Causes of the Financial Crisis

In his Friday press conference, President Obama made some comments about the causes of the recession, both in his opening remarks and in response to the first question from the press. You can see it here –

Starting at 8:22, talking about the policies of the previous administration he says this –

These policies of cutting taxes for the wealthiest Americans, stripping away regulations that protect consumers, running up a record surplus to a record deficit, those policies finally culminated in the worst financial crisis we’ve had since the Great Depression.

It’s not surprising that he would want to tie the entire financial crisis to the the Bush administration and without doubt plenty of blame rests there. However, over the last week I’ve been reading Mihm and Roubini’s Crisis Economics, which addresses in Chapter 3 precisely the issue of the causes of the economic crisis, and they paint a much more complex picture that doesn’t really match the President’s diagnosis very closely. Let me try to briefly summarize their account here…

They maintain that the financial crisis was caused by a combination of six primary factors:

  1. Financial innovation – the practice by banks of creating and selling mortgage-backed securities emerged in the 1970’s and became more and more prevalent over the decades that followed. This resulted in two things: (i) a reduced incentive for the original lenders to ensure that their borrowers were in a sound financial position, (ii) difficulty assessing how risky these mortgage backed securities were, which led to excessive reliance on mathematical models that turned out to be highly optimistic.
  2. Moral hazard – employees of financial firms responsible for dealing in mortgage, investment and insurance products had more to gain by making short term profits than by taking seriously the medium to long term risks of these products. This was accentuated by the magnitude of bonus payments available to these people. Further, because financial firms were themselves so highly leveraged, their own shareholders had little incentive relative to the total assets of the companies they owned to exert any discipline on them. Even more importantly, creditors who loaned money to these companies also lacked incentive to force them to moderate the risks they took because of (i) Government-run deposit insurance schemes and (ii) an assumption that the Government as lender-of-last-resort would always bail them out if things turned very bad.
  3. Government action and inaction – (i) excessively loose monetary policy, notably by Federal Reserve Chairman Alan Greenspan in the wake of the dot-com crash of 2000 leading to the housing and mortgage bubble later in the decade. (ii) Alan Greenspan’s failure to use the provisions of the Home Ownership and Equity Protection Act of 1994 to regulate subprime lending and crack down on predatory lending. (iii) the Financial Services Modernization Act of 1999 which repealed the Glass-Steagall Act of 1933, enabling finance companies to combine investment banking, commercial banking and insurance businesses. (iv) the Commodity Futures Modernization Act of 2000, which eliminated regulation of much of the derivatives market, including credit default swaps that provided insurance against defaults on complex mortgage-backed securities. (v) Government subsidies for home ownership in the form of tax deductions for mortgage interest payments and property payments and the involvement in the mortgage market of government-sponsored enterprises such as Fannie Mae, Freddie Mac, the Federal Housing Administration and the Federal Home Loan Banks.
  4. Shadow banks – From the 1980’s onward a wide range of non-bank investment vehicles emerged that typically financed themselves with predominantly short term debt but invested in long-term illiquid assets. These entities were not subject to the risk-limiting regulations that banks must submit to and were not eligible for deposit insurance or lender-of-last-resort support from the Federal Reserve. Yet they grew in the amount of money they lent to rival the conventional banking system.
  5. Foreign cash – a surplus of savings in a number of other countries, notably Japan and China, found its way into the US where they were used to purchase both Government bonds and private securities. The authors suggest that “40 to 50% of the securities generated by US financial institutions ended up in the portfolios of foreign investors”. This ‘easy money’ fueled a boom that enabled Americans to live beyond their means for a very long time.
  6. Excessive leverage – Over a period of several decades there was a huge increase in the level of debt in all parts of the economy. It’s worth quoting some of the numbers the authors mention in order to underscore this point – Bank leverage increased by 50% from 1960 to 1974. From 1981 to 2008, private sector debt increased from 123% of GDP to 290%. Of that, corporate debt increased from 53% to 76% of GDP, household dept from 48% to 100% (in 2007) and the finance sector’s debt from 22% to 117%. Further, much of this debt was compounded in ways that were difficult to recognize – people borrowed to invest in entities that would themselves borrow more, and so on. The result was a financial system that was incredibly sensitive to a drop in asset prices.
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