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Analysis and Commentary
The 2008 financial crisis was complex and had numerous contributing factors. Consequently, many people have misdiagnosed the problem or overemphasized some factors and underemphasized other, more important factors. The sheer volume of factors, some of which cross analytical disciplines, such as macroeconomics and geopolitics, also obfuscate accurate diagnosis of cause and effect. Moreover, there is an interplay among various factors, such as among policy, macroeconomics and microeconomics. Some factors have gained more popularity than others in the media or with particular political cohorts, making existing beliefs about the crisis an impediment to objective analysis. We performed a holistic analysis of the 2008 financial crisis; we focused on identifying the causal factors that led to excesses in the housing, mortgage, and financial markets, rather than on the crisis itself, which we treat as a symptom of larger underlying problems.
By magnitude, four primary causes of the crisis can be identified:
We will first explore these factors from a theoretical perspective, then (in separate subsections below) we will examine them from an empirical perspective. The US government pushed into residential housing with a variety of policy changes that dramatically increased the demand for housing. The policies brought large numbers of low-quality mortgages into the market and, simultaneously, reduced many of the time-tested buffers against financial excess in the system (e.g., required bank capital, required down payments on home purchases, etc.), making the housing market, mortgage market, banking industry, and ultimately, financial markets unstable. Of course, many governments globally (UK, France, Germany, Australia, Ireland, Scotland, Spain, Italy, Canada, etc.) had implemented similar policies also exerting similar impact on their respective mortgage and housing markets.
The large and growing current account deficits and the Fed’s lowering of interest rates were both policy decisions enacted at various times and in different magnitudes, but both factors materially enhanced demand for credit and housing. From a macroeconomic perspective, these policies conspired to reduce interest rates from what they otherwise might have been thereby lowering mortgage rates as well (which are typically priced off of ten-year US treasuries). Lower mortgage rates, in turn, captured larger areas under the demand curve for housing. As illustrated in the graph below, US Current Account Policy and Federal Reserve Monetary Policy combined to reduce the price of mortgages (mortgage rates) from P1 to P2. Consequently, banks and mortgage brokers were better able to supply mortgages as both short and long term costs of funding declined, shifting supply from Supply 1 to Supply 2.
But the government push into mortgages also exerted significant force on the mortgage industry to expand supply of credit as represented by Supply 3. Likewise, as credit standards were reduced by the suppliers (through so-called NINJA – i.e. “No Income, No Job, No Assets” – loans, down payment assistance, subprime credit standards, etc.) it also shifted the demand curve from Demand 1 to Demand 2. So, at any given price (mortgage rate), a new segment of low-quality borrowers were able to borrow and buy homes shifting the demand curve from Demand 1 to Demand 2. As these policies were put into place and exerted force in the marketplace, the amount of demand that was satisfied ultimately shifted from Q1 to Q4 over a period of about 5 years. This incremental demand for housing helped build up the bubble in home prices. The graph above illustrates how policy influenced the housing bubble in the United States. All other claims of causes for the crisis must be weighed against these factors which shifted supply and demand in large and measurable ways.
Ancillary factors include lax lending standards by banks and mortgage brokers, investors seeking high returns (buying riskier assets) in a low-interest-rate environment (which created demand for subprime MBS), homeowners taking on more expensive and/or riskier mortgages than they could afford, the securitization of subprime loans, and inadequate rating of securities by the rating agencies.
US Government Push into Housing and Mortgages
The US government has made many forays into the housing and mortgage areas throughout its history. The traces of the 2008 housing crisis began in the 1970s with the Community Reinvestment Act of 1977, which eased lending criteria to encourage depository institutions to help meet the credit needs of their surrounding communities (particularly low- and moderate-income neighborhoods). The impact of this policy was trivial until the late 1990s, when the United States enacted new policies to accelerate “affordable housing” goals. In 1995, the US Housing and Urban Development (HUD) agency set target goals for Fannie and Freddie to raise home ownership rates among low-income groups (which significantly expanded the market for subprime borrowers). Beginning in 1996, the Attorney General of the United States issued numerous warnings against officers of banks that didn’t meet government targets for subprime loans. In 1999, Fannie Mae eased origination requirements for lenders. In 2003, Congress passed the American Dream Downpayment Initiative Act, which was intended to subsidize the down payments and closing costs of low-income first-time homebuyers. In 2004, HUD urged Fannie and Freddie to increase their purchases of subprime and so-called Alt-A MBS. In combination, these policies (and others) brought many marginal buyers into the housing market and dramatically shifted the demand curve for housing upward. Because many in this cohort had bad credit, however, these mortgage loans eventually defaulted (on an unprecedented scale). According to Federal Reserve data, low-quality loans (subprime and Alt-A combined) went from 5.6% of the mortgage market in 2000 to 50.5% of the market in 2005. Also according to Federal Reserve data, delinquency rates on single-family residential mortgages averaged about 2.0% from 1995 through 2005; then began to spike in 2006, reaching 11.3% by the first quarter of 2010 (and plateaued there as the various bailout programs began to take effect).
