What went wrong ?

Robert Waldmann

Kevin Drum tries to list all proposed explanations for the financial crisis. I see if I can add others after the jump.

The Drum roll

1. Housing bubble (i.e., the pure mania aspect of the thing).
2. Massive increase in leverage throughout the financial system.
3. Global savings glut/persistent current account deficits.
4. Shadow banking system as main wholesale funder for banking system/Run on the repo market.
5. Fed kept interest rates low for too long.
6. De facto repeal of Glass-Steagall in 90s (and de jure repeal in 1999) allowed banks to get too big.
7. Commoditization of old-school banking drove increasing reliance on complex OTC securities as the only way to earn fat fees
8. Mortgage broker fraud.
9. Explosive growth of credit derivatives magnified and hid risk.
10. Overreliance on risk models (VaR, CAPM) that understate tail risk.
11. Wall Street compensation models that reward destructive short-term risk taking.
12. Originate and distribute model for mortgage loans.
13. Three decades of deregulation/political economy of lobbyists.
14. Endemic mispricing of risk throughout market.
15. Ratings agency conflict of interest.
16. Investment bank change from partnerships to public companies.
17. Government policies that recklessly encouraged homeownership.

That’s quite a list. Some of my proposed additions might be on the list. It is especially likely that they are the interaction of two terms on the list. My additions.

18. Banks that are too big to fail know that they are too big to fail and count expected bailout flows as part of their value. They chose to risk bankruptcy.

19. If all fail, no one suffers. Bankers know that we can’t do without all of them, so if they all make the same mistake few can be punished.

20. The Gaussian copula. This is under 10, but it includes two particular errors. First the Gaussian part – it was assumed that if small fluctuations in two random variables have low correlation then large fluctuations have low correlation. This follows from the assumption that all random variables are jointly normal which assumption doesn’t follow from anything. It also used the assumption that financial markets are perfectly efficient when looking for ways to make profits off of financial market inefficiency which brings us to

21. Schizzo-finance. Active traders must believe that markets aren’t efficient. However, they assumed market efficiency when measuring risk. Turning the efficient markets hypothesis on and off makes it possible to think that you can make excess returns without much risk.

22. Regulatory arbitrage. Firms were willing to pay for high ratings even if they didn’t believe the ratings. Explicit references to ratings in prudential regulations and Basel I capital requirements make it possible for an entity which wants to evade those regulations to pay for ratings which it knows are invalid.

23. Firms which think they are profiting from regulatory arbitrage can believe in the efficient markets hypothesis except for those silly regulations and convince themselves that they are making huge returns with low risk. A story for how money can be made promotes recklessness and fraud.

24. Accountants effectively assume that financial corporations have risky assets and safe liabilities. Unusual liabilities like CDSs written appear on accounts at market value. Balance sheets look very different depending on whether firm A issues a bond and B writes a CDS on that bond or vice versa.

25. The financial system is Wobegone – that average participant thinks he’s above average. This means that people are eager to gamble against each other. Supply rises to meet demand and financial products which made it possible to gamble were invented. When people don’t know who won and who lost, people don’t know who is solvent.

26. Shopping for regulators. When Glass Steagal was repealed sectors were merged but the regulators weren’t merged. This means that firms could shop for the regulator they wanted. Regulatory agencies were financed with the fees of regulated firms. So they competed in laxness. The obscure office of thrift supervision sure isn’t obscure any more.

27. Most people had no clue what was happening. Top bosses are computer semi-literate and scared by computers and quants. The quants could trick them into allowing the quants to play heads I win tails I go back to being a physicist.

28. Some people understood what was happening. If an assumption is made, and is known to have been made, they can profit by making it invalid. So when ratings agencies decided to assume that the data on the mortgage tapes stayed about the same, mortgage initiators profited by making it get worse. When investors assume that ratings are a good indicator of risk, Paulson and Magnetar could make money by selecting the worst instruments with a given rating. Etc. If risk assessment isn’t rule based, it’s harder to trick the risk assessor.

29. Money market funds were like bank deposits except for the bit about the FDIC. There were old fashioned bank runs when it turned out that the FDIC exists for a reason. The bottom line was that the FDIC insured money market funds providing
insurance without having collected premiums.

30. 31 32 … in comments.

update 30. I understand that the same securities could be used as collateral for two different deals. I don’t see how this can be legal given the (not so) plain English meaning of “collateral.”