THE CURRENT crisis in the financial system was well over a decade in the making. A combination of new incentives to increase home ownership, long-term low interest rates, the taking on of increased leverage by banks, and the creation of financial products that were not properly overseen or managed led to a catastrophic economic meltdown. The question now is can we learn from this and also prevent what ended up being a disastrous handling of the crisis itself from happening again.
Any responsible government has a plan in place should a national-security disaster strike. It is clear from the uncoordinated actions taken by the U.S. Treasury and the Federal Reserve, however, that they did not have a similar set of contingencies at the ready for a financial calamity. Rather than respond on an ad hoc basis to the fallout from the crisis, making it up as we go along, the United States needs a thoughtful approach as we move forward.
IT ALL began seemingly innocently enough with the quite-honorable programs of the Clinton administration to provide the opportunity for more people to own their own homes. To do this, the government loosened the credit requirements that applied to Fannie Mae and Freddie Mac, allowing them to underwrite far riskier loans than in the past. And thus were the first seeds of our present-day predicament sown. When Fannie Mae and Freddie Mac got into the loan-underwriting business in a very big way, prerequisites for obtaining a mortgage became far more malleable. Fannie Mae and Freddie Mac bought mortgages from the local banks, turning the local banker into nothing more than a servicing agent receiving an origination and a service fee. And with many of these loans subprime at best, repayment became an increasingly unlikely prospect. Yet this unwise practice went further still, with numerous mortgage brokers entering the fray as well, originating subprime loans to feed the securitization business of many of the investment banks like Lehman Brothers that were later to face failure.
In essence, the credit controls and commonsense requirements that used to be necessary in granting a mortgage were weakened, local banks were no longer invested in the process and the creation of a distorted housing market was well on the way. As far back as 1999 the potential risks involved were obvious. As one New York Times author wrote:
In moving, even tentatively, into this new area of lending, Fannie Mae is taking on significantly more risk, which may not pose any difficulties during flush economic times. But the government-subsidized corporation may run into trouble in an economic downturn, prompting a government rescue similar to that of the savings and loan industry in the 1980's.1
Added to this, rightly or wrongly, then-Chairman of the Federal Reserve Alan Greenspan kept interest rates extremely low for an extended period of time. Inevitably, that led to an asset bubble. When you compound this with increasing home prices due to easier credit, the inflation of the real-estate market was massive.
Banks-in particular investment banks-also began to increase their leverage. Normally these institutions may have held debt-to-equity ratios at relatively low levels. But they increased that number to a ratio of over thirty to one, and for reasons still unknown, regulatory authorities and lenders approved this incredibly risky behavior. This meant that investment banks that would normally and historically borrow short-term to invest in short-term assets-like government securities-were now using this extended capital to buy long-term illiquid assets including real estate. Bottom line: they got locked into long-term real-estate deals with short-term, borrowed money. This was a disaster in the making. Reinvesting short-term, borrowed funds in illiquid long-term investments means you believe that there will be no downturns in the market at any point in the foreseeable future. Clearly, this was unrealistic thinking.
But the basis for the crisis goes further still. Adding to the mix was the creation of complex financial products that went largely unregulated-the now-infamous credit-default swap, which is in essence nothing more than an insurance policy on investments like bonds or collateralized debt obligations.2 When an investor buys a bond or a CDO, he or she wants to be sure that at the time the asset matures the payment will be made, thus the purchase of a credit-default swap as insurance.
Yet, even as the creation and purchase of these credit-default swaps grew, absent was any regulation or exchange-think for example of the New York Stock Exchange-where one could see the value of these instruments. There was no transparency, and this lack of regulation, supported by then-Treasury Secretary Robert Rubin, was dangerous. What was needed was a transparent market in which one could value a given product, making it possible to compare it to other products on offer-the only way to reasonably assess the value and risk involved in the purchase of a given asset.
Making matters worse, some of these CDOs were backed by mortgages. The investment banks that had begun to package mortgages into mortgage-backed securities operated under the not-very-wise thinking at the time that since mortgages were coming from all over the country, they created a sound, diversified investment. Of course, some of these mortgage-backed securities were made from sounder loans; others, from the less-likely-to-be-paid-back heap. Others still were a combination. Essentially, the credit worthiness of these mortgage-backed securities was not universal. But the rating agencies like Moody's and Standard & Poor's gave many of these products AAA ratings, indicating that the credit risk associated with them was near zero.