Skip to main content

Q&A: Answers from an economist

Remember the first half of 2008? The stock market was healthy, unemployment low, and inflation under control. Then, seemingly in the blink of an eye, the financial world fell into chaos. Within a few months, Wall Street investment banks were on the brink of collapse.

Their struggles spilled into the commercial banking sector, impacting banks ordinary people deal with daily. And not just small banks: Mighty Wachovia went under, forcing the government-sponsored takeover by Wells Fargo. Other large commercial banks required help from the Federal Reserve System to prevent them from failing. Nearly four years later, the economy is still underperforming and citizens are increasingly irate.

Neil Skaggs

Economics Professor Emeritus Neil Skaggs.

The media pay attention to protests tied to the nation’s largest financial meltdown since the Great Depression, focusing intently on the Occupy Wall Street movement. There is little in-depth discussion, however, as to how the economy spiraled into such turmoil. Economics Professor Emeritus Neil Skaggs, who taught ISU money and banking classes as well as monetary theory for 31 years, provides an explanation.

Illinois State: What caused our financial catastrophe?

Skaggs: I believe the major forces that brought down the housing market and Wall Street were greed and hubris. Everyone knows what greed can do, but we often overlook hubris: excessive pride or self-confidence. The main players in the Wall Street firms were exceedingly confident in their own abilities. And after reading All the Devils Are Here by Bethany McLean and Joe Nocera, I’m convinced sheer greed played a substantial role in the mistakes that were made.

Illinois State: Why did the crisis come as such a surprise?

Skaggs: The short answer is the nature of the financial system. Following the Great Depression, during which thousands of banks failed, the federal government and state governments enacted laws limiting the scope of commercial banking. Most of those laws remained in place until the 1990s, at which time intense competition threatened to force a substantial percentage of U.S. banks out of business. The government had no choice but to loosen bank regulations.

Illinois State: How did the large commercial banks respond?

Skaggs: They began moving into areas that promised much higher profit margins, such as financial derivatives, and particularly derivatives based on residential housing.

Illinois State: What is a financial derivative?

Skaggs: It’s the financial market’s version of Frankenstein’s monster. Any particular derivative contains pieces of hundreds of mortgages that were made by banks, savings and loans, and mortgage companies. Some mortgages were really good—such as AAA mortgages obtained by buyers who could make sizable down payments and handle their debts. Other mortgages were riskier. At the bottom you find the really risky sub-prime mortgages with substantial default risk. The companies that purchase derivatives can buy anything from the AAA portion of the derivative to the “toxic waste,” meaning the riskiest assets in the derivative.

Illinois State: Why would anyone make a “toxic” investment?

Skaggs: High risk, but potentially high return. Some mortgage companies earned very good returns on lower-rated mortgages for years. Then came a lethal combination of greed, an over-heated housing boom fueled by FANNIE MAE and FREDDIE MAC, and loose monetary policy orchestrated by Alan Greenspan at the Federal Reserve. Sheer dishonesty also played a significant role.

Illinois State: What kind of dishonesty?

Skaggs: Primarily overstating the quality of synthetic assets. A financial derivative was linked to particular securities. The triple-A tranche (slice) of a derivative is supposed to contain pieces of high quality individual assets. In their lust for profits, some companies added less than triple-A quality securities to their superior tranches. They were, in effect, lying to and stealing from their customers. Ratings agencies of Moody’s and Standards and Poors aided the companies. They were willing, for hefty fees, to rate junk much higher than it should have been rated. FANNIE and FREDDIE were up to their eyeballs in creating derivatives. As government sponsored entities, they should have held to a higher standard, but instead were a big part of the problem.

Illinois State: What brought down this house of cards?

Skaggs: First, the housing boom ran out of steam. With fewer people buying new homes, there were fewer assets to be collateralized, fewer derivatives to sell, and prices were falling. Second, the default rates of subprime mortgages rose precipitously, so the prices of derivatives fell precipitously. This process was aided and abetted by short selling by insiders, who owned huge quantities of derivatives.

Illinois State: What is short selling?

Skaggs: Insiders borrowed derivative assets and sold them while prices were still high. A few weeks later, they replaced the borrowed derivatives. In the meantime, derivative prices fell precipitously. So the “short buyers” spent a fraction of the price to replace the securities they had borrowed. It was insider trading. Very quickly, the market for mortgage securities deteriorated. Companies that had invested in housing securities began spewing red ink.

