What caused the current financial crisis?

The search for the cause of the Financial Crisis will soon heat up.  On April 21, 2009, Bloomberg News reported that Speaker of the House Nancy Pelosi planned to push for a Congressional inquiry of Wall Street.  (Click the “Pelosi Probe Bloomberg News Article” link on the right.) However, any Congressional investigation into the causes of the Crisis is likely to become a partisan affair, and Congress is unlikely to look into the mirror.  The search for the culprits who started this mess should cast a wide net.  “Wall Street” just doesn’t seem wide enough, and limiting the search to Manhattan Island is more likely to find only scapegoats.

Perhaps the best explanation turns to that observer of human nature, Pogo:  “We have met the enemy and he is us.” A list of causes would need to include:

  • A patchwork of regulatory agencies with competing agendas, which allowed financial firms and financial products to engage in “regulatory arbitrage” or escape regulation completely.  One over-riding theme is not “deregulation” but a massive failure of overlapping, inconsistent, and conflicting regulations.  Basel II international standards on bank capital need to be included.  Those standards allow for banks to use their own “approved” risk models to calculate how much capital needs to be maintained for varying risks of different financial investments.  (Whoops!)
  • Legislative (and some Executive) acquiescence in maintaining the patchwork to protect turf and pet priorities (e.g. Fannie Mae and Freddie Mac; Community Reinvestment Act; Congressional stonewalling attempted regulatory reform by claiming “no need to fix what isn’t broken.”)
  • Mortgage originators who underwrote mortgages without standards (e.g. those the market began calling “liar loans”) for investment bankers who could likewise transfer the risk (until the music stopped) because they had protected agency purchasers. The culprits also need to include private buyers of mortgage and other consumer debt, who, through numerous “right sizing” reorganizations, had reduced in-house research, opting instead for…
  • Over-reliance on credit rating agencies with a protected oligopoly and a strong financial incentive to assign the highest rating the bond issuer demanded.
  • Shareholders (also known as equity investors) who pressured chief executives to produce growth in financial services companies to match that of tech companies, all the while having no say about base-pay and incentive compensation packages approved by Boards of Directors who were supposedly independent, but who, in reality, were members of the same tight little country club set as the chief executives.  (My mother, a retired high school English teacher, would be appalled at that elongated sentence.)
  • Undisciplined fiscal policy with massive tax cuts (usually good, except) with no spending cuts to match.  The Republicans forgot part of Ronald Reagan’s formula:  you cut Congress’ allowance in order to cut its spending; rather, as The Economist correctly pointed out, the Republican Congress “spent like drunken sailors.”  Now, the tax and spend Democrats are back!
  • Monetary policy, which created moral hazard by consistently slashing interest rates to bail out over-leveraged trading desks and consumers and, therefore, started to feed the next bubble.  Concern grew that the equity and bond markets came to expect that the “Greenspan Put” and a new “Bernanke Put” would bail them out.
  • Currency policies of emerging market governments in an effort to keep the local currency value relative to the dollar at a level which would maintain exports (which also benefited the over-leveraged U.S. consumer.)

Bob Decker, CFA

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