While it is still too soon to make definite conclusions, below are some of the potential causes that are being circulated amongst economists.

Government Policies:

Federal Reserve’s manipulation of interest rates

In an attempt to control inflation and short-term growth, the Federal Reserve manipulates short-term interest rates. It is highly unlikely that a small group of people could possible know what the “correct” level of interest rates should be for our multi-trillion dollar economy, so we should come to expect huge errors. To prop up the economy after the tech-bubble and 9/11, the Fed lowered interest rates from 6.5% to 1.75% in 2001 alone. They later dropped rates further to a mere 1%. Fearing deflation, the Fed decided to hold down interest rates at its historically-low level of 1% for another year. These extremely low interest rates flooded the market with liquidity and enhanced the attractiveness of adjustable-rate mortgages.

Stanford economist, John Taylor, puts forth convincing evidence in his most recent paper for the Fed’s role in the current crisis (see http://www.stanford.edu/~johntayl/FCPR.pdf). Taylor shows that housing booms were highest in countries that with the most expansive monetary policy:

Quote :

"Most important is the evidence that interest rates at several other central banks also deviated from what historical regularities, as described by a Taylor rule, would predict. Even more striking is that housing booms were largest where the deviations from the rule were largest...The country with the largest deviation from the rule was Spain, and it had the biggest housing boom, measured by the change in housing investment as a share of GDP. The country with the smallest deviation was Austria; it had the smallest change in housing investment as a share of GDP."

Tax Policies that increased mal-investment

A second government policy that contributed to the housing boom was the tax code. By allowing mortgage-interest payments to be tax deductable, the government was, in effect, subsidizing mortgages. An article in Slate explains its implications well:

Quote :

"But the once-modest deduction has evolved into a very large and highly inefficient rent subsidy. The deduction plainly causes distortions. People are willing to pay more for houses and buy bigger houses than they otherwise would because they can deduct the interest from their taxes. "When Americans invest the bulk of their life savings in housing, that's a redistribution of capital from the productive business sector," said Sullivan. What's more, the expansion of the deduction seems occasionally to have more to do with stimulating the financial-services industry than with allowing Americans to turn their homes into assets. Consider the growth of interest-only mortgages. With the deduction, the government is effectively subsidizing your monthly payment. But you're not building any equity, you're just paying rent. It's hard to say how an interest-only loan encourages home "ownership." "

http://www.slate.com/id/2116731

A more recent development in tax policy, via the Taxpayer Relief Act of 1997, allows most home sales to be exempt from capital-gains taxes. Per the NYT:

Quote :

"…many economists say that the law had a noticeable impact, allowing home sales to become tax-free windfalls. A recent study of the provision by an economist at the Federal Reserve suggests that the number of homes sold was almost 17 percent higher over the last decade than it would have been without the law. Vernon L. Smith, a Nobel laureate and economics professor at George Mason University, has said the tax law change was responsible for “fueling the mother of all housing bubbles.” By favoring real estate, the tax code pushed many Americans to begin thinking of their houses more as an investment than as a place to live. It helped change the national conversation about housing. Not only did real estate look like a can’t-miss investment for much of the last decade, it was also a tax-free one. Together with the other housing subsidies that had already been in the tax code — the mortgage-interest deduction chief among them — the law gave people a motive to buy more and more real estate. Dean Baker, co-director of the Center for Economic and Policy Research, a liberal policy group in Washington, criticized the exemption as “a backward policy” that “helped push more money into housing.” "

http://www.nytimes.com/2008/12/19/business/19tax.html?_r=1&hp

Other likely culprits:

Greed

The most simplistic explanation for the housing and financial crises is greed. While this is a convenient explanation for some, it is flawed. Greed is a constant. Greed is a human condition that has always been and will continue to be present. Humans maintain a level of greed that neither increases nor decreases. Blaming greed would be like blaming gravity for a rise in plane crashes. If greed was not a constant, we would have to assume that Wall Street was somehow less greedy in 1995 than they were in 2005.

Deregulation/Lack of regulation

While it is comforting to think that regulators have greater omniscience than the millions of market participants with huge sums of their own money at stake, there is little evidence to believe additional regulations could have prevented the housing bubble and subsequent credit crisis. There is little tenable evidence that deregulation caused the current crisis or that a lack of regulation could have prevented it. (Let us not forget that two of the most highly-regulated entities, Fannie Mae and Freddie Mac, were also the most insolvent) As for deregulation, there were few regulations removed over the last decade and there is little evidence that those few had any substantial impact on the current crisis. Additionally, if lax regulations in the United States caused the financial crisis, we would see a direct correlation between economic contraction and the strength of regulatory bodies in other countries. Surely European banks, with heavier regulatory oversight, would have fared better than their allegedly loose-regulated US counterparts. The fact that financial systems around the world, each with varying degrees of regulation, have experienced the same stress suggests the level of regulation is irrelevant.


Ability to accurately measure risk

In my opinion, what played the biggest role in perpetuating housing investment and led to under-capitalized banks was the misinterpretation of risk. With 20/20 hindsight, it would appear that the financial industry should have seen this coming. A further look, however, shows their risk management was misguided, but not irrational.

The single piece of evidence that influenced home buyers to continue coming to the market, financial institutions to continue issuing mortgages and investors to continue buying mortgage-backed securities (MBS) was the very-long, historical record of home-price appreciation. The data below was what was primarily used by these participants in their decision-making.



Again, in retrospect this seems irrational. But don’t we do this every day with a host of other decisions? Many of us consume certain chemicals, like NutraSweet or Splenda, with the belief that past data accurately reflects its risks. For those that bought houses in areas like California and Florida, they rationally believed that, while prices will not continue their trajectory, they will not fall in value. We now know people were too reliant on historical data.

