According to the dominant narrative, which is again on display in the film version of Michael Lewis’s “The Big Short,” the great financial crisis that began in 2007 was the result of greedy capitalists pursuing their own self-interest to the detriment of others in society. The narrative typically goes like this: bankers bundled mortgage debt into mortgage backed securities (MBS) and collateralized debt obligations (CDOs) that were then classified as AAA by corrupt rating agencies and sold on to gullible investors. As a result, banks were able to move debt off their balance sheets and expand lending, especially to subprime borrowers. To increase demand for mortgages, banks relaxed their lending criteria and created adjustable rate mortgages with balloon payments. Meanwhile, mortgage brokers engaged in fraud to enable impecunious individuals to purchase homes. The resultant bubble in property prices eventually burst and millions of homeowners found themselves with negative equity. At the same time, the decline in value of MBS and CDOs caused bond markets to freeze, as investors reassessed counterparty risk, causing a lack of liquidity among banks, who were forced to stop lending.
This narrative is not entirely inaccurate; banks did offer ARMs and bundle mortgages as MBS and CDOs; mortgage brokers did breach lending standards and some engaged in fraud; and rating agencies were complicit in using models that ignored correlated risks. A bubble was created and when it burst, severe problems resulted in a range of markets. However, this narrative misses some important, indeed crucial elements, without which the crisis would most likely never have occurred.
The narrative fails to explain why the housing bubble occurred in the mid-2000s in the U.S. rather than in an earlier era or other place. The first MBS was underwritten by Ginnie Mae in 1968; ARMs are the main type of mortgage in nearly all other countries and do not appear to be a main cause of house price bubbles in those countries; and corruption or the witting collusion of rating agencies could in principle have taken place at any time.
There were clearly other factors that contributed to the creation of a bubble in house prices and the wider expansion of liquidity in asset markets to which it contributed. Arguably the most important factor was the progressive lowering of the Federal Funds Rate from 6.5 percent in December 2000 to 1.75 percent in December 2001 and then to 1 percent in June 2003, where it stayed until June 2004. By reducing the cost of borrowing and the value of saving, the Federal Reserve’s actions encouraged borrowing on an industrial scale.
Another major factor was federal government interventions intended to expand home ownership. These included a 1994 Department of Housing and Urban Development requirement that the Government Sponsored Entities (GSEs), Fannie Mae and Freddie Mac, buy 30 percent of their mortgages from low income homeowners – increased to 50 percent in 2000 and 52 percent in 2005. In response, the GSE’s lowered their lending standards. For example, in 1997 Fannie Mae introduced a mortgage that required only a 3 percent down payment. In addition, new rules issued under the Communities Reinvestment Act in 1995, required all mortgage lenders to prove that they were lending to the underprivileged. In combination, these efforts increased lending to subprime borrowers and led to the creation of GSE-guaranteed subprime MBS.
Adding fuel to the fire, under Basel rules MBS issued by GSEs carried a much lower capital ratio (1.6 percent) than mortgages (4 percent). So, banks had strong incentives to hold MBS rather than mortgages, since the former enabled them to leverage their capital more effectively. And that’s what they did. In 2006, banks owned 51 percent of all subprime mortgage MBS.
Banks attempted to cover some of the risk of holding MBS by purchasing insurance, typically in the form of credit default swaps (CDS). Insurance works by pooling uncorrelated risks; premiums paid to cover one risk effectively become collateral against other risks. When risks are correlated with one another, there is no collateral and pooled funds may be insufficient to cover all liabilities.
But what explains the failure of the ratings agencies – why did they provide “investment grade” (BBB and higher) ratings to hundreds of billions of dollars of bonds that should have been rated as junk? Arguably the most important factor is SEC regulation, which had a dual effect. First, SEC regulated financial firms were prohibited from holding bonds with below investment-grade ratings. Second, under SEC rules only “nationally recognized statistical rating organizations” (NRSROs) could provide ratings to SEC regulated financial firms. By 2003, following consolidation, only three NRSROs remained; Moody’s, Standard and Poor and Fitch. These three competed fiercely to keep clients happy, but as long as they all followed a similar rating methodology, they were reasonably assured that they would not lose their NRSRO status. So, they chose a rating methodology that presumed house prices would continue to rise.
The rating agencies justified this optimistic presumption by reference to the fact that since the end of the great depression, there had never been a significant nationwide drop in house prices. (There had been some major local declines that fed into modest national falls – less than 20 percent – in the early 1950s, the early 1980s and the early 1990s.) But the nation also had not experienced an extended period of rising rates of house price growth – until the 2000s. In past booms, the rate of price increase rapidly declined, leading to a concave curve. In the house price boom that started in 1997, the curve was convex until 2006, when prices rapidly descended.
