Too Little, Too Late?

At long last, the Financial Crisis Inquiry Commission released its final report today on the causes of the great financial crisis of 2008. Unfortunately, the report probably raises more questions than answers due to the fact that the commission was split on the true cause of the crisis. The Democrat majority provided their view that the crisis was ultimately caused by greedy Wall Street bankers coupled with a lax regulatory system. On the other hand, the Republican minority of three panel members portrayed the following more complicated series of causes in their dissenting view.

1. Credit bubble. Starting in the late 1990s, China, other large developing countries, and the big oil-producing nations built up large capital surpluses. They loaned these savings to the United States and Europe, causing interest rates to fall. Credit spreads narrowed, meaning that the cost of borrowing to finance risky investments declined. A credit bubble formed in the United States and Europe, the most notable manifestation of which was increased investment in high-risk mortgages. U.S. monetary policy may have contributed to the credit bubble but did not cause it.


2. Housing bubble. Beginning in the late 1990s and accelerating in the 2000s, there was a large and sustained housing bubble in the United States. The bubble was characterized both by national increases in house prices well above the historical trend and by rapid regional boom-and-bust cycles in California, Nevada, Arizona, and Florida. Many factors contributed to the housing bubble, the bursting of which created enormous losses for homeowners and investors.


3. Nontraditional mortgages. Tightening credit spreads, overly optimistic assumptions about U.S. housing prices, and flaws in primary and secondary mortgage markets led to poor origination practices and combined to increase the flow of credit to U.S. housing finance. Fueled by cheap credit, firms like Countrywide, Washington Mutual, Ameriquest, and HSBC Finance originated vast numbers of high-risk, nontraditional mortgages that were in some cases deceptive, in many cases confusing, and often beyond borrowers’ ability to repay. At the same time, many homebuyers and homeowners did not live up to their responsibilities to understand the terms of their mortgages and to make prudent financial decisions. These factors further amplified the housing bubble.


4. Credit ratings and securitization. Failures in credit rating and securitization transformed bad mortgages into toxic financial assets. Securitizers lowered the credit quality of the mortgages they securitized. Credit rating agencies erroneously rated mortgage-backed securities and their derivatives as safe investments. Buyers failed to look behind the credit ratings and do their own due diligence. These factors fueled the creation of more bad mortgages.


5. Financial institutions concentrated correlated risk. Managers of many large and midsize financial institutions in the United States amassed enormous concentrations of highly correlated housing risk. Some did this knowingly by betting on rising housing  prices, while others paid insufficient attention to the potential risk of carrying large amounts of housing risk on their balance sheets. This enabled large but seemingly manageable mortgage losses to precipitate the collapse of large financial institutions.


6. Leverage and liquidity risk. Managers of these financial firms amplified this concentrated housing risk by holding too little capital relative to the risks they were carrying on their balance sheets. Many placed their firms on a hair trigger by relying heavily on short-term financing in repo and commercial paper markets for their day-to-day liquidity. They placed solvency bets (sometimes unknowingly) that their housing investments were solid, and liquidity bets that overnight money would always be available. Both turned out to be bad bets. In several cases, failed solvency bets triggered liquidity crises, causing some of the largest financial firms to fail or nearly fail. Firms were insufficiently transparent about their housing risk, creating uncertainty in markets that made it difficult for some to access additional capital and liquidity when needed.


7. Risk of contagion. The risk of contagion was an essential cause of the crisis. In some cases, the financial system was vulnerable because policymakers were afraid of a large firm’s sudden and disorderly failure triggering balance sheet losses in its counterparties. These institutions were deemed too big and interconnected to other firms through counterparty credit risk for policymakers to be willing to allow them to fail suddenly.


8. Common shock. In other cases, unrelated financial institutions failed because of a common shock: they made similar failed bets on housing. Unconnected financial firms failed for the same reason and at roughly the same time because they had the same problem: large housing losses. This common shock meant that the problem was broader than a single failed bank–key large financial institutions were undercapitalized because of this common shock.


9. Financial shock and panic. In quick succession in September 2008, the failures, near-failures, and restructurings of ten firms triggered a global financial panic. Confidence and trust in the financial system began to evaporate as the health of almost every large and midsize financial institution in the United States and Europe was questioned.


10. Financial crisis causes economic crisis. The financial shock and panic caused a severe contraction in the real economy. The shock and panic ended in early 2009. Harm to the real economy continues through today.

In total, the report and dissenting viewpoints provide a great analysis of the risk event. However, both fail to provide a forward-looking view on how such a crisis can be avoided in the future. In addition, the results of their analysis have emerged months after the U.S. Congress finalized the Dodd-Frank Financial Reform Act of 2010. Unfortunately, this is too often the case when it comes to risk management exercises. Most people will spend an inordinate amount of time debating past events rather than determining strategies to prevent emerging risk events.

Too Much Risk

Yesterday, the Financial Crisis Inquiry Commission conducted a hearing to examine the failure of Bear Stearns in 2008.  The theme of the testimony by Bear Stearns was that there was too much risk in the broker-dealer's capital structure. Here is what the Wall Street Journal reported.

Former Bear Stearns Chief Executive Officer James Cayne said Wednesday that his firm's risk level was too high in the year before it collapsed. "That was the business," Mr. Cayne told a hearing held by the Financial Crisis Inquiry Commission, a congressional panel scrutinizing the financial crisis. "That was really industry practice. In retrospect, in hindsight, I would say leverage was too high." Commission Chairman Phil Angelides said Bear Stearns was leveraged at a ratio of 38 to 1, sometimes as high as 42 to 1, and held $46 billion in exposure to mortgages. "How is that model sustainable in the event of any market disruption of significance?" he asked.

The simple answer to Chairman Angelides' question is that the model is not sustainable at that level of leverage. The problem is that in 2004 the SEC allowed firms like Bear Stearns to increase leverage from a prior limit of 12 to 1 to much higher levels.  So, the government can also look to itself when seeking to place blame for the market collapse.

An Industry on Steroids?

The Financial Crisis Inquiry Commission ("FCIC") held its first series of hearings this week on Capitol Hill in Washington.  The stated mission of the 10 member panel composed of bi-partisan members of Congress as well as private citizens is, "To examine the causes, domestic and global, of the current financial and economic crisis in the United States."  Similar to the Pencora Commission that investigated the causes of the Great Depression in the 1930s, the FCIC has the authority to conduct hearings and issue subpoenas for documents and witnesses.  The deadline for their final report is December 15, 2010.  Of the people called to testify this week, one of the more interesting and compelling was banking securities analyst, Michael Mayo.  He compared the financial services industry to major league baseball in its rampant use of performance enhancing steroids. Much like Mark McGwire, who admitted to long-time steroid use this week, bankers enhanced their performance artificially with significant long-term side effects.  Mr. Mayo noted the following:

"....the banking industry has been on the equivalent of steroids.  Performance was enhanced by excessive loan growth, loan risk, securities yields, bank leverage, and consumer leverage and conducted by bankers, accountants, regulators, government and consumers.  Side effects were ignored and there was little short-term financial incentive to slow down the process despite longer-term risks."

The only way to rid steroids from major league baseball was to implement a drug testing program with significant penalties for use.  Likewise, the banking industry must also implement programs to deter excessive risk-taking and allow firms to fail when they have ignored the potential catastrophic downside of their actions.