Causes of the US Financial Crisis
Extremely large banks:
o Included banking plus investing branches
o Bank models did not include period of prior crises or steep asset price declines. Therefore they mispriced the assets at a higher rate. These models also work only when one person or group is using them. If everyone uses these models, “herd” actions may follow.
Excessively expansionary policies:
o Interest rates lowered after dot-com bubble burst. After the dot-com crash and the subsequent 2001–2002 recession, the Federal Reserve cut short-term interest rates to historically low levels, from about 6.5% to just 1%, which allowed more people to purchase homes for a lower cost. Easy credit, combined with the assumption that housing prices would continue to appreciate, encouraged many subprime borrowers to obtain ARMs they could not afford after the initial incentive period.
o Finance grew massively even though real production did not grow as much. Underlying subprime mortgages were only worth $400 billion but securitization was worth several times that amount. Credit default swaps alone were worth trillions of dollars. The value today of these securities in unknown.
Poor regulation system:
o New mortgage products. Lenders offered increasingly high-risk loan options and incentives.
o Automated underwriting. Mortgage underwriters who used automated methods may have led them to approve borrowers that under a less-automated system would never have made the cut.
o Exaggerated credit ratings. Credit rating agencies gave investment-grade ratings to securitization transactions based on subprime mortgage loans.
o Securities moved off balance sheets into Special Investment Vehicles (SIVs) or Collateralized Debt Obligations (CDOs). Many mortgage lenders had passed the rights to the mortgage payments and related credit/default risk to third-party investors via mortgage-backed securities (MBS) and collateralized debt obligations (CDOs). Corporate, individual and institutional investors holding MBS or CDOs faced significant losses, as the value of the underlying mortgage assets declined.
Failure to address problem of risk after crisis began:
o Problem was not of liquidity, which was provided in spades, but of risk, not knowing how much banks held in bad assets, since these could not even be quantified.
Literature on Causes of the Crisis:
Stephen Cecchetti discusses monetary policy's role in the crisis: http://fmwww.bc.edu/ec-j/sems2008/Cecchetti.pdf.
James Crotty, "Structural Flaws in Deregulated Financial Markets Caused the Current Crisis: A Critical Evaluation of the ‘New Financial Architecture’" Download Crotty2008.doc (223.5K)
C.A.E. Goodhart discusses causes of the crisis in The Background to the 2007 Financial Crisis: http://www.springerlink.com/content/r08nh65g5j367211/. Goodhart discusses the regulatory response to the crisis as well: http://iei.uv.es/macro_conference/pdf/Goodhart_new2.pdf.
Wim Grommen discusses a pattern in the current crisis: Download Present crisis, a pattern
George Soros discusses the flaws of the paradigm for financial markets that led to the crisis, in The New Paradigm for Financial Markets. A summary of the book can be found here: http://www.nybooks.com/articles/22113. Soros benefits from the crisis: http://www.dailymail.co.uk/news/worldnews/article-1164771/Im-having-good-crisis-says-hedge-fund-manager-1billion-world-plunged-recession.html.
Useful Graphs:
From Brunnermeier, Crockett, Goodhart, Persaud, and Shin (2009), http://www.voxeu.org/reports/Geneva11.pdf:
Outcomes of the Crisis
1. Increased monitoring role of Federal Reserve. The Federal Reserve has been a watchdog of the economy before the crisis began, but since the crisis started, it has been requiring banks to evaluate more comprehensively the possible unintended consequences of proposed new financial instruments as well as how those instruments are likely to perform under stressed market conditions.
2. Changes in monetary policy. Monetary policy is more likely to be evaluated for the potential of creating asset price bubbles in the future. Monetary policy is also more likely to be used to counter sharp downturns, and may be coordinated globally.
3. Issue of valuing bad assets. When this crisis winds down, we will have found ways to value bad assets, whether it is through Treasury Secretary Geithner’s method of purchasing bad assets, or whether through other means. This will likely be instructive for future events.
4. Revised role of IMF. The IMF has been used to deliver loans to countries facing severe credit crises: Hungary, Iceland, etc, and also received pledges of support at the G-20 Meeting in April. The IMF will also include a successor to the Financial Stability Forum called the Financial Stability Board, which will have a strengthened mandate to watch for systemic risks.
5. Improvement of financial regulation
a. Less procyclical. The G20 summit in April resolved to reduce procyclicality by the end of 2009, by working with accounting standard setters, including a requirement for banks to build buffers of resources in good times that they can draw down when conditions deteriorate;
b. Changes in dealing with financial vehicles. The G20 summit concluded that “risk-based capital requirements should be supplemented with a simple, transparent, non-risk based measure which is internationally comparable, properly takes into account off-balance sheet exposures, and can help contain the build-up of leverage in the banking system.”
