What Caused the
Financial
Crisis of 2008?
A Story
of Adverse Incentives
February 24, 2012
Teaching Financial
Crises
Norm Cloutier, Director
UW-Parkside Center for
Economic Education
A special thanks to SC Johnson for
sponsoring this event.
A 20th
Century Understatement:
“The
war situation has developed not necessarily to Japan’s
advantage.”
−Emperor
Hirohito, 1945
Announcing Japan’s surrender
A 21st
Century Understatement:
“Market
discipline has in some cases broken down, and the
incentives to follow prudent lending procedures
have, at times, eroded.”
−Ben
Bernanke, 2007
Explaining the financial
crisis
The Financial Crisis
Inquiry Report
- FCIC established by the
Fraud Enforcement and Recovery Act of 2009
- Charged with determining
the underlying causes of the financial crisis
- Democratic leadership appointed
6 members, Republican 4 members
- Reviewed millions of pages
of documents, interviewed more than 700 witnesses, held hearings over
19 days
- Was not charged with developing
recommendations
Major Findings of
the
Financial Crisis Inquiry Report
- The crisis was avoidable
- Widespread failure in:
- Regulatory supervision
- Corporate: governance, risk
management, accountability, ethics
- Rating agencies
- Lending standards
- Government response
- Excessive leverage and
risk without transparency
Missing From the
FCIC List?
- Federal government housing
policy
- HUD’s affordable housing goals
- Community Reinvestment Act
- Role of Government Sponsored
Enterprises
- Fannie Mae and Freddie Mac
- Excessive liquidity
- Federal Reserve policy
- International saving inflows
Setting the Table:
What We Need to Know
- Derivative → a contract,
or promise, whose value is derived from another asset
or event
- Securitization → the
pooling of debt
Pre-2000 Financial
and Regulatory Conditions
- The S&L Crisis of the
late-1980s saw 747, or nearly 25% of S&Ls failed
- Resolution Trust Corp sell-off
of $402 billion in assets
- Private sector assistance
and underwriting innovation
- 1993, Commodity Futures
Trading Commission exempts certain financial derivatives from regulation.
- decentralized
- unregulated
- opaque
- limited price discovery
Pre-2000 Financial
Scandals
- After the CFTC exemption,
derivative volume exploded… and so did losses and scandal.
- Sept 1998, Long Term
Capital Management
- leveraged 25-1…, at
least
- threat of a system-wide
financial impact
- Fed orchestrated a $3.6
billion bailout
“…
regulation of derivatives transactions that are privately negotiated
by professionals is unnecessary.”
- Alan Greenspan, July
1998
Regulation Exemption
- In 1999, Pres Clinton’s
Working Group on Financial Markets issues a report urging Congress
to broadly deregulate the OTC derivatives
- In 2000, Congress passes
the Commodity Futures Modernization Act effectively eliminating
OTC derivates from regulation and oversight
- It also preempted states
from issuing regulation over OTC derivatives
- Financial derivatives experienced
phenomenal growth
The Giant Pool of
Money
- In the early-2000s, the
Fed kept interests rates low :
- Burst of the .com bubble,
stock market decline
- Recession
- 9-11
- War
- Corporate scandal: Enron,
Arthur Anderson, Worldcom, Tyco, Qwest Communications, Global Crossings,
etc…
- As economic growth increased
in oil producing and less developed countries, the pool of global savings
increased
Fed Funds and 30-Year
Mortgage Rates
30-Year Mortgage
Fed Funds
July 2004
Recession End
Nov 2001
Capital Flows into
the U.S.
(in billions of constant
2006 $)
Desperately Seeking:
Higher Returns
- As global savings sought
higher returns than U.S. Treasuries it turned to the U.S. housing market
- 30-year fixed rate mortgage
offered 1.5-2.0% points higher return than Treasury bonds
- Securitization offered
a channel for domestic and foreign financial capital to flow into the
U.S. housing market
MBS and CDOs
- The good news:
- Made investing in the U.S.
housing market more accessible to foreign and domestic investors
- Pooling could reduce
risk through diversification across households and across regions of
the country
- The bad news:
- Extreme complexity made
it difficult for buyers to understand and rating agencies to assess
risk
- Adverse incentives
broke the critical tie between profits and risk taking
Desperately Seeking:
Safety
- Buyers of complex CDOs sought
further assurance of their safety
- Credit Default Swaps (CDS)
are “insurance” policies
purchased against the failure of CDOs
- No capital requirements
- “Insurable
interest”
is not required
- Exempt from regulation
(remember? CFMA of 2000)
- American International
Group (AIG) was a large supplier
Home Prices Began
to Rise Dramatically
Credit Expansion:
Alternative Loans and Subprime
Lending
- As home prices increased,
more conventional prime borrowers opted for adjustable rate mortgages
(ARMs).
