros is a Hungarian-American business magnate, investor, philosopher, and philanthropist. He is the chairman of Soros Fund Management. Soros supports progressive-liberal causes...
commented that "The super-boom got out of hand when the new products became so complicated that the authorities could no longer calculate the risks and started relying on the risk management methods of the banks themselves. Similarly, the rating agencies relied on the information provided by the originators of synthetic products. It was a shocking abdication of responsibility."
Off-balance sheet financing
Complex financing structures called structured investment vehicles (SIV) or conduits enabled banks to move significant amounts of assets and liabilities, including unsold CDO's, off their books. This had the effect of helping the banks maintain regulatory minimum capital ratiosCapital requirement
Capital requirement refers to -The standardized requirements in place for banks and other depository institutions, which determines how much capital is required to be held for a certain level of assets through regulatory agencies such as the Bank for International Settlements, Federal Deposit...
. They were then able to lend anew, earning additional fees. Author Robin Blackburn
Robin Blackburn
Robin Blackburn is a British socialist historian, a former editor of New Left Review , an author of essays on Marx, capitalism and socialism, and of books on the history of slavery and on social policy...
explained how they worked: Off balance sheet financing also made firms look less leveraged and enabled them to borrow at cheaper rates.
Banks had established automatic lines of credit to these SIV and conduits. When the cash flow into the SIV's began to decline as subprime defaults mounted, banks were contractually obligated to provide cash to these structures and their investors. This "conduit-related balance sheet pressure" placed strain on the banks' ability to lend, both raising interbank lending rates and reducing the availability of funds.
In the years leading up to the crisis, the top four U.S. depository banks moved an estimated $5.2 trillion in assets and liabilities off-balance sheet into these SIV's and conduits. This enabled them to essentially bypass existing regulations regarding minimum capital ratios, thereby increasing leverage and profits during the boom but increasing losses during the crisis. Accounting guidance was changed in 2009 that will require them to put some of these assets back onto their books, which will significantly reduce their capital ratios. One news agency estimated this amount to be between $500 billion and $1 trillion. This effect was considered as part of the stress tests performed by the government during 2009.
During March 2010, the bankruptcy court examiner released a report on Lehman Brothers
Lehman Brothers
Lehman Brothers Holdings Inc. was a global financial services firm. Before declaring bankruptcy in 2008, Lehman was the fourth largest investment bank in the USA , doing business in investment banking, equity and fixed-income sales and trading Lehman Brothers Holdings Inc. (former NYSE ticker...
, which had failed spectacularly in September 2008. The report indicated that up to $50 billion was moved off-balance sheet in a questionable manner by management during 2008, with the effect of making its debt level (leverage ratio) appear smaller. Analysis by the Federal Reserve Bank of New York indicated big banks mask their risk levels just prior to reporting data quarterly to the public.
Regulatory avoidance
Certain financial innovation may also have the effect of circumventing regulations, such as off-balance sheet financing that affects the leverage or capital cushion reported by major banks. For example, Martin WolfMartin Wolf
Martin Wolf, CBE is a British journalist, widely considered to be one of the world's most influential writers on economics. He is associate editor and chief economics commentator at the Financial Times.-Early life:...
wrote in June 2009: "...an enormous part of what banks did in the early part of this decade – the off-balance-sheet vehicles, the derivatives and the 'shadow banking system' itself – was to find a way round regulation."
Financial sector concentration
Niall FergusonNiall Ferguson
Niall Campbell Douglas Ferguson is a British historian. His specialty is financial and economic history, particularly hyperinflation and the bond markets, as well as the history of colonialism.....
wrote that the financial sector became increasingly concentrated in the years leading up to the crisis, which made the stability of the financial system more reliant on just a few firms, which were also highly leveraged:
By contrast, some scholars have argued that fragmentation in the mortgage securitization market led to increased risk taking and a deterioration in underwriting standards.
Macroeconomic conditions
Two important factors that contributed to the United states housing bubble were low U.S. interest rates and a large U.S. trade deficit. Low interest rates made bank lending more profitable, while trade deficits resulted in large capital inflows to the U.S. Both made funds for borrowing plentiful and relatively inexpensive.Interest rates
Federal funds rate
In the United States, the federal funds rate is the interest rate at which depository institutions actively trade balances held at the Federal Reserve, called federal funds, with each other, usually overnight, on an uncollateralized basis. Institutions with surplus balances in their accounts lend...
target from 6.5% to 1.0%. This was done to soften the effects of the collapse of the dot-com bubble
Dot-com bubble
The dot-com bubble was a speculative bubble covering roughly 1995–2000 during which stock markets in industrialized nations saw their equity value rise rapidly from growth in the more...
and of the September 2001 terrorist attacks, and to combat the perceived risk of deflation.
The Fed then raised the Fed funds rate significantly between July 2004 and July 2006. This contributed to an increase in 1-year and 5-year adjustable-rate mortgage (ARM) rates, making ARM interest rate resets more expensive for homeowners. This may have also contributed to the deflating of the housing bubble, as asset prices generally move inversely to interest rates and it became riskier to speculate in housing.
