THE 2008 FINANCIAL CRISIS: WHAT'S OLD AND WHAT'S NEW

 

TRADITIONAL PRECURSORS TO FINANCIAL CRASHES/CRISES	THIS TIME
Monetary ease: money supply and/or interest rates	Federal Reserve keeps fed funds rate <2% 2002-2004
Rapid expansion of new financial institutions/instruments	Rapid expansion of money market funds and securitization of financial instruments, 1990s – 2007
Financial risk elements (default, interest rate, liquidity risk) subject to increasing discounts (“can’t happen this time”)	Devaluation of credit rating agency marks; implied or contractual investor puts given freely by borrowers/guarantors/ underwriters/financial insurers
Leverage by individuals/firms increases sharply	No-money down mortgages; Basel II capital standards dilution; SEC relaxation of limits on large investment bank leverage, 4/2004
At least one asset class in unsustainable upward revaluation	Single-family homes
Precipitation of crash by unexpected failure of new financial institution/instrument	Subprime mortgage underwriting revealed as flawed (late summer 2006) leading to Lehman bankruptcy → Reserve Fund money fund  “breaks the buck” on 9/16/2008

 

 

WHAT WAS NEW

 

1.       Very strong foreign demand (e.g. Chinese central bank, European investors) for $U.S. housing-related financial assets

 

2.       Strong political pressure/programs to  encourage “affordable”  (e.g. no down payment) home ownership.

 

3.       Variety of new financial instruments that were difficult to price in “thin” markets, CLOs, CDOs, CDSs

 

4.       Global distribution of “tainted” assets via securitization (e.g. subprime & Alt-A mortgages)

 

5.       Quarterly mark-to-market accounting for financial institutions

 

 

Professor James Burnham, 1/21/2008

Comments

[zach]

Four or five of the items listed, both old and new, indicate governments were abetting the upside of the bubble. We are talking individuals in government joining the mob. Calls for changed and improved regulation overlook this fact. Regulatory agencies worked ok until they were needed the most, and then they aggravated the situation. Legislatures are good at this also. The extent to which the mania(s) penetrated governmant both here and abroad indicates it's going to be a long time, if ever, before Humpty Dumpty sits on the wall again.