What caused the financial crisis?
Was the it the models, the expectations, correlated risks, non-transparency, dangerous financial innovation, or weak regulations?
It was probably all of the above, but recently it has become clear that the banks caused it as well.
While people have long observed that mismatched incentives, poor models, and lax regulation allowed and encouraged the banks to make mistakes, it has only recently become clear that some banks (+ hedge funds, etc) helped create the crisis by stimulating investment that fed the housing bubble so they could bet on it bursting. Specifically, those who were betting on a housing bust enhanced the bubble by creating Collateralized debt obligations (CDOs) they wanted to bet against. By continually creating and buying these CDOs they almost certainly enhanced the bubble, causing a bigger burst and made more money on the bust. The extent to which this actually promoted the bubble has only recently become clear.
Magnetar, a hedge fund made a lot of money by creating bad CDOs and then insuring them using Credit Default Swaps (what destroyed AIG). It used the insurance as a bet that the CDO would fail. ProPublica, This American Life and Planet Money recently reported on this hedge fund, and this American life compared them to Mel Brook’s movie and musical The Producers – about how musical producers scheme to make money buy creating a show that is doomed to fail. On ProPublica Jesse Eisinger and Jake Bernstein write:
…short bets can be helpful; they can serve as a counterweight to manias and keep bubbles from expanding.
Magnetar’s approach had the opposite effect — by helping create investments it also bet against, the hedge fund was actually fueling the market. Magnetar wasn’t alone in that: A few other hedge funds also created CDOs they bet against. And, as the New York Times has reported, Goldman Sachs did too. But Magnetar industrialized the process, creating more and bigger CDOs.
They explain how CDOs and the trade work:
Banks bundled pools of mortgages into large bonds, which they combined to create even larger investments. These were the now-infamous collateralized debt obligations. Each month, homeowners paid their mortgages. Each month, payments flowed to investors. (Here is an excellent video explaining CDOs.)
Large investors across the globe snapped up the CDOs, which took the hottest investment around — the U.S. housing market — and transformed it into something that supposedly had little or no risk. Wall Street preached that the risk had been diluted because it was spread out over such large collections of mortgage bonds. (CDOs can also be based on side bets that rise and fall with the value of other mortgage bonds. These are known as “synthetic” CDOs. Magnetar’s deals were largely synthetic.)
Just as they did with mortgage-backed securities, investment banks divided CDOs into different layers, called tranches. As the mortgages were paid, money flowed to investors holding the top tranche. Since they were the first to get paid, and thus took the least amount of risk, they earned low interest rates. Next came the middle levels — the so-called mezzanine tranches.
Last in line for money were investors in what’s known as the equity. In return for being at the bottom, equity investors got the highest returns, sometimes 20 percent interest — money they would receive only as long as the vast majority of mortgage holders made their payments.
Even back then, Wall Street insiders called the equity “toxic waste,” and as anxiety built in late 2005 that the housing boom was over, investment banks struggled to find takers.
To Magnetar, the toxic waste was an opportunity.
At a time when fewer investors were stepping up to buy equity, the little-known hedge fund put out the word that it wanted lots and lots of it. Magnetar concentrated in a particularly risky corner of the CDO world: deals that were made up of the middle, or mezzanine, slice of subprime mortgage-backed bonds. Magnetar CDOs were big, averaging $1.5 billion, about three times the size of earlier deals built on subprime mortgages.
Magnetar’s purchases solved a crucial problem for the banks. Since the equity was so risky and thus difficult to sell, banks didn’t like to create new CDOs unless someone committed to buy them. Indeed, such buyers were so crucial that Wall Street referred to them as the CDOs’ “sponsors.”
Without sponsors, Wall Street’s mortgage bond assembly line could grind to a halt, and with it bank profits and banker bonuses. A top CDO banker could earn $3 million to $4 million annually on the CDOs he created and sold.
Usually, investment banks had to go out and find buyers of the equity. With Magnetar, the buyer came right to the bank’s doorstep. Wall Street was overjoyed.
“It seemed like a miracle,” says one mortgage market investment banker, because “no one” had been buying equity.
“By the end of 2005, the general sense was that the CDO market would slow down. These trades continued to fuel the fire,” says Bill Tomljanovic, who worked for a firm that helped build a Magnetar CDO. Magnetar was “a driving force in the market.”
According to JPMorgan data, Magnetar’s deals amounted to somewhere between a third and half the total volume in the particularly risky corner of the subprime market on which the fund focused.