Globalization and Trade deficits
Globalization and trade imbalances contributed to enormous inflows of money into the U.S. from high savings countries, fueling debt-driven consumption and the housing bubble. The ratio of household debt to disposable income rose from 77% in 1990 to 127% by 2007. The steady entry into the world economy of new export-oriented economies began with Japan and the Asian tigers in the 1980s and peaked with China in the early 2000s, representing more than two billion newly employable workers. The integration of these high-savings, lower wage economies into the global economy, combined with dramatic productivity gains made possible by new information technologies and the globalization of corporate supply chains, decisively shifted the balance of global supply and demand. By 2000, the world economy was beset by excess supplies of labor, capital, and productive capacity relative to global demand. But the collapse of the consumer credit and housing price bubbles brought an end to this pattern of debt-financed economic growth and left the U.S. with the massive debt overhang.This globalization can be measured in growing trade deficits in developed countries such as the U.S. and Europe. In 2005, Ben Bernanke
Ben Bernanke
Ben Shalom Bernanke is an American economist, and the current Chairman of the Federal Reserve, the central bank of the United States. During his tenure as Chairman, Bernanke has overseen the response of the Federal Reserve to late-2000s financial crisis....
addressed the implications of the USA's high and rising current account
Current account
In economics, the current account is one of the two primary components of the balance of payments, the other being the capital account. The current account is the sum of the balance of trade , net factor income and net transfer payments .The current account balance is one of two major...
deficit, resulting from USA imports exceeding its exports. Between 1996 and 2004, the USA current account deficit increased by $650 billion, from 1.5% to 5.8% of GDP. Financing these deficits required the USA to borrow large sums from abroad, much of it from countries running trade surpluses, mainly the emerging economies in Asia and oil-exporting nations. The balance of payments
Balance of payments
Balance of payments accounts are an accounting record of all monetary transactions between a country and the rest of the world.These transactions include payments for the country's exports and imports of goods, services, financial capital, and financial transfers...
identity
Identity (mathematics)
In mathematics, the term identity has several different important meanings:*An identity is a relation which is tautologically true. This means that whatever the number or value may be, the answer stays the same. For example, algebraically, this occurs if an equation is satisfied for all values of...
requires that a country (such as the USA) running a current account
Current account
In economics, the current account is one of the two primary components of the balance of payments, the other being the capital account. The current account is the sum of the balance of trade , net factor income and net transfer payments .The current account balance is one of two major...
deficit also have a capital account
Capital account
The current and capital accounts make up a country's balance of payment . Together these three accounts tell a story about the state of an economy, its economic outlook and its strategies for achieving its desired goals...
(investment) surplus of the same amount. Hence large and growing amounts of foreign funds (capital) flowed into the USA to finance its imports. This created demand for various types of financial assets, raising the prices of those assets while lowering interest rates. Foreign investors had these funds to lend, either because they had very high personal savings rates (as high as 40% in China), or because of high oil prices. Bernanke referred to this as a "saving glut." A "flood" of funds (capital
Financial capital
Financial capital can refer to money used by entrepreneurs and businesses to buy what they need to make their products or provide their services or to that sector of the economy based on its operation, i.e. retail, corporate, investment banking, etc....
or liquidity) reached the USA financial markets. Foreign governments supplied funds by purchasing USA Treasury bonds and thus avoided much of the direct impact of the crisis. USA households, on the other hand, used funds borrowed from foreigners to finance consumption or to bid up the prices of housing and financial assets. Financial institutions invested foreign funds in mortgage-backed securities. USA housing and financial assets dramatically declined in value after the housing bubble burst.
Chinese mercantilism
Martin WolfMartin Wolf
Martin Wolf, CBE is a British journalist, widely considered to be one of the world's most influential writers on economics. He is associate editor and chief economics commentator at the Financial Times.-Early life:...
has argued that "inordinately mercantilist
Mercantilism
Mercantilism is the economic doctrine in which government control of foreign trade is of paramount importance for ensuring the prosperity and security of the state. In particular, it demands a positive balance of trade. Mercantilism dominated Western European economic policy and discourse from...
currency policies" were a significant cause of the U.S. trade deficit, indirectly driving a flood of money into the U.S. as described above. In his view, China maintained an artificially weak currency to make Chinese goods relatively cheaper for foreign countries to purchase, thereby keeping its vast workforce occupied and encouraging exports to the U.S. One byproduct was a large accumulation of U.S. dollars by the Chinese government, which were then invested in U.S. government securities and those of Fannie Mae and Freddie Mac, providing additional funds for lending that contributed to the housing bubble.
Economist Paul Krugman
Paul Krugman
Paul Robin Krugman is an American economist, professor of Economics and International Affairs at the Woodrow Wilson School of Public and International Affairs at Princeton University, Centenary Professor at the London School of Economics, and an op-ed columnist for The New York Times...
also wrote similar comments during October 2009, further arguing that China's currency should have appreciated relative to the U.S. dollar beginning around 2001. Various U.S. officials have also indicated concerns with Chinese exchange rate policies, which have not allowed its currency to appreciate significantly relative to the dollar despite large trade surpluses. In January 2009, Timothy Geithner wrote: "Obama -- backed by the conclusions of a broad range of economists -- believes that China is manipulating its currency...the question is how and when to broach the subject in order to do more good than harm."
End of a long wave
The cause of the crisis can be seen also in principles of technological developmentTechnological change
Technological change is a term that is used to describe the overall process of invention, innovation and diffusion of technology or processes. The term is synonymous with technological development, technological achievement, and technological progress...
and in long economic waves based on technological revolutions. Daniel Šmihula
Daniel Šmihula
JUDr. MUDr. Daniel Šmihula PhD. Dr.iur. is a Slovak lawyer, political scientist, journalist and writer.- Life :...
believes that this crisis and stagnation are a result of the end of the long economic cycle originally initiated by the Information and telecommunications technological revolution in 1985-2000.
