The 2008 Financial Crisis

Objective: To understand how the financial crisis in 2008 was caused by (1) bad bets in the housing market (2) excessive borrowing (3) domino effects and (4) twenty-first-century bank runs.¹

The financial crisis and the Great Recession is a complex topic, full of jargon and complex institutions. Yet, to understand it we must simplify, so I am using the following metaphors in place of official terminology.

• Investment Banks—actual investment banks, hedge funds and quasi-government institutions like Fannie Mae and Freddie Mac
• Gamblers—managers of investment banks who borrow money from other people (Sponsors) to invest in the housing market.
• Sponsors—individuals and groups who lend money to Gamblers for investment management.
• Bets—investments related to the housing market. I call them bets instead of investments because the investments were held considerable risk, and because every dollar of profits made by one person reduced another person's wealth by one dollar.
• Generally, if the Gamblers made successful bets they earned enormous profits and Sponsors make moderate profits. Conversely, if Gamblers' made poor bets they earned earned a moderate profit and Sponsors lost all their money. For this reason, Gamblers received all the benefits that risky bets had to offer, while Sponsors paid all the costs.

(1) Bad bets in the housing market

The period between 2008 and 2012 is often referred to as the Great Recession, as its origin is similar to that of the Great Depression in the 1930's, and because many people believe the Great Recession would have mimicked the Great Depression in magnitude, if the government had not taken an active role in stopping the panic and fighting the subsequent recession.

Like the Great Depression, it all began with bad bets, though in houses instead of stocks. Figure 1 shows home prices from 1890 until 2010, providing a clear illustration of a price bubble. Beginning in 2000 house prices departed from its long-run trend, rising fast and then "popping", after which prices plummeted. In hindsight the bubble seems obvious, but at the time most people convinced themselves the high house prices were justified and would remain high, even if they could not articulate this justification well.

Figure 1—House Prices From 1890-2010²

For most people it didn't matter why house prices rocketed upwards; the only thing that mattered was the opportunity for easy money. People began buying homes only to "flip" them at a higher price later. Other people built new homes, believing a customer could be easily found who would pay a high price for it. Stories of how ordinary people became rich from flipping houses were passed around, and in 2005 a show called Flip This House began to air on television.  The recent bubble in technology stocks had caused the Federal Reserve to lower interest rates, making it cheaper for people to buy and construct homes. Homes were no longer a place to live. They were a ticket to greater wealth.

People can only buy homes if investors are willing to lend them money. It used to be that ordinary banks would loan the money and keep the loan, giving them ample incentive to thoroughly investigate the person's ability to repay. Nowadays these banks are only brokers. The bank meets with you, considers your ability to pay (though with less diligence), lends you the money, and then sells your mortgage to investors, which means your monthly mortgage payment goes to these investors, not the bank that initially lent you money. The investors who purchased the mortgages from the banks cared little about the borrowers ability to repay the loan, because when house prices continue to rise such loans are always profitable. If Jim defaults on his mortgage, the investor simply takes ownership of the house and sells it at a higher price. So long as home prices are rising, all home loans are profitable.

When those lending the money pay little attention to the borrowers, there will not only be unwise loans but fraud. A woman in Chicago was lent $360,000 to purchase a home in Chicago, when she only made $1,300 per month as a house-keeper. A dairy foreman made a similar income, and he was able to borrow $350,000; he couldn't even speak English. Another person who had been unemployed since 1989 was able to borrow almost $400,000. In each of these instances the bank approving the loan helped the borrower lie on their credit report. Those who ultimately lent the money were clueless—that is, until the borrowers began to default in large numbers.³

Throughout this time house prices continued to rise, and no one could offer a credible explanation for why homes were more valuable. Still, most people "drank the punch", refusing to believe there was a house bubble until house prices declined in 2007. As the video below shows, even the most respected and powerful economist in the world—Fed Chairman Ben Bernanke—could not see he was in the middle of a house bubble. If the Fed Chairman says there is no bubble, then most people will assume there is indeed no bubble.

