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What Really Started the Financial Crisis?

By: Ben Domenech (Diary) | December 17th, 2010 at 10:35 AM |

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On today’s edition of Coffee and Markets, Brad Jackson and Ben Domenech are joined by Francis Cianfrocca to discuss what the dead $1.1 Trillion Omnibus spending bill means for small businesses, and what really started the financial crisis.

We’re brought to you as always by BigGovernment and Stephen Clouse and Associates. If you’d like to email us, you can do so at coffee[at]newledger.com. We hope you enjoy the show.

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Tags: Ben Domenech, Brad Jackson, Coffee and Markets, Earmarks, FCIC, Financial Crisis, Francis Cianfrocca, Harry Reid, Keith Hennessey, Mitch McConnell, Omnibus

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Death_of_the_Donkey

has three main sources of cause:
1) the CFMA of 1999 that deregulated (and prevented regulation of) derivatives
2) the SEC ruling in 2005 that enabled leverage to be dramatically increased (ie the Bear Stearns exemption)
3) The ratings agencies essentially selling away their AAA ratings that enabled many more participants to buy subprime backed MBS.

I will say with 100% certainty that the CRA had little to no effect on the financial crisis.

wonkish1

The problems were much deeper.

1) Low fed interest rates in 01-05
2) The fed allowing reduced capital requirements and more leverage for assets for a lot of crap risk mitigation(CDS’s primarily) which was on top of the very low capital requirements of the Basel accords. Similar to your #2, but the more egregious occurred at the Fed
3) The quants at the ratings agencies were using a 8% property appreciation in perpetuity as their assumption in their models. I don’t see ratings agencies making that mistake again as they will most definitely use longer term data sets for their model assumptions from now on.

Death_of_the_Donkey

since the Fed doesn’t regulate AIG or the I-banks, it had little ability to affect the outcome of the CDS explosion once CFMA was passed (at the behest of Enron let’s not forget). Sometimes the removal of regulation isn’t necessarily a good thing.

wonkish1

Banks: CDS’s really didn’t have all that much value to a bank unless the ownership of a CDS would allow banks to lower their capital requirements allowing them to take on more leverage. It was the fed that granted different capital requirements for assets protected by CDS’s vs. ones that weren’t. When the Fed made that decision CDS exploded overnight. Read Fools Gold which details the team at JP Morgan that invented the CDS, and who refused to participate in the MBS market. They admit in the book it was the Fed’s allowance of different capital requirements that unleashed the boom in CDS literally within a month. 90% of those offering CDS protection after that were monoline insurance companies that everybody new weren’t worth the paper they were written on because at that point most of bank ownership of CDS wasn’t about risk it was about lowering capital requirements and increasing their juice.

Derivatives: They have interest rates attached to them. As interest rates rise derivatives become more expensive as interest rates fall they become cheaper to use. There would never have been the boom in derivatives if interest rates were never that low

The I-Banks: Granted the Fed doesn’t regulate the I-Banks, but also if you don’t have massive quantities of MBS CDOs flowing through them because of lower interest rates then you don’t have a desire by I-Banks to hold CDS protection against them.. Without a CDO market you don’t have a CDS market. Without low interest rates you don’t have a CDO market.

That only leaves AIG. I will tell you this I’m not opposed to increased collateral requirements for those that offer CDS protection, but I can bet that no I Bank or C Bank is ever going to want to get CDS protection from anyone that doesn’t put up an adequate amount of collateral anyway. I think the private sector is solving that one.

Again the financial sector still comes down to some pretty basic things that regulate just about everything. Fed Interest rates, Capital requirements, reserve ratios, adequate balance sheet reporting, and thats about it.

Also we need to replace mark to market with market to market multi year rolling averages.

Death_of_the_Donkey

at least not entirely. And it wasn’t the Fed that changed capital requirements/leverage ratio’s, it was the SEC in 2005 that removed the 12:1 leverage ratio for the five largest I-banks. And while yes, money may have gone in search of yield, without the CFMA it would have at least had to flow to “regulated” areas of the market that were governed by both open markets and reserve requirements. Also, since the vast majority of the investors buying these MBS instruments had ratings requirements (ie they couldn’t buy crap), had the ratings agencies done their jobs, the damage would have been limited. You also left out the origination of most of the subprime crap, which came from private mortgage nonbank lenders (and therefore not regulated by the Fed or the CRA), in other words it wasn’t the banks making these loans.