The market has been already saturated by new “technical wonders” (e.g. everybody has his own mobile phone) and – what is more important - in the developed countries the economy reached limits of productivity
Productivity
Productivity is a measure of the efficiency of production. Productivity is a ratio of what is produced to what is required to produce it. Usually this ratio is in the form of an average, expressing the total output divided by the total input...
in conditions of existing technologies. A new economic revival can come only with a new technological revolution (a hypothetical Post-informational technological revolution). Šmihula expects that it will happen in about 2014-15.
Private capital and the search for yield
In a Peabody AwardPeabody Award
The George Foster Peabody Awards recognize distinguished and meritorious public service by radio and television stations, networks, producing organizations and individuals. In 1939, the National Association of Broadcasters formed a committee to recognize outstanding achievement in radio broadcasting...
winning program, NPR correspondents argued that a "Giant Pool of Money" (represented by $70 trillion in worldwide fixed income investments) sought higher yields than those offered by U.S. Treasury bonds early in the decade, which were low due to low interest rates and trade deficits discussed above. Further, this pool of money had roughly doubled in size from 2000 to 2007, yet the supply of relatively safe, income generating investments had not grown as fast. Investment banks on Wall Street answered this demand with the mortgage-backed security
Mortgage-backed security
A mortgage-backed security is an asset-backed security that represents a claim on the cash flows from mortgage loans through a process known as securitization.-Securitization:...
(MBS) and collateralized debt obligation
Collateralized debt obligation
Collateralized debt obligations are a type of structured asset-backed security with multiple "tranches" that are issued by special purpose entities and collateralized by debt obligations including bonds and loans. Each tranche offers a varying degree of risk and return so as to meet investor demand...
(CDO), which were assigned safe ratings by the credit rating agencies. In effect, Wall Street connected this pool of money to the mortgage market in the U.S., with enormous fees accruing to those throughout the mortgage supply chain, from the mortgage broker selling the loans, to small banks that funded the brokers, to the giant investment banks behind them. By approximately 2003, the supply of mortgages originated at traditional lending standards had been exhausted. However, continued strong demand for MBS and CDO began to drive down lending standards, as long as mortgages could still be sold along the supply chain. Eventually, this speculative bubble proved unsustainable.
Significance of the parallel banking system
In a June 2008 speech, U.S. Treasury Secretary Timothy Geithner, then President and CEO of the NY Federal Reserve Bank, placed significant blame for the freezing of credit markets on a "run" on the entities in the "parallel" banking system, also called the shadow banking systemShadow banking system
The shadow banking system is the infrastructure and practices which support financial transactions that occur beyond the reach of existing state sanctioned monitoring and regulation. It includes entities such as hedge funds, money market funds and Structured investment vehicles...
. These entities became critical to the credit markets underpinning the financial system, but were not subject to the same regulatory controls. Further, these entities were vulnerable because they borrowed short-term in liquid markets to purchase long-term, illiquid and risky assets. This meant that disruptions in credit markets would make them subject to rapid deleveraging, selling their long-term assets at depressed prices. He described the significance of these entities: "In early 2007, asset-backed commercial paper conduits, in structured investment vehicles, in auction-rate preferred securities, tender option bonds and variable rate demand notes, had a combined asset size of roughly $2.2 trillion. Assets financed overnight in triparty repo grew to $2.5 trillion. Assets held in hedge funds grew to roughly $1.8 trillion. The combined balance sheets of the then five major investment banks totaled $4 trillion. In comparison, the total assets of the top five bank holding companies in the United States at that point were just over $6 trillion, and total assets of the entire banking system were about $10 trillion." He stated that the "combined effect of these factors was a financial system vulnerable to self-reinforcing asset price and credit cycles."
Run on the shadow banking system
Nobel laureate and liberal political columnist Paul KrugmanPaul Krugman
Paul Robin Krugman is an American economist, professor of Economics and International Affairs at the Woodrow Wilson School of Public and International Affairs at Princeton University, Centenary Professor at the London School of Economics, and an op-ed columnist for The New York Times...
described the run on the shadow banking system as the "core of what happened" to cause the crisis. "As the shadow banking system expanded to rival or even surpass conventional banking in importance, politicians and government officials should have realized that they were re-creating the kind of financial vulnerability that made the Great Depression possible—and they should have responded by extending regulations and the financial safety net to cover these new institutions. Influential figures should have proclaimed a simple rule: anything that does what a bank does, anything that has to be rescued in crises the way banks are, should be regulated like a bank." He referred to this lack of controls as "malign neglect." Some researchers have suggested that competition between GSEs and the shadow banking system led to a deterioration in underwriting standards.
For example, investment bank Bear Stearns
Bear Stearns
The Bear Stearns Companies, Inc. based in New York City, was a global investment bank and securities trading and brokerage, until its sale to JPMorgan Chase in 2008 during the global financial crisis and recession...
was required to replenish much of its funding in overnight markets, making the firm vulnerable to credit market disruptions. When concerns arose regarding its financial strength, its ability to secure funds in these short-term markets was compromised, leading to the equivalent of a bank run. Over four days, its available cash declined from $18 billion to $3 billion as investors pulled funding from the firm. It collapsed and was sold at a fire-sale price to bank JP Morgan Chase March 16, 2008.
