What Caused the Financial
Crisis of 2008?
A Story of Adverse Incentives
February 24, 2012
Teaching Financial Crises
Norm Cloutier, Director
UW-Parkside Center for Economic Education
A special thanks to SC Johnson for sponsoring this event.
A 20th Century Understatement:
“The war situation has developed not necessarily to
Japan’s advantage.”
−Emperor Hirohito, 1945
Announcing Japan’s surrender
A 21st Century Understatement:
“Market discipline has in some cases broken
down, and the incentives to follow prudent
lending procedures have, at times, eroded.”
−Ben Bernanke, 2007
Explaining the financial crisis
The Financial Crisis Inquiry Report
• FCIC established by the Fraud Enforcement and Recovery
Act of 2009
 Charged with determining the underlying causes of the financial
crisis
 Democratic leadership appointed 6 members, Republican 4
members
 Reviewed millions of pages of documents, interviewed more
than 700 witnesses, held hearings over 19 days
 Was not charged with developing recommendations
Major Findings of the
Financial Crisis Inquiry Report
1. The crisis was avoidable
2. Widespread failure in:





Regulatory supervision
Corporate: governance, risk management, accountability, ethics
Rating agencies
Lending standards
Government response
3. Excessive leverage and risk without transparency
Missing From the FCIC List?
• Federal government housing policy
HUD’s affordable housing goals
Community Reinvestment Act
• Role of Government Sponsored Enterprises
Fannie Mae and Freddie Mac
• Excessive liquidity
Federal Reserve policy
International saving inflows
Setting the Table:
What We Need to Know
• Definitions:
– Leverage → debt
– Derivative → a contract, or promise, whose value
is derived from another asset or event
– Securitization → the pooling of debt
• MBS and CDO
Pre-2000 Financial and Regulatory Conditions
• The S&L Crisis of the late-1980s saw 747, or nearly 25%
of S&Ls failed
Resolution Trust Corp sell-off of $402 billion in assets
Private sector assistance and underwriting innovation
• 1993, Commodity Futures Trading Commission
exempts certain financial derivatives from regulation.
decentralized
unregulated
opaque
limited price discovery
Pre-2000 Financial Scandals
• After the CFTC exemption, derivative volume
exploded… and so did losses and scandal.
“… regulation of derivatives transactions that are privately
negotiated by professionals is unnecessary.”
- Alan Greenspan, July 1998
• Sept 1998, Long Term Capital Management
leveraged 25-1…, at least
threat of a system-wide financial impact
Fed orchestrated a $3.6 billion bailout
Regulation Exemption
• In 1999, Pres Clinton’s Working Group on
Financial Markets issues a report urging Congress
to broadly deregulate the OTC derivatives
• In 2000, Congress passes the Commodity Futures
Modernization Act effectively eliminating OTC
derivates from regulation and oversight
It also preempted states from issuing regulation over
OTC derivatives
• Financial derivatives experienced phenomenal
growth
The Giant Pool of Money
• In the early-2000s, the Fed kept interests rates low :
 Burst of the .com bubble, stock market decline
 Recession
 9-11
 War
 Corporate scandal: Enron, Arthur Anderson, Worldcom,
Tyco, Qwest Communications, Global Crossings, etc…
• As economic growth increased in oil producing and less
developed countries, the pool of global savings
increased
Fed Funds and 30-Year Mortgage Rates
Recession End
Nov 2001
20.00
18.00
July 2004
16.00
14.00
30-Year Mortgage
12.00
10.00
8.00
6.00
Fed Funds
4.00
2.00
0.00
Oct-69
Apr-75
Oct-80
Mar-86
Sep-91
Mar-97
Sep-02
Feb-08
Capital Flows into the U.S.
(in billions of constant 2006 $)
Capital Flows
$2,000
$1,800
$1,600
$1,400
$1,200
$1,000
$800
$600
$400
1995
1997
1999
2001
2003
2005
2007
Desperately Seeking: Higher Returns
• As global savings sought higher returns than
U.S. Treasuries it turned to the U.S. housing
market
30-year fixed rate mortgage offered 1.5-2.0%
points higher return than Treasury bonds
Securitization offered a channel for domestic and
foreign financial capital to flow into the U.S.
housing market
MBS and CDOs
• MBS and CDOs explained
• The good news:
 Made investing in the U.S. housing market more accessible to
foreign and domestic investors
 Pooling could reduce risk through diversification across
households and across regions of the country
• The bad news:
 Extreme complexity made it difficult for buyers to understand
and rating agencies to assess risk
 Adverse incentives broke the critical tie between profits and risk
taking
Desperately Seeking: Safety
• Buyers of complex CDOs sought further
assurance of their safety
• Credit Default Swaps (CDS) are “insurance”
policies purchased against the failure of CDOs
No capital requirements
“Insurable interest” is not required
Exempt from regulation (remember? CFMA of 2000)
American International Group (AIG) was a large
supplier
Home Prices Began to Rise Dramatically
Home Price Index
200
180
160
140
120
100
80
60
1890
2000
1910
1930
1950
1970
1990
2010
Credit Expansion:
Alternative Loans and Subprime Lending
“…recent research within the Federal Reserve suggests that
many homeowners might have saved tens of thousands of
dollars had they held adjustable-rate mortgages…”
−Alan Greenspan, Feb 2004
Speaking to the Credit Union National Association's meeting
• As home prices increased, more conventional
prime borrowers opted for adjustable rate
mortgages (ARMs).
