Financial crisis of 2007-2008

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There are two theories of what caused the Financial crisis:

  1. Too little government: Big Banks / Wall St. and under-regulation (the removal of Glass-Steagall) allowed banks to inject risk into the system (with fancy derivatives) which created the bubble, and the bail-out sheltered them from any ramifications
  2. Too much government: The Housing Bubble was over inflated by the CRA, Fannie/Freddie, the risks spread thru MBS’s, and over-regulation (FAS-157) froze the credit markets and magnified the correction

Both of these fit each sides political agendas. Glass-Steagall theory (GST) is simpler, but CRAFFT (CRA, Fannie/Freddie theory) matches the data/facts far better, and explains far more. I'll cover both. But every one of the claims of GST or “too little government” falls apart with the slightest scrutiny, like regulation increased over that time by over 17%, with thousands of pages of new regulations, or if repealing Glass Steagall caused it, you’d have seen the failure in the new Universal banks, but they’re the ones that bailed out and saved the other banks (not the other way around).

NOTE: You can jump to the Financial Terms section, or just reference them as you go; like read what a Bank does (and differences between investment/commercial/universal), what a GSE like Fannie/freddie does, or what an MBS’s are or Mark-to-market accounting is.

Glass-Steagall Theory (GST)

The idea is:

  1. Bill Clinton lifted the Glass-Steagall act (under pressure from Republicans) and signed the bipartisan Gramm-Leach-Bliley Act (GLBA)
  2. This allowed banks/investment houses to merge and over-leverage themselves (using Credit-Default Swaps, and MBS’s) and rampant predatory capitalism of evil bankers caused them to oversell loans to people that people couldn't afford them (subprime mortgages) and get into over-leveraging themselves
  3. The bankers knew they were risking all (and going to crush the economy), thus they were actively defrauding the people by selling/making the loans (criminal activity to get their bonuses), and they should go to prison.
  4. The bubble popped, and everything came down (as expected), but they all got bail-outs / cash from Uncle Sam and consumers paid the bills ($700 billion for TARP AND $831B for ARRA / American Recovery Reinvestment Act / Stimulus), and they walked away scott-free with big bonuses.

To these folks, it was collusion between the the Fed and Banks that allowed crimes to be committed and not punished, the little guy got screwed and got their homes taken away, and because Big-Government did nothing, thus we need Bigger-Government and wealth-redistribution to fix it and go after these crooks and evil 1%’ers. (This is the Occupy theory).

It's a great theory to appeal to emotions, but none of it makes sense or fits the facts/evidence, or explains anything. Think about the following.


Glass steagall.png
Glass-Steagall was the 1930's new deal regulation that said Commercial and Investment had to be separated. There would be no universal banks. In theory, by separating sides there would be more transparency, and people might behave less risky. In truth, there's just more inefficiency and the same risk. If Glass-Steagall prevented catastrophe, then how come Asia and Europe didn't have financial meltdowns, since they never had Glass_Steagall?

We know: Transparency inside banks hasn’t been a problem, adding steps didn't alter what happened, there was no change in how much leverage there was (either by you or the banks), European/Asian banks didn't have Glass-Steagall and didn't crash.

If G-S was the problem, then during the collapse it would have been the unified banks that had the biggest problems (over-leveraged/under-capitalized). It wasn’t. The Unified banks outperformed the Commercial banks (Countrywide) and the Investment Banks went out of business (Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers, Bear Stearns). The Unified banks that never had problems; JP Morgan Chase (Unified) bailed out Bear Stearns (Investment), while B of A (Unified) helped by taking over Merrill Lynch (Investment) and Countrtywide (Commercial). This is backwards from what GST says should have happened!

This has been widely researched, after a few bad books and articles promoting this G-S theory. Bill Clinton, the CBO, the SEC, and dozens of other economists all concluded the same thing: Glass-Steagall had nothing to do with the crisis, or the credit freeze!