Illinois State: And FANNIE and FREDDIE were hit hard too?

Skaggs: They were hit very hard. Investment banks that had invested heavily in the housing market, as well as FANNIE and FREDDIE and a hand-full of commercial banks, were bleeding red ink too. Some investment banks, and eventually some commercial banks, couldn’t meet their obligations. They began pleading for help from the federal government.

Illinois State: Why did bankers think the federal government would bail them out?

Skaggs: Because as a group, and in some cases individually, they were too big to fail.  Since the Great Depression, the U.S. government and the Federal Reserve have committed to mitigating financial collapses. The bank failures in the 1930s caused such terrible and long-lasting economic harm that our government has taken a “never again” stance when facing financial meltdowns. And yet, there was resistance to the bailout within the government—especially within the Federal Reserve Board. The presidents of the St. Louis and Dallas Federal Reserve Banks, in particular, were initially reluctant to commit massive resources to rescue rich investment firms in New York City. The leadership of Ben Bernanke helped. The new Federal Reserve Board chairman, Bernanke was a consensus builder. A former Harvard University economics professor, he was known as the expert on the financial collapse in the 1930s.

Illinois State: How did the Fed respond?

Skaggs: They ramped up the money loaned to investment banks. Although the Fed had no authority to lend to investment banks in general, there is a clause in the relevant law that allows the Fed to lend to entities other than commercial banks in extreme circumstances. So the Fed loaned quite a lot of money to Bear Stearns to keep it afloat. Some other investment banks also got loans from the Fed or the Treasury.

Illinois State: Why, when the government bailed out Bear Stearns and other investment banks, did it refuse to bail out Lehman Brothers?

Skaggs: In part because Lehman Brothers had been skirting the edge of the law. Their dealings with Famco, a mortgage outfit with a sleazy reputation, made Lehman an easy choice to be the example for corruption in the housing finance industry. In political terms, the Bush Administration and the Federal Reserve had done about as much as they figured the American public could stomach.

Illinois State: Have we weathered the storm?

Skaggs: The economy is beginning to gain traction, but monetary problems in Europe could reduce the demand for U.S products, leading to a more anemic rebound for the U.S. economy than we might like.

 

Comments

Several questions;
* Please specify the terms "greed and hubris". Very rhetorical but disappointing for an esteemed dukie. Perhaps these 'forces' have been ubiquitous thruout history? Perhaps a comment on historical bubble markets and context is useful.
* Reference to Frankenstein is similar nonsense; like euro references to Frankenfoods. Financial derivatives are not an economic monster in any sense more than genetic engineering is a biologic monster. They have risks and returns.
* If one discounts greed and hubris as immaterial, the role of Fannie and Greenspan is consequential. More discussion in this area has substance.
* The terms "lying to and stealing from customers" might be loose language. If so, have there been a vast amount of successful criminal prosecutions? These transactions had very sophisticated investors on both sides of the deals
* This dialog about a huge historical event seems worthy of enhancement. Perhaps the fraud of Ninja mortgage applicants, gross malfeasance at Fannie/Freddie abetted by political cover, and deeper thinking/discussion about derivatives and short sellers is important in documenting the record.
Hope you are well Neil. I just could not let this go without comment.
Mack

Suggest review of this thinking

http://www.becker-posner-blog.com/2012/02/is-capitalism-in-crisis-becker.html

John : I appreciate your points. Certainly, one can lay blame on a variety of political and business leaders over a substantial period of time. Though I am a mere academic, not an insider in any markets, it was clear o me by 2006 (and perhaps a year earlier, though I can't document the additional year) that political heavy-weights were working hard to increase "home ownership." My first response, when I began studying the situation was that the politicians pushing housing were not worrying much about the financial consequences of the subsidization of residential construction.

RE derivatives, what really caught my attention was the ratio o hight powered mathematics used to define derivatives relative to the paucity of time-series data used to guage how the derivatives would behave. A Chinese matematician formulated Li's copula, a guide to building derivatives that could, theoretically, offset nearly any sort of shock the market lealt out. Unfortunately, the model was tested on a data set that was, if memory serves, about six years long. That's not a lot of data to build an accurate expectation of how the derivatives would behave if hit with substantial "shocks".

It's also true that the book "All the Devils aAre Here" by Bethany McLean and Joe Nocera formed my viewpoint when writing the piece.

NTS