American homeowners, consumers, and corporations owed roughly $25 trillion during 2008. American banks retained about $8 trillion of that total directly as traditional mortgage loans. Bondholders and other traditional lenders provided another $7 trillion. The remaining $10 trillion came from the securitization markets, meaning the parallel banking system. The securitization markets started to close down in the spring of 2007 and nearly shut-down in the fall of 2008. More than a third of the private credit markets thus became unavailable as a source of funds. In February 2009, Ben Bernanke
Ben Bernanke
Ben Shalom Bernanke is an American economist, and the current Chairman of the Federal Reserve, the central bank of the United States. During his tenure as Chairman, Bernanke has overseen the response of the Federal Reserve to late-2000s financial crisis....
stated that securitization markets remained effectively shut, with the exception of conforming mortgages, which could be sold to Fannie Mae and Freddie Mac.
The Economist
The Economist
The Economist is an English-language weekly news and international affairs publication owned by The Economist Newspaper Ltd. and edited in offices in the City of Westminster, London, England. Continuous publication began under founder James Wilson in September 1843...
reported in March 2010: "Bear Stearns and Lehman Brothers were non-banks that were crippled by a silent run among panicky overnight "repo
Repurchase agreement
A repurchase agreement, also known as a repo, RP, or sale and repurchase agreement, is the sale of securities together with an agreement for the seller to buy back the securities at a later date. The repurchase price should be greater than the original sale price, the difference effectively...
" lenders, many of them money market funds uncertain about the quality of securitized collateral they were holding. Mass redemptions from these funds after Lehman's failure froze short-term funding for big firms."
Mortgage compensation model, executive pay and bonuses
During the boom period, enormous fees were paid to those throughout the mortgage supply chain, from the mortgage broker selling the loans, to small banks that funded the brokers, to the giant investment banks behind them. Those originating loans were paid fees for selling them, regardless of how the loans performed. Default or credit riskCredit risk
Credit risk is an investor's risk of loss arising from a borrower who does not make payments as promised. Such an event is called a default. Other terms for credit risk are default risk and counterparty risk....
was passed from mortgage originators to investors using various types of financial innovation
Financial innovation
There are several interpretations of the phrase financial innovation. In general, it refers to the creating and marketing of new types of securities.- Why does financial innovation occur? :...
. This became known as the "originate to distribute" model, as opposed to the traditional model where the bank originating the mortgage retained the credit risk. In effect, the mortgage originators were left with nothing which was at risk, giving rise to moral hazard
Moral hazard
In economic theory, moral hazard refers to a situation in which a party makes a decision about how much risk to take, while another party bears the costs if things go badly, and the party insulated from risk behaves differently from how it would if it were fully exposed to the risk.Moral hazard...
in which behavior and consequence were separated.
Economist Mark Zandi
Mark Zandi
Mark Zandi is an Iranian American economist and co-founder of Moody's Economy.com, a widely-cited source of economic analysis.. Moody's Economy.com is part of Moody's Analytics. Prior to founding Economy.com, Zandi was a regional economist at Chase Econometrics.He was born in Atlanta, Georgia of...
described moral hazard
Moral hazard
In economic theory, moral hazard refers to a situation in which a party makes a decision about how much risk to take, while another party bears the costs if things go badly, and the party insulated from risk behaves differently from how it would if it were fully exposed to the risk.Moral hazard...
as a root cause of the subprime mortgage crisis
Subprime mortgage crisis
The U.S. subprime mortgage crisis was one of the first indicators of the late-2000s financial crisis, characterized by a rise in subprime mortgage delinquencies and foreclosures, and the resulting decline of securities backed by said mortgages....
. He wrote: "...the risks inherent in mortgage lending became so widely dispersed that no one was forced to worry about the quality of any single loan. As shaky mortgages were combined, diluting any problems into a larger pool, the incentive for responsibility was undermined." He also wrote: "Finance companies weren't subject to the same regulatory oversight as banks. Taxpayers weren't on the hook if they went belly up [pre-crisis], only their shareholders and other creditors were. Finance companies thus had little to discourage them from growing as aggressively as possible, even if that meant lowering or winking at traditional lending standards."
The New York State Comptroller's Office has said that in 2006, Wall Street executives took home bonuses totaling $23.9 billion. "Wall Street traders were thinking of the bonus at the end of the year, not the long-term health of their firm. The whole system—from mortgage brokers to Wall Street risk managers—seemed tilted toward taking short-term risks while ignoring long-term obligations. The most damning evidence is that most of the people at the top of the banks didn't really understand how those [investments] worked."
Investment banker incentive compensation was focused on fees generated from assembling financial products, rather than the performance of those products and profits generated over time. Their bonuses were heavily skewed towards cash rather than stock and not subject to "claw-back" (recovery of the bonus from the employee by the firm) in the event the MBS or CDO created did not perform. In addition, the increased risk (in the form of financial leverage) taken by the major investment banks was not adequately factored into the compensation of senior executives.
Bank CEO Jamie Dimon
Jamie Dimon
James "Jamie" Dimon is a business executive. He is the current chairman, president and chief executive of JPMorgan Chase, and previously served as a Class A director of the Board of Directors of the New York Federal Reserve, a three year term which started January 2007...
argued: "Rewards have to track real, sustained, risk-adjusted performance. Golden parachutes, special contracts, and unreasonable perks must disappear. There must be a relentless focus on risk management that starts at the top of the organization and permeates down to the entire firm. This should be business-as-usual, but at too many places, it wasn't."
Regulation and Deregulation
Critics have argued that the regulatory framework did not keep pace with financial innovationFinancial innovation
There are several interpretations of the phrase financial innovation. In general, it refers to the creating and marketing of new types of securities.- Why does financial innovation occur? :...