CRA, Fannie/Freddie Theory


The idea of the CRA->Fannie/Freddie theory (CRAFFT) is as follows:

Inflating the bubble

  • (1) Fannie/Freddie (F/F) was created to help the poor get better loans (sell sub-prime loans, using MBS’s).
  • (2) The CRA (Community Reinvestment Act) started under Carter, magnified under Clinton (and Bush), and was a way for communities to use Community Organizers (ACORN, Obama, etc), to punish banks/bankers who didn’t loan enough to sub-prime customers.
  • (3) Think of F/F as the carrot (they buy/bundle/resell these loans into MBS’s), and CRA was the stick (community organizers punish banks that aren’t giving out enough liar loans in their community) .
  • (4) Fannie/Freddie had quotas (forced on them by congress) on who they had to loan to (ratios), and this was continuously getting pushed down by politicians.
  • (5) Banks didn't know how much risk was in the system (F/F doesn't report well on total types of loans, etc), banks only knew what F/F was buying from them (individually). And these unsecured sub-prime mortgages were being snapped up by the government (F/F), so Banks were happy to keep selling them. ( It's a Banks job to sell the loans that others are buying). Government blamed banks, because they weren't going to own their own mistake.
  • (6) Banks started following Fannie/Freddie and bundling their own MBS's as well (they had always bought/sold/bundled loans too). Still, remember Fannie/Freddie is bigger than all the banks combined, and they set most of the standards. If banks didn't lower their risk profile to match Fannie/Freddie then they won’t be selling enough loans to keep on CRA’s good graces. When Franklin Raines took over Fannie (Clinton appointee), he said he wanted to use the influence of Fannie and Freddie to induce the private sector to lower credit standards. The banks FOLLOWED Fannie/Freddie.
  • (7) Politicians/Congress also incentivized the population to take on this debt through tax policies like home interest deduction, and inflationary spending will drive up the costs of everything (meaning you HAVE to put you money in investments like housing, or it will lose it's value).

This is why politicians didn't attack commercial bankers: getting them on the stand would mean they would explain to the public what happened, and it would all point back to the politicians/government (democrats especially, as they controlled congress/senate). So they would demagogue that it was all their fault, but they wouldn’t give them the microphone of any high publicity trials to defend themselves. And the left-leaning media wasn’t going to let them explain how the business works.

Bursting the Bubble

Many will get mad at the facts and say, "you're blaming the poor"
but no judgement intended, we're just looking at what happened and why.
Now whether you think Glass-Steagall or CRA/Fannie/Freddie caused the bubble,
the following happened after the bubble popped.
The GST folks don’t want to talk about this part (how it played out),
because this destroys the “Government will fix it” philosophy.

When things go bad, they go really bad:

  • The problem is with all these sub-prime loans, too many folks had nothing down, poor government oversight to get in, as soon as the market goes down at all, lots of the people can walk away with no risk or accountability. They have no skin in the game. So we had our first down-blip in 20 years, and many people in sub-primed started defaulting on the loans (like many had warned).
  • That put way too much real-estate on the market at the same time, which caused crashing housing values.
  • And that loss of paper equity (for many Americans), convinced people to invest less, or take money out of their stock accounts (causing stock market to go down). Wall St. didn't cause this, they were a victim of it.

