The Causes of the 2008 Crisis (Pt 2) by Paul Cottrell

In terms of household debt, it was extremely high in 2008. Remember the middle class has been losing their percentage of national income since 1980’s. To maintain their life style middle class households started working multiple jobs, spouses entered the work force, used credit cards, and took home equity loans out. This middle class debt dynamic led to extreme household debt.

The Reagan and Thatcher doctrine of liberalization of capital markets and fiscal restructuring did help produce the great bull market of the 20th century, but at a cost. It was through this doctrine that deregulation of financial markets started.

The next big wave of deregulation of the financial industry and the adoption of the North American Free Trade Agreement (NAFTA) was in the 1990’s. This new wave of deregulation was spearheaded by the Clinton administration and the Federal Reserve Chairman.

What was so unique during the 1980’s and 1990’s that would lead to the financial crisis of 2008? Relaxed financial regulation usually causes over speculation. Financial regulation can take many forms. For example, capital flows in and out of a country can be regulated. Another type of financial regulation is the leverage ratios of banking institutions and trading margins. Another important dynamic is free trade agreements with other nations, which disrupts labor markets with the countries participating in the free trade agreement. Within these free trade agreements are free flow of capital and goods between nations. But not only did deregulation of financial markets help cause the financial crisis of 2008, but also the lack of regulation on new financial engineered products.

The derivatives market exploded exponentially in the 1990’s and 2000’s. Simple derivative markets are energy and bond markets. But more complex derivative markets were mortgage backs securities (MBS) and the close cousin—the credit default obligation (CDO). As MBS’s became more popular to reduce risk in the mortgage markets, CDO’s began to be used for reducing the default risk of the MBS owner. This complex web of derivative were not well regulated and led to over speculation in these markets many times larger than the actual annual size of the economy. This buildup of speculation in the derivatives markets eventually collapsed like all other over speculative markets in the past. The financial regulators were not equipped to survey the economic landscape and visualize the actual systemic risk building up in the financial sector.

I would like to present a few comments of the over confidence in the great moderation in the United States. The great moderation was during the tenure of Federal Reserve Chairman Greenspan. With low inflation and good economic growth the USA experienced a certain hubris that the financial engineering of Wall Street and the Federal Reserve’s fine tuning approach to interest rates could maintain a stable economy. Within this mindset, whenever the economy seemed to slow down the FED would just lower interest rates to increase aggregate demand—leading to further inflation of the speculative bubble in financial assets. Part of the orthodoxy of the Federal Reserve was that markets are efficient and that financial institutions would be rational agents. Of course markets are somewhat efficient but are clearly not rational. The failure of leading economists within the Federal Reserve and in the US government did not apply the lessons learned within the behavioral finance and economic fields of research, i.e. market participates’ fear and euphoria can outweigh any logic. In short, with the combination of deregulation of financial markets, lack of new oversight in complex engineered financial products, and the over reliance of Federal Reserve market intervention the system was primed for a major nonlinear event we all now call the crash of Lehman.

Since housing prices were not in balance with true affordability, the creation of exotic mortgages were used to keep the loan machine going. What was the incentive for the creation of these exotic mortgages? Banks no longer kept the actual loan on their balance sheet. What was going on was the securitization of mortgages and passing the actual loan risk to the buyers of a MBS. The banks received loan processing fees and MBS packaging. Therefore there was, and still is, an incentive to just process as many loans as possible without fully appreciating the systemic risk that their securitization actions were building up. This is a classic example of a feedback loop pushing the financial system into speculative equilibrium only to lead to a serious financial correction.

When too many of these types of loans from banks are going into construction of commercial or residential properties signs of an unhealthy economy emerges. This unhealthy economy is caused by over building properties and not concentrating on long term endeavors, such as loaning to actual businesses to increase production or investments in research and development. The big problem the banking industry has is that they want to loan out with as little risk as possible; therefore they usually do not have incentives to loan out to actual job creating businesses, but to property construction. Construction of property is a job creating endeavor, but only short term and I am not sure we need more major building constructions and strip malls in America. What we do need is better infrastructure and more research and development to increase our economic productivity in the long term. As can be seen in the S&P Case–Schiller composite index record housing prices coincided with record household debt. When combined, the ability to absorb a financial shock at the household level is diminished and that the risk models from the Wall Street banks and MBS holders did not fully capture the systemic risk building up in system. The key takeaway is that just because a financial engineered product can pass risk to another party there are still negative feedback loops that affect all financial participants.