When demand for housing grows, development typically grows outward from urban centers. And when development of a city cannot grow outward, it typically grows upward (i.e., by way of high-rise buildings). And when rising demand meets stagnant supply, prices go up. In many localities, national policies were in conflict with local policies and laws. Many US cities (and counties)—for example, Boston, Massachusetts; San Francisco, California; San Jose, California; and Phoenix, Arizona—had enacted local ordinances regarding environmental protection, open spaces, growth limits, and so on, that severely restricted housing supply. This restricted supply of housing in these markets occurred at the same time that supply of mortgages and hence demand for housing was rising. The combination of constrained supply and swelling demand in many US cities caused prices to rise sharply. It is no coincidence that these cities and counties are the very same markets that experienced the most dramatic price booms and busts in the housing crisis. According to the S&P/Case-Shiller National Home Price Index, the San Francisco home price index went from 100 in January 2000 to a peak of 218.12 in June 2006 (up 118% in 5.5 years). Similarly, the Phoenix home price index escalated from 100 in January 2000 to a peak of 227.42 in June 2006 (up 127% in 5.5 years).
Then, by 2011, home prices in many city markets had ceded almost all of the gains made in the boom. For instance, by 2011, San Francisco had returned to an index value of 130—almost all of its gains gone. By 2011, the Phoenix home price index was back where it started at 100—ceding all of its gains. In contrast, cities that did not have local laws that restrict supply, such as Dallas, Texas, did not see a dramatic run-up in home prices. In 2000, the S&P/Case-Shiller home price index for Dallas was 100, and by June of 2006, its level was 124.5 (a gain of only 24.5% in 5.5 years). By 2011, the Dallas index had fallen only to about 115—7.6% off its peak.
Ironically, this situation is far from the first time the US government has intervened in the housing markets with negative consequences. During the 1920s, a Republican housing plan was enacted. In the 1930s, a Democratic plan was enacted as part of the New Deal. After World War II, many US programs that enjoyed bipartisan support were enacted. Ultimately, each of them failed; although none as dramatically as the crisis of 2008.
So, all this discussion of policy begs the question: Is policy to blame, then, for the 2008 financial crisis? The short answer is yes, but the long answer is far more nuanced and complicated. In public policy decision making, there is often an interplay between public-sector politicians and private-sector actors. And to be sure, private-sector lobbying for change influenced policy in this case. For instance, the Gramm-Leach-Bliley Act in 1999 (i.e. getting rid of the Glass-Steagall Act) effectively eliminated the barriers between investment and commercial banking. This policy was lobbied hard by the industry itself and was led primarily by the major wirehouses, like Citigroup and Goldman Sachs. The repeal of Glass Steagall paved the way for the major investment and commercial banks to own subprime mortgage securities. It further paved the way for regulators to push the major banks to own subprime MBS to meet Basel II regulatory objectives. Since it all blew up, however, apparently nobody has stepped up to own their role in the crisis. As the old saying goes, success has many fathers and failure is an orphan. As investors, we must recognize that politicians and others champion their programs’ successes and often avoid blame for their failures.
Large and Growing Current Account Deficits
The second major factor behind the 2008 financial crisis was the rapid escalation in the US current account deficit from 1996 to 2006. Large and growing US current account deficits distorted labor markets, international trade, and asset prices, and eventually they lowered interest rates. This factor is important because the development materially lowered interest rates through a complex process. A current account deficit arises when Country A sends more of its currency to Country B than Country B sends back to Country A (through foreign trade, foreign direct investment, transfers, etc.). In the case of the US during the years preceding the crisis, the surplus countries, such as China, ramped up their holdings of US dollars and used those US dollars to purchase US dollar–denominated assets—primarily, US Treasury securities. Many other “surplus” countries did the same to keep their currency exchange rates from rising against the dollar (which would have made their currency more expensive and, hence, their exports less competitive). Note also that such a run-up of deficits is possible only in the absence of a gold standard. So, the policy analysis must reach all the way back to President Nixon taking the United States off the gold standard in 1971. Clearly, policy impacts can have very long tails.