, such as the increasing importance of the shadow banking system
Shadow banking system
The shadow banking system is the infrastructure and practices which support financial transactions that occur beyond the reach of existing state sanctioned monitoring and regulation. It includes entities such as hedge funds, money market funds and Structured investment vehicles...
, derivatives
Derivative (finance)
A derivative instrument is a contract between two parties that specifies conditions—in particular, dates and the resulting values of the underlying variables—under which payments, or payoffs, are to be made between the parties.Under U.S...
and off-balance sheet financing. In other cases, laws were changed or enforcement weakened in parts of the financial system. Several critics have argued that the most critical role for regulation is to make sure that financial institutions have the ability or capital to deliver on their commitments. Critics have also noted de facto deregulation through a shift in market share toward the least regulated portions of the mortgage market.
Key examples of regulatory failures include:
- In 1999, the U.S. Congress passed the Gramm-Leach-Bliley ActGramm-Leach-Bliley ActThe Gramm–Leach–Bliley Act , also known as the Financial Services Modernization Act of 1999, is an act of the 106th United States Congress...
, which repealed part of the Glass–Steagall Act of 1933. This repeal has been criticized for reducing the separation between commercial banks (which traditionally had a conservative culture) and investment banks (which had a more risk-taking culture). - In 2004, the Securities and Exchange Commission relaxed the net capital ruleNet capital ruleThe uniform net capital rule is a rule created by the U.S. Securities and Exchange Commission in 1975 to regulate directly the ability of broker-dealers to meet their financial obligations to customers and other creditors...
, which enabled investment banks to substantially increase the level of debt they were taking on, fueling the growth in mortgage-backed securities supporting subprime mortgages. The SEC has conceded that self-regulation of investment banks contributed to the crisis. - Financial institutions in the shadow banking systemShadow banking systemThe shadow banking system is the infrastructure and practices which support financial transactions that occur beyond the reach of existing state sanctioned monitoring and regulation. It includes entities such as hedge funds, money market funds and Structured investment vehicles...
are not subject to the same regulation as depository banks, allowing them to assume additional debt obligations relative to their financial cushion or capital base. This was the case despite the Long-Term Capital ManagementLong-Term Capital ManagementLong-Term Capital Management L.P. was a speculative hedge fund based in Greenwich, Connecticut that utilized absolute-return trading strategies combined with high leverage...
debacle in 1998, where a highly-leveraged shadow institution failed with systemic implications. - Regulators and accounting standard-setters allowed depository banks such as CitigroupCitigroupCitigroup Inc. or Citi is an American multinational financial services corporation headquartered in Manhattan, New York City, New York, United States. Citigroup was formed from one of the world's largest mergers in history by combining the banking giant Citicorp and financial conglomerate...
to move significant amounts of assets and liabilities off-balance sheet into complex legal entities called structured investment vehicles, masking the weakness of the capital base of the firm or degree of leverage or risk taken. One news agency estimated that the top four U.S. banks will have to return between $500 billion and $1 trillion to their balance sheets during 2009. This increased uncertainty during the crisis regarding the financial position of the major banks. Off-balance sheet entities were also used by EnronEnron scandalThe Enron scandal, revealed in October 2001, eventually led to the bankruptcy of the Enron Corporation, an American energy company based in Houston, Texas, and the dissolution of Arthur Andersen, which was one of the five largest audit and accountancy partnerships in the world...
as part of the scandal that brought down that company in 2001. - The U.S. Congress allowed the self-regulation of the derivatives market when it passed the Commodity Futures Modernization Act of 2000Commodity Futures Modernization Act of 2000The Commodity Futures Modernization Act of 2000 is United States federal legislation that officially ensured the deregulation of financial products known as over-the-counter derivatives. It was signed into law on December 21, 2000 by President Bill Clinton...
. Derivatives such as credit default swaps (CDS) can be used to hedge or speculate against particular credit risks. The volume of CDS outstanding increased 100-fold from 1998 to 2008, with estimates of the debt covered by CDS contracts, as of November 2008, ranging from US$33 to $47 trillion. Total over-the-counter (OTC) derivative notional value rose to $683 trillion by June 2008. Warren BuffettWarren BuffettWarren Edward Buffett is an American business magnate, investor, and philanthropist. He is widely regarded as one of the most successful investors in the world. Often introduced as "legendary investor, Warren Buffett", he is the primary shareholder, chairman and CEO of Berkshire Hathaway. He is...
famously referred to derivatives as "financial weapons of mass destruction" in early 2003.
Author Roger Lowenstein
Roger Lowenstein
Roger Lowenstein is an American financial journalist and writer. He graduated from Cornell University and reported for the Wall Street Journal for more than a decade, including two years writing its Heard on the Street column, 1989 to 1991. Born in 1955, he is the son of Helen and Louis Lowenstein...
summarized some of the regulatory problems that caused the crisis in November 2009: "1) Mortgage regulation was too lax and in some cases nonexistent; 2) Capital requirements for banks were too low; 3) Trading in derivatives such as credit default swaps posed giant, unseen risks; 4) Credit ratings on structured securities such as collateralized-debt obligations were deeply flawed; 5) Bankers were moved to take on risk by excessive pay packages; 6) The government’s response to the crash also created, or exacerbated, moral hazard. Markets now expect that big banks won’t be allowed to fail, weakening the incentives of investors to discipline big banks and keep them from piling up too many risky assets again."
