What really caused the financial crisis?

by on September 26, 2008 at 6:05 am in Economics | Permalink

Kashyap, Rajan, and Stein have lots of explanation but here is the initial bottom line:

The proximate cause of the credit crisis (as distinct from the housing crisis) was the interplay between two choices made by banks. First, substantial amounts of mortgage-backed securities with exposure to subprime risk were kept
on bank balance sheets even though the “originate and distribute” model of securitization that many banks ostensibly followed was supposed to transfer risk to those institutions better able to bear it, such as unleveraged pension funds. Second, across the board, banks financed these and other risky assets with short-term market borrowing.

In other words, one problem was not enough (!) securitization.  They also call for counter-cyclical capital requirements.  They like mandatory capital insurance — with payments triggered by capital disasters — even better.  My main worry, of course, is how we should regulate (or not) the entities which offer this insurance.  Will they too engage in liquidity transformation and if so who ensures them?

And, going back to banks, part of the governance problem was this:

…it is very hard, especially in the case of new products, to tell whether a financial manager is generating true excess returns adjusting for risk, or whether the current returns are simply compensation for a risk that has not yet shown itself but that will eventually materialize.

Their phrase "recapitalization as a public good" should not soon be forgotten.  And it is leverage which is dangerous, a lesson becoming clearer every day.

This paper is essential reading for anyone following the crisis and it makes more sense than just about anything else I’ve read on the topic.  I thank David L., a loyal MR reader, for the pointer.

1 dearieme September 26, 2008 at 6:56 am

“And it is leverage which is dangerous, a lesson becoming clearer every day.”
Clearer to whom? It was pelucidly clear to me in my youth, when I read Galbraith on The Great Crash. Lousy economist, perhaps, but a fine journalist and comic writer.

2 ogmb September 26, 2008 at 7:52 am

especially in the case of new product

How many of those new products are actually designed to optimize the risk portfolio, and how many are designed to obfuscate risk transaction and holding? If the latter >> the former, make all derivative contracts legally unenforceable except N types to be traded on m designated markets.

3 eccdogg September 26, 2008 at 8:52 am

As this link says and I believe, securitization itself was not the problem.

The problem was that the banks really did not securitize fully. They decided that they needed to hold large numbers of these securities on their books instead of selling them to investors as had been traditionally thier business model.

The fact that they had to keep the assets on their books to get a deal done means to me that they were holding those securities at above market prices on the day they were done or at least they were speculating that they were worth more than market.

This combined with high leverage led to the problems. Had the banks stuck to thier traditional model of securitization and selling off all of the tranches of the mortgage backed securities they would not have been in this situation. Sure lots of investors would have lost money but it would not have been a threat to bring down our financial system.

4 Podunk September 26, 2008 at 9:47 am

Something that was pointed out in the paper and that has been bandied about by commentators but doesn’t seem to be considered in any of the “official” proposals is flexible capitol requirements. It’s never made much sense to me to have capitol requirements and then not allow that capitol to be used in the event that it’s needed. All it does is tie up a certain amount of capitol permanently and gets creditors a few more cents on the dollar in the event of a bankruptcy.

I assume that the argument for strict and inflexible capitol requirements is some sort of moral hazard thing. As it stands, banks really have to keep some percentage of liquid capitol above the standards to use to pay when a depositor withdraws, pay interest, etc. If they knew that in a big crisis they could dip into their reserves, then they would sensibly hold less above the capitol requirements. Couldn’t this be protected against by putting strict conditions or penalties on dipping into the emergency capitol?

5 samik September 26, 2008 at 10:41 am

How about an even simpler proposal. I propose a new kind of convertible debt, one that converts when the stock price drops. This would mimic the insurance proposal suggested above but without worrying about the solvency of the insurer. Effectively this would be a kind of subordinated debt and would obviously require a higher rate of return than conventional debt.

6 Bernard Yomtov September 26, 2008 at 11:25 am

In other words, one problem was not enough (!) securitization.

Yes, but why? My guess is poor judgment on the part of the banks as to which mortgages to keep. The rates on the subprimes may have been so attractive that the banks were unwilling to accept market prices, which reflected higher (and more accurate) assessments of risks than the banks’ own assessments.

An odd sort of adverse selection problem, perhaps, where the seller knows less about the risk than the buyer. Or maybe just greed overcoming good sense.