During the run-up to the crisis of 2008, foreign central banks of surplus countries showed a strong preference for buying the sovereign debt of deficit countries. This preference should be no surprise; it prevents a country’s currency from appreciating, thereby extending the ability of the country to export its goods to deficit countries, such as the United States. This incremental demand for sovereign debt increased sovereign bond prices and, hence, reduced interest rates. The lower interest rates then stimulated the housing and mortgage markets to take on even more debt (capturing more demand).
The US current account grew sharply in the period 1995 – 2006 where it went from being roughly in balance (the country posted a modest deficit of 0.5% of GDP in 1995) to posting a large deficit of more than 6% of GDP in 2006, reaching $800 billion in that year alone (and more rapid escalation came later in the period). Between 1996 and 2006, the cumulative current account deficit was about $6.1 trillion, with about $1 trillion of that comprising incremental foreign demand for US Treasuries. In short, this deficit moved $6 trillion into foreign hands (including China, whose government maintained a peg to the US dollar), and foreign ownership of US Treasuries skyrocketed, just as economic theory predicts. Between 2000 and 2005, foreign ownership of US financial assets increased from about 60% to 80% of GDP (Council of Foreign Relations). Moreover, foreign ownership of US Treasuries increased by about $1 trillion. Hence, growing current account deficits in the United States had a large cumulative impact on the demand for US Treasuries, which led to reduced interest rates.
This phenomenon appears to have been fueled by the so-called Reverse Plaza Accord, in which in April 1995, the Federal Reserve agreed to increase the value of the dollar (relative to the Japanese yen and the German mark), which prevented US deficits from returning to equilibrium. In the subsequent 18 months afterward, the US dollar spiked by approximately 50% relative to the yen and mark. This change in exchange rates marked the turning point in the current account, which had been roughly in balance over the preceding 25 years. The increased foreign demand for Treasuries bid up bond prices and bid down yields (i.e., interest rates).
Some economists suggest that current account balances do not have a discernible impact on interest rates, but it is harder to argue that the large, escalating bid on Treasuries from foreign governments did not have an impact on sovereign bond prices or yields. Moreover, some argue that money simply flows around an economy, so whether US consumers or foreign governments spend it matters little. This analysis misses a key distinction between the local private sector and foreign central banks: Foreign central banks exhibit a strong preference for US Treasuries and so-called low-risk securities, whereas the private sector does not exhibit those same preferences. The impact on interest rates, therefore, is best related to this cumulative incremental foreign demand for US Treasuries relative to what the US public might have demanded had this money stayed inside the United States.
The Fed Lowering of Interest Rates
The third primary cause of the 2008 financial crisis is that the Federal Reserve chose to reduce interest rates to very low levels in the 2001–2005 time frame, thereby expanding credit markets beyond what they would have been on their own.
In June of 2000, the US federal funds target rate was 6.5%. By June 2003, in response to the collapse of the technology bubble, the Fed had reduced the federal funds rate to 1.0%. As foreign trade flows with low-cost deficit countries such as China grew, the Greenspan Federal Reserve publicly discussed worries about the United States importing deflation from these countries. For that reason, the Fed then raised rates slowly throughout 2004, 2005, and 2006. Lowering interest rates on the front end of the cycle stimulated the funding of mortgages by banks, enabling the market to clear at a point farther out on the demand curve and capturing more of the demand than would be possible at a higher price (more movement along the demand curve). This development was unsustainable because interventions in markets force industries to clear at volumes and prices that are materially different from where they would clear if the public were allowed to choose the supply and demand freely on their own. The result was mal-investment in the housing market. The combination of the artificially reduced cost of credit (lower mortgage rates) and increased demand for homes (by moving along the demand curve) drove up home prices.
