Who Caused the Financial Crisis?

The cause of the financial crisis is likely to be debated for a long time. Most American's believe the crisis was caused by greedy Wall Street executives, shabby lending practices by mortgage companies and banks, and the deregulation of financial institutions by our elected representatives in Washington. No doubt there is plenty of blame to go around.


John Taylor, a professor of economics at Stanford and a senior fellow at the Hoover Institution, shares his perspective on the Wall Street Journal--

How Government Created the Financial Crisis.

The classic explanation of financial crises is that they are caused by excesses -- frequently monetary excesses -- which lead to a boom and an inevitable bust. This crisis was no different: A housing boom followed by a bust led to defaults, the implosion of mortgages and mortgage-related securities at financial institutions, and resulting financial turmoil.

Monetary excesses were the main cause of the boom.

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How Government Created the Financial Crisis
Research shows the failure to rescue Lehman did not trigger the fall panic.
By JOHN B. TAYLOR

Many are calling for a 9/11-type commission to investigate the financial crisis. Any such investigation should not rule out government itself as a major culprit. My research shows that government actions and interventions -- not any inherent failure or instability of the private economy -- caused, prolonged and dramatically worsened the crisis.

The classic explanation of financial crises is that they are caused by excesses -- frequently monetary excesses -- which lead to a boom and an inevitable bust. This crisis was no different: A housing boom followed by a bust led to defaults, the implosion of mortgages and mortgage-related securities at financial institutions, and resulting financial turmoil.

Monetary excesses were the main cause of the boom. The Fed held its target interest rate, especially in 2003-2005, well below known monetary guidelines that say what good policy should be based on historical experience. Keeping interest rates on the track that worked well in the past two decades, rather than keeping rates so low, would have prevented the boom and the bust. Researchers at the Organization for Economic Cooperation and Development have provided corroborating evidence from other countries: The greater the degree of monetary excess in a country, the larger was the housing boom.

The effects of the boom and bust were amplified by several complicating factors including the use of subprime and adjustable-rate mortgages, which led to excessive risk taking. There is also evidence the excessive risk taking was encouraged by the excessively low interest rates. Delinquency rates and foreclosure rates are inversely related to housing price inflation. These rates declined rapidly during the years housing prices rose rapidly, likely throwing mortgage underwriting programs off track and misleading many people.

Adjustable-rate, subprime and other mortgages were packed into mortgage-backed securities of great complexity. Rating agencies underestimated the risk of these securities, either because of a lack of competition, poor accountability, or most likely the inherent difficulty in assessing risk due to the complexity.

Other government actions were at play: The government-sponsored enterprises Fannie Mae and Freddie Mac were encouraged to expand and buy mortgage-backed securities, including those formed with the risky subprime mortgages.

Government action also helped prolong the crisis. Consider that the financial crisis became acute on Aug. 9 and 10, 2007, when money-market interest rates rose dramatically. Interest rate spreads, such as the difference between three-month and overnight interbank loans, jumped to unprecedented levels.

Diagnosing the reason for this sudden increase was essential for determining what type of policy response was appropriate. If liquidity was the problem, then providing more liquidity by making borrowing easier at the Federal Reserve discount window, or opening new windows or facilities, would be appropriate. But if counterparty risk was behind the sudden rise in money-market interest rates, then a direct focus on the quality and transparency of the bank's balance sheets would be appropriate.

Early on, policy makers misdiagnosed the crisis as one of liquidity, and prescribed the wrong treatment.

To provide more liquidity, the Fed created the Term Auction Facility (TAF) in December 2007. Its main aim was to reduce interest rate spreads in the money markets and increase the flow of credit. But the TAF did not seem to make much difference. If the reason for the spread was counterparty risk as distinct from liquidity, this is not surprising.