6. Review of bank models. Given the lessons learned from this crisis, bank models will likely be reviewed more closely to ensure that conditions are accurately modeled, rather than oversimplified, or presented without appropriate historical data.
7. Revisiting idea of new world reserve currency. The idea of creating a new world reserve currency to reduce the dollar hegemony and its inherent risks was revisited by Russia and China, but rejected by the United States. Russia and China suggested creating a new world reserve currency based on a basket of currencies. This way, reserves would not be at risk if the dollar suddenly loses value.
8. Suggestions for improving impact of current world financial order on poor. The UN and the WTO met in April and made suggestions for revising the global financial structure to improve the lot of the poor. Some suggestions were to reduce procyclicality and volatility, to protect food and energy (commodities) from speculation, to implement global stimulus measures, and to ensure commercial practices do not destroy the environment.
9. Recognition that financial crisis is not just a developing world phenomenon. The US financial crisis brought to light the fact that financial crisis is not just something which occurs in “underdeveloped” economies, but can occur anywhere due to the inherent instability of finance.
10. Disproves idea that financial markets tend toward efficiency. It was assumed, before this crisis, that financial crisis was a developing world phenomenon and that developed countries did not experience such events because markets were efficient. However, this crisis has shown that financial markets are unstable and require constant supervision and regulation.
11. Possible end to Japanese carry trade. During this crisis, carry trades across the globe reversed as liquidity shortages at home arose, and overseas capital returned home. The Japanese carry trade, in particular, faced a possible end as domestic interest rates looked likely to increase. However, interest rates are lower now; it is possible but uncertain whether the carry trade will end.
12. The question of moral hazard. The government has bailed out most large financial institutions in trouble. Will lenders abuse their positions because the government may bail them out if necessary? There's a bipartisan legislation on [Capitol] Hill that has the FHA coming in and putting a floor on the market. There's something to be said for that kind of response where the lenders take a loss and the investors take a loss. But they do it, and then in return for it the federal government then takes the risk of further price declines, which hopefully then will be slowed down.
13. Impact of fiscal policy. It is likely that we will see clear evidence, by the end of this year, that fiscal policy used to assuage the impacts of the financial crisis was successful in bringing back economies across the globe. The assumption upon implementing fiscal stimulus packages was that they were critical in stemming the worst effects of the crisis. Given improvements in production, it looks as if this assumption will have proven accurate.
New Financial Architecture, Implemented
A (Very Slightly) New Financial Architecture was agreed upon at the G-20 meeting in London in late March 2009. The NFA is not as radical as some have proposed, but it does appear to address some major global concerns in order to reduce financial risk-taking. The full report is available on the G-20 website: http://www.g20.org/. A good discussion of the $1 trillion promised to the IMF is available here: http://thestar.com.my/columnists/story.asp?file=/2009/4/6/columnists/globaltrends/3639424&sec=globaltrends. Whether risk reduction will actually occur in the US is unclear, possibly unlikely: http://roomfordebate.blogs.nytimes.com/2009/09/11/why-wall-street-reforms-have-stalled/.
Structural problems that have been addressed:
Structural problems that still need to be addressed:
- Reduction of US current account deficit
- Creation or expansion of institution to ensure international coordination and cooperation in staving off financial risk
- Use of dollar as reserve currency
- Separation of classic banking from riskier financial transactions
- Further reform of IMF to ensure counter-cyclical policy lending
- Global stimulus approach to ensure assistance to developing countries
Joseph Stiglitz commentary that we need further revision of the financial architecture, March 2009: http://www.guardian.co.uk/commentisfree/2009/mar/27/global-recession-reform.
Gertrude Tumpel-Gugerell, May 2009, The New Financial Architecture and the Role of Europe, http://www.bis.org/review/r090522e.pdf.
President Obama unveiled a broad financial oversight plan on June 17, 2009: http://www.pbs.org/newshour/bb/business/jan-june09/finance_06-17.html. But there is little chance that this plan will be implemented. Wall Street reforms have stalled: http://roomfordebate.blogs.nytimes.com/2009/09/11/why-wall-street-reforms-have-stalled/.
Paul Goldschmidt, June 2009, Belgian High Level Committee Report on a New Financial Architecture: Commentary, http://institut-thomas-more.org/pdf/352_en_ArtPG-2-June2009-Eng.pdf, http://www.premier.fgov.be/files/Lamfalussyreport_0.pdf.
