After being so mean to banks in my article earlier this week, today, I felt the need to defend them. Looking through my Quora feed this morning, I saw the question about the cause of the 2008 financial crisis, and even though I didn’t have time to, I simply had to pen a response.
The 2008 financial crisis was caused by two main factors: human greed and reliance on theory. These factors were exacerbated by the interplay of politics on both.
I am progressive, politically, but hearing fellow progressives talk about how banks caused the crisis makes me cringe. Americans in general seem to like to identify bad guys and good guys and divide the world into one of the two camps. Usually, the truth is that people are doing what they perceive as sensible and beneficial to their own interests at the time and sometimes, that leads to problems that hurts others.
Let’s look at all three factors individually
Employees at banks are compensated to do a certain job well. Back in the mid-aughts, people were involved in a business of making loans, “structuring” debt securities according to academically and professionally recognized criteria, and selling those structured securities to the market.
Each person working in that line of business was trying to do the best job they could to maximize their own income and position in the company. The executives sitting at the top of this business knew that competitors were generating booming profits doing the same thing. An executive is compensated on the basis of factors like Earnings-per-Share (EPS) growth, stock price appreciation, etc. From an executive’s perspective, supporting and encouraging this business was a rational thing to do to increase his or her own standing at the company.
This set of conditions meant that the banks sold a lot of mortgages, structured a lot of securities, and sold a lot of derivative instruments that were unwise to sell. The banks are certainly culpable.
Every consumer in the U.S. is bombarded with signals every day about how much better their life could be were they to buy (or rather lease) a certain car, use a certain product, sit on a certain couch, etc. The American Dream is (was?) home ownership — we consider owning our own home to be equivalent to being the master of our own lives.
In the mid-aughts, consumers and home buyers realized that they could live in a very nice home — better than they ever thought they would be able to afford — and by using Home Equity Lines of Credit (HELOCs), buy some really great stuff to go in that very nice home. They could live a similar lifestyle to popular TV stars, even if their salary was relatively low. (Their salaries were relatively low, because median incomes have been stagnant for a very long time in the U.S. We have shifted from having one breadwinner per household with a good salary to having two co-breadwinners making so-so salaries).
The value of housing was going up so quickly from an historical perspective, that they became relatively sure that they could take out all this debt buy all this stuff, and cash out any time they wanted by selling their house and moving to a better one.
This set of conditions meant that consumers borrowed money, bought monstrous trucks, flat-screen TVs, vinyl siding, garden gnomes, and leather sectional recliners. The consuming public is certainly also culpable.
Hedge fund managers make money and achieve fame by making investments that are proven wise after some period. Some hedge fund managers noticed that the mortgage markets were “frothy” and that some people getting loans should probably not have been loaned the money. They began to make investments that expressed the opinion that eventually, these highly valued structured securities would loose value. If an when the securities lost value, the hedge fund manager would be famous and wealthy, and his or her investors would also have made a nice return.
Over time, as lending standards became looser, hedge fund managers became more convinced that their investment opinion was correct, so looked to increase the size and concentration of their bets against the housing market. They demanded more securities to “sell short” and because hedge funds are very good clients of big banks, the employees at big banks wanted to structure more securities for the hedge fund managers to sell short. This meant that the bank employees made dodgier and dodgier loans and more people with No Income – No Job bought pretty nice houses and filled them with flat screen TVs and garden gnomes.
This set of conditions meant that hedge fund managers demanded securities to sell short, which banks obliged by structuring securities that could be sold short. The hedge funds are certainly culpable.
German Landesbanks (regional banks) — like all banks — take in client deposits in return for interest payments. If they can get a higher yield on their own investments while not paying much in interest to clients, they will make money for their bank. However, Landesbanks are conservative, state-run institutions and are prevented from buying speculative securities.
