No doubt, economic historians will argue for years to come about the causes of the global financial crisis. The primary causal factor was macroeconomic, but appropriate regulation might have averted or ameliorated the crisis. Low interest rates in the United States, Japan, and elsewhere, China’s exchange rate policies, and the growth of oil wealth and other wealth in sovereign wealth funds all contributed to excess liquidity, which in turn contributed to the development of an asset bubble. There was a lot of cheap money around, and it needed to be reinvested. Not only that, but because there was a lot of cheap money, investors were constantly seeking increased returns. Those who promised them higher returns could command great followings and fees.
Much of this excess liquidity flowed into U.S. housing. During the run-up to the crisis, U.S. housing had the characteristics of a classic bubble. Those who invested in housing, either as owners or as lenders, looked like financial geniuses. Mortgage lenders could not really lose money because the value of their collateral would continue to rise, forgiving lending mistakes. As legendary investor Warren Buffett has said, “It’s only when the tide goes out that you learn who’s been swimming naked.”
Mortgage lenders were no longer the traditional local savings and loan associations, planning to hold the mortgage loans that they originated until maturity. Rather, these loans were packaged into pools and these pools were securitized, with individual investors and merchant banks trading in and investing in these securities. Therefore, the mortgage lenders often did not take a long-term view and did not worry about the ability of their borrowers to service their mortgages in a financial downturn. The amount of mortgage-backed securities issued skyrocketed beginning in late 2003. The profit model for many financial institutions had changed from one based on interest rate spreads to one based on fees and trading. This changing business model also brought with it changes in compensation — providing bonuses for executives who were able to produce these fees and trading profits.
Securitization required good pools of loans, according to the underwriting requirements specified, and it also often required credit enhancements through insurance or other backing. These mortgage-backed securities, meeting the requirements specified by rating agencies such as Moody’s and Standard & Poor’s, generally received top credit ratings. The rating agencies competed with one another for business and often relied on historical experience, rather than on forward-looking models that included the possibility of an asset bubble, to determine the creditworthiness of these pools.
The U.S. regulatory structure may be accused of both sins of commission and sins of omission. The Bush administration sought to extend home ownership to lower-income people through zero-equity lending. Increased capital requirements imposed on U.S. mortgage giants Fannie Mae (Federal National Mortgage Association) and Freddie Mac (Federal Home Loan Mortgage Corporation) opened the home financing market to securitization by other institutions. The Basel capital requirements provided incentives for securitization, and the expected reduction in capital requirements relating to mortgages under Basel II induced U.S. banks to increase their holdings of mortgage-backed securities. Investment banks were permitted to increase their leverage. All of these regulatory changes may be said to have been driven by the available liquidity and to have accentuated the growth of the mortgage-backed securities market and of its risks. While individual regulators may have seen some of the problems growing, the authorities lacked the political will to intervene strongly.
The corporate governance of many financial institutions was placed under severe stress by the fee and trading-based model, the drive to promote businesses that produced greater profits, the competitive pressure resulting from other firms’ risky activities, and the inability to develop a persuasive model of long-term risk. Under these circumstances, shareholders, boards of directors, and senior management were unable to assess and curtail the risk that their institutions absorbed. In congressional testimony in October 2008, Alan Greenspan, former chairman of the U.S. Federal Reserve Bank, stated that “those of us who have who looked to the self-interest of lending institutions to protect shareholder’s equity — myself especially — are now in a state of shocked disbelief.” This is a stunning indictment of American corporate governance: The mechanisms of corporate governance are insufficient to ensure that executives will manage in the long-run interests of shareholders, rather than in their own short-run interest.
By Joel P. Trachtman http://www.america.gov/