Another early policy response was the Economic Stimulus Act of 2008, passed in February. The major part of this package was to send cash totaling over $100 billion to individuals and families so they would have more to spend and thus jump-start consumption and the economy. But people spent little if anything of the temporary rebate (as predicted by Milton Friedman's permanent income theory, which holds that temporary as distinct from permanent increases in income do not lead to significant increases in consumption). Consumption was not jump-started.

A third policy response was the very sharp reduction in the target federal-funds rate to 2% in April 2008 from 5.25% in August 2007. This was sharper than monetary guidelines such as my own Taylor Rule would prescribe. The most noticeable effect of this rate cut was a sharp depreciation of the dollar and a large increase in oil prices. After the start of the crisis, oil prices doubled to over $140 in July 2008, before plummeting back down as expectations of world economic growth declined. But by then the damage of the high oil prices had been done.

After a year of such mistaken prescriptions, the crisis suddenly worsened in September and October 2008. We experienced a serious credit crunch, seriously weakening an economy already suffering from the lingering impact of the oil price hike and housing bust.

Many have argued that the reason for this bad turn was the government's decision not to prevent the bankruptcy of Lehman Brothers over the weekend of Sept. 13 and 14. A study of this event suggests that the answer is more complicated and lay elsewhere.

While interest rate spreads increased slightly on Monday, Sept. 15, they stayed in the range observed during the previous year, and remained in that range through the rest of the week. On Friday, Sept. 19, the Treasury announced a rescue package, though not its size or the details. Over the weekend the package was put together, and on Tuesday, Sept. 23, Fed Chairman Ben Bernanke and Treasury Secretary Henry Paulson testified before the Senate Banking Committee. They introduced the Troubled Asset Relief Program (TARP), saying that it would be $700 billion in size. A short draft of legislation was provided, with no mention of oversight and few restrictions on the use of the funds.

The two men were questioned intensely and the reaction was quite negative, judging by the large volume of critical mail received by many members of Congress. It was following this testimony that one really begins to see the crisis deepening and interest rate spreads widening.

The realization by the public that the government's intervention plan had not been fully thought through, and the official story that the economy was tanking, likely led to the panic seen in the next few weeks. And this was likely amplified by the ad hoc decisions to support some financial institutions and not others and unclear, seemingly fear-based explanations of programs to address the crisis. What was the rationale for intervening with Bear Stearns, then not with Lehman, and then again with AIG? What would guide the operations of the TARP?

It did not have to be this way. To prevent misguided actions in the future, it is urgent that we return to sound principles of monetary policy, basing government interventions on clearly stated diagnoses and predictable frameworks for government actions.

Massive responses with little explanation will probably make things worse. That is the lesson from this crisis so far.

Mr. Taylor, a professor of economics at Stanford and a senior fellow at the Hoover Institution, is the author of "Getting Off Track: How Government Actions and Interventions Caused, Prolonged and Worsened the Financial Crisis," published later this month by Hoover Press.

Original content All American Investor

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Six Errors on the Path to the Financial Crisis

Alan Blinder wrote an interesting article in the New York Times last week. He spells out in easy to understand terms the six errors that led us into this financial mess. He points out that if simple choices has been made along the way the situation would not be as dire as it is today. He goes on to point out that the current situation is not the failure of capitalism but about human errors. By putting a clear, concise "frame" around the current situation he makes it easier to understand. A better basic understanding of the problem would help our politicians in Washington to make decisions about how "taxpaper" money should and could be used to exacerbate the current financial problems. The real issue right

now is whether or not the way taxpayer money is being used is helping or just delaying the inevitable.

My list of errors has six whoppers, in chronologically order. I omit mistakes that became clear only in hindsight, limiting myself to those where prominent voices advocated a different course at the time. Had these six choices been different, I believe the inevitable bursting of the housing bubble would have caused far less harm.

Six Errors on the Path to the Financial Crisis

By ALAN S. BLINDER

WHAT’S a nice economy like ours doing in a place like this? As the country descends into what is likely to be its worst postwar recession, Americans are distressed, bewildered and asking serious questions: Didn’t we learn how to avoid such catastrophes decades ago? Has American-style capitalism failed us so badly that it needs a radical overhaul?

