What Caused the Financial

Crisis of 2008?A Story of Adverse Incentives

February 24, 2012Teaching Financial CrisesNorm Cloutier, Director

UW-Parkside Center for Economic Education

A special thanks to SC Johnson for sponsoring this event.

A 20th Century Understatement:“The war situation has developed not necessarily to Japan’s advantage.”

−Emperor Hirohito, 1945Announcing Japan’s surrender

A 21st Century Understatement:“Market discipline has in some cases broken down, and the incentives to follow prudent lending procedures have, at times, eroded.”

−Ben Bernanke, 2007Explaining the financial crisis

The Financial Crisis Inquiry Report• FCIC established by the Fraud Enforcement and Recovery

Act of 2009

Charged with determining the underlying causes of the financial crisis

Democratic leadership appointed 6 members, Republican 4 members

Reviewed millions of pages of documents, interviewed more than 700 witnesses, held hearings over 19 days

Was not charged with developing recommendations

Major Findings of the Financial Crisis Inquiry Report

1. The crisis was avoidable

2. Widespread failure in: Regulatory supervision Corporate: governance, risk management, accountability, ethics Rating agencies Lending standards Government response

3. Excessive leverage and risk without transparency

Missing From the FCIC List?• Federal government housing policy

HUD’s affordable housing goalsCommunity Reinvestment Act

• Role of Government Sponsored EnterprisesFannie Mae and Freddie Mac

• Excessive liquidityFederal Reserve policyInternational saving inflows

Setting the Table: What We Need to Know

• Definitions:

– Leverage → debt

– Derivative → a contract, or promise, whose value is derived from another asset or event

– Securitization → the pooling of debt• MBS and CDO

Pre-2000 Financial and Regulatory Conditions

• The S&L Crisis of the late-1980s saw 747, or nearly 25% of S&Ls failed

Resolution Trust Corp sell-off of $402 billion in assetsPrivate sector assistance and underwriting innovation

• 1993, Commodity Futures Trading Commission exempts certain financial derivatives from regulation.

decentralized unregulated opaquelimited price discovery

Pre-2000 Financial Scandals• After the CFTC exemption, derivative volume

exploded… and so did losses and scandal.

• Sept 1998, Long Term Capital Management leveraged 25-1…, at least threat of a system-wide financial impact Fed orchestrated a $3.6 billion bailout

“… regulation of derivatives transactions that are privately negotiated by professionals is unnecessary.”

- Alan Greenspan, July 1998

Regulation Exemption• In 1999, Pres Clinton’s Working Group on

Financial Markets issues a report urging Congress to broadly deregulate the OTC derivatives

• In 2000, Congress passes the Commodity Futures Modernization Act effectively eliminating OTC derivates from regulation and oversightIt also preempted states from issuing regulation over

OTC derivatives

• Financial derivatives experienced phenomenal growth

The Giant Pool of Money

• In the early-2000s, the Fed kept interests rates low :Burst of the .com bubble, stock market declineRecession9-11WarCorporate scandal: Enron, Arthur Anderson, Worldcom,

Tyco, Qwest Communications, Global Crossings, etc…

• As economic growth increased in oil producing and less developed countries, the pool of global savings increased

Fed Funds and 30-Year Mortgage Rates

30-Year Mortgage

Fed Funds

July 2004

Recession EndNov 2001

Capital Flows into the U.S.(in billions of constant 2006 $)

Desperately Seeking: Higher Returns

• As global savings sought higher returns than U.S. Treasuries it turned to the U.S. housing market30-year fixed rate mortgage offered 1.5-2.0%

points higher return than Treasury bondsSecuritization offered a channel for domestic and

foreign financial capital to flow into the U.S. housing market

MBS and CDOs• MBS and CDOs explained

• The good news: Made investing in the U.S. housing market more accessible to

foreign and domestic investors Pooling could reduce risk through diversification across

households and across regions of the country

• The bad news: Extreme complexity made it difficult for buyers to understand

and rating agencies to assess risk Adverse incentives broke the critical tie between profits and risk

taking

Desperately Seeking: Safety

• Buyers of complex CDOs sought further assurance of their safety

• Credit Default Swaps (CDS) are “insurance” policies purchased against the failure of CDOs No capital requirements “Insurable interest” is not requiredExempt from regulation (remember? CFMA of 2000) American International Group (AIG) was a large

supplier

Home Prices Began to Rise Dramatically

Credit Expansion:Alternative Loans and Subprime Lending

• As home prices increased, more conventional prime borrowers opted for adjustable rate mortgages (ARMs).– Proliferation of ARMs caused and was caused by

rising home prices

“…recent research within the Federal Reserve suggests that many homeowners might have saved tens of thousands of dollars had they held adjustable-rate mortgages…”

−Alan Greenspan, Feb 2004Speaking to the Credit Union National Association's meeting

Credit Expansion:Alternative Loans and Subprime Lending

• The financial “wisdom” of ARMs is predicated on: short term occupancy falling interest ratesand/or continued increases in home prices

• Investment banks moved into mortgage origination to ensure a steady supply of inputs for the continued strong demand for CDOs.

