What caused the financial crisis?

Forget about particular details for a moment, in conceptual terms what led so many financial institutions to take so much excess risk?  Bob Frank addresses that question and here is my list of major factors:

1. Collective stupidity: A lot of Greeks believed in Zeus and a lot of people in 1938 thought Hitler would be good for Germany.  They were just plain, flat out wrong.  I’ll also put "model error" under this heading.  The relevant stupidity concerned both the fate of home prices and the degree of acceptable leverage.

2. Writing the naked put: This is Bob Frank’s main explanation, noting that he uses different terminology and adds a relative status dash to the argument.  If you don’t know options theory, just imagine betting against the Washington Wizards to win the NBA title every year.  For a lot of years you’ll earn super-normal returns, but one year (not anytime soon, I can assure you) you’ll be wiped out.  That is essentially the strategy the banks were playing.  They were going "short on volatility," so to speak.  In the meantime they reaped high returns and some amazing perks for private life.  It’s hard to just call the party to an end, even if you have a relatively long time horizon.

3. The neutering of debtors. This is the sophisticated form of the moral hazard argument.  Bailouts mean that debtors and depositors don’t have enough incentive to keep safe the firms they give their money to.  Note that #3, as a corollary, suggests that equity holders do not on their provide adequate safeguards against a crash.

Evaluation: You can pin most of the blame on #3 provided you think that a) our government really could let these firms default on their debts ex post and b) society is willing to live with significantly less liquidity transformation up front and also lower returns for depositors.  I reject this mix for reasons of time inconsistency, namely that ex post the bailout is always on its way so this is simply something we have to live with. 

You’re left with #1 and #2 but it is hard to assign relative weights because they work together.  The people earning money under #2 won’t work terribly hard to disillusion the fools and frauds operating under #1.

At times I am tempted to add #4 to the mix:

4. The increasing value of human capital: Bankruptcy is no longer so painful for the wealthy.  You can always get another high-paying job plus you have $10 million squirreled away somewhere in Switzerland.  You could end up working for the guv’ment for $130K a year and your life still is pretty good once you get over the shock of adjustment.  So why not take lots of risk and try to get ahead of the other guy?

The full story then involves additional resources being put on the table — for possible risky investment — as a result of easy monetary policy, pro-housing government policies, the global savings glut, and simple bad luck.  I’ll cover those factors in more detail soon.  And I’ll also have more to say about some of the details of mortgage-backed securities and accounting practices and regulation; those were factors too, although not at the level of generality I am covering here.

Addendum: Here’s Mark Thoma and Barry Ritzholz.  In the comments Robert Feinman is square on, read him.

Second addendum: Megan McArdle adds quite a bit.


Mr. Cowen,
What about the scope creep of the Federal Government, where the idea that anything improving the "general welfare" goes,
and let the 10th Amendment be damned?
Once could argue that the New Deal opened pandora's box of moral hazards, and "The Paul Wellstone Mental Health and Addiction Equity Act of 2007" is just another in the sequence of foul things pouring forth from the precedent.

How about this for an incredibly simple-minded summary:

The Fed has understood its job to keep rates as low as possible (and growth and employment as high as possible) so long as inflation remained under control. The ultra-low rates did not cause a big spike in the CPI, so the Fed didn't feel the need to raise them, but cheap money did cause (or contribute to) the bubble.

So, going forward, the Fed will be charged with preventing bubbles as well as inflation and should never again accept the argument that "this time it's different".

there are so many things that fall under the general stupidity category.

i will add to the list the culture of "you must own a house." and the tax code that encourages it, and the way people get so emotionally attached to housing. I think housing should be thought of as a durable good that appreciates in value rather than this major goal that you must accomplish or your life is incomplete.

Feinman is right on in the comments though. This mess would've been way more contained if it weren't for the derivative products--and their lack of regulation. For that reason it bothers me a lot that there are still many people who place the blame for the crisis squarely on the shoulders of stupid decisions on the part of homeowners or predatory lenders.

#4 is true and it isn't entirely new. I was a junior trader at a hedge fund in '95, and it was well known that a failed trader would just got a job somewhere else, often for more pay! The result is that bonuses are a call option on one year of trading performance, and good risk managers/internal controls are necessary to keep gambling in check.