Freezing the Credit Market

  • Once the housing costs started dropping, people started defaulting on those bad loans. And that caused the crisis.
  • Republicans had fought for more transparency and regulation of Fannie/Freddie (from 2001-2006), but Democrats obstructed this because these community organizers and special interests were a powerful lobby that paid handsomely, and their voters were the recipients of all these sub-prime loans, so as long as housing costs were going up, it looked like everything was great. (And if it went down, they could point fingers, and their constituents were gullible enough to buy-in. Win-win!)
  • MBS's were complex and opaque (as F/F had been designed: to hide the poison and get everyone to drink a little), but that meant that when the market was correcting, no one was sure how much poison they had (how many of these bad loans and what areas) were going to be impacted and how much exposure you had in your securities. And that was going to take 12-24 months to unravel and figure out.
  • Banks were regulated by law to keep a certain debt-to-asset ratios -- so if their assets (MBS's) were dropping, they couldn't loan to people, or to other banks. Thus government regulations required that they seize up the cashflow, and sell some assets (MBS's) to get their debt-to-equity (cash) balances right.
  • Democrats (in 2007) had passed something called FAS 157 which said that banks had to use Financial Terms#Mark-to-Market accounting. Before this banks could value their assets based on things like a 3 or 5 year rolling average of asset sales (to slow up/down trends). Mark-to-market said they had to peg all their like assets value, to the last market sale: immediately!
  • Since Bank-A had to sell MBS's (because of their debt-to-equity ratio), and no one was buying them (since the bank couldn't explain how much poison/exposure F/F had stuffed in them), then they were required to sell for whatever the market would bear. Let's say that bank was stressed and had to take $.10 on the dollar (10% of prior value, immediately). Boom, every other bank had to mark all their assets to the last market sale, and all their like assets dropped 90% in value immediately. Which meant they too had to sell more assets (to get their asset ratios up), and certainly couldn't loan money. And the markets froze! No one would loan (to keep their debt-to-equity rates up), and thus companies suddenly couldn't buy the inventory (which they buy on credit) to keep operating/growing/etc. It was going to be ruin that made the 1929 crash look like cakewalk.

What were the fixes

So the banking market froze up because of Government regulations causing a bigger drop than before, and requiring banks to sell their assets to keep liquidity high enough to comply with other regulations (so they couldn't loan). And they were scared a further drop would squeeze them more, so they didn't want to take on more liability. So what could they have done?

  • The quick/simple fix would have been repealing FAS 157 (which would have freed up assets) -- but that would have been publicized and shown that congress/government was wrong to pass it (and is what caused the problem in the first place). Since that Democrats wouldn't let that happen, instead of playing politics and publicly hammering Democrats to repeal FAS 157, while the economy collapsed around us, he pushed for a compromise: TARP.
  • TARP (Troubled Asset Relief Program) was the Government FORCING banks to take massive' LOANS', to give them a HUGE buffer on their debt-to-equity ratios, so they could start loaning again. On top of that, there were only a few banks that were in trouble, but the Fed made ALL the banks take loans, so people didn't know which banks had the worst problems (and cause a run on those banks). But we know after the fact it mostly the investment banks (not the Unified Banks that G-S theory says should have the problems).

NOTE: these were just LOANS, not give-aways to the banks. Once things stabilized, and we figured out the floor on the housing market, and the actual value of MBS's stabilized, the liquidity crunch abated, banks paid back the government ALL the loans in TARP. They didn't keep that money: it was money loaned to banks so they had credit to loan out TO THE PEOPLE! The public benefited, not the rich bankers.

Technically, there's nuances to that. Increasing banks equity allows them to loan more, which is how they make money. So the banks did benefit with all that free / low-interest cash. But the reason was so they could loan money to the people. Anyone who claims "the pubic got stuck with the bill", "evil bankers got a bail-out", "the little guy got screwed", are fools or frauds. Like Elizabeth Warren, Bernie Sanders or any of the far left movements that made this a talking point, that preyed on the ignorance of their base.

And the banks paid all those loans back. While Congress authorized more (to have head-room), they only loaned $414B out, and the banks pad back $405B (with interest).[1] The other money was to auto-companies, Democrat supporters (Unions), and not the bankers or Wall St.

Which is why no bankers went to prison, because there was no crimes you could convict them of, other than complying with the many bad government regulations that nearly destroyed them, and paying back the loans they were forced to take (but most didn’t need), to cover for the few that were most compliant with CRA and Governmental pressure.

If Congress/Democrats dug too deeply, all the systemic problems pointed back at them. Some banker was going to explain what happen well enough on TV that the media might start doing its job and explain to the public what had really happened (instead of the Democrat version), and then they'd be in trouble. That's why despite Democrats controlling Senate, House and President, they did rhetoric -- but very thin "investigations". Politicians might be dumb, but they're not THAT dumb.


