This is a long post. I think a long discussion is justified for arguably the most important financial event in decades that set events in motion that could affect the US and world economy for a very long time.
Economists will probably debate the causes of the 2008 recession and financial crash at least as long as they have been studying the Great Depression. And just as the stock market crash of 1929 was only the harbinger of the Great Depression, news from Greece and Europe indicates that the events of 2008 are still echoing throughout the world economy. However, since governments are already enacting policies to recover from what many are calling the Great Recession, and trying to prevent it from recurring, we need to try and understand it as soon as possible.
Everyone agrees that the Great Recession was associated with the collapse of a housing bubble. After going up at double digit rates for most of the decade, US housing prices crashed. Losses and defaults on associated investments and loans caused a credit crisis which the US government addressed with extraordinary measures – bailing out AIG, big banks, Chrysler, and GM – to restore some order to financial markets and the economy. In retrospect, it was irrational to assume housing prices would continue to rise much more than historical trends, just like it was irrational to assume dot com stocks with little revenue were fairly valued in 2000.
There are some great books on the details of the crash already in print. I read The Big Short: Inside the Doomsday Machine by Michael Lewis, a fellow Princetonian, which tells the story of the crash from the perspective of a few investors he found who predicted it and placed substantial financial bets on their predictions. I just started The End of Wall Street by Roger Lowenstein, a fellow Newtonite. So far, it tells the story of a mortgage market that evolved to a state where there was a total disregard of sound financial practice. Some banks had policies to discourage their people from asking applicants to back up anything they put on their mortgage applications, no matter how improbable, lest it result in the loan not getting approved ! Federal policies to increase home ownership, backed by Fannie Mae and Freddie Mac, also contributed to a situation where more money was lent to less qualified buyers in an overheated housing market.
The mortgage markets had other problems. Investment banks produced esoteric financial instruments like Collateralized Debt Obligations (CDOs), a type of derivative that aggregated mortgages, and synthetic CDOs without underlying mortgages but which tracked real CDOs. Insurers like AIG wrote Credit Default Swaps (CDS) protecting CDO issuers based on risk assessments from rating agencies like Moody’s and Standard and Poors. Unfortunately, the models used to assess risk were fatally flawed. The largest drop in housing prices allowed by the models was much less than what subsequently came to pass or what had been experienced twice since 1970. In addition, the models incorporated a logical fallacy that assembling a mix of low quality asset backed securities resulted in a high quality one.
The rating process for these esoteric securities was skewed in favor of the investment banks issuing them. Michael Lewis points out that the rating agency employees were Wall Street’s bottom of the barrel who couldn’t get hired by the investment banks and got paid much, much less. The contrast was visually apparent with the investment bankers wearing Armani suits and the rating agency employees clothed off-the-rack. Amazingly, the entire rating process had a huge conflict of interest, as agencies were paid by the issuers of the securities and only got paid if they gave a favorable rating !
Though these problems seem obvious in hindsight, they were not obvious at the time. In early 2007, I joined a stock club. We invested in AIG in June 2007 to have a presence in financial services. Soon after we bought, AIG started sinking. We knew there was exposure to subprime mortgages and tried to figure out what that exposure was. Our research showed the exposure should be limited, based on the figures we could discern, so we bought some more in February 2008. But the stock kept dropping, even after pundits said the price fully reflected the possible losses. So we sold, with a 50% loss in June 2008. As bad as that was, we felt like geniuses for getting out when we did when the company was bailed out and the stock became nearly worthless !
If you listen to certain politicians, the crash was the result of unchecked greed due to financial deregulation under Bush. I wish it were that simple. Some deregulation arguably contributed to the crash. Under Clinton, parts of the Glass-Steagall act were repealed that blurred the lines of commercial banks (think low-risk) and high-risk investment banks. Self-regulation of derivatives markets was enacted in 2000, also by Clinton, so pricing of the CDO and CDS derivatives was largely hidden from the market. In 2004, the SEC (not Bush) unanimously relaxed the net capital rule which some have argued led to overleveraging by investment banks such as Lehman Bros. which failed in 2008. In at least one instance, Congressional Democrats blocked Bush’s attempt to regulate Fannie Mae and Freddie Mac. The NY Times called the proposed legislation “the most significant regulatory overhaul in the housing finance industry since the savings and loan crisis.” And since government spending on financial regulation went up 26% in real terms during his presidency, it is hard to argue markets were radically deregulated by Bush.
Though he is more interested in telling the story than explaining its root causes, Michael Lewis points to the 1980s when the investment banks, originally partnerships, became public corporations as a significant factor. Goldman Sachs was undoubtedly more conservative when the partners were investing their own money, not other people’s.
David Frum points to something else as the cause. While it is indisputable that elevated housing prices, and mortgages on that housing, were the proximate causes of the crash, someone had to fund that runup in prices. Frum advances the theory that China, in its effort to fuel its growing economy with foreign demand while keeping its currency low enough so exports kept flowing, lent us money so we could buy Chinese goods. That money had to go somewhere, and much of it helped inflate our real estate prices. While I don’t pretend to understand the money supply (I never got that part of Econ 101), it sounds plausible.
I don’t think we can neglect the impact of the Federal Reserve Board, either. The Fed lowered interest rates dramatically after 9/11 to keep the economy from collapsing. By 2004, concerns about inflation led to increased rates which peaked in 2006-7. This 4-point swing, down then up in 5 years, clearly added instability to financial markets and caused some foreclosures when adjustable rate mortgages reset with higher rates.
If you look at airplane crashes and similar disasters, they often turn out to be caused by the conflation of several events, each of which has low probability. The Great Recession is not that sort of catastrophe. Falling housing prices were the driver behind the financial crisis. But since housing prices have fallen 10-20% in real terms twice before in my lifetime (peaks in 1979 and 1989), that cannot be considered a low probability event unless you believed that the rules of the economy had changed. Some people may have believed that Alan Greenspan’s fiscal policy had tamed the business cycle, but the Great Recession has effectively shattered that notion.
As a scientist, I believe that there are immutable laws of nature that govern how the world works. Even in the messy world of social science, there are some inviolable principles. One of them is that from time to time, markets exhibit irrational exuberance where some commodity will increase in value at rates well above the historical norm. There is no way to eliminate these bubbles. Eventually, the market corrects and the commodity returns to a reasonable valuation. There is no way to eliminate the pain or loss of those who bought during the bubble unless government steps in and makes them whole (and makes other people cover their loss).
If you accept that the Great Recession was just a particularly bad collapse of a bubble and downward portion of the business cycle, it doesn’t mean that we cannot try and find policies that mitigate the frequency and severity of such events in the future. I will have more to say about that, as well as on the financial ‘reform’ bill, in future posts.