What caused the financial crisis?

The column is titled "Three Trends and a Train Wreck."  I attempt to explain the financial crisis in as simple and general terms as possible.  Here is one paragraph:

Over all, then, the three fundamental factors behind the crisis have
been new wealth, an added willingness to take risk and a blindness to
new forms of systematic risk. All three were needed to bring about the
scope of the current mess – so that means we’ve had some very bad luck
on top of everything else.

I have about nine hundred words to flesh this out and to discuss Fischer Black as well; Black is a neglected but insightful macroeconomic theorist who starts with ideas from finance.  Here is another paragraph:

Subprime loans collapsed first because those were the investments most
dependent on relatively poor borrowers who were the most likely to
fail. Since then, we’ve seen asset values fall throughout the economy.
Subprime borrowing was the canary in the coal mine, but it was hardly
the only problem. It now seems that a wide range of asset prices were
artificially inflated. The market for contemporary art, which depends
almost exclusively on very wealthy buyers, will probably be the last
market to plummet but that development is almost certainly on its way.

One thing to keep in mind is how international the crisis has been; any explanation should start there.  I wish in the column I had had space to discuss Spain, which has had relatively prudent banking regulation but still will have one of the biggest downturns in Europe.  It is also worth considering Norway, Canada, and some of the other countries which limited their risk exposure all along.  I mention Japan, but Brazil and Mexico also already have their banking crises behind them in the former decade and they too form other valuable points of comparison.

I am not sure I understand this Daniel Davies post, but it may have some overlap with my arguments.

Addendum: You might want to read this Jacob Weisberg column saying that the financial crisis refutes libertarianism.  His paragraph starting with "There’s enough blame to go around…" is exactly the foil I had in mind.  His overall thesis is worth pondering but he doesn’t once consider any cross-sectional variation across nations; such consideration wouldn’t help his thesis.  Am I allowed to say that the experience of Iceland refutes the small nation, social democratic model?  Probably not, nor should I be.

Second addendum: Tim Harford has a humorous piece comparing the crisis to Monopoly the board game.


It seems to me, that the nations most avoiding the collapse were ones who's banks already collapsed in the 90's, and then recovered after a short period of turmoil.

as a banker (in a very cautious group at a cautious firm), i am personally greatful that someone is finally making the it's-not-stupidity argument. imho it is impossible to make the 'banks were stupid' argument without also accepting one of the Gold Standard, fractional-reserve-banking-should-be-illegal, interest-is-sinful, or mattress-under-the-bed arguments too -- all of which involve the alleged stupidity of the government and not just of the banks.

now, some specific groups at specific firms _were_ stupid, but that is to be expected, and we had all better hope that there will be some stupid groups in the future, because if not, then our society will be poorer due to a societywide excessively high price of risk. an excessively high price of risk isn't as spectacularly catastrophic as the excessively low price of risk of the last 10 years, but compounded over time it can do just as much damage

A better and simpler explanation comes from Anna Schwartz, interviewed yesterday in the WSJ:


Well, since we're on the subject of what was done to quell speculative excess in the 1930s, the 800 lb gorilla in the room happens to be Bretton Woods. Why? What led to derivatives (recently rightly referred to in Congressional testimony as the latest incarnation of Bucket Shop practices) engulfing the world monetary system? It was none other than the end of the system of settling imbalance of trade among nations in gold. After the Nixon administration pulled the plug on this in 1971 the scene was set for a global casino of currency speculation. One bubble after another was created and blown out. Now we are at the point of either attempting insanely to further hypothecate our economies or to return to the Bretton Woods system of stability.


As your title implies, wrecks of trains, airplanes, finamcial systems, etc., occur whatever the trends. We therefore employ, signalmen, mainatenance staff, trained pilots, etc. to prevent and limit the malfunction that experience tells us is an ever-present risk. When a wreck occurs, the point at which we look for the critical failure is where it should have been prevented. In the financial system, that is the regulators. Anna Schwartz points to one way and one place where regulators did not do their job in this crisis. I think there were more. And the proof that they could have done their job is in Spain (where I am sitting now).

The apparent functions of financial regulatorsare three:

1. Keeping the possibilities of false markets, including fraudulent ones, to a minimum.
2. Preventing crises.
3. Preparing for recovery from such false markets and crises that do develop.

