Is there a single factor, or one predominant factor, that caused the crisis? I’ve been asked this a lot. Is there a single thing we can point to and say that was the villain, that did it, that’s who we should blame? Was it greedy CEOs, Greenspan and the Fed, lying homeowners, real estate agents with bad incentives, Chinese savers, the ratings agencies, the quants, the economists who didn’t see it coming, the regulators who failed to regulate, is there a single, predominate cause?
I don’t think so. For the crisis to have occurred, there must have been (1) a source of vast amounts of liquidity, (2) a reason for most of that liquidity to go to one sector, the housing sector, rather than being spread around to a variety of industries, and (3) a failure to detect and prevent the bubble from developing in the industry where the excess liquidity found a home.
The source of the excess liquidity is well known, it came from China, the oil producing countries, and low interest rate policy from the Fed. China could have accumulated less reserves, invested them at home, etc., and the US could have pursued a higher interest rate policy (but at what cost to the economy as it was trying to recover from the bursting of the tech stock bubble), that’s true, and it might have made the bubble less severe, but were these things, and these things alone, the cause of the bubble?
There’s no reason why the excess liquidity could not have been invested in a variety of industries rather than flowing mainly to housing. If that happens, the risks are spread far more broadly, and we don’t have such a large bubble, one that endangers the broader economy when it pops. So we have to ask, why did the money flow almost entirely to one industry? It was the false perception that financial innovation could produce higher rewards without increasing risk, there were lots of complex mathematical models around to prove it, and there were ratings agencies to validate the claims. So the combination of excess liquidity with the false promise of higher returns without higher risk caused the money to flow into a particular industry rather than into a wide variety of investment opportunities. It was safe as houses.
But even that wasn’t enough to produce a bubble by itself, we have to ask why the checks and balances within the housing sector, both from the market and from regulators, failed to stop the massive flow of money into these assets. The reason is that there were incentive problems all the way through the system. The homeowner gets a non-recourse loan which makes risks mostly one-sided, real estate agents are paid on commission giving them to incentive to maximize the number of houses sold at the highest price they can get, real estate appraisers were in the pocket of the real estate agents (that’s obvious when you buy a house), if they don’t give the values the agents are looking for, their phone stops ringing. The mortgage brokers were being paid, essentially, on commission and they were able to move these loans off their books – sell them as repackaged securities – so as to remove any long-run interest in the outcome of the loans (so they didn’t care what the appraisers said). Their incentive was to sell as many loans as possible with no real concern for quality. Why did people buy these repackaged loans from banks and brokers? Here we come again to the ratings agencies and the poor risk assessment models, the culture within these institutions, moral hazard from implicit or explicit government guarantees, compensation structures, and so on. The incentives at just about every step of the process were to create as many loans as possible with little regard to quality, every check and balance that ought to be in place was missing. The market did not self correct, and regulators clearly fell down on the job, fixing any one of these incentives could have made a big difference by plugging up the pass-through of the excess liquidity from China and the Fed, but the regulators were absent. Whether this is due to incompetence, poorly structured regulatory procedures, or regulatory capture – money talks and nobody wanted to spoil the party – I don’t know for sure. But the regulatory failures were clearly broad based.
So I can only narrow the villains down and place them into broad categories, I can’t point fingers at any one of them and say you did it, you were the cause of this. The managers at places like AIG were part of the problem, and they surely don’t deserve rewards for their performance, that is not the argument here, but they and others like them were only one part of the problems we now have, they didn’t cause the problems by themselves. It was a combination of things working together that produced this crisis, that is, excess liquidity, very poorly structured incentives, and incorrect assessment of the risks all came together to produce the problems we are seeing. I wish I could point to a single villain, it would be easier in a many, many ways to be able to do that, but I don’t think we can, and doing so runs the risk of delaying the reform that is needed by causing us to focus on only a small set of the larger set of “villains”. There’s plenty of blame – and reform – to spread around.