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«Abstract What caused the crisis? Initially many thought that it was due to incentive problems in the U.S. mortgage industry. However, after the large ...»

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An Overview of the Crisis:

Causes, Consequences and Solutions*

Franklin Allen

University of Pennsylvania



Elena Carletti

European University Institute


November 26, 2009


What caused the crisis? Initially many thought that it was due to incentive problems in

the U.S. mortgage industry. However, after the large economic meltdown following

Lehman Brothers' bankruptcy in September 2008, it seems that much more was going on.

We argue that there was a bubble in real estate prices in the U.S. and a number of other countries. The main causes of the bubble were loose monetary policy, particularly by the U.S. Federal Reserve, and global imbalances. The combination of cheap credit together with the easy availability of funds contributed to create the bubble. Many other factors such as subprime mortgages, weak regulatory structures, and high leverage in the banking sector exacerbated the effects of the crisis. We consider possible reforms aimed at minimizing the occurrence of future crises in the governance structure of central banks, measures to reduce global imbalances, and changes in banking regulation.

* Presented at the conference on Global Market Integration and Financial Crises at HKUST, July 12-13,

2009. We are grateful to the participants and particularly to our discussant Susan Wachter for very helpful comments and suggestions.

1. Introduction As Carmen Reinhart and Kenneth Rogoff remind us in the title of their book, This Time is Different: Eight Centuries of Financial Folly, financial crises are nothing new (Reinhart and Rogoff 2009a). However, they often come as a surprise to many people because in most countries they appear only periodically. The current crisis has come as a particular shock partly because it has been over seventy years since the Great Crash of 1929 and the Great Depression that followed. There have been crises in many other parts of the world in the last few decades. Many of these were in emerging or middle income countries such as Argentina, Mexico, and Turkey, but not all. The crises in Japan and in Scandinavia in the 1990’s stand out as being particularly severe. However, they had little impact on U.S. policymakers and institutions. For example, after Sweden’s Riksbank started to publish a Financial Stability Review, about forty other central banks followed their lead. One notable exception was the U.S. Federal Reserve.

This paper considers the causes and consequences of the crisis started in the summer 2007 and how the financial system should be reformed in terms of institutions and regulations to prevent such damaging episodes in future. Despite its severity and its ample effects, the current crisis is similar to past crises in many dimensions. Reinhart and Rogoff (2008a, 2008b, 2009a, 2009b) document the effects of banking crises using an extensive data set of high and middle-to-low income countries. They find that systemic banking crises are typically preceded by credit booms and asset price bubbles.

This is consistent with Herring and Wachter (2003) who show that many financial crises are the result of bubbles in real estate markets. In addition, Reinhart and Rogoff find that crises result, on average, in a 35% real drop in housing prices spread over a period of 6

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unemployment rises 7% over a period of 4 years. Central government debt rises 86% compared to its pre-crisis level. Reinhart and Rogoff warn that the global nature of this crisis will make it far more difficult for many countries to grow their way out.

A thorough overview of the events preceding and accompanying the current financial crisis is provided in Adrian and Shin (2009), Brunnermeier (2009), Greenlaw et al. (2008), and Taylor (2008). The seeds of the crisis can be traced to the low interest rate policies adopted by the Federal Reserve and other central banks after the collapse of the technology stock bubble. In addition, the appetite of Asian central banks for (debt) securities contributed to lax credit. These factors helped fuel a dramatic increase in house prices in the U.S. and several other countries such as Spain and Ireland. Taylor (2008) documents that these were the countries where monetary policy was loose according to standard measures. In 2006 this bubble reached its peak in the U.S. and house prices there and elsewhere started to fall. Mayer, Pence and Sherlund (2009) and Nadauld and Sherlund (2008) provide excellent accounts of the developments in the housing market preceding the crisis.

The fall in house prices led to a fall in the prices of securitized subprime mortgages, affecting financial markets worldwide. In August 2007 the interbank markets, particularly for terms longer than a few days, experienced considerable pressures and central banks were forced to inject massive liquidity. Conditions in collateralized markets also changed significantly. Haircuts increased and low quality collateral became more difficult to borrow against. The Federal Reserve and other central banks introduced a wide range of measures to try to improve the functioning of

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continued to fall and many financial institutions started to come under strain. In March of 2008 the Federal Reserve bailed out Bear Stearns through an arranged merger with J.

P. Morgan. Public funds and guarantees were required to induce J. P. Morgan to engage in the transaction.

Although the financial system and in particular banks came under tremendous pressure during this time, the real economy was not much affected. All that changed in September 2008 when Lehman’s demise forced markets to re-assess risk. While Lehman's bankruptcy induced substantial losses to several counterparties, its more disruptive consequence was the signal it sent to the international markets that credit risk in the banking sector and financial industry was a serious concern. Reassessing risks previously overlooked, investors withdrew from the markets and liquidity dried up.

In the months that followed and in the first quarter of 2009 economic activity in the U.S. and many other countries declined significantly. Unemployment in the U.S. and a number of other countries rose dramatically as a result. The general consensus is that the crisis is the worst since the Great Depression.

In what follows we analyze in more detail the causes and consequences of the crisis as well as the need for a series of reforms in the financial system. In particular, we start discussing the causes of the crisis in Section 2 and we focus on the real estate bubble in Section 3. The effects of the crisis on the real economy are analyzed in Section 4 and those on the financial system in Sections 5 and 6. Section 7 considers the role of banking regulation in the current crisis while Section 8 considers how the crisis will evolve.