The answers, I believe, are yes and no. Our capitalist system did not condemn us to this fate. Instead, it was largely a series of avoidable — yes, avoidable — human errors. Recognizing and understanding these errors will help us fix the system so that it doesn’t malfunction so badly again. And we can do so without ending capitalism as we know it.

My list of errors has six whoppers, in chronologically order. I omit mistakes that became clear only in hindsight, limiting myself to those where prominent voices advocated a different course at the time. Had these six choices been different, I believe the inevitable bursting of the housing bubble would have caused far less harm.

WILD DERIVATIVES In 1998, when Brooksley E. Born, then chairwoman of the Commodity Futures Trading Commission, sought to extend its regulatory reach into the derivatives world, top officials of the Treasury Department, the Federal Reserve and the Securities and Exchange Commission squelched the idea. While her specific plan may not have been ideal, does anyone doubt that the financial turmoil would have been less severe if derivatives trading had acquired a zookeeper a decade ago?

SKY-HIGH LEVERAGE The second error came in 2004, when the S.E.C. let securities firms raise their leverage sharply. Before then, leverage of 12 to 1 was typical; afterward, it shot up to more like 33 to 1. What were the S.E.C. and the heads of the firms thinking? Remember, under 33-to-1 leverage, a mere 3 percent decline in asset values wipes out a company. Had leverage stayed at 12 to 1, these firms wouldn’t have grown as big or been as fragile.

A SUBPRIME SURGE The next error came in stages, from 2004 to 2007, as subprime lending grew from a small corner of the mortgage market into a large, dangerous one. Lending standards fell disgracefully, and dubious transactions became common.

Why wasn’t this insanity stopped? There are two answers, and each holds a lesson. One is that bank regulators were asleep at the switch. Entranced by laissez faire-y tales, they ignored warnings from those like Edward M. Gramlich, then a Fed governor, who saw the problem brewing years before the fall.

The other answer is that many of the worst subprime mortgages originated outside the banking system, beyond the reach of any federal regulator. That regulatory hole needs to be plugged.

FIDDLING ON FORECLOSURES The government’s continuing failure to do anything large and serious to limit foreclosures is tragic. The broad contours of the foreclosure tsunami were clear more than a year ago — and people like Representative Barney Frank, Democrat of Massachusetts, and Sheila C. Bair, chairwoman of the Federal Deposit Insurance Corporation, were sounding alarms.

Yet the Treasury and Congress fiddled while homes burned. Why? Free-market ideology, denial and an unwillingness to commit taxpayer funds all played roles. Sadly, the problem should now be much smaller than it is.

LETTING LEHMAN GO The next whopper came in September, when Lehman Brothers, unlike Bear Stearns before it, was allowed to fail. Perhaps it was a case of misjudgment by officials who deemed Lehman neither too big nor too entangled — with other financial institutions — to fail. Or perhaps they wanted to make an offering to the moral-hazard gods. Regardless, everything fell apart after Lehman.

People in the market often say they can make money under any set of rules, as long as they know what they are. Coming just six months after Bear’s rescue, the Lehman decision tossed the presumed rule book out the window. If Bear was too big to fail, how could Lehman, at twice its size, not be? If Bear was too entangled to fail, why was Lehman not?

After Lehman went over the cliff, no financial institution seemed safe. So lending froze, and the economy sank like a stone. It was a colossal error, and many people said so at the time.

TARP’S DETOUR The final major error is mismanagement of the Troubled Asset Relief Program, the $700 billion bailout fund. As I wrote here last month, decisions of Henry M. Paulson Jr., the former Treasury secretary, about using the TARP’s first $350 billion were an inconsistent mess. Instead of pursuing the TARP’s intended purposes, he used most of the funds to inject capital into banks — which he did poorly.