While imprudent, I do not think it is necessarily irrational. As for the banks, MBS investors, and regulators, they, too, were using historical data to assess their portfolio risk. While they may have stress-tested falling home prices in certain areas of the country, they believed a portfolio of mortgages would provide the necessary diversification to prevent overall deterioration. (For those familiar with modern-portfolio theory, the correlation of assets was underestimated, again because of the emphasis on historical data) It was not greed or short-term gains that made them take what we now know to be excessive risk, but rather the inability to conceive of an event they had not seen in their lifetimes. (i.e. a black-swan event). For a great article on the banks’ risk-management practices, specifically regarding value-at-risk (VaR), see: http://www.nytimes.com/2009/01/04/magazine/04risk-t.html?_r=3&pagewanted=all)

To conclude, I think the housing bubble and subsequent crisis is far too complicated for us to assign a single cause. It most likely was a combination of many factors. It is important, therefore, to place the onus on government officials to make their case for further restricting our freedoms for what they perceive to be our benefit. We should also avoid the mistake of assuming government bureaucrats are anything but human. They have no better means of predicting the future than the rest of us mere mortals. As such, if millions of market participants underestimate risk, so, too, will regulators. We also should not rule out the role that government played in creating the mess to begin with.

While capitalism is not perfect, it is far more perfect than its collectivist cousin. To say that we need to abandon free markets simply because of one recession is like saying one should never invest in stocks because of there is an occasional bear market. Imagine the magnificent loss in prosperity such a policy would have caused…



[Edited on January 6, 2009 at 1:56 PM. Reason : .]

1/6/2009 1:54:26 PM

The DOW isn't even a direct measure of return (doesn't include dividends and changes what stocks are listed in it), much less a measure of prosperity.

And the scale is complete nonsense anyway. How many loves of bread would a share of the DOW buy in 1935 versus today?

1/6/2009 2:15:59 PM

3 part summary by the WSJ on what happened
http://www.ritholtz.com/blog/2009/01/end-of-wall-street-what-happened/

1/6/2009 3:08:51 PM

its you. You are the cause of the crisis.

1/6/2009 3:15:14 PM

Quote :

"The DOW isn't even a direct measure of return (doesn't include dividends and changes what stocks are listed in it), much less a measure of prosperity"

I wasn't using the DOW as a proxy for prosperity. I was merely equating the foolishness of abandoning capitalism with the foolishness of abandoning equities as an asset class. The chart was used to visualize the latter. As for including divs, this would only steepen the curve and thus prove the point further. I could have used inflation-adjusted returns and it would have had the same trajectory.

[Edited on January 6, 2009 at 3:26 PM. Reason : .]

1/6/2009 3:24:38 PM

1. Lust
2. Gluttony
3. Greed
4. Sloth
5. Wrath
6. Envy
7. Pride

1/6/2009 3:42:37 PM

8. Gwyneth Paltrow

1/6/2009 4:10:44 PM

^ Very true. I'm embarrassed I missed that one.

1/6/2009 4:24:01 PM

This is not the end of the world -- This is the end of the world as we know it. There will be a flood and there will be a fire, and then there will be a new ark.

No longer will the tail wag the dog. We will go back to creating real value. Money will once again be a conduit for value, and real value will have be created by work producing real "stuff".

The I-banks that survive can still earn a living mostly by advising M&A and underwriting a few IPOs here and there. 2009 will be the year of Pharma & Biotech M&A, followed by M&A & and a few new IPOs in clean/free energy. There will also be plenty of financing needed for mining operations.

If 'stuff' relative to currency will be worth more, there will be new entrants operating to produce more stuff. The capital markets can still work to finance these operations that want to make stuff, and the public will buy stock and or debt in these operations.

Goldman & the Morgans will still be on top, but we will see new top dogs like Evercore and Lazard that fill the void of the Bear Stearns and Lehmans of the world. And ofcourse the overall size and influence of the street will be a lot less than in the past few decades. FYI Evercore was founded by Roger Altman, former clinton Secretary - not a coincidence - he's smart as hell.

1/6/2009 5:06:16 PM

I like how so many other countries blamed their economic woes on America's poor policies. Their investors were all too glad to share in the profits, but when the inevitable crash came it was all our fault.

I guess we should borrow some money from Saudi Arabia to bail out the banks that were bought up by Saudi Arabians over the past few years. Oh wait, WTF is this shit? They can just suck some more oil out of the ground to make up for their poor investments.

1/6/2009 5:12:55 PM

overheard:
"The natural laws of free market capitalism are no more to blame for this economic crisis than the natural laws of gravity are to blame for a hailstorm."

1/7/2009 12:33:28 AM

Eugene Fama has a new blog with Kenneth French. They tackle the following (note KRF is French's response and EFF is Fama's):

Quote :

