Academics on What Caused the Financial Crisis

David Wessel writes:

Understanding what caused the recent financial crisis is essential to successfully refining the practice of finance to reduce the odds of repeating it. So the Financial Crisis Inquiry Commission on Friday and Saturday heard several academic economists’ take on what led to a near meltdown of the global economy.

“We are now very slowly emerging from the worst financial and housing crisis since the Great Depression,” Christopher Mayer of the Columbia Business School told the commission. The panel, he said, “stands in a unique place to examine the causes of this crisis so we can understand how to prevent this from happening in the future….It is important for us to take a critical look at what went wrong and strive not to repeat it.”

Here are some highlights of the professors’ prepared testimony, as posted on the commission’s Web site.

Randall Kroszner, University of Chicago Booth School of Business and a former Fed governor:

On reducing moral hazard: “Given the extent of interventions world-wide, issues of moral hazard will remain. The Rubicon cannot be uncrossed and financial market behavior will surely anticipate the return of the “temporary” programs and guarantees in the event of another crisis. To maintain the stability of the system and to protect taxpayers, the “too interconnected to fail” problem needs to be addressed in two ways: through improvements in the supervision and regulation framework as well as improvements in the legal and market infrastructure to make markets more robust globally.”

“Ultimately, to mitigate the potential for moral hazard, policy makers must feel that the markets are sufficiently robust that institutions can be allowed to fail with extremely low likelihood of dire consequences for the system.”

On the Volcker Rule: “Some have argued that a return to the separation of commercial and investment banking embodied in the Glass-Steagall Act would insulate banks from financial market shocks and help to promote stability6. The experience of the last few years, however, does not provide strong support for such an argument. In addition, re-introducing a Glass-Steagall separation (or Glass-Steagall “lite” such as the Volker rule) or limiting the size of institutions7 would likely result in greater fragmentation of the financial system, with the likely consequence of increasing rather than decreasing interconnectedness of banking institutions funding sources to other financial institutions and markets.

Kroszner offers a useful one-page chart summarizing all the Fed’s unusual lending with date announced, date first used, authorized and actual maximum lending and objectives (lengthen maturity, broaden collateral, expand counterparties). Read full remarks.

Pierre-Olivier Gourinchas, University of California at Berkeley:

How did subprime bust trigger a financial tsunami? “Three factors ensured that the collapse in what was a minor segment of the U.S. financial markets turned into a global financial conflagration. First, profound structural changes in the banking system, with the emergence of the ‘originate-and-distribute’ model, coupled with an increased securitization of credit instruments, led to a decline in lending standards and a general inability to re-price complex financial products when liquidity dried-up. This lowered dramatically confidence between financial intermediaries, severely disrupting interbank markets and the flow of credit. Second, banks relied increasingly on short-term financing –either directly or through off-balance-sheet vehicles— exposing themselves to significant funding risk. Lastly, increased financial globalization and the strong appetite of foreign –especially European– financial institutions for U.S. structured credit instruments quickly propagated the crisis to Europe and the rest of the World.”

Was Fed monetary policy a cause? Neither “U.S. monetary policy in the years leading to the crisis” or “the growing external deficits of the United States, the so called ‘Global Imbalances’” explains the crisis. “The fundamental disequilibrium at the root of the crisis, both in the U.S. and the global economy lies elsewhere: in the imbalance between the global demand for safe and liquid debt instruments –both within and outside the U.S.—and the limited supply of this asset.” Read full remarks.

John Geanakoplos, Yale University

On the importance of leverage: “The present crisis is the bottom of a recurring problem that I call the leverage cycle, in which leverage gradually rises too high then suddenly falls much too low. The government must manage the leverage cycle in normal times by monitoring and regulating leverage to keep it from getting too high. In the crisis stage the government must stem the scary bad news that brought on the crisis, which often will entail coordinated write downs of principal; it must restore sane leverage by going around the banks and lending at lower collateral rates (not lower interest rates), and when necessary it must inject optimistic capital into firms and markets than cannot be allowed to fail. Economists and the Fed have for too long focused on interest rates and ignored collateral. Read full remarks.

Annamaria Lusardi, Dartmouth College

On financial literarcy: “Levels of financial knowledge are strikingly low and, moreover, there is a sharp disconnect between how much people think they know and what they actually know. “ Read full remarks.

