Posted by: Jeff | April 29, 2010

FinReg: The Story of the Financial Crisis

I had this big idea that I was gonna write a bunch of in-depth posts on financial regulation – or FinReg as the blogosphere has dubbed it – this week. When I actually started writing, I realized that, well, most of this stuff is waaaay over my head. However, one way to at least try and get a handle on things is to tell the story of what actually happened. And from there try to isolate which steps in that story financial regulation is aimed at. (Ezra Klein did this too the other day, and like him I lean heavily on this amazing episode This American Life did on the crisis. They followed up with another one here. Frontline’s “Inside the Meltdown” is also worth your time.)

1) Economic development, primarily in Asia, resulted in a huge amount of new capital that had never been available before to the global market. For various reasons, some circumstantial and some having to do with specific policies, most of this capital wound up parking itself in the American housing market.

2) This new capital, and the enormous profit potential it represented, created a huge hunger for new financial instruments* in which it could be invested. Innovation in mortgage-backed securities** went through the roof, as did their complexity. This hunger also drove the financial industry to push the envelope in terms of the quality of mortgages it was willing to invest in. Substandard and risky lending practices became ever more common because they were more profitable, adding ever more risk to the system. At the same time, growing complexity was making that risk ever more difficult to assess. Eventually, a combination of bad historical models, poor conceptualization and overly complex math resulted in a whole host of extremely risky financial instruments being rated as if they have no risk at all. Hence the creation of the now infamous “toxic asset.”

3) At the same time, deregulation had allowed the country’s major banks to begin participating in a “shadow world” of derivatives trading, leaving all their fates intertangled in a hopelessly complex web of overlapping bets. These same banks were also often being leveraged at ratios at or above 30 to 1. (Which is to say, for every $1 they have on-hand in capital, they were risking $30 on bets in the market.) The derivatives trading created a massive need for new collateral, and the banks turned to mortgage-backed securities to fill that role. As a result, toxic assets infected the balance sheets of pretty much all the major banks.

4) The housing bubble popped, and the bad mortgages came home to roost. Because so many of these toxic assets were spread throughout the system, and no one knew the actual risk they entailed, what commenced was in effect a bank run on the shadow banking world. Hopelessly interconnected and over-leveraged, the banks didn’t have the capital on hand to weather the storm.

5) The government had neither the know-how to understand the derivatives market, nor apparently the necessary legal tools to dismantle a failing bank without posing a systemic risk to the economy as a whole. So, faced with a rapidly cascading financial crisis, it turned to the bailouts to stop the slide into hell. (There’s an argument that the government should have simply nationalized the failing banks wholesale. While this would have been more “fair” to the taxpayers, I’m persuaded it would also have been riskier, less practical, and more likely to fail to actually arrest the crisis.)

And that’s Jeff’s Story of the Financial Crisis, as best I can understand it. If any readers have any additions, corrections or thoughts to add, please do so. I’ll try to get to how all this relates to the various parts of financial reform in the coming days.

* A few definitions, starting with financial instruments; These are weird, because while they’re products, they aren’t actually things. They’re just conceptual, and exist purely on paper. The best way I’ve come with to think of them is as agreements on how various amounts of money will be moved around should various things happen.

Innovation in financial sector basically means coming up with ever newer and more nuanced ways of making those agreements. And in theory, this is a good thing. Better agreements mean better and more precise ways of getting money where it needs to go in the economy, and thus making society more productive. One of the big “meta” questions before us, I think, is whether financial innovation can hit a point of diminishing returns: the economic benefits plateau, but the complexities and the risks keep accumulating.

Mortgage-backed securities and derivative are both types of financial instruments.

** Mortgage-backed securities. These basically divy up ownership of mortgages. If an institution owns one of these securities, then they benefit from the interest and cash-flow from that mortgage. They’re also on the hook of the mortgage defaults.

Two things to remember: One, an individual security will be made up of bits and pieces of lots of different mortgages. Two, an individual security will got through lots of different hands, from the institution that makes the loan, to the one that chops up the loan and forms the security, to the one that buys the security. (And that’s a very simplified version.) So there’s complexity both in assessing the structure of the security, and thus how it will perform and what its risks are, and in assessing is chain of ownership.

*** Derivatives. Basically a bet that financial institutions and players trade with each other on how some asset in the market will perform. The value of the instrument is “derived” from the performance, hence the name. As Klein put it, “All you really need to know is that financial firms trade derivatives, they’re worth an extraordinary amount and there’s a category of them that’s almost totally unregulated.”

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