– Proliferation of ARMs caused and was caused by rising
home prices
Credit Expansion:
Alternative Loans and Subprime Lending
• The financial “wisdom” of ARMs is predicated on:
 short term occupancy
 falling interest rates
 and/or continued increases in home prices
• Investment banks moved into mortgage origination
to ensure a steady supply of inputs for the continued
strong demand for CDOs.
Growth of Alternative Mortgages
Excessive Leverage
• 2004 SEC “net capital” ruling:
 increased allowable leverage
 allowed for internal risk monitoring
 Some banks were leveraged as high as 40-1
"We have a good deal of comfort about the capital cushions
at these firms at the moment.“
−Christopher Cox, SEC Chairman, March 11, 2008
• Securitizing banks and mortgage companies were
financing their borrowing with short-term loans in the
commercial paper market
 …Remember this fact…
Leverage: The Good and the Ugly
The Watchmen
• The securitization machine required the
cooperation of the “watchmen”:
Appraisers
Rating agencies
Regulators
• All three watchmen were plagued by adverse
incentives.
Adverse Incentives: Appraisers
• Selected by the lender, appraisers were under
pressure to over-value homes in order to justify
higher loan values.
• 11,000 appraisers across the U.S. signed a petition
charging lenders with:
 withholding business
 refusing to pay for appraisals
 black listing
if they refused to inflate home values
Adverse Incentives: Rating Agencies
“It is difficult to get a man to understand something when his
salary depends on him not understanding it.”
−Upton Sinclair
• Rating agencies are paid by the securitizing bank and
fundamentally have the same adverse incentives as appraisers
to over-value CDOs
• Many buyers of CDOs were statutorily required to purchase
only highly rated “safe” securities
 e.g. five Wisconsin school districts
• As the housing bubble burst, AAA CDO tranches and the
companies who created them were massively downgraded,
some to worthless.
Adverse Incentives: The Regulators
• Some financial institutions choose their
regulators
• …and in turn, regulators are funded by those
same financial institutions
• Regulators actively court financial institutions
for their business
Office of Thrift Supervision:
James (Chainsaw) Gilleran
Example: The Office of Thrift Supervision
• S&L Crisis, Federal Home Loan Bank Board, and
the Office of Thrift Supervision
• Financial institutions got the message and began
purchasing savings and loans:
General Motors
H&R Block
IndyMac
WaMu
Countrywide
American Express
AIG
Bank United
Capital One
• Although AIG’s thrift comprised 0.1% of its total
balance sheet, it could choose OTS as its “lead
regulator”
Credit Expansion:
Adverse Incentives and Declining Standards
• A Fed study of ARM homeowners revealed that:
 38% did not understand how high their interest rate could
be reset at one time
 50% did not understand how high their interest rate could
rise over the life of the loan
• Homeowner incentives to default and walk away from
their mortgage obligation
• As the securitization machine demanded ever more
loans, mortgage originators began lowering the
creditworthiness bar → NINJA loans
 Verify a credit score and a pulse
600
Consumers with New Foreclosures
Begin to Increase in 2006 (thousands)
500
400
300
200
100
1999
2001
2003
2005
2007
2009
2011
The Unraveling
• As mortgages delinquencies and foreclosures
mounted, CDO values declined
• Between 2007:2 and 2008:2 rating agencies
downgraded $1.9 trillion worth of CDOs
• Securitizing banks were holding unsold CDOs
tranches
• As CDOs failed, investors holding credit default
swaps expected to be paid
– The failure of AIG
That Fateful Day: Sept 16, 2008
“It was overwhelmingly clear that we were staring into the
abyss… this was a catastrophe that we were watching unfold.”
—Patrick McCabe
Federal Reserve Bank economist testimony to the FCIC.
That Fateful Day: Sept 16, 2008
• The Reserve Primary Fund “broke the buck”
 Lehman Brothers’ bankruptcy Sept 15
 commercial paper market
 Bear Stearns bailout “moral hazard”
• Panic!!!
 Within 1 week $349 billion withdrawn from MMMFs, or
about 1/3 total MMMF balances.
• December 9, 2008 the yield on Treasury bills turns
negative
Where Were the Regulators?
• Ben Bernanke’s Congressional testimony
“AIG exploited a huge gap in the regulatory
system…”
The “Real” Economy is Hit Hard
• 2008-2011, 407 failed and Fed assisted banks
• Unemployment peaked at 10.1% October 2009
Jan 2012= 8.3%, with 12.8 mil workers unemployed
Jan 2012 U-6= 15.1%
• Economic growth is sluggish and is forecasted to
remain so
Have We Fixed the Adverse Incentives
that Caused the Financial Crisis?
• Dodd–Frank Wall Street Reform and Consumer
Protection Act of 2010
 Corporate Governance & Executive Compensation
 Credit Rating Agency Regulation
 Securitization Retention Requirements
 Regulation of Over-the-Counter Derivatives
 Financial Stability Oversight Council
 Systemic Regulation and Emergency Powers
 Resolution Authority
 Consumer Financial Protection Bureau