What Caused the Financial Crisis of 2008? A Story of Adverse Incentives

1. What Caused the Financial Crisis of 2008?A Story of Adverse Incentives February 24, 2012 Teaching Financial Crises Norm Cloutier, Director UW-Parkside Center for Economic Education A special thanks to SC Johnson for sponsoring this event.

2. A 20th Century Understatement: • “The war situation has developed not necessarily to Japan’s advantage.” • −Emperor Hirohito, 1945 • Announcing Japan’s surrender • A 21st Century Understatement: • “Market discipline has in some cases broken down, and the incentives to follow prudent lending procedures have, at times, eroded.” • −Ben Bernanke, 2007 • Explaining the financial crisis

3. The Financial Crisis Inquiry Report • FCIC established by the Fraud Enforcement and Recovery Act of 2009 • Charged with determining the underlying causes of the financial crisis • Democratic leadership appointed 6 members, Republican 4 members • Reviewed millions of pages of documents, interviewed more than 700 witnesses, held hearings over 19 days • Was not charged with developing recommendations

4. Major Findings of theFinancial Crisis Inquiry Report • The crisis was avoidable • Widespread failure in: • Regulatory supervision • Corporate: governance, risk management, accountability, ethics • Rating agencies • Lending standards • Government response • Excessive leverage and risk without transparency

5. Missing From the FCIC List? • Federal government housing policy • HUD’s affordable housing goals • Community Reinvestment Act • Role of Government Sponsored Enterprises • Fannie Mae and Freddie Mac • Excessive liquidity • Federal Reserve policy • International saving inflows

6. Setting the Table: What We Need to Know • Definitions: • Leverage → debt • Derivative → a contract, or promise, whose value is derived from another asset or event • Securitization → the pooling of debt • MBS and CDO

7. Pre-2000 Financial and Regulatory Conditions • The S&L Crisis of the late-1980s saw 747, or nearly 25% of S&Ls failed • Resolution Trust Corp sell-off of $402 billion in assets • Private sector assistance and underwriting innovation • 1993, Commodity Futures Trading Commission exempts certain financial derivatives from regulation. • decentralized • unregulated • opaque • limited price discovery

8. Pre-2000 Financial Scandals • After the CFTC exemption, derivative volume exploded… and so did losses and scandal. • Sept 1998, Long Term Capital Management • leveraged 25-1…, at least • threat of a system-wide financial impact • Fed orchestrated a $3.6 billion bailout “… regulation of derivatives transactions that are privately negotiated by professionals is unnecessary.” - Alan Greenspan, July 1998

9. Regulation Exemption • In 1999, Pres Clinton’s Working Group on Financial Markets issues a report urging Congress to broadly deregulate the OTC derivatives • In 2000, Congress passes the Commodity Futures Modernization Act effectively eliminating OTC derivates from regulation and oversight • It also preempted states from issuing regulation over OTC derivatives • Financial derivatives experienced phenomenal growth

10. The Giant Pool of Money • In the early-2000s, the Fed kept interests rates low : • Burst of the .com bubble, stock market decline • Recession • 9-11 • War • Corporate scandal: Enron, Arthur Anderson, Worldcom, Tyco, Qwest Communications, Global Crossings, etc… • As economic growth increased in oil producing and less developed countries, the pool of global savings increased

11. Fed Funds and 30-Year Mortgage Rates Recession End Nov 2001 July 2004 30-Year Mortgage Fed Funds

12. Capital Flows into the U.S.(in billions of constant 2006 $)

13. Desperately Seeking: Higher Returns • As global savings sought higher returns than U.S. Treasuries it turned to the U.S. housing market • 30-year fixed rate mortgage offered 1.5-2.0% points higher return than Treasury bonds • Securitization offered a channel for domestic and foreign financial capital to flow into the U.S. housing market

14. MBS and CDOs • MBS and CDOs explained • The good news: • Made investing in the U.S. housing market more accessible to foreign and domestic investors • Pooling could reduce risk through diversification across households and across regions of the country • The bad news: • Extreme complexity made it difficult for buyers to understand and rating agencies to assess risk • Adverse incentives broke the critical tie between profits and risk taking

15. Desperately Seeking: Safety • Buyers of complex CDOs sought further assurance of their safety • Credit Default Swaps (CDS) are “insurance” policies purchased against the failure of CDOs • No capital requirements • “Insurable interest” is not required • Exempt from regulation (remember? CFMAof 2000) • American International Group (AIG) was a large supplier

16. Home Prices Began to Rise Dramatically

17. Credit Expansion:Alternative Loans and Subprime Lending • As home prices increased, more conventional prime borrowers opted for adjustable rate mortgages (ARMs). • Proliferation of ARMs caused and was caused by rising home prices “…recent research within the Federal Reserve suggests that many homeowners might have saved tens of thousands of dollars had they held adjustable-rate mortgages…” −Alan Greenspan, Feb 2004Speaking to the Credit Union National Association's meeting

18. Credit Expansion:Alternative Loans and Subprime Lending • The financial “wisdom” of ARMs is predicated on: • short term occupancy • falling interest rates • and/or continued increases in home prices • Investment banks moved into mortgage origination to ensure a steady supply of inputs for the continued strong demand for CDOs.

