Causes of Current Crisis - And What Might Cause the Next One

by: Michael Panzner

In response to the bogus argument (propagated by anti-financial reform interests, among others) that nobody really knows what caused the worst financial crisis this century, Mother Jones blogger Kevin Drum highlights 17 reasons -- most of which I agree with -- that explain why it all went wrong in "Financial Reform and American Politics":

1. Housing bubble (i.e., the pure mania aspect of the thing).

2. Massive increase in leverage throughout the financial system.

3. Global savings glut/persistent current account deficits.

4. Shadow banking system as main wholesale funder for banking system/Run on the repo market.

5. Fed kept interest rates low for too long.

6. De facto repeal of Glass-Steagall in 90s (and de jure repeal in 1999) allowed banks to get too big.

7. Commoditization of old-school banking drove increasing reliance on complex OTC securities as the only way to earn fat fees

8. Mortgage broker fraud.

9. Explosive growth of credit derivatives magnified and hid risk.

10. Overreliance on risk models (VaR, CAPM) that understate tail risk.

11. Wall Street compensation models that reward destructive short-term risk taking.

12. Originate and distribute model for mortgage loans.

13. Three decades of deregulation/political economy of lobbyists.

14. Endemic mispricing of risk throughout market.

15. Ratings agency conflict of interest.

16. Investment bank change from partnerships to public companies.

17. Government policies that recklessly encouraged homeownership.

In "What Went Wrong?" Angry Bear's Robert Waldmann uses Mr. Drum's list as a starting point and points to at least twelve other factors that contributed to the mess, including:

18. Banks that are too big to fail know that they are too big to fail and count expected bailout flows as part of their value. They chose to risk bankruptcy.

19. If all fail, no one suffers. Bankers know that we can’t do without all of them, so if they all make the same mistake few can be punished.

20. The Gaussian copula. This is under 10, but it includes two particular errors. First the Gaussian part – it was assumed that if small fluctuations in two random variables have low correlation then large fluctuations have low correlation. This follows from the assumption that all random variables are jointly normal which assumption doesn’t follow from anything. It also used the assumption that financial markets are perfectly efficient when looking for ways to make profits off of financial market inefficiency which brings us to

21. Schizzo-finance. Active traders must believe that markets aren’t efficient. However, they assumed market efficiency when measuring risk. Turning the efficient markets hypothesis on and off makes it possible to think that you can make excess returns without much risk.

22. Regulatory arbitrage. Firms were willing to pay for high ratings even if they didn’t believe the ratings. Explicit references to ratings in prudential regulations and Basel I capital requirements make it possible for an entity which wants to evade those regulations to pay for ratings which it knows are invalid.

23. Firms which think they are profiting from regulatory arbitrage can believe in the efficient markets hypothesis except for those silly regulations and convince themselves that they are making huge returns with low risk. A story for how money can be made promotes recklessness and fraud.

Of course, what should really matter to most Financial Armageddon visitors at this point is what might extend or worsen the current crisis, or bring on an entirely new one. In that regard, I nominate the accelerating pace of government borrowing as a main culprit. Other knowledgeable observers apparently feel the same way, as the Washington Post reveals in "IMF: Mounting Debt Threatens Global Recovery":

Historic levels of government debt in the developed world could throw the global financial system back into crisis and clear plans are needed to bring it under control, the International Monetary Fund said Tuesday.

In one of its first broad surveys since the recent recession gave way to renewed growth, the agency said that "sovereign risk" -- the chance that sovereign nations have racked up so much debt they won't be able to borrow enough money to pay their bills -- is now perhaps the central threat to the global financial system.

Governments in the United States and across Europe have accumulated levels of debt not seen since World War II as the recession crimped tax receipts, spending rose on entitlement programs, and emergency measures were put in place to support the economy.

Any other suggestions?