"Q&A: Regulation Some people have argued that the turmoil was caused by a lack of government regulation. What do you think? Do we need more regulation? KRF: It is not obvious that financial regulations were weakened during the last few years. This claim seems to have been the product of a Presidential election in which both candidates were running against the incumbent. In fact, one could easily point to important new laws and regulations such as Sarbanes-Oxley to argue that market regulation increased. As more tangible evidence, the SEC's budget increased from $377 million in 2000 to $906 million in 2008. It is certainly true that different regulations could have reduced the magnitude of the current turmoil, but that is like saying a different portfolio allocation could have produced higher returns. The challenge is to develop regulations that will reduce the probability and cost of future problems without imposing unnecessary burdens on the economy. Although we have to resist the temptation to fight the last war, the current turmoil and the ongoing bailout do teach us a lot about how we can improve financial regulation. First, we should improve the resolution mechanism for financial firms. Counterparty risk is a primary concern in financial transactions. As a result, bankruptcy is essentially a death sentence for banks and other financial institutions. It is almost impossible, for example, for an investment bank to file for bankruptcy, reorganize, and emerge as a viable business. The process the FDIC uses to take over failed banks seems to be a good foundation for developing a more general resolution mechanism. Second, we should improve the capital requirements and other regulations that limit the default risk of financial firms. The ongoing bailout of Wall Street is probably not a one-time event. Even with an improved resolution mechanism, it is easy to imagine that under similar circumstances we will bail out the banks again. If so, they have a strong incentive to take more risk. When things work out their shareholders keep the profits and when they don't taxpayers cover the losses. As we saw with Freddie Mac and Fannie Mae, this is not a good business model for taxpayers. If we are going to insure financial firms, we need regulations that will limit the risk they take. EFF: Before the turmoil, most financial innovations (mortgage backed securities, credit default swaps, collateralized debt obligations, etc.) seemed like good ideas. After the fact, some turned out poorly. Could regulation have prevented the bad outcomes? Perhaps, if regulation were ideal, but probably at the expense of stifling financial innovation. If the norm is that the Government (taxpayers) bails out the financial sector when things go wrong, and financial firms go along with the bailouts, then more regulation is in order. The prospect of bailouts if things go bad allows managers to take more risk, and this "moral hazard" problem requires regulation of risk taking. Legislators and regulators will have to decide which institutions are the likely recipients of bailouts, and then regulate their risk taking. Sounds simple, but the devil is in the details. The ideal legal and regulatory system would be ground rules that allow bad financial innovations to fail and work themselves out of the system without government intervention. Again, the devil is in the details. More generally, current events are certain to produce more regulation, and much of it is likely to be counterproductive. My longtime colleague, George Stigler, was famous for his argument, buttressed by empirical evidence, that regulators are eventually captured by the regulated. As a result, regulation often has results opposite those intended. "

http://www.dimensional.com/famafrench/2008/12/q-some-people-have-argued-that-the-turmoil-was-caused-by-a-lack-of-government-regulation-what-do-you.html

1/8/2009 7:11:48 PM

Quote :

"It is not obvious that financial regulations were weakened during the last few years."

uhh, what?
1) Glass-Steagall was basically repealed (yes, under Clinton)
2) the SEC relaxed leverage limits (i.e. regulations) to completely unreasonable levels, allowing these companies to run themselves in the ground.

those two changes alone can be blamed for a lot of this mess, and those two changes should immediately be reenacted as soon as Obama takes office

1/8/2009 8:22:50 PM

Quote :

"uhh, what? 1) Glass-Steagall was basically repealed (yes, under Clinton) 2) the SEC relaxed leverage limits (i.e. regulations) to completely unreasonable levels, allowing these companies to run themselves in the ground."

1) This has been debunked thousands of times. Rather than respond, I'll put the onus on you to walk us through how Gramm-Leach-Bliley led to either the over-investment in housing or the subsequent credit market turmoil

2) While it is easy to define these limits as "unreasonable" ex post, it is difficult to say they were unreasonable given the data at the time (e.g. the data at the time showed that housing prices were uncorrelated among national markets, thus a portfolio of mortgages originated from a large number of diversified local markets would not deteriorate significantly. The probability of such an event, based on historical data, was extremely low. In retrospect, it seems such an event should have been acknowledged. If that is the case, what other low-probability events should we also have provisioned for. Should we raise capital requirements even further just in case half the country experiences a 100% increase in tornadoes? Provisioning for all such low-probability events cripples banks ability to lend.There is more reason to blame Katrina victims for not provisioning for Katrina as there is to blame risk managers for missing the then minutely-probable event that occurred in housing markets nationwide.

(I recommend this article for further clarification on why the SEC's move was not deemed unreasonable at the time, neither by the SEC, the I-banks nor the academic community: http://www.nytimes.com/2009/01/04/magazine/04risk-t.html?_r=3&pagewanted=all)


Also, from my original post...

Quote :

"if lax regulations in the United States caused the financial crisis, we would see a direct correlation between economic contraction and the strength of regulatory bodies in other countries. Surely European banks, with heavier regulatory oversight, would have fared better than their allegedly loose-regulated US counterparts. The fact that financial systems around the world, each with varying degrees of regulation, have experienced the same stress suggests the level of regulation is irrelevant."

[Edited on January 8, 2009 at 9:11 PM. Reason : .]

1/8/2009 9:07:00 PM

Quote :

"1) This has been debunked thousands of times. Rather than respond, I'll put the onus on you to walk us through how Gramm-Leach-Bliley led to either the over-investment in housing or the subsequent credit market turmoil"

it allowed companies to get "too big to fail" by allowing them to offer investments, banking and insurance. By doing so, it removed tons of transparency and market forces that were previously in force when banks had to make investments through other companies, who had to buy insurance from yet other companies. Now, though, AIG for example, can take bank deposits from customers, take that money and invest it themselves, then buy insurance from themselves to cover their own investments. It sets up huge conflicts of interest and shuts down much needed transparency.
Not to mention, it looks like some of this breaking up is going to happen anyway, as CitiGroup starts to fall apart. Of course, they should have never been allowed to get that big to begin with.

Quote :

"2) While it is easy to define these limits as "unreasonable" ex post, it is difficult to say they were unreasonable given the data at the time (e.g. the data at the time showed that housing prices were uncorrelated among national markets, thus a portfolio of mortgages originated from a large number of diversified local markets would not deteriorate significantly. The probability of such an event, based on historical data, was extremely low."

this is absurd. pure insanity. you're blinded by ideology.
So, you're actually saying that because the jerkoffs running the major iBanks didn't have their models right and saw money sitting on the table, and demanded something that according to their models was OK, but then turned out to be disasterous when their models ended up being based in fantasy land, that it's not their fault? That it was the "right move" to remove the leverage limits, for just those 5 firms? The 5 firms who now no longer exist, at least not as investment banks?