I would argue though that this is a good thing! The point of hedge funds, VC, PE, and traditional financial intermediaries is to take on risk, which on average increases society's returns/wealth even if some desks and some years turn out badly. We are better off now than we were in the early '90's, and even a severe recession won't wipe out 15 years of growth.

The problem with the mortgage market, IMHO, is that in too many firms sales and trading escaped risk management's control. And that too much of risk management was based on historical projections and not enough consideration of unprecedented risks like a nationwide home price decline.

Global savings glut: So, reduced demand caused a bubble eh? Not only did they give up all their loot and didn't use our bucks to invest in things that would yield high returns, they got hammered. Suckers.

We all know why Greenspan has been AWOL lately. But what about the Fed on the back end? There is still a lot of value in the houses. Had the GDP kept growing at 3%/yr the value would have caught up with price if the market had had a soft landing. Bernanke held interest rates high for a long time. Which came first, foreclosures, housing values dropping, or increasing rates? There was shift in perceived costs versus values, but when did it hit the tipping point? Who cares?

I am thankful to live in a country that can have a rip-roaring bubble from time to time. We found the point of diminishing returns on securitizing real-estate and put some folks into houses along the way. So, now these people who tried to make money leveraging other people's property will have to get real jobs where they invest real money into real productivity. Yay!

Re #4: But when wasn't this the case? Bankruptcy has been a part of the high-risk finance playbook since Jay Gould, at least.

As phrased here, number two sounds as if the participants were completely aware of the game they were playing but might be even more potent shrouded in uncertainty. How can it be separated from the collective madness of number one and the moral hazard and agency problems of number four?

But what is the solution to this problem? It seems pretty deep rooted. How should banks decide when to stop? Is there any feedback mechanism between pre-emptive self-denial and market crash? Without a good one the severity of the current crisis may be a function of the increased concentration of the financial services sector. That concentration is only increasing so does that mean the next crash will only come to a head with an existential crisis for the new big three?

Proper, end-user, investors didn't buy enough of the mortgage backed securities which is why so much was left on on bank balance sheets. In other words lenders did turn down many of the problem investments, it's the intermediaries who did not.

Andrew Lo also stressed #2, the naked put, a few years ago although I think he stressed a "deep out-of-the-money naked put"


The Fed was trying to keep rates as low as possible without inflation--- ok. But, the metric they were using for inflation had a huge flaw. They included rent but not house prices in the housing component of inflation. That meant that they really were causing inflation; they just didn't know it.

"Preventing bubbles" is, in general, not possible. Encouraging bubbles-- as the fed and freddie and fannie did here-- is all to easy.

I'm willing to concede that this may have been a small factor overall, but would contend it was a large factor at least for AIG: the role the government plays in skewing investments towards assets with a higher return in exchange for a low risk of calamitous outcome. When you can get a AAA-rating by protecting against the first 10% downside in a CDO (by segmenting that 10% out into a separate tranch) it becomes the preferred investment vehicle, given insurance company requirements to go for such-rated instruments.

However, I wish I could find the cite, I remember reading Mises on the dangers of incentive pay -- that when you reward a manager for upside only without a corresponding liability to share in downside you get inherently risky decision-making.

I would add

#5 the ability to distribute failure.

Mortgage brokers didn't care because so long as minimal standards were met, they could sell to banks. Banks could sell to investors. Intermediaries such as Fannie/Freddie developed Congress as a cushion. [etc.]

Financial intermediaries assumed liquidity would continue to grow, not shrink, and they'd never be stuck with things they couldn't sell.

But #1 is my favorite -- anyone who's served on committees knows that occasionally the committee will recommend something that's dumber than anything any single member of the committee would recommend.

Clawback the bonuses, make people accountable with prison terms, and you'll see this problem go away quickly.

You can't stop a bubble if you don't see one. The Fed didn't see a bubble.

There were clues; they should have been in the inflation rate, properly measured. But they didn't see it:

2005, Bernanke: "There is no housing bubble"

I guess that argues for option 1.--- stupidity. And Bernanke is one of the smart guys.

http://www.marginalrevolution.com/marginalrevolution/2008/02/was-there-a-hou.html - collective stupidity?

