Sometimes, when you lose a debate, you have to just let it go. That seems to be a problem for those who are unwilling to accept the complex realities of what actually caused the financial crisis.
I have been saying for a long time that many elements contributed to the global financial meltdown. From ultralow rates to misaligned incentives to radical deregulation to changes in the business models of the credit-rating companies to plain old bad decision-making by homebuyers — the list is long.
Discussions of causation frustrate those who seek to oversimplify the complex as they pursue a political agenda (see Peter Wallison at the American Enterprise Institute).
A new group of economists recently challenged the prevailing theory for what caused the crisis. Rather than repeat my earlier admonitions, I want to try a different tack, taking a page from Nicolaus Copernicus, best known for positing that the earth rotates around the sun, not the other way around.
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What is so interesting is that he started out with an implied challenge to explain movements of the planets without resorting to “cheats” — unsupported explanations for observable planetary motions in order to make the data fit a flawed model.1
So let’s follow Copernicus’ example and pose a series of challenges. Any theory that claims to explain the financial crisis should be able to answer these 10 questions:
No. 1. Federal Reserve Chairman Alan Greenspan engaged in unprecedented interest rate cuts: From the end of 2001 to the end of 2004, the federal funds rate was less than 2 percent; for an entire year, he kept it at 1 percent.
What was the impact of ultralow interest rates on housing, credit and derivatives?
No. 2. The credit-rating companies, including Standard & Poor’s and Moody’s, were originally research firms, selling their credit analysis and debt ratings, mainly to corporate bond issuers. That changed in the late 1990s to a model where syndicators and securitizers became their dominant clients.
What was the impact of this model change on securitized products? How did this affect the quality of ratings on AAA-rated junk securities?
No. 3. The Commodities Futures Modernization Act of 2000 removed all oversight, including reserve requirements, exchange listings and disclosures, from derivatives.
How did this affect the risk appetite of American International Group Inc. for underwriting derivatives? What was its effect on Bear Stearns Cos., Lehman Brothers Holdings Inc., Citigroup Inc., Bank of America Corp. and Merrill Lynch?
No. 4. From 1975 to 2004, brokerage firms were limited to 12-to-1 leverage by the Securities and Exchange Commission’s net capitalization rule. The five largest investment banks asked for an exemption from those leverage restrictions. It was granted, and became known as “the Bear Stearns exemption” (it was the smallest investment bank that qualified for it).
What did this do to bank leverage subsequently? How much did this affect the crisis?