Video 1—Even Ben Bernanke Didn't See the Bubble⁴
(scene from movie Inside Job (2010))

A few people did recognize the bubble and were able to profit considerably. Mrs. Pellegrina was on vacation in the Caribbean when she checked her account balance at an ATM. There was more in the account than she thought: $45 million more!  She couldn't figure out why; neither could her husband. It turned out that was a bonus he his employer, John Paulson, had given him for helping him profit from the bubble. While home prices continued its unprecedented rise, John Paulson was one of the few to consider the possibility of being in a bubble. He asked Mr. Pellegrina to investigate the market for houses. Pellegrina created a graph much like the one in Figure 1, and unable to find any justification for the rise in house prices, deduced it must be a bubble. What could he do?  If you believe house prices will rise your strategy is obvious: buy a home, wait, and sell later at a higher price. But what if you believe house prices will fall? How do you profit from that? He figured out a way, and made his employer billions in the process.⁵

The question we must ask is: why didn't other people recognize the bubble? There were some who suspected the bubble but continued investing in homes anyway, believing they could have all their houses sold before the bubble burst. Most people who lost money simply made irrational decisions, and it is hard to explain why (isn't that the definition of irrationality?). This is not some anomaly of human behavior though, as our lives are filled with beliefs for which we have no rational justification. People continue to believe in ghosts and UFO. Can their beliefs be rationally explained?

Video 2—Humans are Rational and Irrational (OpenLearn @ BBC)

Some have argued the government caused the bubble, but I disagree. At least some of the blame is attributable to ordinary people and professional investors whose desire for quick money overwhelmed their rational faculty—I argue most of the blame resides here. The government certainly made things worse, though. The Federal Reserve artificially lowered interest rates by printing money, and much of this new money entered the economy in the form of new home loans. While firms like Freddie Mac and Fannie Mae may technically be privately-owned firms, they are de facto a government organization. These de facto government institutions made massive investments in sub-prime mortgages. Roughly two-thirds of all sub-prime mortgages were owned by Fannie Mae and her siblings (about three times more than the private sector).^6,7 There was widespread belief the government would bail out Fannie Mae and her siblings if they went bankrupt, and this belief was proven correct, explaining why they were so willing to make risky bets. At the same time the Federal Housing Authority reduced considerably the down-payment required for a mortgage. By the time the bubble burst, half of all mortgages in America were sub-prime, and 74% of these sub-prime mortgages were backed by government agencies.⁷ The financial sector led us down a path of ruin, but ordinary people and the government followed closely. Who caused the financial crisis?  Everyone: the financial sector, government, and homeowners.

Investors tend to act in herds, so if many investors believe in an ever-rising house market this belief will spread to otherwise smart people. Those less knowledgeable in financial markets were encouraged by experts to dismiss the possibility of a bubble, and people tend to believe the experts. Below is a picture of a calculator Freddie Mac provided people to help them decide whether they should rent or own their residence. Notice there is a box where the user can enter a home appreciation rate, desribing the expected annual percent change in home prices in the future. This calculator does not allow a negative rate, which means it forces the user to believe house prices cannot fall! If Freddie Mac will not allow you to consider the possibility of falling house prices, and if you do not know much about economics, why would you believe otherwise?

Figure 2—Decision-Making Tool Provided by Freddie Mac⁸

What did the house bubble teach us about markets? Not much, other than things haven't changed much. There were many bubbles before the house bubble, some of which are given below.

1. European Tulip Bubble (1634-1638)
2. Britain South Sea Company Bubble (1720)
3. U.S. California Gold Rush (1848-1855)
4. U.S. Railroad Bubble (1860-1873)
5. U.S. Bicycle Bubble (1890-1905)
6. U.S. Stock Bubble (1920's)
7. Japanese  Real Estate and Stock Bubble (1985-1990)
8. Mexican Tequila Crisis (1991-1994)
9. U.S. Dot-Com Bubble (1997-2000)

The Great Recession began with bad bets made in the housing market, but how bad were these bets? One estimate suggests that homes were overvalued by five trillion dollars, and that is in an economy whose total annual income is around fifteen trillion dollars!¹ They were not just bad bets, but spectacularly bad bets.