Conflicts of interest and lobbying
A variety of conflicts of interestConflicts of Interest
"Conflicts of Interest" is an episode from the fourth season of the science fiction television series Babylon 5.-Arc significance:* Garibaldi begins to work for William Edgars. In the process Garibaldi is reintroduced to his ex-girlfriend, Lise, who is currently married to Edgars.* The "Voice of...
have been argued as contributing to this crisis:
- Credit rating agencies are compensated for rating debt securities by those issuing the securities, who have an interest in seeing the most positive ratings applied. Further, changing the debt rating on a company that insures multiple debt securities such as AIGAIGAIG is American International Group, a major American insurance corporation.AIG may also refer to:* And-inverter graph, a concept in computer theory* Answers in Genesis, a creationist organization in the U.S.* Arta Industrial Group in Iran...
or MBIA, requires the re-rating of many other securities, creating significant costs. Despite taking on significantly more risk, AIG and MBIA retained the highest credit ratings until well into the crisis. - There is a "revolving door" between major financial institutions, the Treasury Department, and Treasury bailout programs. For example, the former CEO of Goldman SachsGoldman SachsThe Goldman Sachs Group, Inc. is an American multinational bulge bracket investment banking and securities firm that engages in global investment banking, securities, investment management, and other financial services primarily with institutional clients...
was Henry PaulsonHenry PaulsonHenry Merritt "Hank" Paulson, Jr. is an American banker who served as the 74th United States Secretary of the Treasury. He previously served as the Chairman and Chief Executive Officer of Goldman Sachs.-Early life and family:...
, who became President George W. Bush's Treasury Secretary. Although three of Goldman's key competitors either failed or were allowed to fail, it received $10 billion in Troubled Asset Relief Program (TARP) funds (which it has since paid back) and $12.9 billion in payments via AIG, while remaining highly profitable and paying enormous bonuses. The first two officials in charge of the TARP bailout program were also from Goldman. - There is a "revolving door" between major financial institutions and the Securities and Exchange Commission (SEC), which is supposed to monitor them. For example, as of January 2009, the SEC's two most recent Directors of Enforcement had taken positions at powerful banks directly after leaving the role. The route into lucrative positions with banks places a financial incentive on regulators to maintain good relationships with those they monitor. This is sometimes referred to as regulatory captureRegulatory captureIn economics, regulatory capture occurs when a state regulatory agency created to act in the public interest instead advances the commercial or special interests that dominate the industry or sector it is charged with regulating. Regulatory capture is a form of government failure, as it can act as...
.
Banks in the U.S. lobby politicians extensively. A November 2009 report from economists of the International Monetary Fund
International Monetary Fund
The International Monetary Fund is an organization of 187 countries, working to foster global monetary cooperation, secure financial stability, facilitate international trade, promote high employment and sustainable economic growth, and reduce poverty around the world...
(IMF) writing independently of that organization indicated that:
- Firms that lobby aggressively are more likely to engage in risky securitization of their loan books, have faster-growing mortgage loan portfolios as well as poorer share performance and larger loan defaults;
- Thirty-three legislative proposals that would have increased regulatory scrutiny over banks were the targets of intense and successful lobbying;
- US business spends $4.2 billion over the four-year election cycle on "targeted political activity", with finance, insurance and real estate ("FIRE") firms accounting for 15% of that total ($479,500 per firm) in 2006; and
- The "lobbying intensity" of the FIRE sector also "increased at a much faster pace relative to the average lobbying intensity over 1999-2006."
The study concluded that: "the prevention of future crises might require weakening political influence of the financial industry or closer monitoring of lobbying activities to understand better the incentives behind it."
The Boston Globe reported during that during January–June 2009, the largest four U.S. banks spent these amounts ($ millions) on lobbying, despite receiving taxpayer bailouts: Citigroup $3.1; JP Morgan Chase $3.1; Bank of America $1.5; and Wells Fargo $1.4.
The New York Times reported in April 2010: "An analysis by Public Citizen found that at least 70 former members of Congress were lobbying for Wall Street and the financial services sector last year, including two former Senate majority leaders (Trent Lott and Bob Dole), two former House majority leaders (Richard A. Gephardt and Dick Armey) and a former House speaker (J. Dennis Hastert). In addition to the lawmakers, data from the Center for Responsive Politics counted 56 former Congressional aides on the Senate or House banking committees who went on to use their expertise to lobby for the financial sector."
The Financial Crisis Inquiry Commission
Financial Crisis Inquiry Commission
The Commission reported its findings in January 2011. It concluded that "the crisis was avoidable and was caused by: Widespread failures in financial regulation, including the Federal Reserve’s failure to stem the...
reported in January 2011 that "...from 1998 to 2008, the financial sector expended $2.7 billion in reported federal lobbying expenses; individuals and political action committees in the sector made more than $1 billion in campaign contributions."
Commodity price volatility
A commodity price bubble was created following the collapse in the housing bubble. The price of oil nearly tripled from $50 to $140 from early 2007 to 2008, before plunging as the financial crisis began to take hold in late 2008. Experts debate the causes, which include the flow of money from housing and other investments into commodities to speculation and monetary policy. An increase in oil prices tends to divert a larger share of consumer spending into gasoline, which creates downward pressure on economic growth in oil importing countries, as wealth flows to oil-producing states. Spiking instability in the price of oil over the decade leading up to the price high of 2008 has also been proposed as a causal factor in the financial crisis.Inaccurate economic forecasting
A cover story in BusinessWeekBusinessWeek
Bloomberg Businessweek, commonly and formerly known as BusinessWeek, is a weekly business magazine published by Bloomberg L.P. It is currently headquartered in New York City.- History :...
