Three Unlearned Lessons of the Financial Crisis of 2008

There are many lessons to be gleaned from the financial crisis of 2008, to be sure. I recently came across Bethany McLean’s article “The Top Five Unlearned Lessons of the Financial Crisis.” Her top five list includes: the pitfalls of capital estimation; the so-called virtues of risk retention; the difficulties of risk management; the misalignment of incentives; and the exploitation of regulatory inefficiencies.

While McLean’s five unlearned lessons are problems — and she will elaborate on her points further at this year’s Financial Analysts Seminar — it seems to me that her list doesn’t go far enough. So I’d like to extend her list to include three additional lessons that are even greater in magnitude: the US government’s push into housing, the Fed’s monetary policy, and US trade policy.

The US Government’s Push into Housing

Subprime mortgage loan originations in the United States, which were approximately 5% of the mortgage market in 2000, grew to a peak of about 40% in 2006, reaching approximately $1.3 trillion in total principal outstanding (out of a total for US mortgages of $10.7 trillion). So what caused the explosion in subprime loans? Was it fraudulent mortgages? Was it runaway growth in Wall Street financing conduits that helped banks unload these bad loans after originating them? Or was it a set of government policies that forced banks to commit to these loans?

The incidence of fraud did indeed escalate sharply throughout the 2000s. At the start of the crisis in 2007, the incidence of fraud was 1.7% of all mortgages — having grown markedly compared to the preceding years. But, if fraud was at 1.7% leading into the crisis, how could it have taken down a banking system in which most banks had equity of 7–12% of their total assets? Interestingly, fraud has continued rising since the crisis. The incidence of fraud more than doubled from 17 cases per thousand originations to 38 between 2007 and 2012. If fraud reaching 1.7% took down the system in 2008, why didn’t it take the system down again in 2012 — when the incidence of fraud was more than twice as much? Moreover, the FBI breaks down mortgage fraud into two discrete types: fraud for property (committed by prospective homeowners who lie on mortgage applications in order to purchase a home) and fraud for profit (where a group of individuals engage in fraud to either steal disbursed mortgage proceeds or fraudulently acquire a property and then sell it). Because mortgage fraud typically leads to foreclosure shortly after the home is purchased, it quickly leads to selling pressure, thereby negating much of the upward pressure on housing prices.

So, was it the easy access to funding allowed by Wall Street securitization (financing vehicles to package a pool of loans into debt securities of varying quality)? Perhaps, but these vehicles typically require the originator to maintain an equity tranche — meaning that they would still experience much of the losses associated with the entire pool of originated loans. But more important that that, during the 1990s, there was a great deal of pressure put on banks to expand their book of subprime loans. Consequently, as small banks protested that they couldn’t reduce their lending standards to meet the government’s affordable housing goals set by Housing and Urban Development (HUD), the government put pressure on the GSEs (Fannie Mae and Freddie Mac) to increase their purchases of subprime loans. Once banks had a reliable mechanism to sell bad loans, they jumped in full force. But it came first from HUD, which impacted the GSEs, and Wall Street embraced the new regulatory regime. In any event, it is more of a regulatory problem in which loan originators need to retain more significant portions of the credit stack. Of course, there were conflicting incentives, which McLean highlights in her article. Moreover, during the bubble era, the meme that “housing prices never do down” was widely repeated and, it seems, as widely believed.

Lastly, the United States government had made many forays into housing beginning in the 1970s starting with the Community Reinvestment Act, but these programs were trivial parts of the system until the late 1990s. Then in the mid- to late 1990s, the US government escalated its foray into housing with new policies, new guidelines, and programs from federal agencies like HUD and the FDIC. Once banks could sell these bad loans to the GSEs and Wall Street, that’s when they started originating them in mass quantities. In combination, these policies brought millions of marginal buyers into the housing market, creating massive upward pressure on home prices. But because this cohort had bad credit, the shift was unsustainable. Because these subprime loans were sold, re-sold, and repackaged to so many banks and financial institutions globally, ownership of these so-called “toxic” assets was held far and wide. As the market value of these toxic assets declined, many financial institutions lost material amounts of equity, threatening their viability due to their leverage.

The US Trade Policy/Fiat Money System

The second major factor in the global financial crisis was the rapid escalation in the US current account deficit during the 1996–2006 time frame. This occurred following the 1995 Reverse Plaza Accord, in which the Fed agreed to increase the value of the US dollar. That made US exports less competitive and led to the increasing US current account deficit. Naturally, discussion of the Reverse Plaza Accord implied an unwinding of the original Plaza Accord. An adequate discussion of the macroeconomic profile of US macroeconomic policy from 1985–1995 is too long to examine here, but suffice it to say that the 1985 Plaza Accord did not create a sharp change in the current account of the United States, but the subsequent Reverse Plaza Accord initiated a massive change. In 1995, the current account was a deficit of 0.5% of GDP, and it exploded to more than 6% of GDP by 2006 (with more rapid escalation later in that period), reaching $800 billion in 2006 alone.