Luckily, the way the banks were structuring mortgage securities was to break them up into tranches. Top tranches were backed by payments from mortgages whose borrowers were very likely to repay; bottom tranches were backed by payments from mortgages whose borrows were relatively unlikely to fully repay. The top tranches had high debt ratings, so the German bank employees were authorized to buy them. They were “safe” not “speculative” because they had a good debt rating.
Not only did they have a good debt rating, they paid a little more than other securities of the same rating. This means that if bank employees bought these securities, they could fulfill their function at the bank — making it money. They bought ever lousy piece of mortgage paper that the investment banks could churn out and they did it mindlessly. As long as it was rated Aaa or Aaa, they would buy it. This created demand for the structured securities that the banks produced, so the banks were incentivized to create more securities. This is the same dynamic as the hedge fund managers, who were “on the other side of the trade” from the Landesbanks.
German Landesbanks are certainly culpable. (Not only Landesbanks. There were plenty of other institutional investors buying mortgage structures willy-nilly, but the Germans were famous for being the buyer of last resort for mortgage securities).
The debt rating agencies are also culpable in this scenario, because they were rating the highest tranches as Aaa based on what seemed like good theory, but which they were not able to verify in practice. (Buffett made this point — the structuring documents were hundreds of pages long and securitized products had hundreds of these structures within them. No investor or analyst on earth could have possibly made an informed judgement on what securities that complex were worth).
So, anyone who took out a mortgage, worked in the mortgage industry, lived in a federal state of Germany, bought a flat-screen TV or garden gnome in the mid-aughts is partially culpable for the 2008 financial crisis.
It still would not have been possible without bad theory.
Allen Greenspan was the Chairman of the Federal Reserve Bank System in the U.S. during most of the lead-up to the mortgage crisis. The Federal Reserve Bank is tasked with a dual mandate: 1) Regulate the banking system, and 2) Supervise and manage the money supply.
Greenspan was a devotee of Ayn Rand and a firm believer in a dangerous fiction of a theory about the so-called “free market.” Various versions of this fiction exists, but by all accounts, Greenspan believed in the version that held that government should step out of the way of rational actors in the market because the market would do a better job of self-regulating than a government could ever do in imposing regulations.
So, of the Fed’s dual mandate, Greenspan effectively abrogated responsibility for one of them – regulate the banking system. I have bank examiner friends at the Fed, and from what they tell me, it was politically unwise to talk too much about issues related to lax lending standards at banks during Greenspan’s tenure.
I honestly cannot quantify the degree to which Greenspan’s influence led to the financial crisis, but certainly, the theory that “If we let the banks regulate themselves, the free market will sort everything out” was part of the chain of culpability. (It was also shown to be completely false in 2008-2009, when the government had to step in because it couldn’t allow all the implications of the “free market” — namely, bankruptcy of very large banks).
This is already running long, so I won’t go into great detail about the theories underlying securitization. They are perfectly sensible, though. Let’s say we have 300 borrowers, 100 who have very high credit scores, 100 who have middling ones, and 100 whose credit its bad. The idea is that, in normal environments, the high credit score people will very likely pay their debts, the middling credit score people will pay their debts generally, but some will fail to, and the low credit score people will pay some but are much more likely to fail to repay the whole thing.
Securities can then be created by pooling together mortgages from different types of borrowers so that under normal circumstances, you’ll have a very good idea of what repayment rates are likely to be in aggregate. This is a “structured” debt security.
Implicitly, this theory assumes that structured security exists in a much larger environment and is independent and a relatively small piece of the whole. It assumes that the environment will not, in other words, be materially affected by whatever happens to these securities.
During the lead-up to the financial crisis, securitized debt became a much larger portion of the market as a whole and so many investors were invested in these things that repayment of one had a knock-on effect on the ability of an investor to make repayment of another. If one or two were not repaid and the effects of that non-repayment could have been isolated from the rest of the market somehow, that would have been okay in the grand scheme of things, but everything was so interconnected, that such an isolation was impossible.
