Tuesday, February 01, 2011

An Objective Forensic View of the Sources of the 2007-08 Financial Crisis

The Wall Street Journal has recently published a spate of editorials and columns regarding the official FCIC final report. One of those editorials was by the authors of a minority report- Messrs. Thomas, Hennessey and Holtz-Eakin. Mr. Thomas is a former Republican congressman from California. Mr. Hennessey served as director of the White House National Economic Council in 2008. Mr. Holtz-Eakin is a former director of the Congressional Budget Office.

Here are some key passages from their Journal editorial synopsizing their report,

"Today, six members of the Financial Crisis Inquiry Commission—created by the last Congress to investigate the causes of the financial crisis—are releasing their final report. Although the three of us served on the commission, we were unable to support the majority's conclusions and have issued a dissenting statement.

In a November 2009 article, Brookings Institution economists Martin Baily and Douglas Elliott describe the three common narratives about the financial crisis. The first argues that the primary cause was government intervention in the housing market. This intervention, principally through Fannie Mae and Freddie Mac, inflated a housing bubble that triggered the crisis. This is the view expressed by one of our co-commissioners in a separate dissent.

The second narrative blames Wall Street and its influence in Washington. According to this narrative, greedy bankers knowingly manipulated the financial system and politicians in Washington to take advantage of homeowners and mortgage investors alike, intentionally jeopardizing the financial system while enjoying huge personal gains. That's the view of the six majority commissioners.

We subscribe to a third narrative—a messier story that emphasizes both global economic forces and failures in U.S. policy and supervision. Though our explanation of the crisis doesn't fit conveniently into the political order of Washington, we believe that it is far superior to the other two.

We recognize that the other two narratives have popular appeal: They each blame a clear entity, and thus outline a clear set of reform proposals. Had the government not supported housing subsidies (the first narrative) or had policy makers implemented more restrictive financial regulations (the second) there would have been no calamity.

Both of these views are incomplete and misleading. The existence of housing bubbles in a number of large countries, each with vastly different systems of housing finance, severely undercuts the thesis that the housing bubble was a phenomenon driven solely by the U.S. government. Likewise, the multitude of financial-firm failures, spanning varied organizational forms and differing regulatory regimes across the U.S. and Europe, makes it implausible that the crisis was the product of a small coterie of Wall Street bankers and their Washington bedfellows.

We believe the crisis was the product of 10 factors. Only when taken together can they offer a sufficient explanation of what happened:

Starting in the late 1990s, there was a broad credit bubble in the U.S. and Europe and a sustained housing bubble in the U.S. (factors 1 and 2). Excess liquidity, combined with rising house prices and an ineffectively regulated primary mortgage market, led to an increase in nontraditional mortgages (factor 3) that were in some cases deceptive, in many cases confusing, and often beyond borrowers' ability to pay.

Losses from the housing downturn were concentrated in highly leveraged financial institutions. Which raises the essential question: Why were these firms so exposed?

Failures in credit-rating and securitization transformed bad mortgages into toxic financial assets (factor 4). Securitizers lowered the credit quality of the mortgages they securitized, credit-rating agencies erroneously rated these securities as safe investments, and buyers failed to look behind the ratings and do their own due diligence. Managers of many large and midsize financial institutions amassed enormous concentrations of highly correlated housing risk (factor 5), and they amplified this risk by holding too little capital relative to the risks and funded these exposures with short-term debt (factor 6). They assumed such funds would always be available. Both turned out to be bad bets.

These risks within highly leveraged, short-funded financial firms with concentrated exposure to a collapsing asset class led to a cascade of firm failures. Some firms had large counterparty credit risk exposures, and the sudden and disorderly failure of one firm risked triggering losses elsewhere. We call this the risk of contagion (factor 7). In other cases, the problem was a common shock (factor 8). A number of firms had made similar bad bets on housing, and thus unconnected firms failed for the same reason and at roughly the same time.

A rapid succession of 10 firm failures, mergers and restructurings in September 2008 caused a financial shock and panic (factor 9). Confidence and trust in the financial system evaporated, as the health of almost every large and midsize financial institution in the U.S. and Europe was questioned. The financial shock and panic caused a severe contraction in the real economy (factor 10).

We agree with our colleagues that individuals across the financial sector pursued their self-interest first, sometimes to the detriment of borrowers, investors, taxpayers and even their own firms. We also agree that the mountain of government programs supporting the housing market produced distorted investment incentives, and that the government's implicit support of Fannie Mae and Freddie Mac was a ticking time bomb.

But it is dangerous to conclude that the crisis would have been avoided if only we had regulated everything a lot more, had fewer housing subsidies, and had more responsible bankers. Simple narratives like these ignore the global nature of this crisis, and promote a simplistic explanation of a complex problem. Though tempting politically, they will ultimately lead to mistaken policies."

The Journal's Holman Jenkins, Jr., a regular columnist, wrote his own piece commenting on the FCIC's various reports. He concurred with these three, and others, in decrying the commission's chairman's politically convenient tactic of simply blaming "Wall Street." But he also criticized Thomas, Hennessey and Holtz-Eakins for not concluding a simple, actionable source of the crisis.

To me, this minority explanation most closely approximates what is probably the truth. It addresses elements of the crisis that other explanations do not, i.e., its global nature, the different types of firms which failed, and the related, but not identical sources of mortgage-lending-sourced and -related factors which spread throughout the global financial system.

I think these authors stretched to arrive at the memorable round number of 10 factors. But, given a choice between competing explanations, I'd go for this one over all the others I've read.

Which leads to a conclusion I've expressed in prior posts on this topic. There were plenty of regulations and regulators already in existence to observe and act upon dangerous behaviors by various sector players. So rewriting regulations, adding more, or reshuffling regulators, won't likely change anything.

Moreover, consumer borrowers, investors, and various financial entities all behaved in ways which exacerbated the crisis, because that's human nature. Borrowers took sweet mortgage deals they couldn't likely afford under most scenarios. Lenders bet that they could pass their mortgage trash to investors before the stuff imploded. Too much greed and belief that creating and circulating mortgage-related assets of questionable value would not result in a systemic disaster.

In an earlier post, I likened it to too many people dumping toxic waste into a common sewer that drained into a drinking water supply. Like actually occurred in London before its modern sewer system, this will cause contagious diseases to spread.

So long as people are allowed to generate and circulate toxic waste with no regard for the systemic consequences, we'll see more of these crises in the future. If you don't believe regulators can effectively stop another crisis, then you should monitor the financial system for simple signs of building asset bubbles and make sure your assets are not in those instruments. Protection from broader equity market consequences and the progression of the shock to the real economy are more difficult effects from which to insulate or isolate oneself.

That appears to be an undiversifiable risk of modern financial systems and economies.

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