Thoughts on the Financial Crisis

Since the financial crisis and resulting hysteria have transpired, I’ve been attempting to wrap my head around what happened — in relatively simple terms — and what we can do (or not do) to avoid something like this in the future.  While the financial instruments Wall Street employed in the recent decade were far from simple, I remain hopeful that there are more basic forces at work and thus solutions that don’t involve thousands of pages of legislation, bailouts and government control.

As an informal spectator of the finance industry, I had whittled things down enough to make myself happy.  I blamed two fundamental causes for all of this:

  1. Artificially low interest rates set by the FED.  More people purchased homes than had the means to.
  2. Rating agencies over-rating the hugely risky financial instruments employed by the big investment banks.  Overconfidence led to risk leaking into places it didn’t belong — insurance policies, pensions and the like.

Others site greed, speculation or lack of regulation.  Some blame capitalism itself.  I concede that there are many ways to skin this cat.  One can probably remove only a couple of the many factors cited by just about everyone and successfully avoid a spectacle of this magnitude.  But I like simplicity and I like freedom.  I believe in capitalism.

Recently I came across a post on the Freakonomics blog that teases with the intro “Too Big to Fail” wasn’t the problem.  OK…  Happily, I clicked through to Russell Roberts’ excellent article entitled Gambling with Other People’s Money: How Perverted Incentives Caused the Financial Crisis.  This is, to date, the best article I have read on the financial crisis and I have adjusted my outlook accordingly.

The executive summary gets to the point:

“In this paper, I argue that public-policy decisions have perverted the incentives that naturally create stability in financial markets and the market for housing. Over the last three decades, government policy has coddled creditors, reducing the risk they face from financing bad investments. Not surprisingly, this encouraged risky investments financed by borrowed money. The increasing use of debt mixed with housing policy, monetary policy, and tax policy crippled the housing market and the financial sector. Wall Street is not blameless in this debacle. It lobbied for the policy decisions that created the mess.”

Now I’m paying attention.  The summary continues:

“In the United States we like to believe we are a capitalist society based on individual responsibility. But we are what we do. Not what we say we are. Not what we wish to be. But what we do. And what we do in the United States is make it easy to gamble with other people’s money—particularly borrowed money—by making sure that almost everybody who makes bad loans gets his money back anyway. The financial crisis of 2008 was a natural result of these perverse incentives. We must return to the natural incentives of profit and loss if we want to prevent future crises.”

Preach it, brother!  The well-cited piece continues to explore the housing market, sub-prime lending, Fannie, Freddie and or course our friends, the investment banks.  The meat of the paper deals with how exactly Wall Street was able to wind up 30-, 40, 50- and even 60-1 leverage and not even blink an eye — by using your money.  Roberts says it best:

“If you don’t know who the sucker is at the table, it’s probably you.  We are the suckers.  And most of us didn’t even know we were sitting at the table.”

Zing.  He provides numerous accounts of government bailouts which made creditors whole (or nearly whole) but wiped out equity holders.  In the sub-prime mortgage debacle, the creditors – big Wall Street banks, were mostly made whole.  The equity holders (most consumers and, later on, the taxpayer) got the very large bill.  With only a cursory look at the relationship between the government and big business during the last two decades, it’s clear that big investment banks and their cronies have very little to worry about.  This freedom to play with our money no matter the outcome was the prime cause of the financial crisis.  And we’re perpetuated the problem by doing exactly what they hoped we’d do — bail them out.

What about the executives?  Surely they have a stake at the table.  Not exactly…

“The worst that could happen to [Jimmy] Cayne in the collapse of Bear Stearns, his downside risk, was a stock wipeout, which would leave him with a mere half a billion dollars gained from his prudent selling of shares of Bear Stearns and the judicious investment of the cash part of his compensation.  Not surprisingly, Cayne didn’t put all his eggs in one basket. He left himself a healthy nest egg outside of Bear Stearns.” (Emphasis mine)

“Richard Fuld did the same thing. He lost a billion dollars of paper wealth, but he retained over $500 million, the value of the Lehman stock he sold between 2003 and 2008. Like Cayne, he surely would have preferred to be worth $1.5 billion instead of a mere half a billion, but his downside risk was still small.”

So while there is risk inherent in the system, it’s not enough to stave off bad business when there is no possibility of bankruptcy.

The rating agencies had their hand in the till, too.  As the Wall Street firms bundled up mortgages and sold them off as CDOs, various rating agencies were engaged to put a risk value on these securities.  In order to make things look more attractive, these mortgage-backed securities are divided up into tranches (French for “slices”) and rated separately.  The least risky slices — the senior tranches — command a AAA rating and so on down the line.  One might think that an investment bank paying for higher ratings would be front page news, but alas, not so much.

“The problem with these explanations is that most investors knew that the issuers were paying the agencies. They also knew that these assets were extremely complex and that the agencies may have lacked the expertise needed to analyze the assets correctly. They took the ratings with many grains of salt. The commercial banks bought the assets, not because they trusted the agencies, but because they could leverage them under the new regulations. The investment banks bought the assets because they were highly profitable and easy to borrow against.

“The lower capital requirements for AAA- and AA-rated securities helped fuel the demand for sub-prime mortgage-backed securities and helped create the crisis. But just because your car can go 120 miles per hour doesn’t mean you’ll choose to go that fast. Why would a firm want to take advantage of this deregulation and put itself at risk of bankruptcy? And how would a firm be able to take advantage of this looser capital requirement? Why would anyone lend them the money?

There are other consequences, too.  The money that drove the housing craze in the 1990s and 2000s necessarily kept funding away from other areas of the economy:

“…And a few trillion dollars flowed from the Chinese and my father and other investors into new houses and bigger houses because the Fannie and Freddie conduit offered such an attractive mix of risk and reward. That flow of money was terribly costly: channeling precious capital into housing meant it didn’t flow into other areas that were more valuable but that were artificially made less attractive. So we got more and bigger houses and less of something else—less money going to fund new medical devices, cars that get better gas mileage, more creative entertainment, or something else creative people could have done with more capital.”

Russel concludes that the system is far too complex to regulate in any meaningful way.  Wall Street is far from unregulated today and still we found ourselves in this mess.  He sums it up thusly:

“Instead of trying to improve a system we only imperfectly understand, we would have better luck letting the natural restraints of capitalism reemerge. Rather than trying to turn this dial or push that lever the optimal amount (holding everything else constant, somehow), we should let natural feedback loops reemerge that encourage prudence as well as risk taking.”

I’ve given only cursory service to the article here so I really recommend reading it in full.  If the original publication is a bit hard to focus on, try the printable version or the PDF.