Section 9 considers reforms to limit risk taking in the public sector, Section 8 looks at

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Finally, Section 12 concludes.

2. What caused the crisis?

From August 2007 until September 2008, there was fairly wide agreement that poor incentives in the U.S. mortgage industry had caused the problem. According to this explanation what had happened was that the way the mortgage industry worked had changed significantly over the years. Traditionally, banks would raise funds, screen borrowers, and then lend out the money to those approved. If the borrowers defaulted, the banks would bear the losses. This system provided good incentives for banks to carefully assess the creditworthiness of borrowers.

Over time, that process changed and incentives were altered. Instead of banks originating mortgages and holding on to them, brokers and also some banks started originating them and selling them to be securitized. This process is termed the “originate to distribute model.” The originators, the brokers and the banks, were paid based on the number of mortgages that they approved so their incentives were to approve as many mortgages as possible. Since they were selling them off, it wasn't their problem in the long run if the borrowers defaulted.

The second stage in this new originate to distribute mortgage system was securitization. The entities that undertook securitizations such as investment banks would pool a whole set of mortgages together. These would be taken from across the country so they would have good risk properties in terms of diversification. The securitizing investment bank would then tranche them so that the risk was spread differentially, depending on the

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default losses first. Then as more losses were accumulated these would exhaust the lowest tranche and start to be allocated to the next most senior one and so on up the seniority chain.

There would have to be a large amount of losses before the most senior ones would bear any losses so they were regarded as fairly risk-free and were rated triple-A. More junior tranches had lower ratings.

Initially with this new system, the most junior tranches were retained by the investment bank or other entity doing the securitization. If there was a problem, they would be hit first. The reason for this was to provide good incentives to those doing the securitization to ensure that the originations and the subsequent sale were done properly.

Increasingly what happened, though, was that all tranches were sold off, including the junior ones. This took away the incentives for the financial institutions doing the securitization to check that everything was done properly. In a careful empirical study, Purnanandam (2009) found that mortgages that were originated under the new originate to distribute model were of significantly lower quality than those originated under the traditional system where they were held on the originating bank’s balance sheet.

Another important incentive issue concerned the ratings agencies. Since buyers of the tranches used ratings as part of the input to their decisions, an important question was whether the ratings agencies were checking the process properly. Many argue that they were not because they began to receive a large proportion of their income from undertaking ratings of the securitized products. The suggestion is that they started to lose their objectivity and to give ratings that weren't justified.

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checking the quality of the borrowers, and the mortgages underlying the securitizations broke down. This view of the world suggested that it would be fairly simple to solve the crisis and stop it from reoccurring. If the government regulated the mortgage industry to ensure everybody had the correct incentives, then this would prevent the problem in the future.

It seems from the statements of the Federal Reserve and the Treasury at the time that initially this was the view that they took. However, as the crisis continued and in particular after the default of Lehman, the dramatic collapse in the global real economy made this view that subprime mortgages were mainly to blame less and less plausible.

At the end of 2008 and beginning of 2009 the economies in many countries in Asia and in Europe were drastically affected even though their banks had very little exposure to U.S. securitizations and remained strong. In Japan, for example, GDP fell by around 4 percent in the first quarter of 2009. Less extreme drops in industrial production and GDP than those experienced in Japan were occurring all over the world and the world economy began to gradually seize up. As this happened it became much more difficult to believe that what caused all of this was an incentive problem in the U.S. mortgage industry. What was going on then?

3. The real estate bubble We shall argue that the basic problem that caused the crisis was that there was a bubble in real estate in the U.S. and also in a number of other countries such as Spain and Ireland. What happened is that the bubble burst, and this caused the huge problems in the securitized mortgage market and in the real economy. The bubble was large and global in 6 many ways. In 2005 The Economist surveyed the widespread increase in property prices

and warned:

[T]he total value of the residential property in developed economies rose by more than $30 trillion over the past five years to over $70 trillion, an increase equivalent to 100% of those countries’ combined GDPs. Not only does this dwarf any previous house-price boom, it is larger than the global stock market bubble in the late 1920s (55% of GDP). In other words it looks like the biggest bubble in history.1 Figure 1 shows the Case-Shiller 10-city index since 1990. The figure illustrates the dramatic acceleration in house price increases in the early 2000s and their fall since July

2006. Figure 2 shows the year-on-year change in this index.

The next question is: What caused the bubble? We argue that there were two main causes. The most important reason that the bubble was so big in the U.S. was the policies of the Federal Reserve back in 2003-2004. What they did to avoid a recession after the collapse of the tech bubble in 2000 and the 9/11 terrorist attacks in 2001 was to cut interest rates to the very low level of one percent. Taylor (2008) has argued that this was much lower than in previous U.S. recessions relative to the economic indicators at the time captured by the “Taylor rule”. During this period housing prices were already rising quite rapidly. For example, it can be seen from Figure 2 that the Case-Shiller 10-City composite index was growing at a rate above 8 percent throughout this period. The Federal Reserve created a significant incentive for people in many parts of the country to go out and borrow at one percent and buy houses going up at much higher rate. In addition there were various other public policies that made it advantageous to buy. These included the tax advantages of being

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plus a number of other policies to encourage poor people to buy houses. All these factors created a large demand for houses that led to increases in house prices as shown in Figure 2.

Even when the Fed eventually started to raise interest rates in June of 2004, it was still worth borrowing because house prices continued to rise at a rate above 8 percent until 2006 as shown in Figure 2. Thus the Fed’s low interest rate policy was the first factor that really caused prices to take off.

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