The Great Unifying Theory of the Financial Crisis

Discussion in 'Economy' started by boedicca, Jan 27, 2011.

  1. boedicca
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    boedicca Uppity Water Nymph Supporting Member

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    This makes great deal of sense:

    We believe the crisis was the product of 10 factors. Only when taken together can they offer a sufficient explanation of what happened:

    Starting in the late 1990s, there was a broad credit bubble in the U.S. and Europe and a sustained housing bubble in the U.S. (factors 1 and 2). Excess liquidity, combined with rising house prices and an ineffectively regulated primary mortgage market, led to an increase in nontraditional mortgages (factor 3) that were in some cases deceptive, in many cases confusing, and often beyond borrowers' ability to pay.

    However, the credit bubble, housing bubble, and the explosion of nontraditional mortgage products are not by themselves responsible for the crisis. Our country has experienced larger bubbles—the dot-com bubble of the 1990s, for example—that were not nearly as devastating as the housing bubble. Losses from the housing downturn were concentrated in highly leveraged financial institutions. Which raises the essential question: Why were these firms so exposed?

    Failures in credit-rating and securitization transformed bad mortgages into toxic financial assets (factor 4). Securitizers lowered the credit quality of the mortgages they securitized, credit-rating agencies erroneously rated these securities as safe investments, and buyers failed to look behind the ratings and do their own due diligence. Managers of many large and midsize financial institutions amassed enormous concentrations of highly correlated housing risk (factor 5), and they amplified this risk by holding too little capital relative to the risks and funded these exposures with short-term debt (factor 6). They assumed such funds would always be available. Both turned out to be bad bets.

    These risks within highly leveraged, short-funded financial firms with concentrated exposure to a collapsing asset class led to a cascade of firm failures. The losses spread in two ways. Some firms had large counterparty credit risk exposures, and the sudden and disorderly failure of one firm risked triggering losses elsewhere. We call this the risk of contagion (factor 7). In other cases, the problem was a common shock (factor 8). A number of firms had made similar bad bets on housing, and thus unconnected firms failed for the same reason and at roughly the same time.

    A rapid succession of 10 firm failures, mergers and restructurings in September 2008 caused a financial shock and panic (factor 9). Confidence and trust in the financial system evaporated, as the health of almost every large and midsize financial institution in the U.S. and Europe was questioned. The financial shock and panic caused a severe contraction in the real economy (factor 10).

    We agree with our colleagues that individuals across the financial sector pursued their self-interest first, sometimes to the detriment of borrowers, investors, taxpayers and even their own firms. We also agree that the mountain of government programs supporting the housing market produced distorted investment incentives, and that the government's implicit support of Fannie Mae and Freddie Mac was a ticking time bomb.

    But it is dangerous to conclude that the crisis would have been avoided if only we had regulated everything a lot more, had fewer housing subsidies, and had more responsible bankers. Simple narratives like these ignore the global nature of this crisis, and promote a simplistic explanation of a complex problem. Though tempting politically, they will ultimately lead to mistaken policies.


    Thomas, Hennessey and Holtz-Eakin: What Caused the Financial Crisis? - WSJ.com


    Many of us here have said there were multiple factors and that regulation aimed at one Blame Recipient is misguided.
     
  2. Toro
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    Toro Diamond Member

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    I read this this morning. It is a reasonable and well thought out thesis.

    However, all bubbles are a function of excess credit creation. The authors mention excess liquidity but do not delve directly into why there was excess liquidity. Thus it is difficult to have a Grand Unifying Theory without an explanation for why there was - and still is - too much money sloshing around the world.
     
  3. boedicca
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    boedicca Uppity Water Nymph Supporting Member

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  4. william the wie
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    william the wie Gold Member

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    This housing bubble although not its size was predicted by virtually every demographic analyst out there in the 90s. The slow motion collapse of the supply and distribution chains in finance was predicted by practically everyone in the financial field going back to Fink and Raneiri's creation of securitization in the 70s and 80s. That DC stuck with the efficient market theory 40 years after Mandelbrot disproved it (an efficient market cannot be fractal and all financial markets so far studied are fractal in price movements) definitely did not help.
     
  5. B. Kidd
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    B. Kidd Gold Member

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    In 2009, India's economy grew by 8 per cent. One of the significant reasons for this, is that India's central bank avoided buying into securitizations that turned toxic, quite simply, because they were too complicated and they didn't understand them.
     
  6. boedicca
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    boedicca Uppity Water Nymph Supporting Member

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    Another big reason is that India has a high birth rate - over 2.7 live births per fertile woman. The replacement rate is 2.1 (which is where the U.S. currently is - Europe and Japan are largely far below this level). Increasing populations help growth.
     
  7. Samson
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    Samson Póg Mo Thóin Supporting Member

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    ^^^^

    Why we all need to learn to speak spanish.
     
  8. boedicca
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    boedicca Uppity Water Nymph Supporting Member

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    The only reason the U.S. has a 2.1 birth rate is because of hispanic immigration.
     
  9. editec
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    editec Mr. Forgot-it-All

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    Of course this economy cannot be blamed on one fact and one fact only.

    Economies are by their very nature effected by everything that happens.

    One of the reasons that I bother coming here is that there's at least five or so players here (people who don't necessarily have my economic POV) who aren't complete idiots counting on the blather of talking heads for the POVs.

    Pretty much anytime anybody tries to convince you that something so complex as our state of the economy is the result of one factor only, you pretty much know that person is clueless.

    The world (and its economy) just doesn't work that way.

    I've spend enormous time studying the root causes of what happened to this economy and I doubt I've even got a glimmer of the whole story, folks.

    The only conclusions I can come up with as yet is that nobody REALLY knows NUTTIN!

    It helps, I think to study the '29 depression just to give you an idea of how IN THE DARK, even the smartest players on the block usually are.


    With the benefit of historical hindsite, you see that what the central bankers think they are doing usually have unexpected (and often very unpleasant!) blowback.

    They operate as though the market was RATIONAL.

    It obviously is not always rational.

    If it were there'd NEVER be a bubble in any economy EVER.
     
    Last edited: Jan 28, 2011
  10. Samson
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    Samson Póg Mo Thóin Supporting Member

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    ^^^^^
    That was my point.
     

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