Securitizing of Loans
The fourth primary cause of the crisis was the proliferation of securitization (i.e. the slicing up of a group of loans and selling them as securities to investors). Securitizing loans (particularly the second-level securitization of equity tranches) effectively removed much, if not all, of the direct exposure many lenders had to the loans they originated (although securitization contracts often have provisions for bad loans to be put back to the lender). This phenomenon created incentives for banks to pursue loan volume without regard to loan quality. Securitizations were initially designed so that lenders would maintain exposure to the performance of the loan pool by owning securities that experienced the first losses of the loan pool. This step helped align the incentives for the investors in the MBS with those of the lenders. In the early 2000s, however, securitization was taken to an extreme whereby many lenders sold off virtually all direct exposure to the underlying performance of loans. Of particular concern was the securitization of the equity tranches of other primary securitizations. This process enabled mortgage lenders to effectively remove all exposure to the performance of a given loan pool. Hence, these incentives caused many lenders to shift focus away from owning mortgages for the life of the loan to growing loan volumes which earned fees at origination. Without exposure to loan losses, lenders’ incentives were now in conflict with the interests of MBS investors, which created material agency costs. Pursuing these incentives, many lenders produced massive amounts of low-quality mortgage loans. The loans enhanced short-term performance for the bank but amplified long-term pain for the banking system. This explosion in subprime MBS dramatically increased demand for homes, weakened bank balance sheets, and because many of the loans were sold globally in securitizations, ensured that large numbers of financial institutions were interconnected when the underlying pool of loans went sour.
The adage that home prices “haven’t declined on a national basis since the Great Depression” was widely repeated even before the 2008 collapse. It was embraced by investors, borrowers, lenders, policy makers, credit-rating agencies, and others. The suggestion that home prices wouldn’t decline enhanced the perception that investments in real estate and MBS were safe. This false presumption was compounded by AAA ratings from rating agencies on subprime MBS and structured notes (such as CDOs), which helped legitimize the whole debacle.
The reliance on ratings from the major rating agencies stretched back many decades. Many bond issuers were required by law to have ratings from the rating agencies. Financial regulatory policies such as Basel II pushed banks to own highly rated securities, such as AA and AAA rated MBS. For instance, MBS rated AA or AAA had a capital requirement of only 2 cents on the dollar (i.e., leverage of 50 to 1). And in 2004, the SEC adopted provisions of Basel II in its regulatory framework for large Wall Street investment banks. In practice, these regulatory frameworks created incentives for investment and commercial banks to own highly rated MBS (regardless of whether or not they deserved the high rating).
Moreover, the nature of securitization meant that one bad loan pool could be owned by many institutions; that is, many institutions were connected to the same bad loans. Given that US subprime mortgage loans reached $1.3 trillion in outstanding balances by 2006, a large number of institutions across the globe owned these faulty subprime MBS. Because of the use of leverage in both commercial and investment banking and ongoing reliance on external funding (deposits, repurchase agreements, loans, etc.), these firms were already interconnected. Large numbers of commercial and investment banks that owned the toxic MBS ended up insolvent. Because the failure of an unhealthy bank can lead to the failure of an otherwise healthy one, the crisis was systemic.
The Unfolding Systemic Crisis
As subprime loans began to sour in early 2007, prices of subprime MBS began to fall, forcing a few high-profile hedge funds out of business (e.g., Bear Stearns High-Grade Structured Credit Fund and Enhanced Leverage Fund in June 2007) and drying up liquidity. The contagion then spread to prime MBS and other asset-backed markets, including money market funds (e.g., the Reserve Primary Fund), to bank funding markets, and finally, to commercial and investment banks. The bust was both a liquidity crisis and a solvency crisis: The collapse in home prices meant that the collateral for many MBS was inadequate and, therefore, worth less than loan obligations they backed (if not completely worthless). The underlying real estate was also in crisis, with many homes selling at prices below their mortgage values. The widespread ownership of collapsing residential MBS meant that the financial institutions that owned them were quickly approaching insolvency. As a result of the cross-ownership of asset-backed securities of all types within financial institutions, the insolvency of some institutions also translated into the insolvency of others that had not necessarily invested in these toxic assets. The Federal Reserve, the US Treasury, and other government agencies scrambled to create emergency programs to arrest the deepening crisis, but without result. The crisis reached its apex in the collapse and complete failure of Lehman Brothers on 15 September 2008. Upon its collapse, bank funding lines, letters of credit, and international trade lines froze around the world. In short, the global financial system was in a complete state of chaos.
In combination, the factors greatly increased systemic risk. The expanded leverage in the private sector made the downside of the business cycle more costly than in the past. The reduced lending standards, smaller down payments, and lighter capital at banks reduced the controls in the financial system. Finally, the packaging and selling of bad loans through securitization proliferated expanding the interconnectedness of the entire system globally. These three pillars of systemic risk (leverage, buffers and interconnectedness) worked in concert to take down the global financial system when the subprime loan market failed. The systemic nature of this event was evident in the seizure of countless markets in the wake of the Lehman Brothers collapse in September of 2008. Large and diverse pieces of the financial system crumbled in the aftermath of the Lehman Brothers bankruptcy. Note that the liquidity crisis that materialized in 2008 was merely a symptom of a much more serious solvency crisis.
