Causes of the Financial Crisis
By Viral Acharya and Matthew Richardson
There is no shortage of proximate causes of the financial crisis. There were mortgages granted to people with little ability to pay them back, and mortgages designed to systemically default or refinance in just a few years, depending on the path of house prices. There was the securitization of these mortgages, which allowed credit markets to grow rapidly, but at the cost of some lenders having little “skin in the game”—contributing to the deterioration in loan quality (Dell’Ariccia, Igan and Laeven 2008; Mian and Sufi 2008; Berndt and Gupta 2008; Keys, Mukherjee, Seru and Vig 2008). Finally, opaquely structured securitized mortgages were rubber-stamped as “AAA” by rating agencies due to modeling failures and possibly conflicts of interest as the rating agencies may have been more interested in generating fees than doing careful risk assessment.
Somewhat surprisingly, however, these are not the ultimate reasons for the collapse of the financial system. If bad mortgages sold to investors hoodwinked by AAA ratings were all there was to it, those investors would have absorbed their losses and the financial system would have moved forward. The crash would have been no different, in principle, than the bursting of the tech bubble in 2000.
In our view, what made the current crisis so much worse than the crash of 2000 was the behavior of many of the large, complex financial institutions (LCFIs) — the universal banks, investment banks, insurance companies, and (in rare cases) even hedge funds — that dominate the financial industry. These LCFIs ignored their own business model of securitization and chose not to transfer the credit risk to other investors.
The legitimate and worthy purpose of securitization is to spread risk. It does so by removing large concentrations of risk from the balance sheets of financial institutions, and placing small concentrations into the hands of large numbers of investors. But especially from 2003 to 2007, the main purpose of securitization was not to share risks with investors, but to make an end run around capital-adequacy regulations. The net result was to keep the risk concentrated in the financial institutions—and, indeed, to keep the risk at a greatly magnified level, because of the overleveraging that it allowed.
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