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ABSTRACT
The inherent complexity of modern financial systems, and their basis in human behavior, make it hard to establish unequivocally the “who, what, where, when, and why” of the global financial crisis. However, after almost a decade, we know enough to discard much of what has, in the meantime, become folk wisdom about the causes of the debacle, including Wall Street bonus culture, bankers’ greed, the moral hazard of “too big to fail,” government intervention (“too much government”) and deregulation (“not enough government”). While each of these factors may have played some role, the crisis can be much more accurately described as one of ignorance than malevolence. The common thread tying the emergence of the bubble to the disastrous consequences of its bursting is the misunderstanding of correlation and causation links in three key domains: economic policy, financial modeling, and the regulatory framework. These misunderstandings helped fuel the housing bubble and introduced fragility into the system, making it vulnerable to the bubble’s subsequent, unavoidable burst.
Notes
1. The full accident report is available at: http://www.ntsb.gov/investigations/AccidentReports/Reports/RAR1001.pdf
2. Data on New York City Securities Industry Average Bonus compiled and published by the Office of the State Comptroller.
3. See, e.g., Acharya and Richardson Citation2009, Admati and Hellwig 2013, Crotty Citation2009, Roubini and Mihm Citation2010, Stiglitz Citation2010, and Turner Citation2009. Cf. also Trenor Citation2008 for a typical news story expressing outrage over executive compensation.
4. Author’s calculations based on data retrieved from company filings and Bloomberg database. Cayne’s case was by no means unique. In 2007 the annual salary of S&P 500 CEOs (excluding bankers) averaged $1.12 million. But it was “only” $800,000 for John Mack (Morgan Stanley) and $600,000 for Lloyd Blankfein (Goldman Sachs).
6. In September 2006, Merrill Lynch announced the acquisition of First Franklin mortgage bank to “materially increase presence and scale in mortgage origination” (see Merrill Lynch, Q3 2006 Earnings Call Transcript). Other firms contemplated similar steps—even as late as early months of 2007. For example, the transcript of the Morgan Stanley Q1 2007 earnings call reveals that the firm still felt “under-represented in the mortgage business” and was considering “increasing [its] footprint” there.
7. That is, RMBS that were not issued by the main quasi-government agencies, Fannie Mae and Freddie Mac.
8. See, e.g., Blinder Citation2013; Calomiris and Haber Citation2014; Johnson and Kwak Citation2010; Krugman Citation2009; and Stiglitz Citation2008, 2009, and 2010;.
9. See e.g., Rajan Citation2011; Taylor Citation2009 and 2013; and Wallison Citation2009, 2011, and 2015.
10. Report GAO-09-739, available at www.gao.gov/new.items/d09739.pdf.
11. In one version of this argument, the push for expanded home ownership was a response to growing income inequality (Rajan 2010).
12. While precise data are difficult to come by, Greenspan and Kennedy Citation2005 estimates that the mortgaged share of home purchases trended up from roughly 86 percent in 1991 to a bit more than 89 percent in the early years of the boom.
13. That said, deregulation and financial innovation probably facilitated the transmission of monetary-policy stimulus and compounded its impact on the American credit markets.
14. Available online at: http://www.bis.org/publ/arpdf/ar2009e1.htm
15. FOMC Meeting Transcript, December 9, 2003, available at http://www.federalreserve.gov/monetarypolicy/files/FOMC20031209meeting.pdf
16. FOMC Meeting Transcript, March 18, 2003, available at http://www.federalreserve.gov/monetarypolicy/files/FOMC20030318meeting.pdf
17. FOMC Meeting Transcript, June 29-30, 2005, available at http://www.federalreserve.gov/monetarypolicy/files/FOMC20050630meeting.pdf
18. FOMC Meeting Transcript, June 29-30, 2005, available at http://www.federalreserve.gov/monetarypolicy/files/FOMC20050630meeting.pdf
19. Strikingly, the role of debt as a key vulnerability propagating and amplifying the initial fallout was rather underappreciated by policymakers. A staff analysis of policy alternatives in the face of a potential “correction” in house prices (amounting to roughly 20 percent) briefed to FOMC members in June 2005 assumed that the most important negative spillovers from falling house prices would include a decline in confidence and a cutback in household spending. Based on these assumptions, the model predicted that—with a proper monetary policy response—a major decline in house prices would raise unemployment to only about 6 percent.
20. A working definition of a subprime borrower includes a FICO (Fair Isaacs Corporation) score of 650 or less, a debt-to-income ratio of 40 percent or more, and an LTV of more than 80.
21. “CDO Market Insights Ratings Actions: Something Had to Give.” MS Fixed Income Research, July 16, 2007.
22. See, e.g., BIS Citation2009a.
23. This point has recently been raised by Morini Citation2011, Gatarek and Jabłecki Citation2015, and Jabłecki Citation2016.
24. On the Recourse Rule, see Friedman and Kraus 2011, ch. 2
25. Value at risk (VaR) measures the greatest loss that a company expects to incur based on historical data (going back one year) and a given confidence level of probability. Statistically, VaR is simply determined as a given (say, 99th) percentile of the historical portfolio loss distribution.
26. See http://www.bis.org/publ/bcbs119.pdf for details
27. Shareholder Report on UBS‘s Write-Downs. www.efinancialnews.com/share/media/downloads/2008/05/2450689704.pdf
28. See Joint Forum report on Credit Risk Transfer, Basel Committee on Banking Supervision, http://www.bis.org/publ/joint10.pdf