19. Growth of Alternative Mortgages

20. Excessive Leverage • 2004 SEC “net capital” ruling: • increased allowable leverage • allowed for internal risk monitoring • Some banks were leveraged as high as 40-1 • Securitizing banks and mortgage companies were financing their borrowing with short-term loans in the commercial paper market • …Remember this fact… "We have a good deal of comfort about the capital cushions at these firms at the moment.“ −Christopher Cox, SEC Chairman, March 11, 2008

21. Leverage: The Good and the Ugly

22. The Watchmen • The securitization machine required the cooperation of the “watchmen”: • Appraisers • Rating agencies • Regulators • All three watchmen were plagued by adverse incentives.

23. Adverse Incentives: Appraisers • Selected by the lender, appraisers were under pressure to over-value homes in order to justify higher loan values. • 11,000 appraisers across the U.S. signed a petition charging lenders with: • withholding business • refusing to pay for appraisals • black listing if they refused to inflate home values

24. Adverse Incentives: Rating Agencies “It is difficult to get a man to understand something when his salary depends on him not understanding it.” −Upton Sinclair • Rating agencies are paid by the securitizing bank and fundamentally have the same adverse incentives as appraisers to over-value CDOs • Many buyers of CDOs were statutorily required to purchase only highly rated “safe” securities • e.g. five Wisconsin school districts • As the housing bubble burst, AAA CDO tranches and the companies who created them were massively downgraded, some to worthless.

25. Adverse Incentives: The Regulators • Some financial institutions choose their regulators • …and in turn, regulators are funded by those same financial institutions • Regulators actively court financial institutions for their business

26. Office of Thrift Supervision:James (Chainsaw) Gilleran

27. Example: The Office of Thrift Supervision • S&L Crisis, Federal Home Loan Bank Board, and the Office of Thrift Supervision • Financial institutions got the message and began purchasing savings and loans: • Although AIG’s thrift comprised 0.1% of its total balance sheet, it could choose OTS as its “lead regulator”

28. Credit Expansion:Adverse Incentives and Declining Standards • A Fed study of ARM homeowners revealed that: • 38% did not understand how high their interest rate could be reset at one time • 50% did not understand how high their interest rate could rise over the life of the loan • Homeowner incentives to default and walk away from their mortgage obligation • As the securitization machine demanded ever more loans, mortgage originators began lowering the creditworthiness bar → NINJA loans • Verify a credit score and a pulse

29. Consumers with New Foreclosures Begin to Increase in 2006 (thousands)

30. The Unraveling • As mortgages delinquencies and foreclosures mounted, CDO values declined • Between 2007:2 and 2008:2 rating agencies downgraded $1.9 trillion worth of CDOs • Securitizing banks were holding unsold CDOs tranches • As CDOs failed, investors holding credit default swaps expected to be paid • The failure of AIG

31. That Fateful Day: Sept 16, 2008 “It was overwhelmingly clear that we were staring into the abyss… this was a catastrophe that we were watching unfold.” —Patrick McCabeFederal Reserve Bank economist testimony to the FCIC.

32. That Fateful Day: Sept 16, 2008 • The Reserve Primary Fund “broke the buck” • Lehman Brothers’ bankruptcy Sept 15 • commercial paper market • Bear Stearns bailout “moral hazard” • Panic!!! • Within 1 week $349 billion withdrawn from MMMFs, or about 1/3 total MMMF balances. • December 9, 2008 the yield on Treasury bills turns negative

33. Where Were the Regulators? • Ben Bernanke’s Congressional testimony • “AIG exploited a huge gap in the regulatory system…”

34. The “Real” Economy is Hit Hard • 2008-2011, 407 failed and Fed assisted banks • Unemployment peaked at 10.1% October 2009 • Jan 2012= 8.3%, with 12.8 mil workers unemployed • Jan 2012 U-6= 15.1% • Economic growth is sluggish and is forecasted to remain so

35. Have We Fixed the Adverse Incentives that Caused the Financial Crisis? • Dodd–Frank Wall Street Reform and Consumer Protection Act of 2010 • Corporate Governance & Executive Compensation • Credit Rating Agency Regulation • Securitization Retention Requirements • Regulation of Over-the-Counter Derivatives • Financial Stability Oversight Council • Systemic Regulation and Emergency Powers • Resolution Authority • Consumer Financial Protection Bureau