Causes of The Current Malaise: Take Two

I have been accused by some of you for having been too general in my listing of causes of the current mess, particularly with respect to the financial side of things. So here is my interpretation of the list given during a speech by Alan Blinder of Princeton University. He spoke last November 11th, but I doubt he would change anything too much. I have re-complied his list and adjusted it to my own liking, but it clearly originates from him:

Who to blame?

One: the bond market. Specifically the large players in that market. The steady creation of esoteric derivative products with no apparent financial purpose other than to generate profits created a whole menagerie of ill understood and ultimately unnecessary products. It is one thing to create a ‘hedge’ or ‘option’: they perform useful risk management purposes; it is another to create ‘Collateralized Debt Obligations’ etc that are nothing more than synthetic products with no underlying risk management or credit creating purpose. Also, these players were unbelievably stupid in their financial model building. They used three or four years of history in their models which is woefully inadequate. That’s a model building 101 error of epic proportions, but they all appear to have done it. They also seem to have forgotten the equally basic nostrum that risk and reward are linked. As American interest rates fell during the Greenspan years, many of these firms sought assets with higher returns. That led them to purchase large amounts of low quality assets. As the demand for those low quality assets rose the returns on those assets dropped – basic supply and demand saw to that – so the risk/return trade off worsened. All of this is a recipe for disaster.

Two: the regulators. All of them. We have four federal regulators and fifty state regulators. They all failed. In particular they failed to step in a prevent the banks, over whom they have the most power, from generating low quality mortgages. Much of this crisis stems from the laxity of underwriting standards – things like no equity loans for instance – which is well within the time honored power of the regulators to prevent. Plus the Fed, in particular, has to shoulder much of the blame for allowing the bubble to inflate as much as it did: there were those in the Fed who argued that interest rates should be raised preemptively, but ideology prevented Greenspan from acting. The most basic analysis would have shown that the business models being executed by the big banks were doomed if, or rather when, the real estate market collapsed. Who failed to raise that alarm? It is within the ambit of the regulators to impose penalties to prevent the kinds of errors we have seen. But they did not, even when they were aware of them.

Three: consumers. You and me. We fell hook line and sinker for the allure of endless real estate price gains. We were willing to take enormous financial bets by entering into mortgages that made absolutely no sense outside of a bubble. The foolishness of the home buying public is just as fundamental to the crisis as the notorious lending practices of the banks. It takes two to tango.

Four: the main banks and other mortgage lenders. What were they thinking? Especially the high street banks who should have known better. It appears that no one could escape the national group think that somehow homes are immune to the laws of economics. The image of sober bankers is obviously not accurate.

Five: mortgage brokers. These are the clowns who originated the loans – i.e. lent the money – but who then turned around and sold the loans off to others who aggregated them into derivatives. They surely knew that some of the loans would almost certainly default. But since it takes, on average, only four days between originating the loan and selling it, they were immune to defaults [how many loans will default after only four days? especially when the first payment is not due for thirty days!]. Mortgage brokers are an unregulated and shady lot. They are a major player in this saga.

Six: risk managers. They are guilty, as in: where were they? All too often risk management was totally overruled in the search for profit. think about the breathtaking size of the bets being taken by the old investment banks. Because the profits on many of the derivative assets these banks bought dropped due to demand the only way they could pump up earnings, and those notorious bonuses, was by leveraging themselves to the hilt. The day it went down Bear Stearns had assets 33 times the size of its equity. Think about that: a mere 3.0% to 3.5% drop in assets prices completely wipes out the equity. The others like Goldman Sachs were almost as bad. Also: after being alerted to the potential risk of these assets by your risk managers, why did the banks still keep huge amounts on their balance sheets? They could have sold them out to minimize risk.

Seven: rating agencies. I suppose it’s impolite to call them outright liars, but it seems appropriate. The problem is that the rating agencies produce something highly valued by investors: an opinion as the the risk of the security being rated. However they are paid by the issuer of the security. So, inevitably, money talks and they end up finding ways to bend their analytical approaches in order to make sure securities are rated AAA even when they ‘know’ full well that the AAA rating depends a few accounting tricks rather than on fundamental economics.

There you have it. A large rogues gallery.

For the record: many of the practices and methods I just mentioned are still going on. Clearly when the dust settles over the immediate crisis there is going to have to be a major re-thinking about risk management, regulation, and the basic business models found throughout the entire financial system.

But that can wait. Let’s hope to survive to see that day.

Addendum:

You will notice that I have not referred to my own bete noir: financial economic theory, which gave much of the above mentioned edifice an intellectual respectability. I demurred to avoid becoming shrill. But what the heck: throw that on the list also!