Over the next several decades many individuals, business schools, finance institutions, etc. will examine the causes of our recent Financial Crisis. Here is my take on three of its causes and one additional event that created the perfect financial/economic storm:
1. Consecutive Rate Hikes by the Fed. As an effort to quell “alarms” at the Fed to avoid inflation, a successive string of interest rate increases occurred from 2004 through 2008. Combined with our most recent real estate bubble, this forced mortgage holders to pay higher and higher rates as their ARMS adjusted upward. Corporations' cost of borrowing also increased during this period. As you can see Figure 1 illustrates a successive increase of the Federal Funds Rate have been followed by a recession 8 out of 11 times since the 1950s. Pay particular attention to the period from 2004 through 2008. During this period the Federal Reserve increased rates from 1.25% to 5.25%.
Figure 1
According to Moneyweek, Feb 7, 2007, an article on mortgage delinquencies reported that “The rise in delinquencies is unusual because it comes at a time when the economy is relatively strong. Even though job growth remains healthy, ‘the total mortgage delinquency rate is the highest that it's been since the depths of the (2001) recession,’ says Mark Zandi, chief economist at Moody's Economy.com. He attributes the increase in part to the weaker housing market and the widespread use of adjustable-rate mortgages, many of which now are resetting at higher rates.” Strange coincidence this parallels the successive Fed Funds Rate increases during this same period.
2. Repeal of the Glass Steagall Act. This removed the wall put up after the Great Depression to prevent banks from engaging in activities which exposed them to excessive risk. In 1933, in the wake of the 1929 stock market crash and during a nationwide commercial bank failure and the Great Depression, two members of Congress put their names on what is known today as the Glass-Steagall Act (GSA). This act separated investment and commecial banking activities. At the time, "improper banking activity", or what was considered overzealous commercial bank involvement in stock market investment, was deemed the main culprit of the financial crash. According to that reasoning, commercial banks took on too much risk with depositors' money. Consequently, to the delight of many in the banking industry (not everyone, however, was happy), in November of 1999 Congress repealed the GSA with the establishment of the Gramm-Leach-Bliley Act, which eliminated the GSA restrictions against affiliations between commercial and investment banks. Furthermore, the Gramm-Leach-Bliley Act allows banking institutions to provide a broader range of services, including underwriting and other dealing activities. The attached Figure 2 taken from an article by the Contrary Investor dated March 1, 2008 illustrates the explosion of derivatives exposure shortly after this event. When the underlying securities began defaulting, the growth of bank derivative exposure was like adding jet fuel to the fire.
Figure 2
3. Relaxed Policy of Lending by Fannie Mae and Freddie Mac to low income buyers. An article in the New York Times entitled “Fannie Mae Eases Credit To Aid Mortgage Lending,” which appeared September 30, 1999 reported how the quasi-government agency will “encourage those banks to extend home mortgages to individuals whose credit is generally not good enough to qualify for conventional loans.” The article further states that, “In moving, even tentatively, into this new area of lending, Fannie Mae is taking on significantly more risk, which may not pose any difficulties during flush economic times. But the government-subsidized corporation may run into trouble in an economic downturn, prompting a government rescue similar to that of the savings and loan industry in the 1980's.” As the economy turned down, those marginal buyers could no longer afford their payments.
4. (Helper Cause). Bankruptcy of Lehman Brothers. This allowed a problem which was mainly restricted to the mortgage and banking industry to spread to other parts of our economy. This is according to a quote given by Noel Collins, Senior Investment Consultant at Mercer given September 17, 2008. Mr Collins noted: "The level of broad market disruption is a concern for pension funds currently involved in asset transitions or implementing changes to strategy. However, there also are a number of more specific knock-on issues, which will affect pension funds on a fund-by-fund basis, depending on where they are invested. This includes issues such as Liability Driven Investment portfolios, stock-lending programmes, and operation of Cash funds". Lehman commercial paper was held by most institutions as investment grade paper. This was eliminated overnight. After the bankruptcy was announced, pension funds, corporations, banks, etc. were all brought into the problem. Many of these institutions were holding 401(k)s and other investments for the common US worker, which then took a hit. The resulting further unwinding of derivatives ensued and the stock market plummeted as many investors (institutional and retail) moved to raise cash to cover their positions.
Sources:
1. "The Truth About US Mortgage Default Rates," Moneyweek, Feb 7, 2007
http://www.moneyweek.com/news-and-charts/economics/the-truth-about-us-mortgage-default-rates.aspx
2. Series: FEDFUNDS, Effective Federal Funds Rate; Economic Research Federal Reserve Bank of St. Louis http://research.stlouisfed.org/fred2/series/FEDFUNDS
3. The Far Too Simple Beauty Of The Promises We've Made, Contrary Investor, March 1, 2008 http://www.gold-eagle.com/gold_digest_08/ci030108.html
4. Impact of Lehman Brothers Bankruptcy on Pension Funds, Mercer newsletter, September 17, 2008
http://www.mercer.com/summary.htm?siteLanguage=100&idContent=1322320
5. Fannie Mae Eases Credit To Aid Mortgage Lending, New York Times, September 30, 1999 http://query.nytimes.com/gst/fullpage.html?res=9C0DE7DB153EF933A0575AC0A96F958260
6. What Was The Glass-Steagall Act? Reem Heakal, Investopedia http://www.investopedia.com/articles/03/071603.asp
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