The Causes of the Financial Crisis: Some Comments on the Comments
It’s interesting that so many comments on my earlier post cited derivatives as a factor in the financial crisis. There is literally no evidence of this. Many people who say it have just been told it’s a fact—mostly by the media, parroting the government-- and have come to believe it. There is only one example of a company being brought down by credit default swaps—AIG—and that was because AIG did an incredibly stupid thing—they took only one side of the risk and did not hedge. They sold credit protection. Everyone else in this market was hedged; they sold protection and they bought protection.
The proof of this is Lehman, which was a major player in the CDS market. Lehman failed, but there is no evidence that any other company was brought down by Lehman’s inability to meet its credit default swap obligations. The reason for that is simple. CDS is like insurance; it protects against a loss. If your insurer fails, you haven’t actually suffered a loss unless you have a fire before you have bought new insurance coverage. Those who had bought protection from Lehman had to go back into the market and buy new protection. There might have been a small loss if the protection was more expensive than what they had been paying to Lehman, but it was not devastating.
This illustrates the point of my original post. Most people have only heard what they have been told about the financial crisis, but this is not the whole truth. In the case of derivatives, it’s not even close to the truth. If you’re interested in the complete story of what caused the financial crisis, you can read my dissent from the majority report of the Financial Crisis Inquiry Commission, which can be downloaded from the AEI website. It’s 100 pages.
If you’re interested in knowing more about CDS, there are two pieces on my AEI scholar page, here and here that might be useful.
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May '11
Re: The Causes of the Financial Crisis: Some Comments on the Comments
That makes sense to me. However it still seems to me that while the implicit government backing of Freddie and Fannie distorted the market enormously the CDSs further leveraged the market and without either TARP or a drawn out bankruptcy process could have cascaded into chaos. I don't understand the situation much better than the average voter, but I think restructuring the risk from Fannie and Freddie would make more sense than a 2000 plus page Dodd- Franks law that stipulates regulations that no one seems to know how to write.
Jun '10
Re: The Causes of the Financial Crisis: Some Comments on the Comments
When financial institutions don't have enough transparency, aren't even required to be transparent, that's a government decision too. The market works. It corrects itself minute by minute if it's allowed to work. That's if it's not saddled with government policies that create wildly artificial incentives.
Oct '10
Re: The Causes of the Financial Crisis: Some Comments on the Comments
I've come to agree with you. Derivatives seem much less scary than they did in the midst of the crisis. Part of it is the private sector began self-regulating before Congress did (e.g. building central clearinghouses to reduce counterpart risk). I was also struck by how vital interest rate and foreign exchange swaps are to a safe economy.
Sep '10
Re: The Causes of the Financial Crisis: Some Comments on the Comments
Wasn't there a false sense of security based on the perceived ability to manage the risk via derivatives that caused these companies to over leverage their balance sheets? I have been of the belief that it wasn't the derivatives per se but the leverage that sunk bear and lehman and that fannie and freddie were major players in both the use of leverage and the use of derivatives. So the mortgage market sort of gave birth to all the other excesses and the lack of transparency scared Paulson et al into believing that this would continue to cascade if they didn't do something?
Re: The Causes of the Financial Crisis: Some Comments on the Comments
Peter, this is really interesting, and you're right--I've accepted this claim far too uncritically. I'm looking forward to reading your report. Thank you.
Jun '11
Re: The Causes of the Financial Crisis: Some Comments on the Comments
If it's not .Com paper, it's mortgages. If it's not mortgages, it's a bunch of biotech stocks with no balance sheets apparently headed higher forever. Or commercial real estate in the late 80's. Or gold going from $200 an ounce or so (when it was declared a "dead" investment by every expert on Wall Street) to its current lofty heights. Take your pick. This is still a free country and so long as we are free, there will magnificent booms and horrific busts. Understanding the root causes is an important task only for the sake of using that understanding to make money in the next boom bust cycle - not to try to prevent it or regulate the cycle out of existence which is what good and loyal Progressives intend to do. It is an irony of the human condition that our suffering teaches us more than our joy and economic suffering is also part of that process.
Re: The Causes of the Financial Crisis: Some Comments on the Comments
This very helpful. Let me pose a question. The subprime mortgage was invented with an eye to enabling less prosperous Americans (especially, black Americans) who could not otherwise qualify for a mortgage with the usual down payment to do so. As I understand it, once the banks started issuing subprime mortgages, more prosperous Americans saw them as a vehicle for speculation. They could buy houses with these that they could not ordinarily afford and flip them when the price went up. There were also other Americans who could afford a house with an ordinary down payment who opted to buy with a subprime mortgage a more expensive house that they would not otherwise have been able to afford. The result was a bubble.