In a general sense, theories developed by humans tend to be reductionist in nature and look at interactions in discreet ways — some event is happening within a larger environment and the theory explains how that singular event works or should work. However, when the event at the heart of the theory becomes a large part of the environment itself, the reductionist logic no longer holds, but people still resort to it.
The theory of structuring works perfectly well on an individual security basis, but as the market grew and become more tightly coupled in a complex way, that theory stopped working. The idea that “I can sell this if the value declines” only works if there is a functioning market and a counterparty to take the other side of the trade.
From ancient Rome to modern times, politicians have know that the way to power is by increasing the population’s perceived well-being. “Bread and circuses”, “A chicken in every pot”, and “Universal health care” are all manifestations of this.
I’m not an expert on the history of the mortgage market, but for years, politicians instituted laws and created semi-governmental institutions dedicated to making sure that people can afford homes. The populace felt better off, the system was more stable (because people had a vested interest in perpetuating it), and the politicians could credit themselves with helping their constituents.
Freddie Mac and Fannie Mae are instruments of government policy. The mortgage interest payments that you’ve made this year will be able to be “written off” of your taxes in a few days (meaning that the government is partially subsidizing the payments).
Municipalities and school boards were happy that more people owned houses and that the value of these houses were going up in the mid-aughts. It allowed them to pull in more tax revenues and build (in the case of the town I’m living) a very nice Village Hall building, a new police headquarters, and a few new fire stations. Local schools could afford to buy cool tech gear for the students (and of course for the teachers and administrators!). Governments simply work better when the populace is wealthy, happy, and stable.
As long as people were able to buy flat screen TVs and garden gnomes and pay increasing taxes on their real estate holdings, politicians were happy! They made laws that encouraged people to borrow to buy real estate and supported the desires of the banks (who had theory on their side and a track record of being “right”), who were also very generous contributors to political campaigns.
In addition, politicians could see that because we had a nice new theory about distributing and structuring risk in such a way that it wasn’t risky any longer, those old rules made back in the 30s about how banks shouldn’t be allowed to make speculative investments using depositors’ capital were simply outdated and unnecessary. Let’s repeal Glass-Steagall because the free market is clearly able to regulate itself. Banks that engage in risky behavior will be punished by the market…
Clinton was a popular president and his popularity increased over his time in office thanks in part to the fact that bankers were making 8-figure bonuses, John Q. Public was happy with his flat-screen TV and his garden gnome, and the local mayor had a really rocking new office.
Politicians were certainly also culpable for the 2008 financial crisis.
Just look what we can accomplish if we all work together!
Everyone, doing the next thing that seemed to be right, justified, and even natural managed to bring about a financial crisis that continues to ripple through the global economy even now.
The U.S. is technically out of recession, but there continue to be major strains in the economy, shown by underemployed workers, stagnant wage growth, bankruptcy of municipalities, etc.
Europe is struggling with low growth and high unemployment. Arguably, the EU is unraveling thanks to a myriad of factors, but one of those must be the stress induced by the sharp falls in asset prices due to the financial crisis.
China pulled the developed world out of the depths of the crisis in 2009 by going over the top in ordering building equipment and raw materials for ghost cities (it helped them too — if export markets shut down, as would have happened since a lot of flat screen TVs and garden gnomes are produced there, the Chinese government would have had a lot harder time keeping population happy, feeling wealthy, and stable). The overbuilding and overcapacity in the Chinese economy have myriad reasons, but the financial crisis is one of them.
So yes, the financial crisis was caused by the big banks. It was also caused by the guy down the street making a $45,000 / year salary and buying a $300,000 house and a $60,000 truck. It was also caused by Frank Fabozzi, an academic expert in the field of fixed income derivative securities and everyone who has read one of his books. It was also caused by that politician you voted for in the last election round and for the politician you’ll vote for in the next.
Oh, yeah. and it was caused by you and me!