magazine claims that economists mostly failed to predict the worst international economic crisis since the Great Depression
Great Depression
The Great Depression was a severe worldwide economic depression in the decade preceding World War II. The timing of the Great Depression varied across nations, but in most countries it started in about 1929 and lasted until the late 1930s or early 1940s...
of 1930s. The Wharton School of the University of Pennsylvania
Wharton School of the University of Pennsylvania
The Wharton School is the business school of the University of Pennsylvania, an Ivy League university in Philadelphia, Pennsylvania. Wharton was the world’s first collegiate business school and the first business school in the United States...
online business journal examines why economists failed to predict a major global financial crisis. An article in the New York Times informs that economist Nouriel Roubini
Nouriel Roubini
Nouriel Roubini is an American economist. He claims to have predicted both the collapse of the United States housing market and the worldwide recession which started in 2008. He teaches at New York University's Stern School of Business and is the chairman of Roubini Global Economics, an economic...
warned of such crisis as early as September 2006, and the article goes on to state that the profession of economics is bad at predicting recessions. According to The Guardian
The Guardian
The Guardian, formerly known as The Manchester Guardian , is a British national daily newspaper in the Berliner format...
, Roubini was ridiculed for predicting a collapse of the housing market and worldwide recession, while The New York Times labelled him "Dr. Doom". However, there are examples of other experts who gave indications of a financial crisis.
Monetary expansion and uncertainty
An empirical study by John B. TaylorJohn B. Taylor
John Brian Taylor is the Mary and Robert Raymond Professor of Economics at Stanford University, and the George P. Shultz Senior Fellow in Economics at Stanford University's Hoover Institution....
concluded that the crisis was: (1) caused by excess monetary expansion; (2) prolonged by an inability to evaluate counter-party risk due to opaque financial statements; and (3) worsened by the unpredictable nature of government's response to the crisis.
Mark-to-Market Accounting
The appropriate valuation of complex and illiquid securities such as MBS and CDO held as assets on the books of financial institutions has been an ongoing debate during the crisis. The debate arises because accounting rules require companies to adjust the value of such securities to market value, as opposed to the original price paid. Many large financial institutions recognized significant losses during 2007 and 2008, as a result of marking-down MBS asset prices to market value. For some institutions, this also triggered a margin callMargin Call
Margin Call is a 2011 American independent drama film, written and directed by J.C. Chandor. The film has an ensemble cast that includes Kevin Spacey, Demi Moore, Paul Bettany, Jeremy Irons, Zachary Quinto, Stanley Tucci, Simon Baker, and Penn Badgley...
, where lenders that had provided the funds using the MBS as collateral had contractual rights to get their money back. The combination of losses and margin calls resulted in further forced sales of MBS and emergency efforts to obtain cash (liquidity). Markdowns may also reduce the value of bank regulatory capital, requiring additional capital raising and creating uncertainty regarding the health of the bank. In other words, writing down the assets presented both liquidity and solvency challenges. Advocates argued that the rule enabled the most accurate estimate of the financial health of the banks.
Systemic crisis
Another analysis, different from the mainstreamMainstream
Mainstream is, generally, the common current thought of the majority. However, the mainstream is far from cohesive; rather the concept is often considered a cultural construct....
explanation, is that the financial crisis is merely a symptom of another, deeper crisis, which is a systemic crisis of capitalism
Capitalism
Capitalism is an economic system that became dominant in the Western world following the demise of feudalism. There is no consensus on the precise definition nor on how the term should be used as a historical category...
itself. According to Samir Amin
Samir Amin
Samir Amin is an Egyptian economist. He currently lives in Dakar, Senegal.- Biography :Samir Amin was born in Cairo, the son of an Egyptian father and a French mother . He spent his childhood and youth in Port Said; there he attended a French High School, leaving in 1947 with a Baccalauréat...
, an Egyptian economist, the constant decrease in GDP
Gross domestic product
Gross domestic product refers to the market value of all final goods and services produced within a country in a given period. GDP per capita is often considered an indicator of a country's standard of living....
growth
Economic growth
In economics, economic growth is defined as the increasing capacity of the economy to satisfy the wants of goods and services of the members of society. Economic growth is enabled by increases in productivity, which lowers the inputs for a given amount of output. Lowered costs increase demand...
rates in Western countries
Western world
The Western world, also known as the West and the Occident , is a term referring to the countries of Western Europe , the countries of the Americas, as well all countries of Northern and Central Europe, Australia and New Zealand...
since the early 1970s created a growing surplus of capital which did not have sufficient profitable investment outlets in the real economy
Economy
An economy consists of the economic system of a country or other area; the labor, capital and land resources; and the manufacturing, trade, distribution, and consumption of goods and services of that area...
. The alternative was to place this surplus into the financial market, which became more profitable than productive capital
Capital (economics)
In economics, capital, capital goods, or real capital refers to already-produced durable goods used in production of goods or services. The capital goods are not significantly consumed, though they may depreciate in the production process...
investment
Investment
Investment has different meanings in finance and economics. Finance investment is putting money into something with the expectation of gain, that upon thorough analysis, has a high degree of security for the principal amount, as well as security of return, within an expected period of time...
, especially with subsequent deregulation. According to Samir Amin, this phenomenon has led to recurrent financial bubbles
Economic bubble
An economic bubble is "trade in high volumes at prices that are considerably at variance with intrinsic values"...
(such as the internet bubble) and is the deep cause of the financial crisis of 2007-2009.
John Bellamy Foster
John Bellamy Foster
John Bellamy Foster is a professor of sociology at the University of Oregon and also editor of Monthly Review, an independent socialist magazine. His writings have focused on political economy, environmental sociology, and Marxist theory...
