This article is going to be the second part of our de facto series on what caused the 2008 financial crisis as we wrap up in explaining the main factors of the greatest economic catastrophe in modern times. In addition to the rise in subprime lending, an unstable housing bubble, historically-low interest rates, and unprecedented financial complexity (all detailed in our previous article), there are just 3 other components that deserve an explanation of their own. Here they are…
Deregulation
In 2011, the Financial Crisis Inquiry Commission (a group of 10 people appointed by US Congress tasked with figuring out, you know, what happened) said “We had a 21st century financial system with 19th century safeguards.” The rolling back of the red tape has long been pointed to as a key culprit of the 2008 financial crisis, in which too much faith was placed in the supposedly self-correcting nature of market forces. Put simply, proper risk management does not always coincide with profit-seeking mechanisms.
The interesting thing about this factor, however, is that we have to go back decades all the way to 1980, a time when the United States was shifting towards ideals such as privatization, loosening business restrictions, lower taxes, etc. Although the deregulation took place across the entire economy, the areas we’re interested in are banking and finance. The pivotal legislations in this regard are as follows:
Depository Institutions Deregulation and Monetary Control Act (DIDMCA). Gave banks greater lending powers as well as loosened restrictions on the handling of depositor money. Credit unions (basically a non-profit, worker co-op commercial bank), for example, were now allowed to offer checking accounts under DIDMCA
Commodity Futures Modernization Act of 2000. Ensured that over-the-counter derivatives (ones that aren’t traded on an exchange) would be unregulated. When financial products, particularly the complicated ones that few actually understand, are suddenly no longer subject to government oversight, they’re going to be used in pretty questionable ways
Garn-St. Germain Depository Institutions Act. Signed into law by President Ronald Reagan in 1982, this bill did 2 main things: began deregulating savings and loan associations (banks that specialize in mortgages) and, perhaps more importantly in relation to the 2008 crisis, allowed banks to offer adjustable-rate mortgages (home loans with variable interest rates that fluctuate in accordance with an underlying benchmark interest rate that changes overtime). That second provision especially is blamed for giving rise to assets such as 2/28 adjustable-rate mortgages (2/28 ARM), in which the mortgage’s interest rate would be based on an index rate plus a margin after 2 years of being stuck with a fixed interest rate
Gramm-Leach-Bliley Act. To understand this law, we need to first understand the Glass-Steagall Act of 1933, which separated commercial and investment banking. What this meant for commercial banks is that they couldn’t involve themselves in assets that weren’t government-approved. Gramm-Leach-Bliley unrolled these restrictions, hence permitting commercial banks and investment banks to compete and do business with one another. As some of you might already know, this law is among the more well-known and controversial ones pertaining to the 2008 financial crisis. Critics argue that Wall Street messing around home mortgages and creating “too big to fail” institutions (companies that are so big that letting them go bankrupt would have catastrophic effects on the entire economy) would’ve all been largely prevented had we kept Glass-Steagall. But others point out that the actual institutions that failed would’ve been allowed under Glass-Stegall, and so not much damage would have been mitigated
Relaxing the net capital rule. In 2004, the SEC increased the amount of debt banks were allowed to take on (which is what relaxing the net capital rule refers to). This allowed huge investment banks such as Goldman Sachs and Morgan Stanley to build up their leverage so that they could get in on the subprime mortgage action
Overleveraging
Leverage refers to using debt as a means to purchase an asset and as shown in the graph above, investment banks went crazy with leverage in the years leading to 2008. Now while leverage may allow people to get their hands on assets that they otherwise would not be able to, it also makes affairs a little more vulnerable. If the buyer, who took out a loan to purchase the asset, buys something that decreases in value, meaning they sell the asset at a net loss, then the person who lent the money won’t get their principle + interest back. In other words, both parties lose.
Keep in mind that leveraging isn’t inherently bad per se, but with the way it was carried out in 2008, it was catastrophic - people were spending cash as if it were actually theirs when it was in fact debt. The problem was that investment banks were using leverage to get their hands on crummy subprime assets instead of reliable ones. This all made it easier to fill portfolios with junk, and doing so with your own money might be bad enough, but with money that you owe to someone else? That’s a recipe for disaster.
And all this debt accumulation wasn’t just concentrated on Wall Street; it was across the entire economy. US home mortgage debt relative to GDP, for example, went from under 50% in 1980 to well over 70% in the years leading to 2008:
Bad Risk Analysis
All investment by nature involves risk. Even buying 30-year T-Bonds and insuring them via credit default swaps is “risky” in that there’s a chance of the investor losing their money. Thus, understanding the risk a given asset bears is crucial to a well-functioning financial system. Conversely, a distorted knowledge of an asset’s riskiness leads money into the wrong places.
In the case of the 2008 crisis, some scholars go as far as to pin the inaccurate risk analysis as the biggest cause of the crash. Think about it - had the financial system known of and acted accordingly with how unsound the subprime assets truly were, there arguably would have never been any major crash once those assets failed since no one would be interested in them. Heck, there might not have been a subprime market in the first place if enough people avoided them.
As for why the risk analysis tanked in accuracy, there are 2 key reasons for this. We alluded to the first one, namely the increasing of financial complexity, in our previous article. In short, the increased distance between investors and the actual mortgages (through a chain of additional assets and derivatives) ended up obfuscating information regarding the mortgages. The second reason has to do with incentives.
In finance, you have what are called investment management professionals and institutional investors. The former essentially maintain a given investment portfolio and ensure that it’s on track to meet the owner’s goals, and the latter are people who invest on others’ behalf, typically other companies. Investment managers are generally compensated based on how many assets are under their assigned portfolio. So when looking to increase their pay, investment managers will accumulate more and more assets under their clients’ portfolios until one day, they hit really risky territory. Given the abundance of these products and their increasing yields at the time, most managers simply descended into the subprime rabbit hole.
Econ IRL
When we talk about school closures in relation to the COVID-19 pandemic, a lot of people’s minds immediately jump to the children. This makes sense given how it’s going to be for the children who now have to continue their education via Zoom meetings instead of walking into a classroom. This week’s paper shines light on the flip side of the coin: the parents. How are parents affected by these school closures? Specifically, how were their working hours affected?
As expected, school closures did indeed reduce parents’ time at work - by nearly 4% for mothers and 2.5% for fathers. This gender disparity, however, is reduced when controlling for higher education attainment as those with college degrees showed significantly less declines in working hours across the board, probably because more-educated workers could work from home and better arrange at-home childcare. Even among unmarried parents, the researchers found that women were more likely than men to shift to part-time work.
‘Till next time,
SoBasically