After this crisis, the western world’s financial regulators face a case to answer on all three functions. In outline, the charges are:

1. The regulators permitted dealing in new types of securities in which the allocation of risk between parties to the transactions was unclear; without signalling that there was reason to doubt the creditworthiness of these securities. Then they permitted regulated banks to transfer risk to “off-balance-sheet† entities without provision for the risks which remained with the banks. Third, they did little – too little – to assure themselves that the basic quality of lending underlying traded securities was maintained. In all these respects, very significant falsity was permitted in the markets.
2. There were many warnings that a crisis was likely, and ample evidence that leverage levels were such that a crisis was likely to prove severe. Little action was taken by most regulators to prevent one.
3. Over the past few years, regulators had done a good deal more than in the past to prepare for recovery from crises. They had thought through much of what needed to be done. That underlay the massive, prompt and unprecedented injections of liquidity that have been a feature of this crisis. They also were clear at the outset that massive recapitalisation of the banks was necessary. However, in Spring 2008 that recapitalisation stalled in the markets, half complete. The regulators took no further relevant action to secure recapitalisation until the full crisis of September/October.

That formidable list of charges does not mean that the regulators’ lacked powers or resources to discharge their functions. In Spain, country that was very much at risk from the collapse of a housing bubble, a regulator with no extraordinary powers did succeed surprisingly well in performing the first two functions. The Bank of Spain made its banks and savings banks both accumulate provisions against eventual losses in the ending of the real estate bubble, and provide 8% of capital if they wished to launch an off-balance-sheet vehicle. Further, they insisted that Spanish banks securitising loans remained liable for a portion of the risk, arguably minimising slide in loan quality. The result has been that the Spanish financial system has sailed through the international crisis with very little damage.

The sharp bout of trouble in the Spanish real economy remains (surely only the most foolish parts of Spanish politics thought it could be avoided). However it is being intensified by no more than weak refections of the international financial crisis, not by domestic financial disaster.

The lesson for those in much of the rest of the Western world looks simple. Our regulators could and should have avoided most of the financial crisis; but had we done so we would still be stuck with a lot of the real downturn.

I think Tom West makes a good point that market pressures may force even cautious managers into excessive risk-taking.

There is lots of talk about the role lousy mortgages played in the crisis, and they are certainly part of the story, but I wonder if their importance is not somewhat overrated.

You can give out lousy mortgages, and resell them, without creating problems, as long as the pricing is accurate. (Of course for some the correct price is zero, or close to it. These mortgages should not have been made). After all, as some wealthy venture capitalists cn tell you, there is nothing wrong with making highly risky investments as long as the price makes sense and you finance them sensibly.

So I wonder if the complexity of the securities - even simple MBS aren't easy to value - combined with lack of transparent markets to help out, led to overreliance on models that mispriced the securities. Then excess greed kicked in - overleverage justified by model-bases prices created disaster when the defaults started.

Part of what I'm saying here is that even if the MBS in your portfolio are based on sound mortgages, if your pricing is off and you leverage way up to hold them, you're asking for trouble.

From the libertarian angle, one of the major functions of government is the prevention of fraud, and there was a tremendous amount of mortgage fraud (both by lenders and borrowers) which was just let run.

The Weisberg piece is the second dumbest article I've ever read. He doesn't have a clue what libertarianism is. And his view that "deregulation" is at the heart of the problem is laughable. Why he has a forum in Slate (or Newsweek) is beyond me.
Oh, I forgot, they're run by libs, who are as uninformed as he is.
Charles Calomiris has a very good article about the panic on this weekend's WSJ op-ed page. Why Tyler links to Weisberg but not Calomiris (or Anna Schwartz's interview there) is a mystery.
Guess it's better to boom a stupid article bashing libertarians by an idiot who might cite you than to mention and link to an intelligent and well-informed interview or article by someone who never will do so.
(Anna Schwartz is 92; and Charles Calomiris works in a narrow field and forgot more about it than practically everyone else will ever know.)

1) Want both the best and most entertaining analysis of how the subprime mortgage disaster was caused . . . starting, earlier in this decade with a doubling of the global pool of hungry money looking for limited investments until it hit upon the financial innovations of subprime loans, which then were packaged together into MBS by Wall Street firms, turned into bonds, and sold in shares to investment groups world-wide --- then magnified by head-spinning leverage levels and shun-the-risk-insurance schemes and Credit Default Swaps and the like?

Go here to Ira Glass's hour NPR program.

Based on months of background work and astonishing interviews with mortgage brokers and bankers, top Wall Street packagers of their imaginary subprime assets, the computer whizards who ran their zonked-out programs based on default mortgage rates of the 1990s to show how sound the packaged CDO were, and the sellers and buyers of these pc-model-sanctioned MBS-pools turned into bonds and sold world-wide to investment groups clamoring --- yes, clamoring rabidly! like horny male and female rabbits left overnight in the same perfumed boudoir --- to give them more and more.

And by 2004, it turns out, there weren't enough even half-sound mortgages to satisfy the owners of these monetarized swamplands around the world.