So what did we learn? 1. ALL the banks paid back all the loans within a couple years (with interest), and most didn't need the money in the first place. In fact, none would have, if it hadn't of been for FAS-157. They weren't crunched because they were over-leveraged for real (their leverage rates going into the crisis was lower than they were when Clinton was in office in the 90's). They only didn't have the paper assets because of Mark-to-market accounting (FAS-157): fuck-you-very-much. 2. There was never a “bail out” of the banks — there was a bail out of bad regulations. The term "bail out" implies they were given money. They were forced to take loans to cover up Democrats incompetence. And they paid it all back, with interest. The taxpayer lost money, but that was on Fannie/Freddie and the Auto Loans and other policies by the Democrats. The only bail out was of government malfeasance, not of banks. 3. The Republicans had been warning about for 5+ years before the collapse about Fannie/Freddie’s problems and trying to fix it. Democrats kept blocking republicans from forcing transparency, because of crony-big-government. Now we can debate whether the Republicans attacking was foresight, or just trying to kick Democrats in a soft-spot, and they weren’t 100% innocent either, Bush had let the CRA and Fannie/Freddie continue to lower standards without taking it to the people. But no one knew when the bubble would pop, and he at least had the excuse of 9/11 or Iraq and F/F was in Congresses purview. 4. There was never any criminal prosecutions because the only thing most were guilty of was compliance with the law (bad regulations), and Democrats in control, they didn’t want that to come out. Which is why they scream so loudly and point fingers at Banks and Wall St. and fund things like Occupy, to distract from their malfeasance. Since the media leans left, they've avoided any real journalism or exposés that might make their party look bad — which is why 90% of Americans don't know/understand what actually happened and why.

The stories about deregulation causing this, and all the other stuff, make no sense on how they could cause anything. Nor do ones about how evil bankers duped the public or the gullible poor into taking loans they couldn't afford. Yes, I'm sure there's a few smarmy sales folks out there (even in banking), but that was a symptom of Fannie/Freddy and government requiring so many of these loans and being so willing to buy them up. If the government was buying only 20% of the loans and the private sector was issuing 80%, I’d firmly blame the banks. But as the numbers were the other way until well into the crisis (and the GSE’s had said their intent was to lower standards), the blame lies on them for the bubble, and on the bad regulations like FAS-157 for the crash afterwards.


Big Fraud Theory


There are a few books or movies like "The Big Short", Liar's Poker, or William Black who float this Big-Fraud theory (BFT), It is loved by Hollywood, the Media, Progressives (Elizabeth Warren, Bernie Sanders), and those who know better but want to distract and enrage the gullible. It's becoming the most widely spread theory because simply hate and ignorance spread faster than information, complexity, and introspection.


Massive greed encouraged massive over-leverage, and while everyone (or a few) knew better, they did it because they were dumb, greedy and corrupt. They screwed the public knowing that the entire system would collapse, but as long as they were making money and bonus's, they didn't care. And it caused everything.

The problem is no one credible has really offered this as a "theory", because it's not economics, it's politics. And it doesn't explain anything, if you think it through.

Now no one is doubting that there were a few unsavory places and events and outliers, or that Countrywide was doing what Fannie/Freddie told them to (and aggressively selling LIAR/NINJA loans) and Fannie/Freddie was buying them up. That hasn't structurally changed anything, nor could it explain what happened. So I don't doubt that happened, but it has nothing to do with G-S, which couldn't have done anything to stop it, and it doesn't change all the things that actually caused the crash and credit markets to seize.


But let's think it through and pretend that fraud is more than a minor contributor to the issue. (And not just fodder for 60 minutes and others).

