Stocks and News
Home | Week in Review Process | Terms of Use | About UsContact Us
   Articles Go Fund Me All-Species List Hot Spots Go Fund Me
Week in Review   |  Bar Chat    |  Hot Spots    |   Dr. Bortrum    |   Wall St. History
Stock and News: Hot Spots
  Search Our Archives: 
 

 

Wall Street History

http://www.gofundme.com/s3h2w8

AddThis Feed Button

   

03/04/2011

The Financial Crisis...the Minority View, Part II

Continuing with my look at the Financial Crisis Inquiry Commission’s findings on the causes of the financial collapse of 2007-09, following are further conclusions of the minority report, as written by three commission members – Bill Thomas, Keith Hennessy and Douglas Holtz-Eakin. 

The Ten Essential Causes of the Financial and Economic Crisis

I.  Credit bubble. Starting in the late 1990s, China, other large developing countries, and the big oil-producing nations built up large capital surpluses. They loaned these savings to the United States and Europe, causing interest rates to fall. Credit spreads narrowed, meaning that the cost of borrowing to finance risky investments declined. A credit bubble formed in the United States and Europe, the most notable manifestations of which was increased investment in high-risk mortgages. U.S. monetary policy may have contributed to the credit bubble but did not cause it.

II.  Housing bubble. Beginning in the late 1990s and accelerating in the 2000s, there was a large and sustained housing bubble in the United States. The bubble was characterized both by national increases in house prices well above the historical trend and by rapid regional boom-and-bust cycles in California, Nevada, Arizona, and Florida. Many factors contributed to the housing bubble, the bursting of which created enormous losses for homeowners and investors.

III. Nontraditional mortgages. Tightening credit spreads, overly optimistic assumptions about U.S. housing prices, and flaws in primary and secondary mortgage markets led to poor origination practices and combined to increase the flow of credit to U.S. housing finance. Fueled by cheap credit, firms like Countrywide, Washington Mutual, Ameriquest, and HSBC Finance originated vast numbers of high-risk, nontraditional mortgages that were in some cases deceptive, in many cases confusing, and often beyond borrowers’ ability to repay. At the same time, many homebuyers and homeowners did not live up to their responsibilities to understand the terms of their mortgages and to make prudent financial decisions. These factors further amplified the housing bubble.

IV. Credit ratings and securitization. Failures in credit rating and securitization transformed bad mortgages into toxic financial assets. Securitizers lowered the credit quality of the mortgages they securitized. Credit rating agencies erroneously rated mortgage-backed securities and their derivatives as safe investments. Buyers failed to look behind the credit ratings and do their own due diligence. These factors fueled the creation of more bad mortgages.

V. Financial institutions concentrated correlated risk. Managers of many large and midsize financial institutions in the United States amassed enormous concentrations of highly correlated housing risk. Some did this knowingly by betting on rising housing prices, while others paid insufficient attention to the potential risk of carrying large amounts of housing risk on their balance sheets. This enabled large but seemingly manageable mortgage losses to precipitate the collapse of large financial institutions.

VI. Leverage and liquidity risk. Managers of these financial firms amplified this concentrated housing risk by holding too little capital relative to the risks they were carrying on their balance sheets. Many placed their firms on a hair trigger by relying heavily on short-term financing in repo and commercial paper markets for their day-to-day liquidity. They placed solvency bets (sometimes unknowingly) that their housing investments were solid, and liquidity bets that overnight money would always be available. Both turned out to be bad bets. In several cases, failed solvency bets triggered liquidity crises, causing some of the largest financial firms to fail or nearly fail. Firms were insufficiently transparent about their housing risk, creating uncertainty in markets that made it difficult for some to access additional capital and liquidity when needed.

VII. Risk of contagion. The risk of contagion was an essential cause of the crisis. In some cases, the financial system was vulnerable because policymakers were afraid of a large firm’s sudden and disorderly failure triggering balance-sheet losses in its counterparties. These institutions were deemed too big and interconnected to other firms through counterparty credit risk for policymakers to be willing to allow them to fail suddenly.

VIII. Common shock. In other cases, unrelated financial institutions failed because of a common shock: they made similar failed bets on housing. Unconnected financial firms failed for the same reason and at roughly the same time because they had the same problem: large housing losses. This common shock meant that the problem was broader than a single failed bank – key large financial institutions were undercapitalized because of this common shock.

IX. Financial shock and panic. In quick succession in September 2008, the failures, near failures, and restructurings of ten firms triggered a global financial panic. Confidence and trust in the financial system began to evaporate as the health of almost every large and midsize financial institution in the United States and Europe was questioned.

X. Financial crisis causes economic crisis. The financial shock and panic caused a severe contraction in the real economy. The shock and panic ended in early 2009. Harm to the real economy continues through today.

[Regarding the housing bubble, specifically, the minority report had the following additional observations.]

The housing bubble had two components: the actual homes and the mortgages that financed them. We look briefly at each component and its possible causes.