If Magnetar was responsible for between a 1/3 and 1/2 of this part of the market, who was doing the rest? Its unclear right now, but other investors were doing the same thing. Goldman Sachs worked with John Paulson, who made $3-4 Billion using CDOs to bet against housing, in a way that the SEC thinks was illegal. Time’s Curious Capitalist reports on this in their article SEC: Goldman Is Actually a Vampire Squid, and Planet Money explains the SEC case against Goldman Sachs. Paul Krugman writes that it is Time to Reread Akerlof and Romer’s Looting: The Economic Underworld of Bankruptcy for Profit. Krugman quotes Akerlof et al’s paper about the S&L crisis of the 80s:
“Our theoretical analysis shows that an economic underground can come to life if firms have an incentive to go broke for profit at society’s expense (to loot) instead of to go for broke (to gamble on success). Bankruptcy for profit will occur if poor accounting, lax regulation, or low penalties for abuse give owners an incentive to pay themselves more than their firms are worth and then default on their debt obligations.”
Obviously, Goldman wasn’t trying to run itself into the ground (although if there’s more like what we’ve just heard, it may have succeeded all the same). But creating securities that are bound to collapse in value, so that you can profit off that collapse, is in the same family of strategies.
However, there is evidence of such direct looting from the collapse of the icelandic banks. Icelandic economist Thorvaldur Gylfason writes on Vox about a recent report (see the report’s English version Special Investigation Commission 2010) to the Icelandic parliament that suggests that shareholders stole from their own bank in much the same way as occurred during the American saving and loan collapse in the 1980s.
At this stage it must be left to the reader and ultimately to the courts to determine whether the facts reported by the [Special Investigation Commission] SIC suggest that the Icelandic banks were brought down by control fraud as defined by Black (2005) or by their “their rapid expansion and their subsequent size” per se. If the banks were looted by their owners with the assistance of politicians, there would be no mystery about how they did it: they would have used the same methods as the convicted criminals who looted the American saving and loan banks in the late 1980s. More than 1,000 elite white-collar criminals (not counting tellers and minor players) were convicted of felonies arising from the S&L debacle. Their methods are described in Akerlof and Romer (1993) and Black (2005).
The language of the SIC report is guarded. It uses the gentle word “neglect” to refer to what might more accurately be called gross dereliction of duties. Let us not forget what happened on the authorities’ watch. Not only did Iceland’s three main banks accounting for 85% of the country’s banking system collapse within a week, but much of the remaining 15% of the banking system went the same way as did other important concerns that had to be propped up at taxpayers’ expense. Assets equivalent to seven times Iceland’s GDP went up in smoke, including foreign creditors’ claims equivalent to five times GDP. Foreign shareholders and some foreign depositors also took a hit. Icelandic residents lost the equivalent of two times GDP. No other country has ever caused such damage relative to its own size, at least not in peacetime.
While inflating the bubble produced both profits and the financial crisis, the financial crisis has had real effects on people across the world. The New York Times, reports on the burning of the world’s poor that was the collateral damage of the strategies of the rich:
In a Global Monitoring Report, released Friday, the bank reported that the economic crisis had slowed the pace of poverty reduction in developing countries. As a result of the crisis, 53 million more people will remain in extreme poverty by 2015 than otherwise would have, the report found. Even so, the report projected that the number of people in extreme poverty — defined as living on less than $1.25 a day — would be 920 million in 2015, a significant decline from the 1.8 billion in 1990.
While on Bloomberg Alan Katz reports on how small towns are being bankrupted for listening to financial exports in Saint-Etienne Swaps Explode as Financial Weapons Ambush Europe:
Saint-Etienne is one of thousands of public authorities across Europe that tried to shave borrowing expenses by accepting derivatives deals whose risks they couldn’t measure. They may be liable for billions of euros, according to the Bank of Italy and consulting and law firms in France and Germany. As global economies climb out of recession, the crisis is hitting Saint-Etienne in central France, Pforzheim in western Germany and Apulia, an Italian regional government on the Adriatic. They may pay for their bets into the next generation.
From the Mediterranean Sea to the Pacific coast of the U.S., governments, public agencies and nonprofit institutions have lost billions of dollars because of transactions officials didn’t grasp. Harvard University in Cambridge, Massachusetts, agreed last year to pay more than $900 million to terminate swaps that assumed interest rates would rise.
For Jefferson County, Alabama, the day of reckoning came earlier than in Saint-Etienne, but the common denominator was the use of complex, unregulated financial instruments known as derivatives that are typically linked to changes in market interest rates, currencies, stocks or bonds. Billionaire investor Warren Buffett, chairman of Berkshire Hathaway Inc., in 2003 called derivatives “financial weapons of mass destruction.”
They pushed Jefferson County close to bankruptcy two years ago. It had refinanced $3 billion of debt with variable-rate bonds and purchased interest-rate swaps to guard against borrowing costs rising. Its interest rates soared when insurers guaranteeing the bonds lost their top credit grades, and the rate the county received under the swap deals fell.
The world’s financial system is not resilient and is working for the public good. It needs to be reformed, but if history provides any guide, such reform will be difficult and produce new problems. However, any reform should consider that while the financial crisis had many causes, it was not an accident, that some people worked to make it happen. And these types of behaviour needs to be included in our economic models of how the world works.