(2) Excessive borrowing

Some people got out of the housing market before the bubble burst. Many did not, and those who sufferred the consequences of their bad bets also harmed others, for the simple reason that they were betting other people's money. They brought down the entire U.S. economy! Perhaps the world economy! The people who made decisions on which bets to take are our Gamblers, defined earlier, and they were betting other people's people, people we call the Sponsors. You would probably recognize the names of many Gamblers, including like investment banks such as Goldman Sachs, Bear Stearns and Lehman Brothers, but they also include small hedge funds. The Sponsors encompass a sundry of people, like individuals investing in hedge funds, teacher retirement systems, and even retired people who purchased money market funds.

When the Gamblers' bets began to lose money they were unable to repay their Sponsors. Some of the Sponsors accepted these loses stoically, as they knew their loans entailed risk. Others had no idea just how much risk the Gamblers were taking. These include retired people who purchased money market funds, accounts that pay a low interest rate but were supposed to be very safe investments. If money market funds began to realize losses it could jeapordize one's entire retirement plan, perhaps forcing one out of the middle class and into poverty. When the bankruptcy of Lehman Brothers threatened these funds: that's when the real panic began.

The main cause of the financial crisis was Sponsors' failure to monitor how their money was being handled by Gamblers. The Gamblers lent large amounts of their Sponsors' money to sub-prime borrowers. Sub-prime borrowers refer to homeowners with bad credit. In the past, sub-prime borrowers would never be able to acquire a home mortgage, but now they could do so with almost no down payment. It was not atypical for sub-prime borrowers to borrow 99.3% of the money to buy a house. The sub-prime borrowers had a sweet deal: they would benefit from all of the rise in house prices, but if house prices fell they could simply walk away from the home, returning it to the Sponsors at a lower price than what the Sponsors paid. Who decided to loan the Sponsors' money to sub-prime borrowers?  The Gamblers, and when gamblers lent money, it was not unusual for them to lend only one dollar of their own money for every thirty dollars lent by the Sponsors.

Video 3—Gambling With Other People's Money⁴
(scene from movie Inside Job (2010))

There was simply too much borrowing, at too great a risk. But why? There is no simple answer, but one reason has to do with the introduction of new financial instruments whose value was derived from home prices. The instruments seemed to take a collection of risky home loans and take all of the risk out. Removing the risk allowed the Gamblers to take riskier bets than the law allowed. The problem is that the new instruments did not remove as much risk as they appeared to remove, and thus regulators were unable to adequately control the Gamblers.

These new financial instruments have a variety of names: mortgage-backed securities (MBS's), derivatives, synthetic derivatives, tranches, credit default obligations, credit default swaps (CDS's), etc. The financial crisis can be understood by learning only two of these instruments—MBS's and CDS's—and so we will concentrate only on these.

• Mortgage-Backed Securities (MBS's)—simply a collection of home mortgages. If you own a MBS, then when the homeowners make their mortgage payment you receive the money. If they default on their mortgage then you take possession of the house. At first these MBS's made good money, so people wanted more, and the only way to create more MBS's is to lend to people with poor credit—what is referred to now as sub-prime mortgages. The owner of a MBS is, albeit indirectly, the person who lent money to the homeowner.
• Credit Default Swaps (CDS's)—Suppose you own a MBS but you are worried many of the mortgages will default. You can buy insurance against this, where you purchase a Credit Default Swap and pay a yearly premium. If the default rate on the MBS exceeds a certain level (e.g., if more than 5% of the mortgages in the MBS default) you receive a fixed sum of money from the company who sold the CDS.