The NPR link, by the way, above is to a shortened version on NPR. The full-hour program --- even more dumbfounding and a source of skyhooting mirth at human folly and greed --- can be linked to here

If you prefer a hard PDF copy, it's here.


2) A question prompts itself here that Glass's program answers. What caused the global pool of insatiable money looking for investments between 2000 and 2006 to reach interstellar levels in just six years?

In 2000, you see, that pool was $35 trillion . . . a figure that had taken centuries of economic growth to reach.

Six years later, it had soared to $75 trillion . . . far greater than the combined GDPs of all the countries world-wide ---- a mix of pension funds, insurance premium funds, cash-rich governments in oil-exporting countries, China's and Japan's Central banks, investment banks, hedge- and mutual funds and the like galore. Many of these can't-believe-how-much-dough-we-have financial groups and countries were poor a decade ago or, for the financial entities, non-existent. The rich countries imports of their oil and natural gas and goods-exports fueled their nouveaux-riches wealth, all hungry for some investment outlets.


3) The chain of avaricious lunacyunrivalled in world-history, it seems: at any rate, since the bad people didn't believe Noah and drowned in their orgies of self-absorption when the Big Flood began! --- is hard to credit until you hear the stories first hand in the extraordinarily canny interviews in the Glass program.


Among other things, the managers of these junk-laden mortgages that they gathered and sold to Wall Street as MBS couldn't find enough good mortgages to satisfy the hungry, buy-it-now! investment groups world-wide. One manager of a mortgage brokerage company in Nevada --- interviewed at length --- was a bar-man in 2003 when, with absolutely no experience in banking, he was hired to oversee a few dozen mortgage salesmen and buyers by an old established mortgage-firm.

His main qualification for the job? As an experienced bar-man with a glib tongue used to dealing with drunks, he inspired his team of scouring arm-twisting salesmen and buyers to get hold of any mortgage in Nevada no matter how junky it was and then sell them for a fee to money-drunk Wall Street types in $3000 suits.


4) By late 2004, the high-octane clamor for new mortgages from the money pool-holders was so ear-splitting that house-buyers didn't have to show that they steady job, didn't have to prove they had any bank accounts, didn't --- come to that --- even have to provide a credit-rating.

There was only one minimal requirement: get hundreds of thousands of bucks in loans, the house-buyers had to be able to sign their names at the bottom of the mortgage-loans . . . after which, wham! they were then put together by the bar-man and sent on to Morgan Stanley and other more so-called sophisticated financial geniuses who put them all together into huge pools of MBS, then sold in shares (or whole) to bond-buyers world-wide.


5) As you'll see if you listen to Glass's program, the big driving cause of the financial pandemonium and crash wasn't t the crazy subprime-loans.

They were a reaction to the hungry pool of global money on the prowl, like hookers in Las Vegas, for outlets that would pay them for their efforts. More concretely, it was the financial systems world-wide that created the spinning, out-of-control explosion of mortgage-backed securities turned into repackaged CDOs in more complex derivative ways . . . with, by 2004 and 2005 --- to repeat ---all traditional credit-analysis of mortgage-loans went by the way-side, Glass's staff interviewing borrowers who had to show that they had neither a job, nor a bank account, nor even a credit-rating.


In Ohio, come to that, 23 of these borrowers didn’t even have to sign their names.

They resided in a cemetery, and the flim-flam brokerage contractors simply took their names, signed them to the loan-contracts, and sent them onto Wall Street for repackaging.


5) The Ira Glass program, please note, is the first in a series of about 4 or 5 programs . . . all based on extensive interviews, all easy to follow, and --- the extraordinary thing of it all --- by far the more illuminating account of the current financial crisis and panic-driven meltdown that you’ll find anywhere.

Compared to Glass and his chief producer and interviewers, economists and financiers of all stripes lag far, far behind in their tonified theory-driven accounts --- crammed with statistics and complex math formulas and told-you-so group-think defenses of their theoretical commitments --- of how self-delusion and delirious avarice combined to lead to financial and economic ruin on a global scale.


Michael Gordon, AKA, the buggy professor


Maybe you should edit your own comment before calling Weisberg pretentious and accusing him of logorrhea.

I'm not getting paid for my opinions. I'm just guy who happens to know vacant BS when I see it. Unlike most, if not all columnists for Slate, I actually have some experience with banking (as an external auditor).

At least I have the guts to offer an opinion other than a single line. But if you prefer Slate's ideological straightjacket, good for you.

Aren't the "math jock" economists the ones who got us into this mess? Aren't the "rocket science" economists the ones who pioneered the new risk instruments? Isn't it the "idiot savant" math economists who are the ones who continually mis-specify the logic of risk?