A further problem is the pervasive view among economists that bubbles will be self-correcting. But as Nobel-prize winning economist Vernon Smith and colleagues had discovered in experiments dating back to the late 1980s, while markets for non-durable goods tend to clear at prices reflecting the fundamental value of an item, markets for durable goods can often veer far from fundamentals. As prices rise, market participants factor in further increases, thereby justifying further investments, and so on, until some event precipitates a realization that prices are far out of whack – triggering a crash.
In their brilliant recent book, “Rethinking Housing Bubbles” (Cambridge University Press, 2014), Chapman University economists Steve Gjerstadt and Vernon Smith relate this experimental work to the problems experienced in the U.S. They note, for example, that permitting insider trading and futures markets tends to dampen bubbles but imposing “circuit breakers” or mark to market rules do not. Meanwhile, poorly structured regulation can make bubbles worse. They emphasize in particular the concatenation of problems emanating from the differential regulation of derivatives, such as MBS and CDS, noting:
“Mortgage markets were flawed by an unsustainable, destabilizing chain from mortgage origination – badly incentivized with upfront origination fees – through mortgage securitization insured by uncollateralized derivative instruments and rated by agencies whose models had a built-in allowance for price appreciation.”
Gjerstadt and Smith examine historic U.S. bubbles/crashes and similar experiences in many other countries. They find that house price crashes typically result in a collapse in fixed investment, as firms and households seek to shore up balance sheets. In such circumstances, neither attempts to expand the money supply nor increases in government expenditure are effective in stimulating sustained recovery. They note, “in fact, most countries that recovered rapidly reduced both government expenditures and government deficits.” They contrast the example of Sweden in the late 1990s with Japan over the past 15 years. Sweden aggressively pursued default and bankruptcy, with the result that balance sheets were repaired rapidly and recovery was swift. By contrast, Japan bailed out bankrupt companies and has experienced a slow and tepid recovery.
In the United States, as house prices continued to fall through 2007, banks with significant portfolios of subprime mortgages and/or subprime MBS and CDOs became insolvent. Most of those banks went into receivership; the FDIC has overseen the orderly bankruptcy of over 500 U.S. banks since February 2007.
However, in March 2008, the Federal Reserve Bank of New York bailed out Bear Stearns with a $29 billion loan as part of a merger agreement with J.P Morgan Chase. This bailout was justified on the grounds that the collapse of Bear Stearns presented a “systemic risk.” But Bear Stearns was an investment bank; it did not have conventional depositors and it is most unlikely that its failure would have had systemic repercussions.
Perhaps realizing its mistake, the Federal Reserve did not intervene in the case of Lehman Brothers, which on Sept. 15, 2008 entered bankruptcy. Unsurprisingly, given the apparent precedent set with Bear Stearns, the markets reacted violently to this news. So, the following day the U.S. government gave insolvent insurer AIG an $85 billion credit facility in return for a 79.9 percent stake in the company. (AIG had been unable to post collateral on $441 billion in CDS it had written, of which $57.8 billion pertained to subprime MBS and CDOs.)
On Oct. 3, 2008, Congress passed the Troubled Asset Relief Program, authorizing the U.S. Treasury to purchase $700 billion of assets from a range of U.S. companies. While TARP represents an implicit acknowledgement that the problems being faced by banks were the result of insolvency rather than a lack of liquidity, the program sent a strong signal that some companies were “too big to fail,” thereby reinforcing the perverse incentives that caused the crisis in the first place.
In 2010, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act. Motivated by a desire to prevent a repeat of the crisis of 2007-2008 and the ensuing recession, Dodd-Frank seeks to regulate every conceivable part of the banking industry (including, for example, payment networks, which played no conceivable role in the crisis).
A year earlier, President Obama had signed into law the American Recovery and Reinvestment Act, aka “the stimulus,” which contained a package of fiscal measures designed, ostensibly, to create jobs and help the economy recover.
Meanwhile, the Federal Reserve continued to purchase assets through a series of rounds of “quantitative easing,” buying a combination of mainly MBS and Treasury securities. The final round of QE ended on Oct. 29, 2014. All told, the Treasury purchased $4.5 trillion of assets.
So, the “solution” to the financial crisis and ensuing recession in the U.S. has been a combination of bailouts, monetary expansion, and massive regulation of the financial sector. While household balance sheets have gradually improved (private debt has fallen from 98 percent of GDP in 2009 to 80 percent today), it is likely no thanks to these interventions.
Indeed, the U.S. economy would almost certainly be much stronger had the bailed-out banks and other companies been allowed to fail. There would then have been no need for the quantitative easing that has resulted in asset price inflation. Nor would there have been a need to impose draconian regulation on the banks.
Unfortunately, these interventions have left the U.S. economy with bloated, bureaucratized financial organizations that are even more obsessed with checking boxes rather than identifying and supporting innovative businesses. Meanwhile, consumers and businesses are saddled with the prospect of decades of higher taxes to pay off debts incurred on their behalf. The prospects for economic growth are thus much curtailed.