Financial Crisis

September 27, 2008

Failures fascinate me, they always have. The current financial crisis is no exception. There is no shortage of opinion on the cause of this crisis. Housing, mortgages, financial institutes, and government regulation are all involved but I see little clarity or consensus on what caused the failure and what interventions might help alleviate the crisis.

I have wondered in the past what is different between the Canadian and U.S. systems. Recently a report claimed that Canada may be heading for an American-like meltdown. Although Canada’s economy is very much tied to the U.S. economy, the fundamental components of the meltdown are different, in my opinion.

I have heard the crisis referred to as a “perfect storm”. In my mind, the perfect storm analogy refers to a well understood system in which independent variables simultaneously reach a state that produce maximum nastiness. Watch the variables and you can predict when it is time to pray.

The U.S. financial crisis is not like a perfect storm. It is a classic nonlinear system in which we don’t understand the critical variables nor their expected behavior when these variables change. Here is my guess at what the critical variables are/were in this crisis:

  1. Government policy/agencies that promote home ownership
  2. Shift to mortgage-backed securities
  3. Foreign investors (e.g. sovereign wealth funds) looking for safe U.S. money market investments
  4. Lowest interest rate in history during 2001-2004
  5. An oversupply of housing

Compared to Canada, the U.S. has many more incentives for people to buy homes. Fannie Mae and Freddie Mac with an implied government insurance policy, tax deductible mortgage interest, and laws that required lending to traditionally high-risk individuals.

Mortgage-backed securities for years were hailed as a major innovation in the financial industry (Canada lagged in this department). Risk was measured by 3rd party rating agencies and shifted in bulk to all the owners of the securities. The incentives in this system encouraged deceit and sometimes fraud by both lenders and borrowers. 

The incredible growth of China and other nations produced central banks and sovereign wealth funds that were flush with cash. There was a great deal of demand for safe money market financial instruments and mortgage-backed securities looked attractive compared to treasury bills at historic lows. Only the U.S. economy is large enough to meet the safety requirements these institutions demanded.

Some blame Alan Greenspan for this mess because he did not investigate the early signs of this crisis and because the historically low interest rate. This interest rate was set low to bolster the economy after 9/11 fueled the mortgage meltdown. Low interest rates together with government incentives for home ownership made buying a home seem “free”. Low interest rates made traditional money market products unattractive and a race was on to offer new alternatives (i.e. mortgage-backed securities). 

Finally, an over-supply of housing made sure that the housing bubble would eventually pop rather than deflate. 

Was there greed? Sure, pockets of it but it was not a key driver like it was for the Internet stock bubble. Fraud, again, pockets of it but certainly many orders of magnitude less than with Enron. Over enthusiastic investors? I find it hard to believe that anyone thought that mortgages were anything other than a safety play (but I certainly could be wrong). Regulators asleep at the wheel? Considering how complex this crisis is, I find it hard to believe that anyone could have prevented the crisis with prescient regulation. I doubt anyone can create new regulations now that would do less harm than good moving forward. 

So will the 700 Billion plan fix things? I dunno. It makes for good theater though doesn’t it. Who says government doesn’t support the arts.