Lest We Forget: Why We Had A Financial Crisis
It is clear to anyone who has studied the financial crisis of 2008 that
the private sector’s drive for short-term profit was behind it. More
than 84 percent of the sub-prime mortgages in 2006 were issued by
private lending. These private firms made nearly 83 percent of the
subprime loans to low- and moderate-income borrowers that year. Out of
the top 25 subprime lenders in 2006, only one was subject to the usual
mortgage laws and regulations. The nonbank underwriters made more than
12 million subprime mortgages with a value of nearly $2 trillion. The
lenders who made these were exempt from federal regulations.
So let’s recap the basic facts: why did we have a financial crisis in 2008? Barry Ritholtz fills us in on the history with an
excellent series of articles in the
Washington Post:
- In 1998, banks got the green light to gamble: The
Glass-Steagall legislation, which separated regular banks and investment
banks was repealed in 1998. This allowed banks, whose deposits were
guaranteed by the FDIC, i.e. the government, to engage in highly risky
business.
- Low interest rates fueled an apparent boom:
Following the dot-com bust in 2000, the Federal Reserve dropped rates to
1 percent and kept them there for an extended period. This caused a
spiral in anything priced in dollars (i.e., oil, gold) or credit (i.e.,
housing) or liquidity driven (i.e., stocks).
- Asset managers sought new ways to make money: Low
rates meant asset managers could no longer get decent yields from
municipal bonds or Treasurys. Instead, they turned to high-yield
mortgage-backed securities.
- The credit rating agencies gave their blessing:
The credit ratings agencies — Moody’s, S&P and Fitch had placed an
AAA rating on these junk securities, claiming they were as safe as U.S.
Treasurys.
- Fund managers didn’t do their homework: Fund
managers relied on the ratings of the credit rating agencies and failed
to do adequate due diligence before buying them and did not understand
these instruments or the risk involved.
- Derivatives were unregulated: Derivatives had
become a uniquely unregulated financial instrument. They are exempt from
all oversight, counter-party disclosure, exchange listing requirements,
state insurance supervision and, most important, reserve requirements.
This allowed AIG to write $3 trillion in derivatives while reserving
precisely zero dollars against future claims.
- The SEC loosened capital requirements: In 2004, the Securities and Exchange Commission changed the leverage rules for just five Wall Street
banks. This exemption replaced the 1977 net capitalization rule’s
12-to-1 leverage limit. This allowed unlimited leverage for Goldman
Sachs [GS], Morgan Stanley, Merrill Lynch (now part of Bank of America
[BAC]), Lehman Brothers (now defunct) and Bear Stearns (now part of
JPMorganChase–[JPM]). These banks ramped leverage to 20-, 30-, even
40-to-1. Extreme leverage left little room for error. By 2008, only two
of the five banks had survived, and those two did so with the help of
the bailout.
- The federal government overrode anti-predatory state laws.
In 2004, the Office of the Comptroller of the Currency federally
preempted state laws regulating mortgage credit and national banks,
including anti-predatory lending laws on their books (along with lower
defaults and foreclosure rates). Following this change, national lenders
sold increasingly risky loan products in those states. Shortly after,
their default and foreclosure rates increased markedly.
- Compensation schemes encouraged gambling: Wall
Street’s compensation system was—and still is—based on short-term
performance, all upside and no downside. This creates incentives to take
excessive risks. The bonuses are extraordinarily large and they
continue–$135 billion in 2010 for the 25 largest institutions and that
is after the meltdown.
- Wall Street became “creative”: The demand for
higher-yielding paper led Wall Street to begin bundling mortgages. The
highest yielding were subprime mortgages. This market was dominated by
non-bank originators exempt from most regulations.
- Private sector lenders fed the demand: These
mortgage originators’ lend-to-sell-to-securitizers model had them
holding mortgages for a very short period. This allowed them to relax
underwriting standards, abdicating traditional lending metrics such as
income, credit rating, debt-service history and loan-to-value.
- Financial gadgets milked the market: “Innovative”
mortgage products were developed to reach more subprime borrowers. These
include 2/28 adjustable-rate mortgages, interest-only loans, piggy-bank
mortgages (simultaneous underlying mortgage and home-equity lines) and
the notorious negative amortization loans (borrower’s indebtedness goes
up each month). These mortgages defaulted in vastly disproportionate
numbers to traditional 30-year fixed mortgages.
- Commercial banks jumped in: To keep up with these
newfangled originators, traditional banks jumped into the game.
Employees were compensated on the basis loan volume, not quality.
- Derivatives exploded uncontrollably: CDOs provided the first “infinite market”; at height of crash, derivatives accounted for 3 times global economy.
- The boom and bust went global. Proponents of the Big Lie ignore the worldwide nature of the housing boom and bust. A McKinsey Global Institute report noted “from 2000 through 2007, a remarkable run-up in global home prices occurred.”
- Fannie and Freddie jumped in the game late to protect their profits:
Nonbank mortgage underwriting exploded from 2001 to 2007, along with
the private label securitization market, which eclipsed Fannie and
Freddie during the boom. The vast majority of subprime
mortgages — the loans at the heart of the global crisis — were
underwritten by unregulated private firms. These were lenders who sold
the bulk of their mortgages to Wall Street, not to Fannie or Freddie.
Indeed, these firms had no deposits, so they were not under the
jurisdiction of the Federal Deposit Insurance Corp or the Office of
Thrift Supervision.
- Fannie Mae and Freddie Mac market share declined.