  1. If Fannie/Freddie weren't buying these loans, it wouldn't have been possible: so it's still a failure of Government Sponsored Entity and thus government.
  2. The leverage was lower in the 2007 than it was in 1998
  3. Leverage doesn't cause crashes or markets seizing up -- it can only magnify what's going on, or mitigate / hedge against it (depending on what the leverage was being used against). Whether you have 10% or 20% equity in your home, or if you owe $5K or $20K on your credit card doesn't change whether you're going bankrupt or not -- the underlying problem is one of cashflow (money in versus money you have to put out). You're less likely to go bankrupt with more debt, if you income still exceeds your outlays.
  4. for a bubble to be big, that means that housing values and stock values would have had to have been all/mostly based on fraud (fiction) to cause a major correction. Which means that they could NOT have recovered within a few years. The banks couldn't have paid the money back (which they did), because there was no underlying value to the assets (it was all/mostly fraud). Either Fraud was the cause, and there was no underlying value to the assets being written against, and the market couldn't recover something that didn't exist (the correction would have to have been permanent). Or fraud was a very minor part of the issue, and once the bigger issues were worked out, the market/housing would rebound (as happened). Thus the fact that the market bounced back (real estate and stocks), says that there was value there, and any fraud was a very small part of it -- and BFT theory is wrong. Pick one.
  5. This theory doesn't explain is why the credit markets seized. Why do people stop loaning, and why did TARP fix it if it was fraud? So it's saying that fraud helped with the bubble, slightly - but everything else in CRAFFT theory was still at play. So it's not an explanation of anything, it's just an excuse to hate.
  6. Why didn't government go after them? To believe the BFT, you have to also believe in a huge conspiracy between Government and Wall Street, that bankers and investors have colluded with Congress to deceive the public and that's why no one went to prison in massive investigations of widespread abuse.

Easier Explanation

The far easier explanation is that while this might have happened in small scale (that TV shows and or sensationalist authors exaggerated for self promotion), that it wasn't that widespread, and they were complying with Fannie & Freddies standards (as demonstrated by Fannie/Freddie trafficking in 60-80% of these loans) -- which is how those loans got in the system. Yes, leverage can injected some risk in the system, but the only reason it could have, is because Fannie/Freddie and regulations allowed it. That's not fraud, that's complying with really badly written rules/regulations by a government sponsored entity. Slimy, but legal. (E.g. not Fraud).

So the real theories posited in the article are the economic explanations. This BFT is just a political agenda masquerading as an explanation for what happened: but doesn't really explain anything.

To me, the fraud theory is the chewbacca defense: it could have happened, it could not have happened, but it's an unsavory side note to what caused the majority of the bubble, or the credit markets to seize afterwards (FAS-157), and what TARP and the other loans did to get credit moving again.


Here's some other tidbits (complexities to note):

Feeding the bubble: many foreign investors (and others) lost trust in their governments for a variety of good reasons, they still needed a place to put their money/savings and if they didn't trust their currency/governments, American MBS's was a great/safe place. They needed to put their money somewhere, and that was safer than in their own countries. And you couldn't trust currencies because of manipulation (China, U.S., EU). You couldn't trust the treasury bills because Greenspan was keeping interest rates too low (in order to encourage more leverage/investment and less savings -- e.g. creating a bubble). So socialist corruption in Europe, U.S. and abroad helped fed the American (Dollar) and real-estate bubble.

Feeding the bubble: in America municipal bonds weren't good investments because cities had defaulted (especially in liberal controlled states like California, NY or Michigan), and other states and municipalities looked higher risk because they couldn't control their debts. (See liberal states like California, Michigan, NY, especially). If you don't trust city/state bonds, then more goes into stocks and real-estate (the bubbles that popped). And tax incentives were further inflating the bubble.

Mis-assessing risk: there's no doubt that the credit agencies mis-assessed risks. But imagine you're Moody's -- and there hasn't been a system wide real-estate drop in 70 years, and the majority of the loans are going through GSE's (Government), and you have government agents like Barney Frank screaming that everything is good and safe? You're going to assume these instruments are very low risk too. But black swans hit once in a while. The credit agencies were wrong, for trusting what the government was telling them!

