Who’s to Blame for the Financial Crisis? Not Who You Think

Written by Keith Ross on October 23, 2008

With banks failing and government officials searching for a way to calm investors and prevent a freezing of capital markets, many are wondering how we got into this mess in the first place. While the situation is a complex one, the financial crisis is understandable. One of the goals of this article is to follow the trail of events back to the root cause and explain it all in layman’s terms. But the search for the root cause is complicated by another factor, something that accompanies all crises, and that is the need to assign blame and mete out punishment. If that need dominates over a reasoned analysis, we get scapegoating instead of understanding.
So, let’s begin by analyzing the root cause and figure out how we arrived at a place where the government is structuring a bailout plan to the tune of $700 billion. Oddly, it has a great deal to do with expectations, ones that were not unreasonable but ultimately proved false. Think of it this way: Imagine that you could invest in something that was as American as apple pie and for fifty to sixty years it generated a return of 5% annually. Yes, there is some variance in a given geographic region, or a particular year, but over any reasonable term the returns are steady. Every year you have to decide if you will make your apple pie investment for another year, so you try to anticipate what the return will be. You look at the last 5, 10, 25, 40 years and every year it’s been 5% or so. After 55 years you don’t even ask yourself the question anymore – it’s a given that this asset will grow by 5% every year, so the only mistake you can make as an investor is to not put as much of your resources into it as possible. As I’m sure you’ve guessed, what we now have is not an apple pie investment, but something just as American, home ownership, and a brief history of investment returns in the housing market over the last six decades. Complicating this scenario is the ability of investors to harvest any gain in value of their property by taking a second mortgage and keeping their actual net equity to a minimum. It was an apparently flawless system for generating wealth: Buy a home, watch it go up in value, borrow for a vacation or home improvement, watch the value go up some more, sell your home to buy a bigger one in a new neighborhood, repeat. Who wouldn’t want a piece of this American dream come true? The lure of steady growth enticed Wall Street. At the point where the increase in value became a given, Wall Street stepped in to make the whole process easier and more efficient by “securitizing” home mortgages. This means that your local bank, which originated your mortgage, actually sold your mortgage to a Wall Street investment bank like Bear Stearns or Lehman Brothers who then bundled a thousand mortgages into one giant security, worth millions of dollars. Your local bank still “services” the mortgage, meaning they collect your payments and inform you if you are late etc., but the local bank does not own your mortgage any more – the investment banks and their customers do. Wall Street investment banks then took these giant “securitized” bundles and allowed investors to buy and trade portions of it. They separated the revenue stream generated by the interest payments from the revenue generated by the principal payments into distinct products so investors could buy and sell them. Also, parts of this securitized bundle were custom tailored to investors’ needs. Then on top of these newly created securities the firms traded derivatives, or option type securities, also based on these bundles of mortgages. Collectively, these are the “mortgage backed securities” that have become a liability to the banking and insurance industries. What complicated matters even more, was that all of these trades were conducted in the “over the counter” market, which is not regulated by an exchange that utilizes a central clearing facility. One of the most important factors in a trade being completed is called “counter party risk” which refers to whether both parties to the trade can fulfill their obligations. Since there is no clearing facility to guarantee the trade in over the counter trading, traders make a good faith assumption that the counter party will make good on the trade. In other words, the losing side of the trade will pay the winner to settle the trade. If the loser defaults – can’t pay up – then the winner is forced to take a loss instead of a gain and may end up defaulting on other trades creating a domino effect of losses. If it appears that a trading firm has a lot of positions that might default, a run on the firm’s capital can start. This is essentially what happened to Bear Stearns (and Lehman Brothers). Traders at other companies who had positions with Bear Stearns required them to put up more margin to guarantee they could make good on their positions. As their capital needs increased, it looked as though Bear Stearns might fail so the Federal Reserve forced Bear Stearns to sell to J P Morgan Chase to prevent a “run on the bank”: If Bear Stearns failed, it would trigger failures at many other firms who were their counter parties. Over the years this process of “securitization” was applied not only to mortgages, but also to car loans, credit cards, and other financial instruments. Also, the group of investors and traders participating grew very large, so that almost every kind of financial institution – investment banks, commercial banks, savings and loans, credit card companies, local banks, regional banks, insurance companies – is now involved. Although today the set of characters is different, the trading and financial relationship of all of these financial institutions creates a situation which seems eerily similar to the financial panic of 1929. If the government does not step in to stabilize the markets at this point in time, it would take many years to untangle the problem, and then many more years for the economy to recover. Even with government intervention, an economic slowdown is inevitable. That’s the reasoned analysis. What began as a shared expectation for perpetually rising housing prices became a financial crisis that threatens to affect every American. Now for the captivating question: Who is to blame and who should be punished? You could make the case that anyone who expected a commodity that had increased in value for 55 years to, by definition, increase for the 56th year contributed to the problem. Blame is currently being heaped upon those who made money trading mortgage backed securities. Perhaps it is unfair to accuse them of being ethically bankrupt or unnaturally greedy. What exactly were they doing that was so wrong? Like the homeowners with second mortgages or subprime mortgages or credit card users taking advantage of low interest rates, they were taking advantage of market opportunities created by the belief in perpetually increasing home values. Everyone from homeowners to investment bankers were participating in what many have called a “culture of greed” that valued profits and wealth over savings or disciplined investing. The entire nation participated in the wealth and prosperity that was created during this time and few were asking the important question: what is the chance that housing prices will decline? Trying to decide who was the greediest, or the most reckless, or the most at fault is like asking which raindrop caused the flood. If the search for the cause is to be about the search for understanding, then each of us needs to accept our corner of responsibility in this system wide failure. Some were in positions of greater responsibility, making decisions about investments or regulation that had impact beyond their own pocketbook and those industry and government leaders need to be held accountable, no doubt about it. But such an exercise in accountability will rise to the level of scapegoating if we deflect the portion of responsibility that is ours onto those leaders or the industries they represent. Targeting one group for particular blame or harsh punishment may make us feel better, but it hardly represents the reality of shared participation in the prosperity that preceded this crisis. Our nation faces a choice: we can engage in the emotionally satisfying game of scapegoating, forcing one or more groups to shoulder more than their fair burden of punishment and blame, or we can all take an honest look at ourselves and admit to our part in the crisis. Regulation, restraint, transparency, spending within our means, and understanding the risk of any trade or investment are as essential to a healthy Wall Street as they are to a healthy Main Street or a healthy Washington. But, let us not ask of others what we are not willing to ask of ourselves. With banks failing and government officials searching for a way to calm investors and prevent a freezing of capital markets, many are wondering how we got into this mess in the first place. While the situation is a complex one, the financial crisis is understandable. One of the goals of this article is to follow the trail of events back to the root cause and explain it all in layman’s terms. But the search for the root cause is complicated by another factor, something that accompanies all crises, and that is the need to assign blame and mete out punishment. If that need dominates over a reasoned analysis, we get scapegoating instead of understanding.

Financial Crisis 2: Let’s Blame the Shortsellers

by Keith Ross on October 23, 2008

Financial Crisis 3: The Golden Parachute

Financial Crisis: Scapegoating’s Perfect Storm

Searching for the truth amid accusations of blame.  Are we headed for a category 5 scapegoating event?  A conversation with Raven Foundation founders Keith and Suzanne Ross.

Who do you think is to blame for the crisis?

Keith Ross, founder of the Raven Foundation, analyzes the role of short sellers in the financial crisis.

Who do you think is to blame?