Things Happen

Abstract

In this essay, I consider various theories about the cause the 2008 credit crisis and by implication what should be done to prevent future such events. These theories include the use or overuse of securitization, the misuse of commercial paper, deregulation of the banking business and the futures markets, and compensation practices that operated as an incentive for excessive risk taking. In the end, none of these factors appears to be sufficient to have caused the crisis. Moreover, none seems to merit significant reform beyond those likely to result from market forces. I also consider the possibility that over-regulation (in the form of mandated changes in accounting standards and reliance on rating agencies) was a significant aggravating factor. Given that none of these factors appears sufficient alone to have triggered the 2008 credit crisis, I consider the housing bubble itself and the monetary policy that some suggest led to it. While the data show significant increases in the flow of money into mortgages and the financial sector in general, the housing market does not appear to have been excessively leveraged in the aggregate although it has grown significantly more leveraged since 1995. Neither does it appear that monetary policy resulted in interest rates that were too low by traditional standards. Nevertheless, it does appear that the supply of capital increased despite stable interest rates – likely because of financial innovations and the inflow of foreign funds – and that traditional measures of money supply failed to detect these significant and fundamental changes in the way the financial economy works. To be sure, the 2008 credit crisis has exposed discrete problems that could be addressed by targeted regulation. Specifically, bankruptcy law could be reformed to permit the revision of mortgages on primary residences, mortgage brokers and originators could be regulated as are investment advisers or insurance agents, and credit default swaps could be traded on exchanges rather than over the counter. But these reforms are likely to evolve as a result of market forces anyway. In the end, the 2008 credit crisis appears to be yet another one-off event such as the 1987 market crash, the thrift crisis of the early 1990s, the 1998 failure of Long Term Capital Management, the dotcom bubble and bust, and the collapse of Enron and others in 2001. It is unlikely that any reform that emerges from the 2008 credit crisis will avoid future crises that are likely to come from as yet unidentified sources. But it is unlikely that the current crisis will repeat itself.

Keywords: credit crisis, securitization, CMO, CDO, MBS, ABS, Fannie Mae, Freddie Mac, GSE, commercial paper, money market mutual fund, deregulation, futures market, executive compensation, risk, accounting standards, mark to market, rating agencies, housing bubble, monetary policy, mortgage market, leverage

JEL Classification: E40, E50, G10, G20