Of course, current account deficits mean these dollars moved into foreign goverment coffers, especially in China, which maintained a peg to the US dollar. These trading partners tended to be long-term owners of US treasuries and had a higher propensity to own Treasury bonds than the average US citizen. Hence, sustained and rising deficits in the United States had a cumulative impact on the demand for Treasuries. Over the 1996–2006 time frame, the cumulative deficit was about $9 trillion, with about $3 trillion of that comprising incremental foreign demand for US Treasuries. This phenomenon appears to have been fueled in part by the Reverse Plaza Accord, which prevented the US trade markets from achieving equilibrium. Similar trade policies with China (and others) effectively inhibited currency markets from reaching equilibrium. In combination, this greater foreign demand for US Treasuries then bid up bond prices and bid down yields (i.e., interest rates), in addition to pushing US manufacturing overseas.

While some economists suggest that current account balances don’t have a discernible impact on interest rates, it is even harder to argue the opposite — that the large, escalating bids on US Treasuries from foreign governments did not have an impact on prices or yields. Moreover, many economists argue that money simply flows around an economy, so it matters little whether US consumers spend it or foreign governments do. However, this misses a key distinction: foreign governments exhibit a strong preference for Treasuries and low-risk securities, while the private sector does not exhibit those same preferences. Again, disproving the opposite, is there any reason for us to believe that the US consumer and foreign governments would have an identical set of preferences for how they spend money?

The impact on interest rates, therefore, is best described by a comparison of 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. So, the net effect is perhaps an incremental difference of $1 trillion. The effect of lower interest was to reduce the cost of home ownership, thereby enabling the market to clear at a point further out on the demand curve, capturing more of the demand than would be possible at a higher price (more movement along the demand curve). This, too, is unsustainable as interventions in markets force industries to clear at volumes and prices that are materially different than they would clear if the public were allowed to choose freely the supply and demand (in this case housing), creating malinvestment. Since the crisis, the Fed has printed lots of currency and devalued the dollar pretty significantly, especially relative to emerging markets, but the intervention in the markets is a departure from the choices made by market participants themselves.

The US Federal Reserve’s Monetary Policy

The third and final primary cause of the financial crisis in my view was the US Federal Reserve, which chose to reduce interest rates to near zero in 2004. Once again, this artificially reduced the cost of home ownership (and credit) and increased demand for homes (by moving along the demand curve), driving up home prices in the process. In combination, these three factors worked in concert to dramatically increase the demand for homes yet also move along this new demand curve to clear at an artificially low price point. It also enabled the mortgage funding mechanisms like securitization and the purchase of MBSs from Fannie and Freddie to proliferate. The meme or belief that home prices “never decline” on a national basis was widely held (before the collapse), enhancing the case that investments in real estate and mortgage-backed securities were safe. This false presumption was compounded by AAA ratings on subprime MBSs and structured notes (CLOs, CDOs, CDO², etc.) from major credit ratings agencies.

Once again, the Fed’s interest rate intervention caused more credit volume to clear than would otherwise be the case, creating unsustainable demand growth. These factors helped to create the unsustainable boom in housing prices which led to the inevitable bust. As subprime loans began to sour, prices of subprime MBSs began to crater, forcing a few high profile hedge funds out of business, and liquidity began to dry up. The contagion then spread to MBS securities and other asset-backed markets, even to money market funds (e.g., Prime Reserve Fund), then to bank funding markets, then to commercial and investment banks.

The bust was comprised of both a liquidity crisis and a solvency crisis. The collapse in home prices meant that the collateral for many mortgage-backed securities was inadequate and therefore worth less (if not worthless). Of course, the underlying real estate was also in crisis, with many homes selling at prices below their mortgage value. The widespread ownership of residential MBSs, which were collapsing, meant the financial institutions that owned them were quickly approaching insolvency. And because of the cross-ownership of asset-backed securities of all stripes within financial institutions, the insolvency of some institutions also translated into the insolvency of others that perhaps did not invest in “toxic” assets. The Fed, the US Treasury, and other government agencies worked tirelessly to arrest the deepening crisis to no avail. The crisis reached its apex in the collapse and complete failure of Lehman Brothers. Upon its collapse, bank funding lines froze, letters of credit froze, and international trade lines froze. In short, the global financial system was in a complete state of chaos.

Today, as of February 2014, these three additional lessons remain largely unaddressed. First, while the Dodd-Frank legislation of 2010 is trying to phase out Fannie and Freddie (which remains to be seen), the requirements on banks to meet subprime goals remain largely in place. Moreover, on the margin, the regulatory environment has encouraged lenders to discontinue certain practices, but like the Hydra, two new heads grow for each one cut off. For instance, while Fannie and Freddie have reduced their activity dramatically and banks are now carrying more capital, the FHA is now guaranteeing subprime mortgage loans, subprime auto lending has taken off, student loans are now more than $1 trillion, and peer-to-peer subprime lending has ramped up markedly since the crisis of 2008.

Second, the Fed retains the ability to set non-market interest rates. Even though the Fed is tapering its QE3 program, it is keeping short-term rates exceptionally low, which further distorts the ways markets allocate capital. Lastly, the massive money printing by the Federal Reserve has reduced the value of the dollar materially since the crisis, which has helped improve the trade deficit in the United States. However, the fiat money system remains in place, enabling a new generation of politicians and central bankers to make economic choices that are politically expedient at the expense of achieving balance.

All of which begs the question: after all we’ve been through, what have we actually learned?

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