The point I am making here is that our actual crisis was not caused by the Fed’s low interest rate policy in and of itself, but by a confluence of things that should have been staved off by better regulation. Your argument that the low interest rates would have created other bubbles may be true, but not all bubbles are created equal or have the same damaging effect on the economy at large (ie the stock bubble of the 90′s crash was relatively contained). The fact is that in this case complete malfeasance by our legislators (who believed that deregulation is always the best answer), the SEC, the I-banks, the ratings agencies, and to a lesser extent the Fed created a true nightmare for the economy that could have been (and should have been avoided).
http://impudent.edublogs.org/ kyle8

played by changing the accounting system. The current system overvalues assets in boom times and undervalues them in a downturn.
wonkish1

Mark to Market needs to move to a rolling average accounting system.. No sane investor bases their investment decisions on their most recent returns; they look at a multi year average. Mark to market with a multi year rolling averages would smooth out a lot of the excesses in that part of things.
wonkish1

First, you don’t know what I’m referring to. You are referring to the SEC’s change in leverage ratios of I Banks. I’m talking about the Fed’s change in capital requirements of *Commercial* Banks. 2 completely different things.

Three Questions

First who was the primary buyers of I-Bank paper in the commercial repo markets?

For those that were other sources, where did they get their credit from?

Then point to a time in the history of the world where broad money supply increases didn’t cause a major crash? (also in every case the size of the crash was in proportion to the amount of excess of money created)

If you can find me a time period in which it didn’t occur then maybe I would take your occur then maybe I would take you’re viewpoint more seriously.

Also, you appear to admit that loose money caused the bubbles, “but claim not all bubbles are created equal”. That tells me that you are only arguing that reduced regulation made the crash that much larger, it appears that you are actually admitting that had there not been fed created asset bubbles there wouldn’t have been a crash at all. But that the lack of regulation exacerbated the problem. Well that is good enough for me because even then that it is an admittance that without loose money it would be impossible for this whole situation to happen.

By the way, I do agree that the SEC allowing more I-bank leverage was a problem, but I also think that the Fed decision to allow more leverage in commercial banks was a bigger problem because it is commercial banks that are always the original source of money for I-banks to leverage up.

Also, if you think that regulation is the holy grail lets look at the most regulated institutions of the entire industry. Fannie and Freddie were the institutions that had the absolute most regulators devoted just to them. One regulator with over 100 people had one job and that job was to regulate Fannie and Freddie. Guess what that didn’t anything to stop them from going to 95 times leverage.

It comes down to mathematics. If broad money supply increases at a higher rate than GDP grows then more money for each asset means price increases. Artificial price increases cause asset bubbles that change the behavior of those involved. I don’t mind if you act like x, y, or z makes it worse. Ultimately, though it appears you agree that the root cause(without it there is no problem for those other factors to “exacerbate” is those loose money induced asset bubbles.

Death_of_the_Donkey

And I don’t think the Fed’s low rates would have been a problem had CFMA not existed, the leverage ratios not been raised, and (especially) the ratings agencies actually did their job. I never understood how an MBS with a huge subprime component could be given the same rating as a US treasury.
wonkish1

Regulators were able to clamp down on the derivatives market. The nature of super low interest rates is that it will drive asset bubbles in a different market instead. Regulation in the face of an expanding money supply is like trying to plug holes in a dyke with a lot of water trying to come through. If you succeed in plugging one it will just find another hole.

This was codified best when the banks admitted that in late 04-07 they had become very “liquidity rich, but asset poor”. Basically they had money flowing into them at insane rates from deposits, other banks, etc. and they couldn’t find enough quality assets and opportunities to drive that money into. Even if you had shutdown the MBS market or the Derivatives in early 04 a new market would have popped up in a matter of months to service the massive amount of liquidity floating around.