1/8/2009 9:38:41 PM

It has been the stand-alone investment banks, who were not affected by GLB, that have thus far failed. The only commercial bank failures have come about because of problems in their bread-and-butter businesses, not their investment banking arms. If anything, GLB has greatly helped the current situation. Without it, Bear would not have been acquired by JPM and Merrill would not have been acquired by BofA. The diversified financials have weathered the storm much better than their stand-alone brethren.

Regarding AIG, I am not aware that they were significantly affected by GLB. Can you provide a reference?

Regarding risk management: their models are not to blame, but the inputs. They were too reliant on historical data. Again, do we blame city officials of New Orleans, state officials of Louisiana and U.S. officials for not acting on the probability of a Katrina-like storm breaking the levies? This is the kind of probability associated with the housing bubble fallout. It was not some simple 3-4 standard deviation event ignored by regulators, intermediaries, investors with their own money at risk, the financial press, independent equity analysts whose sole job is to follow the housing and financial sectors, and academics. What occurred was an extremely rare event that many had not even fathomed. Things always seem simple in hindsight.


[Edited on January 8, 2009 at 11:28 PM. Reason : .]

1/8/2009 11:21:02 PM

Quote :

"Regarding AIG, I am not aware that they were significantly affected by GLB. Can you provide a reference?"

no, i can't - i should not have cited AIG for that example. AIG was affected by the massive amounts of CDSs they wrote, a result of the Commodity Futures Modernization Act, not of Gramm-etc.

Quote :

"Again, do we blame city officials of New Orleans, state officials of Louisiana and U.S. officials for not acting on the probability of a Katrina-like storm breaking the levies?"

actually, yeah - we sure as hell should have.
N.O. is a massive city sitting below sea level. It has been known for decades that the levy's could withstand something like a Cat 3 hurricane. That's all they were built to withstand. People have been petetioning for years to upgrade to a Cat 5, which given N.O.'s proximity in the Gulf was a certain eventuality.

Quote :

"This is the kind of probability associated with the housing bubble fallout."

any investment manager dealing in mortgages could have taken one look at the Case-Schiller Index and said "woah, back the fuck up - this is going to burst, and it's going to burst big at any moment here"

Quote :

"What occurred was an extremely rare event that many had not even fathomed. "

that still doesn't excuse the thwarting of regulations that had been in place, for good reason, for decades, just because someone thought the rules of the game had changed and we can now make money forever and ever on houses.

[Edited on January 8, 2009 at 11:56 PM. Reason : .]

1/8/2009 11:50:54 PM

Quote :

"that still doesn't excuse the thwarting of regulations that had been in place, for good reason, for decades, just because someone thought the rules of the game had changed and we can now make money forever and ever on houses."

I missed that. Exactly which regulations were thwarted that you believe led to this crisis?

1/9/2009 1:54:14 AM

don't be dense - i just said them. I'm not talking about companies ignoring regulations (although that did happen, even with the help of the regulators http://www.bloomberg.com/apps/news?pid=20601087&sid=aS9iOxIIhClw ), but about previous regulations that were outlawed or overturned by Congress or the administration

1) Gramm-Leach-Bliley essentially "thwarted" Glass-Steagall by overturning it
2) the SEC relaxing/removing leverage limits for the 5 biggest investment banks
3) Commodity Futures Modernization Act which overturned Shad-Johnson

1/9/2009 9:22:10 AM

1)

Quote :

"It has been the stand-alone investment banks, who were not affected by GLB, that have thus far failed. The only commercial bank failures have come about because of problems in their bread-and-butter businesses, not their investment banking arms. If anything, GLB has greatly helped the current situation. Without it, Bear would not have been acquired by JPM and Merrill would not have been acquired by BofA. The diversified financials have weathered the storm much better than their stand-alone brethren."

2) I won't beat the dead horse any longer, but will say this was driven by an over reliance on Gaussian distributions by risk managers. In hindsight, we know this to be the wrong assumption. This is how we better understand to measure and control for risk, however. We learn from past mistakes and correct them. It is always in hindsight that we think others were negligent. I was an analyst at the Fed and don't remember any stir over this SEC exemption. Only with 20/20 hindsight are people able to act like they could have somehow seen the world through a more omniscient lens.

3) Wider spreads in the CDS market were a symptom of the financial crisis, not the cause.


[Edited on January 9, 2009 at 10:38 AM. Reason : .]

1/9/2009 10:24:35 AM

Agentlion, what major banks were brought down by your #1? As far as I know, the only banks to fail had no investment-bank arms, and all the investment banks that failed had no traditional bank arms.

And while your #2 made things worse for those five banks, there were not the only speculators (such as FANNIE/FREDDIE) and do you seriously believe not granting that exemption would have prevented the speculative froth?

Booms and busts occur; they occur because you have not had one in awhile. And if there is a credible human story as to why this time will be different then it is going to be a big one. I believe this one was inflated by the presence of Fannie and Freddie and other government pushes to increase sub-prime lending. But all this does is make the peak higher, it does not change the fact that we were going to cycle whatever happened.

