The Financial Crisis: Understanding the Causes
February 11, 2009 6 Comments
Many people know and hear about the recession, but do not understand how we got to this point. This post seeks to provide a concise high-level account of the key factors contributing to the downturn.
The current financial crisis has been the focus of nearly all media attention, policy debate, and popular conversation for the past five months. Both the depth and ferocity of the downturn makes this a truly historic time, and the decisions made to solve the crisis will have an enduring impact on both our financial system and national economy. In order to frame these discussions properly, it is important to have an understanding of what happened and how we got to this point.
The Housing Bubble: The root cause of the crisis can be traced back to the burst of the housing bubble, which began by most estimates in early 2006. The build-up of the bubble was, like all bubbles, based on the façade of massive profit with little regard to risk. Banks were offering the now famous NINJA loans (no income, no job, no assets) to people who were at a high risk to default, and sub-prime mortgages swiftly became the norm. These banks were chasing the enormous profits inherent in bulk loans, but with shockingly little regard to the enormous risk they were taking on. When the bubble finally burst, and no one was able to pay their mortgages, the banks got stuck with all of the bad debt you now hear so much about.
Wall Street Doubles Down: Behind the scenes of the mortgage defaults was wide spread investment in complex financial instruments called Collateralized Debt Obligations (CDOs). Essentially, a CDO is a type of asset-backed security–a bond backed by a mortgage in this case. The problem with CDOs is that the originators of the loan retain no risk for the poor loans they make, but still collect the interest on those loans. Simply put, a bank would make a sub-prime loan, give the mortgage risk to an investor (passing the risk to the investor), and still collect the loan payments.
With housing shooting through the roof in the early 2000s, Wall Street investors invested heavily in CDOs, essentially doubling down the risk on the sub-prime mortgages. This was all exacerbated by mismanaged rating from credit agencies, who undervalued the risk inherent in these complex financial instruments. The bottom line is that Wall Street doubled down on the heavy risk the banks were already taking. Everyone wanted the profit grab from the bubble, and nobody seemed to care about the risk.
The Bubble Bursts: When you loan people money who shouldn’t be loaned money, they will default. Millions of people were given mortgages $100,000 to $200,000 more than they could actually afford, and eventually they weren’t able to pay. Finally, the housing bubble burst. When this happened, revenue the banks had relied upon from mortgage payments and interest was no longer there, and Wall Street’s CDO investments all crumbled almost overnight. With commercial banks struggling to cover losses, and Wall Street investment banks taking hits from CDOs and mortgages, the market began to collapse quickly.
Credit Crunch: The massive losses in both commercial and investment banks created a classic credit crunch, meaning that banks were unwilling and unable to loan money out to investors and consumers. Since credit forms the basis for much of the market’s function, the freeze meant a halt to nearly all significant investment. Essentially, banks now had to pay for the risks they had taken, so they could not afford to loan out any money. The lending system forms the foundation for our economy, so a credit and liquidity crisis meant a full stop to investment and growth.
Consumer Fear: The sharp downturn decimated millions of 401(k)s and portfolios, and brought fear into the marketplace. Consumer spending declined sharply as people worried about job loss and their rapidly shrinking portfolios, and justifiabily sought to save to cover losses. Consumer confidence reached a 30 year low at the end of 2008 and job loss accelerated quickly in a stalling economy (2.6 million lost in 2008 alone). Combine low confidence, falling wealth (from investments), and massive job loss, and the economy moves rapidly into a classic recession.
A Vicious Cycle: Unfortunately, as you can see from the chart, we are in a terrible cycle. Recession and job loss only further accelerate mortgage defaults, which fuel the credit crisis and so on.
-Matt Benchener from TruPolitics.net
I think you are might be missing the most important piece that led to the financial crisis. The root cause was actually the CRA passing in 1977. The Community Reinvestment Act (which was orchestrated by the infamous ACORN) pressured banks into giving people loans that would not normally qualify for them. In 1995, Clinton/Reno with the Department of Housing and Urban Developement passed legislation that strengthened the CRA. This government interference in the free market compelled the banks to make these loans.
Banks did not want to give the unqualified buyers loans, but were forced to by the government. The laws were changed to pressure banks into these no money down, no interest loans. If the banks did not comply they were accused of redlining. This would create a situation where banks would not be able to open new branches or do any merging or acquiring. Thus severely limiting the banks ability to operate.
If you start the story in 2006, you completely let socialism off the hook. If not for the government forcing the market to make decisions it did not want to we would not be where we are today.
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I believe what you say is accurate except for the idea that you started at the beginning. There are some big questions that remain unanswered or are ignored altogether. Why was housing booming? Was population growth the cause of the boom? Or was it something else? Was this bubble the same as all other bubbles? Do bubbles occur in a free market without government intervention? What might the government have done to precipitate this crisis? What might they have done to avoid it? What would cause banks with fiscally sound track records to reject logic and take on huge risk? All of these questions and more point to the oversimplification that blaming this on a run-of-the-mill bubble bursting is.
While I agree that the CRA contributed directly and indirectly to the formation and eventual burst of the housing bubble, that argument ignores the CDO and Mortgage-Backed Security collapse that accelerated almost the whole of the downturn. CDOs and MBSs created leveraging on the risk inherent in all loans to nearly insurmountable levels. Investors, specifically investment banks, were leveraged at over 20 times the normal risk level, meaning that once defaults hit, they took over 20x the normal loss. You could argue that if the defaults never occurred then the collapse would never have happened, but defaults always occur in varying measures.
Most importantly, the presence of CDOs allowed banks to pass much of the risk onto the investors. So, if you can make money on a bad loan without absorbing its risk, wouldn’t you? Definitely–even in absence of the Community Reinvestment Act. This is a very important argument that needs to be forwarded, and I’m afraid that conservatives (which I am) are trying to place the blame fully on liberals, rather than take a hard look at Wall Street’s failure.
First, I wasn’t trying to imply the CRA was the only reason behind the collapse, but it was a huge reason that you completely ignored.
Second, Yes, the CRA alone did not cause the whole thing to crash, The Federal Reserve, Fannie Mae and Freddie Mac all played a role and all have one thing in common: government intervention in the free market. The CRA loosened lending standards, Fannie and Freddie drove up demand for the poor loans, The Fed’s monetary policy fueled the housing bubble.
Third, I’m not trying to pin this on liberals. I’m trying to pin it on government intervention in the Free Market. Without the government’s involvement does this happen to the extent that we are seeing it? No, of course not.
Fourth, you said that the bubble was “based on the façade of massive profit with little regard to risk.” Let’s assume this is true, what is your solution? Should the government give each bank a profit goal each year that they cannot exceed? Should the government disallow banks from taking risk? Should there be only one central bank run by the government? Maybe, the government should just outlaw bad decisions?
I think the lesson here and throughout history is that government involvement creates these situations not the free market.
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