What Caused the Financial Crisis

I wrote this in another forum in September when all of the hoopla started. It was quick and dirty back then and it could definitely use some filling out and additions. Maybe one day. But for now I'll just throw it up here. I should say that this takes for granted the "normal" business cycle courtesy of our Fed money managers and credit expanders. For this piece, I focused on why this recession (which started in late 2007 / early 2008 as indicated by the industrial production numbers) turned into a financial train wreck.
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As far as what "caused" this crisis, I don't have the time to argue much for this so I'll just lay it out. I see 4 significant causes here:

(1) The general social context of greed. This is nearly everywhere in our lives and it affects all aspects of the economy. This is this context -- the atmosphere in which this kind of thing can take place. For example, compare the national savings rate to the various credit levels (http://yellowroad.wallstreetexaminer.com/blogs/?p=32). We are quite simply living way beyond our means and the "credit bubble" is a big part of the result. I put fractional reserve banking (FRB) here. It is part of the background problem and functions as an exacerbating factor. But that's been around for years. The huge credit bubble is the new aspect here.

(2) There certainly appears to have been political pressure applied to lenders in order to make them lend "sub-prime." (http://query.nytimes.com/gst/fullpage.html?res=9C0DE7DB153EF933A0575AC0A96F958260&sec=&spon=&pagewanted=1 and http://www.nypost.com/seven/09292008/postopinion/opedcolumnists/os_dangerous_pals_131216.htm). I don't discount this as a real cause but I think it is clear that talking-point Republicans try to make way too much of this. And why not. Any stick to beat Democrats with is good enough. But this, by itself, cannot explain numerous aspects of this crisis such as the problems associated with mortgage backed securities (MBS), the collapse of the Baltic dry goods index, the unwinding of the carry trade, or the massive "credit crunch" (i.e., delevering) to name just a few. Moreover, I think the pressure explanation only explains so much of the crazy lending. The fact is that lenders, investment banks, rating agencies, and nearly everyone one else on this gravy train were making a killing off of the sub-prime and alt-A markets. Pressure was applied but it is also the case that much of the risky business was self-imposed. They saw the profits to be made and they went for it. So for example...

(3) There was some real funny business going on in the packaging and rating of these mortgage backed securities.

E.g., http://www.bloomberg.com/apps/news?pid=20601109&sid=ah839IWTLP9s
and http://www.bloomberg.com/apps/news?pid=20601109&sid=ax3vfya_Vtdo and
http://www.minyanville.com/articles/C-citigroup-banks-Investment-loans-RMBS/index/a/19103 and
http://www.minyanville.com/articles/jpm-Credit-fre-fnm-ms-mortgage/index/a/18766

This whole area significantly obscured, masked, and misrepresented the risks involved and it appears to be ripe for criminal investigation.

(4) And now to what is probably the grand daddy of them all. This is why we have massive cross defaults (or at the very least, the threat of it): leverage. These investment banks and "special investment vehicles" were levered up to the top of Everest. I've seen various numbers mentioned: 20 to 1, 30 to 1, 40 to 1, and sometimes more. These guys made the FRB system look miserly. Without this, you would have a recession but you wouldn't have a credit implosion. Delevering ratios this big will always be ugly. Look at the LIBOR right now. Banks don't have any actual money to cover losses or lend out because most of what they had was ex nihilo hot air. The metaphor of a bubble or balloon losing a lot of air quickly is quite appropriate. We can add some grimy but important details by pointing to such things as a 2004 SEC change in the net capital rule which allowed investment banks and the MBS market to go from huge levers to ludicrous levers (http://www.nysun.com/business/ex-sec-official-blames-agency-for-blow-up/86130/ and http://www.nytimes.com/2008/10/03/business/03sec.html?_r=1&ref=business&pagewanted=print&oref=slogin). Of course it figures that Henry Paulson was one of the ones pushing for the change (http://paul.kedrosky.com/archives/2008/10/03/quote_of_the_da_6.html).

Moreover, this situation inherently socialistic. Some conservatives are complaining that they don't want to move away from "free market principles" by "bailing out" these companies. But with respect to this aspect of the economy, we never had a free market. If someone levers up 30x, he cannot possibly cover his losses when the economy goes south. So much of the risk (potential losses) is socialized and spread to others. When his business does goes under, the potential losses becomes actual losses. This isn't socialistic if a single individual or small company were to do this provided the other entities who took on the 29x of risk/loss that the levered one couldn't handle did so voluntarily. And if they can handle it (i.e., they have sufficient capital/assets), then the damage is contained to them alone. But when a significant number of huge companies lever up like this, they have in fact spread the extra 29x of risk/liability that they can't pay for to the rest of the economy -- to everyone.

Saying that they were "too big to fail" leaves out the crucial factor. In reality, they were too big and too levered to fail. If a few of them were to go down, they very well could destroy the entire banking system and credit markets (depending on the size of the lever). Only an underwriter the size of the entire country could insure such huge debts. And so those in Government knew that if these levered goliaths ever started to shake, the State/Fed would rush to shore them up at all costs. This means that we have all been underwriting these banks for years, and now that they have begun to shake, all of us are forced to absorb the losses associated with 29x worth of leverage. The socialism doesn't start with a "bail out." All of us were already on the hook for these investments. This is a clear case of an economic "externality" -- no different in principle from pollution. The massive levering meant that the companies had taken a significant part of the cost of the economic process and dumped it onto everyone else. Companies like Goldman Sachs privatized the massive profits (some mid-level execs were getting 7 figure bonuses in addition to their usual pay) while many risks and costs were socialized throughout the economy and onto taxpayers. This is not a free market, it is theft.

In sum, this is not something so small or simple as a "U.S. sub-prime lending crisis." This is massive, world-wide, debt/lever problem. We created a collective asset bubble (in housing, credit cards, equities, commodities, etc.) the size of Titan and now the hot air is rushing out. Recessions come and go due to our "normal" inflationary operations (e.g., Fed easy credit). But this time around, heavy debt (taken on by nearly everyone) and even easier credit (especially in the housing market) magnified by massive lever arms (MBS, credit debt swap market) and clouded by highly dubious security rating schemes (Moody and S&P voodoo) and opaque security packaging/repackaging created a titanic asset bubble that turned a recession into something much nastier. The bigger the bubble, the louder the noise when it pops.