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|Jonathan A. Neuberger specializes in financial economics, valuation, and damages analysis. He has extensive experience in banking and other financial services industries.|
Financial markets around the world continue to suffer from declining asset values, heightened concerns about risk, lack of available credit, and prospects for a global economic slowdown. The speed with which this crisis developed surprised many observers. Nonetheless, the seeds of the current financial crisis have been apparent for some time. In this article, I discuss several direct causes of this crisis and describe how these causes interacted to create the conditions for a severe financial meltdown.
An obvious starting point for this discussion is the U.S. residential mortgage market. In this context, the current crisis began as part of the late stages of a fairly typical credit cycle. In such a cycle, lenders gradually relax lending standards during the course of an economic expansion as they pursue increasingly risky and less creditworthy borrowers to sustain the expansion. In the typical cycle, credit quality eventually suffers, bank loan losses mount, and lenders subsequently contract the availability of credit. These kinds of credit-cycle swings are common and often have accentuated business cycle fluctuations.
In the current crisis, several factors combined, in a sort of financial “perfect storm,” to turn a typical credit cycle into a major financial calamity. First is the worldwide availability of credit and liquidity. For more than a decade, monetary authorities around the world have provided an accommodating monetary policy that has supported an enormous global financial expansion. In the U.S., for example, the growth rate of the monetary aggregate known as M2 has been almost 30 percent higher in the past 12 years than it was in the prior 12 years. Moreover, the Fed funds rate, the interest rate banks charge each other for overnight loans, has averaged more than 250 basis points lower since 1996 than between 1984 and 1996. This expansionary policy stance has helped to fuel rising asset prices, including tech stocks in the 1990s and, more recently, housing-related assets.
Second, U.S. financial markets have faced declining (or disappearing) levels of regulatory oversight. During the past decade, politicians of both parties supported efforts to deregulate financial markets, limit enforcement of existing regulations, or eliminate regulations altogether. These efforts enabled development of whole classes of financial instruments and investment vehicles that are largely or completely unregulated, and encouraged financial institutions to increase leverage and bear more risk.
Third, the pace of financial innovation has accelerated significantly in recent years, as finance professionals have adopted increasingly complex quantitative methods to design and develop new securities and to measure and manage risk. One area where this quantitative expertise was applied is in the development of new asset-backed securities. For example, while financial instruments backed by residential mortgages are not new, the variety and complexity of such mortgage-backed securities grew rapidly during the past decade. Mortgage-backed securities now offer a dizzying array of “tranches” or payment patterns in which mortgage cash flows are sliced and diced in creative ways. Similar financial innovation and securitization also has occurred with other types of consumer debt, such as credit cards, as well as with corporate debt.
The confluence of these various forces can be demonstrated by reference to housing and mortgage markets. Lenders aggressively marketed loans to potential borrowers, offering low teaser rates, increasingly lax documentation requirements, and small or no down payments. Consumers, driven by the prospect of unlimited growth in property values and easy credit terms, purchased ever more expensive homes. Lenders discounted the risks of questionable lending practices because they could easily sell loans to underwriters of mortgage-backed securities, thereby passing along the risk. Securitizers further transferred the risks of these loans to a global market of investors eager to purchase asset-backed securities. Finally, in the absence of meaningful regulatory oversight, few if any warnings were issued or heeded regarding the systemic risks posed by these activities.
Favorable conditions in financial markets were sustainable as long as the cash flows feeding these new and various kinds of securities were uninterrupted. The slump in U.S. housing markets that began in 2007, however, exposed the vulnerability of enormous quantities of mortgage-related assets. As housing values declined and foreclosures rose, the cash flows supporting trillions of dollars of such securities declined dramatically or disappeared altogether. Holders of these securities, including major financial institutions in the U.S. and abroad, faced crippling margin calls on leveraged positions or were forced to recognize substantial losses in their portfolios. In some instances, such as Bear Stearns, the losses exceeded capital reserves, and the companies declared bankruptcy or were acquired at fire-sale prices.
How will this financial crisis resolve itself? With respect to mortgage-backed securities, the underlying cash flows come from pools of residential mortgages. While the U.S. government has proposed purchasing billions of dollars of underwater mortgage-related assets, the values of these securities will only recover as the bottom of the housing slump is reached, foreclosures decline, and mortgage cash flows and values return to more “normal” levels. That situation has not yet occurred. Cash flows from other types of securitized assets are similarly uncertain as economic conditions continue to deteriorate worldwide. Moreover, heightened concerns about counterparty risk have added to uncertainty and frozen many credit markets, including interbank markets. U.S. and foreign governments are proposing policies to provide liquidity, financial guarantees, or otherwise attempt to place a floor under the values of many types of financial assets and to unlock credit markets. The success of these efforts remains to be seen.