The 2008 Financial Crisis – Was this all the fault of the Banks or is there a more complext tale of error and incompetence to be considered?
I was asked recently by a friend (who is not an investment banker) to explain the causes of the 2008 Financial Crisis. At the time I found myself struggling to coherently explain the complex factors and events which led up to the crisis.
I will be posting one post a day from today for six days as I take you through my brief guide to the 2008 Financial Crisis.
I have therefore done some research and have attempted to present a six part Six Minute Strategist blog post explanation of the crisis. In doing this I have avoided apportioning blame or criticising the protagonists. I have tried to bring out the salient points and issues without going too deeply into the complex detail and jargon. This will inevitably mean missing out huge amounts of detail but hopefully will give you an overview and understanding of what happened and some of the reasons why the crisis developed and why its impact was so devastating.
At the end I have provided a brief appendix with further reading which will enable the reader who wishes to go into more detail to do so. I am indebted to Wikipedia for its wide range of articles and to Michael Lewis (“The Big Short, 2010) and Gillian Tett (Fool’s Gold, 2009) for their excellent books on the subject.
1. US Home Ownership
The origins of any crisis are normally to be found in the solutions taken to solve the crises of the past. The 2008 Financial Crisis is no different but I want to take as my starting point the Financial Crisis of the 1930s. One major tenet of US Government policy which arose from this crisis was the belief in the right for US citizens to own their own homes. It was strongly held at the time that indebted (mortgaged) home owners had a stake in society which would make them less likely to go on strike. This aside the growth of home ownership was one of the great US economic trends of the 20th century and led directly to the suburbanisation of America.
US homeownership in 2009 stood at just under 67.4%. Mortgage interest is a tax deductible expense in the US. This 70% threshold is significant as shall become apparent in the context of the sub-prime mortgage lending market.
2. Labour vs Capital (for the Marxists)
The 1960s and 70s saw a significant increase in the power of labour, achieved largely through the vehicle of militant unionism. The backlash lasted from 1975 to 1985 when Governments (particularly in the UK) reclaimed their right to govern by enacting a broad swathe of legislation curbing many of the uncontrolled excesses of the earlier period.
In Marxist terms this struggle between labour and capital resulted in a victory for capital and those who control it. While I do not subscribe to this particular dogma, it is fair to say that those believing in Free Markets (as opposed to Government dominated and controlled economies) were in the ascendant. The growth of innovation and complexity in the financial markets could not have taken place under the Bretton Woods system, particularly where the global movement of capital was significantly restricted.
3. Clinton Administration Policy
In the late 1990s the Clinton administration actively encouraged extending home ownership in the US, particularly to low and moderate income families. As a consequence, lenders subject to the Community Reinvestment Act legislation, which was updated in 1995, increased lending to this segment of the population by 80%.
4. British Government Policy
This is not an anti Labour Government diatribe. Several measures were taken by successive Labour administrations (as they were in other developed countries), which, with hindsight played a contributing part to the crisis.
The first measure was taken in 1997 when the then Chancellor of the Exchequer, Gordon Brown, granted independence to the Bank of England. At the same time he set up the Securities and Investment Board, which took over the regulatory oversight of the Financial Services industry (including Bank Supervision). With the subsequent regulatory failures, this measure may be reasonably criticised as several critical issues in the build up to the crisis subsequently fell between the two stools of the Financial Services Authority (the successor to the SIB) and the Bank of England.
Through the first five years of the 21st Century, Brown (still Tony Blair’s Chancellor) copied the low interest rate policies of the US Fed and oversaw a significant growth in borrowing, indebtedness, house price rises (becoming a UK bubble in its own right) and increasing Government expenditure. His claim to have abolished Boom and Bust, made at the height of this low interest/fiscally expansionist period, was subsequently to be proven significantly inaccurate.
Tim Geithner, now US Treasury Secretary but Chairman of the New York Fed during the crisis, recently criticised the UK Government prior to 2008 for running a very light touch regulatory environment which was done with the specific aim of drawing financial services business into the London market from New York, Frankfurt and Tokyo. At the time, Financial Services were providing 10% of UK Government tax receipts, which the Chancellor was very grateful to have and to spend. The degree to which the regulators failed to keep up with the innovation and complexity of the market became one of the significant causes of the crisis.