Richard Posner has a post addressing this same question. He gives far greater weight, as would I, to the global savings glut driving down interest rates and (he doesn't phrase it quite this way) compressing credit spreads.

I'm very interested to see Tyler's thoughts on it, but my money (metaphorically) has been on the global savings glut explanation. The total value of global fixed-income investment doubled from $36 trillion in 2000 to $70 trillion in 2007. China has been growing at 10-12% per annum for quite a while now, generating $4 trillion in GDP but only consuming 1/3 that domestically. And not just China--GDP growth in the developing Asian countries has averaged 6 or 7% for the last couple decades, and without well-developed financial markets domestically much of that money has poured into our sophisticated, stable markets in the West (ha ha), particularly after the '98 crisis.

Sure, China was mostly buying Treasuries, not subprime mortgage-backed CDOs, but that kept interest rates low and pushed institutional investors who needed AAA product that would pay more than 1% off into these "AAA" tranches paying 500bps over Treasuries. #2 in Tyler's list is a huge factor--the misaligned incentives in the financial services industry are tremendous, and tricky to design around even if there had been any political or institutional will to do so. But, as others have pointed out, this has always been the case (although the payouts involved got a lot higher the past decade). And indeed bubbles and manias have always been with us, and with increasing frequency through the 80s and 90s.

The problem is that this bubble lasted too long, and got way too big, before it finally popped. And the culprit for that, I think, the thing that made this one different from the rest, is too much money chasing too few productive places to invest it. And, perhaps, the rise of strategies to spread risk until it was systemic, although those could just be an obvious response to the savings glut in the first place.

If there wasn't anyone like that, wouldn't we prefer the term "institutional stupidity" or "ponzi stupidity"?

Grant is asking some of the right questions. The question to add to this is, "exactly who had identified these forms of stupidity, encouraged them, and took advantage of them?"

How about someone comment on the huge gyrations in interest rates we have seen in the last 40 years? How, exactly, did banks that reported enormous profits over the last 10 years suddenly fail to have any capital?

Joe in Morgantown: "You can't stop a bubble if you don't see one. The Fed didn't see a bubble"

Are you kidding? Bernanke saw the bubble. Everyone saw the bubble. The fact that Bernanke (and Frank, and everyone else) claimed publicly that there was no bubble doesn't mean they didn't see one. It just meant they were all positioning themselves to profit maximally after the blowup. Like infopractical, I watched this form over the past few years and heard plenty of dire apocalyptic warnings from many of the insiders -- I often wondered how people could be so stupid as to trust the politicians, and I'm happy to say I put my money someplace safer more than a year ago.

If you think that Bernanke was so honest back then, what do you have to say about the fact that he and Paulson just took a trillion dollars of taxpayer money and IT DIDN'T SAVE YOUR 401K LIKE THEY PROMISED? Is that just another oversight on Bernanke's part? Another silly mistake that he couldn't have been expected to see?

I don't think the word you are looking for is "Stupidity." I believe it is "Hubris."

From wikipedia:

"Hubris is a term used in modern English to indicate overweening pride, self-confidence, superciliousness, or arrogance, often resulting in fatal retribution. In ancient Greece, hubris referred to actions which, intentionally or not, shamed and humiliated the victim, and frequently the perpetrator as well. It was most evident in the public and private actions of the powerful and rich. The word was also used to describe actions of those who challenged the gods or their laws, especially in Greek tragedy, resulting in the protagonist's downfall."

Stupidity can not be an explanation. That raw material has always and will always be present.

Naked puts appear to be a variant on the stupidity argument. In times of volatility, naked puts are dangerous. If you believed in low volatility, then you just weren't looking.

But one conclusion that is inescapable is:

the science of economics doesn't work.

Megan agrees: "What we need is better economic theory of how these things play out, so that the regulators have better tools to assess and prevent systemic risk."

So what caused the crisis?

Assets were bid up unsustainably. Why? Because no one could get a real return on their investments otherwise. Why? Because the world is engaged in a destructive race to the bottom.

