The Financial Crisis

September 17, 2008

I don’t often get requests, so I might as well take the time to reply to the ones I do get. My cousin writes:

I don’t really understand how a lack of regulation / oversight of Wall Street contributed to this (as is commonly credited).  Can you shed any light?

Well, here’s the best I can do off the top of my head:

The “lack of regulation/oversight” explanation is convenient, but unfortunately not backed by any facts.

The two biggest factors that contributed to the current problems were the housing “bubble” and the creation of a new kind of bond called a collateralized debt obligation (CDO). Nobody did anything illegal or even immoral, really. Banks bought billions of dollars worth of these CDOs, which basically involve putting a bunch of home mortgages together, which decreases the risk caused by any single person defaulting on their home loan. The problem is, everyone misestimated what these CDOs were really worth. The value being ascribed to them was based on the expectation that home prices would continue to go up, as they had been doing for about a decade, and that the historical rates of default would be an accurate guide to the default risk of current borrowers.

When home prices started going down and more borrowers defaulted on their loans than was expected, the CDOs had to be revalued. That caused big problems because still, people didn’t know what the underlying value really was, and there were now a ton of banks trying to sell their CDOs, and nobody wants to buy them because they now seem so much riskier than they did before. The result was a huge loss in value for these assets, which is a big problem for banks, since they need money to keep operating. Plus, nobody is willing to loan anybody money anymore, so it’s just a lot harder to do business if you’re a bank.

Still, it’s important to remember that nobody was lying or cooking the books on these CDOs. The values being ascribed to them were the best estimates of people who do asset valuation for a living and have an incentive to get those values right (they are being bought and sold all the time, and banks don’t want to pay more than they have to). Their estimates turned out to be wrong, but there’s no reason to believe that government evaluators would have done a better job than these people.

And there’s nothing inherently wrong with a CDO as a type of debt instrument. It allows investors to get a given rate of return with a lower risk, which is a good thing. There’s nothing shady or sinister about packaging a bunch of mortgages together. The government could have made a regulation saying “All CDOs are illegal,” but that would be throwing the baby out with the bathwater. If you make every investment that carries with it any type of uncertainty illegal, you will not be left with any investment options.

Normally, free market types say that people can buy whatever assets they want, and if the assets lose value, it’s their problem. As Bob Solow puts it,

A can bet B that C will be unable to meet its obligation to pay D. Should the rest of us care if A and B want to gamble their fool heads off, whether on credit-default swaps or basketball games?

The problem at Fannie Mae and Freddie Mac was that their assets were sort-of kind-of guaranteed by the US Government. They weren’t technically government entities, but the government gave them their mandate and partially determined their loan conditions. A loss of investor confidence in Fannie and Freddie, then, would lead to a loss on confidence in US Government debt, which could cause a huge problem for the US Government if, say, China were to try to dump its $1 trillion in Treasury Bills, bonds actually issued by the US Government. The US Government never explicitly guaranteed the debts of these companies, but they implied that they were safe investments.

The big worry now is the effect that bankruptcies will have on other investors and the US Government. On the one hand, the government wants people to live with the consequences of their mistakes, since we can’t have private companies taking all the profits when assets go up, and getting bailed out by the government when assets lose value. On the other hand, a widespread loss of investor confidence could be very damaging to the overall market. The Fed and the Treasury are now trying to find the right balance between these two competing goals.

So that’s the main story. If you’re still interested, the radio show This American Life did a program devoted to the issue called “The Giant Pool of Money,” which is mainly about what CDOs are and why investors wanted to buy them.


2 Responses to “The Financial Crisis”

  1. 4fooey Says:

    Who do we blame for the financial crisis sweeping the globe? Bankers and regulators should certainly shoulder a lot of the blame: bankers for taking on too many risky and dodgy deals, and offering too much easy money and credit for consumers; and regulators for taking their collective eye of the ball and allowing this all to happen.

    But individuals should also take some of the blame for taking on too much debt, based on the rising value of their homes, and spending too much money (funded by the easy credit) on more and more comsumer goods and services. This was a bubble waiting to burst.

  2. tripinchina Says:

    Well on the one hand, if there’s total financial meltdown then my 401k is gone. On the other hand, if the government has to step in to try to prevent said meltdown, they’re using my tax dollars to do it. Either way, I’m screwed out of money because CDO traders were taking ridiculous risks without thinking things through. Which they had every incentive to do! Which means the incentive structure is screwed up — and that’s where regulation would theoretically come into the picture. Though I’m sure it would be ridiculously inefficient….

    That is a great episode of TAL!

Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out /  Change )

Google+ photo

You are commenting using your Google+ account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )


Connecting to %s

%d bloggers like this: