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.


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