Financial Crisis Recap

Causes

The global financial crisis is considered to have originated from an asset bubble in the US housing market. Various financial innovations contributed to a spreading of risks within the financial sector and led to a magnification of the underlying housing bubble. Overall, (1) developments in the financial markets, (2) the regulatory, institutional and political framework as well as (3) structural causes played key roles in facilitating the transmission of the financial crisis.

Developments in the financial markets

Prior to the crisis a noticeable trend towards financialization existed in UK and the US. Profit opportunities in the financial relative to the non-financial sector were superior, and hence the financial sector grew excessively. Moreover, financial innovations with complex structures, e.g. CDOs, emerged and sped up the accumulation of financial wealth. 

An important financial innovation was the securitization of bank assets, particularly mortgages. The originate-and-distribute model of bank lending allowed banks to earn considerable profits and fuelled banks' appetite for engaging in real estate lending. 

Securitization of mortgages typically involves the following production chain: At the beginning of the chain, a bank transfers a pool of mortgages from its balance sheet to the balance sheet of a special purpose vehicle (SPV). The SPV then uses this pool as collateral and issues against it a collateralized debt obligation (CDO), consisting of multiple tranches with different repayment priority and risk profile. These CDOs were typically bought by banks and institutional investors. 

Banks were investing in these complex financial assets by creating structured investment vehicles (SIVs). Investments by these SIVs would not be on the banks' balance sheets and hence were not subject to regulatory capital requirements. Thus, SIVs' investment in CDOs and other asset-backed securities with longer maturity, financed by short-term asset backed commercial papers (ABCP) was highly profitable. Since the SIVs did not have to comply with any capital requirements, they were highly levered and enjoyed credit guarantees provided by their parent banks. Short-term financing, however, was risky as the possibility of a run on SIVs existed and due to their high leverage, there was not a lot of buffer to withstand a run. 

Due to the restructuring of the underlying mortgages in even more complex financial products (CDO2, CDO3, etc.) the link between the underlying mortgage loan and the structured product became less clear. This meant higher uncertainty about the value of the structured product and hence, higher uncertainty about the financial standing of banks' SIVs. 

In the wake of the crisis home owners defaulted on their mortgages. As expected, ABCP holders reacted by not rolling over short-term debt and hence reducing the short-term funding of many SIVs. SIVs further experienced heavy losses on their investment in complex financial products, i.e. CDOs and ABSs. As a result, SIVs could in some cases not repay the holders of their short-term debt and had to utilize credit guarantees, provided by their parent banks. Parent banks had to step in and reassume part of their SIVs' liabilities and account for them in their balance sheets. This added further stress on banks and posed severe liquidity losses, increasing uncertainty in the financial system further. Eventually, interbank markets froze and governments and central banks had to act. 

Regulatory, institutional and political framework   

Aside from these developments in the US housing market, the evolution of the crisis was facilitated by weaknesses in the regulatory, institutional and political framework. Particularly problematic were the lax regulation of shadow banks, the conflict of interest within credit rating agencies, the impulses of monetary policy and the concurrent political aims.

First, shadow banks such as SPVs and SIVs invested in similar securities as banks but were not subject to similar capital requirements and accountability standards. Hence, shadow banks could provide similar services as banks at lower costs due to less regulatory prudence. This regulatory gap led to a migration of highly risky subprime credits into the less supervised and regulated shadow banking sector. Thus, shadow banks became big players in the securitization business.

Second, credit rating agencies played an important role in facilitating the sale of the complex financial products. With favorable ratings the agencies contributed to the structured products' successful placement throughout the whole financial system. While the optimistic credit ratings were explained by diversification benefits, potential risks of default correlation across mortgages were largely ignored. Moreover, conflicts of interests within rating agencies - rating agencies not only rated financial products but also advised financial institutions on the design of structured products - may have led to biased ratings in the run-up to the crisis. 

Third, loose monetary policy after the burst of the dotcom-bubble in early 2000s further augmented credit growth. Although the Fed tightened monetary policy in 2004, it could not affect long-term interest rates due to the existing saving glut. Interest rates in the housing market only started to rise in 2006, which led to an increase in the number of defaulting mortgages and many houses were seized by banks and sold. This decelerated the house price boom and house prices started declining after being on the rise for almost a decade.

Lastly, increasing home ownership was on the political agenda for some time. In order to comply with the Community Reinvestment Act (CRA), banks had to satisfy the credit demand of their community and in particular, of low- and moderate-income households. Therefore, banks issued and purchased risky loans. Nevertheless, many recent studies show that "CRA-related loans were a small fraction of the subprime market during the mortgage boom" and that "the CRA was not a significant contributor to the financial crisis" (Bhutta et al. (2015)). 

Structural causes

Young (2014) concludes that income and wealth disparities as well as macroeconomic imbalances on a global level facilitated the occurrence of the financial crisis.

Disparities in global income and wealth can be attributed to ongoing financialization, from which only the top wealth strata with access to financial markets benefitted. Increases in inequality weakened global demand and prompted monetary authorities to cut policy rates to stimulate the economy. The drop in interest rates enabled low-income households to increase consumption by accumulating debt. Moreover, it incentivized high-income households to take more risk in the search for yield, fuelling investments in structured products. 

Another contributor to the formation of the asset bubble were global macroeconomic imbalances, particularly current account deficits and surpluses. They also benefitted the financial sector, since the financing of large current account deficits was accommodated by high-quality financial services. In particular, cheap capital was flowing into the US capital markets as US deficit was financed to a large extent by Chinese surpluses. This saving glut further helped to keep interest rates low.

Continue: Transmission to Europe