We’re talking about root causes here, and the root cause of asset bubbles in general is loose money.

wonkish1

Going back to the Tulip and the Mississippi bubbles in the 17th century and in every single case loose money was there as a driving force.

Death_of_the_Donkey

in keeping rates low for far too long into the recovery (especially when the actual recession was so mild in the first place), thus creating an endless quest for yield. However, it is interesting to note that even longer term rates (ie those not controlled by the fed) also stayed low during the period when the fed began tightening.

wonkish1

“Thats Not To Surprising” below

http://impudent.edublogs.org/ kyle8

absurd lending practices, low reserve requirements, low or non-existent down payments. And a bad accounting system.

Yes, pretty much that causes or exacerbates all bubbles.

And all of those things are regulated by law, so you can go out on a limb and say that once again, Government is to blame.

wonkish1

Low central bank rates, fed injections, fed printing, and low reserve requirements.

A bad accounting system is icing on the cake.

And yes we can all agree this was government created.

tedpomeroy

Has anybody done any research into the investable asset shortage of 2004 to 2007?

Think back to where we were. There was a shortage of medium to long term US Treasuries. The US had run surpluses in the years running up to 2001 and GWB really did not run big deficits (3% of GDP on average).

In effect we were only offering MBS to our trading partner, China, and Wall Street. China was really not thrilled at this prospect, they wanted the safety and liquidity of US Treasuries. They tried to buy Unocal (the oil company) but Congress said no.

Quite a misbalance don’t you agree? Bernanke calls this a surplus of capital.

But this is where I see it as a misplacement of capital, during 2004 to 2007 the US oil companies returned $190 billion to their shareholders by share repurchases. Using normal leverage ratios that means they gave up $1 Trillion in investable funds. And we had $4.25 a gallon gas in winter of 2008.

wonkish1

In the equity markets, we were at 120% of GNP(you don’t use GDP in this calc) in total market capitalization. Buffett(and me included wont) hold equities when it goes much beyond 100%. Treasuries weren’t very common and didn’t offer very attractive interest rates. Corporate bonds didn’t offer much. Yield chase was going on, but on top of that if you were a bank everywhere you looked was junk with bad balance sheets that was grossly overvalued. All of this was the case because overly accommodative fed policy prevented the correction in the markets that would have allowed for better valued assets to be purchased.

Then you add to the equation huge increases in the money supply and all of sudden you are a bank will trillions of low interest(but rising) deposits coming in and no reasonable place to put it.

You are left with to choices.
A) Lower deposit rates, orderly slowdown your bank, layoff a bunch of people and let your reserves expand. Now 99% of banks wont do that. 1 did it was called Beale in Plano, Texas. Everybody laughed at him and now he is a multi multi billionaire
B) Through cautious into the wind at put those deposits into increasingly more crappy assets.

In retrospect A was probably the better choice. But lets be real how many on here would actually close down your multi national business because there was a possibility that a crash would happen. I bet not many.

Again, asset bubbles are dangerous things and if you create them you will create the incentives for people to engage in stupid things. Its just they don’t know it.

Death_of_the_Donkey

I disagree about the markets going up once the tax deal was announced. The upward trend in the market correlates back almost to precisely when Bernanke first brought up QE2 in August and the even more recent uptrend (if you want to try to distinguish them), started a full week before the announcement of a tax deal. In other words, I think the extension of the current rates had been priced into the market long ago.

wonkish1

Agreed. They most definitely were.

But the market’s were bullish before the fed decision as well. I turned from bearish to bullish back around July territory when M3 started showing signs of heading up. My entry point was mostly all around Dow 10K. Now I will say that nailing that close to the bottom had a considerable amount of luck in it. I was only looking at getting a reasonable entry point when I determined that M3 was bottoming out and turning towards positive territory. I thought it was likely that the Dow was going to head down into the lower 9s, and that I wanted to enter early in around 10 well that ended up being pretty much the bottom.

You don’t see complaining about that though.

wonkish1

You create a boom in any industry(such as fix income) and you might find a little bit of resistance to it correcting.

Don’t underestimate the power of a feedback loop in keeping fed interest rates low.