1/9/2009 11:40:35 AM

well, i can't help but imagine CitiGroup wouldn't be disintegrating in front of our eyes if it wasn't for GLB, seeing as how CitiGroup never would have existed in it's current form had Glass-Steagall still been in action


on a lighter note, here's a pretty good satirical overview of the crisis (it's not a Big Picture publication - it's embedded youtube videos from UK)
http://www.ritholtz.com/blog/2009/01/bird-fortune-silly-money-part-1-2/

1/18/2009 11:20:36 PM

I agree with Andy Kessler:

Quote :

"Contrary to the reregulation crowd, it wasn't the repeal in 1999 of the Depression-era Glass-Steagall Act (which had separated commercial and investment banking) that killed Citi. It was bad management. J.P. Morgan and Bank of America and Wells Fargo didn't have SIVs -- and while they too were caught in the credit crunch, these institutions have emerged as net acquirers of broken banks."

http://online.wsj.com/article/SB123207111431688593.html

1/19/2009 10:11:35 AM

Quote :

"J.P. Morgan and Bank of America and Wells Fargo didn't have SIVs -- and while they too were caught in the credit crunch, these institutions have emerged as net acquirers of broken banks."

however, one of the side effects of the large conglomerate companies is that we still don't really have a clear and full understanding of their internal health, as some arms of the company can still prop up and sometimes hide the ailments of the other arms.

1/19/2009 6:21:53 PM

1. Credit default swaps.
2. ???
3. Profit.

1/19/2009 10:03:06 PM

^^ Yeah, I agree.

1/20/2009 6:48:02 AM

Quote :

"1. Credit default swaps. 2. ??? 3. Profit."

This has already been addressed...

Quote :

"Wider spreads in the CDS market were a symptom of the financial crisis, not the cause."

1/20/2009 6:54:20 AM

this is a great interview (yes, yes, by the evil liberal Terry Gross) with Frank Partnoy, a former Morgan Stanley derivatives trader. He reviews the history of the derivatives business from the early 80s through today and what they have to do with the crisis now

http://www.npr.org/templates/story/story.php?storyId=102325715

3/27/2009 1:07:59 PM

Quote :

"A second government policy that contributed to the housing boom was the tax code. By allowing mortgage-interest payments to be tax deductable, the government was, in effect, subsidizing mortgages"

I think mortgages should only be deductible (if not already) on just your primary residence.

The interest deduction is needed to give a financial incentive and help provide an edge to primary residence seekers who otherwise would have to compete against wealth investors who put upward pressure on the market to buy properties to which they rent.

My candidates for the cause

1.) Greed
2.) Irresponsible home buyers
3.) Lack of oversight on a deregulated market (its like taking the governor off your Fearri; you may not wreck or hurt anybody 10 times driving 180mph down I40; but the one time you do screw up it will be nasty.)

[Edited on March 27, 2009 at 1:25 PM. Reason : l]

3/27/2009 1:23:57 PM

I agree with number two.

I addressed # 1 in the first post. It is mostly theoretical, so cannot really be proved or disproved. Nonetheless, here is my two cents:

Quote :

"The most simplistic explanation for the housing and financial crises is greed. While this is a convenient explanation for some, it is flawed. Greed is a constant. Greed is a human condition that has always been and will continue to be present. Humans maintain a level of greed that neither increases nor decreases. Blaming greed would be like blaming gravity for a rise in plane crashes. If greed was not a constant, we would have to assume that Wall Street was somehow less greedy in 1995 than they were in 2005."

3) Which part of the market? The market for subprime loans, CDS, MBS?

Here is what I had to say above in general:

Quote :

"While it is comforting to think that regulators have greater omniscience than the millions of market participants with huge sums of their own money at stake, there is little evidence to believe additional regulations could have prevented the housing bubble and subsequent credit crisis. There is little tenable evidence that deregulation caused the current crisis or that a lack of regulation could have prevented it. (Let us not forget that two of the most highly-regulated entities, Fannie Mae and Freddie Mac, were also the most insolvent) As for deregulation, there were few regulations removed over the last decade and there is little evidence that those few had any substantial impact on the current crisis. Additionally, if lax regulations in the United States caused the financial crisis, we would see a direct correlation between economic contraction and the strength of regulatory bodies in other countries. Surely European banks, with heavier regulatory oversight, would have fared better than their allegedly loose-regulated US counterparts. The fact that financial systems around the world, each with varying degrees of regulation, have experienced the same stress suggests the level of regulation is irrelevant."

[Edited on March 27, 2009 at 2:06 PM. Reason : ,]

3/27/2009 2:05:48 PM

^ yes, your response to #3 shows that you're clearly just taking your knee-jerk reaction to what your gut tells you is the cause of the problem, then ignoring any evidence to the contrary.

3/27/2009 2:34:13 PM

America
presents....


a
Bipartisan
production....


The Financial Crisis


starring....

Gravity
...as Free-Market Capitalism


The Earth
...as Greed


Wings of Wax
...as the Government


and introducing...

Flying Too Close to the Sun
...as the Banking System


(Stay tuned for movie reviews by TWW's The Soap Box, coming up next...)

3/27/2009 3:04:14 PM

Quote :

"^ yes, your response to #3 shows that you're clearly just taking your knee-jerk reaction to what your gut tells you is the cause of the problem, then ignoring any evidence to the contrary."

That may be true, so enlighten us with your evidence. What you have mentioned thus far in this thread was inadequate, as I and others have pointed out.

3/27/2009 3:27:55 PM

take a listen to, or read, the interview I linked to above. The interview mostly just goes over the facts, and does very little commentating on the implications of the actions taken in the derevitives markets. But after hearing those facts, many of the conclusions that the unregulated and not-publicly traded derivatives and CDS markets played a large role in this crisis are unescapable.

If you disagree with anything factually in the interview, please let us know where he was wrong. If you accept all those facts, but draw different conclusions from it, what are your conclusions.

3/27/2009 3:32:10 PM

^ i may be wrong, but doesn't the interview mostly imply the problem was a lack of regulations as opposed to "deregulation" (which is what you were saying earlier and what most Dems have been saying for a long time because it allows them to put the blame on the Obama admin's less popular Republican predecessors).

