My Books, Essay #9

Explaining the Financial Crisis of 2008

Policy makers did not anticipate the financial crisis of 2008. They did not really understand what was happening. They were unable to contain the economic damage. But they succeeded in controlling the narrative. The public was taught to believe that the crisis was due to bankers run amok and that the country was saved from another Great Depression by the unprecedented steps taken by Federal Reserve Chairman Ben Bernanke, Treasury Secretary Henry Paulson, and other public officials.

In a white paper published by Mercatus in September of 2009, I made a quixotic attempt to correct the record. This was Not What They Had in Mind: A History of Policies that Produced the Financial Crisis of 2008.¹

Bernanke enjoys a reputation as a hero. But I point out that rather than understanding the risks that were piling up at major financial institutions, in a speech in June of 2006 he extolled “the evolution of risk management,” praising both bank executives and regulatory supervisors for innovative uses of securities and derivatives that, less than two years later, had the financial system to the brink of collapse.

The crisis began with a rash of defaults on home mortgages and culminated in tremors on Wall Street, putting major financial institutions on the brink of failure. In my paper, I describe the event as having four components.

The groundwork was laid by what I called bad bets.

When consumers in 2005 through 2007 purchased houses primarily on the expectation that prices would rise, those were bad bets. When lenders held securities backed by mortgages made to borrowers who lacked equity or the income to keep their payments current during a downturn, those were bad bets.

…[The peak-to-trough in the total value of owner-occupied housing in the U.S.] is roughly a $5 trillion loss. This is a reasonable estimate of the order of magnitude of the losses from bad bets.

I believed that there was a housing bubble, inflated in part by policy makers who kept pressuring lenders to increase home ownership by lowering lending standards.² But although the collapse of a housing bubble was a necessary condition for the financial crisis to occur, it was not sufficient.

The second component I termed excessive leverage, by which I meant that some major financial institutions lacked the capital to absorb the losses from their bad bets.

Commercial banks had insufficient capital to cover losses in their mortgage security portfolios. Freddie Mac and Fannie Mae had insufficient capital to cover the guarantees that they had issued on mortgage securities. Investment banks, such as Merrill Lynch, had insufficient capital to cover losses on mortgage securities and derivatives.

The third component I called domino effects, meaning

connections in the financial system that made it difficult to confine the crisis to only those firms that had made bad bets. Healthy institutions could be brought down by the actions of unhealthy institutions.

At the heat of the crisis, the bankruptcy of Lehman Brothers caused losses at one money market fund. This in turn caused a crisis of confidence in the money market fund industry at large.

The final component I called 21st century bank runs. These were not consumer-led runs on main street banks. They were institutional runs on “shadow banks,” meaning large financial firms that were not banks.

Banks that had purchased protection on mortgage securities from AIG [an insurance company that was one of the “shadow banks”] were not sure that AIG had the resources to make good on its swap contracts. These counterparties [demanded] good-faith collateral from AIG in the form of low-risk securities…The demands for collateral soon exceeded the available liquid assets at AIG…

Like a bank that is solvent but suffers from a run, AIG was helpless to meet the demands that it post collateral against its swap contracts. Similar institutional runs took place against investment banks that dealt in mortgage securities.

The centerpiece of Not What They Had in Mind is a matrix showing what I believe were the main drivers of bad bets, excessive leverage, domino effects, and 21st century bank runs. I consider five causal factors: housing policy, capital regulation, evolution of industry structure, innovation, and monetary policy.

I end up arguing that only two of those factors—housing policy and capital regulation—were very important. And I put the largest emphasis on capital regulation.

In particular, regulators distorted the incentives of financial institutions, encouraging them to hold little capital against securities deemed by the regulators to be low risk. These turned out to include complex mortgage securities engineered to be granted AAA and AA ratings from rating agencies. In fact, these securities defaulted at a rate that would have shamed a portfolio of junk bonds.

In the mainstream narrative of the crisis, capital regulation gets no mention. Other than my treatment, only the even lesser-known Engineering the Financial Crisis, a book by Jeffrey Friedman and Wladimir Kraus published in 2011, shines a light on the way that capital regulations were at the base of the crisis.

Clueless Policy Makers

The main point of my paper is not just that policy makers created incentives that exacerbated the crisis, but that they did not realize they were doing so.

I have stressed the differences between the way that policies were viewed at adoption and the way they are viewed in retrospect. For example, basing capital requirements on risk and on the market value of assets made sense in light of the S&L crisis [back in the 1980s], but such policies are now recognized to be procyclical [they contributed to domino effects]…Other policies…such as the reliance on credit rating agencies and approval of dispersing risk into the “shadow banking system,” were at the time viewed as beneficial…

The history of past regulatory mistakes suggests we will not come up with a fool-proof system going forward. In fact, there is a risk of creating a financial system even more dependent on centralized regulation…at least as vulnerable to catastrophic failure.

The prospects for regulatory policy are even more fraught given the extremely skewed conventional narrative of the financial crisis…the conventional narrative looks only at private-sector excesses and an absence of regulatory oversight. It is unlikely that our financial system will benefit from a rush to create new rules and institutions based on a distorted perspective on how the crisis emerged in the first place.

Today, I think of an analogy between the financial crisis and COVID. Just as American officials had a strong desire to suppress any suggestion that the virus could have been man-made or that U.S. government funds might have been involved, in 2008 they had a strong desire to promulgate a narrative that put all of blame for the crisis on private-sector excesses. In both crises, government ended up exercising unprecedented powers.

As Robert Higgs pointed out in Crisis and Leviathan, emergency powers once exercised are never relinquished. For example, Bernanke increased the Fed’s balance sheet by orders of magnitude as a “short-term” crisis response. It is even larger today.

Higgs said that this is a ratchet phenomenon. Government failure leads to a crisis, and the response of government to the crisis is to increase its power.

As part of this ratchet process, government officials strive mightily to control the history of the crisis. Their goal is to ensure that the narrative portrays government intervention as the solution and not as the problem.

1. Although the link takes you to a free download, Mercatus also sells the paper version on Amazon as a book, so I am including it in this series of essays summarizing my books.

2. If you read subsequent analysis by Scott Sumner or Kevin Erdmann, you will see them suggest that monetary policy should have kept nominal GDP on its trend growth path. Erdmann, especially, came to argue that the collapse of house prices could have been avoided with looser monetary policy. (For Sumner, monetary policy did not need to save the housing market in order to sustain nominal GDP.) I reject their views, especially Erdmann’s.

Robert Shiller pointed out that surveys of home buyers showed that they expected 10 percent annual appreciation of home prices. As long as these expectations were realized, home buying was a no-lose proposition. But that required always finding new buyers willing to pay more. This is the essence of an unsustainable bubble.