The relative market share of Fannie Mae and Freddie Mac dropped from a
high of 57 percent of all new mortgage originations in 2003, down to 37
percent as the bubble was developing in 2005-06. More than 84 percent of
the subprime mortgages in 2006 were issued by private lending
institutions. The government-sponsored enterprises were concerned with
the loss of market share to these private lenders — Fannie and Freddie
were chasing profits, not trying to meet low-income lending goals.
- It was primarily private lenders who relaxed standards: Private lenders not subject to congressional regulations collapsed lending standards.
the GSEs. Conforming mortgages had rules that were less profitable than
the newfangled loans. Private securitizers — competitors of Fannie and
Freddie — grew from 10 percent of the market in 2002 to nearly 40
percent in 2006. As a percentage of all mortgage-backed securities,
private securitization grew from 23 percent in 2003 to 56 percent in
2006.
The driving force behind the crisis was the private sector
Looking at these events it is absurd to suggest, as Bloomberg did,
that “Congress forced everybody to go and give mortgages to people who
were on the cusp.”
Many actors obviously played a role in this story. Some of the actors
were in the public sector and some of them were in the private sector.
But the public sector agencies were acting at behest of the private
sector. It’s not as though Congress woke up one morning and thought to
itself, “Let’s abolish the Glass-Steagall Act!” Or the SEC spontaneously
happened to have the bright idea of relaxing capital requirements on
the investment banks. Or the Office of the Comptroller of the Currency
of its own accord abruptly had the idea of preempting state laws
protecting borrowers. These agencies of government were being
strenuously lobbied to do the very things that would benefit the
financial sector and their managers and traders. And behind it all, was
the drive for short-term profits.
Why didn’t anyone say anything?
As one surveys the events in this sorry tale, it is tempting to
consider it like a Shakespearean tragedy, and wonder: what if things had
happened differently? What would have occurred if someone in the
central bank or the supervisory agencies had blown the whistle on the
emerging disaster?
The answer is clear: nothing. Nothing would have been different. This
is not a speculation. We know it because an interesting new book
describes what
did happen to the people who
did speak out and try to blow the whistle on what was going on. They were ignored or sidelined in the rush for the money.
The book is
Masters of Nothing: How the Crash Will Happen Again Unless We Understand Human Nature by Matthew Hancock and Nadhim Zahawi (published in 2011 in the UK by Biteback Publishing and available on pre-order in the US).
In 2004, the book explains, the deputy governor of the Bank of
England (the UK central bank), Sir Andrew Large, gave a powerful and
eloquent warning about the coming crash at the London School of
Economics. The speech was published on the bank’s website but it
received no notice. There were no seminars called. No research was
commissioned. No newspaper referred to the speech. Sir Andrew continued
to make similar speeches and argue for another two years that the system
was unsustainable. His speeches infuriated the then Chancellor, Gordon
Brown, because they warned of the dangers of excessive borrowing. In
January 2006, Sir Andrew gave up: he quietly retired before his term was
up.
In 2005, the chief economist of the International Monetary Fund,
Raghuram Rajan, made a speech at Jackson Hole Wyoming in front of the
world’s most important bankers and financiers, including Alan Greenspan
and Larry Summers. He argued that technical change, institutional moves
and deregulation had made the financial system unstable. Incentives to
make short-term profits were encouraging the taking of risks, which if
they materialized would have catastrophic consequences. The speech did
not go down well. Among the first to speak was Larry Summers who said
the speech was “largely misguided”.
In 2006, Nouriel Roubini issued a similar warning at an IMF gathering
of financiers in New York. The audience reaction? Dismissive. Roubini
was “non-rigorous” in his arguments. The central bankers “knew what they
were doing.”
The drive for short-term profit crushed all opposition in its path, until the inevitable meltdown in 2008.
Why didn’t anyone listen?
On his
blog, Barry Ritholtz puts the truth-deniers into three groups:
1) Those suffering from Cognitive Dissonance — the intellectual crisis that occurs when a failed belief system or philosophy is confronted with proof of its implausibility.
2) The Innumerates, the
people who truly disrespect a legitimate process of looking at the data
and making intelligent assessments. They are mathematical illiterates
who embarrassingly revel in their own ignorance.
3) The Political Manipulators,
who cynically know what they peddle is nonsense, but nonetheless push
the stuff because it is effective. These folks are more committed to
their ideology and bonuses than the good of the nation.
He is too polite to mention:
4) The Paid Hacks, who
are being paid to hold a certain view. As Upton Sinclair has noted, “It
is difficult to get a man to understand something, when his salary
depends upon his not understanding it.”
Barry Ritholtz concludes: “The denying of reality has been an issue,
from Galileo to Columbus to modern times. Reality always triumphs
eventually, but there are very real costs to it occurring later versus
sooner .”
The social utility of the financial sector
Behind all this is the reality that the massive expansion of the financial sector is not contributing to
growing the real economic pie.
As Gerald Epstein, an economist at the University of Massachusetts has
said: “These types of things don’t add to the pie. They redistribute
it—often from taxpayers to banks and other financial institutions.”
Yet in the expansion of the GDP, the expansion of the financial sector counts as increase in output. As Tom Friedman
writes in the New York Times:
Wall Street, which was originally designed
to finance “creative destruction” (the creation of new industries and
products to replace old ones), fell into the habit in the last decade of
financing too much “destructive creation” (inventing leveraged
financial products with no more societal value than betting on whether
Lindy’s sold more cheesecake than strudel). When those products blew up,
they almost took the whole economy with them.
Do we want another financial crisis?
http://www.forbes.com/sites/stevedenning/2011/11/22/5086/