In other words, in this present crisis, the mathematical "economics" of risk is not the solution to our problem; mathematical "economics" of risk IS the problem.

The economists have a lot to answer for in the present crisis. And almost none of you are fessing up.

The "rocket science" of financial risk just blew up on the launching pad, didn't it?

The regulators have prevented 9 of the last 5 future crises.

"With hindsight, it is easy to argue that regulation should have done more, but in most countries, governments were happy about rising real estate and asset prices and didn’t seek to slow down those basic trends."

I suppose most people think that leaders in a democracy can be ahead of the curve and ahead of people, and maybe I used to think so too, but at this point, I don't even understand where those people are coming from.

As for Weisberg, the same people that make up the market make up the electorate. The situation proves nothing about libertarianism except that a government that shows that it believes itself omnipotent yet again didn't prevent a damn thing.

Someone once said, "you cannot transfer risk, only share it." We certainly are sharing....

Am I the only one consistently unimpressed with Tyler's analysis of anything (except Chinese food)? Alex is a much better economist. I read this blog for his insights.

Rather random note from my accounting class. Reading articles from between 1997-2001 on a company called Green Tree financial that was acquired by Conseco--which then went bankrupt as a result of losses on Green Tree's subprime loans on mobile homes--it reads remarkably like today's crisis. Seems to have been largely ignored though...

Look, there will always be another bubble and another bust, but the fewer and more spaced out they are, and the less they impact your country directly, the better off you are in the long run.

The current credit freeze originated in bad mortgages handed out like candy mostly in four states, California, Nevada, Arizona, and Florida. They account for 50% of the foreclosures and maybe 70% or more of defaulted dollars.

What had been going on in those four states? A huge influx of immigrants from Latin America, typically with very low human capital. The government, under both Clinton and Bush, was wildly enthusiastic for handing out mortgages to low income and minorities with bad credit so they could get a piece of the American Dream and settle down in America. See the NYT article today on Clinton HUD secretary Henry Cisneros, who went on to work for Countrywide and KB Homebuilders, both major players in the fiasco. Or read Bush's speeches from 2002-2003 about getting rid of down payments to help meet his goal of 5.5 million more minority homeowners.

So, many of these fancy financial instruments being sold back and fourth on Wall Street were based on the assumption that Jose, a drywaller from Chiapas, would either be able to scrounge together $4,000 per month for the next 28 years to pay off his mortgage, or Jose would find an even Greater Fool wanting to pay even more to live in the barrio.

So, the amount of mortgage money going to Hispanics to purchase homes increased by 693% from 1999 to 20006. Similarly, blacks were up 397%, while whites were up only about 100%.

Over 2004 to 2007, half of all subrpime dollars went to minorities. (Thanks to Tino for crunching the numbers from the federal database).

Obviously, the idea that millions of Jose with grade school education were going to be able to pay off their monster mortgages was insane, but in our politically correct age, questioning it in an email that would show up in the discovery section of an anti-discrimination lawsuit. On average, the current population of California, which scores between 44th and 49th out of the 50 states on the federal NAEP school achievement tests is simply too dumb to earn the money to pay off those ridiculous mortgages of 2003-2007. That's the bottom line, but how many people had the balls to state it in writing?

So, suspicions were muted on Wall Street because of politically correct censorship.

It seems to me that the Jacob Weisberg misses the mark widely. The USSR did not fail because it could not work, it failed because it proved to be inferior. Now we might debate which countries provide the superior life the more libertarian or the less libertarian. I still like the more libertarian societies. I think that we could use more liberty further, considering the incentives to voters, I do not see how in a democracy regulation could have avoided this problem. IMO it is better for a country be as rich as possible so that the people are more capable of withstanding the inevitable storms.

How could a crisis caused in large part by government policy refute libertarianism? That doesn't even pass the laugh test. I mean obviously libertarianism isn't exactly bulletproof, as much as I would like it to be, but this line of attack is hardly the place to start.

"Superheater," ("Superhot"?)

I have given up trying to convince people that they should keep these
phony monikers to a minimum. While I figure most people using them are
just trying to be cool (if not superhot), some are genuinely concerned
about maintaining their employment situations.

However, my point is that if you are going to use a phoney moniker, do
not start parading around as Mr. Brave Person With Lots of Guts. This
is beneath laughable.

However, my point is that if you are going to use a phoney moniker, do
not start parading around as Mr. Brave Person With Lots of Guts. This
is beneath laughable.

If you go baqck to the original see that I responded to a one-line criticsm
that said I the "guts" to offer an opinion. Never said it made me
"Mr. Brave Person".

Incidentally, "superheater" is an industrial appliance,
it is not a meant to convey any personal characteristics.

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It is enlightening! all the people should think about the things

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