With all the financial engineering going on, people focused only on the mathematical sophistication of the investments but lost sight of who they were actually lending to. Both those who bought MBS's and those who sold CDS's had no idea of how risky the mortgages truly were, and all underestimated the riskiness of their investments.

Video 4—How a House Bubble Created a Financial Crisis⁹
(scene from movie Too Big To Fail (2011))

(3) Domino effects

Everybody owes money to somebody in the financial world, and during the house bubble it seemed like everybody had some money invested in homes. This means that each person's ability to repay loans depends on them being repaid. Jim, who manages money in teacher's retirement plans, lends money to Sally, who purchases mortgage-back securities from Adam, who bought thousands of home loans from Janet at Countrywide Financial, who interviewed hundreds of home loan applicants and was told by her boss to approve everyone, regarldess of their credit history.

Remember Jim? He is responsible for making sure the money lent out of teacher's retirement plans is repaid with interest, so the teacher's retirement plans depend on Sally repaying him, and Sally's ability to repay depends on the performance of mortgage-backed securities purchased from Adam. Did Adam investigate the loans he purchased from Janet at Countrywide Financial? Why would he, when he turned around and sold them within a day. And why should Janet care who she makes loans to, if the loans are turned around and sold within a week, long before the borrowers have a chance to default?

Where is the integrity, the trust, in this system? It might be surprising, but usually there is remarkable integrity in the financial sector. Would you lend money to your neighbor, or your sibling? Do you lend money to your bank? You do if you have a savings account, or purchase a certificate-of-deposit (CD). Most of us do lend money to strangers at a bank but never lend to people we actually know, which means we place more trust in the strangers in financial markets than people we interact with daily. The problem is that if you lend money to your brother and do not get repaid, only you suffer; but when investments lose money in the financial market it creates a domino effect where one bad investment turns into dozens.

This is what is meant by domino effects. When one component of the financial sector suffers it can affect all other sectors. An easy way to visualize this is to note that when homeowners defaulted on their mortgages the owner of an MBS took control of the house and sold it.  When default rates rise, causing more homes to go on the market, this depresses home values. Now everyone who owns MBS's see their investments go down in value, because the value of the investment is partly dependent on the market value of the home.

If Samuel lends money to Claire, who owns many MBS's, the fact that MBS's lose money causes you to question Claire's ability to repay. You then have the right to ask Claire to repay the loans earlier (or put up collateral, if you know what that is), but this limits Claire's ability to repay other people, and causes a chain-reaction of lenders insisting on being paid back immediately.

The problem is that investments are not intended to make money immediately. By definition, it takes time for loans to translate into returns. The financial sector can only operate effectively when money is invested wisely and lenders are patient. When these domino effects induces panic the financial sector cannot operate. We have a financial meltdown, caused by twenty-first-century bank runs.

Video 5—Illustration of Domino Effects¹⁰
(abbreviated version of http://www.youtube.com/watch?v=qqUGoVez8xg)

(4) Twenty-first-century bank runs

Most of us are familiar with the term "bank-run", and we visualize people from the Great Depression forming long lines outside the bank to retrieve the money they deposited, only to find the bank runs out of money before the even get inside the building. Or maybe we saw a bank-run in the movie It's a Wonderful Life or Mary Poppins. Bank runs of this nature caused hundreds of banks to go bankrupt during the Great Depression, and is the primary factor for the depression being "Great". Fortunately, these type of bank runs are no longer a concern. Next time you are at the bank look for a label at the teller with the acronym "FDIC". This stands for Federal Deposit Insurance Corporation, and on that label it will tell you your deposits are insured up to $250,000 (or some other large sum). No need for a bank-run anymore. If the bank runs out of money, the government will step in.

