The many ways to explaining the last financial crisis

Sometimes, when you lose a debate, you have to just let it go. That seems to be a problem for those who are unwilling to accept the complex realities of what actually caused the financial crisis.

I have been saying for a long time that many elements contributed to the global financial meltdown. From ultra-low rates to misaligned incentives to radical deregulation to changes in the business models of the credit-rating companies to plain old bad decision-making by homebuyers — the list is long.

Discussions of causation frustrate those who seek to oversimplify the complex as they pursue a political agenda.

A new group of economists recently challenged the prevailing theory for what caused the crisis. Rather than repeat my earlier admonitions, I want to try a different tack, taking a page from Nicolaus Copernicus, best known for positing that the earth rotates around the sun, not the other way around.

What is so interesting is that he started out with an implied challenge to explain movements of the planets without resorting to “cheats” — unsupported explanations for observable planetary motions in order to make the data fit a flawed model. So let’s follow Copernicus’ example and pose a series of challenges

Any theory that claims to explain the financial crisis should be able to answer these 10 questions:

No. 1. Federal Reserve Chairman Alan Greenspan engaged in unprecedented interest rate cuts: From the end of 2001 to the end of 2004, the federal funds rate was less than 2 per cent; for an entire year, he kept it at 1 per cent.

What was the impact of ultralow interest rates on housing, credit and derivatives?

No. 2. The credit-rating companies, including Standard & Poor’s and Moody’s, were originally research firms, selling their credit analysis and debt ratings, mainly to corporate bond issuers. That changed in the late 1990s to a model where syndicators and securitisers became their dominant clients. What was the impact of this model change on securitised products? How did this affect the quality of ratings on AAA-rated junk securities?

No. 3. The Commodities Futures Modernisation Act of 2000 removed all oversight, including reserve requirements, exchange listings and disclosures, from derivatives.

How did this affect the risk appetite of American International Group Inc for underwriting derivatives? What was its effect on Bear Stearns Cos, Lehman Brothers Holdings Inc, Citigroup Inc, Bank of America Corp and Merrill Lynch?

No. 4. From 1975 to 2004, brokerage firms were limited to 12-to-1 leverage by the Security and Exchange Commission’s net capitalisation rule. The five largest investment banks asked for an exemption from those leverage restrictions.

It was granted, and became known as “the Bear Stearns exemption” (it was the smallest investment bank that qualified for it). What did this do to bank leverage subsequently? How much did this affect the crisis?

No. 5. The Glass-Steagall Act of 1933 separated commercial banks from their riskier securities businesses. The Gramm-Leach-Bliley Act repealed much of it in 1998. Before this, financial-market crashes (1966, 1970, 1974 and 1987) didn’t spill over into the rest of the economy.

How much more leverage and risk was assumed by banks as a result? Did the repeal of key parts of Glass-Steagall make the banking crisis worse?

No. 6. In 2006, more than 84 per cent of sub-prime mortgages were issued by private lenders not regulated by either the Federal Reserve or by the state overseers where they were located.

How different were the mortgages made by these banks from the typical conforming mortgages? What was the impact of different private mortgage underwriting standards on the economy, mortgage markets and derivatives?

No. 7. Greenspan called these lenders “innovators”, and they made a variety of unusual mortgages available to people who wouldn’t have otherwise qualified for credit. How much was non-bank sub-prime lending a factor in the crisis?

No. 8. Housing prices rose globally. Overseas markets had an even bigger boom and bust than the US. How did the US government-sponsored entities, such as Fannie Mae and Freddie Mac, affect the global boom? What impact did legislation such as the Community Reinvestment Act have on global markets?

No. 9. Individual states that had anti-predatory lending laws typically had lower defaults and foreclosure rates than those that did not. The US Office of the Comptroller of the Currency pre-empted state laws regulating mortgage credit and national banks in 2004. What was the impact of this decision?

No. 10. Wall Street securities firms used to be partnerships, with full responsibility for any losses falling on the partners personally. Most of these firms had became publicly traded corporations by the end of the 1990s.

What was the impact of this change in liability on the risk-taking of senior management at Wall Street banks?

I’ll stop at 10. How did your model do in explaining these issues? If you can adequately answer these questions and have the data to back them up, you may be on to a successful model of the financial crisis

source : gulfnews