There was a housing bubble in the United States – the price of U.S. housing increased by more than could be explained by market developments. This included both a national housing bubble and more concentrated regional bubbles in four “Sand States”: California, Nevada, Arizona, and Florida.

Conventional wisdom is that a bubble is hard to spot while you’re in one, and painfully obvious after it has burst. Even after the U.S. housing bubble burst, there is no consensus on what caused it.

While we still don’t know the relative importance of the possible causes of the housing bubble, we can at least identify some of the most important hypotheses:

--Population growth. Arizona, Florida, Nevada, and parts of California all experienced population growth that far exceeded the national average. More people fueled more demand for houses.

--Land use restrictions. In some areas, local zoning rules and other land use restrictions as well as natural barriers to building, made it hard to build new houses to meet increased demand resulting from population growth. When supply is constrained and demand increases, prices go up.

--Over-optimism. Even absent market fundamentals driving up prices, shared expectations of future price increases can generate booms. This is the classic explanation of a bubble.

--Easy financing. Nontraditional (and higher risk) mortgages made it easier for potential homebuyers to borrow enough to buy more expensive homes. This doesn’t mean they could afford those homes or future mortgage payments in the long run, but only that someone was willing to provide the initial loan. Mortgage originators often had insufficient incentive to encourage borrowers to get sustainable mortgages….

As house prices rose, declining affordability would normally have constrained demand, but lenders and borrowers increasingly relied on nontraditional mortgage products to paper over this affordability issue. These mortgage products included interest-only adjustable rate mortgages (ARMs), pay-option ARMs that gave borrowers flexibility on the size of early monthly payments, and negative amortization products in which the initial payment did not even cover interest costs. These exotic mortgage products would often result in significant reductions in the initial monthly payment compared with even a standard ARM. Not surprisingly, they were the mortgages of choice for many lenders and borrowers focused on minimizing initial monthly payments.

Fed Chairman Bernanke sums up the situation this way: “At some point, both lenders and borrowers became convinced that house prices would only go up. Borrowers chose, and were extended, mortgages that they could not be expected to service in the longer term. They were provided these loans on the expectation that accumulating home equity would soon allow refinancing into more sustainable mortgages. For a time, rising house prices became a self-fulfilling prophecy, but ultimately, further appreciation could not be sustained and house prices collapsed.”

This explanation posits a relationship between the surge in housing prices and the surge in mortgage lending. There is not yet a consensus on which was the cause and which the effect. They appear to have been mutually reinforcing.

---

Wall Street History will return next week.

Brian Trumbore



AddThis Feed Button

 

-03/04/2011-      
Web Epoch NJ Web Design  |  (c) Copyright 2016 StocksandNews.com, LLC.

Wall Street History

03/04/2011

The Financial Crisis...the Minority View, Part II

Continuing with my look at the Financial Crisis Inquiry Commission’s findings on the causes of the financial collapse of 2007-09, following are further conclusions of the minority report, as written by three commission members – Bill Thomas, Keith Hennessy and Douglas Holtz-Eakin. 

The Ten Essential Causes of the Financial and Economic Crisis

I.  Credit bubble. Starting in the late 1990s, China, other large developing countries, and the big oil-producing nations built up large capital surpluses. They loaned these savings to the United States and Europe, causing interest rates to fall. Credit spreads narrowed, meaning that the cost of borrowing to finance risky investments declined. A credit bubble formed in the United States and Europe, the most notable manifestations of which was increased investment in high-risk mortgages. U.S. monetary policy may have contributed to the credit bubble but did not cause it.

II.  Housing bubble. Beginning in the late 1990s and accelerating in the 2000s, there was a large and sustained housing bubble in the United States. The bubble was characterized both by national increases in house prices well above the historical trend and by rapid regional boom-and-bust cycles in California, Nevada, Arizona, and Florida. Many factors contributed to the housing bubble, the bursting of which created enormous losses for homeowners and investors.

III. Nontraditional mortgages. Tightening credit spreads, overly optimistic assumptions about U.S. housing prices, and flaws in primary and secondary mortgage markets led to poor origination practices and combined to increase the flow of credit to U.S. housing finance. Fueled by cheap credit, firms like Countrywide, Washington Mutual, Ameriquest, and HSBC Finance originated vast numbers of high-risk, nontraditional mortgages that were in some cases deceptive, in many cases confusing, and often beyond borrowers’ ability to repay. At the same time, many homebuyers and homeowners did not live up to their responsibilities to understand the terms of their mortgages and to make prudent financial decisions. These factors further amplified the housing bubble.

IV. Credit ratings and securitization. Failures in credit rating and securitization transformed bad mortgages into toxic financial assets. Securitizers lowered the credit quality of the mortgages they securitized. Credit rating agencies erroneously rated mortgage-backed securities and their derivatives as safe investments. Buyers failed to look behind the credit ratings and do their own due diligence. These factors fueled the creation of more bad mortgages.