Do I have this right? And here is my question. What percentage of holders of subprime mortgages falls into each of the three categories of borrowers that I have listed?
Sep '10
Re: The Causes of the Financial Crisis: Some Comments on the Comments
Dr. Rahe, I am no expert on this subject but I believe that the catagory of borrowers who had decent credit but got overextended would be more likely found among what are refered to as Alt-A borrowers rather than subprime. I believe there was a slavish devotion to credit scoring instead of traditional underwriting. Traditional underwriting being the subjective judgement of a banker who uses credit scoring as well as knowledge of the individual's character in making the loan. Of course, subjective judgement could be influenced by prejudice but slavish devotion to credit scoring and sophisticated computer modeling to manage the risk of owning mortgage pools took human judgement out of the process altogether and not surprisingly lead to collapse.
Jan '11
Re: The Causes of the Financial Crisis: Some Comments on the Comments
I take the point that derivatives are not necessarily bad, especially with proper hedging. However, to say they didn't play a role in the financial crisis still doesn't sound correct. Part of the problem when credit markets froze up in 2008 was that no one knew who was properly hedged and who wasn't.
No one would lend to each other because a) they didn't know if the institutions that were holding the CDSs they had bought could cover them, and b) they also didn't know what the mortgage backed securities they had issued CDSs against were worth because of the mark to market problem discussed in the other thread, so they didn't know what their exposure was on the CDS they had sold. All of this created a total lack of certainty and mistrust in the system, which made everyone hold on to their money and hunker down.
In the end a big part of the problem wasn't just that people who shouldn't have gotten loans defualted, it was that the banks were too leveraged to absorb the defaults, and the CDSs had helped make the overleveraging possible.
Jul '10
Re: The Causes of the Financial Crisis: Some Comments on the Comments
I think that the bottom line is that if the underlying assets had been of the quality advertised by the ratings agencies it would not matter a whit what types of exotic instruments based upon them were created. The most important element in a market is accurate information. The mystery for me is why no one at any of the ratings agencies have not been charged with fraud or some other applicable form of malfeasance, or at the very least lost their jobs.
Sep '10
Re: The Causes of the Financial Crisis: Some Comments on the Comments
Many mathematicians have ranted about the misuse of mathematics and physics in the Quantitative Finance industry (see Paul Wilmott, Nassim Taleb, Emmanuel Derman). I am very curious if your father or his friends and acquaintances have any thoughts on the matter.
Jan '11
Re: The Causes of the Financial Crisis: Some Comments on the Comments
Because its not against the law to suck at your job, necessarily. I think it's a big burden of proof to show that these agencies were deliberately overvaluing these instruments rather than just not really understanding them. Reform in the ratings agency field would be great, but as long as the ratings agencies are being paid by the firms they are rating, you are going to have problems.
Edited on Jun 17, 2011 at 6:56amJan '11
Re: The Causes of the Financial Crisis: Some Comments on the Comments
With all respect, and maybe your dissent addresses this Mr. Wallison, I don't understand you stating that AIG was the only firm brought down by CDSs. In the very next paragraph, after all, you say that Lehman failed because it couldn't cover its CDS obligations. Obviously that means that Lehman wasn't properly hedged either. And the reason other investment banks didn't also go down like Lehman was not that they were properly hedged, but that Paulson strong armed the big banks to buy the troubled investment banks. If the Morgan Stanley, Merrill Lynch, et al had been properly hedged in their CDS portfolios, why would the big banks have needed to buy them?
Edited on Jun 17, 2011 at 7:04amJul '10
Re: The Causes of the Financial Crisis: Some Comments on the Comments
BThompson
... I think it's a big burden of proof to show that these agencies were deliberately overvaluing these instruments rather than just not really understanding them.... Jun 17 at 6:55am
Edited on Jun 17 at 06:56 am
It's not the instruments themselves but the underlying assets that were so grossly overvalued in terms of risk. (AAA? really?) They used empirical data for the previous thirty years' mortgage performance when they HAD to have known that these mortgages were contracted under starkly different terms. (and to starkly different people) There have been accusations that since the ratings agencies were owned by or otherwise connected to the investment companies (who were selling said instruments) that there was some collusion involved and I think that if there is credible evidence of it it should be investigated thoroughly. Maybe Issa's committee will do so; we can only hope.