Figure 3—Bank Run in the U.S. (1933)¹¹

What is especially dangerous about a bank-run is that it can occur without valid justification. If a rumor circulates about a bank failing people will create a run on the bank, ensuring it will fail, but the rumor may had been false. We fear bank-runs because they can be a self-fulfilling prophecy. Our fear alone—justified or not—can bring down an economy. Perhaps this is why Franklin D. Roosevelt told us we have nothing to fear but fear itself. This self-fulfilling fear still presents us with danger: not in traditional banks, but in investment banks—and they can be equally devastating.

Video 6—Bart Simpson Starts a Bank-Run¹²

The government is unable to prevent our modern-day equivalent to the bank run, what we call a twenty-first-century bank run. They occur not in traditional banks but investment banks. Both types of banks serve the same function: the connect people who want to lend money with people who want to borrow money. These lenders must be patient with borrowers, because the investments borrowers make take years to begin generating profits. If lenders become impatient and demand their money now, borrowers can only repay a portion of what they borrowed, and the borrower may be out of money before he has repaid everyone. Fearful they will be the last lender to demand immediate repayment, lenders become even more impatient. The result is that businesses can no longer invest money in productive enterprises. Private investment stalls, and large-scale projects that were planned are now postponed. People are laid-off. Businesses can no longer acquire loans to buy inventory. Construction companies can no longer pay their bills. A recession results, perhaps a "Great" one.

In the fall of 2008, the world learned what financial stability is, through its absence. Over a few short weeks, Fannie Mae and Freddie Mac entered federal conservatorship, Lehman Brothers filed for bankruptcy, Merrill Lynch was purchased by Bank of America, and AIG received an $85 billion loan from the Federal Reserve to continue operating.

Meanwhile, the Reserve Primary Fund, the country's oldest prime money-market mutual fund, officially "broke the buck"—meaning its net asset value fell below $1 a share—igniting a run on prime money-market funds that led to the disruption of short-term credit flows and a deepening of the crisis spreading to Main Street. As is often the case after financial crises, we experienced a long and deep recession—and a painfully slow recovery that persists to this day.

—Eric S. Rosengren. President and CEO of the Federal Reserve Bank of Boston. Excerpt of editorial published in The Wall Street Journal on April 27, 2012 (A15).

Economists can't say much about how twenty-first-century bank runs causes recessions or how to stop one, but, in unity, we emphatically remark that they do cause recessions. During the Great Depression we acquired direct experience with a defunct financial system, and eventually acknowledged the impossibility of wealth creation without financial health. This is why the Federal Reserve, Congress, and the President have gone to enormous lengths to support today's bankers, investors, hedge-fund managers, and the like. Although Paul Giamatti is not Ben Bernanke, and although this scene may not have actually taken place, I believe the following scene from Too Big To Fail depicts the beliefs of the real Ben Bernanke, and why as Fed Chairman during the Great Recession he executed unprecedented manevuers to prevent the Great Recession from becoming another Great Depression.

This is my opinion: although we are unfortunate to have experience the Great Recession, we are blessed that Ben Bernanke was the Fed Chairman at the time.

Video 7—Ben Bernanke's Warning⁷
(as depicted in Too Big To Fail)

(Coda) This time is not different

Whenever we wonder if we are in a bubble, we have a tendency to look back at all the financial booms and busts in the past and say, "This time is different." That is certainly what people were saying in 2005, right before the house bubble burst. I can't explain why we don't seem to learn from history, just as I can't explain why people continue to believe in ghosts. I can't explain it because I don't understand it.  What I do understand is that the boom and bust caused by speculative bubbles have always occurred and thus will probably always occur. It is our responsibility as educated people not to delude ourselves into thinking, "This time is different."

Video 8—This Time Is Not Different¹³
(scene from Margin Call (2011))

Who really pays the price of speculative bubbles?  Generally it is not the professional investors, whom we call the Gamblers. Indeed, they are often wise to the presence of a bubble, but instead of avoiding it they make money off the more gullible. When the housing bubble burst and government began to bail people out it was not the Gamblers who needed bailing out. Most of the investment bank managers still made a killing because they withdrew from the market in time. It was not the gambler who needed bailing out but the people who lent money to the gambler: the Sponsors.