To illustrate what might have been, consider Fed programs to buy commercial paper and mortgage-backed securities. These facilities do roughly what TARP was supposed to do: buy troubled assets. And they have breathed some life into those moribund markets. The lesson for the new Treasury secretary is clear: use TARP money to buy troubled assets and to mitigate foreclosures.

Six fateful decisions — all made the wrong way. Imagine what the world would be like now if the housing bubble burst but those six things were different: if derivatives were traded on organized exchanges, if leverage were far lower, if subprime lending were smaller and done responsibly, if strong actions to limit foreclosures were taken right away, if Lehman were not allowed to fail, and if the TARP funds were used as directed.

All of this was possible. And if history had gone that way, I believe that the financial world and the economy would look far less grim than they do today.

For this litany of errors, many people in authority owe millions of Americans an apology. Richard A. Clarke, former national security adviser, set a good example when he told the commission investigating the 9/11 attacks that he wanted victims’ families “to know why we failed and what I think we need to do to ensure that nothing like that ever happens again.” I’m waiting for similar words from our financial leaders, both public and private.

Alan S. Blinder is a professor of economics and public affairs at Princeton and former vice chairman of the Federal Reserve. He has advised many Democratic politicians.

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Original content All American Investor

CNBC Bonus Bucks Trivia Answers/ Financial Meltdown Revisted

Good morning. If you are wondering why you can't get the Bonus Bucks answer here right now--the CNBC contest website is not working. When it comes back up we will have the questions and answers.

If you have the time you can take a look at my post from September 15, 2008 about the impending financial disaster. When I posted the article the S & P 500 was trading around 1200.

Financial Meltdown--Where there is Smoke, there is Fire

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Financial Meltdown--Where there is Smoke, there is Fire

This article was originally written on September 15, 2008.

At dinner he described the situation to me. He said, “Where there is smoke there is fire”. He went on to explain that any time a major financial institution gets in trouble you could draw a circle around its location and expect the problem to spread to any other financial institution in a 150 mile radius (keep in mind this was the 1980s and before the Internet). He went on to explain the interconnectivity of financial institutions in a geographic proximity....His trip and fact finding mission convinced him that there was going to be a real financial crisis in Texas and that it would likely devastate the major banks and savings and loans. This was a very unpopular stance that cost him his job....It also was the catalyst of a stock market crash in 1987....I am reminded of other sayings that I heard early in my career on Wall Street—“never try and catch a falling knife”. I find myself thinking right now—“Cash is King”.

Financial Meltdown--Where there is Smoke, there is Fire

Back in the 1980s I learned an important lesson. At the time, I was with Bear Stearns and working in their Dallas, Texas office. The head of credit came to Texas to visit the state’s major banks and Savings and Loans to discuss their financial statements. Specifically he was trying to get a handle on their financial viability. There was a growing concern about the quality of credit and soundness of financial institutions in the southwest and California. The head of credit spent a couple of days in Dallas and Houston talking to the CFOs of these banks. Late in day, at the end of the trip, I saw him sitting alone in the office and asked him what he was doing. He informed me he was done but was not scheduled to fly out until the next morning. I saw this as an opportunity to “pick” his brain and learn something. So, I invited him out to dinner.

At dinner he described the situation to me. He said, “Where there is smoke there is fire”. He went on to explain that any time a major financial institution gets in trouble you could draw a circle around its location and expect the problem to spread to any other financial institution in a 150 mile radius (keep in mind this was the 1980s and before the Internet). He went on to explain the inter connectivity of financial institution is a geographic proximity. His trip and fact finding mission convinced him that there was going to be a real financial crisis in Texas and that it would likely devastate the major banks and savings and loans. This was a very unpopular stance that cost him his job. At the end of the day he was right. Both of the major banks in Dallas failed (Republic and First Interstate) and all of the major S and L’s in Texas failed (Sunbelt and Bright Bank to name two). This resulted in the formation of the Resolution Trust Corporation a government agency set up to dispose of the massive amount of defaulted loans owned by these financial institutions. It also was the catalyst of a stock market crash in 1987.

