Saturday, February 6, 2010

What caused the sub-prime crisis?

Though the sub-prime mortgage crisis has been the focus of intense debates, there is still no agreement about what were its proximate causes. In an excellent post, Barry Ritholtz (via Mark Thoma) draws the distinction between its primary and secondary causes - what caused the crisis and what exacerbated it. It may be appropriate to refine this further into factors that contributed to the inflation of the sub-prime bubble, institutional and environmental factors that laid the ground for the bubble, factors that triggered its bursting, and those that amplified its adverse consequences.

Ritholtz has three primary causative factors - ultra low rates (blew up the housing boom and forced bond managers into scrambling for yield and searching for alternatives to low yielding Treasuries); unregulated, non bank, subprime lenders (sub-prime lenders inflated the credit bubble, and enabled millions of unqualified borrowers purchase homes they could not afford); and ratings agencies slapping AAA on junk paper (created the AAA market).

His list of three secondary or exacerbatory factors are - The Commodity Futures Modernization Act of 2000 (it exempted derivatives from all oversight and regulation - unreserved for, off exchanges, no disclosures of counter parties, no capital requirements - and thereby created the shadow banking system); Net Cap Rule Change of 2004 (aka Bear Stearns exemption) (it allowed banks to go from 12 to 1 leverage to 25, 35 even 40 to 1 leverage, and the increased leverage certainly made the damages much greater); and the repeal of Glass Steagall in 1998 (allowed banks to get much bigger than they would have, which made their losses that much bigger).

These amplifying factors, while also contributing towards the build up of the bubble, were more responsible for ensuring that the markets deviated too far from the fundamentals that when it ran out of steam it crashed with an intensity that was unmanageable. I am in broad agreement with Barry Ritholtz on the causative and exacerbatory factors.

Here is my list of secondary institutional and environmental factors

1. Rapid development of the market in securitization of asset based mortgages meant that in the absence of the need to hold loans on their balance sheets, banks had little incentive to exercise caution in their lending.
2. The rapid proliferation of Credit Default Swaps as insurance instruments made banks and other financial institutions take on excessive risks after hedging with these instruments.
3. Skewed executive compensation structure distorted incentives
4. Moral hazard from the feeling that the big banks are too-big-to-fail encouraged excess risk taking
5. Savings glut and search for safety and liquidity among emerging economy investors provided a never-ending pool of easy money

And the list of events/factors that triggered off the bursting of the bubble
1. The dramatic decision of March 2008 to bailout the securities trading firm Bear Stearns, through its sale to JP Morgan in an arrangement where Fed undewrote $29 billion in losses on $30 billion of Bear’s assets shook Wall Street and was the first needle to prick the sub-prime bubble and Wall Street began to have nightmares of LTCM.
2. The wave of housing foreclosures suddenly drove a massive hole in the market for mortgage based derivative securities. Over-leveraged financial institutions facing steep margin calls were induced into forced sell-offs (which drove the markets down further) to cover for losses or flight to redeem their CDS's, which in turn brought down firms who sold these insurance contracts.
3. The final nail in the coffin was the decision to not bailout Lehman, which triggered off a sharp increase in counterparty risk and initiated a freeze in the credit markets. In the aftermath of the Bear Stearns bailout, the markets had developed a moral hazard that the Fed and Treasury will step in and bailout Wall Street majors since they were "too-big-to-fail".

Free Exchange has this post which while conceding the harmful effects of modern financial engineering, feels that the same (or related) forces were responsible for helping more than a billion people escape the scourge of poverty over less than two decades.

Update 1 (20/3/2010)
Alan Greenspan points to "a dramatic decline and convergence of global real long-term interest rates" that engendered "a dramatic global home price bubble heavily leveraged by debt and a delinking of monetary policy from long-term rates". He also writes that "the global bubble was exacerbated by the heavy securitization of American subprime and Alt-A mortgages that found willing buyers at home and abroad, many encouraged by grossly inflated credit ratings" and the reduction of "global risk aversion to historically unsustainable levels" due to "more than a decade of virtually unrivaled global prosperity, low inflation, and low long-term interest rates".

He also admits that the "major failure of both private risk management and official regulation was to significantly misjudge the size of tail risks that were exposed in the aftermath of the Lehman default".

Update 2 (5/4/2010)
Times an excellent op-ed which argues that regulators knew all along what was happening and their permissiveness encouraged the banks to indulge in excessive risk taking.

As the Lehman bankruptcy examiner revealed — about the bookkeeping scam at Lehman known as "Repo 105" - which allowed Lehman to disguise how much debt it was carrying, right up until it collapsed. Lehman got new loans to pay off old loans, pretended the new loans were 'sales', and through a complicated series of steps made both the old and new loans disappear just in time for its quarterly reports.

Michael Burry rubbishes claims that nobody predicted the sub-prime crisis.


Dylan Bale said...

Regarding your assertion that the March 08 collapse/bailout of Bear Stearns - this event, while obviously a major domino on the way to the financial crisis - was not a cause of the subprime crisis. The subprime crisis was going on LONG before Bear collapsed. Indeed, Bear Stearns itself - through its own low underwriting standards and its role as a major securitizer of junk mortgages - certainly helped to cause the subprime crisis which, in turn, helped cause Bear Stearns to fail. But the subprime lending industry collapsed during the first half of 2007 and securitization and sales of subprime mortgages was done by the second half of 07. Just my two cents. Brett Sherman, editor, The Wall Street Law Blog www.wallstreetlaw/

gulzar said...

Dylan, I could not agree more. the sub-prime bubble was inflating all through the decade, and the failure of two Bear Stearns hedge funds in June-July 2007 was an early symptom.

However, in Bear's collapse, I was referring more to the classic Minsky moment, when the momentum suddenly turned and the market panic started to build up to a crescendo. and i do think, Bear's collapse was a significant minsky moment, if there was one.

in fact, apart from the bear stearns collpase, the nationalization of Northern Rock in February 2008 by the British government was another defining global financial market event that may have contributed towards decisively reversing the momentum.