We have not answered the question of why the Great Recession occurred until we explain why the Sponsors lent money to the Gamblers. Some simply didn't know better. Some of them did know that risky bets were being made, but they also believed that if the housing market stumbled so much of the American economy would be threatened that the government would bail them out, limiting the loses they would experience from giving the Gambler money. For decades the government had stepped in whenever the economy was threatened, and we did so again in 2008-2010. As a result, people in the future will continue to believe in the probability of a bailout when financial markets falter, and for this reason Sponsors will continue to lend money to the Gambler to bet.

How can we prevent bailouts in the future? How can we prevent financial crises? We have two choices, and endless combinations of these two choices.

• Stop bailing people out now, and allow people to suffer the consequence of risky choices. This will force people to be more prudent in how they invest their money, and they will take less risk.
• Enact stringent regulations on the financial sector, to the point that the government has complete (and thus arbitrary) power over investment banks.

There seems little evidence we will stop bailing people out. It is also becoming evident that government barely has the ability to understand financial markets, much less regulate it well, and it is possible that bad regulations can be worse than no regulations. On top of this is the always present regulatory-capture, where government attempts to enact tough regulation, but through lobbying some firms are able to craft the legislation to their favor, such that the regulations have only a minor impact. Sometimes regulatory-capture allows firms to profit from the regulations. For example, if the regulations make it difficult for new investment banks to become establish, and if they penalize small banks in favor of big banks, the regulations can help the bank acquire considerable market power.

Video 9—Regulatory Capture after 2008 Bailouts¹⁴
(excerpt from Frontline: Money, Power, and Wall Street (2012))

I wish I could tell you that we (government and economists) have a solution to financial crises and bailouts, but we do not. It seems booms and busts will remain a fact of life, and with them, bailouts. So be vigilent about the possibility of price bubbles, and be wise about how you invest your money.

References

(1) Kling, Arnold. 2009. Not What They Had in Mind: A History of Policies that Produced the Financial Crisis of 2008. Mercatus Center. George Mason University.

(2) Barry, Steve. January, 2011. "A History of Home Values." The Big Picture blog.

(3) Mclean, Bethany and Joe Nocera.2010. All The Devils Are Here. Portfolio/Penguin: NY, NY.

(4) Producers: Audrey Marrs and Charles Ferguson. Director: Charles Ferguson. 2010. Inside Job. U.S.A. Sony Pictures Classics.

(5) Zuckerman, Gregory. October 31, 2009. "Profiting From the Crash." The Wall Street Journal.

(6)  Peter Wallison. June, 2012. "The Financial Crisis Was the Result of Government Housing Policy."  Reason magazine.

(7) American Enterprise Institute. Ten Alarming Facts about the Great American Housing Bust. Slideshow accessed on May 5, 2012 at http://www.slideshare.net/AEIorg/the-us-governments-role-in-building-and-bursting-the-housing-bubble-12705359.

(8) Planet Money Podcast. November 5, 2010. "Finally, an Apology." Podcast and blog posting.

(9) Producer: Ezra Swerdlow. Director: Curtis Hanson. 2011. Too Big To Fail. U.S.A. HBO Films.

(10) Understanding the Financial Crisis-very well explanation! YouTube.com. Accessed on April 19, 2012 at http://www.youtube.com/watch?v=qqUGoVez8xg

(11) Franklin D. Roosevelt Library Collection Photo. ARC Identifier 195559. Photo taken February 23, 1933

(12) The Simpsons. "The PTA Disbands." Season 6. 1995.

(13) Producers: Robert Ogden Barnum, Michael Benaroya, Neal Dodson, Joe Jenckes, Corey Moosa, Zachary Quinto, Laura Rister, and Cassian Elwes. Director: J.C. Chandor. 2011. Margin Call. Lionsgate and Roadside Attractions.

(14) Public Broadcasting System. Frontline: Money, Power and Wall Street: Part Three. 2012.