For years I have been telling my friends that the derivatives and swaps markets would turn out to be the equivalent of the savings and loan fiasco but on a scale that could never be imagined. Let me ask you, do you know anyone that predicted Bear Stearns, Lehman Brothers and AIG would go up in smoke? That Merrill Lynch would be offered at a fire sale? Have you heard prior discussions about the inter connectivity of all these financial institutions? Are they within a 150 mile radius?

AIG, the next to go, is a good example of the direness of the current situation. AIG has been racking up enormous profits for a very long time. Just last week they were considered to be solvent. They are loaded with cash. They are claiming $1,000,000,000,000 in assets (Trillion). They operate world wide. Now if you ask AIG they will tell you their problem is not a solvency issue it’s a liquidity issue. It seems that the financial community is no longer buying this argument and no one is willing to stand up and throw money at the problem. AIG does not have the necessary assets to collateralize the $75 billion in loans it needs right now to keep operating. If they go down someone will be on the hook for the insurance side of the business. I bet you thought as an insurance company there were being regulated. Partially true but this does not include the part of the business that is all wrapped up in the credit default swaps market and other derivatives designed to leverage the balance sheet and create “monster” profits. It appears the Fed and government regulators have finally decided that bailouts aren’t working and decided to say no to Lehman and AIG. Lehman is bankrupt and it appears that AIG will declare bankruptcy soon. The too big fail rule is no longer in effect.

It would be foolish to believe that once AIG goes over the cliff it will bring an end to the financial crisis we are seeing today. You should be thinking of the inter connectivity of AIG and all the counterparties they are doing business with AIG worldwide. Companies doing business with them will get wounded, maybe mortally wounded. What looked like a US problem is now a global problem. This will spill into financial markets world wide.

It appears it is finally being recognized that this is not smoke, it’s a FIRE. It appears that “too big to fail” is no longer a workable strategy to fix the problem. It appears the reality of the credit swaps derivatives market is finally being recognized. It’s likely that much of this paper is worthless or only worth cents on the dollar. This financial crisis is not likely to go away over night. There is more to come before all this “paper” can get unwound or find a home. In the interim there is an enormous risk in the stock and other financial markets.

The Fed will address this issue by adding massive liquidity to the markets. The world’s central banks will do the same. It is the right thing to do. But, it is a short term fix that is like prescribing an aspirin for a major infection. It might lower your fever but it won’t cure your illness.

In closing, I am reminded of other sayings that I heard early in my career on Wall Street—“never try and catch a falling knife”. But, right now I find myself thinking—“Cash is King”.

Financial Meltdown--Where there is Smoke, there is Fire

At dinner he described the situation to me. He said, “Where there is smoke there is fire”. He went on to explain that any time a major financial institution gets in trouble you could draw a circle around its location and expect the problem to spread to any other financial institution in a 150 mile radius (keep in mind this was the 1980s and before the Internet). He went on to explain the interconnectivity of financial institutions in a geographic proximity....His trip and fact finding mission convinced him that there was going to be a real financial crisis in Texas and that it would likely devastate the major banks and savings and loans. This was a very unpopular stance that cost him his job....It also was the catalyst of a stock market crash in 1987....I am reminded of other sayings that I heard early in my career on Wall Street—“never try and catch a falling knife”. I find myself thinking right now—“Cash is King”.