- Proliferation of ARMs
caused and was caused by
rising home prices
“…recent
research within the Federal Reserve suggests that many homeowners might
have saved tens of thousands of dollars had they held adjustable-rate
mortgages…”
−Alan
Greenspan, Feb 2004
Speaking to the Credit Union National Association's meeting
Credit Expansion:
Alternative Loans and Subprime
Lending
- The financial “wisdom” of ARMs
is predicated on:
- short term occupancy
- falling interest rates
- and/or continued increases
in home prices
- Investment banks moved into
mortgage origination to ensure a steady supply of inputs for the continued
strong demand for CDOs.
Growth of Alternative
Mortgages
Excessive Leverage
- 2004 SEC “net capital” ruling:
- increased allowable leverage
- allowed for internal risk
monitoring
- Some banks were leveraged
as high as 40-1
- Securitizing banks and mortgage
companies were financing their borrowing with short-term loans in the
commercial paper market
"We have a good deal of comfort
about the capital cushions at these firms at the moment.“
−Christopher Cox,
SEC Chairman, March 11, 2008
Leverage: The Good
and the Ugly
The Watchmen
- The securitization machine
required the cooperation of the “watchmen”:
- Appraisers
- Rating agencies
- Regulators
- All three watchmen were
plagued by adverse incentives.
Adverse Incentives:
Appraisers
- Selected by the lender,
appraisers were under pressure to over-value homes in order to justify
higher loan values.
- 11,000 appraisers across
the U.S. signed a petition charging lenders with:
- withholding business
- refusing to pay for appraisals
- black listing
Adverse Incentives:
Rating Agencies
- Rating agencies are paid
by the securitizing bank and fundamentally have the same adverse incentives
as appraisers to over-value CDOs
- Many buyers of CDOs were
statutorily required to purchase only highly rated “safe” securities
- e.g. five Wisconsin school
districts
- As the housing bubble burst,
AAA CDO tranches and the companies who created them were massively downgraded,
some to worthless.
“It
is difficult to get a man to understand something when his salary depends
on him not understanding it.”
−Upton
Sinclair
Adverse Incentives:
The Regulators
- Some financial institutions
choose their regulators
- …and
in turn, regulators are funded by those same financial institutions
- Regulators actively court
financial institutions for their business
Office of Thrift
Supervision:
James (Chainsaw) Gilleran
Example: The Office
of Thrift Supervision
- S&L Crisis, Federal
Home Loan Bank Board, and the Office of Thrift Supervision
- Financial institutions got
the message and began purchasing savings and loans:
- Although AIG’s thrift
comprised 0.1% of its total balance sheet, it could choose OTS as its “lead
regulator”
General Motors
IndyMac
Countrywide
H&R Block
WaMu
American Express
AIG
Bank United
Capital One
Credit Expansion:
Adverse Incentives
and Declining Standards
- A Fed study of ARM homeowners
revealed that:
- 38% did not understand
how high their interest rate could be reset at one time
- 50% did not understand
how high their interest rate could rise over the life of the loan
- Homeowner incentives to
default and walk away from their mortgage obligation
- As the securitization machine
demanded ever more loans, mortgage originators began lowering the creditworthiness
bar →
NINJA loans
- Verify a credit score and
a pulse
Consumers with New
Foreclosures Begin to Increase in 2006 (thousands)
The Unraveling
- As mortgages delinquencies
and foreclosures mounted, CDO values declined
- Between 2007:2 and 2008:2
rating agencies downgraded $1.9 trillion worth of CDOs
- Securitizing banks were
holding unsold CDOs tranches
- As CDOs failed, investors
holding credit default swaps expected to be paid
That Fateful Day:
Sept 16, 2008
“It
was overwhelmingly clear that we were staring into the abyss…
this was a catastrophe that we were watching unfold.”
—Patrick
McCabe
Federal Reserve Bank economist testimony to the FCIC.
That Fateful Day:
Sept 16, 2008
- The Reserve Primary Fund “broke
the buck”
- Lehman Brothers’ bankruptcy
Sept 15
- commercial paper market
- Bear Stearns bailout “moral
hazard”
- Panic!!!
- Within 1 week $349 billion
withdrawn from MMMFs, or about 1/3 total MMMF balances.
- December 9, 2008 the yield
on Treasury bills turns negative
Where Were the Regulators?
- Ben Bernanke’s Congressional
testimony
- “AIG
exploited a huge gap in the regulatory system…”
The “Real”
Economy is Hit Hard
- 2008-2011, 407 failed and
Fed assisted banks
- Unemployment peaked at 10.1%
October 2009
- Jan 2012= 8.3%, with 12.8
mil workers unemployed
- Jan 2012 U-6= 15.1%
- Economic growth is sluggish
and is forecasted to remain so
Have We Fixed the
Adverse Incentives that Caused the Financial Crisis?
- Dodd–Frank Wall Street Reform and Consumer Protection
Act of 2010
- Corporate Governance
& Executive Compensation
- Credit Rating Agency
Regulation
- Securitization Retention
Requirements
- Regulation of Over-the-Counter
Derivatives
- Financial Stability
Oversight Council
- Systemic Regulation and
Emergency Powers
- Resolution Authority
- Consumer Financial Protection
Bureau