It is actually the fault of all the democrats. While the republicans were seriously busy governing from the white house for last eight years and from the congress for ten of the last 12 years at great sacrifice to their own well being, the democrats were busy undermining the financial system in secret.

The democrats conspired to create this October surprise, in order to get Obama elected. Republicans should unleash the CIA and bring these financial terrorists to justice.

Or the answer could be simpler - whenever you do not regulate capitalists, they get greedy and screwup.

How can Tyler say Feinman is spot on? People can only have 30:1 leverage if someone is willing to lend them the money. Why are they willing? #3 is the main reason, but there is also an in-built possiblilty for bubbly behavior in any trading system. Heck, Vernon Smith induced bubbles in the shares of simple dividend-paying securities with a known terminal date in an experimental market. Five periods left, five $1 dollar dividends to come, and the damn things are trading for over $5.

Blaming innovations in derivative securities for the bubble and the crash is silly. We've had bubbles and crashes long before derivatives were invented. If anything, derivatives create greater liquidity and distribution of diversifiable risks. Economists have long noted that it makes little sense for individuals to have their wealth tied up in one local housing market instead of a diversified portfolio. Of course, derivatives mean that non-diversifiable risks get spread to a larger number of players.

First, I would like to say that Tyler Cowen did a very good job of expressing new ideas and many eye opening opinions. I agree with many points that Cowen made in this blog. I really agreed with the first reason listed, entitled collective stupidity, I also believe what is hindering to the economy dealing with the aspect of collective stupidity is that the mass majority of the population blindly follows a small percentage. Perhaps one solution to this reason of financial crisis would be to diverge from the norms of society and form our own opinions about economics. We as a society place to much trust in the small percentage of the population that is the elite class and therefore our blind following of this small group of people has caused stupidity in economic decisions to spread like and infectious disease.
Cowen also makes a good point in reason number two, writing the naked put, that it will be hard just to abruptly stop this behavior. I also really agree with the point made in reason number three, the neutering of debtors, that bailouts in long term hinders our ability to take responsibility for our own economic actions. Bailouts are simply a quick and easy solution and while they may work, bailouts also foster our ideals of being invincible. If the government continues to bail us out then as Cowen states what will stop us as citizens from being continually careless in economic decisions.
While I do also agree with reason number four, the increasing value of human capital, I feel that to add it to the mix as it is so called by Cowen would be a mistake. While it is true that the wealthy will continue to take extreme economic risks because in most cases the rewards out way the risks, I believe the majority of the population that is effected by the financial crisis does not fall into the category of wealthy that is described by reason number four. So while it makes sense I would not categorize it with the other three main reasons.

Ricardo, thanks for posting that.

"Isn't California filling up with Latinos? How are a bunch of Latinos going to pay off these monster mortgages? Are people really going to keep paying monster mortgages to send their kids to school with Mexicans?"

I'm a Celt, and I have no problem sending my kids to school with "Mexicans". What I have a problem with (other than way too much government at all levels) is sending my kids to school with the children of people who trash their neighbors and don't encourage their children to work hard. (And it wasn't all that long ago that the dirty Celts were the problem....)

And is it only "Latinos" who are having problems paying off their "monster mortgages"? Or is it anyone who borrowed more money than they could afford to repay, aided and abetted by government policies designed to encourage home ownership?

The only thing I wish is that the "Mexicans" and "Latinos" would encourage all their children, including the girls, to play soccer. My daughters play youth soccer, and the disparity between the numbers of "Mexican" and "Latino" boy and girl soccer players is downright discouraging.

Sailer blames "Political Correctness"?

Geez, we have what are supposedly the finest financial / statistical / economic brains in the world at these firms [just ask them], and they ruin their companies and the world's economies because they are afraid to hurt someone's feelings?

That's a stretch. [and I did read your "Karl Rove" article]

When are the free market fundamentalists such as Tyler going to admit that the failure to regulate under existing law is the proximate cause of the mortgage mess and consequent freezing up of the credit markets?

Interesting thread, I enjoyed reading it. Check this artichle as well: http://peekablog.net/2008/10/what-caused-the-financial-crisis/

Sometimes, instead of thinking what or who went wrong we need to focus how to cope up with the crisis instead.

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