Swedroe: Understanding The Financial Crisis

October 01, 2018

The 10th anniversary of the Great Financial Crisis is the subject of lots of articles and media coverage. As a result, I’ve been getting many questions about what caused that crisis and what, if any, lessons we can take away from it to help prepare for the almost inevitable next one.

I’ll begin with a brief review of the main causes. (Entire books have been written on the subject.) Unfortunately, while the media often focuses on the failure of financial models, the real causes can be found elsewhere.

Origin Story

The origin of the crisis stemmed from the political objective of increasing home ownership, beginning with FDR and including Reagan, Clinton and George W. Bush. This goal was aided by the enactment of the Community Reinvestment Act (CRA) of 1977. The CRA’s intent was noble—to encourage depository institutions to help meet the credit needs of the communities in which they operate and to eliminate “redlining” (not lending to anyone in certain neighborhoods) and discrimination.

Next up was the Housing and Community Development Act of 1992, which established an “affordable housing” loan purchase mandate for Fannie Mae and Freddie Mac. That mandate was to be regulated by HUD. Initially, the 1992 legislation required that 30% or more of Fannie's and Freddie's loan purchases be related to "affordable housing" (borrowers who were below normal lending standards). However, HUD was given the power to set future requirements, and HUD persistently increased the mandates, which encouraged “subprime” mortgages.

By 2007, the goal had reached 55%. In other words, more than half the loans originated were “affordable housing” loans. Like many well-intentioned ideas, they failed to anticipate the unintended consequences, especially when taken to an extreme.

In this case, the goals went too far, with required down payments dropping from 20% to 10% to 5%, then 3% and eventually to 0%. And Fannie Mae and Freddie Mac (backed by an implied government guarantee) were operating with very high amounts of leverage while making these now-very-risky loans.

Another related contributing factor was that in 1995, Fannie Mae and Freddie Mac introduced automated underwriting systems, designed to speed up the underwriting process and approve more loans. These systems, which soon set underwriting standards for most of the industry (whether or not the loans were purchased by the government sponsored entities), greatly relaxed the underwriting standards.

Then we had the 1999 repeal of the Glass Steagall Act, which led to the separation of investment banks and commercial banks. On top of that, we had the failure of the bank regulators to address the issue of depository banks moving risky assets and their associated liabilities off-balance sheet via so-called special purpose vehicles. This allowed the banks to remove those amounts from the capital requirements computation, allowing them to take on more risk.

Additional Factors

Following is a short list of the other major issues that added fuel to the fire that was simmering, and without which the crisis could never have become the conflagration it did. It was a total failure of regulators across the system.

A) Appraisals were massively fraudulent, with a total failure of state and local regulators in the mortgage industry to actually do their jobs and prevent those frauds—the problem wasn’t the lack of regulation but the failure of regulators to do what they were paid to do.

B) Financial institutions massively over-leveraged, and regulations favored housing loans for bank capital standards. Because government policies favored housing, bank capital requirements were much lower for mortgages than for other risk assets. Again, it was a failure of regulators—in this case the Federal Reserve, which oversees the banking industry—to do their job, allowing banks to park assets offshore and not hold sufficient capital given the riskiness of those assets.

C) An often-overlooked cause was the conversion of private investment banks to public companies. That changed the nature of risk-taking at the institutions, which were no longer just investing their own personal capital but that of shareholders and lenders as well. That created a potential misalignment of interests. When they were private companies, the leverage of these banks tended to be in the low single digits. However, once they went public, leverage not only jumped into double digits (while much riskier assets were taken on at the same time), but some were leveraging at more than 20 and 30 to 1. Regulators had oversight of these investment banks and could have prevented that increased leverage. Yet they did nothing. The problem was so large, that by 2007, the five top investment banks had more than $4 trillion in debt, roughly 30% of the size of the U.S. economy.

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