Tuesday, December 28, 2010

Causes of the Financial Crisis

The end of the year, and more than two years into the Great Recession is a good time to summarize the
Causes of Financial Crisis
The too-big-to-fail banks are blaming the financial crisis and the subsequent Great Recession on greedy home buyers who bought and mortgaged houses they could not afford. The accusation is very convenient because it holds the banks and financial organizations blameless and suggests no need for legislative reform. This is disingenuous. Who offered house buyers non-traditional liar loans with low starter rates that would balloon in a few years? Profits on the difference between home mortgage rates and the lender’s cost of money were too plebian for the high flyers of the financial sector. So the commercial and investment banks packaged mortgages into bonds and resold them to other banks, governments and pensions funds around the world. The market for these derivative bonds was marked by use of absurd levels of leverage, as high as 30 to one. This market was not regulated as are stocks. This allowed unheard of levels of profit as long as the price continued upwards. But, as any finance student knows it creates gigantic losses if the music stops. The losses could be several times larger than the capital reserves of the financial organizations.
The bond rating firms (e.g. Warren Buffet’s Moody’s and Standard and Poor’s) cooperated (co-conspired?) to anoint these bonds with ratings making them suitable for pensions funds, etc. The bond raters reasoned (if we can call it that) that real estate values had increased steadily for years with little volatility. Low volatility meant low risk to them.
If the rating firms had bothered to look at the individual mortgages contained in the bonds, they would have seen that a large number of them were taken out by people with poor credit who could only survive in an environment of rapidly and continuous escalation of housing prices.
The incentives for the players were all wrong and this explains why a lot of smart, calculating people went wrong. The mortgage brokers did not hold the mortgages and were paid on volume and not quality. The investment banks such as Goldman and Lehman did not expect to hold the mortgages either, but rather resell them as packages of derivatives whose value depended on a steady stream of payments by the home buyers. Firms such as Goldman resold the derivatives to Iceland, USB, etc. Everyone wanted in on the golden goose as firms like GE and GM, who formerly made real goods, switched to earning a big share of their profit on leveraged financial contracts. Fannie Mae and Freddy Mac, originally government chartered to support home mortgages, were now private, seeking big returns like all the rest. Paulson of the US Treasury was forced to nationalize them in 2007 or there would be no one to buy home mortgages.
For those it kept, Goldman (and Merrill Lynch, Bear Sterns, CityGroup, etc.) bought insurance against lower prices from AIG, called Credit Default Swaps. Goldman assumed they were fully hedged and safe, but gave no thought to what would happen if everyone headed for the exit at the same time. AIG itself was beguiled by the promise of returns much larger than its conventional insurance business earned.
When Goldman experienced falling prices, it and others went to AIG to recover its looming losses. The Government’s highest purpose during the crisis was to rescue the banks, under the guise that otherwise credit markets would freeze. It had 700 billion to buy troubled assets of banks. The government did nothing for the mortgaged home buyers who were dying as house prices fell and interest rates increased after the sucker rates expired. The unpaid balance on their mortgages soon exceeded the market value of the house. Many walked away leaving empty houses behind. In spite of the trillions government spent, it is no wonder that the prevailing public opinion said it didn’t work as they observed persistent unemployment.
Granted that in 2007 the President , Treasury and Federal Reserve officials were making decisions in an unprecedented financial crisis, nevertheless their failure to insist that the banks and their shareholders take some of the loss and write off some of the amount home buyers owed in inexcusable.
When the big picture is grasped, it is clear that the problem was not greedy home buyers, but super greedy avaricious, (yes, immoral) brokers, banks, and bond raters. The system was rotten and needs fixing, including a return to the Glass-Steagall rules passed in the Great Depression prohibiting combining commercial banks and investment banks. This would prevent the losses in bond trading from destroying the commercial banks. The fix still has not fully happened because the big players are willing to expose the system to cataclysmic failure for their own short-term profit.
This experience is an example of how smart individuals within a faulty system produce an aggregate result few desire. It cries out for institutional change.

Note: Some such as Steve Eisman saw the train wreck coming and figured out how to short newly invented CDOs and made billions. Brooksley Born, chair of the Commodity Futures Trading Commission, tried to write rules for regulating derivatives, but was told to desist by White House advisers Greenspan, Rubin, and Summers who, when the independent agency ingored them, persuaded Congress to prohibit any kind of regulation. They probably thought the profits of the financial sector, seemingly a large portion of economic growth, were too important to risk derailing. But, these profits were just paper. Casinos are not the stuff to build an economy on.

I wish all my readers a Happy New Year, though I fear the economy will not be happy.

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