Governments around the world unleashed desperate attempts to save the system. Through programs (e.g., the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility, the Commercial Paper Funding Facility), the discount window, and single-tranche open market operations, the Federal Reserve extended $16 trillion in support for global financial markets. Over the ensuing months and years, central banks around the world launched massive quantitative easing (printing of money) programs, which dramatically expanded the balance sheets of these institutions with newly printed money and purchased a variety of assets—especially troubled MBS. These actions brought both benefits and drawbacks. On the positive side, the actions did, in fact, arrest the decline in markets and restore stability to the system. These same actions prevented the various markets, however, from correcting the imbalances. The large imbalances that remain have put consistent downward pressure on developed economies worldwide. This downward pressure on the economy has been met with an ongoing monetary policy response in the form of continued low interest rates and quantitative easing. In the United States alone, the Fed’s balance sheet expanded from some $850 billion before the crisis to $4.4 trillion today—all on the back of freshly printed money. The monetary spigot has flowed into the stock and bond markets around the world and reflated them. Governments and the private sector have taken advantage of low rates to take on even more debt, however, and many of the same programs that channeled loans to low-quality borrowers remain. As of this writing, the story is far from over because the problems that were arrested in the aftermath of the crisis are in a state of stasis and new problems have been added on top of the old. The buffers in the financial system have been improved, but the rescue and stimulus programs themselves have shifted more risk from the private sector to government finances, currencies, prospective inflation, and new asset bubbles.
Some popular explanations for the 2008 financial crisis do not stand up under scrutiny. For instance, many analysts of the crisis have said, or implied, that the root of the crisis was greedy lenders that threw caution to the wind in pursuit of profit. To be sure, some lenders appear to have thrown caution to the wind and acted recklessly with business practices. But pinning the blame on greed overstates the case. For starters, the greed hypothesis does not address the four central causes discussed here. Consider how much of the bubble came from banks’ needs to meet the government’s affordable housing goals and the effort to get those low-quality loans off their books by selling them. How much came from the incentives of low interest rates? How much came from competition for business? How much came from policy events like the passing of the Gramm-Leach-Bliley Act which diminished the wall between commercial and investment banks? How much came from rule changes at the SEC that let large banks carry less capital? How much came from banks’ ability to sell off tranches of loan pools that effectively removed all exposure to a given loan pool from their balance sheet? However much or little greed was present before the crisis, it is unlikely that it could have been exploited without the combination of policy events detailed here.
That having been said, one factor was the willingness of lenders to make loans to borrowers with small down payments, poor credit history, and little documentation. Such lending practices, for whatever reason they were created, reduced the buffers that were necessary for the smooth operation of the financial system. In addition, selling those loans through securitization conduits helped the lenders make money off of the origination and limited their exposure to the repayment risk, creating an incentive problem at the lender level. Clearly, some lenders were influenced by this incentive, and many cases occurred of lenders aggressively pushing the envelope to drive volume with little regard for quality. Examples are Countrywide, Citigroup, and Washington Mutual. The growth in subprime lending maps closely, however, to the various regulatory moves made by the federal government to increase mortgage lending to low-income buyers. Changes in housing policy put in place by the various federal regulatory bodies and agencies (e.g., HUD, Fannie Mae, Freddie Mac) and the Attorney General preceded the changes in the amount of subprime lending. These were the very agencies that regulated the lenders in question.
Another popular myth is that lender fraud drove the housing crisis. This argument fails to explain, however, how fraud drove home prices upward. Fraud cases generally create selling pressure in the market within months of origination. Fraud cannot explain the rapid increase in home prices in many markets. The MBS conduits did present an opportunity for banks to pass risk onto others. Like insurance and reinsurance, however, many banks kept the first loss position by owning equity tranches as well as some of their own MBS while the owners of the MBS held the second loss positions (as in reinsurance). Had these institutions fully understood the risks to the housing market and been committing fraud, why would they have retained any of these securities on their balance sheets? Evidently, many commercial banks apparently expected housing prices to remain resilient as they had over the preceding 70 years or so. To be sure, many originators were aggressive with their risk profiles, but to cite greed as the primary cause of the crisis ignores the long list of events detailed here that had large and measurable impacts on interest rates, housing prices, and credit quality. In the end, analysis with facts confirms what we would expect from theory.
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