At the height of the Lehman Crisis in September 2008, Barclay’s Bank had an opportunity to acquire Lehman’s in the weekend before it failed. To do so required UK Government approval as it would require the Bank to short cut many of its legal obligations to get shareholder approval, as well as requiring approval from the UK regulator. At this time, Brown was now Prime Minister and his Chancellor of the Exchequer; Alistair Darling refused to sanction the deal on the grounds that he did not wish to import the US (subprime) disease. Had the deal gone through it is likely that either Goldman Sachs or Merrill Lynch would have become the next brokerage house that the market would have challenged and the crisis would only have been postponed. The event does signal though that senior members of the UK Government had no idea of the complexity of the problem or the systematic risk to the whole financial system.
5. US Interest Rate Policy
US Interest rate policy is formulated by the Federal Open Market Committee (FOMC) whose Chairman is also the Chairman of the Federal Reserve. The last two Chairmen, Alan Greenspan (1987-2006) and Ben Bernanke (2006-to date) have both been supporters of free markets. Greenspan particularly actively encouraged low interest rates in the first half of the first decade of the 21st Century and set the tone for the global interest rate environment.
This low interest rate environment was an essential pre-condition to the US house price bubble, which in turn led to the subprime crisis.
6. Credit Bubble and House Prices
The encouragement of Government fiscal and economic policy to expand house ownership led to a rise in investment and then speculation in the housing market. Underlying this was a belief (subsequently proven wrong) that house prices would always continue to rise and even if one state suffered from a temporary decline in house prices, this had never happened widely across the US and would not do so. Unfortunately the Bond Market analysts in Wall Street Investment Banks for whom it was an essential core assumption of their financial modelling shared this assumption.
The Crisis of 2008 has its roots in Housing Policy, Sub Prime lending and an asset price inflation bubble, which was stimulated by easy lending terms and low interest rates. The crisis was not however a subprime mortgage lending crisis. This particular asset bubble was simply the catalyst which precipitated the crisis, just as the fall of Lehman was the tipping point event which triggered the financial earthquake.
Here is the Appendix to the posts which list some of the more useful references and some good books to follow up with if you would like to know more:
Appendix – Further Reading
Wikipedia: See entries regarding:
- I. Subprime Mortgage Crisis – http://en.wikipedia.org/wiki/Subprime_mortgage_crisis –
- Subprime crisis background information – http://en.wikipedia.org/wiki/Subprime_crisis_background_information
- The Financial Services Authority – http://en.wikipedia.org/wiki/Financial_Services_Authority
- Credit Rating Agencies – http://en.wikipedia.org/wiki/Credit_rating_agency
- FICO Scores – http://en.wikipedia.org/wiki/FICO_score#FICO_score_and_others
- Fannie Mae – http://en.wikipedia.org/wiki/Fannie_Mae
- Freddie Mac – http://en.wikipedia.org/wiki/Freddie_Mac
- Sub Prime Lending – http://en.wikipedia.org/wiki/Subprime_lending
- Credit Derivative – http://en.wikipedia.org/wiki/Credit_derivative
- Credit Default Swaps – http://en.wikipedia.org/wiki/Credit_default_swap
- AIG Financial Products – http://en.wikipedia.org/wiki/AIG_Financial_Products
- Shadow Banking System – http://en.wikipedia.org/wiki/Shadow_banking_system
- Housing Bubble Formation – http://en.wikipedia.org/wiki/File:Lending_%26_Borrowing_Decisions_-_10_19_08.png
- Sub Prime Crisis Diagram – http://en.wikipedia.org/wiki/File:Subprime_Crisis_Diagram_-_X1.png
- Black Scholes Model – http://en.wikipedia.org/wiki/Black–Scholes
Gillian Tett – Fool’s Gold, How Unrestrained greed corrupted a dream, shattered global markets and unleashed a catastrophe, 2009
Michael Lewis, The Big Short, Inside the Doomsday Machine, 2010
Andrew Ross Sorkin, Too Big to Fail, Inside the Battle to Save Wall Street, 2010
Hank Paulson, On the Brink, Inside the Race to stop the Collapse of the Global Financial System, 2010
In my next post I will look in more detail at the Protagonists involved in the 2008 Financial Crisis.
If you enjoyed this or wish to comment please do so on the Blog. I would be delighted to discuss this or other Corporate Strategy issues with you – you can contact me at jbdcolley [at]aol[dot]com. My full contact details can be found on my About page here.