The banks sold sub-prime loans and MBS's too! Yes, a few did. But if you look at scale, they were not most of them (government was), and they were kind of arm-twisted into following by the successes of Fannie/Freddie. So they might be wrong, but they were wrong second -- thus if you want to get to the root of the problem, you look at who did it first and bigger. Banks listened to government and credit agencies that said these things were safe, so they FOLLOWED! (They did not LEAD) into bundling their own MBS's, as well as selling the sub-prime loans that Fannie/Freddie and the CRA was pushing them to. And as long as Government (GSE's) were buying these loans, there was virtually no risk to signing up as many people as you could: it looked like free money (backed up by the government).

After government had chummed the waters, the feeding frenzy started, then investment houses created derivative/instruments to magnify the results (like CDO's) which magnified leverage. (Note derivative and leverage aren't bad things). The reason lefty-politicians focus on it, is because they can make it sound complex and distract people from root causes, and their base doesn't understand that both can LOWER your risk. (In fact, that's what hedging as in hedge-fund managers does). So the fundamental problem here was that investors (and investment banks) listened to Moody's and Government's mis-represented risks, and reacted accordingly. And they paid the price (by being driven out of business).

What about smarmy companies selling bad loans or selling investments they knew were bad? Both are a failure of government: it is their job to stop those criminal activities. If they were widespread (and they really weren't from a systemic level), then it shows how bad government was at doing its job of stopping abuse. Blaming the industry for a few exceptions is daft. Not blaming government for doing their job and catching, stopping, or punishing it, is dafter.

What about Credit default Swaps (CDO's)? These are just two companies insuring each other. I agree that if your assets go down, I'll cover you, as long as you do the same. It's really low cost insurance -- but if BOTH sides go down at once, you're screwed. But we hadn't had a case of that in 70+ years, so they thought (wrongly) that it was safe. Thus there was a lot of greed and failure to assess risks, and this cross insurance and complex derivatives chewed up the Investment Banks and Insurance Companies. They thought they were collecting risk free premiums and got raped for that mis-assumption (and increased leverage). But it wasn't that companies weren't insured, it was that their cross-insuring each other, caused as much exposure as it covered it. But that wasn't because of deregulation (government was writing more new regulation than ever in our history with Sarbanes Oxley and so on), it was a failure of government to realize where we needed new regulation targeted, while simultaneously telling them that there was no risk in housing. (These guys were dumb to believe government -- so both sides own that mess).

Some companies were betting against themselves or their investors? Yes. This is called hedging (or "insurance" in gambling). It's a common technique to lower risk -- if you've made a ton of money on one investment, you normal bet against it (by a short or derivative against it): if it keeps going up, the asset growth will cover the cost of the insurance/hedge, and if the asset goes down, the insurance/hedge will grow in value and cover the cost of the asset drop -- you're not betting against yourself/customers as much as locking in a gain. Some are trying to flim-flam the gullible that hedging is a bad thing -- but the alternatives are usually worse.

CountryWide was the worst! You're correct -- they were the most aggressive at selling MBS's and sub-prime loans. What lead to all that confidence? They owned too many Democrats in congress (and had become a revolving door for congressmen), and they donated heavily, and Barney Frank protected them. So there was a corruption problem with CounrtyWide, but it was government-CountryWide collusion with Democrats. This is the problem of empowering Government/Politicians, they lease that protection to the highest bidder.


Financial Terms

These are a bunch of financial terms (concepts really), that you can scan to get familiar with the jargon and ideas. Especially before reading the Financial crisis of 2007-2008, but they're good jargon to know when watching financial shows or reading financial press.


Glass steagall.png
Glass-Steagall was the 1930's new deal regulation that said Commercial and Investment had to be separated. There would be no universal banks. In theory, by separating sides there would be more transparency, and people might behave less risky. In truth, there's just more inefficiency and the same risk. If Glass-Steagall prevented catastrophe, then how come Asia and Europe didn't have financial meltdowns, since they never had Glass_Steagall?

CRA, Fannie/Freddie Theory