Edited on Jun 17, 2011 at 9:18amRe: The Causes of the Financial Crisis: Some Comments on the Comments
There are a few comments I'd like to respond to. # 13 from BThompson notes that I said Lehman failed and could not meet its CDS obligations. True, but my point was that Lehman's failure--and its consequent inability to meet its CDS obligations--did not cause any other firnm to fail, proving that CDS did not create the "dangerous interconnections" that the government told us were the reason they had to save AIG and Bear. Lehman failed not because it had CDS obligations--those only mature, like an insurance policy, when the losses they are insuring against actually occur--but because of all the bad mortgages and MBS they were holding. AIG could also have been allowed to fail, but the government panicked.
The idea expressed in # 9 by BThompson is also, I think, misplaced. No one who knew anything about the CDS market really thought that CDS obligations were a problem. All market participants except AIG were hedged, and in any event many of the losses had not actually occurred. Almost all the losses that were being "recognized" in 2008 were accounting losses, coming from the requirement for marking securities assets to market.
Re: The Causes of the Financial Crisis: Some Comments on the Comments
Paul A. Rahe's comment is correct that there were several different categoies of nad loans--subprime taken taken out by people who didn't have the resources to pay, Alt-A by people who had the resources, but wanted use them to invest in the stock market instead of a downpayment on a house, Alt-A by people who were borrowing on their home to take vacations or grow their business, and Alt-A by people who just didn't have the downpayments. There isn't sufficient data to determine how many people were in each category, but half of all mortgages, 27 million loans, were in one of these categories and over two thirds of these were on the books of government agencies or organizations like banks required to make these weak loans by government policies. It probably doesn't matter how many we in each category--the default rates were unprecedentedly high for all subprime and all Alt-A, and that's what caused the financial crisis.
Jun '11
Re: The Causes of the Financial Crisis: Some Comments on the Comments
Paul A. Rahe: This very helpful. Let me pose a question. The subprime mortgage was invented with an eye to enabling less prosperous Americans (especially, black Americans) who could not otherwise qualify for a mortgage with the usual down payment to do so. As I understand it, once the banks started issuing subprime mortgages, more prosperous Americans saw them as a vehicle for speculation. They could buy houses with these that they could not ordinarily afford and flip them when the price went up. There were also other Americans who could afford a house with an ordinary down payment who opted to buy with a subprime mortgage a more expensive house that they would not otherwise have been able to afford. The result was a bubble.
Do I have this right? And here is my question. What percentage of holders of subprime mortgages falls into each of the three categories of borrowers that I have listed? · Jun 17 at 5:10am
Yes, you do have that right in a free market auction.
You point to the real danger here: "The subprime market was invented...."
The government invented the secondary market for mortgages. Did it have that right?
No.
Jun '11
Re: The Causes of the Financial Crisis: Some Comments on the Comments
A further note on Paul Rahe's question, "Do I have this right?"
If I'm not mistaken, broader civic freedoms in Ancient Greece coincided with the development of the phalanx which required more bodies to win victory on the field than cavalry did. Democracy was born because the culture needed more bodies in order to prosper.
Economic success in the modern Republic is similar. The broadening of freedoms and the birth of the Republic coincided with a massive economic leap forward. The widening of freedom and the extension of liberty to more people was to some degree a product of this economic leap. Again, for the leap, the culture needed more participants.
Put another way, those who had previously been slaves in history were allowed to participate in open markets, buy, sell, trade and speculate. Participation in the free market is one of the fruits of liberty. It is immoral to defraud, cheat and steal. It is not wrong, however, to speculate.
In one sense, every properly balanced American should have at least a little speculation in her or his nature.
Jan '11
Re: The Causes of the Financial Crisis: Some Comments on the Comments
Thank you for the clarification Mr. Wallison. That helps me understand your argument much better. I am coming around to your point of view regarding CDS. However, it still seems that loose monetary policy helping inflate the housing bubble and the way the SEC loosened the requirements for leverage ratios for investment banks were a part of this as well. Or would those increased leverage ratios not have been a problem without mark to market?
Jan '11
Re: The Causes of the Financial Crisis: Some Comments on the Comments
The Hayak book is at the top of the list, of course, but let me recommend that those interested in thoughtful discussions of such things also read Milton Friedman and Thomas Sowell. The three make up a family of broad spectrum humanistic thought, all of it relational, Check out the relevant Peter Robinson interviews on Uncommon Knowledge - a virtual goldmine of intellectual curiosity done well.
You will re-read them.