Engineering the Financial Crisis

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Interest Rates

Though the low interest rates were considered to be one of the conventional reasons behind the financial crisis, the author argues that the 30-year mortgage rates were relatively stable between 5.25% and little over 7%. This was because the banks were aware that the low interest rate environment wouldn’t last forever, and in anticipation of that risk, banks began to issue adjustable-rate mortgages (ARM) which would be reset at prevailing interest rates. This was the generally accepted cause of trouble experienced by the subprime borrowers as people below adequate standards were able to take ARMs which caused these loans to go bad due to their inability to pay higher interests. But the author says that these low interest rates were limited to only impacting the housing market due to the above nature of the transaction and no other markets. The low interest rate played limited role in the overall financial crisis as seen in question two.

Banks "Too Big to Fail"

Another conventional reason for the financial crisis was considered to be the fact that the bankers knowingly took risky bets as they "knew" that they would be bailed out if the bets went sour. The author argues that if that would have been the case the bankers would have levered their bets to the legal maximum; and they would have bought disproportionate quantities of bonds from the high-yielding mezzanine tranches of PLMBS and CDOs, not from comparatively low-yielding triple-A PLMBS and CDO tranches and even lower-yielding agency bonds. This reasoning was typically on the lines of the arguments presented against the earlier allegation that the bankers were heavily compensated to take risks. This theory also assumes that due to the earlier bailouts of Continental Illinois Bank and hedge fund LTCM, the big banks would similarly be bailed out and thus these banks had no downside. However, these 2 bailouts resulted into the managers being fired and shareholders losing their wealth. Therefore, the author argues that it wouldn’t be logical for any bank to be aware of this fact and still want to be bailed out due to its reckless investing. Further, the creditors of these 2 previous bailouts were asked to settle at a discount so there was no reason for creditors of these TBTF banks to act recklessly as it would backfire. Further, the spreads offered by the three largest banks were more than double than that offered by GSEs showing that creditors were willing to take that extra premium for added risk without any guarantee that these TBTF banks would be bailed out compared to Fannie and Freddie which did back the government support.

Irrational Investors

The conventional reason holds that the investors acted irrationally by investing in these instruments with high LTVs being fully aware of the fact that the housing bubble would burst in the foreseeable future. However, the authors argues that this argument is flawed because of the same reasons which explain the banker’s compensation and TBTF theory. Commercial bankers who were irrationally exuberant about the endless rise of house prices would have levered up more than they did; and they would have purchased the riskier, more lucrative mezzanine tranches of PLMBS and CDO mortgage bonds, not low-paying agency bonds and senior tranches of PLMBS. The author goes on to say the term “irrational” for the investors is not correctly used in this case. The specific usage of "irrationality" treats people's errors as inexplicable. Since the correct interpretation of what was going on seems obvious to us now, we assume that it must have been obvious to any calm, rational person then, such that only emotion or irrationality can explain behavior that did not take account of our retrospectively self-evident interpretation of the housing boom. The author further explains his point by pointing out the hindsight bias. In hindsight, people consistently exaggerate what could have been anticipated in foresight. They not only tend to view what has happened as having been inevitable but also to view it as having appeared "relatively inevitable" before it happened. People believe that others should have been able to anticipate events much better than was actually the case. They even misremember their own predictions so as to exaggerate in hindsight what they knew in foresight. Therefore the author says that there was no reason for investors to not invest in safe bonds (over collateralized, AAA bonds) because it represented housing boom in the country which had never experienced a housing bubble before.

What is the reason the authors argue is behind the financial crisis, and why?

The author argues that there is reason to believe that the deregulation of finance caused the crisis. If the Fed had acted by banning ARMs or subprime lending then the crisis would have been prevented as banks were incentivized to put its capital into mortgage loans as lesser equity was required to for the same. The author also points out that the mandatory placement of CDS on the exchange would have helped the in reducing the financial crisis. This is because if an exchange would have been set up then an immense cash reserve would have been accumulated which would have reduced the panic. This is contrary to what actually happened as even though the government backed AIG the fear that drove the panic was not AIG’s CDS insurance but the underlying subprime mortgage bonds that the CDS were insuring. Therefore the non-regulation of derivatives is not the reason but the overconcentration of residential mortgage bonds is. The author also pointed out that the GLBA allowed commercial banks themselves to have investment-bank subsidiaries with similar restrictions. Therefore the key problem according to the author lay with the commercial banks, not the investment banks as convention wisdom believes it to be.

The author further says that there is evidence that the crisis was caused by capital-adequacy regulations, which influence the leverage ratios of banks around the world and, more important, the types of assets banks hold. Basel I, the first international agreement on capital-adequacy regulation, required banks to use twice as much capital for business and consumer loans as for mortgages. Basel II required banks to use five times as much capital for business and consumer loans as for mortgage-backed securities that were rated AAA. During the consultative process that eventually culminated in Basel II, U.S. financial regulators enacted a capital-adequacy regulation that was applicable only to American banks, the Recourse Rule (2001), which also required five times as much capital for business

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