Financial Meltdown--Where there is Smoke, there is Fire

Back in the 1980s I learned an important lesson. At the time, I was with Bear Stearns and working in their Dallas, Texas office. The head of credit came to Texas to visit the state’s major banks and Savings and Loans to discuss their financial statements. Specifically he was trying to get a handle on their financial viability. There was a growing concern about the quality of credit and soundness of financial institutions in the southwest and California. The head of credit spent a couple of days in Dallas and Houston talking to the CFOs of these banks. Late in day, at the end of the trip, I saw him sitting alone in the office and asked him what he was doing. He informed me he was done but was not scheduled to fly out until the next morning. I saw this as an opportunity to “pick” his brain and learn something. So, I invited him out to dinner.

At dinner he described the situation to me. He said, “Where there is smoke there is fire”. He went on to explain that any time a major financial institution gets in trouble you could draw a circle around its location and expect the problem to spread to any other financial institution in a 150 mile radius (keep in mind this was the 1980s and before the Internet). He went on to explain the inter connectivity of financial institution is a geographic proximity. His trip and fact finding mission convinced him that there was going to be a real financial crisis in Texas and that it would likely devastate the major banks and savings and loans. This was a very unpopular stance that cost him his job. At the end of the day he was right. Both of the major banks in Dallas failed (Republic and First Interstate) and all of the major S and L’s in Texas failed (Sunbelt and Bright Bank to name two). This resulted in the formation of the Resolution Trust Corporation a government agency set up to dispose of the massive amount of defaulted loans owned by these financial institutions. It also was the catalyst of a stock market crash in 1987.

For years I have been telling my friends that the derivatives and swaps markets would turn out to be the equivalent of the savings and loan fiasco but on a scale that could never be imagined. Let me ask you, do you know anyone that predicted Bear Stearns, Lehman Brothers and AIG would go up in smoke? That Merrill Lynch would be offered at a fire sale? Have you heard prior discussions about the inter connectivity of all these financial institutions? Are they within a 150 mile radius?

AIG, the next to go, is a good example of the direness of the current situation. AIG has been racking up enormous profits for a very long time. Just last week they were considered to be solvent. They are loaded with cash. They are claiming $1,000,000,000,000 in assets (Trillion). They operate world wide. Now if you ask AIG they will tell you their problem is not a solvency issue it’s a liquidity issue. It seems that the financial community is no longer buying this argument and no one is willing to stand up and throw money at the problem. AIG does not have the necessary assets to collateralize the $75 billion in loans it needs right now to keep operating. If they go down someone will be on the hook for the insurance side of the business. I bet you thought as an insurance company there were being regulated. Partially true but this does not include the part of the business that is all wrapped up in the credit default swaps market and other derivatives designed to leverage the balance sheet and create “monster” profits. It appears the Fed and government regulators have finally decided that bailouts aren’t working and decided to say no to Lehman and AIG. Lehman is bankrupt and it appears that AIG will declare bankruptcy soon. The too big fail rule is no longer in effect.

It would be foolish to believe that once AIG goes over the cliff it will bring an end to the financial crisis we are seeing today. You should be thinking of the inter connectivity of AIG and all the counterparties they are doing business with AIG worldwide. Companies doing business with them will get wounded, maybe mortally wounded. What looked like a US problem is now a global problem. This will spill into financial markets world wide.

It appears it is finally being recognized that this is not smoke, it’s a FIRE. It appears that “too big to fail” is no longer a workable strategy to fix the problem. It appears the reality of the credit swaps derivatives market is finally being recognized. It’s likely that much of this paper is worthless or only worth cents on the dollar. This financial crisis is not likely to go away over night. There is more to come before all this “paper” can get unwound or find a home. In the interim there is an enormous risk in the stock and other financial markets.

The Fed will address this issue by adding massive liquidity to the markets. The world’s central banks will do the same. It is the right thing to do. But, it is a short term fix that is like prescribing an aspirin for a major infection. It might lower your fever but it won’t cure your illness.

In closing, I am reminded of other sayings that I heard early in my career on Wall Street—“never try and catch a falling knife”. But, right now I find myself thinking—“Cash is King”.

Paul Volkers's Comments to Congress on the Financial Crisis

Paul Volcker made these comments this week.

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