The origins of the sub-prime crisis: Inappropriate policies, regulations, or both?

Abstract

This article analyses the origins of the sub-prime crisis. It argues that a series of serious policy errors in the United States created the conditions in which the sub-prime lending phenomenon took root, which were then compounded by regulatory developments and further policy mistakes as the credit crisis unfolded. These factors further explain why the sub-prime crisis assumed such global proportions.

Keywords:

• Global financial crisis
• Sub-prime mortgages
• US current account deficit
• Greenspan monetary policy
• Shadow banking system
• Collateralised debt obligations

Notes

1 Excluding the Obama initiatives, the cost of the monies pledged by the US government in the sub-prime crisis was estimated as US$4.62 trillion. The only event that comes close to this figure is the US government spending during World War II which was US$288 billion or an inflation-adjusted figure of US $3.6 trillion in current terms. By comparison, adding together the cost of the Marshall Plan, the Louisiana Purchase, the race to the moon and all NASA spending, the savings and loan crisis, the Korean, Vietnam and Iraq wars gives an inflation-adjusted figure that amounts to US $3.9 trillion, still less than the current crisis (Hughes, 2008).

2 It has been estimated that $100 billion of sub-prime linked investments offered a money-back guarantee (Business Week, December 10, 2007, p. 026).

3 Norma was a ‘mazzanine’ CDO because of the middling average credit rating (triple-B) of its investments, most of which were not actual securities but were derivatives such as credit default swaps based on sub-prime residential mortgage-backed securities (Mollenkamp and Ng, 2007). Many investment banks favoured such derivative-based CDOs because they could be put together without buying the underlying securities, and because banks could create a number of CDOs linked to the same mortgage-backed bonds.

4 The following account draws extensively upon the analysis in that volume.

5 The estimation proceeds as follows. First, an ex post real Federal funds rate is calculated, subtracting the GDP deflator as the inflation measure from the effective Federal funds rate. The ex ante real rate is then estimated by regressing the ex post rate on a constant time trend and four lags of the nominal Federal funds rate, the deviation of GDP from trend and inflation. The fitted values of this equation are estimates of the ex ante real Federal funds rate.

6 In the six monetary policy tightening cycles preceding the 2004–2006 episode, the yield on the 10-year Treasury note was on average almost 100 basis points (bp) higher after 1 year. By mid-2005, 10-year Treasury yields were some 70 bp lower than at the onset of tightening in June 2004. It was not until mid-2006, with the Federal funds rate having been raised 425 bp to 5.25 per cent that 10-year yields had finally moved up by some 60 bp 2 years after the onset of the tightening cycle (see Iley and Lewis, 2007, figure 3.13).

7 Of the Big Five, Lehman Brothers was forced to file for bankruptcy, Merrill Lynch had to be acquired by Bank of America, Bear Stearns was bought by JP Morgan Chase, while Goldman Sachs and Morgan Stanley converted their charter to bank holding companies to gain the protection that bank status brings. Between 2000 and 2006, the Big Five earned 54 per cent of revenues from trading relative to fee-based advisory business and underwriting as they evolved from ‘agents to risk-takers’ (Main, 2009). Their leverage, measured by assets as a multiple of equity, jumped from 30:1 in 2002 to 41:1 in 2007, relying on a constant stream of short-term funding to finance their portfolios (Tully, 2008). Much of this increase apparently came after 2004 when the Securities and Exchange Commission eased the rules about the amount of borrowing or gearing up that the Big Five could do (Main, 2009). In addition, Adrian and Shin (2008) find that the Big Five’s leverage behaved in a procyclical manner, so that the expansion and contraction of balance sheets amplified, rather than counteracted, the credit cycle.

8 I am indebted to Peter Smith for drawing my attention to this condition.

9 Georgia in 2001 and New Jersey in 2003 passed legislation against ‘predatory lending’ practices. Ameriquest, a leading lender to low-income homeowners, threatened to stop doing business in Georgia and lobbied (and gave donations to) politicians. Standard & Poor’s in October 2002 said that it could not assign credit ratings to mortgage securities containing sub-prime loans from Georgia because of the legal risk of non-compliance with the tangible net benefit requirement, which the State Senate then removed shortly afterwards. Much the same scenario played out in New Jersey with S & P refusing to rate securities containing loans from the state. An additional stumbling block came from federal banking regulators who issued orders banning states from applying state consumer protection provisions to federally chartered banks, which would have the effect of putting state-chartered institutions at a competitive disadvantage. New Jersey removed the tangible-net benefit rule in June 2004 (Simpson, 2008).