What Caused The Financial Crisis?

 

Sad but true — the financial crisis was all about bad monetary policy, a housing bubble, and poor bank risk management

There are a lot of opinions being trotted around ten years after the financial crisis. A lot of them are self-serving, to deflect blame from areas that they want to protect.  What you are going to read here are my opinions. You can fault me for this: I will defend my opinions here, which haven’t changed much since the financial crisis. That said, I will simplify my opinions down to a few categories to make it simpler to remember, because there were a LOT of causes for the crisis.

Thus, here are the causes:

1) The Federal Reserve and the People’s Bank of China

For different reasons, these two central banks kept interest rates too low, touching off a boom in risk assets in the USA.The Fed kept interest rates too low for too long 2001-2004. The Fed explicitly wanted to juice the economy via the housing sector after the dot-com bust, and the withdrawal of liquidity post-Y2K.Also, the slow, predictable way that they tightened rates did little to end speculation, because long rates did not rise, and in some cases even fell.

The Chinese Central Bank had a different agenda.It wanted to keep the Yuan cheap to continue growing via exporting to the US.In order to do that, it needed to buy US assets, typically US Treasuries, which balanced the books – trading US bonds for Chinese goods – and kept longer US interest rates lower.

Both of these supported the:

2) Housing Bubble

This is the place where there are many culprits.You needed lower mortgage underwriting standards. This happened through many routes:

• US policy pushing home ownership at all costs, including tax-deductibility of mortgage interest.
• GSEs guaranteeing increasingly marginal loans, and buying lower-rated tranches of subprime RMBS. They ran on such a thin capital base that it was astounding. Don‘t forget the FHLBs as well.
• Politicians and regulators refused to rein in banks when they had the power and tools to do so.
• Securitization of private loans separated origination from risk-bearing, allowing underwriting standards to deteriorate. Volume was rewarded, not quality.
• Mortgage insurers and home equity loans allow people to borrow a far greater percentage of the value of the home than before, for conforming loans.
• Appraisers went along with the game, as did regulators, which could have stopped the banks from lowering credit standards. Part of the fault for the regulatory mess was due to the Bush Administration downplaying financial regulation.
• The Rating Agencies gave far too favorable ratings to untried asset classes, like ABS and private RMBS securitizations. This is for two reasons: financial regulators required that the companies they oversaw must use ratings for assessing capital needed to cover credit risk, and did not rule out asset classes that were unproven, as prior regulators had done. Second, CDOs and similar structures needed the assets they bought to have ratings for the same reason.
• There was a bid for yieldy assets on the part of US Hedge funds and foreign financial firms. Without the yield hogs who bid for CDO paper, and other yieldy assets, the bubble would not have grown so big.
• Financial guarantors insured mortgage paper without having good models to understand the real risk.
• People were stupid enough to borrow too much, assuming that somehow they would be able to handle it. As with most bubbles, there were stupid writers pushing the idea that investing in housing was “free money.”