V. Financial institutions concentrated correlated risk. Managers of many large and midsize financial institutions in the United States amassed enormous concentrations of highly correlated housing risk. Some did this knowingly by betting on rising housing prices, while others paid insufficient attention to the potential risk of carrying large amounts of housing risk on their balance sheets. This enabled large but seemingly manageable mortgage losses to precipitate the collapse of large financial institutions.

VI. Leverage and liquidity risk. Managers of these financial firms amplified this concentrated housing risk by holding too little capital relative to the risks they were carrying on their balance sheets. Many placed their firms on a hair trigger by relying heavily on short-term financing in repo and commercial paper markets for their day-to-day liquidity. They placed solvency bets (sometimes unknowingly) that their housing investments were solid, and liquidity bets that overnight money would always be available. Both turned out to be bad bets. In several cases, failed solvency bets triggered liquidity crises, causing some of the largest financial firms to fail or nearly fail. Firms were insufficiently transparent about their housing risk, creating uncertainty in markets that made it difficult for some to access additional capital and liquidity when needed.

VII. Risk of contagion. The risk of contagion was an essential cause of the crisis. In some cases, the financial system was vulnerable because policymakers were afraid of a large firm’s sudden and disorderly failure triggering balance-sheet losses in its counterparties. These institutions were deemed too big and interconnected to other firms through counterparty credit risk for policymakers to be willing to allow them to fail suddenly.

VIII. Common shock. In other cases, unrelated financial institutions failed because of a common shock: they made similar failed bets on housing. Unconnected financial firms failed for the same reason and at roughly the same time because they had the same problem: large housing losses. This common shock meant that the problem was broader than a single failed bank – key large financial institutions were undercapitalized because of this common shock.

IX. Financial shock and panic. In quick succession in September 2008, the failures, near failures, and restructurings of ten firms triggered a global financial panic. Confidence and trust in the financial system began to evaporate as the health of almost every large and midsize financial institution in the United States and Europe was questioned.

X. Financial crisis causes economic crisis. The financial shock and panic caused a severe contraction in the real economy. The shock and panic ended in early 2009. Harm to the real economy continues through today.

[Regarding the housing bubble, specifically, the minority report had the following additional observations.]

The housing bubble had two components: the actual homes and the mortgages that financed them. We look briefly at each component and its possible causes.

There was a housing bubble in the United States – the price of U.S. housing increased by more than could be explained by market developments. This included both a national housing bubble and more concentrated regional bubbles in four “Sand States”: California, Nevada, Arizona, and Florida.

Conventional wisdom is that a bubble is hard to spot while you’re in one, and painfully obvious after it has burst. Even after the U.S. housing bubble burst, there is no consensus on what caused it.

While we still don’t know the relative importance of the possible causes of the housing bubble, we can at least identify some of the most important hypotheses:

--Population growth. Arizona, Florida, Nevada, and parts of California all experienced population growth that far exceeded the national average. More people fueled more demand for houses.

--Land use restrictions. In some areas, local zoning rules and other land use restrictions as well as natural barriers to building, made it hard to build new houses to meet increased demand resulting from population growth. When supply is constrained and demand increases, prices go up.

--Over-optimism. Even absent market fundamentals driving up prices, shared expectations of future price increases can generate booms. This is the classic explanation of a bubble.

--Easy financing. Nontraditional (and higher risk) mortgages made it easier for potential homebuyers to borrow enough to buy more expensive homes. This doesn’t mean they could afford those homes or future mortgage payments in the long run, but only that someone was willing to provide the initial loan. Mortgage originators often had insufficient incentive to encourage borrowers to get sustainable mortgages….

As house prices rose, declining affordability would normally have constrained demand, but lenders and borrowers increasingly relied on nontraditional mortgage products to paper over this affordability issue. These mortgage products included interest-only adjustable rate mortgages (ARMs), pay-option ARMs that gave borrowers flexibility on the size of early monthly payments, and negative amortization products in which the initial payment did not even cover interest costs. These exotic mortgage products would often result in significant reductions in the initial monthly payment compared with even a standard ARM. Not surprisingly, they were the mortgages of choice for many lenders and borrowers focused on minimizing initial monthly payments.

Fed Chairman Bernanke sums up the situation this way: “At some point, both lenders and borrowers became convinced that house prices would only go up. Borrowers chose, and were extended, mortgages that they could not be expected to service in the longer term. They were provided these loans on the expectation that accumulating home equity would soon allow refinancing into more sustainable mortgages. For a time, rising house prices became a self-fulfilling prophecy, but ultimately, further appreciation could not be sustained and house prices collapsed.”

This explanation posits a relationship between the surge in housing prices and the surge in mortgage lending. There is not yet a consensus on which was the cause and which the effect. They appear to have been mutually reinforcing.

---

Wall Street History will return next week.

Brian Trumbore