I believe the key underlying causes of the crisis include: the creation and ultimately the bursting of the housing bubble; excessive leverage that pervaded the system; the dramatic growth of structural risks and the unanticipated damage they could cause; regulatory lapses and mistakes; the pro-cyclical nature of policies, actions and events; and the impact of huge trade and financing imbalances on interest rates, consumption and speculation. Each of these causes had multiple contributing factors, many of which were known and discussed before the crisis.
As the housing bubble grew, new and poorly underwritten mortgage products helped fuel asset appreciation, excessive speculation and far higher credit losses. Mortgage securitization had two major flaws that added risk: nobody along the chain had ultimate responsibility for the results of the underwriting for many securitizations, and the poorly constructed tranches converted a large portion of poorly underwritten loans into Triple A-rated securities. In hindsight, it’s apparent that excess speculation and dishonesty on the part of both brokers and consumers further contributed to the problem.
Excessive leverage by consumers, some commercial banks, most U.S. investment banks and many foreign banks, pervaded the system. This included hedge funds, private equity firms, banks using off-balance sheet arbitrage vehicles, nonbank entities, and even pension plans and universities.
Several structural risks or imbalances grew in the lead-up to the crisis. Many structures increasingly relied on short-term financing to support illiquid, long-term assets. A small structural risk in money market funds that allowed investment in up to 180-day commercial paper or longer term asset-backed securities became a critical point of failure when losses on such securities encouraged investors to withdraw their funds and liquidity was not available to meet redemptions. Over time, repo financing terms became too loose, with some highly leveraged financial institutions rolling over this arrangement every night.
Financial institutions were forced to liquidate securities at distressed prices to repay short-term borrowing. Investors caused enormous flows out of the banking and credit system as they collectively acted in their own self- interest.
In many instances, stronger regulation may have been able to prevent some of the problems. I want to be clear that I do not blame the regulators. The responsibility for a company’s actions rests with the company’s management. However, it is important to examine how the system could have functioned better. The current regulatory system is poorly organized with overlapping responsibilities, and many regulators did not have the statutory resolution authority needed to address the failure of large, global financial companies.
While banks in the mortgage business were regulated, most of the mortgage industry was not or lacked uniform treatment – mortgage brokers were not regulated and insurance regulators were essentially unaware of large and growing one-sided credit insurance and credit derivative bets by some companies. Basel II capital standards, which were adopted by global banks and U.S. investment banks, allowed too much leverage. Extraordinary growth and high leverage of Fannie Mae and Freddie Mac were allowed where the fundamental premise of their credit was implicit support by the U.S. government.
The abundance of pro-cyclical policies has proven harmful in times of economic distress. Loan loss reserving causes reserves to be at their lowest levels at times when high provisioning is needed the most. Although we are a proponent of fair value accounting in trading books, we also recognize that market levels resulting from large levels of forced liquidations may not reflect underlying values. Continuous credit downgrades by credit agencies in the midst of a crisis also required many financial institutions to raise more capital.
Many macroeconomic factors also contributed to the crisis, including the impact of huge trade and financing imbalances on interest rates, consumption and speculation. The U.S. trade deficit likely kept U.S. interest rates low, and excess demand kept risk premiums depressed for an extended period of time.
Saturday, January 30, 2010
Jamie Dimon: What Caused The Financial Crisis
Jamie Dimon's testimony at the Financial Crisis Inquiry Commission (on what caused the financial crisis):