If that is correct, shouldn't we be asking ourselves why we expect a government that failed to see this particular problem coming will do any better in the future?

Seems to me that the feds do a good job of closing the barn door after all the horses have left--always fixing yesterday's crisis with a blind-eye to tomorrows. And if Sarbanes-Oxley is any indiciation, they really don't do that good a job of even fixing yesterday's crisis.

[Edited on March 27, 2009 at 4:15 PM. Reason : ``]

3/27/2009 4:10:46 PM

Quote :

"^ i may be wrong, but doesn't the interview mostly imply the problem was a lack of regulations as opposed to "deregulation" (which is what you were saying earlier and what most Dems have been saying for a long time because it allows them to put the blame on the Obama admin's less popular Republican predecessors)"

well maybe i'm using the terms wrong, but I have been using the term deregulation as a lifting of regulations, and therefore leading to a lack of regulations. So..... i'm not sure what your point is.

Gramm-Leach-Baily was clearly a "regulation" that "deregulated" a large segment of an industry. So technically, yes, the derivatives market was "deregulated" by law, but that effectively meant that there was a lack of regulation overseeing the market.

3/27/2009 4:46:54 PM

Quote :

"well maybe i'm using the terms wrong, but I have been using the term deregulation as a lifting of regulations, and therefore leading to a lack of regulations. So..... i'm not sure what your point is."

I think his point is fairly obvious, if you take the time to actually read what he said. It's the difference between backward-looking (i.e., lifting existing regulations) and forward-looking (regulations which never existed).

It's one thing to blame the repeal of regulations - which we shall call "deregulation", for particular problems. It is entirely another to have a problem which occurred due to the lack of a regulation which has hiterto never existed.

The difference is night and day. One cites a problem of removing regulations when one shouldn't, the other is a matter of never proposing regulations when one should have (in theory). Now, the question Socks``, among others asks, is if it is a case of regulations which should have existed but never did, why then did few people (including the regulators) not foresee this problem in advance?

In other words, it's epistelogical problem: could we have known about the need for regulation in advance of the problem, or are we inherently limited to a framework of backward-looking regulations?

Quote :

"Gramm-Leach-Baily was clearly a "regulation" that "deregulated" a large segment of an industry. So technically, yes, the derivatives market was "deregulated" by law, but that effectively meant that there was a lack of regulation overseeing the market."

You're going to have to go a lot farther than simply throwing out GLBA / Glass-Steagall to prove your point. GLBA removed the barrier of ownership between commercial and investment banks. It did not create a complex derivatives market sprung fully-formed from the head of Zeus.

3/27/2009 4:55:56 PM

I'll have to listen when I have time. In the meantime, here are several reasons why CDS are not at fault:

1) The CDS losses at commercial and investment banks are not significant enough to explain their balance-sheet problems. This is mostly due to the fact that they run a "matched book," whereby they try to match buy and sell orders as closely as possible to reduce exposure. To sum up, banks did not fail because of their CDS exposure.

2) While $58 trillion is used to describe CDS exposure, this is a gross notional amount, which ignores netting of positions. As mentioned above, CDS dealers offset their positions, which reduces their overall exposure, but is counted in the gross notional figure. To give an idea of how much of the $58 trillion is true exposure, the settlement of Lehman CDS totalling $72 billion in notional value ended up being only $5.2 billion. In other words, only 7.2% of that total notional value was net exposure. For illustrative purposes, applying this to the $58 trillion CDS market implies only $4 trillion in net exposure. And CDS are contingent liabilities, so only a fraction of the $4 trillion would ever pay out (just like a car insurance company pays out only a fraction of their gross liabilities.)
http://www.dtcc.com/news/press/releases/2008/dtcc_closes_lehman_cds.php

3) While the volume of MBS issuance has grinded to a halt, the issuance of CDS has remained stable, despite increasing default probabilities, which implies greater liabilities for CDS dealers. If market participants recognized CDS as a "toxic" instrument that is bound to blow up, the market would dry up as it has for MBS.

4) AIG's mangement of its CDS no doubt contributed to its downfall. It is important to note, however, that it was not payouts on CDS themselves that triggered their liquidity problems, but rather collateral calls. In other words, AIG's CDS never "blew up" in the sense that they required AIG to make due on the insured assets. What happened was AIG's counterparties had the right to request AIG post collateral as a safeguard against potential payouts. AIG treated its CDS as long-term instruments, which would require payout if the underlying security defaulted. They did not, however, provision for adverse market conditions that lead the market value of their CDS to trade at levels requiring short-term collateral. This is more a function of poor management than it is with the "toxic-ness" of CDS. For example, a pension fund can make the same mistake by weighting their portfolio with too much equity exposure. This does not mean that stocks are toxic, it means the pension-fund manager is inept.

5) As far as CDS being unregulated, they are already regulated in various ways. Federal bank regulators have full oversight authority. For commercial banks, the Office of the Comptroller of the Currency (OCC) has oversight. They can do daily examinations of CDS trading and review its books for stability. The Fed also has authority and was very much involved with CDS in 2005 (albeit, more to do with outstanding trade confirmations). I-banks not registered as a broker-dealer were subject to indirect oversight by the SEC at the consolidated-entity level. Thrift holding companies, such as AIG and GE Capital, are under the supervision of the Office of Thrift Supervision (OTS). To sum up, the regulatory framework was/is in place. Some will disagree, but my explanation for why they were not more active in identifying risk was that they were using the same risk-evaluation techniques as those they regulated. Most used Value-at-Risk (VaR), which assumes a Gaussian distribution and thus vastly underestimates the occurrence of rare market events. As a matter of fact, the SEC institutionalized the use of VaR. Ex post, it is clear this was foolish. Ex ante, legitimate arguments could be used for its use. Like I mentioned above, we seem to forget that regulators are no better at identifying systemic risk than the thousands of market participants with their own money at risk.