, a political economy analyst and editor of the Monthly Review
Monthly Review
Monthly Review is an independent Marxist journal published 11 times per year in New York City.-History:The publication was founded by Harvard University economics instructor Paul Sweezy, who became the first editor...
, believes that the decrease in GDP
Gross domestic product
Gross domestic product refers to the market value of all final goods and services produced within a country in a given period. GDP per capita is often considered an indicator of a country's standard of living....
growth
Economic growth
In economics, economic growth is defined as the increasing capacity of the economy to satisfy the wants of goods and services of the members of society. Economic growth is enabled by increases in productivity, which lowers the inputs for a given amount of output. Lowered costs increase demand...
rates since the early 1970s is due to increasing market saturation
Market saturation
In economics, "market saturation" is a term used to describe a situation in which a product has become diffused within a market; the actual level of saturation can depend on consumer purchasing power; as well as competition, prices, and technology....
.
John C. Bogle wrote during 2005 that a series of unresolved challenges face capitalism that have contributed to past financial crises and have not been sufficiently addressed: "Corporate America went astray largely because the power of managers went virtually unchecked by our gatekeepers for far too long...They failed to 'keep an eye on these geniuses' to whom they had entrusted the responsibility of the management of America's great corporations." He cites particular issues, including:
- "Manager's capitalism" which he argues has replaced "owner's capitalism," meaning management runs the firm for its benefit rather than for the shareholders, a variation on the principal–agent problem;
- Burgeoning executive compensation;
- Managed earnings, mainly a focus on share price rather than the creation of genuine value; and
- The failure of gatekeepers, including auditors, boards of directors, Wall Street analysts, and career politicians.
Interaction of the housing and financial markets
Thomas Friedman
Thomas Friedman
Thomas Lauren Friedman is an American journalist, columnist and author. He writes a twice-weekly column for The New York Times. He has written extensively on foreign affairs including global trade, the Middle East, and environmental issues and has won the Pulitzer Prize three times.-Personal...
summarized some of this interaction in November 2008:
Questionable assumptions underlying the financial system
Various experts have summarized the causes as a series of questionable assumptions underlying the U.S. financial and economic system.- Housing prices would not fall dramatically. Warren BuffettWarren BuffettWarren Edward Buffett is an American business magnate, investor, and philanthropist. He is widely regarded as one of the most successful investors in the world. Often introduced as "legendary investor, Warren Buffett", he is the primary shareholder, chairman and CEO of Berkshire Hathaway. He is...
testified to the Financial Crisis Inquiry CommissionFinancial Crisis Inquiry CommissionThe Commission reported its findings in January 2011. It concluded that "the crisis was avoidable and was caused by: Widespread failures in financial regulation, including the Federal Reserve’s failure to stem the...
: "There was the greatest bubble I've ever seen in my life...The entire American public eventually was caught up in a belief that housing prices could not fall dramatically." Housing prices declined on average by approximately 20% from their 2006 peak to 2009 bottom, with much larger declines in certain markets.
Former Fed Chair Paul Volcker
Paul Volcker
Paul Adolph Volcker, Jr. is an American economist. He was the Chairman of the Federal Reserve under United States Presidents Jimmy Carter and Ronald Reagan from August 1979 to August 1987. He is widely credited with ending the high levels of inflation seen in the United States in the 1970s and...
summarized several other assumptions:
- Free and open financial markets supported by sophisticated financial engineering would most effectively support market efficiency and stability, directing funds to the most profitable and productive uses. He questioned whether the capture of 35-40% of U.S. corporate profits by financial firms at the peak of the bubble was beneficial to society.
- Concepts embedded in mathematics and physics could be directly adapted to markets, in the form of various financial models used to evaluate credit risk. While repetitive patterns and normal distribution curves are part of the physical sciences, financial markets are heavily influenced by herd behavior, emotional swings, political intervention and uncertainty.
- Economic imbalances, such as large trade deficits and budget deficits indicative of over-consumption, were sustainable. Private debt relative to GDP tripled over 30 years. Trade deficits increased the flow of capital into the U.S. and put downward pressure on interest rates, making the housing bubble worse.
- Regulation of the shadow banking industry was not needed. Investment banks, hedge funds, and other components of the shadow banking systemShadow banking systemThe shadow banking system is the infrastructure and practices which support financial transactions that occur beyond the reach of existing state sanctioned monitoring and regulation. It includes entities such as hedge funds, money market funds and Structured investment vehicles...
were not subject to the regulations of traditional depository banks and were allowed to become "too big to fail," creating a significant moral hazardMoral hazardIn economic theory, moral hazard refers to a situation in which a party makes a decision about how much risk to take, while another party bears the costs if things go badly, and the party insulated from risk behaves differently from how it would if it were fully exposed to the risk.Moral hazard...
. Further, derivatives such as credit default swaps (a $60 trillion market far larger than the underlying credits) were not regulated.
External links
- Financial Crisis Inquiry Commission Homepage
- CNBC-David Faber-The House of Cards-Video
- PBS Frontline -Inside the Meltdown-Video
- New Left Review-The Subprime Mortgage Crisis-Robin Blackburn
- Leveraged Losses Paper-Greenlaw Hatzius Kashyap Shin
- Reinhart and Rogoff - Is the U.S. 2007 Subprime Financial Crisis So Different? Feb 2008 Paper
- Testimony of Ben Bernanke on the Causes of the Recent Financial and Economic Crisis