The 2007–2009 Financial Crisis
Most economists thought that financial crises of the type experienced during the Great Depression were a thing of the past for the United States. Unfortunately, the financial crisis that engulfed the world in 2007–2009 proved them wrong. Causes of the 2007–2009 Financial Crisis We begin our look at the 2007–2009 financial crisis by examining three central factors: financial innovation in mortgage markets, agency problems in mortgage markets, and the role of asymmetric information in the credit rating process. Financial Innovation in the Mortgage Markets Before 2000, only the most creditworthy (prime) borrowers could obtain residential mortgages. Advances in computer technology and new statistical techniques, known as data mining, however, led to enhanced, quantitative evaluation of the credit risk for a new class of risky residential mortgages. Households with credit records could now be assigned a numerical credit score, known as a FICO score (named after the Fair Isaac Corporation that developed it), that would predict how likely they would be to default on their loan payments. In addition, by lowering transactions costs, computer technology enabled the bundling together of smaller loans (like mortgages) into standard debt securities, a process known as securitization. These factors made it possible for banks to offer subprime mortgages to borrowers with less than stellar credit records. The ability to cheaply bundle and quantify the default risk of the underlying high risk mortgages in a standardized debt security called mortgage backed securities provided a new source of financing for these mortgages. Financial innovation didn’t stop there. Financial engineering, the development of new, sophisticated financial instruments products, led to structured credit products that are derived from cash flows of underlying assets and tailored to particular risk characteristics that appeal to investors with differing preferences. One of these products, collateralized debt obligations (CDOs) paid out the cash flows from subprime mortgage backed securities into a number of buckets that are referred to as tranches, with the highest rated tranche paying out first, while lower ones paid out less if there were losses on the mortgage backed securities. There were even CDO2s and CDO3s that sliced and diced risk even further, paying out the cash flows from CDOs and CDO2s. Agency Problems in the Mortgage Markets The mortgage brokers that originated the loans often did not make a strong effort to evaluate whether the borrower could pay off the loan, since they would quickly sell the loans to investors in the form of security. This originate to distribute business model was exposed to principal–agent problems (also referred to more simply as agency problems), in which the mortgage brokers acted as agents for investors (the principals) but did not often have the investors’ best interests at heart. Once the mortgage broker earns her fee, why should she care if the borrower makes good on his payment? The more volume the broker originates, the more she makes. Not surprisingly, adverse selection became a major problem. Risk loving investors lined up to obtain loans to acquire houses that would be very profitable if housing prices went up, knowing they could “walk away” if housing prices went down. The principal–agent problem also created incentives for mortgage brokers to encourage households to take on mortgages they could not afford, or to commit fraud by falsifying information on a borrower’s mortgage applications in order to qualify them for their mortgages. Compounding this problem was lax regulation of originators, who were not required to disclose information to borrowers that would have helped them assess whether they could afford the loans. The agency problems went even deeper. Commercial and investment banks, who were earning large fees by underwriting mortgage backed securities and structured credit products like CDOs, also had weak incentives to make sure that the ultimate holders of the securities would be paid off. Large fees from writing financial insurance contracts called credit default swaps, which provide payments to holders of bonds if they default, also drove units of insurance companies like AIG to write hundreds of billions of dollars of these risky contracts. Although financial engineering has the potential benefit to create products and services that match investors’ risk appetites, it too has a dark side. The structured products like CDOs, CDO2s, and CDO3s can get so complicated that it can be hard to value the cash flows of the underlying assets for a security or to determine who actually owns these assets. Indeed, at a speech given in October 2007, Ben Bernanke, the Chairman of the Federal Reserve, joked that he “would like to know what those damn things are worth.” In other words, the increased complexity of structured products can actually destroy information, thereby worsening asymmetric information in the financial system and increasing the severity of adverse selection and moral hazard problems. Asymmetric Information and Credit Rating Agencies Credit rating agencies, who rate the quality of debt securities in terms of the probability of default, were another contributor to asymmetric information in financial markets. The rating agencies advised clients on how to structure complex financial instruments, like CDOs, at the same time they were rating these identical products. The rating agencies were thus subject to conflicts of interest because the large fees they earned from advising clients on how to structure products that they were rating meant that they did not have sufficient incentives to make sure their ratings were accurate. The result was wildly inflated ratings that enabled the sale of complex financial products that were far riskier than investors recognized.