Stimulate demand for new debt –> New Debt gets taken out —> The velocity of money grows —> the money supply goes —-> more available money per good causes prices to rise —-> most of the price increases go into assets(such as real estate and gold) —-> the rise of real estate appreciation makes mortgages seem safer —-> demand for banks to issue more debt increases —> more mortgage debt gets taken out —-> the velocity of money speeds up faster —-> prices rise further…

This cycle builds and builds. That is the nature of loose money, it can develop its own life relatively fast.
mikerazar

1. Badly written contracts.

2. Lazy or dishonest fiduciaries who fail to perform adequate due diligence.

Sure, loose money encourages such bad behavior but it doesn’t cause it.

Wonkish: we should talk…

wonkish1

Loose money causes asset bubbles. Asset bubbles cause dishonest and short sided behavior.

wonkish1

By creating the incentives for it to occur. And incentives beget the behavior the incentives encourage. But even if you removed the bad behavior from the equation you still get a bubble and a crash because most parties involved still thought they were doing the “right thing”. But it was based on false assumptions like “real estate doesn’t go down in value,” “CDS’s reduce risk and therefore should lower capital requirements,” “Home ownership is always better than renting,” “Super Senior tranches have no risk,” and the list goes on and on. All of these thought processes were reinforced by an asset bubble where people that thought this way were rewarded financially and those that thought differently weren’t.

mikerazar

Loose money is a necessary condition. But fiduciaries are supposed to exercise due diligence before investing in equity or lending money to a firm. When a firm levers up thirty to one, who is to blame?

1. Senior managers who put their own interests (via various incentives) ahead of shareholders’ and bondholders’ interests?

2. Boards of Directors who fail to stop them.?

3. Shareholders who elect the Boards?

4. Lazy lenders (includes ALL bondholders)?

Everyone on Wall Street knew for decades about the mismatched incentive problem. Yet dozens of authors seem to think the problem began only a few years ago with the popularity of derivatives.

I disagree with Wonkish’s description of the false assumptions to this extent. Most parties were swindled by people who DID know the risks and suppressed them in order to make an unearned profit. The Achilles heel of capitalism has always been a lack of integrity on the part of fiduciaries.

Without the lazy lenders to enable them, the dishonorable managers could not have levered up. I call them lazy because the knew or should have known that betting all the firms equity on housing prices not declining by 5% would put their loans at risk.

I am more sympathetic to investors whose fiduciaries let them down. After all the advisors and decision makers on these loans rarely had a personal stake in the decision. More mismatched incentives.

I would love to blame that moron Barney Frank, but he never had the power to force people to make bad loans.

The lesson is never learned. If you trust your money to crooks they will steal it. What part of that is so hard to understand?

As a postscript, next time someone with a conflict offers free advice, either run away or pay someone without a conflict to give you unbiased advice. No free lunches, children.

http://www.americanthinker.com/2009/01/the_ten_trillion_dollar_black.html

(sorry it isn’t pasted as a link)

.

wonkish1

You agree that loose money is a necessary condition for all of what you listed occurring. If we could get the financial world to agree on at least that, then a huge amount of progress would be made.

A firm leveraging up 30 to 1. You have to add that if there isn’t low interest rates then no sane firm will leverage up 30 to 1 because the cost of that leverage is prohibitively high. And all of a sudden it becomes obvious that it isn’t that smart to take large amounts of leverage risk to only potentially gain a small spread between interest on the leverage and the returns on the assets.

I would definitely not say that everybody on wall street knew about the mismatched incentives. Some did, some didn’t. Those that did usually found it to be less of a big deal(assuming that firms had their risk under control) than it actually was. They didn’t really understand how right they were until after the crash.

What is a more believable explanation for people’s behavior?
A) Everybody(I bankers, traders, structured finance desks, regulators, ratings agencies, quants, analysts, managers, shareholders, lenders, etc.) all knew that their were insane amounts of risks being taken by their firms and themselves. Then they decided to not care, and take them anyway putting their firms, their portfolios, and their jobs at risk.
or
B) That everybody underestimated how much risks they were taking assuming everybody else was doing their job to mitigate those risks. And everything broke down because many of their false assumptions were proved to be very incorrect.