7 Phil P September 26, 2008 at 12:12 pm

It seems to me a lot of people are making this way too complicated. At the heart of the crisis, like most financial crises was excessive leverage on the part of financial institutions, or what some call the development of a shadow banking system. Regulation to deal with excessive leverage, which I think is going to happen, seems to me the least intrusive, most free market form of regulation. Everything else is micromanaging the system. You can regulate mortgage brokers, regulate CDOs, regulate CDSs, maybe some of these are good ideas, but ten years from now someone will invent something else. Here’s another way of looking at it: the Fed tries to prevent excessive money supply growth to prevent inflation, now we need to prevent excessive credit growth to prevent asset bubbles.

8 Peter Fane September 27, 2008 at 12:14 am

Slumlord had a point. The problem was one of human nature. However, I don’t think it was that complicated.

The problem was more one of laziness, and not just of economists but everyone involved. Particularly the highly paid executives of the various financial institutions, both private and public.

The financial institutions found it was easier to manage HR with less people in their employment=> engage agents on commission working from their garages to source mortgages on their behalf.

The garage based salespersons were able to keep their commissions on all mortgages that they sourced if the mortgagor did not default within the first three months of the loan. AFter that, presumable, the mortgages were supposed to be offloaded to an unsuspecting investor and the financial institution was supposed to be safe.

This modus operandi was great news for that part of the organisation that was paid bonuses for delivering lending services. It was a lazy way to make money. Some call it predatory lending. But the borrower isn’t that stupid. Let’s just call it lazy lending and predatory on the end investors in the mortgage backed securities. There is no need for us to feel sorry for the borrowers who had no hope of repaying the loan without significant promotions in salary, or inflation…It was the risk they took with someone else’s money, compliments of the financial institution’s lending arm.

However, someone forgot to tell the firm’s investment management arm that these CDOs/CDSs were toxic and not meant for investment. And the investment managers just took for granted whatever the rating agencies said was the credit risk. Pure laziness. Both on the part of the rating agencies who obviously failed to properly analyse the risk in the bonds (assuming incompetence was not the reason that the bonds were not given a junk rating, given the 3 month “seasoning” period of the mortgages), and the investment managers since they appear to have not done their own analysis but relied on the rating agencies’ assessments.

Unless we can regulate against stupidity and laziness, then increased regulation is not likely to avoid a similar problem in the future.

But boards should adopt a strategy for making bonus payments that take into account future performance based on current decisions, rather than merely past performance. That could be an interesting exercise!!

It should also be noted that Paulson’s plan is far from optimal but appears to have suffered from the same lazy analytical approach as did the CDOs. Give the money to the social welfare agencies to buy foreclosed properties at their current market values. This will support the housing market, which is the real fear of the banks, consumers and end investors alike, and will also provide cash into the CDOs/CDSs/MBSs, which will support the holders of the securities.

9 Intrigued September 27, 2008 at 9:01 am

The first line should read, ” … put off by the slightly arrogant title of the post” and not paper.

10 Nick September 27, 2008 at 7:47 pm

In other words, one problem was not enough (!) securitization.

The post and the linked paper completely neglected the elephant in the room: the problems of moral hazard and adverse selection caused by securitization. Banks that offload their risk greatly reduce their incentives to properly judge credit quality — their incentives become to push high volumes of loans out the door with much less concern about whether they will eventually default.

Securitization doesn’t just distribute risk, it creates additional risk. Indeed, any distribution of risk, whether by insurance or securities, also creates new risk in the forms of adverse selection and moral hazard. For the most common kinds of securities (e.g. stocks and bonds) over hundreds of years we’ve evolved highly elaborate systems to minimize that risk creation, such as the elaborate accounting, auditing, internal control and governance, and external regulatory apparatus required to issue trustworthy stocks and bonds.

Under a highly simplistic set of mathematical models that captured the risk distribution but not the risk creation, the mortgage securitization market ignored the adverse selection and moral hazard created when risk is distributed and short-circuited the need to evolve (through extensive periods of trial and error) the reporting and control mechanisms needed for a securities market to work sustainably: to provide more value in distributing risk than it destroys by creating additional risk. (n.b. one can also refer to the problem as an agency problem between the security issuer/obligor and the security holder/obligee: moral hazard is the more general term: this agency terminology is often used for equity, i.e. stocks, but it’s basically the same adverse selection and moral hazard problem as for debt and other methods of distributing risk).

To the extent banks didn’t securitize completely (and it would be nice to have some real numbers here — I didn’t see any in the paper) I would imagine at least some investors demanded that the banks eat some of their own cooking before they would partake — a crude signalling and incentive-sharing substitute for the necessary controls to sufficiently reduce the adverse selection and moral hazard created by distributing the risk. Given the massive wave of foreclosures, this didn’t provide nearly enough reduction in the adverse selection and moral hazard of securitization, especially in the form of preposterously lax lending standards.