[Edited on March 27, 2009 at 5:02 PM. Reason : .]

3/27/2009 4:56:50 PM

DrSteve feels what i'm saying.

Quote :

"You're going to have to go a lot farther than simply throwing out GLBA / Glass-Steagall to prove your point. GLBA removed the barrier of ownership between commercial and investment banks. It did not create a complex derivatives market sprung fully-formed from the head of Zeus."

Aye. I'm surprised that so many people have gotten away with just asserting this for so long. If there is a good connection between GLBA and what happened in the derivatives market, I don't see it.

3/27/2009 5:51:43 PM

Quote :

"You're going to have to go a lot farther than simply throwing out GLBA / Glass-Steagall to prove your point. GLBA removed the barrier of ownership between commercial and investment banks. It did not create a complex derivatives market sprung fully-formed from the head of Zeus"

Quote :

"If there is a good connection between GLBA and what happened in the derivatives market, I don't see it."

i meant to say the Commodities Modernization Act as the bill that took a previously unregulated market and then expressly prohibited regulation of it. As such, people (again, like Gramm and Leach) clearly saw something in the derivatives market and decided to step in the way of allowing it to be regulated (much less, by slipping it into an 11,000 page omnibus spending bill 3 hours before the end of a lame duck session)


GLBA, of course, has plenty of blame for places like AIG, which allowed different arms of AIG to buy and sell crap to and from each other to hide problems on their balance sheet, which would have been impossible to hide if they had been different companies


[Edited on March 27, 2009 at 9:32 PM. Reason : glba]

3/27/2009 9:23:40 PM

^ could you provide a link or something expressing that argument in more detail? I am wanting to lrn more about it.

3/27/2009 10:39:36 PM

are you serious?
or bullshitting me?

I don't see how anyone attempting to argue any side of this debate can not be aware of how the Commodities Futures Modernization Act has been blamed, true or not.

[Edited on March 27, 2009 at 10:53 PM. Reason : (futures)]

3/27/2009 10:45:50 PM

^ Well, like before, I am only aware that it has been blamed for causing the crisis (along with pretty much every other piece of legislation related to financial markets people can name). Yet I have never seen anyone provide a good story for how it actually did that.

Here's a good example. Fingers pointed, but no dots connected.
http://crooksandliars.com/tags/commodity-futures-modernization-act

If it is obvious, help me out with a link. It shouldn't take long and would help my understanding greatly.

[Edited on March 28, 2009 at 1:45 AM. Reason : ``]

3/28/2009 1:38:59 AM

you seem to be taking evidence and just claiming it is "finger pointing". I mean, you're not going to find a memo somewhere that says "because of the CFMA, we're going to run up our CDS liability to an untenable level that will render us insolvent should one of the dozens of banks that makes up this CDS house of cards fails"

http://www.motherjones.com/politics/2008/05/foreclosure-phil

Quote :

"Credit default swaps are essentially insurance policies covering the losses on securities in the event of a default. Financial institutions buy them to protect themselves if an investment they hold goes south. It's like bookies trading bets, with banks and hedge funds gambling on whether an investment (say, a pile of subprime mortgages bundled into a security) will succeed or fail. Because of the swap-related provisions of Gramm's bill—which were supported by Fed chairman Alan Greenspan and Treasury secretary Larry Summers—a $62 trillion market (nearly four times the size of the entire US stock market) remained utterly unregulated, meaning no one made sure the banks and hedge funds had the assets to cover the losses they guaranteed. In essence, Wall Street's biggest players (which, thanks to Gramm's earlier banking deregulation efforts, now incorporated everything from your checking account to your pension fund) ran a secret casino. "Tens of trillions of dollars of transactions were done in the dark," says University of San Diego law professor Frank Partnoy, an expert on financial markets and derivatives. "No one had a picture of where the risks were flowing." Betting on the risk of any given transaction became more important—and more lucrative—than the transactions themselves, Partnoy notes: "So there was more betting on the riskiest subprime mortgages than there were actual mortgages." Banks and hedge funds, notes Michael Greenberger, who directed the CFTC's division of trading and markets in the late 1990s, "were betting the subprimes would pay off and they would not need the capital to support their bets." These unregulated swaps have been at "the heart of the subprime meltdown," says Greenberger. "I happen to think Gramm did not know what he was doing. I don't think a member in Congress had read the 262-page bill or had thought of the cataclysm it would cause." In 1998, Greenberger's division at the CFTC proposed applying regulations to the burgeoning derivatives market. But, he says, "all hell broke loose. The lobbyists for major commercial banks and investment banks and hedge funds went wild. They all wanted to be trading without the government looking over their shoulder.""

http://www.npr.org/templates/story/story.php?storyId=89338743 (fresh air w/ Micharl Greenberger)
http://www.npr.org/templates/story/story.php?storyId=102185942 (All THings Considered w/ Michael Hirsh)
http://www.stanfordalumni.org/news/magazine/2009/marapr/features/born.html
http://www.michaelgreenberger.com/files/Feb_3_2009_House_Ag_Hearing_Discussion_Draft_Legislation.pdf

3/28/2009 10:25:33 AM

^ I addressed each of the fallacies expressed above:

Quote :