Ignorance is always a better explanation than sinister conspiracy.
wonkish1

What is the Reagan quote, “There are usually simple solutions, but that most simple solutions aren’t easy.” Or something like that.

What is easier to believe?

That we can somehow invent a regulation for each an every one of these behaviors before they occur. Figure out every mismatch of incentives in existence and regulate it away. Find every single conflict of interest and regulate it away.

Or

Is it much easier to just remove the condition that allows for all those mis matches in incentives and conflicts of interest from going systemic? From allowing the juice to be added into all of those situations.

You can’t pass a law that will do away with greed, but you can prevent any one asset or industry from growing way out of control by preventing the incentive to juice that industry or asset.
mikerazar

You are far too easy on the people who knew what they were doing to their shareholders and bondholders.

It was not a sinister conspiracy. It was a bunch of crooks acting in their own perceived self interest, using false naivete as cover.
wonkish1

Think that it is much more likely that everybody from you’re standard local mortgage broker, to the analysts, to the regulators, to the structured finance desks, to the sell side brokers, to the pension managers, to the shareholders were all crooks.

Instead of the fact that they were all ignorant.

That is your position.

Don’t forget for you to be a successful crook, you better have your job, you’re shares sold, you’re firm still intact, etc. when the music stops. It appears all those crooks you are referring to couldn’t have been that good at being crooks because they all got burned.

I have read, watched, and listened to how those meetings went in the Wall Street I-Banks, Ratings Agencies, etc. It was all ignorance. Up and down and everywhere. It was ignorance blinded by the money they were making, that is it.

That is what loose money does. It rewards ignorance, and if you come in telling them that they should be doing something else like in all human nature they are going to defend that ignorance because currently that is what is making them all their money.
mikerazar

My position is that the heads of the Wall Street banks who bet their shareholders’ equity and bondholders’ cushion on wagers that no sane person would do with his own money were crooks.

If you need any convincing, look at how fast they were to embrace a federal bailout of their firms without even having the decency to resign. These men were not capitalists. They were socialists with a taste for the finer things in life, just as all socialist leaders.

It is a shame that the feds have no interest in pursuing criminal indictments and that fund managers aren’t pursuing civil suits.
wonkish1

Well Dick Fuld is disgraced and lost a lot of his wealth. The previous CEO Kaine is portrayed as an idiot and lost almost the entirety of his wealth. Prince got shellacked. The list continues.

And all portrayals of the bailout aren’t exactly the top Wall Street Banks embracing a federal bailout. Instead its a story of Hank Paulson blackmailing the heads of the big firms to either take the bailout or make an enemy of the US government.

Now in terms of some sinister types. Yes, the heads of Frannie and Freddie were pretty corrupt. Also, Blankfein showed some sinister and corrupt traits. Same with the head of Countrywide.

But the real story at the top of the big Wall Street firms was they weren’t as smart as they thought they were.
wonkish1

Big Wall Street firms don’t run like the way you describe.

The head honcho’s don’t make many decisions on what is bet or not. Big Wall Street firms are pretty decentralized(as they should be). Most “bets” are taken by individuals inside of the firm. And when they do well they get larger chunks of capital to play with. Also, there is a lot of group think in big Wall Street firms.

Firms that made out the best like JP Morgan, did so because they had superior risk mitigation structures put into place. That is also why Goldman was positioned better than Bear or Lehman.

Big CEO’s don’t make to many decisions on a lot of decisions because there is a mismatch between the intellectual capability of the quants and analysts and the CEO’s. They aren’t smart enough to make many calls(and if they were given that power there would have likely been bigger crashes in their companies).
mikerazar

much the firm is leveraged is made by novice traders? If anything is certain it is that the CEOs knew that a small drop in real estate would wipe out the firm’s equity. Choosing to increase their own income by ignoring that fact cannot be ascribed to anything but willful behavior.

I agree that Paulson waterboarded some execs until they agreed to accept tens of billions in government loans. Yeah…please don’t throw me in the brier patch.