11 gatekeep September 29, 2008 at 6:49 am

Slumlord has a point about the cause of this downward spiral..human nature….more precisely greed! The failure to perform due diligence(the cornerstone of all prudent banking practise),the cavalier attitudes of bankers fuelled by the shockingingly excessive renumeration packages,the silencing of crtics who advised against over exposure a trait common to all the major players,all combined to send everything south the moment the system became gridlocked.Get back to basics and check the fundamentals…this great nation has endured much but this was the cruellest cut of all!

12 ANGELOS BACKUS October 2, 2008 at 10:30 am


Published: September 30, 1999

In a move that could help increase home ownership rates among minorities and low-income consumers, the Fannie Mae Corporation is easing the credit requirements on loans that it will purchase from banks and other lenders.

The action, which will begin as a pilot program involving 24 banks in 15 markets — including the New York metropolitan region — will encourage those banks to extend home mortgages to individuals whose credit is generally not good enough to qualify for conventional loans. Fannie Mae officials say they hope to make it a nationwide program by next spring.

Fannie Mae, the nation’s biggest underwriter of home mortgages, has been under increasing pressure from the Clinton Administration to expand mortgage loans among low and moderate income people and felt pressure from stock holders to maintain its phenomenal growth in profits.

In addition, banks, thrift institutions and mortgage companies have been pressing Fannie Mae to help them make more loans to so-called subprime borrowers. These borrowers whose incomes, credit ratings and savings are not good enough to qualify for conventional loans, can only get loans from finance companies that charge much higher interest rates — anywhere from three to four percentage points higher than conventional loans.

”Fannie Mae has expanded home ownership for millions of families in the 1990’s by reducing down payment requirements,” said Franklin D. Raines, Fannie Mae’s chairman and chief executive officer. ”Yet there remain too many borrowers whose credit is just a notch below what our underwriting has required who have been relegated to paying significantly higher mortgage rates in the so-called subprime market.”

Demographic information on these borrowers is sketchy. But at least one study indicates that 18 percent of the loans in the subprime market went to black borrowers, compared to 5 per cent of loans in the conventional loan market.

In moving, even tentatively, into this new area of lending, Fannie Mae is taking on significantly more risk, which may not pose any difficulties during flush economic times. But the government-subsidized corporation may run into trouble in an economic downturn, prompting a government rescue similar to that of the savings and loan industry in the 1980’s.

”From the perspective of many people, including me, this is another thrift industry growing up around us,” said Peter Wallison a resident fellow at the American Enterprise Institute. ”If they fail, the government will have to step up and bail them out the way it stepped up and bailed out the thrift industry.”

Under Fannie Mae’s pilot program, consumers who qualify can secure a mortgage with an interest rate one percentage point above that of a conventional, 30-year fixed rate mortgage of less than $240,000 — a rate that currently averages about 7.76 per cent. If the borrower makes his or her monthly payments on time for two years, the one percentage point premium is dropped.

Fannie Mae, the nation’s biggest underwriter of home mortgages, does not lend money directly to consumers. Instead, it purchases loans that banks make on what is called the secondary market. By expanding the type of loans that it will buy, Fannie Mae is hoping to spur banks to make more loans to people with less-than-stellar credit ratings.

Fannie Mae officials stress that the new mortgages will be extended to all potential borrowers who can qualify for a mortgage. But they add that the move is intended in part to increase the number of minority and low income home owners who tend to have worse credit ratings than non-Hispanic whites.

Home ownership has, in fact, exploded among minorities during the economic boom of the 1990’s. The number of mortgages extended to Hispanic applicants jumped by 87.2 per cent from 1993 to 1998, according to Harvard University’s Joint Center for Housing Studies. During that same period the number of African Americans who got mortgages to buy a home increased by 71.9 per cent and the number of Asian Americans by 46.3 per cent.

In contrast, the number of non-Hispanic whites who received loans for homes increased by 31.2 per cent.

Despite these gains, home ownership rates for minorities continue to lag behind non-Hispanic whites, in part because blacks and Hispanics in particular tend to have on average worse credit ratings.

In July, the Department of Housing and Urban Development proposed that by the year 2001, 50 percent of Fannie Mae’s and Freddie Mac’s portfolio be made up of loans to low and moderate-income borrowers. Last year, 44 percent of the loans Fannie Mae purchased were from these groups.

The change in policy also comes at the same time that HUD is investigating allegations of racial discrimination in the automated underwriting systems used by Fannie Mae and Freddie Mac to determine the credit-worthiness of credit applicants.

13 Mike Smith October 9, 2008 at 9:52 pm

Trying again: NY Times article

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Is it realistic?

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