Growth of Alternative Mortgages

Excessive Leverage

• 2004 SEC “net capital” ruling: increased allowable leverage allowed for internal risk monitoring Some banks were leveraged as high as 40-1

• Securitizing banks and mortgage companies were financing their borrowing with short-term loans in the commercial paper market …Remember this fact…

"We have a good deal of comfort about the capital cushions at these firms at the moment.“

−Christopher Cox, SEC Chairman, March 11, 2008

Leverage: The Good and the Ugly

The Watchmen

• The securitization machine required the cooperation of the “watchmen”:AppraisersRating agenciesRegulators

• All three watchmen were plagued by adverse incentives.

Adverse Incentives: Appraisers

• Selected by the lender, appraisers were under pressure to over-value homes in order to justify higher loan values.

• 11,000 appraisers across the U.S. signed a petition charging lenders with:withholding business refusing to pay for appraisalsblack listing if they refused to inflate home values

Adverse Incentives: Rating Agencies

• Rating agencies are paid by the securitizing bank and fundamentally have the same adverse incentives as appraisers to over-value CDOs

• Many buyers of CDOs were statutorily required to purchase only highly rated “safe” securities e.g. five Wisconsin school districts

• As the housing bubble burst, AAA CDO tranches and the companies who created them were massively downgraded, some to worthless.

“It is difficult to get a man to understand something when his salary depends on him not understanding it.”

−Upton Sinclair

Adverse Incentives: The Regulators

• Some financial institutions choose their regulators

• …and in turn, regulators are funded by those same financial institutions

• Regulators actively court financial institutions for their business

Office of Thrift Supervision:James (Chainsaw) Gilleran

Example: The Office of Thrift Supervision

• S&L Crisis, Federal Home Loan Bank Board, and the Office of Thrift Supervision

• Financial institutions got the message and began purchasing savings and loans:

• Although AIG’s thrift comprised 0.1% of its total balance sheet, it could choose OTS as its “lead regulator”

General Motors IndyMac CountrywideH&R Block WaMu American Express

AIG Bank United Capital One

Credit Expansion:Adverse Incentives and Declining Standards

• A Fed study of ARM homeowners revealed that:38% did not understand how high their interest rate could

be reset at one time 50% did not understand how high their interest rate could

rise over the life of the loan

• Homeowner incentives to default and walk away from their mortgage obligation

• As the securitization machine demanded ever more loans, mortgage originators began lowering the creditworthiness bar → NINJA loansVerify a credit score and a pulse

Consumers with New Foreclosures Begin to Increase in 2006 (thousands)

The Unraveling• As mortgages delinquencies and foreclosures

mounted, CDO values declined

• Between 2007:2 and 2008:2 rating agencies downgraded $1.9 trillion worth of CDOs

• Securitizing banks were holding unsold CDOs tranches

• As CDOs failed, investors holding credit default swaps expected to be paid– The failure of AIG

That Fateful Day: Sept 16, 2008

“It was overwhelmingly clear that we were staring into the abyss… this was a catastrophe that we were watching unfold.”

—Patrick McCabeFederal Reserve Bank economist testimony to the FCIC.

That Fateful Day: Sept 16, 2008

• The Reserve Primary Fund “broke the buck” Lehman Brothers’ bankruptcy Sept 15 commercial paper market Bear Stearns bailout “moral hazard”

• Panic!!! Within 1 week $349 billion withdrawn from MMMFs, or

about 1/3 total MMMF balances.

• December 9, 2008 the yield on Treasury bills turns negative

Where Were the Regulators?

• Ben Bernanke’s Congressional testimony “AIG exploited a huge gap in the regulatory

system…”

The “Real” Economy is Hit Hard

• 2008-2011, 407 failed and Fed assisted banks

• Unemployment peaked at 10.1% October 2009Jan 2012= 8.3%, with 12.8 mil workers unemployed Jan 2012 U-6= 15.1%

• Economic growth is sluggish and is forecasted to remain so

Have We Fixed the Adverse Incentives that Caused the Financial Crisis?

• Dodd–Frank Wall Street Reform and Consumer Protection Act of 2010Corporate Governance & Executive Compensation Credit Rating Agency Regulation Securitization Retention Requirements Regulation of Over-the-Counter Derivatives Financial Stability Oversight Council

Systemic Regulation and Emergency Powers Resolution Authority

Consumer Financial Protection Bureau