Part 1        Part 2         Part 3

In this last part in the analysis, lets look at the Micro causes that contributed to the crisis.

BEWARE: MANY FINANCE TERMS AHEAD!(Click on the hyperlink to get a succinct explanation)

  1. Financial Deregulation

In 1933, after the outbreak of the Great Depression, Congress fundamentally reformed banking with the Glass-Steagall act. A key feature of the act  prohibited banks from being “engaged principally” in non-banking activities, such as the securities or insurance business. Firms were thus forced to choose between becoming a bank engaged in simple lending or an investment bank engaged in securities underwriting and dealing.

However, faced by a deregulation spree during Reagan’s time as a need to combat stagflation, financial institutions used this opportunity to campaign against the need for greater oversight. The act was finally repealed in 1990s as commercial banks were allowed to hold 25% of their revenues in investment banking, which were deemed to be more risky and susceptible to panic. This led to the increased involvement of commercial banks in the ‘shadow banking’ industry. This increased the risk of systematic failure as the funds from Main Street which were deposited into commercial banks were brought into the unconventional areas of financial innovation. The credit expansion resulted in massive leverage across major banks, fueling the bubble while increasing the possibility of systematic default.

  1. Market Failure – Asymmetric Information

As a result of the financial deregulation that occurred, financial innovation led to the expansion of the security market and the creation of complex financial products such as collaterized debt obligations(CDOs) and credit-default swaps.

For example, CDO was a structured financial product that brought together various cash-flow generating assets such as mortgages, bonds which were essentially debt obligations acted as collateral(essentially something you lay claim on if the borrower fail to repay you). They were sold to investors with various returns, the higher the returns the less they were protected if the borrower were to default. [BY NOW, JUDGING FROM THE DIFFICULTY I EXPERIENCE IN PUTTING IT INTO LAYMAN’S TERM, YOU UNDERSTAND HOW COMPLEX IT IS]

These financial products were seldom understood by investors and many failed to take into account the risk that they were holding. It was a classical example of the principal-agent problem where sellers understood the financial products than the buyers. Moreover, credit-rating agencies gave these financial products AAA profile which was a signal to investors as safe investment.They should be acting as an independent oversight but lacked credible information in assessing the concentrated risks that these financial products posed. Moreover, there was a conflict of interest as credit rating agencies were paid by the banks who issued these financial products. Thus, they lack incentives to scrutinize the system.

Insurance companies(AIG) joined into the mayhem through the selling of credit-default swaps(CDS). Simply put, a CDS is an insurance policy against a default. Click the diagram below for a hypothetical situation:

Picture1

However, while most insurance situations such as car insurance or life insurance are isolated cases. Mortgage defaults are cumulative situations. As the prices of mortgages fall, more individuals end up in liquidity crisis thus the risk of market default grow exponentially with each individual default. In other words, blinded by profit, insurance companies failed to evaluate the risk they were taking, another case of asymmetric information.

The various degrees of asymmetric information between investors and banks, between credit-rating agencies and banks, between banks and insurance companies misallocated large amount of capital into the industry. These financial products were deemed safe and provided massive yield to various parties. However, in actual fact, they were all dependent on the growth of the real estate industry. As long as housing prices rose, the game was on. But, once the music stop, the massive panic triggered a feedback loop that involved the fire-selling of financial assets and the  massive fall in prices and liquidation. The result is an expansion of a real estate bubble that was intertwined with the financial industry and thus will destroy the financial sector as the bubble pops.

  1. ‘Too Big To Fail’ – Moral Hazard

There is a common consensus that the financial deregulation that occurred in the 1990s resulted in the rapid expansion of banks and their role in the global economy. Large corporations such as Goldman Sachs and Citibank opened up branches all over the world and they acted as key financial intermediaries to the global economy. However, their size became a major liability to the global economy. Since they were overly large, they were deemed to be overly important to the US economy for them to fail. Thus, this resulted in a form of moral hazard. Understanding that the US government will intervene provide liquidity during a financial crisis, it encouraged these major corporations to excessively pick up risks, further destabilizing the financial sector.

Loan to deposit ratio were over 100% in 2007 just before the break up of the crisis which effectively meant that banks were incapable of providing liquidity in the event of massive defaults. The default of Lehman Brothers or Northern Rock is largely a result of overly leverage portfolio that led to their susceptibility to bank runs. Moral hazard thus encouraged unwanted risk taking.

  1. Market-distorting American legalization

While there is a common consensus that the cause of the crisis was a housing bubble, the massive defaults were largely a result of the fact that 40% of all U.S. mortgages were held by sub-prime borrowers- individuals who had low credit ratings and low income who would not have acquired loans without the aid of the government and the government state-enterprises(GSEs) Fannie Mae and Freddie Mac. In 1992, Congress gave a ‘new affordable housing’ mission to both GSEs. Thereafter, it made its first ‘trillion dollar commitment’ to provide affordable housing, often to sub-prime borrowers who ran a high risk of defaulting on their debts.

Moreover, possibly politically motivated, the Community Reinvestment Act was enacted in 1995 which required that banks displayed proof that they were providing loans to underserved communities. However, though well intended to prevent racially discriminating practices, these communities were filled with large percentages of borrowers who have low credit standing that did not qualify them for a conventional mortgage loan.

To meet this new requirement and to achieve ‘affordable housing’ for various communities, GSEs bought mortgages from banks and property developers and sold them to sub-prime borrowers at discounted rates, approving lending practices that they once denounced. The erosion of credit standards posed systematic risk to the whole real estate industry.

Shortly after these new mandates went into effect, the nation’s homeownership rate–which had remained at about 64% since 1982 increased to 67.5% in 2000 under President Clinton, and an additional 1.7% during the Bush administration.

The percentage of mortgages held by GSEs over all mortgage originations increased from 37% to 57% from 1994 to 2003. Leverage ratios reached 75 to 1 which were a clear sign of government support but triggered systematic risk. Since many of these loans were offered to borrowers with low credit ratings, the result was a rapid expansion of default risk across the whole real estate industry. It thus destabilize the whole real estate industry and capital was misallocated into the industry further encouraging the bubble.

Conclusion

By now, you would have realized that the global financial crisis in 2008 was a result of a myriad of factors in which some I have failed to mention. Though it has been 7 years since the collapse of Lehman Brothers, we must not forget to draw important lessons from the crisis to avoid a repeat of such a disaster.

Final Pondering Questions:

  1. Is there any justification to prosecute bankers for their mistakes given the complexity of the crisis and the various groups of individuals contributing to the crisis?
  2. How has the study of Economics been affected by the crisis? Check out Behavioural Economic.
  3. An going hypothesis claims that the period of sustained economic growth and low inflation from 1987 to 2003 – ‘The Great Moderation’ resulted in the crisis? How is this possible in terms of human perceptions?
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