Christopher Mayer, Columbia Business School

On the housing bubble: “For the housing market, the picture is much more complex than it might first appear. The housing bubble was global in nature and also included commercial real estate, so simple explanations that rely solely on predominantly American institutions like subprime lending or highly structured securitizations cannot be the only factor leading to real estate market excesses. …My own research shows the important role played by declining long‐term, real interest rates in helping drive real estate prices to high levels, at least up to 2005. However, at some point, speculation by both borrowers and lenders took over, leading to excessive appreciation in many parts of the United States and the rest of the world.”

On securitization: “Securitization itself created incentives that led servicers to foreclose too quickly in the face of a payment default. First, theory suggests that agents (mortgage servicers) acting with perverse incentives and without proper monitoring may not act in the best interests of the principal (investors). Second, although not all authors agree, I believe there is compelling empirical evidence showing that third party servicers have undertaken more foreclosures than would otherwise have taken place if all mortgages had been made by portfolio lenders. “ Read full remarks.

Dwight Jaffee, Haas School of Business, University of California at Berkeley

On the government’s role in creating the housing bubble: “I find the GSEs [government sponsored enterprises including Freddie Mac and Fannie Mae] to have been a significant factor in expanding the mortgage crisis as a result of their high volume of high-risk mortgage purchases and guarantees. Furthermore, I find that the GSE housing goals for lending to lower-income households and in lower-income regions were secondary to profits as a factor motivating the GSE investments in high-risk mortgages.

‘I find that the FHA [Federal Housing Administration] played a minor, and basically irrelevant, role in creating or expanding the mortgage crisis, as evidenced by its rapidly falling share of total mortgage lending during the housing bubble.

“I find no evidence that CRA [Community Reinvestment Act] incentives played a significant or unique role in expanding highrisk lending during the housing bubble. The CRA is open, however, to claims of “guilt by association”, and thus I endorse any further empirical tests that could determine more precisely any role the CRA may have played in creating or extending the recent rounds of high-risk and undesirable mortgage lending.” Read full remarks.

Markus Brunnermeier, Princeton University

On why things got so bad: “Four economic mechanisms through which the mortgage crisis amplified into a severe financial crisis: 1) Borrowers’ balance sheet effects cause two “liquidity spirals.” When asset prices drop financial institutions’ capital erodes and, at the same time, lending standards and margins tighten. Both effects cause fire-sales, pushing down prices and tightening funding even further. 2) The Lending channel can dry up when banks become concerned about their future access to capital markets and start hoarding funds (even if the creditworthiness of borrowers does not change). 3) Runs on financial institutions, like those that occurred at Bear Stearns, Lehman Brothers, and Washington Mutual, can cause a sudden erosion of bank capital. 4) Network effects can arise when financial institutions are lenders and borrowers at the same time. In particular, a gridlock can occur in which multiple trading parties fail to cancel out offsetting positions because of concerns about counterparty credit risk. To protect themselves against the risks that are not netted out, each party has to hold additional funds.” Read full remarks.

(For more on Brunnermeier, see Justin Lahart’s May 2008 story on Bernanke’s Bubble Laboratory.)

Anil K Kashyap, University of Chicago Booth School of Business.

On why the banks were so vulnerable: “The proximate cause of the credit crisis (as distinct from the housing crisis) was the interplay between two choices made by banks. First, substantial amounts of mortgage-backed securities with exposure to subprime risk were kept on bank balance sheets even though the “originate and distribute” model of securitization that many banks ostensibly followed was supposed to transfer risk to those institutions better able to bear it, such as unleveraged pension funds. Second, across the board, banks financed these and other risky assets with short-term market borrowing. This combination proved problematic for the system. As the housing market deteriorated, the perceived risk of mortgage-backed securities increased, and it became difficult to roll over short-term loans against these securities. Banks were thus forced to sell the assets they could no longer finance, and the value of these assets plummeted, perhaps even below their fundamental values—i.e., funding problems led to fire sales and depressed prices. And as valuation losses eroded bank capital, banks found it even harder to obtain the necessary short term financing—i.e., fire sales created further funding problems, a feedback loop that spawned a downward spiral. Bank funding difficulties spilled over to bank borrowers, as banks cut back on loans to conserve liquidity, thereby slowing the whole economy.” Read full remarks.

Real Time Economics previously previewed a presentation by Gary Gorton of Yale University’s School of Management. Read it here.