As to Morgan and Goldman, you may be right. I never said that every manager was corrupt.

The real story is that they were all very smart and knowledgable. Some were just more honorable than others.
wonkish1

Obviously decisions as to how much leverage to take were born by folks higher up in the organizations. But again those decisions were made more out of ignorance out of any sinister beliefs. Keep in mind that it wasn’t so much of a question. Should we leverage up from 5 to 1 to 40 to 1 over night. It occurred more gradually than that. Those that leveraged more grew in size and made more money. So yes as time went on, leverage was increasingly seen as a good thing, and they were ignorant to the risks.

But again leveraging up is a much, much less desirable thing to do if the cost of that leverage is higher.

tedpomeroy

Great to find someone who also has read Fool’s Gold.

Are you agreed that this all could have been prevented by one 1/2 point Fed rate increase from 2005 to 2007 instead of the measly 1/4 pts at every FOMC meeting during that period? I was wondering when Chairman Greenspan was going to step it up. Meanwhile at my desk (large commercial real estate brokerage and finance) I was wondering when my more foolish clients were going to get their brains bashed in. Well, it happened.

But now I understand that Greenspan was under the spell of Bernanke and the view that deflation was the rule. How can we get to Ron Paul’s people that Bernanke needs to be taken down by refuting his deflationary views?

I very much like the work of Steve Hanke of Johns Hopkins along these lines.

wonkish1

I don’t think they really should have reduced interest rates all that much in 2001 to begin with. The recession wasn’t to bad, and granted 911 definitely shocked the system, but I don’t think its reasonable to hold ultra low interest rates in 02, 03, 04, and 05 as a response.

Personally, I think that in general I’m okay with accommodative in federal funds rate in the case of a recession. But that is a far cry from ultra low interest rates. If normal is around 4%, I don’t really think that you really need to go below 3% in the federal funds rate. It causes way to much in market distortions.

So yeah I think they should have increased it by 50 instead of 25, but I rather they would have started earlier also, and I rather they would have never lowered it that low to begin with.

If you have ever seen the movie Road to Perdition you will understand my views on Greenspan. I feel like Tom Hanks shooting down Mr. Rooney at the end when I criticize him. But regardless of whether I like it or not it needs to be done because no single man is more responsible for causing this crisis than him, and personally that is a certainty.

It is quite sad to because he devoted his entire life to sound economic policy and was originally apart of the Austrian school. But when the pressure was on, when the moment for decision was at hand he folded like a cheap suit. He threw out everything he had believed and worked on for his entire life so that he wouldn’t be blamed for forcing people to undergo some economic pain back in 01. And in doing so he caused the greatest economic crisis in the last 80 years. It saddens me, but its true.

In terms of Ron Paul, well obviously I can’t really think of a better place for him to be nor a better person to hold that chair. That said besides hearings he might not be able to do much for a while. Maybe he can slip a piece into a bill changing the mission of the fed from keeping prices stable and unemployment low to just keeping prices stable, but a move like that would largely be symbolic. Maybe he can successfully score some fed audits or something, but unlikely to change much. Ultimately the only way to get Bernanke out is to get a new president in that cares about sound Fed policy.

Scope

and Paulbots are not supported widely at Redstate. I wondered why you had sooo much to say here at RS with less than a 2 month membership. Now we know. Paulbots are very vocal.

wonkish1

I agree with Paul on fed policy that is about it.

Otherwise, I’m currently mostly a Paul *Ryan* type hence the name.

wonkish1

I find Ron Paul to be highly unstable, kind of a conspiracy theorist type, someone that doesn’t really understand much of what he espouses, very naive, and kind of crazy.
wonkish1

much with Paul of Fed policy is pretty incorrect.

The people that I trust on Fed policy are apart of what is called the Shadow Open Market Committee or SOMC it is a body that is made up of Fed “Hawks” that make recommendations on Fed policy because they find the FOMC to be run by Keynesians.

My appreciation of Ron Paul heading the Fed Subcommittee is mostly because of a lack of better options. Not many people in congress no really anything about Fed policy so Paul is the best available that I know of.

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