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.
This was an inaccurate undertaking of risk by buyers, sellers and rating agencies alike. And there seems to have been an almost-universal lapse in the basic due diligence of reviewing and understanding the documentation associated with the sale of a credit-default swap or a CDO. The piles upon piles of papers involved in these transactions indicated the complexity of the deals at hand and the need to examine the intricacies involved. Yet, blinded by the euphoria of the marketplace, investors didn't feel they needed to look at the details within these documents. Many originating institutions paid large bonuses to their traders based on volume and short-term gains regardless of the quality of the instrument. And because of the relatively high interest rates paid by these mortgage-backed securities, investors made bigger and bigger and riskier and riskier deals instead of looking at the long-term soundness of any given transaction, relying only on the superficial analysis by the rating agencies.
WITH THE making of the crisis based on such a broad spectrum of errors, it seems inevitable that an asset bubble would be created. And thus we come to the year 2007, when a number of intervening factors finally brought down the financial house of cards.
Rating agencies began belatedly to withdraw their AAA ratings on many of the collateralized debt obligations, which in turn caused the cost of credit-default swaps undertaken by the guarantors to skyrocket. The CDO market came to a screeching halt. Institutions that had issued the credit-default swaps against what they perceived to be a nearly riskless asset were forced to face the probability of substantial future losses. Institutions that had purchased the credit-default swaps became worried about the soundness of the issuers and demanded collateral against the possibility of nonperformance. Credit-default swaps may also have been used in a less straightforward way (one that the SEC should investigate to see if this form of market manipulation took place), for it has been suggested that speculators were buying credit-default swaps and shorting the stock of the same company as a way of enhancing their profit.
Accelerating the meltdown further still was the institution of mark-to-market accounting. The Financial Accounting Standards Board (FASB), for which the SEC has oversight responsibilities, instituted these guidelines to theoretically help companies (and investors) more accurately gauge the value of the company and the health of the balance sheets. This mark-to-market accounting required companies to value their assets at present market value rather than at value at maturity. Although this may sound reasonable, and certainly for some companies with certain kinds of assets it is, for others it is inappropriate, making many companies seem far less stable and profitable than they actually are. The added problem in coming up with mark-to-market values is that with respect to a CDO, for example, there could be, literally, hundreds of underlying instruments. It has been argued that one would need a Cray supercomputer to dissect all the underlying positions to enable a market value to be computed. Simply put, in a lot of cases, the market values used were pure fiction. As the Institute of International Finance commented in a report issued in April 2008:
Essay Types: The Realist
Often dramatic write-downs of sound assets required under the current implementation of fair-value accounting adversely affect market sentiment, in turn, leading to further write-downs, margin calls and capital impacts in a downward spiral that may lead to large-scale fire-sales of assets, and destabilizing, pro-cyclical feedback effects. These damaging feedback effects worsen liquidity problems and contribute to the conversion of liquidity problems into solvency problems.