"1) The CDS losses at commercial and investment banks are not significant enough to explain their balance-sheet problems. This is mostly due to the fact that they run a "matched book," whereby they try to match buy and sell orders as closely as possible to reduce exposure. To sum up, banks did not fail because of their CDS exposure. 2) While $58 trillion is used to describe CDS exposure, this is a gross notional amount, which ignores netting of positions. As mentioned above, CDS dealers offset their positions, which reduces their overall exposure, but is counted in the gross notional figure. To give an idea of how much of the $58 trillion is true exposure, the settlement of Lehman CDS totalling $72 billion in notional value ended up being only $5.2 billion. In other words, only 7.2% of that total notional value was net exposure. For illustrative purposes, applying this to the $58 trillion CDS market implies only $4 trillion in net exposure. And CDS are contingent liabilities, so only a fraction of the $4 trillion would ever pay out (just like a car insurance company pays out only a fraction of their gross liabilities.) http://www.dtcc.com/news/press/releases/2008/dtcc_closes_lehman_cds.php 3) While the volume of MBS issuance has grinded to a halt, the issuance of CDS has remained stable, despite increasing default probabilities, which implies greater liabilities for CDS dealers. If market participants recognized CDS as a "toxic" instrument that is bound to blow up, the market would dry up as it has for MBS. 4) AIG's mangement of its CDS no doubt contributed to its downfall. It is important to note, however, that it was not payouts on CDS themselves that triggered their liquidity problems, but rather collateral calls. In other words, AIG's CDS never "blew up" in the sense that they required AIG to make due on the insured assets. What happened was AIG's counterparties had the right to request AIG post collateral as a safeguard against potential payouts. AIG treated its CDS as long-term instruments, which would require payout if the underlying security defaulted. They did not, however, provision for adverse market conditions that lead the market value of their CDS to trade at levels requiring short-term collateral. This is more a function of poor management than it is with the "toxic-ness" of CDS. For example, a pension fund can make the same mistake by weighting their portfolio with too much equity exposure. This does not mean that stocks are toxic, it means the pension-fund manager is inept. 5) As far as CDS being unregulated, they are already regulated in various ways. Federal bank regulators have full oversight authority. For commercial banks, the Office of the Comptroller of the Currency (OCC) has oversight. They can do daily examinations of CDS trading and review its books for stability. The Fed also has authority and was very much involved with CDS in 2005 (albeit, more to do with outstanding trade confirmations). I-banks not registered as a broker-dealer were subject to indirect oversight by the SEC at the consolidated-entity level. Thrift holding companies, such as AIG and GE Capital, are under the supervision of the Office of Thrift Supervision (OTS). To sum up, the regulatory framework was/is in place. Some will disagree, but my explanation for why they were not more active in identifying risk was that they were using the same risk-evaluation techniques as those they regulated. Most used Value-at-Risk (VaR), which assumes a Gaussian distribution and thus vastly underestimates the occurrence of rare market events. As a matter of fact, the SEC institutionalized the use of VaR. Ex post, it is clear this was foolish. Ex ante, legitimate arguments could be used for its use. Like I mentioned above, we seem to forget that regulators are no better at identifying systemic risk than the thousands of market participants with their own money at risk."

3/28/2009 2:06:27 PM

ok, well, if that's what you want to believe, that's fine.
Maybe you can take it up with Warren Buffett, who has been against derivatives like this all along, and Alan Greenspan who has recently come around to the same position

3/28/2009 2:09:32 PM

the one thing that makes me a bit squirrelly about this thing is what I heard on Fresh Air the other day: that the credit ratings agencies get paid more by an instrument's peddlers when they rate that instrument higher. That is absurd. Can anyone explain to me why in the hell we would allow this?

3/28/2009 2:13:14 PM

yeah, that is insane.

but i guess you have to look at the alternatives. The most logical alternative, at first, would be the buyers of the assets should pay for the ratings, instead of the issuers, which is what happens now. But, that's not totally fair, right, because should each buyer pay the credit agency to rate the asset? How would that work - how would each one know how much to pay, when it is unknown how many buyers there will be? Or should just the first buyer pay for the rating, and the subsequent buyers don't have to pay? If that happens, then buyers will keep holding off on buying until finally someone makes the jump and pays the ratings fee, then there is a flood of buyers behind him waiting to get into the asset after the ratings fee is paid.

So, if we start of with the assumption that there must be credit rating agencies (maybe this is a bad assumption, and I'm sure there are plenty of discussions to be had arguing against it), then someone has to pay to pay the ratings fee. But the issuer has a conflict of interest and the buyer low motivation to pay.

but maybe the ratings agencies aren't necessary. maybe it should be up to the buyer to do due diligence on an asset to see how risky it is (especially considering Moody's and/or S&P recently said they don't do due diligence, to try to deflect blame from themselves). And if the assets are forced into an open, public market with multiple interested buyers, then the buyers have a vested interest in doing the research themselves.

3/28/2009 2:24:20 PM

off the top of my head, I think there should be a liability on the credit ratings agency that is, *gasp*, progressive in nature with respect to the rating. So, if a B-rated instrument tanks, they face a $1000 fine, for instance, but if a AAA-rated instrument fails, they get slapped with a $1mil fine. Maybe not exactly like that, but put some kind of monetary punishment on those agencies for when something tanks

3/28/2009 2:55:25 PM

Quote :

"off the top of my head, I think there should be a liability on the credit ratings agency that is, *gasp*, progressive in nature with respect to the rating. So, if a B-rated instrument tanks, they face a $1000 fine, for instance, but if a AAA-rated instrument fails, they get slapped with a $1mil fine. Maybe not exactly like that, but put some kind of monetary punishment on those agencies for when something tanks"

Or...they could purchase insurance much like doctors have to purchase malpractice insurance. Isn't that essentially what the rating agencies have done, committed malpractice? As such, once they've fucked up a few times and had to fork over huge payments, no one will insure them and they will be forced out of business.

3/28/2009 3:38:00 PM