This was an assignment for my Financial Markets class. If you want to learn about the financial crisis, why it happened, and whats being done to solve it, read on. If you do not understand a word or term or idea, it is probably just technical mumbo jumbo and is unnecessary for understanding the general idea. FI means Financial Institution.
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The 2008 financial crisis was set in motion by the numerous and unexpected meltdowns of financial institutions. This analysis uses this moment as a reference point, and back-tracks until critical failures are identified. The crisis was a result of systematic and widespread fraud and stupidity. Though the Federal Reserve’s efforts limited the harm, the underlying causes were outside their control. The game of finance is deeply broken, and no action can be called a solution unless it aligns financial incentives with the public good.
Collateralized Loan Obligations (CLOs) were the security which collapsed to begin the cascading failures of FIs in 2008. They were a relatively new type of security which packaged and resold mortgages, and were an innovative way to create an instrument to divide the mortgage lending process. They managed risks and payouts associated with loans, which were usually subprime (made to less qualified borrowers). FIs bought thousands of these subprime mortgages and packaged them into CLOs to be resold in the capital markets. These CLOs were intentionally incomprehensible and opaque, so that buyers would not have the ability to truly evaluate their value and risk.
The CLO-selling FIs manipulated the structure of CLOs so that, given rating agencies’ inadequate methods of analyzing risk, the securities would receive the highest rating. They were treated as diversified investments, even though the constituent parts derived from same sector (subprime mortgage) and were affected by the same forces. The ratings models assumed that housing prices would continue to rise forever. The fact that these FIs were paying ratings agencies for evaluations created additional pressure for the ratings agencies to underestimate these assets’ risk.
Because CLOs were a pool of highly correlated and risky mortgages, there was a heightened demand for loans, which eroded lending practices. Banks soon began lying and giving loans to people did not qualify by falsifying paperwork. They engaged in unsavory lending practices such as “teaser rates.” Neither banks nor CLO-creating FIs cared that the mortgages or resulting CLOs were risky, because they were almost instantly sold off to other entities. These mortgages began to default all at once, which caused the CLOs to plummet in value and to spark the meltdown in 2008.
Many FIs were heavily invested in Collateralized Loan Obligations (CLO). The difficulty of understanding these securities increased the buyers’ reliance on ratings agencies. CLOs were generally understood as absolutely safe assets, and several firms bought high amounts with debt. When mortgages began to fail en masse and the value of CLOs plummetted, many FIs were overly leveraged. The resulting panic also constricted short term credit markets, which hurt both Wall Street and Main Street, causing the financial crisis of 2008.
From this explanation, it seems that the crisis was inevitable. The crisis was a convergence of many economic forces pushing in the wrong direction. Banks made a good profit writing fraudulent loans, and bore no risk because the loans were sold immediately. CLO-creating FIs were making a good sum of money from these deals, and made CLOs more incomprehensible to keep demand high (lest investors realize they’re buying junk). Ratings agencies were paid for AAAs, not to ask questions or to develop more rigorous models. Buyers were just happy to buy “risk-free” assets that were more profitable than the alternative. Some buyers (AIG) ended up acting in self interest (knowingly or unknowingly), as they were bailed out by the government.
If anything, this crisis shows how little collective wisdom resides in the financial world. Financial institutions have been crashing from overexposure for decades, and new regulations only prevent crashes resembling previous ones. Soon enough, FIs will find a new exotic way to lose money, and markets will burn down again. The only incentive to keep financial managers from overexposure is the fear of busts, but these managers have nothing to lose. They risk other people’s money, and when their portfolios are wiped out, they keep their jobs. The government pays for their bonuses and keeps the companies afloat, and the world keeps turning. Until these managers are coerced by fear (of sanction, unemployment, or imprisonment) to play it safe, its only a matter of time before the next crash happens. When it does, everyone will blame each other; regulation will prohibit the drivers of the crash, and FIs will find other bets that may or may not bust.
To solve the financial crisis is to remove the incentives for these harmful transactions before the harm manifests. However, the government did not have the regulatory power to identify these transactions, stop them from happening, and punish those responsible. It is the role of regulatory authorities to create an environment where the self interest of one is in the self interest of all. It must also prevent fraud from becoming as wide-spread as it did during the crisis. However, deterring crime (and harmful stupidity) has been the reason for government for thousands of years, and they have yet to find a working solution.
Because the crisis was not stopped preemptively, the Federal Reserve could only remedy the symptoms. One of the Fed’s shortfalls was its inability to lend to shadow banks, because they can only lend to nondepository institutions in “unusual or exigent circumstances.” If the Fed had recognized the crisis earlier, perhaps the problems stemming from short-term liquidity could have been prevented.
As far as movements in interest rates, the Fed can only do so much. The uncertainty in stability and price of short term lending had stalled the economy long before the Fed began to make plays. Jump-starting a multi-trillion dollar economy is not something with absolute solutions; thus, there are few people smart enough to make any comments on the Fed’s post-crash actions.
New regulations are a step in the right direction. The ending of “too big to fail” will stop big institutions from believing that they are fully (and freely) insured. High-risk high-reward is a game meant for smaller institutions, so new SIFI (strategically important financial institutions) limitations are a good thing. However, as long as there is a mismatch between personal greed and public good, history will repeat itself. Finance will continue to threaten the world economy until profitable finance produces the greatest good for the greatest number.
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